Odorless, colorless: The quiet rise of American Big Gas

FORTUNE -- (This article is part of Fortune's series on fracking .)

The big draw at the Broome County Forum Theater in Binghamton, NY this September wasn't the usual fare of pro-wrestling matches, circus performances, or headliners like Rob Zombie. It was the sight of locals testifying before the Environmental Protection Agency. Two by two, neighbors stepped forward to argue for and against a controversial drilling technique called horizontal hydraulic fracturing, or fracking.

While the process has been the natural gas industry's greatest boon in the last decade, fracking opponents who rely on well water fear fracking will ruin their water supply, and some say it already has. After holding similar meetings in Dallas, TX, Denver, CO, and Canonsburg, PA, the EPA came to Binghamton to gather public input for its upcoming study on the relationship between fracking and drinking. The issue is so contentious that New York State has placed a temporary ban on the practice.

Those who have followed the national controversy over fracking are familiar with scenes like the Broome County hearing. EPA panel members pleaded for data and input regarding their study (which will not be released before 2012). One concerned landowner, local pastor Emrys Tyler, offered up his property for the study. And people who want corporations like Chesapeake Energy (CHK, Fortune 500) and Halliburton (HAL, Fortune 500) worry that they will miss out on jobs and money if the natural gas industry is forced to slow down.

Natural gas has grown at a breathtaking pace, even for an energy sector not accustomed to taking it slow when it comes to exploration and production. Over the course of about a decade, natural gas has become a key part of the nation's energy mix -- a transformation abetted by a patchy regulatory safety net, exemptions from federal environmental protection laws, and by politicians eager to wean the country from its dependence on coal and foreign oil. But the New York State's moratorium on fracking and public interest generated by the EPA study have given the government a rare opportunity to reverse years of loose oversight and slow the breakneck growth of natural gas, both measures that usually occur after catastrophe strikes.

Before the ban, a boom

Given natural gas' ultra-fast expansion, regulators have no choice but to play catch up. Natural gas as a major source of fuel in the US has arrived. It provides the country with 22% of its total energy, largely thanks to a revolution in drilling techniques that allowed companies to pull gas from shale, deep, dense rock formations that were once made extraction too difficult and costly. It was Halliburton, the oil and gas services giant, that made it all possible.

Hydraulic fracking, a technique that dates back to the 1950s, calls for injecting a mix of water, sand, and chemicals up to a mile into the earth at a pressure so great that it cracks the rock. The so-called fracking fluid rushes into the fissures. Sand fills the openings and pushes natural gas -- and some of the fluid -- up and out of the well. The process became even more effective when combined with horizontal drilling. Wells had long been drilled vertically, accessing the layer of shale at a single point. But in 1992, drills were sunk into the ground and turned horizontally to move along the length of the shale formation, creating more access to the natural gas. Halliburton combined the two techniques at the Barnett Shale formation near Fort Worth, TX in 2003, and gas wells became exponentially more productive.

Horizontal hydrofracking technology sparked a gold-rush like fever among gas exploration companies, who descended on shale formations throughout the country including Fayetteville in Arkansas, Woodford in Oklahoma and Haynesville in Louisiana. The number of horizontal drilling rigs skyrocketed from 40 in the 1990s to over 500 in 2008. The country currently consumes just under 23 trillion cubic feet of gas per year and half of that amount is produced from wells drilled within the last 3.5 years, using the combination of horizontal drilling and hydraulic fracking.

Analysts understood that the trillions of cubic feet of natural gas trapped in shale could fuel revenue growth, and began to cite exposure to shale gas as a source of future profits. Beneficiaries included independent gas drillers like Chesapeake, EnCana (ECA), and Anadarko (APC, Fortune 500), and services companies like Halliburton, which provide tools and expertise. Big oil was not about to be left out of the boom, and many of the largest players acquired companies with exposure to gas or partnered with them on exploration projects. For example, Exxon Mobil (XOM, Fortune 500) acquired gas exploration company XTO Energy in December of 2009 for $41 billion, while Indian energy giant Reliance Industries recently paid $1.7 billion to form a joint venture with gas exploration company Atlas Energy.

Drillers came east to explore the Marcellus Shale, which promised to be a rich source of potential profits. Marcellus is the largest natural gas deposit in North America (and the bone of contention in Binghamton). Referred to by geologists as a "super giant" gas field, it spans six states including New York, Pennsylvania, and West Virginia. Terry Engelder, a Penn State professor of geosciences, and Gary Lash, a SUNY Fredonia geosciences professor, said in January 2008 that the Marcellus could yield as much as 516 trillion cubic feet of natural gas, with Engelder later narrowing the figure down to 489 trillion cubic feet. By comparison, the US produces about 24 trillion cubic feet a year. Their findings sparked a recent exploration frenzy that has pushed lease values into the stratosphere. For example, oil and gas company Rex Energy (REXX) sold a 15% stake in its Butler County, Pennsylvania properties for $10,000 per net acre. Similar properties were leased for hundreds of dollars in the late 90s.

People feel like shale gas drilling snuck up on them, partially because it did, says Doug Morris, a reserves and production expert with the Energy Information Administration's Office of Oil and Gas. "I shouldn't say shale gas came out of nowhere, but it just kind of exploded," he says. "You go back ten years and nobody predicted this boom in shale gas."

The explosion in shale drilling was aided by exemptions from the nation's strictest environmental laws. "The Energy Policy Act of 2005 exempted fluids used in the natural gas extraction process of hydraulic fracturing from protections under the Clean Air Act, Safe Drinking Water Act, and the Clean Water Act," notes Dr. William J. Pammer, Jr., an associate professor of public management at John Jay College. The Energy Policy Act was crafted by then vice president Dick Cheney, who was the former chief executive of Halliburton, in a series of then-secret White House meetings with executives from the oil and gas industry. The EPA produced a study in 2004 that declared fracking safe which was used to help justify the exemptions. Critics contended that a pro-drilling White House motivated the report, and that its scope was too narrow to truly assess the environmental consequences of natural gas drilling.

Natural gas exploration also falls under a hodgepodge of regulators with competing agendas, making it difficult to maintain comprehensive industry oversight. Regulations vary state by state. Each part of the drilling process is regulated by a different set of state and federal administrators. Treatment and disposal of the fracking fluid, which drilling opponents allege has contaminated property, is subject to different federal regulations depending on whether the fluid is below or above ground.

Finally, the government has also taken an active role in pushing the oil and gas industry forward. One law passed in 1995 to promote drilling in the Gulf waived royalty payments from oil and gas companies to the government for leases signed during 1998 and 1999, due to faulty implementation of the law. The exemption, which was supposed to end as soon as prices hit $40 per barrel, has not been fully phased out. The Obama administration has spoken out about ending about $36.5 billion worth of oil and gas subsidies, but the gas industry has pushed back hard in Washington, arguing its exploration boom would come to a screeching halt if the subsidy were removed.

Not only is there rhetoric from politicians and think tanks about the myriad advantages of natural gas over coal and oil, legislative activity is underway that could increase demand for gas. Senate Majority Leader Harry Reid recently filed a bill that would grant $5 billion in subsidies for fleets of trucks that replace diesel with natural gas. Oil investor and natural gas supporter T. Boone Pickens supports the bill as a key step toward switching America's vehicle fleet to natural gas. "It won't happen overnight, but the technology is there," says Pickens. And the Obama administration's war against carbon emissions should be a boon to the industry, too. Should the president push through a carbon pricing mechanism or tax emissions, he will raise the cost of using coal. Until some kind of surcharge on carbon emissions makes coal use more expensive, power producers will always fall back on coal whenever gas prices rise.

From deep underground, problems surface

Natural gas may be clean to burn, but critics say that it has been dirty to produce. In recent years there have been several documented cases where drillers may have damaged property and perhaps made people sick. Some of the most infamous incidents took place in Dimock, PA, where Cabot Oil & Gas (COG) was fined $240,000 by the Pennsylvania Department of Environmental Protection. The company's poorly constructed wells contaminated the groundwater of 14 homes with methane. One Cabot well exploded, and others had insufficient or improperly cemented casings. The Houston-based company also spilled about 8,000 gallons of fracking fluid, polluting wetlands and a creek. Cabot blamed the spill on failed pipe connections.

In two other cases, Atlas Energy (ATLS) was fined over $150,000 by Pennsylvania for violating the state's Oil and Gas Act, Clean Streams Law, and the Waste Management Act. Atlas dumped waste including diesel fuel and fracking fluid onto the ground. Atlas implemented poor erosion and sedimentation controls, allowing silt-laden runoff to hit the ground. A group at the forefront of the anti-fracking movement called Damascus Citizens for Sustainability has received hundreds of letters and emails from people across the country claiming to have spotted incorrectly installed casings that line wells to protect groundwater, and improperly treated and stored fracking fluid.

These incidents have led people to fear hydraulic fracturing, though the actual act of fracking may not be the problem, say government officials like the EIA's Morris and geologists like Penn State's Engelder. Engelder notes that horizontal drilling and hydraulic fracking take place about 8,000 feet below the water table, and that fracking fluid would have to travel against gravity up through impermeable rock to contaminate the water supply, an unlikely event. The real culprit seems to be an industry that has undergone rapid growth with little oversight or consistent regulation of the work that happens above ground.

"The industry takes the position that it's not hydrofracking, it's inefficient casing," says Morris. "The folks who own the water say, we don't really care. They don't want fracking until they feel all of the activity above ground is handled responsibly." And they are skeptical that companies will faithfully observe state environmental laws if they can get away with corner cutting. "We have a really long history of trashing the places where our energy comes from," says Wes Gillingham, director of a conservation group called the Catskill Mountainkeeper. Coal mining's well-known environmental and health issues were studied years after environmental devastation and mining related health issues became apparent. The recent Deepwater Horizon spill in the Gulf of Mexico shed light on a dangerously lax attitude toward safety taken by BP (BP) and abetted by regulators who failed to enforce existing rules.

Regulation debate

The New York Senate moratorium created an unprecedented hiccup for the industry. Historically, regulators and politicians take a hard look at mining and drilling only after environmental damage has occurred. But New York will not allow drilling to resume until a safety review is completed by the state's Department of Environmental Conservation. Some New York landowners feel that the ban gives the state time to figure out whether it can properly oversee drilling activity. New York's got this right," local resident Frank Davenport told the EPA during their appearance in Binghamton. "Keep your moratorium until they figure out what's going on."

People like Pammer of John Jay who want more regulation say that the patchwork quilt of rules allows problems to slip through the cracks. They want federal oversight of the drilling process, or at least a clear and consistent set of standards and punishments that will be enforced no matter the state.

It's tempting to compare the disarray in fracking to the regulatory failures that helped cause the global financial crisis; that's a comparison people in the field reject. "We're a mineral industry," says Jeff Venture, the president and chief operating officer of Range Resources (RRC), a $5.7 billion gas exploration company. "Unlike finance companies, we're driven by geologic and engineering opportunities that can be hurt by bad practices." Venture says his industry is already drowning in a sea of rules. "The regulations we adhere to in Pennsylvania alone make a stack of paper two feet tall," he says. "We don't need more rules or federal regulation. We need to enforce the rules we have on the books and create a culture of doing things the right way."

Venture says that, for the most part, the states have done a remarkable job of policing the industry. He and Engelder both argue that the current system of state regulation is the most effective way to oversee drilling. The Penn State professor agrees that there are plenty of rules on the books, and points out that geology differs so dramatically around the country that best drilling practices in Texas will vary wildly from those in Pennsylvania.

Venture also believes that drillers have an economic incentive to self-police. "When Cabot was fined, all of the stocks in the industry took a hit." Range, one of the first companies to explore Marcellus back in 2004, is often cited by analysts as having one of the best management teams of any company working in the region. "Range is a responsible player in Marcellus," says analyst Chris Pikul at Morgan Keegan. The company reuses fracking fluid, cutting down dramatically on the amount of water used, and is experimenting with methods to make fracking water potable. Range has also voluntarily disclosed the chemicals it uses in its fracking fluid to aid the EPA's effort to determine whether the practice is dangerous.

While Venture believes that a handful of companies could do more to adhere to rules and regulations on the books, he doesn't believe that the way to accomplish better practices is to slow the breakneck pace of exploration. Economic activity would be lost needlessly to ban a drilling practice that has never been proven unsafe.

There is a lot of money on the line, especially for companies that entered Marcellus long after Range, when lease prices began to soar. "These companies have to maintain drilling activity to hold onto their leases, but natural gas pricing doesn't justify the capital investment," Pikul says. "They have compromised their balance sheets, there is not enough demand for gas prices to jump higher, and these shale wells keep producing more gas than anyone expected, keeping prices low. It's already a perfect storm of bearish factors." Commodities future pricing shows that few traders expect natural gas prices to rise significantly before many of the three-year leases inked after 2008 expire. If the fracking ban is extended, Pikul says that smaller companies with more liabilities than cash flow would likely file for bankruptcy.

Residents who support drilling are thinking in terms of dollars and cents, too. Range estimates that natural gas drilling has created 100,000 to 200,000 jobs in Pennsylvania alone. And some residents want to cash in on current high lease rates and the possibility of royalties from productive wells. "I'm not leased, but at the soonest possible moment, I will be," Sandra Davis, a member of the Joint Landowners Coalition in New York, told the EPA panel in Binghamton.

The debate may boil down to the amount of human error that people are ultimately willing to accept. "There are going to be incidents, there are going to be accidents, and if companies make mistakes they need to pay," says Chris Tucker, spokesman for an industry trade group called Energy In Depth, of which Halliburton is a member. Tucker believes the risk is worth the payoff. So does Morris, who says that the United States can't afford to write off natural gas. "In the future, you're going to need energy from all sources."

Engelder says that there have been about 30 significant environmental impacts in Pennsylvania since drilling began in Marcellus, out of about 1,900 drilling sites. While gas advocates argue the next or '31st impact' will be minor thanks to the industry's self-policing and adequate regulations, foes fear it will be of Valdez or Macondo-like proportions. Either way, our current trajectory makes environmental impact from gas inevitable. That's why questions about America's fossil fuel hunger -- and the risks we take to satiate it -- are fast moving beyond "if?" and decidedly on to "when?" Perhaps, some argue, too fast.