Once again, shale oil and gas production dominated energy headlines in 2014, with a number of key economic, political, and legal developments making news across the country.
Bolstered by technologies like hydraulic fracturing and horizontal drilling, the U.S. oil and gas industry continued its surging growth in 2014, with domestic oil production reaching its highest level in almost 30 years. Already the world’s largest natural gas producer, the United States appeared to be poised to overtake Saudi Arabia as the world’s largest oil producer.
However, the significant drop in oil prices at the end of 2014 has persisted well into the first quarter of 2015, significantly impacting the progress of drilling, as well as the strategic planning of oil and gas companies, in the United States. If these reduced oil prices continue for an extended period of time, there undoubtedly will be an uptick in pre-insolvency and distressed debt acquisitions and workouts within the oil and gas industry.
In addition, transportation issues, allegations of environmental damage caused by advanced drilling techniques, ballot initiatives seeking to ban hydraulic fracturing and an ever-changing regulatory landscape continue to threaten to impede the growth of the industry within the United States.
This report examines the important legal developments in the shale oil and gas industry in 2014 and looks ahead to the key issues that will continue to shape this industry in 2015.
Legislative and Regulatory Developments
Hydraulic fracturing bans
Local hydraulic fracturing bans dominated headlines in 2014, with several ballot initiatives appearing in November’s midterm elections.
But the biggest news came in December, with New York Governor Andrew Cuomo announcing that he would move from a temporary moratorium of hydraulic fracturing in the state to a permanent statewide ban of the practice after the state released its long-awaited environmental impact study. New York joined Vermont and Hawaii – two states with little or no known shale gas potential – in prohibiting advanced drilling practices like hydraulic fracturing. Recent polls show that a majority of New York voters support the ban.
New York’s ban on hydraulic fracturing will likely have little impact on supply, as shale development has been stalled in the state since 2008. In fact, the ban may spur new development in neighboring Pennsylvania, now that whatever limited hope of drilling in New York existed is effectively disappearing.
At the local level, voters in Denton, Texas – a college town about 40 miles north of Dallas – approved a hydraulic fracturing ban that effectively halts all shale development within the city limits, although there are already more than 250 oil and gas wells operating within Denton. Loveland, Texas, rejected a similar ban in June. In fact, Denton became the first city in Texas to enact such a ban after the city council rejected an earlier version in July by a 5-2 vote. The oil and gas industry immediately responded, filing lawsuits seeking to have the ban overturned. Those lawsuits remain pending.
In New Mexico, commissioners from Mora County – the first U.S. county to prohibit hydraulic fracturing – voted 2-1 to continue the ban. But with a new commissioner set to start his term in 2015, that may be repealed in the coming year.
In California, the state senate rejected a statewide ban on hydraulic fracturing in May, but voters split on three local initiatives on the ballot in November. San Benito and Mendocino counties passed initiatives to prohibit unconventional drilling techniques, while voters in Santa Barbara rejected a similar ban. The Los Angeles City Council also passed legislation clearing the way for the council to begin drafting rules that would ban hydraulic fracturing in the city starting in February 2015.
Three of the four fracing initiatives on municipal ballots in Ohio likewise failed, with Youngstown, Kent, and Gates Mills all rejecting hydraulic fracturing bans. Voters in Athens, Ohio – which is also a small college town like Denton, Texas – became the fifth city in Ohio to enact a fracing ban, joining Yellow Springs, Oberlin, Mansfield, and Broadview Heights.
In March, voters in Johnson County, Illinois, voted down a hydraulic fracturing ban heavily backed by environmental groups. And in August, New Jersey Governor Chris Christie vetoed legislation that would have banned the treatment, discharge, and disposal of wastewater from hydraulic fracturing within the state.
Keystone XL Pipeline
Another hot political topic in 2014 was the proposed Keystone XL Pipeline, a project designed to transport oil from Canada’s tar sands to the Gulf of Mexico through parts of Montana, South Dakota, Kansas, Nebraska, Oklahoma, and Texas.
The project stalled in early 2014 after a Nebraska court struck down the state law allowing the governor to approve the pipeline’s route through the state. The government appealed the decision up to the Nebraska Supreme Court, and in early January 2015 the court failed to reach the necessary supermajority – five of seven votes – to strike down the law, thus potentially clearing the way for the pipeline. Since the decision, Keystone has filed for eminent domain in Nebraska along the proposed route.
Meanwhile, the Republican-controlled Congress has passed legislation approving the pipeline. President Obama, however, has pledged to veto the new legislation.
It is unclear at this time whether the reduction in oil prices will affect any of the decision-making surrounding this project.
Concerns about earthquakes near hydraulic fracturing sites increased dramatically in 2014, after several high-profile quakes occurred in both Ohio and Texas. Recent studies have purported to find links between hydraulic fracturing and seismic activity. Although Texas, Ohio, and California have all adopted regulations designed to prevent earthquake-related drilling accidents, these studies could likely trouble voters.
In April, the Ohio Department of Natural Resources (ODNR) announced that it would be tightening permit conditions for horizontal drillers after a report from state geologists found a “probable connection” between hydraulic fracturing and a string of small earthquakes near Youngstown, Ohio.
These new rules require companies drilling in Ohio within three miles of a known fault or an area of seismic activity greater than 2.0 magnitude to install sensitive seismic monitors to detect future disruptions. If the monitors detect seismic activity in excess of 1.0 magnitude, drilling at the site will be halted pending an investigation. Evidence of a connection between the seismic activity and hydraulic fracturing activities will result in the suspension of drilling.
The announcement came a month after Ohio suspended Hilcorp Energy’s drilling operations in western Ohio after five seismic events occurred in the vicinity.
Texas likewise experienced a surge in seismic activity in 2014. In October 2014, the Texas Railroad Commission finalized amendments to permitting regulations for injection wells, which became effective in November. Among other things, the new rules: (1) require that drillers submit additional information as part of the permit application process for injection wells in areas designated as high-risk for seismic activity, including information to the U.S. Geological Survey; (2) expand the definition of “high risk” seismic areas; and (3) grant the commission power to suspend or terminate a permit if seismic activity occurs near an injection well.
With shale oil and gas development reaching new heights in 2014, states continued to look for ways to capitalize on the boom by expanding tax revenue.
Pennsylvania has considered replacing its current system of impact fees with a 4.9 percent severance tax. Opponents say that impact fees have already generated significant revenues – at least $600 million, in addition to about $2 billion in other state taxes paid by the industry – and argue that a new tax could slow the continued growth in natural gas production. In 2013, Pennsylvania’s production of natural gas was over 3 trillion cubic feet, an increase of more than 37 percent from 2012.
Advocates of the tax may have renewed leverage, however, as incoming Governor Tom Wolf has supported the severance tax. Outgoing Governor Tom Corbett is among those who have opposed the severance tax.
Ohio is facing a similar debate over Governor John Kasich’s severance tax proposal. In May 2014, the Ohio House of Representatives passed H.B. 375, which would set a 2.5 percent tax on gross receipts from horizontal wells, 0.25 percent lower than the 2.75 percent severance tax first proposed by Governor Kasich. H.B. 375 stalled in the Ohio Senate and efforts to revive the severance tax have so far been unsuccessful. But with the newly re-elected governor placing tax reform near the top of his 2015 agenda, it appears Ohio’s severance tax may be back on the table in the coming year.
Hydraulic fracturing regulations
Both the federal government and individual states continued to introduce or alter regulations governing shale oil and gas development in 2014.
For example, in December, North Carolina approved new hydraulic fracturing regulations after holding public hearings on the proposed rules in August. The 126 new rules cover a wide range of topics including chemical disclosure, drilling distances from homes and water wells, baseline testing of drinking water, and the risks of storing chemical-laced fluids in open-air pits. Legislators are expected to finalize the new rules in mid-2015.
Coupled with these new regulations, North Carolina will also lift its moratorium on hydraulic fracturing and begin issuing new drilling permits, perhaps as soon as this spring. But with low natural gas prices, high startup costs, and the state’s likely low-yield shale plays, few industry experts anticipate North Carolina seeing much activity from shale developers in the near future. Additionally, in early January 2015, an environmental group filed a complaint in state court seeking to invalidate the new hydraulic fracturing rules, claiming that the formation of the commission violated the separation of powers provisions of the state constitution.
In Illinois, the third time proved to be the charm as the Department of Natural Resources finally published regulations under the state’s 2013 oil and gas law in November after two unsuccessful attempts. Among the changes to the final rules were requirements that drillers wanting to flare or burn excess gas explain why it is “economically unfeasible” to capture the gas, and that drillers’ water source management plans conserve water to the “maximum extent feasible.”
In May, the Environmental Protection Agency (EPA) took the first step toward requiring drillers to disclose the chemicals used in hydraulic fracturing operations, releasing an “advanced notice of proposed rulemaking” seeking public comment on the topic.
The EPA has not yet drafted a proposed regulation but said in the notice that it will consider both mandatory and voluntary rules. The EPA explained that the “mechanism could be regulatory (under [Toxic Substances Control Act] Section 8(a) and/or Section 8(d)), voluntary, or a combination of both, and could include best management practices, third-party certification and collection, and incentives for disclosure of this information.”
The oil and gas industry has strongly opposed any mandatory disclosure requirements, citing trade secret concerns with the exact mix of chemicals used in hydraulic fracturing fluid. The EPA’s disclosure rules will be an important topic to watch in 2015.
Methane and greenhouse gas emissions
In November 2014, the EPA announced new rules for reporting greenhouse gas emissions that will apply to the oil and gas sector, part of its plan to institute a comprehensive strategy for dealing with methane in oil and gas production.
Specifically, the new rules will change the calculation methods for oil and gas emissions by changing the units of measurement; altering the equations used for collecting and reporting data; and requiring separate reports for methane, carbon dioxide, and nitrous oxide rather than a single category for “carbon dioxide equivalent.” Additionally, the new rules will alter the equations for global warming potential and require oil and gas operators to calculate individual emissions in metric tons.
The proposal predicts that these new rules will “reduce the likelihood of errors and inconsistencies” by “reduc[ing] the number of calculations that need to be completed by reporters” and otherwise improving consistency among reporting entities.
The rule is slated to apply to natural gas transportation and distribution, including by pipeline, as well as petroleum and natural gas extraction.
Also in November, the EPA submitted a proposed rule setting effluent limitations on wastewater from oil and gas drilling sent to publicly owned water treatment works. The rule will likely be published for comment in 2015.
In December, the EPA announced that it will delay a proposed rulemaking on fugitive emissions following the release of five technical white papers in April 2014. Some industry organizations have expressed support for the rulemaking in a limited form.
At the state level, the Ohio Environmental Protection Agency announced in April 2014 that it would be tightening requirements for horizontal drillers aimed at reducing air pollution from so-called fugitive emissions, which are generally caused by leaking valves or connectors in drilling equipment. The regulations specifically target methane and other volatile organic compounds used in the drilling process.
The new rules will require operators to conduct quarterly scans of all well site equipment with infrared cameras or other devices designed to detect hydrocarbon emissions. Operators must fix any leaks revealed by the scans within five days and must submit any detection and repair reports to state regulators on an annual basis. If operators consistently record leaks of less than 2 percent, they can reduce the frequency of the scans.
The new rules apply only to horizontally drilled wells, which studies have shown may emit up to twice the methane of traditional vertical wells – between 1 and 8 percent of methane from individual wells.
Throughout 2014, the Department of Transportation – acting through the Federal Railroad Administration, the Pipeline and Hazardous Materials Safety Administration, and the Surface Transportation Board – scrambled to address issues related to the increasing use of railroads to transport crude oil. Reacting in large part to safety flaws exposed by the July 2013 derailment in Lac-Mégantic, Quebec, the agency issued a number of emergency orders, which culminated with the publication of a proposed rule on August 1, 2014. Among other things, the emergency orders required notification of any crude oil transportation, along with very specific information about the volume, destination, and timing of the shipment.
With the proposed rule, the agency hopes to ensure the proper classification of crude oil prior to rail transport, improve the safety design of tank cars most often used to transport crude oil, and update railroad operating procedures. While awaiting finalization, the proposed rule interjects uncertainty into 2015 as companies must guess at which design standards the agency will adopt for new tank cars and to what extent the agency will require retrofitting of older models. Furthermore, depending on the railroad operating procedures the agency imposes, companies shipping or receiving crude oil by rail may face increased delays caused by slower speed limits and less-direct routes.
Unhappy with attempts to thwart aspects of crude oil transportation by rail at the federal level, environmental groups have increased their focus on state and local issues. Although federal law preempts state or local control over most aspects of railroad and crude oil transportation, some areas of traditional state and local control remain.
In California, environmental groups filed a lawsuit alleging that a local agency failed to comply with the California Environmental Quality Act when it granted a permit to a crude oil transloading facility. In response to the lawsuit, the agency revoked the permit. In New York, environmental groups filed a petition requesting that the New York State Department of Environmental Conservation ban the use of the most common tank car for crude oil transportation. Although the agency likely will not act on the petition, the petition evidences environmental groups’ desire to push the boundaries of state control. Fueled by some success in 2014, environmental groups will likely increase their legal challenges in areas where state or local authorities retain control – or where environmental groups hope to extend state and local control – over aspects of crude-by-rail transportation.
If public perception of crude-by-rail transportation deteriorates, state and local governments may attempt to exert more regulatory control. For example, one North Dakota town passed an ordinance limiting the amount of time trains could block intersections. But after Canadian Pacific filed suit in federal court – alleging federal preemption over railroad operating procedures – the town council voted to repeal the ordinance. In the coming year, additional states and localities may pass similar regulations, which will lead to increased litigation concerning the supremacy of federal control over crude-by-rail transportation.
Courts continued to confront important shale energy issues in 2014, with a number of cases making their way through the appellate system and to the states’ highest courts, with state vs. local supremacy among the hottest legal topics of the past year, especially in light of new local bans on hydraulic fracturing in a number of states.
For example, just hours after Texas voters passed the Denton ordinance banning hydraulic fracturing, the Texas Oil and Gas Association filed a lawsuit in Denton County arguing that the ban is unconstitutional and preempted by state law. The Texas General Land Office filed a similar suit in Travis County. Both local and national environmental groups are now seeking to intervene in the cases to defend the ban.
These lawsuits will likely force Texas courts to clarify the role local governments can play in regulating oil and gas development, and more specifically whether comprehensive state regulations preempt inconsistent local laws.
In November, the Colorado Oil & Gas Association (COGA) filed a lawsuit in the Broomfield District Court for declaratory judgment to invalidate the city’s temporary ban on hydraulic fracturing. The ban, known as Question 300, passed in November 2013 by 20 votes, places a five-year moratorium on hydraulic fracturing and prohibits storage in open pits and disposal of waste from hydraulic fracturing in Broomfield.
The COGA argues that Colorado law expressly allows for oil and gas development, including hydraulic fracturing. It claims that the Broomfield ban conflicts with the state’s interest in the efficient production of oil and gas resources and is therefore preempted by state law.
A February 2014 ruling by Colorado District Court Judge Chris Melonakis upheld the five-year ban on unconventional drilling in Broomfield after the Broomfield Balanced Energy Coalition challenged the results of the 2013 election in which the ban passed. The coalition argued that the election was flawed because mistakes were made in counting the ballots. The court disagreed, holding that the city and county of Broomfield substantially complied with state election laws.
In two other Colorado cases brought by the COGA, courts struck down a city’s voter-approved moratorium on hydraulic fracturing.
In Fort Collins and Boulder, the voters passed a five-year moratorium on in-town drilling in late 2013, while in Lafayette the voters amended the city charter to ban the practice completely.
Larimer County District Court Judge Gregory Lammons granted the COGA’s motion for summary judgment and agreed that the city may not ban drilling entirely – a practice that Colorado regulates extensively within the state.
Specifically, he held that Fort Collins’ ban on fracing is “preempted by the Colorado Oil and Gas Conservation Act for two reasons: the five-year ban substantially impedes a significant state interest and the ban prohibits what state law allows.”
Similarly, Boulder County District Judge D.D. Mallard ruled that Longmont’s ban on hydraulic fracturing clearly conflicted with the state’s regulations. Although Judge Mallard noted that the city may regulate aspects of oil and gas production related to the health and safety of its citizens, he ultimately held that Longmont’s regulation caused an untenable “operational conflict” and that the state rules take precedence.
In Illinois, a group of landowners has sued the Illinois Department of Natural Resources (IDNR), complaining that the IDNR failed to follow the appropriate rulemaking procedures when it adopted the new regulations. The court recently denied the plaintiffs’ request for a preliminary injunction – thus clearing the way for Illinois to publish the new regulations and start issuing drilling permits – but the suit remains pending.
In Ohio, the Ohio Supreme Court has decided that the state’s “home rule” doctrine does not allow counties and municipalities to regulate drilling activities concurrently with the state. The extent of this prohibition on local authority, however, remains a question.
The case – brought by the city of Munroe Falls against Beck Energy Corp. for violations of its local zoning laws – concerns the constitutionality of Ohio Revised Code § 1509.02, which grants the ODNR sole authority to regulate oil and gas drilling activities (i.e., activities on the drilling site) within the state.
Attorneys for Beck Energy and for the state of Ohio urged the court to uphold § 1509.02, arguing that by granting the ODNR “sole and exclusive authority” over drilling activities, including the “location” of oil and gas wells, the statute effectively preempts local zoning laws.
But at least some of the justices expressed skepticism at this notion. Justice Paul Pfeifer, for example, questioned whether the “citizens of Ohio . . . [should] just rely on there [being] good people at [ODNR]” to determine the proper scope of drilling, rather than having input through their local zoning commissions.
The city, on the other hand, argued that “the state statute doesn’t say anything about local zoning” and that “the home rule amendment [to the Ohio Constitution] gives the power to cities to regulate local zoning.” Thus, the city argued, drillers should be required to satisfy both the ODNR’s requirements and local zoning laws.
The case drew a great deal of attention, with a number of other municipalities filing amicus briefs on behalf of Munroe Falls. Likewise, members of the energy industry and local chambers of commerce have lined up support behind Beck Energy. The state of Ohio also intervened on Beck’s behalf to defend the constitutionality of § 1509.02.
A divided Ohio Supreme Court invalidated all five local ordinances, resulting in a clear victory for Beck Energy. A close reading of the multiple opinions, however, shows that the court did not categorically preempt all forms of local regulation that impact drilling operations. Rather, it left the door open for further litigation regarding whether “local land use ordinances that address only the traditional concerns of zoning laws, such as ensuring compatibility with local neighborhoods, preserving property values, or effectuating a municipality’s long-term plan for development, by limiting oil and gas wells to certain zoning districts . . .” pass constitutional muster. In other words, the court invalidated what it considered to be a “separate permitting regime” at the local level but declined to rule on whether proper local zoning ordinances that impact drilling operations are enforceable.
Also on the subject of the “home rule” doctrine, in June, New York state’s highest court – the New York Court of Appeals – upheld in a 5-2 decision local bans on shale gas drilling designed to eliminate hydraulic fracturing. The court held that the state’s “Oil, Gas, and Solution Mining Law does not preempt the home rule authority vested in municipalities to regulate land use” and therefore could not restrict municipalities’ ability to eliminate drilling through its zoning powers. The decision’s practical effect is likely small in the face of Governor Cuomo’s decision to continue the state’s ban on hydraulic fracturing. Undoubtedly, the governor’s decision to ban unconventional drilling in New York state will be a hotly contested legal issue in 2015.
Private nuisance plaintiffs gained traction in 2014, with two Texas cases – Crowder v. Chesapeake Operating, Inc. and Parr v. Aruba Petroleum Inc. – resulting in damages verdicts. In Parr, the jury awarded an unprecedented $2.9 million on the plaintiffs’ intentional nuisance claim against a hydraulic fracturing operator.
Texas is also waiting on a high-profile case pending in the state’s supreme court with potentially huge consequences for the energy industry. The dispute between FPL Farming and Environmental Processing Systems (EPS) asks whether wastewater from one of EPS’ wells that migrated to a subterranean pool underneath FPL Farming’s property constitutes a trespass under Texas law.
At trial, the jury ruled in favor of EPS, but the court of appeals overturned the verdict, holding that FPL had shown sufficient evidence of trespass. The Texas Supreme Court heard oral arguments on the case in January 2015 and could issue a decision at any time.
After the Pennsylvania Supreme Court made headlines in 2013 by striking down parts of the commonwealth’s oil and gas law, “Act 13,” the court is considering another energy case, this time brought by the Pennsylvania Public Utilities Commission (PPUC). Specifically, the PPUC is asking the Pennsylvania Supreme Court to review a July ruling by the Pennsylvania Commonwealth Court that stripped PPUC of its authority to review and approve local drilling ordinances.
Specifically, PPUC is appealing the commonwealth court’s rejection of PPUC’s right to withhold “impact fees” imposed under Act 13 from municipalities that have enacted rules restricting drilling. A divided appeals court ruled against the PPUC, relying in part on prior decisions that invalidated other sections of Act 13, including the Pennsylvania Supreme Court’s December 2013 decision striking down a provision that imposed a statewide municipal planning code on natural gas operations and limited local governments’ authority to impose additional restrictions on drilling.
Other provisions of Act 13 have also come under attack in the courts, including the so-called gag order on chemical exposures from oil and gas drilling. In July, the commonwealth court rejected arguments that those provisions violated the Pennsylvania Constitution.
Another important high-court decision in 2014 came from Nebraska, where the Nebraska Supreme Court cleared the way for the Keystone XL Pipeline by failing to reach the required supermajority (five of seven votes) to overturn the governor’s approval of the pipeline route. In the wake of the court’s “non-decision” on the issue, however, several new lawsuits have already been filed and may further stall the pipeline project, and a court just recently issued an unopposed temporary injunction on TransCanada’s ongoing eminent domain proceedings, pending the outcome of the constitutional challenges to the state’s law related to the approval of the pipeline.
Looking Ahead to 2015
After a tumultuous end to 2014, more changes are on the horizon in 2015 for the shale energy industry. There is little doubt that lower oil prices will garner significant attention in 2015, especially because the impact of it is already being felt in varying ways throughout the industry. As has been the case in the past, following an extended “boom period,” the “bust period” has begun and the extent of the “bust” is going to depend, in large part, on where oil and gas prices trend in the coming years. There are going to be a number of “bargain” transaction opportunities as the industry responds to this new challenge. With respect to midstream operations, while no doubt some proposed projects will be scrapped, most midstream companies are taking the opportunity to “catch up” with the recent years of increased drilling and to develop planned projects on a more measured time frame (thereby decreasing debt load going forward). New rules on hydraulic fracturing will go into effect in states like California, Illinois, Michigan, and North Carolina, with other states poised to make big changes in the way shale energy is regulated and taxed in the future. In addition to activity by regulators, states like Ohio and Pennsylvania may push forward on long-debated severance taxes for oil and gas operators.
Meanwhile, we expect the Republican-controlled Congress and the president to continue their standoff over energy policy in the United States. Congress already has criticized a budget from the president that seeks to remove tax incentives for the oil and gas industry, and the House of Representatives appears poised to introduce new energy-related legislation in the coming months. Given Congress’ ability to approve the Keystone XL Pipeline, it is possible that we may see some meaningful energy-related legislation in 2015.
We expect the federal government to remain active on the regulatory side, with rulemakings expected from the EPA, the Bureau of Land Management (BLM), and other agencies in 2015. Specifically, the EPA will likely issue proposed rulemakings on so-called fugitive emissions as well as effluent rules for wastewater from the hydraulic fracturing process. Proposals related to the reduction of greenhouse gas emissions from the oil and gas industry are expected. And the BLM has targeted 2015 for issuing best drilling practices, with the oil and gas industry poised to challenge any rulemaking in court.
Several important pieces of litigation will likely be resolved in 2015 as well, with a decision on state preemption already issued by the Ohio Supreme Court and one expected from the Texas Supreme Court. States will likely continue to clarify the lines between state and local authority to regulate drilling, and challenges to drilling bans will continue to work their way through the appellate courts. Nuisance cases are also on the rise and may be further bolstered by large, well-publicized plaintiffs’ verdicts in Texas.