While most observers of Washington have their eyes fixed on health-care and financial reform, energy is likely to be thrust into the spotlight in 2010 as climate change and clean energy become focal points for Congress.

As strange as it may sound, the timing of energy legislation depends on health-care and financial reform, as well as on the looming midterm elections. In other words, should either of the reform measures creep beyond the first quarter of 2010, far-reaching energy legislation will become less likely.

Nevertheless, several issues relating to oil and gas could impact players throughout the industry, including climate-change/clean-energy legislation, the NAT GAS Act, legislation directed towards hydraulic fracturing, and potential changes to the tax code.

Favorable trends

There appears to be a growing, albeit as-yet unquantifiable, trend in Washington in favor of natural gas. Provisions in the Senate’s Kerry-Boxer climate bill (S 1733) require the Environmental Protection Agency (EPA) to develop an “incentive payment” program for natural gas (including renewable biogas) utilities emitting 25% less greenhouse gas per megawatt hour than 2007 national averages.

Although the “payment” part of the program is left largely undefined, 2007 Energy Information Administration data suggest natural gas-fired electric power facilities emitted 26.9% less greenhouse gas than the national average (and 57.2% less than coal-fired generation). Thus this provision, along with measures to give local distribution companies 9% of all credit allocations, can reasonably be considered “nods” in favor of natural gas.

Further, in mid-November, President Obama and President Hu Jintao of China reached agreement on several clean-energy measures, including a “U.S.-China Shale Gas Resource Initiative.”

The White House fact sheet announcing the initiative included language suggesting, “The development of shale gas is expected to significantly increase U.S. energy security and help reduce greenhouse-gas pollution.”

This overt mention of shale gas by a sitting U.S. president illustrates that natural gas has gained the attention of the Obama administration. This is not entirely surprising, considering White House chief of staff Rahm Emanuel, while a member of Congress, introduced legislation requiring that 10% of new vehicles be natural gas-powered by 2018. In general, the November Sino-U.S. energy agreement represented somewhat of a shift in the administration’s focus away from renewables—for the time being, and recognizing consumers’ fiscal pain—and toward making the existing conventional fuel mix greener and more efficient.

Natural gas vehicles

There could be legislation in 2010 to incentivize vehicles fueled by compressed (CNG) or liquefied natural gas (LNG). The NAT GAS Act of 2009 (S 1408/HR 1835), introduced in April 2009, includes long-term extensions of alternative-fuel and alternative-vehicle credits (CNG/LNG only). It would also increase refueling property credits, offer production tax credits and Department of Energy grants (to original equipment manufacturers), and require the U.S. government to purchase natural gas vehicles for fleet use.

At a Senate Energy Committee hearing in late October, NAT GAS Act sponsor Sen. Menendez (D-NJ) indirectly suggested the motivation behind the legislation is to dampen oil-price volatility. Clearly, the argument of using domestic natural gas resources to reduce U.S. dependence on foreign oil is attractive from a political point of view. Sen. Sessions (R-AL) also voiced support for natural gas “commercial fleets and large vehicles” during the same hearing. (Note that Honda, Toyota and Mercedes-Benz have manufacturing facilities in Alabama.)

Other known proponents of natural gas vehicles include Majority Leader Reid (D-NV), Sen. Pryor (D-AR), Sen. Inhofe (R-OK), and Sen. Hatch (R-UT), and, as mentioned above, chief of staff Emanuel. While the NAT GAS Act is unlikely to gain momentum as a stand-alone piece of legislation, it could gain traction in first-half 2010 as a component of broader energy legislation.

Hydraulic-fracturing regulation

Although incentivizing natural gas use for power generation and transportation would clearly be positive for the industry, both hydraulic-fracturing regulation and tax-policy changes pose risks for producers.

With the rapid increase in shale drilling, hydraulic fracturing has generated considerable attention from the media and environmental groups. The Energy Policy Act of 2005 (EPAct05) exempted hydraulic fracturing from regulation under the Safe Drinking Water Act (SDWA), yielding authority to state regulators to oversee the “underground injection of fluids or propping agents” that facilitate the flow of oil and gas.

Despite movements to re-regulate hydraulic fracturing under federal law—including mandatory disclosure of fracing-fluid contents—we believe the practice remains safe from regulatory shifts for the time being. In fact, Congress recently opted only to encourage EPA to study the issue, rather than request rules that could materially impact production costs and reduce drilling (a politically challenging proposition in a cash-strapped economy approaching its next round of national elections).

In a conference report accompanying the FY2010 Interior Appropriations Bill (HR 2996), Congress “urged” EPA to conduct a study on “the relationship between hydraulic fracturing and drinking water.” This does not represent an explicit requirement with a defined timeframe for completion of the study, as a request was not included in the legislation signed into law on October 30, 2009.

However, we expect EPA will, in fact, conduct an examination of whether existing state regulations are sufficient to protect groundwater from contamination associated with fracing gas wells. An earlier EPA study that suggested hydraulic fracturing posed little threat to underground drinking-water sources has been widely criticized by environmentalists—and House Energy & Commerce chairman Henry Waxman (D-CA)—since its June 2004 release.

Tax code changes

In his FY2010 budget proposal released February 26, 2009, President Obama proposed eliminating “oil and gas company preferences,” suggesting such provisions could raise $31.5 billion over 10 years to offset the cost of major legislative initiatives (e.g. health care, climate change, education, etc.). Major provisions include repealing Section 199 manufacturing tax deductions, repealing the percentage depletion allowance, increasing Gulf of Mexico severance taxes, repealing intangible drilling cost expensing, and increasing the G&G amortization period to seven years, from five.

The magnitude of “revenues” the president’s budget highlighted as being available from oil and gas companies represents political capital under pay-as-you-go rules requiring lawmakers to offset new federal outlays with cuts in existing programs or an increase in taxes (the latter is less politically palatable, particularly in an election year). That said, while oil companies have lost advocates in Congress due to this decade’s M&A activity and Republican resignations and retirements in recent years, only coal enjoys a more substantial geographic (and therefore electoral) footprint than natural gas, which translates into supporters (or defenders, in this case).

The provisions are candidates to serve as “pay-fors” to offset the cost of energy/climate legislation in 2010. When/if the provisions surface in the context of a 2010 energy/climate bill, it is worth noting there remain several staunch defenders of natural gas in the Senate, and therefore, opponents to the repeal of intangible drilling cost expensing, for example. Influential senators in this camp may include Senate Energy chairman Bingaman (D-NM), Senate Energy Subcommittee chairman Dorgan (D-ND), and Utah Republicans Hatch (R-UT) and Bennett (R-UT), among others.

On the other hand, measures that would negatively impact integrated oil companies, for example, are more at risk.

The year 2010 could be a crucial one for the oil and gas industry in defining its role under national carbon constraints. In general, the natural gas industry significantly stepped up its organizational and lobbying effort with the formation of America’s Natural Gas Alliance (ANGA) about a year ago. ANGA has helped spread the message that the U.S. has a massive domestic resource base of clean-burning natural gas, a thought which appears to be gaining traction in Washington.

With the potential for far-reaching energy legislation on the horizon this year and beyond, an improved organizational structure is a crucially important, but often underappreciated, factor in fulfilling the industry’s need to promote greater use of its product.

Michael Glick and Patrick Hughes are co-heads of the energy group at Height Analytics, a Washington, D.C.-based independent research firm providing investment analysis in key regulated sectors by integrating fundamental and policy research. The firm assists institutional clients with risk mitigation, due diligence, and the generation of non-market-correlated investment themes and ideas.

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