Due to recent media coverage of concerns about the water contamination risk and potentially related public health problems from oil and natural gas drilling and hydraulic fracturing activities,¹ as well as recent media reports casting doubt over the actual productivity of natural gas wells and the accuracy of reported natural gas reserves,² public oil and gas companies, particularly those with shale operations, and oilfield services companies that provide hydraulic fracturing services should expect increased scrutiny from the Securities and Exchange Commission (SEC) and other regulators. In fact, the Staff of the SEC’s Division of Corporation Finance (Staff) has recently issued comment letters seeking detailed disclosures regarding hydraulic fracturing and shale industry risks and the amount and specific nature of the hydraulic fracturing chemicals used. Hydraulic fracturing, in addition to water and sand, uses a small percentage (often aggregating less than one percent) of certain chemicals that assist in the extraction of natural gas from non-permeable formations. In addition, the SEC has issued subpoenas to certain shale producers requesting information pertaining to proved reserve estimates from shale gas wells and the actual productivity of producing shale wells. It has been reported that the New York attorney general has also recently issued subpoenas to certain energy companies seeking information regarding shale gas wells.

While much of the media and SEC attention has focused on hydraulic fracturing and those oil and gas companies that are characterized as shale gas producers, hydraulic fracturing is also used with conventional non-shale oil and gas wells, generally using lower injection volumes. Thus, the risks associated with hydraulic fracturing impact almost all oil and gas development companies. 

We recommend that public oil and gas companies and public oilfield services companies that provide hydraulic fracturing services review their current environmental disclosures as well as risk factors in light of the Staff’s comments and recent legislative and regulatory developments in the oil and gas and oilfield services industries to see if their disclosures could be enhanced to add more specificity about their hydraulic fracturing operations. Oil and gas companies should also review their reserve estimates and related public disclosures (including disclosures in investor presentations) to ensure that they are accurate and consistent with the SEC’s oil and gas reporting rules.

By revisiting the disclosure matters identified by the Staff during the comment letter process, including disclosures about the uncertainty of reserve estimates, companies may be able to identify and address hydraulic fracturing and reserve disclosure issues proactively in future filings and therefore potentially avoid Staff comments and subpoenas, possible future amendments to their SEC filings and the potential for successful stockholder claims of material misstatements or omissions relating to hydraulic fracturing or reserve estimates. Enhanced risk factor disclosures should focus on the potential risks associated with environmental issues and regulatory developments associated with hydraulic fracturing, including the proposed Environmental Protection Agency (EPA) rules discussed below, while avoiding any statements the Staff may view as "mitigating" or not specifically disclosing risks.

Recent Staff Comments on Oil and Gas Producer Filings

Hydraulic Fracturing Activities. The Staff has recently issued very detailed comments seeking disclosure of:

• the location of hydraulic fracturing activities;
• the acreage subject to hydraulic fracturing activities;
• the percentage of reserves subject to hydraulic fracturing activities;
• the percentage of services involved in hydraulic fracturing;
• the anticipated costs and funding, including any capital expenditures, associated with the hydraulic fracturing activities;
• any incidents, citations or suits related to hydraulic fracturing activities for environmental concerns, including the circumstances, any penalties and the response to these matters;
• the steps taken to minimize any potential environmental impact of hydraulic fracturing activities, including whether:
  • there are established steps to ensure that drilling, casing and cementing adhere to known best practices;
  • there is real time monitoring of the rate and pressure of the fracturing treatment for any abrupt rate or pressure change;
  • there is evaluation of the environmental impact of additives to the fracturing fluid;
  • there is any effort to minimize the use of water and/or dispose of it in a way that minimizes the impact to nearby surface water; and
  • there are any established remediation plans or procedures to deal with the environmental impact that would occur in the event of a spill or leak;

• the consequences of the loss of hydrocarbon containment during drilling;
• all material information regarding potential liability in connection with an environmental contamination related to hydraulic fracturing activities, including:
  • the applicable policy limits related to insurance coverage;
  • the related indemnification obligations and those of customers, if applicable;
  • insurance coverage with respect to any liability related to any resulting negative environmental effects; and
  • the insured risks for the hydraulic fracturing activities; and

• a report (provided to the Staff supplementally) detailing for representative wells in each of the material resource plays where the company operates all chemicals used in the hydraulic fracturing fluid formulation/mixture, the volume/concentration of the chemicals and total amounts utilized.

Shale Operation Risks. The Staff has also issued comments seeking disclosure of certain information regarding the risks associated with shale operations. For example, the Staff has sought disclosure of the risks associated with the shale gas industry, including contemplated state legislative restrictions to shale gas development and the recent industry reports indicating that production decline curves associated with shale gas wells may be steeper than originally anticipated.

Company Responses to SEC Comments will be Publicly Available. The Staff’s comments and a company’s responses generally become publicly available on the SEC’s EDGAR website 45 days after the Staff has concluded its review of the subject filing. As some of the Staff’s comments may require responses containing potentially sensitive information (such as a third party contractor’s proprietary chemical formulas used in the fracturing operations), companies should seek confidential treatment for the sensitive information where appropriate. When providing supplemental information to the Staff, companies should seek return of the information pursuant to Securities Act Rule 418(b) or Exchange Act Rule 12b-4.

SEC Subpoenas Indicate More Formal Investigation of Shale Industry is Underway

The SEC has recently taken other actions indicating that it is conducting a more formal investigation of the shale industry and the disclosures provided by shale gas companies. Three public companies have recently disclosed the receipt of SEC subpoenas requesting the production of documents. While each company provided different disclosures regarding the content and context of the subpoenas, at least one of the subpoenaed companies disclosed that:

• the subpoena requested information pertaining to proved developed producing shale gas wells, reserve estimates and well economics;
• the SEC noted its investigation is a fact-finding inquiry;
• the SEC noted that the investigation arose out of recent media reports questioning the projected decline curves and economics of shale gas wells; and
• it was the company’s understanding that a number of other shale gas producers have received similar SEC subpoenas.

Shale companies that receive an SEC subpoena should request confidential treatment of the information provided in response to a subpoena to prevent public disclosure of potentially sensitive information. Those companies should also consider whether receipt of a subpoena warrants public disclosure. Absent unusual circumstances, we recommend disclosure of the receipt of an SEC subpoena.

New York Attorney General Subpoenas

It has recently been reported that the New York attorney general has issued subpoenas to three energy companies (and posed similar information requests to a fourth energy company) as part of an investigation under New York’s Martin Act.³ According to the published reports, the subpoenas seek information as to whether the companies have accurately disclosed the estimated commercial life of shale gas wells, the prospects for their natural gas wells and reserve estimates. The companies that received the subpoenas were reportedly selected because New York State pensions have more than $45 million invested in those companies and if the energy company disclosures are inaccurate New York State could lose some of its investment; they were not selected solely based on their operations in New York. Oil and gas companies with significant investments by New York pensions could be faced with similar subpoenas if the attorney general expands his investigation.

If history is any guide and depending on the outcome of the New York attorney general’s investigation, these subpoenas could serve as a precursor to settlement agreements between subpoena recipients and the attorney general that require public disclosure of additional information regarding shale gas operations as well as SEC interpretive guidance clarifying disclosure requirements with respect to shale gas operations.⁴

Other Hydraulic Fracturing Disclosure Issues

In addition to SEC requests for more detailed hydraulic fracturing and shale operation risk disclosures, public oil and gas and oilfield services companies should consider other legislative and regulatory developments when drafting upcoming disclosures. Some of these developments are briefly discussed below.

EPA Air Regulations. The EPA recently issued proposed regulations that are intended to reduce air pollution from the oil and natural gas industry, including the first federal air standards for wells that are hydraulically fractured. The EPA proposed four air regulations:

• a new source performance standard for volatile organic compounds that will affect wells that are hydraulically fractured and refractured, compressors, pneumatic controllers, condensate and crude oil storage tanks and natural gas processing plants;
• a new source performance standard for sulfur dioxide that will affect natural gas processing plants;
• an air toxics standard that will affect certain glycol dehydrators, crude oil and condensate storage tanks and valves at oil and natural gas production and processing facilities; and
• an air toxics standard that will affect glycol hydrators at natural gas transmission and storage facilities.

Federal Legislation. The Energy Policy Act of 2005 specifically exempted the underground injection of fluids and propping agents (other than diesel fuels) from regulation under the Safe Drinking Water Act. The Fracturing and Responsibility and Awareness of Chemicals Act (FRAC Act) was introduced in the 111^th Congress to repeal this exemption. Although the FRAC Act failed to pass, it is likely to be reintroduced.

State Legislation and Regulations. A number of states, including Arkansas, Michigan, Montana, Pennsylvania, Texas and Wyoming, require the disclosure of hydraulic fracturing chemicals while other states are considering requiring such disclosure. For example, Texas recently adopted legislation which requires online disclosure of hydraulic fracturing chemicals beginning in July 2012. On August 29, 2011, the Texas Railroad Commission (Railroad Commission) issued a proposed rule to implement the Texas disclosure legislation that would apply to a hydraulic fracturing treatment performed on a well in the State of Texas for which the Railroad Commission has issued an initial drilling permit on or after the effective date of the rule.  

The West Virginia Department of Environmental Protection recently issued an emergency rule that includes new requirements for drilling and operating horizontal gas wells used for hydraulic fracturing. In July, New York’s Department of Environmental Conservation issued a preliminary revised draft supplemental generic environmental impact statement that discusses, among other things, certain limitations on hydraulic fracturing activities.

Local Ordinances. Many cities and other local authorities are issuing ordinances to limit, or in some cases ban, hydraulic fracturing activities.

Activist Petitions. Several environmental groups recently petitioned the EPA to adopt rules under provisions of the Toxic Substances Control Act to require toxicity testing of all exploration and production chemicals and identification of all chemical substances and mixtures tested.

Ongoing Studies and Investigations. Based on the findings of the EPA study, Congressional investigations and Secretary of Energy Advisory Board Report briefly discussed below as well as other studies and investigations that may be instituted, regulatory initiatives could be implemented at the state or federal level that could impact the hydraulic fracturing process as well as treatment and disposal of wastewater.

EPA Study. The EPA is currently conducting a study of the environmental, public health and safety impacts of hydraulic fracturing in shale formations. An interim report is expected by the end of 2012 and the final report is due in 2014.

Congressional Investigations. The U.S. House of Representatives Committee on Energy and Commerce is conducting an ongoing investigation of hydraulic fracturing impacts and practices. The investigation is focused on the practices of oil and gas service companies. In addition, the Chairman of the Senate Environment and Public Works Water and Wildlife Subcommittee has asked the U.S. Government Accountability Office to investigate, among other things, how hydraulic fracturing might adversely affect water resources.

Secretary of Energy Advisory Board Report. The Shale Gas Subcommittee of the Secretary of Energy Advisory Board recently released a report that presents recommendations to reduce potential environmental impacts from shale gas production.

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1. See, e.g., Ian Urbina, "Regulation Lax as Gas Wells’ Tainted Water Hits Rivers," N.Y. Times (Feb. 26, 2011); Ian Urbina, "Wastewater Recycling No Cure-All in Gas Process," N.Y. Times (Mar. 1, 2011); Ian Urbina, "Millions of Gallons of Hazardous Chemicals Injected Into Wells, Report Says," N.Y. Times (Apr. 16, 2011); Ian Urbina, "A Tainted Water Well, and Concern There May Be More," N.Y. Times (Aug. 3, 2011).

2. See, e.g., Ian Urbina and Robbie Brown, "Insiders Sound an Alarm Amid a Natural Gas Rush," N.Y. Times (Jun. 25, 2011); Ian Urbina and Robbie Brown, "Behind Veneer, Doubt on Future of Natural Gas," N.Y. Times (Jun. 26, 2011); Ian Urbina, "S.E.C. Shift Leads to Worries of Overestimation of Reserves," N.Y. Times (Jun. 27, 2011); Ian Urbina, "Lawmakers Seek Inquiry of Natural Gas Industry," N.Y. Times (Jun. 28, 2011).

3. Ian Urbina, "New York Subpoenas Energy Firms," N.Y. Times (Aug. 18, 2011).

4. In 2007, the New York attorney general issued subpoenas under the Martin Act to several major energy companies for information on whether disclosures to investors in SEC filings adequately described the companies’ financial risks related to their emissions of global warming pollution. In 2008, certain of these companies entered into settlement agreements with the New York attorney general requiring the companies to disclose to investors in SEC filings the material financial risks that climate change poses. See, e.g., Press Release, Office of the New York Attorney General, Attorney General, Joined by Vice President Gore, Announces Agreement with Major Energy Company, Dynegy Inc. (Oct. 23, 2008). In February 2010, the SEC issued an interpretive release to provide guidance to public companies regarding how existing SEC disclosure requirements apply to climate change matters.