Government regulation could actually help shale-gas producers Talisman Energy (UNKNOWN:TLM.DL) and Chesapeake Energy (NYSE:CHK). The U.S. Environmental Protection Agency's decision to regulate greenhouse gas (GHG) emissions was not taken too kindly by the coal sector, but the Supreme Court has reaffirmed the EPA's new regulations.
The Supreme Court gave the EPA the right to regulate 83% of America's stationary sources generating GHGs. Now utilities already subject to pollution controls have one more reason to switch to natural gas.
The death of dirty coal
Coal is not going anywhere, but dirty coal faces a difficult future in the U.S. The difference between cleaner Powder River Basin (PRB) coal and eastern coal is significant. Arch Coal (NASDAQOTH:ACIIQ) points out that more than 90% of U.S. PRB coal should survive the EPA's new GHG regulations thanks to PRB's relative cleanliness.
GHG regulations are not the only factor hurting eastern thermal coal. High-quality formations are removed first, leaving older eastern mines with rising costs and falling grades. It is no surprise that from 2009 to 2013, met coal grew from 17% to 48% of Arch Coal's sold Appalachian tons. The obvious corollary is that thermal production as a percent of tons Appalachian sold is falling as eastern utilities sink more funds into alternatives. Now Arch Coal is becoming more dependent on the seaborne thermal-coal market, exposing it to tough competition from large Australian producers.
Alpha Natural Resources (NASDAQOTH:ANRZQ) is in a tough position. In 2013 eastern thermal coal accounted for 42% of its revenue and 51% of its reserves. PRB is only 16% of Alpha Natural Resources' year-end 2013 reserves versus 61% of Arch Coal's reserves.
Arch Coal's and Alpha Natural Resources' profit margins are quite ugly, at -23.1% and -22.4% respectively. Still, Alpha Natural Resources' lack of PRB exposure suggests that its day of reckoning may come sooner rather than later.
Follow the growth
Drillers in the Marcellus shale could not be happier. While some suggest the Northeast is heading for a power crisis thanks to closing coal power plants, natural gas is coming in to fill the gap.
Talisman Energy is trying to turn itself around and focus on high-margin plays. After accounting for royalties, direct opex, transportation costs, and local taxes, it is making $2.5 per thousand cubic feet equivalent (mcfe) in the Marcellus shale. While Talisman Energy's capital outlays may increase in 2015, in the latter part of this decade it expects to cut back on capital expenditures and pocket as much revenue as possible.
Chesapeake is another big player in the Marcellus shale. In 2014 slightly less than 15% of its exploration and production (E&P) capex is expected to flow into the play. With seven to eight rigs expected to stay in the region during 2014, Chesapeake will continue developing its acreage without shifting too many assets away from its Midwestern liquid plays.
The importance of growing local Northeastern natural gas sales is obvious. Talisman is forced to ship 475 million British thermal units per day (mmbtupd) all the way to the Gulf Coast. Thanks to a pipeline with access to the Manhattan market, 30% of Chesapeake's net first-quarter 2014 Northern Marcellus production received an average $5 per mcf above Henry Hub spot rates. Right now the margins on the Eagle Ford and other oil-rich plays are hard to pass up, but long-term structural changes will drive demand for Chesapeake's and Talisman Energy's Marcellus assets over the coming years.
Take the Supreme Court into consideration when investing
The Supreme Court has decided that the EPA has the power to regulate large GHG producers. These new regulations will have a major impact on the U.S. energy sector. Now is a great time to focus on growing natural gas drillers like Talisman Energy and Chesapeake. U.S. natural gas spot rates are still low, but the Northeast's growing usage of natural gas will boost margins in the Marcellus region.