The EPA And Fracking: How To Capitalize - Part 2

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In the first article of this series, I focused on what looks to be tougher regulations with respect to fracking. In reality, it has little to do with fracking as water should be the headline. Drilling for unconventional oil and gas has produced little by the way of proof of pollution, but there are a large number of accusations. To be clear, I do not mean oil and gas production has never caused contamination. There have been thousands of fracked wells, but only a few instances where accusations have been made. Whether there is a problem or not, we will see tighter regulations. Here are some of the issues to be addressed:

Proper placement and cementing of casing

Reserve Pit contamination from run off

Fracking fluid ingredients

Separating and processing of frac water

Amount of frac water left underground

There are several ways to play these changes. Cameron (CAM) is the leaderin oil field water treatment with over 50% of the market. Siemens (SI) and Veolia (VE) each have 8% of the market, but expect other big names to take market share like GE (GE). Water treatment is a difficult business to break into, and it would seem the big players have an advantage.

Cameron's business is broken into three partsand had third quarter revenues of:

Drilling and Production Systems: $977.2 million

Valves and Measurement: $434.4 million

Process and Compression Systems: $274.3 million

Its current backlog is $5787.5 million. This percentage of backlog by division is:

Drilling and Production Systems: 57%

Valves and Measurement: 26%

Process and Compression Systems: 17%

Cameron is just beginning to see its Process Systems business grow. As oil sands and shale plays grow companies will need Cameron's equipment. Its process equipment includes:

Hydrocarbon Treatment Units

Oil and Water Separation Loop

Solids Separation Test Loop

Process Simulation and Test Loop

Because Cameron is a process leader, it not only proves equipment and service, but can custom make specific solutions to meet need. A good portion of Cameron's business is treating water for oil and gas. It is more levered than other larger companies providing the same service.

Another player of interest is Xylem (XYL). It is a technologyprovider that specializes in transporting, treating, testing and the efficiently using water. Xylem supplies many industries with its products, and some of which are in oil and gas. It provides pumps, mixers, valves, and actuation equipment. Most important is its analytical instrumentation for ground water testing. Its recent acquisition of YSI increased this platform to $300 million. Xylem is a broad based play on water, not just oil and gas. Business has been good as it reported third quarter revenue growth of 17%.

A more specific play on frac water is Heckmann Corporation (HEK). This company fits a business model that is starting to show up in all of the major shale regions of the United States. Heckmann has a complete frac and produced water service line. It is capable of providing service to some of the biggest shale oil and gas producers in the country. Heckmann is present in four major shale plays with in the United States. In the Haynesville shale, it has:

21 salt water disposal wells

Over 200 trucks

515 frac tanks

50 miles of pipeline

In the Eagle Ford it has:

3 salt water disposal wells

55 trucks

290 frac tanks

180 miles of temporary piping

In the Marcellus and Utica shales it has:

115 trucks

265 frac tanks

In the Barnett shale it has:

55 trucks

30 frac tanks

These numbers are all increasing rapidly as Heckmann continues to increase growth. The main reason for this is the significant amount of water that will be needed to meet the growth of oil and gas production in U.S. shales. Heckmann estimates with the current rig count, there will be a total of 11400 shale wells drilled in 2011. The average amount of water used per well is 6.3 million gallons. For the total number of unconventional wells drilled this year in the United States, it is estimated 71.8 billion gallons of water will be used. In the first two to three weeks 20% of flow back water will be produced. It currently has a joint venturewith Energy Transfer (ETP) in the Marcellus and Haynesville shales. Heckmann's size has allowed for contracts to be signed with very large oil companies. Some of these companies are:

• Anadarko (APC)
• Chesapeake (CHK)
• Chevron (CVX)
• El Paso (EP)
• Encana (ECA)
• EXCO (XCO)
• XTO (XOM)
• Goodrich (GDP)
• Petrohawk (BHP)
• Shell (RDS.A)

Heckman has had some very good growth. In the third quarter of this year, it posted a 25 fold year over year increase in revenue. It posted a net income of $2.6 million versus a loss of $2.2 million a year ago.

There are a large number of ways to play what could be a renaissance in the frac water business. Some are larger companies that derive very little, to small companies more levered to this business. I find it hard to believe we will not see changes in regulations, although less than what the environmentalists want. These regulations will make it more expensive for the oil producers that want to distance themelves from the liability and ultimately the bad press associated with it. Look for consolidation in this space to drive valuations up in the moderate to long term.

Continue to Part 3 >>

Disclosure: I am long HEK. This is the second article in a series on how to capitalize from changes to regulations in water used in fracking. It is not a buy recommendation.