Tighter Regulatory Environment to Hurt Bakken

Various news outlets reported in early July that the United States has succeeded in becoming the world's largest producer of oil. The combined total output of 11 million barrels per day - which includes other liquids besides crude oil, such as natural gas liquids - was enough to move past Russia and Saudi Arabia into the top spot.

U.S. oil production is now at its highest level since 1972, and the Energy Information Administration projects growth will continue for at least the next several years.

Much of the success for the dramatic growth in American oil production can be attributed to a few shale formations - most notably the Eagle Ford and the Bakken. That has made a lot of companies very rich. The Bakken alone is now producing five times as much oil as it was producing in 2009.

But there are several reasons why the glory days of rapid growth may be a thing of the past.

Only a few years ago, drillers came in and drilled at a record pace with little oversight. That came with a lot of consequences and drawbacks for the state, and regulators are finally catching up.

First, are the bomb-trains. The extraordinary increase in fiery explosions of trains carrying Bakken crude - the worst of which killed 47 people in Lac-Megantic in the summer of 2013 - have raised the ire of local communities and the media. Until recently, the trains operated largely in secret, with their itineraries unknown even to safety regulators of the states through which they passed.

Now, regulators are finally taking some action. Rail companies now have to report logistical data on rail shipments to state officials according to a recent order by the federal Department of Transportation. This in itself won't necessarily affect the profitability of drillers in the Bakken or rail companies transporting crude, but more data may assist safety regulators in their effort to put an end to derailments and explosions.

More importantly, the federal Pipeline and Hazardous Materials Safety Administration sent draft rules to the White House for review, which could be published soon and could have a significant impact on oil shipments. While the details are murky, regulators could force rail companies transporting oil to reduce speed limits to 30 miles per hour. This could do a lot to improve safety, but it would also reduce the rate at which rail companies could move oil to market, cutting into profits.

BNSF (NYSE: BNI) is a major transporter of crude, and strongly opposed the rule in a meeting with White House officials. According to a document submitted by BNSF, the company said that a speed limit would sap capital that could otherwise go to handling more crude. "BNSF will have to invest in substantial added track in the form of otherwise unneeded sidings or additional mainline tracks. … This is essentially an unfunded investment mandate, and would absorb capital that we (like other railroads) would prefer to spend on expanding our capacity to handle more trains with better performance," the company said in the document.

BNSF said the speed limit alone would cost the company $2.8 billion.

Federal Transit officials will also likely implement new safety regulations on the DOT-111 car, the thinly layered train car implicated in so many of the oil explosions. Canada has already announced aggressive moves to entirely phase out the DOT-111 car within a few years, and the U.S. will likely propose similar rules sometime soon.

All this is to say that the landscape for oil train shipments is rapidly changing, and could cause a hit to rail companies that have until now profited enormously from the Bakken boom. BNSF was already mentioned, but its peers Union Pacific (NYSE: UNP), and Canadian Pacific Railway (NYSE: CP) will also see a negative impact from pending regulations.

Drillers are also looking at an increasingly tighter regulatory environment. The Wall Street Journal reported on July 7 about the possibility of new regulations on oil processing, a move that could slow Bakken production.

Oil from the Bakken is more volatile than traditional crude, owing to a series of fuel gases that make the product more like jet fuel. Oil companies could theoretically remove the danger using equipment called stabilizers, which use heat and pressure to boil out the volatile fuel gases.

However, drillers in the Bakken decided not to invest the money in stabilizers - only one has been built and it has not yet entered operation.

Now safety regulators are considering rules that would require oil companies to stabilize the crude oil before shipping it by rail. "We are open to any recommendations with a demonstrated ability to improve safety, including the stabilizing or further processing Bakken crude," the Chief of Staff to Transportation Secretary Anthony Foxx, told the Wall Street Journal.

If the federal government decides to require stabilizers, it could cost oil companies in the Bakken substantially. That is why, unsurprisingly, several operators oppose regulation. "There is nothing wrong with the crude oil," the Vice Chairman of Continental Resources (NYSE: CLR), Jeff Hume told the Journal. "It does not need stabilization." Requiring stabilization would force companies to invest in the necessary equipment, raising the cost of production.

And while the federal government is tightening safety standards, state regulators are also stepping in. The North Dakota Industrial Commission recently ordered oil and gas companies to reduce their flaring. Flaring has taken off in North Dakota due to a lack of pipeline infrastructure - drillers essentially don't know what to do with all of the associated natural gas that comes out of the ground with the oil they are after.

For several years now, they have simply flared the gas. But that has led to local air and light pollution, and while leniency was given in the early stages of the Bakken boom, regulators are trying to rein in the party.

Beginning in January 2015, drillers will not be able to flare more than 23% of their natural gas. This is considerably lower than the 30% flare rate in April of this year. By 2020, the state says that flaring must drop to 10% of natural gas produced, and it could be lowered to 5% thereafter.

Building enough pipeline infrastructure could cost billions, and would still be years away. That means drillers will have to find a use for the natural gas on site, such as powering the rigs themselves.

If drillers fail to comply with the new limits, they will be forced to cut back on production. This could have a big impact on the bottom line of many operators in North Dakota. By way of comparison, Texas only flares natural gas at a rate of 0.8%.

Obviously, all of these regulations in the Bakken will hit smaller companies much harder. That means companies like Oasis Petroleum (NYSE: OAS), Kodiak Oil & Gas (NYSE: KOG), and Triangle Petroleum (NYSEMKT: TPLM), could see lower share prices in the months ahead.

But overall, these regulations will affect all drillers in North Dakota, so investors should be aware of the suite of regulations coming down the pike. Taken together, they amount to a downgrade of the entire region.