Shale Game

Hydraulic fracturing, widely known as fracking, is meant to promote accessibility, affordability and profitability in the dogged pursuit of energy sources that can be packaged and sold. But what are the risks of coaxing — some would say forcing — natural gas from shale deep underground to the surface? Does fracking fit comfortably within well-entrenched insurance products for the oil and gas sector, or will it require a new form of risk transfer? Identifying insurance products that respond to risks associated with fracking may be a mix of art and science, since there are still many outstanding questions about just what those risks are.

Fracking, really, is an example of “What is old is new again.” In existence for well over a half-century, it involves injecting pressurized water containing chemical additives into geologic formations — in this case, shale — to create micro-fractures artificially. Adding sand (proppant) prevents fractures from closing, thereby allowing natural gas to escape when the pressure is released and fluids return to surface.

Natural Resources Canada reports potential and producing shale gas resources in this country are found in British Columbia, Alberta, Saskatchewan, Manitoba, Ontario, Quebec, New Brunswick and Nova Scotia, although most current drilling and production is in northeast British Columbia. “The extraction of natural gas at commercially viable rates has become possible only because of the recent combination of two techniques: horizontal drilling and multi-stage hydraulic fracturing,” the department notes. “The assessment of shale gas potential has led to a complete redrawing of the North American energy map.”

Shale gas is still in its nascent stages here at home, but the United States has more than 40,000 producing wells. A recent investor presentation by Valero Energy Corp., one of the largest independent refiners south of the border, notes that abundant and growing U.S. shale oil and Canadian production will provide a feedstock cost advantage, which will increase in the future.

“It’s remarkable how the industry has shifted in such a short time period and more change is expected to come with technological innovation as a key driver,” Scott Bolton, PwC’s Canadian energy leader, said in May 2011 following the release of the Canadian Annual Energy Survey report. “Now, we’re trying to deal with a wave of shale gas production that will be flowing to market for decades to come.”

Joe Restoule, president and director of the William H. McGannon Foundation and vice president of strategic opportunities for NOVA Chemicals, appears equally bullish. “It’s as important as the oil sands,” Restoule says. “I don’t think we’ve discovered its potential.”

FULL BORE

Also not yet discovered is the full spectrum of risks associated with fracking and insurance coverage required to mitigate these exposures. As the use of fracking increases, its public profile has drawn some negative publicity. In the United States, in particular, fracking has been the subject of numerous studies, lawsuits and protest movements. Consequently, regulators are investigating the environmental and other risks of fracking.

Natural Resources Canada reports that hydraulic fracturing is permitted only well below the deepest freshwater aquifers. But this does not seem to have eased concerns that fracking can foul water supplies.

“When the treatment fluid returns to the surface, it is alleged that there is a serious risk of pollution, either from a blowout or from any storage pits in which the well fluid is stored,” notes Willis’ Energy Market Review, released in

April 2012.

“Contaminants of concern to drinking water include fracturing fluid chemicals and degradation products, and naturally occurring materials in the geologic formations (e.g. metals, radionuclides) that are mobilized and brought to the surface during the hydraulic fracturing process,” notes a fact sheet from the U.S. Environmental Protection Agency (EPA). The link between fracking and water contamination, if any, is currently being evaluated as part of an EPA study.

The Energy Institute at the University of Texas at Austin conducted a review of available evidence and drew the following conclusions:

• hydraulic fracturing of shale formations has no direct connection to reports of groundwater contamination;

• overall, surface spills of fracturing fluids pose greater risks to groundwater sources than from hydraulic fracturing itself; and

• the lack of baseline studies in areas of shale gas development makes it difficult to evaluate the long-term, cumulative effects and risks associated with hydraulic fracturing.

The outstanding questions relating to the environment have the insurance industry focusing on longer-term risk solutions. The Willis review notes that three keys areas of the insurance market are particularly affected by hydraulic fracking operations:

• operator’s extra expense: indemnifies the assured’s costs of regaining control of a well following a blowout, including the re-drilling of the well and the cost of clean-up of any resulting seepage and pollution;

• comprehensive general liability and excess umbrella liability cover: in essence, these cover the assured for damage to third-party property and bodily injury arising out of the assured’s operations; and

• environmental impairment liability: covers the assured from legal liabilities related to pollution conditions arising out of the assured’s operations or general pollution conditions at the site itself.

MANAGING FRACKING RISKS

Traditional insurance packages for oil and gas activities might focus on general liability and the protection against “sudden and accidental” events that it provides. Information from Chartis notes that basic elements of a comprehensive insurance program include:

• insurance of property against named risks (to protect against such risks as fire, explosion, action of water and natural disaster);

• insurance of machinery and equipment from damage (includes errors in equipment design or installation, overheating, power supply disruptions and human error); and

• insurance against business interruption (financial loss caused by partial or full stoppage of the enterprise as a result of events insured under the previous two sections).

Shale gas drilling essentially adds a new element to the mix: environmental impairment liability. Zurich reports that risks include potential chemical spills causing pollution of local pond and irrigation canals; natural gas or fracturing chemicals seeping into the water table because of an inadequate casing cementing; natural gas leaching into municipal drinking water; inappropriate disposal of fracturing mixture; and high water volume required for shale gas fracturing.

Mary Ann Susavidge, managing executive underwriter for XL Group’s environmental insurance unit, says “both general liability and environmental impairment coverage are appropriate for oil and gas operators, as there are events that can occur on drill sites that clearly fall outside of the time element coverage provided by general liability.”

Whereas general liability covers only sudden and accidental events, the following coverages can be used for both gradual as well as sudden and accidental pollution events. Contractor’s pollution liability, for example, offers coverage for both sudden and accidental and gradual pollution conditions resulting from trade contractors performing services at drilling sites (this includes risks related to site infrastructure, hauling raw materials or hauling waste materials). Pollution legal liability provides sudden and accidental and gradual coverage for pollution conditions for s ite operators and non-working interests at both oil and gas well sites.

“Regulators and the public would expect companies to be adequately insured in the event that something unforeseen occurs, either at the time or as a latent issue,” says Restoule.

DEVELOPING PICTURE

It’s tough to silence all “what ifs?” given the scant number of frackingrelated claims. “In Canada thus far, we have not seen any large or substantive claim that is uninsurable,” Restoule says. “What we’ve seen are small claims, and certainly we’ve not had any sort of frequency of loss in the fracturing arena. There haven’t been enough test points in the insurance industry to tell us whether it’s adequate or not.”

Restoule says he’s not aware of any trends among reported claims. “The losses are similar to any other industry: it’s human error, it’s mechanical breakdown or failure and act of God.”

Canada is not without incidents, of course. Last January 13, for example, hydraulic fracturing operations appear to have affected a nearby oil well, resulting in a release of fracturing fluids, notes Alberta’s Energy Resources Conservation Board. There were no injuries or any confirmed effects on wildlife, but both wells were shut down and a clean-up had to be done, the board reports.

The United States has more claims experience, including through lawsuits. “If there’s any concern from the insurance market,” says Jeffrey Hanneman, director of Aon Environmental Services Group, it has been around the negative publicity associated with claims related to contaminated drinking water. “If this trend continues, do we see more claims?” he asks. “What’s the frequency of those claims? What is the severity of those claims? There really haven’t been a lot of claims that have gone from lawsuit to settlement. So it’s hard to gauge from a loss standpoint what a typical loss should cost.”

That said, notes John O’Brien, president of Ironshore Environmental, “to date our losses don’t match with anything that people would look at and say, ‘Fracking causes this.’ So my losses don’t look like a Spike Lee movie at all.”

NEW OPPORTUNITIES

In the absence of an established claims history, the insurance industry has room to consider product opportunities, Restoule says. “What new products do they offer that’s unique to the fracking industry?”

Susavidge adds: “Policy language is currently consistent with the potential exposures. However, a gap may exist for emerging issues that have yet to be quantified. This has been true for many industries/exposures over the 25-year evolution of environmental insurance.”

Hanneman suggests “the amount of coverage available for anything pollution-related from a casualty standpoint, from general liability and excess liability, is very narrow.” He takes the view that fracking-related gradual pollution coverage would best go it alone.

“What we’ve seen from the large national, international insurance companies has been a mixed bag to date regarding who will offer standalone pollution coverage to owners and operators of wells where fracking is being done,” Hanneman says.

Probably five or six carriers will “write that coverage on a primary basis,” he reports. “Some might be more comfortable writing it as an excess layer on top of another carrier writing the primary pollution. You have some markets that, while they write environmental coverage for energy risks, will not write it for anyone conducting hydraulic fracturing. It’s just a matter of appetite.”

A pollution policy offering “gradual accidental coverage” that does not have defined reporting provisions can help to bridge the coverage gap created by shale gas exploration and production, notes information from Zurich. Sudden accidental coverage in a gas operator’s general liability insurance often has “a defined reporting and discovery period — sometimes as little as 72 hours for discovery and 30 days for reporting,” it adds.

Environmental impairment opens the door to new issues. The matter of “location, location, location” may be a costly one should an incident occur, Restoule says, citing the example of a pipeline leak in a remote area.

Response crews would need to be deployed, usually from large centres, equipment would need to be sent and people would need to be fed, housed and demobilized. Underwriters report the costs “are just huge in these remote areas,” Restoule says. One might believe claims in remote areas “should be relatively benign and should not be significant, but I am told that that is not the case.”

Another consideration is the cost of defending, a consideration distinguishable from whether or not an insured is ultimately held liable. An Aon Exposure Alert points to new environmental products that offer enhancements meant to fill in the gaps left by casualty and control of well insurance. One such product provides gradual pollution coverage (including defence and investigation costs), affirmative coverage for hydraulic fracturing fluids, coverage for evacuation expenses and image restoration expenses, and blanket insured contract definition for non-operating assets.

Getting into the game in situations in which fracking plays a central role is not necessarily attractive to all. Some companies may choose to opt out completely, while others may wait for a clearer picture of risk to develop, both in the short- and long-terms.

Asked if XL has seen insurers exclude fracturing from their policies, Susavidge answers yes, primarily in the Marcellus shale region in the United States. In the U.S., the Marcellus area runs through New York, northern and western Pennsylvania, eastern Ohio, western Maryland, and throughout most of West Virginia. In Canada, it can be found below Lake Erie, stretching into southern Ontario, including Port Stanley, Long Point and St. Thomas.

“For various risks, carriers have considered and continue to consider the impact of potential adverse accumulations of risk in particular geographies,” Susavidge points out.

Commenting on the environmental market, O’Brien says he is seeing insurance companies choosing not to “write any exposure in that space.”

At the same time, a whole lot of new clients — some of whom were not previously involved in the environmental space — need or want cover. “The genesis, I think, of this becoming a market where people want to buy environmental insurance is really partially due to the media,” O’Brien says. “But also, and I think even more importantly, due to Deep Water Horizon — even though Deep Water Horizon is not a fracking-related loss.”

The breadth of the liability spectrum for these types of losses may be spurring some organizations to consider: “What sort of things do we invest in that have these same patterns of liability?”

ALLOCATING RISK

Given the potential for negative longterm environmental effects related to fracking, what is the next move for risk managers involved in this arena?

Restoule expects this question will be among the issues discussed as part of an upcoming forum in Calgary on the myths and realities of fracking. “Do we understand the technical risks associated with the activity?” he asks. “Do we understand what coverages are available and, more importantly, what coverages are not available? How is risk allocated between the driller, the operator and the owner?”

Restoule advises companies needing fracking-related coverage to differentiate themselves through good practice.

At Encana Corporation, for example, “every natural gas well has an en gineered steel casing system that is cemented externally to prevent any fluids from moving from the well bore to groundwater aquifers,” notes an FAQ from the company. “The case design and cementing program conform to a written, engineered design which is specific to each well.”

Canadian operators and drillers are trying to educate underwriters about the risk assessments that their operations are performing, in addition to “their technology, their techniques and, more importantly, the safety precautions they are implementing in terms of risk mitigation and risk control,” Restoule says.

“To quantify whether or not prospects meet our underwriting criteria in the oil and gas arena, we analyze areas such as baseline screening processes, integrity management processes, emergency response programs, well construction protocol, pad site and pond construction, as well as vendor selection and contractual language,” Susavidge says. All of these factors are considered to address groundwater, soil and emission risk at a drill site, she adds.

“Premiums are based on risk,” says Susavidge. “Simply stated, a marginal operator that does no hydraulic fracturing will still receive a higher premium than a solid operator that engages in hydraulic fracturing of wells.”

Hanneman sees well count as a key factor influencing premium. “If you’re a very small operator, in U.S. dollars you might see a minimum premium of $25,000 to $50,000 if you have a handful of wells and you’re buying a low limit like $1 million,” he says. For clients with a large number of wells and buying $25 million, $50 million or more in limits, premiums are “going to run $200,000 to $500,000 depending on the number of wells and ultimate limits purchased.”

Best practices publications, historical claims/loss information and continuing technology improvements, among other things, offer sufficient “knowledge to identify oil and gas operators that are operating in a safe and prudent manner,” Susavidge says. “This information forms a basis for criteria to price this risk properly based on the analytics,” she notes. “What is difficult to quantify is the social and political risk in different geographies.”

Still up in the air is the influence of the EPA study on fracking and water supplies, expected perhaps late this year or early next. “The social and legal reaction to the report may influence the availability of coverage,” Susavidge suggests. “We expect that will take some time to develop.”

Plenty of market capacity is available right now, Hanneman reports. That said, “some markets are still definitely in a wait-and-see pattern as to whether or not they want to offer environmental coverage for this class of risk.”

Although certain opportunities have been created, “I can tell you that there has been some contraction as of late,” O’Brien reports. “I think that really has to do more with fear of the unknown than anything else.”

PUBLIC DISPLAY

Restoule believes that risks associated with fracking activities go beyond hazard and operational risk. “We’re tending to forget about the ERM [enterprise risk management] process and that of reputation and brand, and how do you manage that as a driller and as an operator,” he says. “Is there a black swan event in there? I don’t know. It’s taking the risk management process across the enterprise and not just focus on operation and hazard.”

Another issue to consider is how water resources may influence business viability. Restoule points to discussions in the U.S. about current drought conditions and a requirement that frackers reuse water. That is indeed an issue for frackers, he says, because the process may increase the costs of operations.

The EPA reports the volume of water needed for hydraulic fracturing varies by site and type of formation: 50,000 to 350,000 gallons of water may be required to fracture one well in a coal bed formation, while two million to five million gallons of water may be necessary to fracture one horizontal well in a shale formation.

“At the price of natural gas, could it impair the whole economics by introducing these closed waste water disposal and reuse systems?” Restoule asks. “In Canada, we haven’t faced that problem yet. But you can bet that the closed disposal system is something that is, in my opinion, probably a good risk mitigation measure and I could see it being imposed upon us.”

Several provincial and state jurisdictions have opted not to jump on the hydraulic fracturing bandwagon at this time. For example, Quebec has said “No” so far.

Meanwhile in Nova Scotia, hydraulic fracturing will have to wait until at least mid-2014 to enter that province as it completes its review. Citing public concerns over drinking water integrity, Nova Scotia’s provincial energy minister, Charlie Parker, said last April: “We will take time to learn from jurisdictions with significantly more experience in this area than Nova Scotia.”

Restoule views the moratorium in Quebec as based on the desire for disclosure of chemicals used in fracking fluids. “If we were able to achieve transparency and educate the public on the technologies and the chemicals used in fracking, I think they could dispel that,” he says.

Hanneman agrees, suggesting that this sort of disclosure “erases uncertainty and mystery.” He expects that “you’re going to see a trend toward more eco-friendly constituents in the fluids, anyway, just as a best practice.”

Encana reports that it prohibits the use of any hydraulic fracturing fluid products containing diesel, 2-Butoxyethanol or benzene. “Our Responsible Products Program helps ensure that the hydraulic fracturing fluid products we use in our operations are as safe, effective and as environmentally responsible as possible,” the company states.

Despite the reviews, the concerns and the rhetoric, fracking may be here to stay, subject to prohibitions or elevated expenses. As claims currently stand, Restoule says that insurance is available and affordable. Asked if he thinks that could change, he replies that everything is subject to change based upon frequency and severity. “It’s really, truly supply and demand, isn’t it?”