Marcellus Shale: A Primer for Business The Current Landscape of the Marcellus Shale

November 9, 2010

Listen to the audio portion of today’s webinar by dialing:

North America Toll-Free: +1.866.322.1348 International Toll: +1.706.679.5933 Audio Conference ID #: 23851729

2

TECHNICAL SUPPORT NUMBERS

If you experience technical difficulties, hit *0 on your telephone keypad and an operator will assist you. Or you can dial: For Web Support: North America: +1.877.812.4520 or International +1.706.645.8758 3

For Audio Support: North America: +1.800.374.2440 or International: +1.706.645.6500

Click this icon to view the slide in full screen mode.

Hit the ‘Escape’ key to return to the normal view.

4

Click the printer icon to download/print the slides.

5

Feel free to submit text questions throughout the webinar

6

OUR LOCATIONS BERWYN 400 Berwyn Park 899 Cassatt Road Berwyn, PA 19312-1183 610.640.7800 FAX 610.640.7835

BOSTON Floor, Oliver Street Tower 125 High Street Boston, MA 02110-2736 617.204.5100 FAX 617.204.5150

15th

HARRISBURG Suite 200 100 Market Street P.O. Box 1181 Harrisburg, PA 17108-1181 717.255.1155 FAX 717.238.0575 PITTSBURGH 50th Floor 500 Grant Street Pittsburgh, PA 15219-2502 412.454.5000 FAX 412.281.0717

NEW YORK The New York Times Building 37th Floor, 620 Eighth Ave New York, NY 10018-1405 212.808.2700 FAX 212.286.9806

ORANGE COUNTY Suite 1200 4 Park Plaza Irvine, CA 92614-5955 949.567.3500 FAX 949.863.0151

PHILADELPHIA 3000 Two Logan Square Eighteenth and Arch Streets Philadelphia, PA 19103-2799 215.981.4000 FAX 215.981.4750

PRINCETON Suite 400 301 Carnegie Center Princeton, NJ 08543-5276 609.452.0808 FAX 609.452.1147

WASHINGTON Hamilton Square 600 Fourteenth Street, N.W. Washington, DC 20005-2004 202.220.1200 FAX 202.220.1665

WILMINGTON Hercules Plaza, Suite 5100 1313 Market Street P.O. Box 1709 Wilmington, DE 19899-1709 302.777.6500 FAX 302.421.8390

www.pepperlaw.com 7

DETROIT Suite 3600 100 Renaissance Center Detroit, MI 48243-1157 313.259.7110 FAX 313.259.7926

We will be starting momentarily…

8

Moderator: Michael P. Weiner

• Partner in the Corporate and Securities Practice Group of Pepper Hamilton LLP, resident in the Princeton office • Leader of Pepper Hamilton's Marcellus Shale Team

609.951.4144 [email protected]

• Concentrates his practice on transactional matters involving clients ranging from sole proprietorships to publicly held corporations engaged in a variety of business pursuits, often acting as the primary outside counsel for business entities interested in having access to a “gatekeeper” for their diverse legal needs • Member of the Sustainability, CleanTech and Climate Change Team.

9

John W. Carroll

• John Carroll is the Chair of Pepper’s Environmental Practice Group. He holds an undergraduate degree in Geology and has been advising clients on oil and gas matters for 38 years. He has taught oil and gas law at the Dickinson School of Law (now Penn State). 717.255.1159 [email protected]

10

Speaker: Philip E. Cook, Jr.

• Of counsel in the Pittsburgh office of Pepper Hamilton LLP, concentrating on state and local tax matters • Co-author of the Guidebook to Pennsylvania Taxes, as well as a contributor to Pennsylvania State Service, published by Matthew Bender 412.454.5075 [email protected]

11

• Chairman of the Tax Section of the Allegheny County Bar Association, director of the Allegheny Tax Society.

Speaker: David J. Tshudy

• Of counsel in the Real Estate Practice Group of Pepper Hamilton LLP, resident in the Harrisburg office • Concentrates his practice in the areas of real estate, land use and land development • Experienced in all aspects of real estate development and transactions 717.255.1127 [email protected]

12

• Regularly lectures and writes on real estaterelated matters, and in May 2010 presented at the Marcellus Shale Land Law seminar in Harrisburg, Pa., sponsored by Half Moon LLC.

Speaker: Erik H. Rudolph

• Managing Director of Farlie Turner & Co. • Prior to joining Farlie Turner, Mr. Rudolph was a Partner and Managing Director of Aquetong Capital Advisors, an investment bank offering advisory services to closely-held, middle market companies • At Aquetong, Mr. Rudolph completed numerous [email protected] sell-side transactions in a variety of industries, including oil & gas services, food & beverage, specialty packaging, branded consumer products, consumer retail and health care.

13

Marcellus Shale November 2010

C O N F I D E N T I A L

Introduction „

Onshore  drilling  has  seen  a  significant  increase  in  activity  due to  the  shale  formations  in  the  U.S.,  particularly the Marcellus Shale, which covers 6 states and underlies nearly 75% of Pennsylvania −

Higher natural gas prices and new technologies, such as water‐intensive, horizontal drilling, have combined to spike  interest in the Marcellus Shale formation, a natural gas play that has the potential to become the biggest gas field in  the U.S. 

−

Downturn in activity that began in 2008 across the industry was offset by continued drilling and production in the  shale formations

Marcellus Shale Location and Depth

−

Industry experts believe the Marcellus formation  contains enough natural gas to supply all U.S.  energy needs for two decades at current  consumption levels 

−

The formation rests 7,000 to 9,000 feet below  ground

−

Wells are high production wells relative to  traditional onshore natural gas plays, making  drillers much less disposed to volatility in  commodities prices than their counterparts 

Source: PhysOrg.com, Penn State Marcellus Center for Outreach and Research.

15

Pricing and Rig Counts „

Natural gas pricing (currently in the $3 ‐ $4 range) continues to slump relative to the price of oil Crude Oil Pricing

Natural Gas Henry Hub Spot

$160

$18 

$140

$16  $14 

$120

$12 

$100

$10  $80

$8 

$60

$6 

$40

$4 

$20

$2 

$0

$0 

2005

„

2006

2007

2008

2009

2005

2010

2006

2007

2008

2009

2010

However, the correlation between onshore rig counts and natural gas prices has diminished over the last  10 months due to continued activity in the shale formations despite historically low price levels  U.S. Onshore Rig Counts and Henry Hub Spot 2,500

$14 $12

2,000

$10 1,500

$8

1,000

$6 $4

500

$2

0 Jan‐07 Source: Baker Hughes.

$0 Jul‐07

Jan‐08

Jul‐08

U.S. Onshore Rigs

Jan‐09

Jul‐09

Jan‐10

Henry Hub Spot

Jul‐10

16

Drilling Permits and Wells „

Drilling permits and wells drilled are key indicators of activity in the Marcellus Shale −

Permits in the Marcellus Shale have increased significantly since 2007, when only 99 Marcellus drilling permits were  issued, compared to over 2,000 permits issued in the first eight months of 2010 

−

Drilling activity has followed suit: From January to August 2010, 950 wells have been drilled in the Marcellus Shale  compared to only 43 wells for the entire year in 2007

−

As a percentage of total permits in Pennsylvania, Marcellus permits have increased from 1.1% in 2007 to 45.2% in the  year‐to‐date period 

Drilling Permits in Pennsylvania 10,000 

8,855 

8,774 

45.2%

8,000 

50% 40%

6,234  6,000 

30%

31.8% 4,037 

4,000 

20% 5.9%

2,000 

10%

1.1% ‐

0% 2007

2008 Total Drilling Permits

„

2009

2010 YTD

% Marcellus

Furthermore, gas drilling bids in the Marcellus Shale area in Pennsylvania have already exceeded the  state’s expectations for the year 

Source: Pittsburgh Today.

17

Drilling Permits and Wells „

The  following  map  presents  the  locations  of  shale  drilling  permits  in  Pennsylvania  by  year,  demonstrating the significant increase in activity in 2010 when compared to previous years

Source: Pennsylvania Department of Environmental Protection.

18

Drilling Permits and Wells „

In addition to permits, the number of wells drilled also demonstrates the increase in activity in the region  that has occurred in 2009/2010

Source: Pennsylvania Department of Environmental Protection.

19

Drivers of Marcellus Shale Activity A number of factors have driven activity in the Marcellus formation: „

„

High  Production  Levels. Marcellus  wells  are  highly  productive,  enabling  drillers/operators  to  be  less  influenced by commodities price levels −

High production of the wells results in a relatively low cost to develop shale gas, particularly as new technologies  have helped to further increase the rate at which gas is extracted

−

Efficient companies can still drill profitably in the Marcellus, despite low natural gas commodity pricing

−

Despite gas prices falling by over 30% in the first half of 2009, rig counts were at record highs in the Marcellus Shale  region and declined by only 2% in the Haynesville formation, while gas drilling activity fell by 79% in the Permian  Basin in Texas and 57% in the Rockies, according to Barclays Capital(1)

Horizontal Drilling Technologies. Horizontal  drilling has contributed  in  part  to  the  increased  levels  of  shale activity over the last 2 years −

Horizontal rigs now account for over 40% of total rigs, up from 5% in the 1990ʹs  and 30% in 2008

−

Combined with multiple types of fracturing techniques, drillers utilize horizontal drilling to extract up to 5x more  natural gas than conventional techniques

„

Lease  Obligations. Because  activity  is  less  dependent  on  demand  or  price  levels,  activity  in  the  Marcellus tends to be more driven by lease obligations 

−

Due to lease terms, many companies must drill and produce resources from the land within a definitive period,  typically 5 years

(1) Davis, Ann, “Pipeline Firms Widen Natural‐Gas Networks.” Wall Street Journal; 2009.

20

Downward Pressure on Natural Gas Prices „

„

Abundance  of  new  natural  gas  supplies  available  through  shale  gas  drilling  has  caused  downward  pressure on prices over the last two years −

Production has increased despite falling prices due to financial hedges put in place when the market was stronger

−

Expected spending slowdown will decelerate growth in North American production 

−

It will likely take 1 ‐2 years before gas prices will stabilize near $6 again

„

In hedging, producers buy/sell contracts in futures market to lock in price for their gas

−

Hedges will begin to expire next year, stabilizing an oversupplied market

−

Producers can no longer lock in high prices that have been source of funding of new drilling due to lowered forward  prices in the futures market

Morgan Stanley analysts stated that out of 26 large natural gas producers covered, approximately 43%  of total production was hedged in 2010 −

Hedged production is expected to shrink to 22% next year

−

Encana had nearly half of its production hedged at above $6/MMbtu in 2010

−

Apache had 41% of its North American natural‐gas production hedged in 2010

21

Drivers of Marcellus Shale Activity Future activity in the Marcellus Shale will be driven by a number of factors: „

Continued Investment in the Region. −

According to a study conducted by Penn State’s College of Earth and Mineral Sciences in 2009, Marcellus shale gas  producers spent a total of $4.5 billion to develop the resource in 2009

−

Perhaps the most indicative transaction of the increased activity in onshore shale plays is Exxon Mobil’s plan to buy  XTO Energy Inc. for $30 billion in stock

−

Additional recent investments support continued activity in the region as well as interest from international players −

Shell Oil recently announced its $5.0 billion investment in East Resources, which owns 1.2 million acres of the Marcellus Shale

−

EXCO Resources Inc. announced a $950 million joint venture deal with British‐based BG Group plc to develop acreage including  considerable Marcellus Shale reserves

−

Oklahoma‐based Chesapeake Energy Corp. announced its sale of a 20% percent stake in its Appalachian operations to raise $3.5  billion (including investments from Temasek Holdings, a Singapore company, and Hopu Investment Management Co. Ltd., a  Chinese private equity firm)

−

Gastar Exploration Ltd said it would sell half its interests in the Marcellus shale to a unit of South Korean investment firm Atinum Partners Co for $70 million

−

Rex Energy Corp agreed to sell some of its Marcellus acreage to a unit of Japanʹs Sumitomo Corp for $140 million

−

Reliance Industries announced the acquisition of a 60% stake in a joint venture with Carrizo Oil & Gas in the Marcellus for $392 million

−

Ultra Petroleum Corp said it would pay about $400 million to an unnamed private company to buy 80,000 net acres in the Marcellus shale, giving it about 250,000 net acres and a potential for 1,800 net drilling sites. (1) 2009 study conducted by Timothy Considine, Robert Watson and Seth Blumsack of Penn Stateʹs College of Earth and Mineral Sciences

22

Drivers of Marcellus Shale Activity Future activity in the Marcellus Shale will be driven by a number of factors (continued): „

Infrastructure Development.   −

A recent article in the Wall Street Journal(1) highlighted opportunities to build new infrastructure to manage the large  amounts of natural gas being extracted from the shale‐rock formations in the U.S. 

−

Certain oilfield service sectors will benefit from the increased activity and the current lack of infrastructure in this  relatively new “frontier” relative to the network of service companies that exist in other areas in the U.S.;  these sectors  include tubular distribution, non‐destructive testing and inspection, directional drilling, engineering and other  support services

Northeast Natural Gas Pipeline Network „

Location  in  the  Northeast. The  formation’s  proximity  to  the Northeast, a region that consumes the nation’s largest  amounts  of  natural  gas  for  heating  purposes,  supports  continued  demand  and  potential  long‐term  increases  in  pricing −

According to the EIA, 20 interstate natural gas pipeline systems operate within the Northeast Region

−

These pipelines deliver natural gas to (i) several intrastate  natural gas pipelines, (ii) at least 50 local distribution  companies in the region, (iii) large industrial companies, and  (iv) natural gas‐fired electric power generation facilities

(1) Davis, Ann, “Pipeline Firms Widen Natural‐Gas Networks.” Wall Street Journal; 2009. Source: EIA.

23

Drivers of Marcellus Shale Activity Future activity in the Marcellus Shale will be driven by a number of factors (continued): „

New  Uses  of  Natural  Gas.    Potential  for  additional  demand  by  utilizing  natural  gas  in  new  industries,  such as transportation

−

According to the Natural Gas Vehicle Coalition, there are currently only 150,000 Natural Gas Vehicles on the road in the  U.S., and more than 5 million worldwide, demonstrating the significant opportunity to increase demand

−

Natural gas is a clean, efficient source of energy and offers a viable alternative to oil for energy needs 

−

The implementation of new environmental regulations or carbon emission caps could bolster demand for natural gas  relative to oil

„

Taxes.  Pennsylvania is the only gas‐producing state yet to impose a tax on shale gas

−

Although declared a dead issue in the current fiscal year by lawmakers in Pennsylvania, imposing a significant severance  tax on Marcellus natural gas output could influence future activity in the region 

„

Environmental Regulation.  

−

Concerns around fracturing techniques and the impact on ground water supplies could negatively impact natural gas in  the future

−

The EPA is currently studying the fracturing process.  Future regulations around waste water collection and treatment  could impose additional costs on operators/drillers and subsequently increase the price to develop the resource

24

Background on Hydraulic Fracturing „

Natural  gas  extraction  from  the  Marcellus  Shale  formation  involves  a  process  known  as  hydraulic  fracturing  

„

In  this  process,  also  known  as  “fracking,” drillers  pump  water,  sand  and  other  fluids  into  the  formation  at  high  pressures  to  fracture  the  formation and allow the gas to flow

„

Once the hydraulic fracturing process is completed,  the used water is reused in the next well or sent to  an approved treatment facility

„

Fracking is  estimated  to  account  for  nearly  90%  of  all new gas wells

Source: Chesapeake Energy, WSJ research.

25

Marcellus Shale in Pennsylvania – Zoning and Land Use Issues

26

Pennsylvania Municipalities

• Pennsylvania is divided into 2,566 municipalities • Under the Pennsylvania Municipalities Planning Code (the “MPC”), 53 P.S. §10101 et seq., all municipalities may adopt zoning ordinances and subdivision and land development ordinances (SALDOs)

27

Municipal Land Use Ordinances

• Zoning ordinances generally regulate the uses of land • SALDOs generally regulate the subdivision and development of land • How do these ordinances affect the production of natural gas?

28

Two Overriding Issues

• The two issues most litigated before Pennsylvania appellate courts related to both land use and oil and gas production are: − Preemption of municipal land use ordinances by the Oil and Gas Act (the “Act”), 58 P.S. §601.101 et seq. − Application of Section 603(i) of the MPC

29

Preemption by the Oil and Gas Act

• Preemption by the Act − The Act regulates the development of Pennsylvania’s oil and gas resources − The Department of Environmental Protection (DEP) administers the Act − Section 602 of the Act contains express preemption language

30

Preemption by the Oil and Gas Act

• Section 602 of the Act Except with respect to ordinances adopted pursuant to the … Pennsylvania Municipalities Planning Code, and the … Flood Plain Management Act, all local ordinances and enactments purporting to regulate oil and gas well operations regulated by this act are hereby superseded. No ordinances or enactments adopted pursuant to the aforementioned acts shall contain provisions which impose conditions, requirements or limitations on the same features of oil and gas well operations regulated by this act or that accomplish the same purposes as set forth in this act. The Commonwealth, by this enactment, hereby preempts and supersedes the regulation of oil and gas wells as herein defined. 58 P.S. §601.602.

31

Preemption by the Oil and Gas Act

• Cases Interpreting §602 of the Oil and Gas Act: • Huntley & Huntley, Inc. v. Borough Council of the Borough of Oakmont, 964 A.2d 855 (Pa. 2009). The Supreme Court of Pennsylvania held that a borough’s zoning ordinance which permitted mineral extraction by conditional use in a residential district was not preempted by the Act when applied to the drilling of a natural gas well. • Range Resources – Appalachia, LLC v. Salem Township, 964 A.2d 869 (Pa. 2009). The Supreme Court of Pennsylvania held that portions of a township’s SALDO that required township permits for drilling-related activities and otherwise regulated the operations of oil and gas wells within the township were preempted by the Act.

32

Preemption by the Oil and Gas Act

• Cases Interpreting §602 of the Oil and Gas Act: • Range Resources – Appalachia, LLC v. Blaine Township, 649 F.Supp.2d 412 (W.D. Pa. 2009). The U.S. District Court for the Western District of Pennsylvania applied §602 of the Act to invalidate a township’s “Disclosure Ordinance,” which allowed the township to deny an oil and gas well operator the right to do business within the township due to a “history of consistent violations of the law.” • Penneco Oil Company, Inc. v. The County of Fayette, 4 A.3d 722 (Pa. Cmwlth. 2010). The Commonwealth Court of Pennsylvania held that a zoning ordinance that permits oil and gas wells in certain districts by special exception and requires a zoning certificate for all land uses, including oil and gas wells, is not preempted by the Act.

33

Section 603(i) of the Pennsylvania Municipalities Planning Code

• Section 603(i) of the MPC − “Zoning Ordinances shall provide for the reasonable development of minerals in each municipality.” 53 P.S. §10603(i) − MPC’s statutory definition of “minerals” specifically includes natural gas. 53 P.S. §10107(a)

34

Section 603(i) of the Pennsylvania Municipalities Planning Code

• Cases interpreting §603(i) of the MPC: − LaRock v. Board of Supervisors of Sugarloaf Township, 866 A.2d 1208 (Pa. Cmwlth. 2005) (LaRock I). The Commonwealth Court of Pennsylvania ruled that challenges based on the “reasonableness” language §603(i) must be evaluated by considering all of the factors delineated in §603, including the special nature of various sites within the municipality, the special protection and preservation allowed for natural resources, the promotion of agriculture, and consistency with the municipality’s comprehensive plan. − Hanson Aggregates Pennsylvania, Inc. v. College Township Council, 911 A.2d 592 (Pa. Cmwlth. 2006) and LaRock v. Board of Supervisors, 961 A.2d 916 (Pa. Cmwlth. 2008). The Commonwealth Court of Pennsylvania ruled in both cases that §603(i) does not require a municipality to provide for “depletion-proof” mineral extraction. “A municipality should not necessarily be required to designate a new area for mineral extraction where an established mineral extraction zone within the township has been depleted.”

35

Marcellus Shale Environmental Issues Obligations and Opportunities

36

Which Oil & Gas Companies Are Drilling The Marcellus Shale In Pennsylvania?

Gas Production Companies engaged in Marcellus drilling in PA Company Name and Location Chesapeake Appalachia, LLC, Oklahoma City, OK Range Resources Appalachia LLC, Canonsburg, PA East Resources Mgmt LLC, Warrendale, PA Talisman Energy USA Inc., Warrendale, PA Atlas Resources LLC, Coraopolis, PA EOG Resources, Inc., Canonsburg, PA Cabot Oil & Gas Corp, Pittsburgh, PA Chief Oil & Gas LLC, Dallas, TX Ultra Resources Inc., Englewood, CO Anadarko E&P Co. LP, Houston, TX EQT Production LLC, Charleston, WV Exco Resources PA, Inc., Warrendale, PA

37

No. of Permits 1,032 646 482 479 394 262 213 190 186 179 169 155

Which Oil & Gas Companies Are Drilling The Marcellus Shale? Company Name and Location CNX Gas Co LLC, Bluefield, WV Seneca Resources Corp, Williamsville, NY PA Gen Energy Co LLC, Warren, PA Phillips Exploration, Inc., Warrendale, PA Energy Corp of Amer, Charleston, WV Williams Production Appalachia LLC, Canonsburg, PA XTO Energy Inc., Indiana, PA Rex Energy Operating Corp, State College, PA Snyder Bros Inc., Kittanning, PA Southwestern Energy Prod. Co., Houston, TX Citrus Energy Corp, Frisco, TX BLX Inc., Kittanning, PA Novus Operating LLC, Royse City, TX Stone Energy Corp, Lafayette, LA JW Operating Co, Addison, TX

No. of Permits 134 122 102 92 76 68 67 57 51 46 22 18 18 18 12

Source: http://www.dep.state.pa.us/dep/deputate/minres/oilgas/new_forms/marcellus/Reports/Marcellus ActiveOperators.htm

38

Who Are The Regulators

• Federal − EPA − Corps of Engineers • Interstate − DRBC − SRBC • State − PA DEP − PFBC − DCNR • Local − 4678 local governments – counties, cities, boroughs and townships

39

Locations of Marcellus Shale Permits - 2010

40

PaDEP’s Role

• PaDEP issues permits under the Oil and Gas Act (OGA) and the Clean Streams Law (CSL) • The CSL was enacted in 1937 and protects all waters of the Commonwealth, which includes streams, springs, wetlands and groundwater • PaDEP is in the process of amending its OGA regulations to increase groundwater protection by tightening the casing and cementing requirements for gas well construction

41

Enforcement Actions Related To Marcellus Shale

• In 2009, PaDEP pursued 173 enforcement actions against Marcellus Shale drillers, resulting in 638 violations recorded in 2009. • In 2010 to date, PaDEP has pursued 560 enforcement actions, resulting in 2,114 violations. • State agencies and/or compact commissions have had to create new field offices to ensure compliance with their regulations in the face of the recent spike in drilling activity. Source: http://www.dep.state.pa.us/dep/deputate/minres/oilgas/OGInspectionsVi olations/OGInspviol.htm and http://www.srbc.net/pubinfo/press/docs/Staff%20Sayre%20Offic%20_Ma y%202010_.pdf

42

Nature Of Environmental Issues

• Surface and Groundwater Contamination − Spills and leaks from frac water and produced water storage facilities − Contaminants entering groundwater aquifers affecting drinking water caused by inadequate casing programs

• Public concern about fracking activities and chemophobia about fracking chemicals • Studies underway to assess air impacts in vicinity of gas operations

43

What Chemicals Are Used By These Companies For Hydraulic Fracturing?

44

What Chemicals Are Used By These Companies For Hydraulic Fracturing?

Source: http://www.dep.state.pa.us/dep/deputate/minres/oilgas/new_forms/marcellus/Reports/Frac%20li st%206-30-2010.pdf 45

Potential Environmental Issues With Using Such Chemicals

• Section 208 of the PA Oil and Gas Act, titled “protection of water supplies”, requires a well “operator” who pollutes a public or private water supply to restore or replace the affected supply with an alternate source of water. In addition, §208(c) creates a rebuttable presumption that the “operator” is responsible for the polluted water supply if the water supply is within 1,000 feet of the well.

46

Potential Environmental Issues With Using Such Chemicals, cont.

• Under the Pennsylvania Clean Streams Law, a “landowner” can be held strictly liable for pollution to the waters of the Commonwealth, regardless of fault. Section 316 of the Clean Streams Law, 35 P.S. § 691.316 provides: − Whenever the department finds that pollution or a danger of pollution is resulting from a condition which exists on land in the Commonwealth, the department may order the landowner or occupier to correct the condition in a manner satisfactory to the department…. For the purpose of this section ‘landowner’ includes any person holding title to or having a proprietary interest in either surface or subsurface rights. • “[F]ault is not a prerequisite to establishing liability under Section 316 of the Clean Streams Law.” Western Pennsylvania Water Co. v. Commonwealth, Dep't of Environmental Resources, 127 Pa. Commw. 26, 32 (1989).

47

Case Study – Dimock

• Natural gas discovered in individual drinking water wells near gas well operations • Driller denies responsibility • PaDEP authorizes $12 million solution for 18 affected homes (5 mile water line), focuses on gas company and its casing program • Opposition by many to extravagent remedy

48

Liability Issues, cont.

• The Pennsylvania Oil and Gas Act does not limit the rights of third parties to bring common law claims against the well owner or operator. Section §208(f) specifically allows a landowner who suffers “pollution or diminution of a water supply” due to the operation of an oil or gas well to seek “any other remedy that may be provided at law or in equity.”

49

Marcellus Shale – Delaware River Basin Commission (“DRBC”)

• The DRBC is a federal-interstate compact commission that was formed in 1961 by the US and the four basin states (PA, NY, NJ, and DE). • On May 19, 2009, the DRBC issued a determination that all natural gas drilling in shale formations in the basin is prohibited unless the project first applies for and obtains DRBC approval. − http://www.state.nj.us/drbc/EDD5-19-09.pdf • Although this determination exempted exploratory wells, a subsequent determination issued on June 14, 2010 removed this exemption. − http://www.state.nj.us/drbc/SupplementalEDD6-14-10.pdf Source: http://www.state.nj.us/drbc/naturalgas.htm

50

Extent of Marcellus Shale Formation in the Delaware River Basin

51

Map of the “Special Protection Waters” Covered By the DRBC Determination

Source:

http://www.state.nj.us/drbc/maps/SPWMarcellusShale.pdf

52

What is the Status of the DRBC “Moratorium” Now?

• The DRBC is drafting regulations to ensure protection of the Delaware River Basin waters related to Marcellus Shale drilling. These regulations would presumably replace the effective moratorium. • The regulations have not yet been proposed, but the DRBC has identified three major areas of concern: − Drilling in the Marcellus Shale may reduce flow in streams and/or aquifers used to supply the significant amounts of fresh water needed in the natural gas drilling and fracking process − On-site drilling operations may discharge pollutants to groundwater or surface water − The recovered “frac water” must be treated and disposed of properly Source: http://www.state.nj.us/drbc/naturalgas.htm

53

Marcellus Shale – Susquehanna River Basin Commission (“SRBC”) • The SRBC is a federal-interstate compact commission created in 1970 between the US and three states: PA, NY, and MD. More than 72% of the basin is underlain by the Marcellus formation. • A rulemaking that became effective on January 15, 2009 subjects all Marcellus or Utica shale well development to regulatory review. Other components of the rulemaking include: − A special administrative process for consumptive use applications related to Marcellus Shale drilling − Projects are regulated on a drilling pad basis rather than a company lease-area basis − Must certify compliance with all state and federal laws for treatment and disposal of flowback fluids/brines Source: http://www.srbc.net/programs/docs/ProjectReviewMarcellus%20Shale122008.pdf and http://www.srbc.net/programs/projreviewmarcellus.htm

54

Marcellus Shale – Susquehanna River Basin Commission

• The SRBC is taking a science-based decision-making approach going forward with respect to Marcellus Shale drilling. • Among other things, SRBC is establishing a remote water quality monitoring network to ensure that sensitive surface waters within the basin are not adversely impacted. Source: http://www.srbc.net/programs/docs/SRBC%20Science%20of%20the%2 0marcellus%20012910.pdf

55

Marcellus Shale – Susquehanna River Basin Commission

56

Opportunities

• New treatment technologies for recycling or cleaning frac water and produced water (brines) for onsite reuse or disposal − Cost of water transport and burden on road infrastructure could be avoided • New treatment facilities or systems • New production technology (casing, cement, etc.) to assure adequate separation of groundwater from contaminants • Pipeline infrastructure • Consulting services • Lobbyists • Investors

57

Pennsylvania Business Tax Issues

58

Severance Tax

59

Pennsylvania is the only major producing state without a severance tax. y Legislative leaders agreed when negotiating the 2010/ 2011 budget to adopt a severance tax by October 1, 2010. − Senate Bill 1155 (SB1155) passed by House of Representatives / died in Senate − SB1155 would have imposed a tax of $.39 per thousand cubic feet (MCF), measured at wellhead (approximately 10% of selling price) − Senate will not return to vote on bills until next year

60

Positions of the Parties ƒ Senate wanted a tax of 1.5% of selling price for first five years with slight increases thereafter. ƒ Rendell Administration proposed 3% tax in first year, 4% tax in second year and 5% tax thereafter. Rendell Administration has placed a moratorium on leasing of state forest land. ƒ Corbett Administration has pledged no new taxes. Corbett Administration promises to immediately rescind the moratorium.

61

Corporation Taxes

62

• Corporate Net Income Tax − rate 9.99% − separate company returns − based on federal taxable income, with adjustments − a “corporation” is any entity that is classified as a corporation for federal tax purposes

• Capital Stock/Franchise Tax − rate 2.89 (.289%) mills on “capital stock value” − separate company returns − value is calculated by formula including net worth and capitalized income for a five year period • formula may produce calculated values with no reasonable relationship to actual value 63

• Capital Stock/Franchise Tax (cont.) − Entities subject to tax include • all limited liability companies, business trusts and joint stock associations • all entities classified as a corporation for federal tax purposes

− scheduled for phase out in 2014 • 2.89 mills – 2010, 2011 • 1.89 mills – 2012 • .89 mills – 2013

64

Personal Income Tax

65

• Applies to individuals, estates and trusts • Also applies to income from S corporations, partnerships and any other entity classified as a partnership for federal income tax purposes is attributed to owners − Note, S corporations, all limited liability companies and all business trusts subject to capital stock/franchise tax

• Residents taxed on all income, with credits for taxes paid on income in other states. Nonresidents taxed on Pennsylvania source income • Rate 3.07%

66

• Eight classes of income subject to tax − compensation − net profits − net gains or income from disposition of property − net gains or income derived from rent, royalties, patents and copyrights − dividends − interest − gambling and lottery winnings (other than PA lottery) − net gains or income from estates or trusts

67

Local Income Tax

68

• Earned income/net profits tax • Applies to compensation earned by resident individuals of local jurisdictions (municipality and school district) and includes income attributed to resident from entities not classified as a corporation for federal income tax purposes. − S corporation income not subject to net profits tax − Income from passive activities not subject to net profits tax • Nonresidents may be taxed by municipalities, but school districts may not tax nonresidents. Municipalities must be given credit for taxes paid to jurisdiction where they reside. • Rates – vary. One percent (shared by municipality and school district) is the general rule, but there are special authorizations to levy at higher rates. See local ordinances/resolutions.

69

Local Business Privilege Mercantile Tax

70

• Applies to gross receipts of entities or individuals engaged in business in local jurisdictions • Some local jurisdictions do not levy a gross receipts tax • In December of 2007, the Supreme Court of Pennsylvania issued a decision in Rendina v. City of Harrisburg. That decision raises questions about where the gross receipts tax should be paid.

− Prior to Rendina the tax was to be paid to the jurisdiction where the taxpayer maintained a base of operations. − Rendina held that jurisdictions where transactions took place can tax, but left unanswered whether “base of operations” must give credit. − Legislation proposed to retroactively overturn Rendina, but nothing has been enacted. • Rates – Vary. Consult local ordinances/resolutions.

71

Sales and Use Tax

72

• Pennsylvania sales and use tax applies to purchase or sale of tangible personal property or certain services delivered in Pennsylvania. − Rate 6%

• Two counties, Allegheny and Philadelphia, impose a local sales tax. The local tax applies to the same tax base, but it’s a point of sale tax. − Rate – Allegheny 1%, Philadelphia 2%

73

• Exemption for property used in “mining,” which includes oil and gas drilling, − property “directly used” in mining activities may be purchased free from tax. Direct use is a subjective determination − entities performing mining activities under contract with mining entity may also claim an exemption

74

Employer Withholding

75

• Wage Withholding – Employers transacting business in Pennsylvania must withhold Pennsylvania personal income tax on compensation to Pennsylvania residents or non resident performing services in Pennsylvania − Pennsylvania has reciprocal agreements with Indiana, Maryland, New Jersey, Ohio, Virginia and West Virginia.

• Withholding by pass through entities – pass through entities receiving income from sources in Pennsylvania must withhold tax on the portion of income allocable to nonresident partners, members or shareholders.

76

• Local Earned Income Tax Withholding − Currently, employers are only required to withhold earned income tax if they have nexus in the jurisdiction where the employee resides. − Effective January 1, 2012, employers will be required to withhold earned income tax for all employees and remit to a tax collector in the jurisdiction where the employer is located.

77

Questions and Answers

78

Marcellus Shale: A Primer for Business

Webinar Two – Nuts and Bolts of Operating a Business in Pennsylvania Thursday, November 18, 2010 12:00-1:30 p.m. EDT Register today at: http://www.regonline.com/marcellus_shale2

79

For more information, visit www.pepperlaw.com.

80