By Edward McAllister

NEW YORK (Reuters) - The end of a drilling ban in New York was meant to be a new dawn for energy companies. After years of waiting, they would finally be able to exploit the richest deposit of natural gas in the country.

But as companies delve into new regulations for drilling in New York, they're discovering a bitter reality: half the land they had leased for drilling may now be out of bounds.

In proposed new rules for drilling, which are expected to be finalized early next year, the state has imposed an off-limits buffer around its waterways due to environmental concerns about the effects that drilling will have on water supplies.

The buffers are as much as 20 times larger than neighboring, industry-friendly Pennsylvania.

After looking at maps of thousands of potentially forbidden acres, some companies are considering leaving the state altogether, Reuters has discovered.

Royal Dutch Shell, which has leased about 90,000 acres for drilling in New York, reckons that 40 percent of that land could be off limits under the proposed laws, a company source told Reuters after Shell completed modeling of its acreage in the state.

"We are looking at a potentially significant impact," the source said.

Inflection Energy, a small independent company with 15,000 acres in New York, is reconsidering drilling there after studies showed that about 60 percent of its acreage might not be drillable.

"It is forcing us to change our business model," said Inflection chief executive Mark Sexton. "If the regulations go ahead we will allocate more resources to Pennsylvania than New York. Originally we had planned to focus more on New York."

Inflection had aimed to increase leased land to 50,000 acres.

The revelation of the stiff restrictions on drilling near aquifers and waterways, a previously unreported aspect of environmental regulations proposed this summer, is the latest set-back for shale drillers in New York, where unusually fierce local opposition has stunted development.

It also highlights how tougher state regulations could rein in the rampant expansion of natural gas produced using hydraulic fracturing, or fracking, a controversial technique to extract gas from shale rock deep below the surface by blasting it with chemical-laced water.

ENVIRONMENTAL SET-BACKS

The moratorium on drilling New York's portion of the huge Marcellus Shale gas deposit -- which extends south through Pennsylvania and West Virginia -- was put in place as environmentalists warned that drilling fluids used in fracking and methane could find their way into underground water sources and taint supply for millions of homes across the state.

The gas industry denies the link and had hoped that a concerted campaign to dispel fears about the impact of fracking would help turn New York policy in their favor.

"This (lease buying) was all done without the knowledge that the DEC was going to propose these increased setbacks," said Thomas West, an attorney in Albany New York who represents oil and gas companies. "It has a significant impact on the drillability of this acreage."

Some New York land has been off limits for years. The state has gone to great lengths to protect its drinking water from the chemicals used in fracking, far more than other gas-producing regions in the United States.

The long wait to drill has hit some companies hard, after they bet the wrong way on New York.

Norse Energy moved its headquarters to Buffalo, New York, four years ago, expecting to find fortune drilling the Marcellus. But after investing $100 million in New York, Norse laid off half its staff last month; its shares on the Oslo stock market have lost nearly all their value.

Norse, which owns leases on 180,000 acres in New York, is also considering leaving the state.

"We are in survival mode. We bet a lot on New York opening up for development and are now talking to the creditors on a regular basis," Norse executive vice president Dennis Holbrook said.

Even before the regulations were proposed, companies have been leaving the state. Last year, Talisman Energy, one of the biggest drillers in the Marcellus shale, moved its U.S. headquarters from Buffalo to Warrendale, Pennsylvania.

JOBS VS WATER

Governor Cuomo wants to lift the ban on fracking by next year, hoping to replicate an energy boom which is already underway and creating jobs in neighboring Pennsylvania.

But Cuomo must reconcile a spiraling economy and the need to boost jobs with concerns that fracking is harmful to the environment and New York's precious fresh water.

The New York Department of Environmental Conservation has recommended that no drilling take place within 500 feet of New York's 18 primary aquifers, within 4,000 feet of the New York City and Syracuse watersheds and within 2,000 feet of rivers or streams.

In Pennsylvania, home to part of the Marcellus, the buffer from rivers and streams is 100 feet, with plans to extend this to 300 feet.

Cuomo's motives are clear: allowing fracking in New York could add nearly 55,000 jobs and $1.7 billion in revenue, the DEC said in a report in September.

But, with proposed regulations open to a ninety day comment period, parties are calling for stricter regulations that could leave even more land out of bounds to drillers.

"In a perfect world the setbacks need not be that far, but incidents will happen," said John Williams, a ground water expert at the U.S. Geological Survey.

A blow-out at a Chesapeake Energy natural gas well in Pennsylvania in April caused fracking fluids to spill into local waterways, heightening the debate about the safety of the chemicals used in the process. In New Jersey, just south of New York, fracking has been banned.

The New York City Department of Environmental Protection (DEP) is calling for a seven-mile buffer from elderly underground water pipes that feed the state's major cities and traverse potentially busy drilling areas in the Marcellus.

Under the current proposed regulations, there are no buffers around New York's aqueducts.

"These tunnels were not designed to withstand this type of subsurface activity," said DEP commissioner Carter Strickland in a statement this month. "By the time one knows there is a problem, it may be too late to avoid serious impacts."

Parties have until December to put their comments to the DEC, after which regulations will be finalized. Drilling permits could be issued as early as mid-2012.

"What is interesting is the growing strength and intensity of public opposition to fracking," Eric Goldstein, a lawyer with the National Resources Defense Council, said after attending a public meeting on fracking in Albany this month.

"It would be nonsensical policy to put the priceless water supply infrastructure for half the state's population at risk for the potential gains from fracking."

(Reporting by Edward McAllister; Editing by Alden Bentley)