Evolving Business Models in the natural gas Shales

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1 Oil & Gas Energy Evolving Business Models in the natural gas Shales AUTHORS Bob Orr Alexander Roinesdal While depressed natural gas prices in the US are creating significant difficulties for pure-play natural gas producers, larger and more diversified players are raising their stakes in shale gas plays. Driven by a long-term view of the natural gas market and drawing on their experience in other business segments, the new players are exploring innovative business models to create more sustainable natural gas operations in the shales. To stay competitive, pure-play operators will also need to adapt.

2 The last year has been rough for US natural gas producers. After suffering from lower than expected spot prices in 2011 mostly hovering in the $4.00-$4.50 range producers watched prices plummet in early 2012, in part because of the mild winter, but also because of their high production rate. (Many players are locked into production requirements from acreage lease agreements, joint venture agreements, and supply contracts.) The resulting gas glut pushed prices below $2 in April 2012 before beginning to rebound. Despite the recent uptick, prices remain below breakeven for many shale gas producers. Consequently, cash-flow pressure on pure-play natural gas producers is intense. The capital costs required to produce in the shales are high, and with fewer dollars coming in for every unit produced, or lowered production while waiting for higher prices, many players are feeling the squeeze. That s especially true for the most ambitious operators, which racked up both acreage and debt at a ferocious pace during the shale boom. Not surprisingly, the markets have rewarded operators that have most effectively managed their cash-flow to debt levels; companies with the worst projected cash-flow to debt ratios have lost value since Large Players Growing Share Larger companies with more diversified revenue streams are better positioned to outlast this current price trough. Recognizing the long-term potential of shale gas, International and National Oil Companies (IOCs and NOCs) have spent billions to acquire attractive positions in the shales. In fact, many majors, which had largely left the US, are taking a close look at domestic onshore upstream opportunities for the first time in years. While ExxonMobil s Exhibit 1: Sample Shale Investments by IOCs and NOCs US $ MILLIONS ,000 15,400 1,900 3,375 2,250 1,300 4,700 2,160 4,300 4,400 BP Statoil ExxonMobil Total Statoil Shell SIZE OF INVESTMENT CNOOC Chevron bhpbilliton Statoil Source: Industry journals and press clippings Copyright 2012 Oliver Wyman 1

3 $41B acquisition of XTO is by far the largest, nearly all the other majors and several NOCs have made sizeable investments in the US shales (see Exhibit 1.) A secure domestic energy source, shale gas provides long-term predictability, which is essential if industries are going to retool their infrastructures to utilize this abundant energy supply. As infrastructure changes, demand for shale gas will increase and drive up prices, as will the likely export of Liquid Natural Gas (LNG) to other continents where natural gas prices are significantly higher. However, these market changes will take time, and shale asset holders need to position themselves now to fully reap these projected benefits. The arrival of IOCs and NOCs in the shales will impact the way all shale players operate. At the most basic level, the larger firms will continue to drive the industry toward low-cost operations. These diversified companies are already experienced process optimizers, so they are applying their operational best practices across all shale assets to most efficiently produce natural gas. Because the production process is largely repeatable across the various shale plays, scale amplifies the cost savings. Some operators have even explored Lean Six Sigma techniques, typically used to optimize processes in manufacturing and plants, in their shale operations. Achieving cost leadership will be a key component of success in the shales in the next phase of development. Large shale operators are also exploring other ways to innovate their business models to improve production efficiency, to spark long-term demand, and to prevent service providers from encroaching on their margins to control more of the value chain. These changes are being felt upstream, midstream, and downsteam in the natural gas value chain. Exhibit 2: Changing business models BUSINESS MODELS NATURAL GAS VALUE CHAIN OBSERVATIONS Shale E&P Specialists Integrated Natural Gas Company Integrated Oil & Gas Company Expanded Midstream Model E&P E&P Oilfield Services Midstream Marketing E&P E&P Midstream Midstream Marketing & Trading Marketing Most early entrants in the shales were focused on drilling and producing as soon as possible, with limited attention to price risk or cash flow diversification. Some shale E&P operators, such as Chesapeake, have sought to take a bigger role in marketing gas directly to consumers to increase demand. Some have also brought oilfield services and midstream assets in-house to control costs. Integrated companies are growing their presence in the shales and can take advantage of their trading and marketing arms to secure more stable cash flows. Midstream asset owners can take advantage of cash-strapped E&P companies to assume favorable supply positions and use their storage and logistical assets to seek arbitrage opportunities. Opportunistic Customer E&P Utilities/ Industrial Consumers Large natural gas consumers, such as power generation and industrial companies, could take advantage of small E&P companies current need for cash flow to lock in favorable long-term supply deals. Core business focus Secondary business segments Source: Oliver Wyman Copyright 2012 Oliver Wyman 2

4 Upstream Impacts: Vertical Integration with Oilfield Services and Midstream Operators As part of the effort to control costs, some of the larger operators are pursuing a greater degree of vertical integration of the value chain. As large amounts of natural gas come on-stream in unconventional fields, operators will need substantial new infrastructure to gather the gas and transport it to where it can be commercialized. The costs associated with this midstream segment will have a sizeable impact on the breakeven price and commercial viability of the natural gas being produced. Taking full or joint ownership of the midstream assets can be an effective way to control midstream costs. While many smaller E&P operators lack sufficient capital to play a significant role in the midstream game, the larger operators do not. The trend toward vertical integration may also emerge in oilfield services, though to a more limited extent. High-tech drilling rigs, a requirement for directional shale drilling, as well as other service equipment, such as for fracking, are now in high demand. Shale operators have been funneling more of their margins to the oilfield service companies for the use of this equipment. To control costs, some operators have brought oilfield services partially inhouse. For instance, Chesapeake Energy, the second largest natural gas producer in the US, acquired Bronco Drilling and its 22 drilling rigs for $315 million in April Chesapeake Exhibit 3: Gas Glut Shifts Domestic Drilling Toward Oil Unprofitable economics have led E&P companies to shift their drilling operations toward shale oil and liquid plays. In April 2011, the number of rigs drilling for oil in the US surpassed the number drilling for natural gas for the first time since the mid-1990s. In May 2012, fewer than 500 rigs were drilling for natural gas the lowest amount since ACTIVE US DRILLING RIGS 1,800 1,600 1,400 1,200 1, Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Aug 12 47% Decline since the end of October 2011 Natural Gas Rigs Oil Rigs Source: Baker Hughes North America Rotary Rig Count (August, 2012) Copyright 2012 Oliver Wyman 3

5 already owned 95 rigs through a subsidiary, and also owns an oilfield services company. It seeks to maintain roughly two-thirds of its oilfield service use in-house. Moving service costs in-house may be tempting when utilization levels and day-rates are high, but it adds significant risks in downturns when the service assets are less valuable, or even idle. The majors have withstood these painful experiences with offshore rigs in past cycles, and that experience will likely limit how aggressively they pursue a similar strategy in the shales. Downstream Impacts: Partnering with Customers and Third Parties to Drive Demand In an interesting twist to the traditional onshore E&P model, which focuses primarily on finding and getting gas out of the ground, some shale producers are also taking steps to integrate downstream. Realizing that ending the natural gas glut caused by the shales requires demand growth, certain shale companies are stepping up their efforts to market natural gas to consumers. Chesapeake, for instance, is partnering with GE and Valero to install hundreds of Compressed Natural Gas (CNG) stations to fuel vehicles. Chesapeake also partners aggressively with large fleet operators to encourage switching from gasoline to natural gas to take advantage of the significant price differential. Other natural gas producers, such as EOG and Cabot Oil and Gas, are converting their fleet vehicles to run on CNG and installing filling infrastructure in their local areas. The integrated majors with large shale gas positions, such as ExxonMobil and Chevron, could potentially leverage their existing gasoline site and marketing networks to market CNG directly to consumers. The near-term impact of these initiatives on demand at a national level will be limited (vehicular use accounted for less than 0.2% of US natural gas consumption in 2011). But impressive concentrations of CNG filling infrastructure are emerging in certain regions, such as gas-rich North Texas and Oklahoma. These are encouraging, albeit early, signs for long-term demand. In the near and medium term, however, the largest demand drivers will be industry and power generation. While the traditional shale E&P business model focused almost exclusively on extracting natural gas, newer business models recognize the importance of developing relationships with large customers to help secure demand. Relationship building is key for players hoping to convince their biggest customers to switch from coal and other fuel sources. If operators can offer long-term natural gas supply contracts at a predictable price, customers fears about price volatility (which pushed many consumers away from natural gas in the period) will be alleviated. Large operators will also continue to prod regulators for natural gas incentives, emphasizing the environmental benefits relative to coal and oil. The flip side of this long-term contract dynamic is that current circumstances provide midstream companies and large natural gas consumers the opportunity to capture value by taking advantage of the cash-strapped natural gas producers, particularly those that are smaller and less diversified. Utilities or industrial companies, for instance, can offer Copyright 2012 Oliver Wyman 4

6 Exhibit 4: Slow Hike Back to Breakeven Pricing With spot prices below $3/MMBtu for much of 2012, producing natural gas from the shales has in many cases been unprofitable. Just four years ago, when many players made investments in the shales, prices were above $10. Many producers won t break even until prices top $4 again. BREAKEVEN NATURAL GAS PRICE BY BASIN Apr. 12 Sept. 12 Sept. 13 Marcellus Wet (Core) Pinedale Marcellus Dry (Core) Fayetteville (3.4 Bcf) Granite Wash (Horizontal) Huron Shale Deep Bossier (E. Texas) Past, Current and future natural gas spot prices July 2008 $11.09 April 2012 $1.95 September 2012 $2.85 Futures price September $3.99 Eagle Ford (Condensate Zone) Cana-Woodford (Core) Piceance (Valley-Core) Barnett (Tier 1) Appalachian-CBM Haynesville Marcellus Dry (Tier 2) Eagle Ford (Gas) Fayetteville (2.8 Bcf) Jonah Woodford (Arkoma) Wattenberg (Core) Uinta (Shallow) Picenace (Highlands) Raton (CBM) GOM Shelf Alberta Shallow Gas Warwick (W. Texas Overthrust) Barnett (Tier 2) BREAKEVEN NATURAL GAS PRICE ($/MCFE) 1 As of October 17, 2012 Source: Company data, Morgan Stanley Research, EIA, CME Group Copyright 2012 Oliver Wyman 5

7 producers a stable cash flow to help service debt in exchange for a long-term supply of natural gas at a favorable price. Going one step further, adding both risk and upside, they could seek to take equity stakes in gas-producing assets, with the goal of capitalizing on the current market environment to lock in supply through partial backward integration. More Sophisticated Business Models Ensure Long-Term Positioning The window of opportunity is closing on the most favorable of such deals, as IOCs and NOCs operating in the shales are ushering in business models that are better suited to manage cash flow and liquidity during downturns. Large players don t rely on natural gas as their only revenue stream, and they are also likely to do a better job of hedging and managing their gas cash flow through in-house trading operations. While small pure-play E&P companies typically have very limited in-house marketing capabilities, the small IOCs and NOCs maintain large trading desks and sales operations to secure off-take of their product and hedge price risks. The natural gas glut ensures that companies are no longer rewarded for simply acquiring as much shale acreage as possible and drilling it as quickly as possible. Managing through the cyclical natural gas business requires a smarter business model, with economical drilling operations and a more sophisticated approach to marketing and cash flow management. Larger operators are leading these business model changes, bringing valuable expertise from their other business segments. While the challenges of the current cycle will weed out some operators, those that successfully navigate the current price environment will be well-positioned to reap long-term value from the natural gas shales. Copyright 2012 Oliver Wyman 6

8 About Oliver Wyman Oliver Wyman is a global leader in management consulting. With offices in 50+ cities across 25 countries, Oliver Wyman combines deep industry knowledge with specialized expertise in strategy, operations, risk management, and organization transformation. The firm s 3,000 professionals help clients optimize their business, improve their operations and risk profile, and accelerate their organizational performance to seize the most attractive opportunities. Oliver Wyman is a wholly owned subsidiary of Marsh & McLennan Companies [NYSE: MMC], a global team of professional services companies offering clients advice and solutions in the areas of risk, strategy and human capital. With 53,000 employees worldwide and annual revenue exceeding $10 billion, Marsh & McLennan Companies is also the parent company of Marsh, a global leader in insurance broking and risk management; Guy Carpenter, a global leader in risk and reinsurance intermediary services; and Mercer, a global leader in human resource consulting and related services. For more information, visit Follow Oliver Wyman on Oliver Wyman specializes in helping clients develop and realize customer-focused, market-tested business designs to capitalize on new customer opportunities, defend against emerging competitive threats, and ultimately grow value. Our consultants have deep expertise across the oil and gas value chain and have worked with leading international and domestic oil and gas companies operating in the Americas, Europe, Asia, Africa, and the Middle East. For more information about Oliver Wyman s perspectives on oil and gas business models, please contact your account representative or one of the following partners: David Hoffman Practice Leader David.Hoffman@oliverwyman.com Bob Orr Partner Bob.Orr@oliverwyman.com