Key Macro Factors

Oil and Natural Gas Prices

The overall health of the exploration and production industry is highly dependent on the market price of oil and natural gas. Firms in this industry are price takers; they are forced to sell their products for whatever the prevailing market price is at the time. Because of this, revenues are almost perfectly correlated with the market price of oil and gas.

Oil Prices
The price of oil is a representation of all of the forces that influence its supply and demand around the world. The highly volatile nature of oil prices stems from the face that prices are highly sensitive to changes in supply and demand. Oil Demand The demand for oil is highly dependent on the overall state of the economy. In addition to being used as a fuel for transportation, oil is also used in the manufacture of a plethora of other products. The demand for oil increases during times of economic expansion due to the rise and industrial production. During times of economic contraction, there is a decline in the demand for oil due to decreasing industrial production rates. Chart 1 shows the high degree of positive correlation between the growth of the nominal global GDP and the growth in the global demand for oil. With an R^2 value of 0.953, approximately 95% of the variability in the demand for oil is explained by changes in the nominal global GDP.

Oil Supply OPEC OPEC is an organization that attempts to actively manage the production of its member countries. According to the Energy Information Administration, approximately 40% of the global production of oil comes from the twelve OPEC member countries. Due to their large market share, changes in the amount of oil they supply to the market can have a significant impact on oil prices. Morgan Downey, author of the book Oil 101, says that OPEC spare production capacity acts as a buffer against global oil supply shortages. Periods of low spare capacity place upward pressure on oil prices because a risk premium is built into prices due to the increased probability of supply disruptions. Low spare capacity also results in more volatile oil prices as shortages cant be compensated for by increased OPEC production rates. Chart 2 shows that between 2003 and 2008, low OPEC Spare capacity coincided with extremely high oil prices. Currently, spare capacity levels are the lowest theyve been since 2008. Downey believes that increased global demand,

maturing fields and few new discoveries will cause OPEC spare capacity to continue its downward trend. This will likely lead to higher oil prices and increased volatility in the future. According to the organizations website, OPEC member countries usually meet semi-annually to decide on their aggregate production target and to allocate this target among their individual member countries. The current price and volatility of oil is one of the main factors in deciding on their aggregate production target. Although one of OPECs goals is to reduce unnecessary volatility in international oil markets, their chief concern is with the well being of their member countries. OPEC will not attempt to reduce volatility or high prices if it's detrimental to its member countries. Chart 2 shows that OPEC tends to increase production targets during times of high prices and decrease them when prices are low. In the past, OPEC has had to make several adjustments to their targets before prices started moving in the right direction. The EIA says that OPEC has no power to enforce the individual country quotas that they set. This means that the effect of changing their aggregate production target depends on individual member countries adhering to their quotas. Historically, there has been a significant amount of cheating among OPEC members. National Inventories Inventories serve are similar to OPEC spare production capacity in the sense that they act as a buffer during supply shortages or during times of high demand. An EIA article on national oil storage says that commercial inventories are usually increased whenever there's excess supply and drawn down whenever current demand exceeds current supply. Building inventories usually means that the market expects higher prices in the future.

Geopolitical Events and Natural Disasters Any event that has the potential to disrupt the supply of oil to consumers can affect prices. When there's adequate spare capacity, from producers or inventories, to offset the possible loss, the affect of the event on prices is reduced considerably, says Downey. For example, the release of oil from the US SPR greatly minimized the affects of Hurricane Katrina on oil prices were minimized due to the release of oil from the U.S. Strategic Petroleum Reserve (See Chart 2). Low spare capacity or inventories can magnify the events impact on prices. Usually, the impact of geopolitical events on the price of oil is only temporary. Prices return to normal after the event dissipates and supply flows return to normal. However, events that cause long lasting shifts in the balance between supply and demand can affect prices for indefinite periods of time. For example, during the Asian Financial Crisis of the late 90s, decreased demand from Asian countries suppressed oil prices for several years (see Chart 2).

Current State of the Industry

Industry Performance
Revenues and Production An improving global economy has helped drive oil prices higher since the recent depression. The average realized price of oil that E&P companies received increased from their low of $57.26 in 2009 to $92.84 in 2011 with a CAGR of 27.33% over the three year period. As a result of the rebound in oil prices, industry revenues for 2011 were approximately $897 Billion and grew with a three year CAGR of 26.86%. Chart 3 shows how revenue growth fluctuates with the growth in global GDP. In Chart 3, it's visible that between 2001 and 2011, the percentage of total revenue coming from natural gas has decreased over the eleven year period. Natural gas production accounted for 18.9% of total revenues in 2011 which is much lower than the eleven year historical average of 27.4%. In contrast, Chart 4 shows that both the volume of natural gas produced (BOE) and its share of total production volume have increased over the same eleven year period. A recent IBIS World Industry Report credits this growth in production volume to new development techniques that have allowed E&P companies to produce deposits of gas in previously inaccessible shale formations in the U.S. and Canada. Excess supply from shale deposits has suppressed natural gas prices and has resulted in the decline in revenues from gas production. In 2011, E&P companies produced approximately 19.74 million barrels of oil per day which accounts for 22.33% of total global production. In Chart 4, it is clear that oil production growth has remained relatively flat between 2001 and 2011. The CAGR for oil production during this period was only 0.92%. This stagnant production growth means that increases in revenues from oil production have come entirely from changes in the price of oil.

Industry Trends
Increasing Consumption from China and other developing economies
The long-term, sustained economic growth of China, India, Brazil and Saudi Arabia has resulted in large increases in oil consumption. This large increase in demand has placed upward pressure on oil prices. There is a twofold explanation for the link between increasing economic development of emerging economies and increasing oil consumption. As economies develop, they gradually become more industrialized. As a result, demand for oil as an input for industrial processes increases. Secondly, as countries become wealthier, vehicular transportation begins to become a more feasible option for people; resulting in the increased consumption of oil for transportation purposes. Chart 5 shows that China, India, Saudi Arabia and Brazil were responsible for 11.08%, 3.94%, 3.28% and 3.01% of annual global consumption during the most recent fiscal year, respectively. Combined, these countries accounted for approximately 21.3% of global oil consumption with a combined consumption of 6.84 billion barrels during 2011. This is a 53.12% increase over their combined percentage of global oil consumption in 2000 of 13.90%.

The aggregate nominal per capita GDP of Brazil, India and Saudi Arabia and the nominal per capita GDP of China grew with a 5-Year CAGR of 6.30% and 10.87%, respectively. The aggregate combined oil consumption of India, Saudi Arabia and Brazil along with the oil consumption in China grew with a 5-Year CAGR of 5.56% and 5.70%, respectively(see Chart 5). Demand growth in these four countries greatly outpaced the 5-Year CAGR of -0.01% for global growth in oil demand during the same five year period (2007-2011).
Chart 5: Increasing demand from China and other developing countries, as a result of sustained economic growth, has been a conintuing trend that has placed upword pressure on oil prices
Percentage of global oil consumption(China, Brazil, India, Saudi Arabi % of Annual Global Oil Consumption 20%

9000 8000

China
15%

India Brazil

SA

2.06%
10%

3.94% 11.08%

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2.67% 2.95%

5%

6.22%

Source:BP Statsitcal

1000 0

0%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Between 2000 and 2011, China accounted for 43.67% (1.822 billion barrels) of the 4.172 billion barrel increase in global oil consumption. Chinas contribution to global consumption growth during the period was typically around 30%, but has varied between a minimum of 14.4% to a maximum of 85.2%.

Nominal Per Capita GDP-USD

3.24% 7000 3.01%

In terms of the year over year change in the actual number of barrels of oil consumed daily (Kbbls/Day), global growth in oil consumption consists mainly of growth in these four countries. As seen in Chart 6, a huge percentage of the growth in global oil demand is due to the consumption growth in China.

Around May of this year, there was some concern about slowing oil consumption in China (see Chart 7). Consumption growth began to pick up in August and has been around 3.75 billion barrels per year.
Chinese Oil Demand (MMbbl/Yr)

Chart 7: Chinese oil demand continuing to grow after slowdown around the middle of the year 3800 Rolling 6mo Average Oil Consumption vs Rolling 6mo CAGR 0.02
Chinese Demand Growth Chinese Oil Demand 3700 0.015

3600

0.01 Rolling 6mo CAGR

To help sustain continued economic growth and shield consumers during times of high oil prices, many developing countries have initiated oil consumption subsidies. Oil consumption subsidies in China, India, and Saudi Arabia have helped to continue the strong growth in consumption from these countries during times of high prices.

3500

0.005

3400

3300

-0.005

Source: EIA Data

3200 -0.01

A recent S&P Industry Survey says that the 2010 2011 2012 continuance of high oil prices into the future is heavily dependent on the continued growth in oil consumption of China as well as other developing countries. The strong relationship between Chinese demand and oil prices can be seen in Chart 8. The high R^2 value means that Chinese demand has a high degree of explanatory power in regards to predicting oil prices.
Chart 8: There is a strong relationship between monthly Chinese oil demand and oil prices Chinese oil demand vs Brent Crude Price
4500

4000 3500 3000 2500 2000 1500 1000 500 0 0 20 40 60 80

y = 18.104x + 1545.8 R = 0.7835

100 120 140

To help sustain continued economic growth and shield consumers during times of high oil prices, many developing countries have initiated oil consumption subsidies. Oil consumption subsidies in China, India, and Saudi Arabia have helped to continue the strong growth in consumption from these countries during times of high prices. I feel this adds to the power of Chinese demands explanatory power in predicting oil prices.

Growth in global oil demand would be stagnant without the growth in consumption from these countries, which would eliminate the current upward pressure on oil prices. This means that the future growth of the exploration and production industry is highly sensitive to changes in the economic growth of China and other developing countries.
Brent Crude Price

Bottleneck at Cushing is Causing the Price Differential between Brent and WTI
Since 20010, WTI has been trading at a discount to Brent. The spread is currently around $22.00 a barrel but in the past has widened to as much as $27.31 a barrel in November of last year. In Chart 09, you can see that Brent-WTI spread oscillated around parity prior to 2010 Cushing inventory levels surged during 2010 because of large production growth from North Dakotas Bakken field and the Canadian oil sands.

Chinese Oil Demand (MMbbl/Year)

According to a recent S&P Industry Report, Cushing was designed to get oil from the Gulf of Mexico and Canada to refineries in the Midwest. This means that most of the pipelines connected to Cushing are set up to flow in the wrong direction to send oil anywhere except refineries in the Midwest. Refiners in the Midwest dont have enough capacity to handle the amount of oil thats flowing into Cushing each month and there is not enough pipeline capacity to get the oil to refineries in the gulf. This bottleneck has caused the Midwest to become greatly over supplied with oil. The substantial discounts of WTI to Brent have resulted from this oversupply.

Chart 9: Bottleneck at Cushing is causing WTI to trade at a discount to Brent 60000 WTI differential and Cusing Inventory(Kbbls)
50000 Cushing Inventory(Kbbls) 40000 30000 20000 10000 Source: EIA Data 0
Jan-08 Mar-07 May-06 May-09 Mar-10 Dec-05 Sep-04 Feb-05 Jan-11 Nov-08 Nov-11 Aug-07 Aug-10 Sep-12 Apr-04 Jul-05 Apr-12 Oct-06 Oct-09 Jun-08 Jun-11

30 25 20 15 10 5 0 Brent-WTI Spread

Midwest Field Production-Left Axis Cushing Inventory-Left Axis WTI-Brent Differential-Right Axis

Brent-WTI Parity

-5 -10

In November of 2011, Enbridge announced that they would reverse the flow of their Seaway pipeline that connects Freeport, TX to the Cushing hub. According to a recent Alliance Bernstein report on oil prices, the reversal of the pipeline is the first stage in a multi phase project that will add 150 Kbbls of pipeline capacity from Cushing to the Gulf Coast. Upon news of the announcement, the spread shrunk from approximately $23/bbl to around $10/bbl, but rebounded back to $20/bbl a few months later. The announcement is marked in Chart xx by the yellow shaded circle. Enbridge completed the first phase of the project in May of 2012 (green circle). This caused the spread to shrink from $16.50/bbl to a low of $12.86 in July. Since July, the spread began to grow and is currently around $22.00 a spread. After the completion of the reversal, inventories at Cushing began to drop until reaching a bottom of 30.4 million billion barrels in October (black arrow). After bottoming out, inventories have shot back up to almost 40 million barrels of oil. It is clear that the WTI differential has closely tracked inventory levels since completion of the reversal. This leads me to believe that the reversal of the Seaway did not add enough capacity to end the bottle neck at Cushing. According to Alliance Bernsteins research, the WTI differential should narrow as new pipeline capacity comes online. This new capacity will come from two possible sources: Additional phases of the Seaway project and TransCanadas Keystone XL pipeline. Phases two and three of the Seaway project are scheduled to be completed by the middle of 2014 and are expected to provide an additional 700,000 BPD of pipeline capacity. TransCanada is planning on re-applying for a presidential permit to construct their Keystone XL pipeline. If the project is approved, management expects the project to be completed by 2015 and to add an additional 510,000 BPD of pipeline capacity.

33 32.5 32 API Density 31.5 31 30.5 30 29.5

Chart 10: Oil input at refineries is getting heavier and more sour. This implies that cheap, easy sources of light/sweet crude are likely long gone.
API Density and Sulfur Content(% Weight)

1.6 Sulfur Content (% by Weight) 1.5 1.4

Light, sweet crude getting more difficult and expensive to find

Chart 10 is a plot of API density and the sulfur content of crude being used in factories in the U.S. You can see that as time has passed the density of the average barrel used in refineries has increased.

API Density Sulfur Content Density Increasing

1.3 1.2 1.1 1

Source: EIA Data 1985 1987 1989 1990 1992 1994 1996 1998 2000 2001 2003 2005 2007 2009

0.9 0.8

According to Oil 101, heavier oils have higher densities because they're hydrocarbon molecules contain more molecules than lighter oils. Heavier crudes are more difficult to turn into higher valued items like gasoline and diesel. This means that heavier crudes trade at a discount to lighter crudes. This translates into fewer revenues for those companies who have assets producing heavy oil. Rising sulfur content is also a sign of decreasing oil quality. Oil 101 explains that sulfur molecules take up space that could be occupied by hydrocarbon molecules and that this decreases the energy content of the oil. In addition, Environmental regulations force refiners to remove sulfur from many of their finished products. Both of these things mean that crudes with higher sulfur will trade at a discount to sweeter crudes. All of the cheap and easily recoverable sources of light sweet crude have already been recovered. This means that as time passes, the cost of finding the additional marginal barrel of oil will increase while its quality will go down.
Chart 11:Companies are having to look deeper and pay more as the shallower, cheaper and easier plays are all gone
Avg Feet Per Well (Exp. and Dev.) and Avg. Real Cost for Drilling a Well 7000 6500 6000 5500 5000 4500 4000 3500 Exploratory wells much deeper Avg. Real Dollar Cost per Well Avg. Ft.-Exp. Well Avg. Ft-Dev. Well Out of cheap, eassy sources here? 4,000.00 3,500.00 3,000.00 2,500.00 2,000.00 1,500.00 1,000.00 500.00 Cost of Wells Drileld in Real USD-1000's

Feet per Well

Source: EIA Data

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The mature nature and high degree of competitiveness between participants in this sector means that it's extremely unlikely that there are any major discoveries just lying out in the open. Companies are going to have to spend a lot to find new sources of oil and gas in the future. Chart 11 shows how companies have had to dig deeper and pay more to find new sources of hydrocarbons. With the exception of the late 70s it appears that well costs were fairly flat until 1994. It's at this point that the cost of drilling wells really started to increase. Between 1994 and 2007, the average real costs of drilling wells increased with a CAGR of 15.93% Also notice on Chart 11 how much deeper exploratory wells were compared to development wells. This large difference means that although companies were undoubtedly finding oil this deep, it just wasnt economical to develop these sources at that period in time. This gap started to decrease after 1994 as companies started to develop sources that were growing deeper. The combination of increasing well costs and deeper developmental wells leads me to believe that the early to mid 1990s was the end of easy to find oil.

Unconventional Oil and Gas in the US

Unconventional resources are one of the biggest things occurring in the industry right now. In a 2011 industry report, Alliance Bernstein analysts compared the importance of unconventional resources to the oil and gas industry to that of the power loom and assembly line for the textile and manufacturing industries. Unconventional resources are the area that holds the most future growth potential for the industry. The Basics A point I would like to make to start off with is that when people talk about shale oil, they're talking about tight oil. Shale oil is just source rock (kerogen) that hasnt been turned into oil yet.

2005

The book Oil 101 describes tight oil as oil that is trapped inside of a source rock due to the low porosity and permeability of the source rock. In order for there to be oil or gas present in the source rock, it has to be at the right temperature and pressure for the right amount of time to be converted into oil or gas. This optimal set of conditions is known as the oil window for oil and gas window for natural gasses. Kerogen is source rock that isnt exposed to these optimal conditions. The low porosity and permeability of the source rock means that if it is drilled into, no resources will be able to flow. In order to be able to recover oil or gas from the well, it has to be completed with hydraulic fractures. Fracturing involves pumping water, chemicals and sand down a well bore at extremely high pressures. This creates fractures throughout the source rock that act as passageways for oil and gas to flow through. Pay zones are usually quite thin and require a great deal of precision to be able to hit them. Horizontal and directional drilling technologies are typically used because they allow you to steer the bit as your drilling. This gives you the ability to access a tremendous amount of resources by allowing you to drill a narrow pay zone for very long distance. Unconventional Trends Sustained $2-$3 natural gas prices have caused exploration and production companies to focus on more liquids rich plays. Alliance Bernstein researchers say that the Bakken, Niobrara, and Eagle Ford shale plays are becoming increasingly popular because they produce a lot more crude oil and natural gas liquids than dry gas. Chart 12 shows the increasing number of rigs drilling for oil over gas as companies make the switch.
Chart 12 :Shifting focus from gas to oil due to low natural gas prices
Number of Oil Rigs and Gas Rigs Operating in the US Oil Rigs in Operation Gas Rigs in Operation

1800 Number of Rotary Rigs in Operation 1600 1400 1200 1000 800 600 400 200 0

Shale Oil Boom

Source: EIA Data

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