Ten Questions for the Global Downstream Industry in 2015

The Great Deflation has created considerable uncertainty within the downstream
sector. In this report, IHS Energy discusses 10 key questions that will set the tone for
our analysis in the coming year.
1. Will US crude export policy change before year-end? Prior to the Great
Deflation, IHS believed that a growing oversupply of domestic light oil would
increase pressure on policymakers to ease restrictions for crude exports. However,
IHS now expects that US crude production growth will grind to a halt by mid-2015,
meaning there is no oversupply pending in the near term and little pressure on
Washington to make a controversial change. The current low price environment
(which is a net positive for consumers) also discourages politicians from doing
something that could be blamed (however erroneously) for increasing gasoline
prices. Then again, politics are nothing if not unpredictable.
2. Will the new low price environment help boost demand quickly? Lower
prices will undeniably provide support to product demand. For example, perhaps
spurred by the low price environment, US sales of pickups and other light-duty
trucks have surged in November and Decembera trend that will affect demand for
years to come. However, working against demand in places such as Japan, Europe,
and the United States are other major structural headwinds (maturing population,
increasing urbanization, and improving vehicle efficiency). Meanwhile, several of the
big developing countries had been increasing their regulated product prices during
2014, such that local prices today are not much lower than they were six months
ago (and in some cases they are higher). For consumers in these markets, there has
been little benefit from the current global price slideand little to provide an
additional boost to demand.
3. Will European refiners receive a stay of execution? Although there are
certainly many well-positioned assets, the European refining sector overall has
struggled in recent years, with negative margins and low utilization the norm for
many facilities. Prior to the Great Deflation, no fewer than five refineries were
publicly on the chopping block for 2015, with several more likely on notice
unofficially. The ongoing low price environment should provide a boost for refiners,
but will it be enough to defer rationalization? After all, most of the at-risk facilities
are owned by large, diversified players that are perfectly willing to offload
underperforming assets. And the European refining industry still faces stiff,
structural headwinds to long-term profitabilitynamely, weak demand and
increasing competition from outside supply.
4. Will Middle East upstream players reevaluate their ambitious downstream
projects? Middle Eastern crude producers have been firmly focused on developing
their downstream sectors as they seek to move up the hydrocarbon value curve.
However, refining projects in these countries have been largely funded by crude
export revenues. High probability projectssome of which are already under
constructionwill bring close to 1 million barrels per day of additional distillation
capacity to the Middle East by the end of 2017. But will these mostly exportoriented refineries, planned at a time of booming economic growth, still be able to
find an outlet for their production in the context of global refining overcapacity and
weak demand in traditional target markets?
5. Will long-planned Russian refining investments be deferred? The
combination of sanctions, falling oil prices, a volatile ruble, and rising export duties
on heavy products is set to give Russian refiners a difficult year. Spurred on by
regulatory and taxation changes, most major downstream players have a significant
(and costly) slate of modernization investments under way and/or on the horizon.

Will Russian players simply delay their much-needed conversion investments,

despite a tax maneuver that will equalize heavy product export duties to those of
crude by 2017? Or will the government yield and delay its long-planned tax changes
yet again? If the tax maneuver is not amended and the low price environment
persists, it would likely compel the closure of several simple, hydroskimming
refineries. The big players will be able to stick it out, albeit with the bare minimum
of refinery investment.
6. Could the events of the past few years convince any companies to
reintegrate? Although there are certainly advantages to specialization, the
robust profitability of the North American downstream sector over the past few
years has made a strong case for integration. And now, with upstream margins
throughout the world falling even with, or perhaps below, the commodity-based
refining margins, it is easier to understand the value of having a hedge against
counter-cyclical volatility. Certain complementary pure-play companies may be
tempted to join forces in an effort to weather the current (and inevitable future)
market volatility. To be sure, a sustained low price environment for any market
sector typically encourages mergers and acquisitions.
7. Will enthusiasm wane for ethanol and other alternative fuels? The US
Renewable Fuel Standard (RFS) was already challenged given the reluctance of the
industry to embrace ethanol blends above the 10% blend wall. Indeed, the US
Environmental Protection Agency has yet to finalize RFS standards for 2014 and
seems in no hurry to do so. Now, with ethanol significantly more expensive than
gasoline and likely to remain so for the coming year, the RFS may be facing an even
more uncertain future. The same uncertainty applies for alternative fuels (and
alternative energy more broadly) throughout the world. Biofuels were already
encountering pushback. Few doubt that hydrocarbon prices will eventually rise
again, but politicians (and voters) can be notoriously short-sighted. Thus, the
current low price environment could certainly affect the prospects for green policies.
8. What are the likely effects of new marine fuel regulations? As of 1 January
2015 the maximum allowable sulfur content of marine fuel burned in Emission
Control Areas (ECAs) has fallen from 1.0% to 0.1%. This affects all ships in the
waters of Northwest Europe and the coastal waters of the United States and Canada
a market of about 350,000 barrels per day (b/d) (or 20 million tons per year). This
tighter specification will most likely necessitate a switch from residual fuel oilbased
marine fuels to gasoil-based ones, as well as result in new, ECA-specific fuels based
on intermediate refinery streams such as vacuum gasoil or atmospheric residues.
There are alternatives to burning 0.1% sulfur fuel, such as liquefied natural gas or
installing exhaust gas scrubbers, but these are unlikely to have a significant impact
in 2015. As a result, an increase in gasoil/diesel demand and a corresponding
decrease in heavy fuel oil demand could be significant, with associated implications
on product pricing and refinery margins.
9. How will pending Latin American refinery additions affect Atlantic Basin
trade flows? Two major Latin American refining projects will be completed over the
next two years: Petrobrass 230,000 b/d Abreu e Lima new build (already partially
operational at end-2014) and the expansion of Colombias Cartagena refinery from
80,000 to 165,000 b/d. Brazil and Colombias addition of a combined 200,000 b/d
proprietary supply of gasoline and diesel will allow them to cut back on US imports,
which have grown dramatically in a decade of booming demand. However, given the
present context of low crude and product prices and regional demand slowdown, it
remains to be seen whether these projects will remain one-off occurrences or will
signal the beginning of longer-term change in the dynamic of Atlantic Basin trade
flows.

10.Will developing countries continue to relax product price controls? Over the
past year, several large demand markets increased their domestic product prices,
loosened controls, or liberalized pricing altogether. This was done in an attempt to
reduce government spending on subsidies or mitigate national oil company losses.
Regulated markets might view the current low price environment as an excellent
opportunity to further liberalize pricingsince they can do so with little to no
immediate impact on price. Eventually, prices will rise organically, but the linkage
between that increase and the policy decision that liberalized pricing will
(hypothetically) be blurred with time. In addition, several of the most subsidized
markets rely heavily on upstream oil and gas revenues. With those revenues now
severely diminished, will their governments feel more pressure to raise domestic
product prices?

Corporate Themes: what to look for in 2015

We assess the challenges facing the Majors, Independents and NOCs in 2015, focusing
on six themes that will shape the corporate landscape: 1) the impact of collapsing oil
prices, 2) managing financial stretch, 3) the industry's cost cutting challenge, 4) the
strategic response of tight oil players, 5) a potential buyers' market in M&A and 6) a
golden opportunity in new ventures.
1. The financial challenge of low prices: lower oil prices pose the biggest threat to
oil and gas industry earnings and financial solidity since the financial crash of 2008.
Brent is now almost 50% below the 2014 average of US$99/bbl (weak currencies may
help translations into , EUR and NoK). More evidence of how this is effecting
performance and strategy will appear in the Q4 results and further pared-back 2015
investment plans. The financial performance in Q1 will deteriorate, as the impact of a
full quarter of low price realisations flows through to earnings. Crude hedging
programmes will provide temporary protection for some for a quarter or two; as will
lagged oil index LNG and European gas contracts which will start to adjust to
December/January crude prices by Q3.
US gas prices have also fallen sharply over the last two months, dragged down by oil
and a mild start to winter. But gas has fared better than oil on a relative basis, and we
expect prices to be closer in 2015 than at any time over the past five years (a gas:oil
price ratio of around 18:1 in 2015, versus 23:1 in 2014). Even so, Henry Hub is now
below the marginal cost for a small number of plays. Upstream asset write downs, gas
and oil, will feature in FY 2014 earnings though will not be universal - IFRS impairment
tests are more challenging than SEC.
Integration will be an effective hedge in the early part of 2015. Refining margins have
bounced temporarily whilst higher demand for gasoline could also boost marketing
volumes, helping support earnings in the next few months at least until crude
stabilises. We could then see European players seize the moment and close excess
refining capacity in the region, targeting lower quartile refineries.
2. Debt management is a critical priority: the fall in revenue will be exacerbated
by higher net debt across much of the sector. Total net debt for the 46 IOCs in Wood
Mackenzie's Corporate Service has risen by 20% (US$53 billion) since 2010 (excludes

conglomerates). The cost of new capital for smaller companies will rise sharply in 2015.
Asset write-downs will lead to higher leverage ratios and increased financial stretch for
some companies. Refinancing could prove difficult in certain cases and covenants
based on reserves, cash flow and market cap ratios could come into play.
International explorers and Australian LNG players took on three quarters of the
additional debt since 2010, funding a major new phase of project investment and
continued exploration. Mid-Cap North American Independents net debt has doubled
since 2010. Lundin, Continental, Range, Pacific Rubiales and Newfield are the
most highly-geared IOCs in our coverage, while NOC Petrobras will also be under
intense financial pressure as it funds pre-salt and downstream developments. Financing
will also be front of mind for Russia's oil champion, Rosneft, as it is frozen out of
western capital markets. In contrast, the balance sheets of many Large-Caps (and some
Mid-Caps) are stable or improved relative to 2010, bolstered by asset sales, portfolio
restructuring and positive cash flow during the last few years. The Majors' average
gearing is a modest 14% and the Large-Caps 18%.
3. Intense cost cutting: the industry will plunge into full-on capital discipline after
dipping its toes in 2014. We estimate companies need to cut costs by US$170 billion or
37% to maintain net debt at 2014 levels at US$60/bbl Brent. Cuts will be spread across
investment in new projects, exploration budgets, operating costs and shareholder
distributions. In 2013/2014 companies were making strategic choices related to
messaging around value versus volume as they tried to increase their appeal to
investors; capital discipline in 2015 will be less about choice and more about survival
for some players. The effects could last well beyond 2015.
Six big greenfield projects were deferred in 2014 for failing to achieve hurdle rates as
rising costs eroded returns. Many more are at risk in 2015 - we estimate US$112 billion
of spend on pre-FID projects in 2015 is vulnerable to being pushed out, and a further
US$145 billion in 2016. Total investment of US$1.2 trillion in this suite of new projects
during this decade could contribute over 7.8 million b/d of liquids alone to global supply
by 2020 (44% of which is US tight oil). Only the most economically robust projects will
proceed, leading to a tighter oil supply/demand balance in a few years. Operators will
push projects back to engineers to reconfigure and cut costs. Service companies will be
under huge pressure to cut supply costs across the value chain, particularly in growth
hot spots like the Lower 48, GoM, Canada and Brazil; but also where investment is
plummeting such as the UK North Sea and Australia.
Dividends and buy-backs made up 25% of total 2014 spend. A lack of free cash flow at
sub-US$60/bbl oil renders the Majors buy-backs highly vulnerable. The Majors will
make every effort to maintain ordinary dividends in 2015 on the assumption that the
collapse in prices is temporary, although dividend per share growth rates are likely to
be modest. Independents will cut dividends hard if low prices persist only a handful
have free cash flow dividend cover at US$60/bbl.
4. Tight oil response under scrutiny: the cost reduction and supply response by
tight oil players to sub-US$60/bbl oil are both big wildcards. Much deeper cuts in spend
will be needed for some players - Continental has already slashed investment by half
to try and balance the books; Chesapeake, Anadarko, Hess and others are likely to
follow and cut aggressively. Further cuts will also be needed by some players that have
already announced 2015 budgets if current prices persist, or deteriorate (Marathon,
Apache). Capital-rich players will be able to drive a hard bargain for play entry and
farm-ins, among them a select group of financially-strong US unconventional
Independents (EOG, Devon and Pioneer) and larger players looking to build long-term

growth platforms.
The current threshold of US$60-US$70/bbl WTI needed to support continued growth in
tight oil supply should also drift lower during the year. Efficiencies and high-grading
could pull near-term breakevens down substantially as companies focus on sweet spots
and halt the drilling of experimental/delineation wells and activity in high cost areas. In
the Bakken alone Wood Mackenzie's North America Supply Chain Analysis Tool
(NASCAT) estimates well costs will fall by 15% in 2015 with a high degree of sensitivity
to short-term oil prices. Combine lower costs with better wells, and tight oil breakevens
in the US could fall by more than US$15/bbl in 2015. Under this scenario, operators will
be doing much more for less, with the potential for greater-than-expected supply and
more downward pressure on prices.
5. Potential for a buyers' market in M&A in 2015: distressed sales asset and
corporate could precipitate the emergence of a true buyers market in 2015. Selling
assets into a market with few buyers will be a last resort. Financially strong players will
put rationalisation programmes on hold but some companies will find themselves with
little choice, unable to achieve the cuts in discretionary spend required to balance the
books. Large-scale corporate consolidation is more likely than at any point since the
late-1990s. History shows that value creation through M&A is largely driven by
commodity prices: for buyers that believe in long-term oil above US$80-90/bbl, 2015
will be a year to go long.
The Majors will weigh up the pros and cons of large-scale M&A; and a first mover could
trigger a wave of deals. Potential targets will be those companies unloved by the
market and/or financially stretched, but holding interests that would address strategic
weaknesses or consolidate in core long-term resource themes such as US tight oil,
deepwater and LNG. Compelling cost synergies and discounted prices will be key to
ensuring investor buy-in.
The Asian NOCs will see opportunities: small to mid-sized acquisitions with long-term
resource themes will be the focus. Independents with the capability to do sizable deals
include ConocoPhillips, Hess, EOG, Murphy, Occidental and Marathon.
Meanwhile, unconventional players and highly geared international E&Ps with big
spending commitments may be forced to merge. Cash rich non-traditional buyers
(private equity, conglomerates, sovereign wealth funds etc.) could also see the heavily
discounted market as a buying opportunity.
6. Is this a golden opportunity for long-term resource capture? it will not be a
vintage year for exploration, but a window of opportunity will open to capture highimpact acreage and discovered resource opportunities. Play-opening discoveries will be
few and far between as scarcer capital is reallocated towards appraisal and higher
returning incremental prospects. Exploration budgets will nose dive, though this will not
have such a profound impact on activity since costs will continue to fall. Seismic will be
cheaper, signature bonuses lower and drilling costs down year-on-year. But a big
unknown is how much and for how long costs will fall many companies will hold fire on
expensive frontier drilling in anticipation that lower drilling and appraisal costs could
materially improve full cycle economics.
New ventures will be the smart thing to focus on. Specialist explorers will continue to
retrench under intense financial pressure, and some will become acquisition targets for
players short on high-impact acreage. The year could be an opportune time for the
internationally active NOCs to get in more on the exploration game, addressing their
lack of exposure and improving long-term portfolio sustainability. Financially strong
Majors and Independents will also focus on new ventures and the capture of high-

potential acreage at low cost.

Mexico and Iran will be under the spotlight as Big Oil seeks to establish new growth
platforms for the next up-cycle, particularly with Russia out of bounds for IOCs. The
downturn could not have come at a worse time for the opening up of the Mexican
industry. There will be greater pressure on the Government to relax the fiscal terms to
ensure that the risk/reward profile is sufficiently attractive to pull in the investment
required. But while low oil prices may constrain the number of bidders, the size of the
prize will still draw in capital from financially strong Majors, Large-Caps and Asian
NOCs. Iran is at an earlier stage, but a breakthrough in sanction talks will see the
industry queuing up for access. Asian NOCs will continue to seize opportunities in
Russia, as the country accelerates its pivot towards the East