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Barclays Capital - US shale energy

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Modest economic and equity market effects set to grow over time

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									                                                                                                                        Cross Asset Research
                                                                                                                                     16 May 2013

US shale energy
Modest economic and equity
market effects set to grow over time
                                                                                                     Economics Research
• Dramatic changes in US energy markets as a result of the revolution in oil and
                                                                                                     Dean Maki*
    natural gas drilling technologies have led to a direct, albeit modest, boost to US               +1 212 526 1731
    GDP and industrial production. Lower natural gas prices could have significant                   dean.maki@barclays.com
    indirect effects on the economy, particularly benefiting US households and
    manufacturers, and the direct and indirect effects will likely grow.                             Commodities Research - Oil
                                                                                                     Helima Croft*
• A two-stage process, first demand- then supply-led, has brought about a halving                    +1 212 526 0764
    in US oil imports since 2007 to the current 6-7mb/d. Further strong growth in                    helima.croft@barclays.com
    tight oil and modest increases in other components of US oil output should more
    than offset a modest move up in demand over the rest of this decade, but even so,                Kevin Norrish*
    we expect the US to remain a net importer of crude oil of 5-6mb/d by 2020.                       +44 (0)20 7773 0369
                                                                                                     kevin.norrish@barclays.com
• Natural gas supply in the US has surged, driven by the successful deployment and
    continued refinement of horizontal drilling and hydraulic fracturing. This has not,              Commodities Research - Natural Gas
    however, been matched by demand, and prices have dropped to levels that                          Biliana Pehlivanova*
    displace coal in power generation. This dynamic will likely remain key to balancing              +1 212 526 1170
                                                                                                     biliana.pehlivanova@barclays.com
    the gas market in the foreseeable future.

• In the near term, we expect a modest effect on US equities from shale. Lower                       Equities Research
    energy costs create competitive advantages for select industries (e.g., refiners and             Barry Knapp
    chemicals), but the decision to relocate the bulk of global manufacturing should                 +1 212 526 5313
                                                                                                     barry.knapp@barclays.com
    be driven by non-energy factors. We prefer capex beneficiaries – major service
                                                                                                     BCI, New York
    companies and pipeline infrastructure – to more commodity-leveraged positions.
    However, US refiners offer attractive risk/reward.                                               Eric Slover, CFA
                                                                                                     +1 212 526 6426
Economics
                                                                                                     eric.slover@barclays.com
A modest direct boost to GDP and job growth                                             2            BCI, New York
In the near term, we expect the effects of increased production of oil and natural gas to
                                                                                                     www.barclays.com
increase aggregate output modestly, with the effects likely to grow over time.

Commodities                                                                                          *This author is from the Fixed Income,
                                                                                                     Currencies and Commodities Research
US to remain a major net oil importer, despite fast growth in tight oil production    6              department and is not an equity research
Even in a relatively supply optimistic and demand pessimistic scenario, we project that              analyst.
the US oil import gap will still be above 5 mb/d by 2020.

Technology unlocks a gusher of natural gas                                        11
The US natural gas industry has flipped from one that was expected to be increasingly
import dependent to one that is fast reaching self-sufficiency.

Portfolio Strategy
US Equities: Expect a modest effect from US shale                                 16
We prefer capex beneficiaries—oil services and pipeline infrastructure—to more
commodity leveraged positions. However, US refiners offer attractive risk/reward.
Barclays Capital Inc. and/or one of its affiliates does and seeks to do business with companies
covered in its research reports. As a result, investors should be aware that the firm may have a
conflict of interest that could affect the objectivity of this report.
Investors should consider this report as only a single factor in making their investment decision.
PLEASE SEE ANALYST(S) CERTIFICATION(S) BEGINNING ON PAGE 23
FOR IMPORTANT FIXED INCOME RESEARCH DISCLOSURES, PLEASE SEE PAGE 23
FOR IMPORTANT EQUITY RESEARCH DISCLOSURES, PLEASE SEE PAGE 23
Barclays | US shale energy: Modest economic and equity market effects set to grow over time


ECONOMICS RESEARCH

                                               A modest direct boost to GDP and job growth
Dean Maki*                                     • Dramatic changes in US energy markets as a result of the revolution in oil and
+1 212 526 1731                                   natural gas drilling technologies have led to a direct, albeit modest, boost to US GDP
dean.maki@barclays.com                            and industrial production.

*This author is from the Fixed
                                               • However, lower natural gas prices could have significant indirect effects on the
                                                  economy, benefiting US households and businesses in the manufacturing sector in
Income, Currencies and
                                                  particular, and the direct and indirect effects are likely to grow in the coming years.
Commodities Research
department and is not an equity                • In the near term, increased production of oil and natural gas should increase
research analyst                                  aggregate output, but once the economy returns to full employment, the lasting effect
                                                  on the economy will depend on how much the energy boom lifts productivity growth.

Softer demand and rising                       The changes in the oil and natural gas markets (discussed in detail in later sections in this
production have led to a                       report) have had a significant effect on a number of macroeconomic indicators, such as
narrowing real US petroleum                    trade, industrial production, employment, and inflation. The decline in US petroleum
deficit                                        demand and the rise in US petroleum production have affected the real US trade balance.
                                               The real trade deficit in petroleum products has narrowed from 1.9% of GDP in Q4 05 to
                                               0.9% in Q1 13 (Figure 1). Over this period, the real nonpetroleum goods deficit has also
                                               narrowed, leaving the overall real goods trade deficit at 4.1% in Q2 12, down from 6.3% in
                                               Q4 05. This has not occurred in a straight line, as the fall-off in import demand during the
                                               recession caused the nonpetroleum deficit to narrow sharply, and this deficit has widened
                                               along with the rise in imports as domestic demand has increased. Overall, the improvement
                                               in the real petroleum trade balance is the largest factor in the narrowing in the overall real
                                               trade deficit since Q4 05.

This has been largely offset by                The picture looks different when we include the effect of price changes by focusing on the
rising petroleum prices, leaving               nominal trade deficit (Figure 2). The nominal petroleum deficit has narrowed only slightly
the nominal petroleum deficit                  compared with Q4 05 (1.7% of GDP, versus 2.1% in Q4 05), as an increase in petroleum
little changed                                 prices has partly offset the narrowing in the real deficit. The overall goods trade deficit is
                                               narrower than in Q4 05, but this has been due mainly to a narrowing in the nonpetroleum
                                               deficit. Thus, the improvement in the real petroleum deficit has been notable, but higher
                                               energy prices mean that the nominal petroleum trade deficit has narrowed less.


FIGURE 1                                                                     FIGURE 2
Real petroleum deficit has been narrowing…                                   …but the nominal petroleum deficit has widened

                  Real goods trade balance % GDP                                               Nominal goods trade balance % GDP
  0.0                                                                          0.0

 -1.0                                                                         -1.0

 -2.0                                                                         -2.0

 -3.0                                                                         -3.0

 -4.0                                                                         -4.0

 -5.0                                                                         -5.0

 -6.0                                                                         -6.0

 -7.0                                                                         -7.0
        00 01 02 03 04 05 06 07 08 09 10 11 12 13                                    00 01 02 03 04 05 06 07 08 09 10 11 12 13
                    Total          Petroleum          Nonpetroleum                               Total          Petroleum   Nonpetroleum

Source: Census Bureau, BEA, Haver Analytics                                  Source: Census Bureau, BEA, Haver Analytics

16 May 2013                                                                                                                                 2
Barclays | US shale energy: Modest economic and equity market effects set to grow over time


Rising petroleum and natural                  The increase in drilling has also lifted GDP growth through a significant pickup in
gas exploration have given a                  investment in petroleum and natural gas exploration and wells, having risen as a share of
modest boost to GDP and                       GDP from 0.48% in Q4 09 to 0.97% in Q1 13 (Figure 3), adding 0.1-0.2pp per year to GDP
industrial production                         growth over this period. The rise in oil and gas production also has had a notable effect on
                                              the industrial production figures. The relative importance of oil and gas extraction in
                                              industrial production has risen in recent years from the low single digits to 10.3%, though it
                                              remains below the peaks of 1982 and 2008, Figure 4. Crude oil extraction represents about
                                              5.5% of industrial production, while natural gas extraction represents 4.5%.

The boom in drilling has                      The increases in crude oil and natural gas extraction and oil and gas pipeline construction have
been a modest help to                         also led to additional jobs. Oil and gas extraction employment has grown 65k since the end of
US job growth                                 2005, while jobs in support activities for oil and gas extraction have climbed 138k and those in
                                              oil and gas pipeline construction have risen 61k over this period. These gains are particularly
                                              noteworthy because overall US employment has risen only 618k since the end of 2005. Still,
                                              these direct effects are modest relative to the current pace of labor market improvement; for
                                              example, the three categories combined have added about 3k per month to job growth over
                                              the past year, whereas overall jobs have increased an average 173k per month.


                                              Indirect effects on activity are harder to measure but could be significant
                                              The direct effects of increased energy production on US GDP and job growth are real, easy
                                              to document, but modest in the context of the overall economy. It is harder to document
                                              the indirect effects on activity. What are these indirect effects? The rise in drilling leads to
                                              lower energy prices, all else equal, which gives households and businesses more money to
                                              spend on other things. In addition, cost advantages associated with the lower prices can
                                              induce firms to locate production in the US that otherwise would have occurred elsewhere.

US households and businesses                  The indirect benefit of the increase in oil production on costs is probably relatively modest;
have benefited from lower                     the higher US production is unlikely to lower oil prices dramatically, since these are set in a
natural gas prices                            global market and the rise in US production is only one of many factors affecting global oil
                                              production. However, on the natural gas side, the effect on prices is much larger because it
                                              is mainly a domestic market. The PPI and CPI for natural gas have fallen since 2011 (Figure
                                              6), partly because of the increased natural gas extraction associated with the new
                                              technology. These cost savings for firms and households free up cash to be spent elsewhere
                                              or saved (and spent in the future). Of course, we cannot tell which dollar saved on natural
                                              gas is spent where, but the cost savings are a way that the standard of living of households
                                              is increased, and many businesses presumably are more profitable with lower input costs.

FIGURE 3                                                                    FIGURE 4
Energy investment has been increasing                                       Oil and gas drilling share of production has risen

 2.0             Oil and natural gas investment as a % GDP                     %                           IP: Relative importance
 1.8                                                                          14

 1.6                                                                          12
 1.4                                                                          10
 1.2
                                                                               8
 1.0
                                                                               6
 0.8
 0.6                                                                           4

 0.4                                                                           2
 0.2                                                                           0
 0.0                                                                               72 75 78 81 84 87 90 93 96 99 02 05 08 11
       59   64     69   74     79   84   89     94   99   04   09                        Oil and gas extraction        Crude oil     Natural gas

Source: BEA, Haver Analytics                                                Source: Federal Reserve, Haver Analytics

16 May 2013                                                                                                                                        3
Barclays | US shale energy: Modest economic and equity market effects set to grow over time


Low natural gas prices give US                The US manufacturing sector is a primary beneficiary of these cost savings. As discussed
manufacturers a competitive                   below, US manufacturers pay less for natural gas than their competitors in other major
advantage                                     developed economies, and presumably firms in those industries that use natural gas heavily
                                              on the margin are more likely to locate facilities in the US than elsewhere. Also, US electricity
                                              costs are somewhat lower than those in other major developed economies, which also
                                              should provide some incentive to locate production in the US. However, it is not possible to
                                              measure how much of this incremental shifting in production has taken place. To date, the
                                              aggregate effect is likely relatively modest, given that overall manufacturing growth has
                                              slowed, rather than picked up, in recent months (Figure 7). This suggests that whatever
                                              boost the manufacturing sector has received from this source has been overwhelmed by
                                              the slowdown in global and domestic demand.


                                              Economic effects likely to grow
The real petroleum deficit                    So far, therefore, the positive effects on GDP and employment growth of shale drilling appear
should narrow further in the                  to be modest. However, there is good reason to expect them to grow larger in the coming
coming years as production                    years. We think increased oil drilling will further reduce net oil imports in the coming years,
ramps up                                      which means that the real petroleum deficit should continue to shrink. Whether this also
                                              reduces the nominal petroleum deficit depends on the path of oil prices in the coming years.
                                              But in our forecast, the US will continue to become gradually less dependent on foreign oil,
                                              although not near complete independence by 2020. The reduced dependence makes the
                                              economy somewhat less sensitive to oil price shocks, but we expect the import share to
                                              remain large enough that large oil shocks would still have the potential to derail US growth.
                                              Even if the US achieves energy independence in coming years, the macroeconomic effects of
                                              this may not be as large as commonly perceived. As discussed earlier, the US petroleum deficit
                                              is 0.9% of GDP in real terms. Some of the more optimistic assessments suggest that the US
                                              might achieve a neutral petroleum balance by 2030; closing the deficit over this time frame
                                              would involve additional growth from this channel of only 0.05pp per year (though this does
                                              not include the effects of additional investment spending or consumption associated with
                                              increased energy production). In any case, the US economy would not be immune to supply-
                                              driven global energy price spikes even if the petroleum trade deficit were to be erased.
                                              Consumers tend to cut back in the face of an energy price spike much faster than energy
                                              producers tend to spend the additional revenues, so the overall economy would still likely slow
                                              in the face of an energy price spike. This is why the global economy tends to decelerate when
                                              confronted with supply-driven energy price spikes, even though by definition it has no
                                              petroleum trade deficit or surplus.


FIGURE 5                                                                     FIGURE 6
Employment in oil and gas drilling has surged                                Firms and households paying less for natural gas

  employment, thous                                                            y/y % chg                         Natural gas prices
 350                                                                           80
 300                                                                           60
 250                                                                           40
 200                                                                           20
 150
                                                                                0
 100
                                                                              -20
  50
                                                                              -40
    0
        72 75 78 81 84 87 90 93 96 99 02 05 08 11                             -60
                         Oil and gas extraction                                     04    05     06         07     08       09   10    11   12   13
                         Support activities for oil and gas extraction
                                                                                                                      CPI        PPI
                         Oil and gas pipeline construction
Source: BLS, Haver Analytics                                                 Source: BLS, Haver Analytics

16 May 2013                                                                                                                                           4
Barclays | US shale energy: Modest economic and equity market effects set to grow over time


Oil and natural gas drilling                     Shale oil and natural gas drilling seems likely to have an increasingly large effect on US
should provide a more                            investment spending, GDP, and employment growth in the coming years. For example, the
significant boost to investment                  completion of export facilities for natural gas is likely five years away, but the investment
spending in the coming years                     spending to construct those facilities could rise notably over the next several years if
                                                 regulatory approval is secured. Similarly, there may be a gradual increase in investment
                                                 spending as manufacturers seek to exploit the lower natural gas costs in the US relative to its
                                                 major competitors, as well as the lower electricity prices that are, in part, the result of lower
                                                 natural gas costs. In addition, there is likely to be greater investment in technologies that use
                                                 natural gas rather than more costly fuels, such as the conversion of truck fleets to run on
                                                 natural gas.

While the US economy is below                    In thinking about the effects of additional oil and natural gas production on output and jobs in
full employment, increased                       the US, it is useful to consider two situations. When the economy is short of full employment,
activity from the energy boom                    the increased output is likely to boost aggregate GDP and employment through both direct
should directly boost overall                    and indirect effects. However, once the economy is at full employment, increased energy
GDP and job growth                               activity is likely to come at the expense of other activities in the economy, unless it raises the
                                                 overall level of productivity. This is because as the increased activity helps push the economy
                                                 above full employment, the Fed would gradually need to reduce accommodation to guide the
                                                 economy back to full employment to prevent inflation from rising above target.

Once the economy returns to                      Thus, when the economy is at full employment, the rise of shale drilling technology is perhaps
full employment, the lasting                     best thought of in the same vein as other technology shocks. They increase productivity as
effect of the energy boom will                   firms figure out ways to take advantage of lower cost methods of doing business. Similar to
depend on how much it lifts                      other productivity shocks, this is likely to allow the economy to grow somewhat faster without
productivity growth                              generating inflation than it would without the shock. However, it is not necessarily the case
                                                 that this will lead to an increase in aggregate productivity growth, which is the sum of not only
                                                 this shock but many other technological shocks. So far, there is not much evidence that shale
                                                 energy development has lifted overall productivity growth much; as after a typical post-
                                                 recession spike, productivity growth appears to be settling in to a trend much like the previous
                                                 cycle (Figure 8). This will be one way to monitor the long-run effect of the energy boom on
                                                 the US economy in the coming years. The boom in technology eventually led to higher
                                                 productivity growth in the late 1990s, which was one factor allowing the economy to grow
                                                 faster than in earlier periods without generating inflation. An important question will be
                                                 whether the energy boom has any similar effects; to track this in the coming years, we suggest
                                                 focusing on whether this technology is able to increase overall productivity growth.



FIGURE 7                                                                        FIGURE 8
US manufacturing growth has slowed                                              No sign of a pickup in productivity growth yet

  y/y % chg, mthly                                                                y/y % chg, qtrly             Nonfarm output per hour
                           Manufacturing production                               7
  15
                                                                                  6
  10
                                                                                  5
   5                                                                              4

   0                                                                              3
                                                                                  2
  -5
                                                                                  1
 -10
                                                                                  0
 -15                                                                             -1

 -20                                                                             -2
       90            95            00               05          10                    90             95              00               05   10
Source: Federal Reserve Board, Haver Analytics                                  Source: Bureau of Labor Statistics, Haver Analytics


16 May 2013                                                                                                                                      5
Barclays | US shale energy: Modest economic and equity market effects set to grow over time


US COMMODITIES RESEARCH - OIL

                                    US to remain a major net oil importer, despite
                                    fast growth in tight oil production
Helima Croft*                       • A two-stage process, first demand- then supply-led, has brought about a halving in
+1 212 526 0764                        US oil import requirements since 2007 to the current 6-7mb/d.
helima.croft@barclays.com
                                    • Further strong growth in tight oil and modest increases in other components of US
Kevin Norrish*                         oil output should more than offset a modest move up in demand over the rest of this
+44 (0)20 7773 0369                    decade, but even so, we expect the US to remain a net importer of crude oil of
kevin.norrish@barclays.com
                                       5-6mb/d by 2020.

*This author is from the Fixed      • The reduction in oil import volumes is likely to lend support to US plans to shift some
Income, Currencies and                 defense assets from the Middle East to the Asian theatre, though it will likely
Commodities Research                   continue to provide security guarantees for regional allies and protect vital shipping
department and is not an equity        lanes in the event of a crisis
research analyst
                                    This section assesses the outlook for US crude oil balances and import requirements of the
                                    surge in US shale oil output and the implications of its growth for US foreign policy,
                                    especially in the Middle East.

                                    There is some confusion about the similarly named oil shale and shale oil. Shale oil is the
                                    widely used term for the majority of unconventional light sweet oil that has recently surged
                                    in popularity in the US and is extracted in a similar way to some natural gas: by fracking or
                                    horizontal well drilling. Oil shales, on the other hand, are abundant but extremely heavy
                                    kerogen-rich formations. Although oil shales could in theory be used for the same purpose
                                    as shale oil (and crude in general), the economics for extraction and refining keep this
                                    energy source uncompetitive. In the interest of clarity and keeping with industry
                                    nomenclature, we shall refer to shale oil as tight oil in this piece.

                                    After over 100 years as a net exporter, the US became a net importer of oil (crude and
A turning point for the
                                    products) in 1970. That watershed was followed by a trend over the course of four decades
US oil import gap in 2007
                                    over which the import gap increased, peaking in some single months above 13 mb/d.
                                    However, after the long move up, the oil import gap reached a significant turning point in
                                    2007 (Figure 1). Over the past five years, the gap has closed 5-6 mb/d, from a 2007 average
                                    of just over 12 mb/d to the most recent readings of 6-7mb/d mark. Within the overall deficit,
                                    the US has, in recent quarters, been running a trade surplus for liquid oil products (combined
                                    with petroleum coke), which is offset and somewhat dwarfed by the size of its continuing
                                    crude oil deficit. To a large extent, the move into a position of net oil product exporter is
                                    somewhat irrelevant, as it simply denotes that domestic refining capacity is large relative to
                                    domestic demand. Net oil product exporter status is not in itself a measure of domestic energy
                                    availability or a metric for the degree of energy independence. For example, while completely
                                    dependent on imported oil for its own consumption, Singapore is a large oil products exporter.
                                    It is the overall reduction of the import gap as shown in Figure 1 that is of importance, not the
                                    composition of the gap between products and crude.




16 May 2013                                                                                                                        6
Barclays | US shale energy: Modest economic and equity market effects set to grow over time


A demand-led process has               The reduction in the import gap has come in two discrete stages. The first was a demand-
become supply-led in the               led process. Over the first couple of years of the process, leading up to mid-2009, the
compression of imports                 primary reason for reduced net imports was the significant slide in the level of domestic oil
                                       demand (Figure 2). Sharp falls in US oil demand began in late 2007, gained pace in early
                                        2008, and became even more severe after the onset of the financial crisis in September
                                        2008. From 20.6 mb/d in May 2007, demand fell to as low as 18.2 mb/d in May 2009. Since
                                        then, the overall trend has been sideways to slightly down, with a recovery in 2010 hauled
                                        back in 2011 and a further weakening in 1Q12, due to abnormally mild winter conditions. In
                                        1Q13, US demand has so far been on a rough par with 1Q10 (about 18.9 mb/d), reinforcing
                                        the view that after the large initial contribution, the demand side has not played a significant
                                        role in the further narrowing of the import gap over the past three years.

                                       The second stage has been supply led (Figure 2). The low points in US oil liquids supply
                                       (including crude oil, natural gas liquids, and biofuels but excluding the volumetric gain
                                       made during the refining process) came in the wake of the hurricanes in 2005 (a low of 6.1
                                       mb/d in September 2005) and 2008 (when the September total hit just 6.2 mb/d,
                                       compared with a then-normal level of about 7.5 mb/d). A sustained period of net oil liquids
                                       supply growth began in 2009, and then accelerated through 2010 and 2011. In late 2011,
                                       the total surged past 9 mb/d and then past 9.5 mb/d in 2012 to stand at about 10.3 mb/d
                                       today. The cumulative rise since early 2009 is close to 2 mb/d, emphasizing the extent to
                                       which reduction has morphed from being a demand-led process to a supply-led one.

Crude oil has recently started         The 3.1 mb/d overall rise in US oil liquids supply since the start of 2007 can be divided into
making up the largest part of          three main elements, the relative scale of which is shown in Figure 3. The largest
oil supply growth                      component is crude oil, which stands just above 7 mb/d, one of the highest recorded levels
                                       – similar numbers were last seen in 1994. First, crude oil has made up 64%, or just under 2
                                       mb/d. Not very long ago, this proportion was lower than 50%, but as tight oil producers
                                       develop new fields and drill new wells, there tend to be focused on crude rich plays (many
                                       with over 90% crude levels). Second, natural gas liquids (NGLs), ie, liquids extracted from
                                       wet natural gas production, have made up 21% of the increase, or 0.64 mb/d. Finally, 15%
                                       of the rise since the start of 2007, or just under 0.5 mb/d, has come from other elements,
                                       primarily corn ethanol. This last element is no longer as dynamic a source of growth as it
                                       once was. Indeed, there has been no growth in it over the past year, and we do not expect it
                                       to make up a significant proportion of the overall rise in output in the period to 2015.




FIGURE 1                                                              FIGURE 2
US crude oil & refined prod. net imports, 1994-2012, mb/d             US oil demand and output, 1991-2012, mb/d
 14.0                                                                 22            US oil demand, mb/d                               11
                                                                                    (LHS)
 13.0                                                                               US oil liquids output,
                                                                      21            mb/d (RHS)                                        10
 12.0

 11.0                                                                 20                                                              9

 10.0
                                                                      19                                                              8
  9.0

  8.0                                                                 18                                                              7

  7.0
                                                                      17                                                              6
  6.0

  5.0                                                                 16                                                              5
        94        97         00   03       06       09       13            94    96     98      00     02    04   06   08   10   12
Source: EIA, Barclays Research                                        Source: EIA, Barclays Research


16 May 2013                                                                                                                               7
Barclays | US shale energy: Modest economic and equity market effects set to grow over time


FIGURE 3                                                                         FIGURE 4
US oil liquids output by type, mb/d                                              Change in crude output, 2007-2012, thousand b/d
12                                                                               1,000       936
                 Crude oil       Natural gas liquids        Biofuels
                                                                                                        TX        ND   OK   NM    CO     LA     CA     AK
10                                                                                 800


  8                                                                                600               539


  6                                                                                400

  4                                                                                200
                                                                                                                  70   68    63
  2                                                                                   0
                                                                                                                                   -18
  0                                                                                                                                           -64
                                                                                  -200
      00   01   02   03    04    05   06   07     08   09    10   11   12   13                                                                       -196
Source: EIA, Barclays Research                                                   Source: EIA, Barclays Research


Texas and North Dakota                          Growth in the crude oil element of US oil liquids supply over the past five years has primarily
have dominated crude                            been concentrated in just two states: Texas and North Dakota (Figure 4). While there is
oil supply growth                               considerable potential elsewhere, thus far, output growth in oil-bearing formations in other
                                                states has been relatively modest and, in the overall scheme, has provided only a partial
                                                offset to the continuing declines in output from Alaska and California. Indeed, the relative
                                                swing in oil output has been so great that North Dakota has overtaken California in recent
                                                months and stands on the brink of overtaking Alaska to become the second-largest
                                                producing state after Texas.

Tight oil prospects are bright,                 Of the potential sources of further crude oil supply increase out to 2015 and 2020, the most
but high decline rates are a                    important is tight oil production, ie, oil from shale plays usually produced by large-scale use
major challenge                                 of horizontal drilling reservoir fracturing and through the injection of water and other
                                                liquids. As of now, US tight oil output is just over 2 mb/d, with the main area for production
                                                being the Bakken formation in North Dakota. A series of other areas have also started tight
                                                oil output or are due for expansion, including Eagle Ford and parts of the Permian basin. The
                                                nature of tight oil wells is very different from conventional production. For example, a
                                                typical Bakken well will produce an initial flow of 400-800 b/d and would then swiftly be
                                                put onto artificial lift. The initial 12-month natural decline rate of a Bakken well is extremely
                                                high, in most cases, 70-90%, when it then flattens out into single digits for the duration of
                                                the well’s life, producing a severe fall in output in a field unless further fracturing is carried
                                                out and new wells are brought in. The technique is relatively expensive ($6-10mn per well)
                                                and is particularly intensive in the use of fracturing crews and other oil service industry
                                                inputs. The overall level of technical sophistication is relatively low compared with
                                                techniques that have been employed in conventional production over the past decade. It is,
                                                therefore, relatively difficult to maintain steady increases from a given tight oil play, as, over
                                                time, decline rates and the increasing draw on specific oil service sector crews become
                                                more onerous once the initial phase of initial output takeoff has passed.

Tight oil output excluding NGL                  Among the current tight oil plays, we expect Bakken output to peak at 1.1-1.2 mb/d and the
content expected to reach                       Bakken to remain the largest single play, followed in order of importance by Eagle Ford.
2.8mb/d by 2015                                 Overall, we estimate that tight oil output is expected to rise at best by 0.23-0.25 mb/d per
                                                year in the medium term, reaching 2.8 mb/d by 2015. With new plays being brought in and
                                                assuming that the level of oil prices remains high, tight oil output (not including any NGL
                                                content) is expected to reach 3.1 mb/d by 2020. We believe the DOE’s views to be slightly
                                                on the conservative side, hence our higher estimates for tight oil plays. The increase in tight
                                                oil output certainly helps to chip away further at the US import gap, but it is also certainly

16 May 2013                                                                                                                                                 8
Barclays | US shale energy: Modest economic and equity market effects set to grow over time


                                    not a decisive factor in that regard, and its cost, decline rates, and potential infrastructural
                                    bottlenecks suggest that achieving the full potential of US tight oil is by no means a done
                                    deal. On the regulatory front, the largest tight oil reserves are in California, and we have
                                    assumed relatively slow progress in utilising that component of the resource.

                                    The other components of potential US crude oil supply include the existing conventional oil
                                    base and its possible sources of expansion. We remain cautious on US Gulf deepwater
                                    output, expecting a relatively slow arc of increase that in the best case compensates for the
                                    decline in conventional crude oil output in other areas. Overall, we expect relatively modest
                                    growth in conventional crude supply out to 2020, with a net increase of about 0.2 mb/d,
                                    assuming prices stay high and some more deepwater prospects make it to the front of the
                                    development queue. Among other non-conventional oils, we do not expect any
                                    development of oil shales by 2020 (ie, kerogen-rich formations), nor do we think gas-to-
                                    liquids will play any significant role in the balance. In the NGL balance, we look for an
                                    increment of just over 0.7 mb/d by 2015 and 0.9 mb/d by 2020, assuming that demand
                                    constraints are non-binding and that a market, probably petrochemical, can be found for
                                    such a relatively high volume of incremental NGLs.

The US will not become a net        Putting together all the potential sources of supply increase, the net changes in US output are
oil exporter this decade            rather significant, but will not eliminate the US as a large net importer of crude oil. We project a
                                    net supply increase of 1.7 mb/d by 2015 and a gain of 2.4 mb/d by 2020, assuming the
                                    maintenance of high prices and a benign development path for deepwater projects. We
                                    estimate that domestic demand will move higher by 0.4 mb/d by 2015 and by 0.7 mb/d by
                                    2020, with economic growth and new demand for NGLs expected to more than offset
                                    efficiency gains. This produces an overall further reduction in the import gap from current
                                    levels of 1.3 mb/d by 2015 and 1.7 mb/d by 2020. In stark terms, even in a relatively supply
                                    optimistic and demand pessimistic scenario, we project that the US import gap (excluding net
                                    trade in refined products) will still be significant, about 5.8 mb/d by 2020. Even allowing for
                                    net refined product exports at over 1mbpd, the US will not be anywhere near a net exporter of
                                    oil this decade, although the supply-side possibilities are such as to offer a further truncation
                                    of the physical import gap in the most benign circumstances.


                                    Waving goodbye to the Middle East?
The US energy boom                  There has been considerable discussion about whether the North American energy
may allow it to focus its           revolution will lead to a major re-alignment in US foreign policy. In particular, it has been
attentions elsewhere                suggested that the surge in domestic supplies will lead the US to slash its security
                                    commitments to the Middle East severely and focus attention and resources elsewhere,
                                    mainly in Asia. Prior to the 1980s, the United States had a very limited military presence in
                                    the Persian Gulf. That changed in 1987, when the US navy began protecting critical Gulf
                                    shipping lanes during the Iran-Iraq tanker wars. The US presence expanded and a string of
                                    regional military bases were established after the First Gulf War. Two of the largest and
                                    most expensive American military outposts are Al-Udeid airbase in Qatar and the US Naval
                                    headquarters in Bahrain. Al-Udeid is a US Central Command (CENTCOM) forward deployed
                                    base that has served as a key staging ground for air operations in Iraq and Afghanistan.
                                    Meanwhile, the naval base in Bahrain is home to the Fifth Fleet, which is tasked with, among
                                    other things, securing sea lanes and key choke points such as the Straits of Hormuz. While a
                                    number of media commentators and members of Congress have suggested that the US can
                                    now scale back such expensive commitments because of a reduced reliance on oil imports,
                                    senior Obama administration officials have gone to lengths to emphasize that the US will
                                    remain engaged in the Middle East. Instead, they have mainly highlighted the strategic
                                    implications of the shale gas revolution and how potential US LNG exports could crack
                                    Russia’s stranglehold on the European gas market.



16 May 2013                                                                                                                           9
Barclays | US shale energy: Modest economic and equity market effects set to grow over time


The pivot towards Asia              However, the 2011 Department of Defense Strategic review outlines a potential plan to shift
implies less of a presence          some resources over to the Asian theater. The document states that “while the US will
in the Middle East                  continue to contribute to security globally, we will of necessity rebalance toward the Asia-
                                    Pacific region.” In a 2012 speech, Deputy Secretary of Defense Ashton Carter said, “We will
                                    have a net increase of one aircraft carrier, four destroyers, three Zumwalt destroyers, ten
                                    Littoral Combat Ships, and two submarines in the Pacific in the coming years.” Given
                                    growing budget constraints, these are unlikely to be net additions to the fleet, rather a
                                    transfer of equipment from other regions to the Pacific theater. With the US war in Iraq over,
                                    the war in Afghanistan winding down, and the Pentagon budget cuts, some reduction in US
                                    defense assets in the Middle East is probably in the offing. In fact, the process may have
                                    already commenced. In February, the Pentagon announced that it was cutting its air carrier
                                    presence in the Persian Gulf from two carriers to one, a move that officials say will save
                                    hundreds of millions of dollars. Nonetheless, a shift of some military assets is not the same
                                    as walking away from the Middle East. As long as there is no other nation capable of
                                    supplanting the United States in the Middle East militarily, it will likely be called on to
                                    provide a security guarantee for regional allies and to protect vital economic assets such as
                                    shipping lanes in the event of a crisis.




16 May 2013                                                                                                                    10
Barclays | US shale energy: Modest economic and equity market effects set to grow over time


US COMMODITIES RESEARCH - NATURAL GAS

                                      Technology unlocks a gusher of natural gas
Biliana Pehlivanova*                  • Natural gas supply in the US has surged, driven by the successful deployment and
+1 212 526 1170                          continued refinement of two technologies, horizontal drilling and hydraulic
biliana.pehlivanova@barclays.com
                                         fracturing. The surge of supply, however, has not been matched by demand, and
                                         prices have dropped to levels that displace coal in power generation. This dynamic
*This author is from the Fixed
                                         will likely remain key to balancing the gas market in the foreseeable future. We
Income, Currencies and
                                         expect prices to average $3.90 per MMBtu in 2013 and $4.10 in 2014.
Commodities Research
department and is not an equity       • The US natural gas industry has flipped from one that was expected to be
research analyst                         increasingly import dependent to one that is fast reaching self-sufficiency. In fact,
                                         gas export projects are now being planned, and the US is on track to become an LNG
                                         exporter in 2015.

                                      • Longer term, upside risks to prices are capped by the ability of producers to deliver
                                         rapid growth of supply. We believe natural gas prices at $4.50-5.00/MMBtu are high
                                         enough to motivate enough gas drilling to meet projected demand: a healthy
                                         recovery from recent $2 prices, but still low enough to preserve a cost advantage in
                                         the US relative to other manufacturing economies.

                                      Driven by the successful deployment and continued refinement of two technologies,
                                      horizontal drilling and hydraulic fracturing, the US natural gas industry has flipped from one
                                      that was expected to be increasingly import dependent to one that is fast reaching self-
                                      sufficiency. Indeed, gas export projects are now being planned for the US. Oil and gas
                                      companies had long known that natural gas (and oil) is trapped in shale rock formations
                                      spanning vast regions of the US, but lacked the technology to unlock that resource. The first
                                      well targeting shale gas was drilled in 1982, but it was not until 2005 that natural
                                      production grew meaningfully from shale.

                                      It is not just favorable geology that has resulted in the growth in US gas production
                                      (Figure 1). Unlocking this supply potential was possible and uniquely swift in the US (and
                                      Canada), owing to a number of factors: several independent oil and gas producers eager to
                                      find new resources; well-established mineral resource laws allowing the quick contracting



FIGURE 1                                                            FIGURE 2
Annual US natural gas production growth (%)                         Lower-48 natural gas residential, commercial and industrial
                                                                    demand (Bcf/d)

 10%                                                                  45                Residential   Commercial   Industrial

  8%                                                                  40
                                                                      35
  6%
                                                                      30
  4%
                                                                      25
  2%
                                                                      20
  0%
                                                                      15
 -2%                                                                  10
 -4%                                                                    5
 -6%                                                                    0
         2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012                            2007                       2013E

Source: EIA, Barclays Research                                      Source: EIA, Barclays Research


16 May 2013                                                                                                                      11
Barclays | US shale energy: Modest economic and equity market effects set to grow over time


                                     of land and settlement of royalties; a vast service industry that could muster the rigs,
                                     pumps, and crews to remote locations to drill the new shale resource; and capital markets
                                     to finance all this activity. In addition, a mature US natural gas industry already possessed
                                     much of the pipeline infrastructure, along with a well-developed commercial market, for
                                     producers to access. Lastly, natural gas prices were quite favorable when shale gas
                                     exploitation began in earnest. While several other countries are endowed with their own
                                     substantial shale gas resources, they often do not have these other important building
                                     blocks. Further, concerns of the environmental risks (principally water use and risk of
                                     contamination) have caused other countries to slow the pursuit of their shale resources.

                                     As opposed to the financially risky nature of conventional oil and gas drilling, with vastly
                                     varying well production results, including frequent dry holes, shale gas drilling has virtually a
                                     100% success rate. Once the shale is located and defined, repeatable drilling results are
                                     commonplace. Continued refinements to the drilling and fracturing process have driven
                                     resource recovery rates higher and drilling costs lower, greatly boosting efficiencies,
                                     pushing unit costs lower. The success of the early shale gas producers resulted in a rush by
                                     other oil and gas firms to shale (and similar) resources, which was complemented by a
                                     surge of capital to the industry. The past few years have been marked by several overseas
                                     firms forming joint ventures with North American oil and gas firms, providing a significant
                                     new source of capital. Added to this mix is the producers’ desire to grow production and
                                     book reserves to meet investor demands for company-level growth. Most gas producers
                                     can readily expand production on a company-level basis if prices warrant.

                                     This surge of supply, however, has not been matched by demand. Leaving power sector use
                                     of natural gas aside for the moment, combined residential, commercial, and industrial
                                     consumption of gas has not grown. Figure 2, which compares consumption in the pre-
                                     recession year of 2007 with current consumption levels, highlights the lack of demand
                                     growth. This has forced gas increasingly into the power sector, where power consumption
                                     growth itself is anaemic. This simply means that natural gas must take market share from
                                     other fuels. Coal has been the hardest hit, resulting in a steady erosion of coal-fired power
                                     market share (Figure 3). This also requires that gas prices fall to coal-equivalent levels. In
                                     2012, in our estimates, over 10% of the gas consumed in the US was used to displace coal-
                                     fired units that would run if gas prices were higher. This adds to the quantity of gas that
                                     was already being consumed in the power sector.



FIGURE 3                                                            FIGURE 4
Coal generation as % of total power generation in the US            Henry Hub prompt futures contract daily settlement prices
                                                                    ($/MMBtu)

 51%                                                                 18

 49%                                                                 16

 47%                                                                 14
                                                                     12
 45%
                                                                     10
 43%
                                                                      8
 41%
                                                                      6
 39%                                                                  4
 37%                                                                  2
 35%                                                                 0
             2008          2009   2010     2011        2012          May-01 May-03 May-05 May-07 May-09 May-11 May-13


Source: EIA, Barclays Research                                      Source: Bloomberg, Barclays Research


16 May 2013                                                                                                                        12
Barclays | US shale energy: Modest economic and equity market effects set to grow over time


                                            The gas market is still facing the consequences of growing supply, but this year has also
                                            brought some notable changes. First, industrial consumption has gathered speed, carried
                                            on the wings of persistent low gas prices: a number gas-intensive industrial facilities
                                            restarted operation in 2012 and others are restarting or expanding capacity this year and
                                            next. The resurgence of industrial consumption is set to persist in the next 3-5 years, with a
                                            long list of plants now in various planning stages. Low gas prices are obviously a boon for
                                            industries that use substantial quantities of the fuel. Yet only a small portion of the US
                                            manufacturing sector is gas intensive, isolated to mainly the petrochemical and fertilizer
                                            industries. Firms had been looking overseas to site new, gas-intensive facilities only a short
                                            time ago, when US natural gas prices were much higher. Several other US industries rely on
                                            natural gas, but the fuel is not a principal component of their input costs (eg, building
                                            materials, food processing, refining, pulp and paper, and the steel and aluminum industries).
                                            Thus, while lower natural gas prices provide a competitive advantage to them, it is not in all
                                            cases decidedly advantageous to US manufacturing. Industrial consumers of power have
                                            also benefited from falling prices in the US (Figure 4), which has been aided by declining
                                            natural gas prices. In fact, power costs for industrial consumers in the US are lower than
                                            those faced by competitors in other industrialized economies (Figure 5). The principal
                                            manufacturing response to persistently low natural gas prices will come from new,
                                            proposed facilities in the petrochemical (including ethanol and methanol), fertilizer, and
                                            gas-to-liquids industries, expected to begin operation after 2015.

                                            Second, net imports are poised to fall in the foreseeable future. While LNG imports have
                                            been running at minimum levels since 2012, imports from Canada are declining and exports
                                            to Mexico are growing. Both are underpinned by structural trends: declining domestic
                                            production and growing domestic consumption. This trend, as well, should tighten natural
                                            gas balances in the next few years.

                                            And third, in the longer run, gas demand for power generation is set to get a boost from
                                            the retirement of a large number of coal fired power plants as a result of new
                                            environmental regulations. While the utilization rate of those facilities is relatively low, the
                                            magnitude of the retirements is significant: the shutdown of 14GW of coal-fired
                                            generation has already been announced for 2015, and we expect another 10-15 GW to
                                            announce plans for retirement as the date when the regulations take effect approaches.
                                            In total, we estimate that if fully replaced by natural gas, coal plant retirements could
                                            boost gas consumption by up to 1.0-1.5 Bcf/d in 2015 from 2014 levels. More shutdowns
                                            are likely to take place in the following years.



FIGURE 5                                                                  FIGURE 6
US gas prices are far lower than in Europe and Asia                       Inflation-adjusted retail natural gas prices ($/Mcf)

 $/MMBtu                        Japan Landed Spot LNG price                18
                                UK NBP
 20                             Henry Hub                                  16
 18                                                                        14
 16                                                                        12
 14                                                                        10
 12                                                                         8
 10                                                                         6
  8
                                                                            4
  6
                                                                            2
  4
                                                                            0
  2
                                                                             1998      2000      2002      2004    2006    2008       2010   2012
  0
  Apr-09          Apr-10           Apr-11        Apr-12       Apr-13                                 Residential          Commercial
                                                                                                     Industrial           Henry Hub

Source: Waterborne, Barclays Research                                     Source: EIA, Barclays Research

16 May 2013                                                                                                                                    13
Barclays | US shale energy: Modest economic and equity market effects set to grow over time


                                    For 2013, an exceptionally cold end of the winter depleted inventories rapidly and sent
                                    prices above the $4 mark. Coal-to-gas displacement remains the most price-elastic
                                    component of balances in the short term, and we expect a reduction in gas demand for
                                    power generation to balance the market and support inventories in rebuilding to
                                    comfortable levels (3.8-3.9 Tcf) by the end of October 2013. Coal displacement responds
                                    more readily to fluctuations in gas prices than coal ones, but it does so with a slight lag.
                                    Coal-fired power plants are less nimble operationally and many utilities lack the market
                                    incentive to respond to shifts in fuel economics promptly. While balances are tighter than
                                    previously anticipated, they are not tight enough to afford to eliminate coal-to-gas
                                    displacement altogether. We expect this dynamic to remain a feature of the gas market at
                                    least this year and next.

                                    Falling natural gas prices have also lowered costs for retail consumers. Figure 6 shows that
                                    the average consumer is paying about 27% less for retail, utility-delivered natural gas than
                                    in the recent peak year of 2008. However, they have not benefited through a reduction in
                                    retail power prices, even though wholesale power prices have fallen significantly, as a result
                                    of low gas prices. Only a relatively small share of utility costs is represented by natural gas:
                                    gas comprised about 14% of total utility expenditures over the past 10 years. Nevertheless,
                                    lower natural gas prices have helped keep retail power prices in check.

                                    Low gas prices have finally slowed the rapid growth of US gas production. Gas producers
                                    have certainly taken notice and responded to low prices. But they have not stopped drilling;
                                    they are simply drilling something else, having shifted a substantial portion of rigs away
                                    from wells that produce solely or principally natural gas to those that principally produce oil
                                    or natural gas liquids (ethane, propane, butane, and longer-chain hydrocarbons that are
                                    used in petrochemicals, refining, and other applications). Producers are attempting to shift
                                    their growth story to liquids and oil. These products sell at a substantial premium to natural
                                    gas, offering superior project economics compared with natural gas wells. This drilling relies
                                    on much of the same technologies as shale gas drilling. We expect production to tip into
                                    modest declines this year and grow only slightly in 2014. Of course, drilling levels are
                                    dependent on gas prices, and while we expect a slowdown of production, it is not for the
                                    lack of an abundant and prolific resource base. Producers have now proven that they can
                                    deliver rapid production growth at relatively low prices, and prices will need to remain low
                                    enough to maintain discipline in gas-directed drilling in the longer run.




FIGURE 7                                                          FIGURE 8
Retail prices for power for US industrial consumers, $/kWh        Retail prices for power for industrial consumers, $/kWh

  0.08                                                               0.25


  0.07                                                                0.2


                                                                     0.15
  0.06

                                                                      0.1
  0.05
                                                                     0.05

  0.04
          2003 2004 2005 2006 2007 2008 2009 2010 2011 2012             0
                                                                                UK          EU     Germany   Japan   China   US

Source: EIA                                                       Source: EIA, Reuters, Barclays Research


16 May 2013                                                                                                                       14
Barclays | US shale energy: Modest economic and equity market effects set to grow over time


                                    For now, North America is essentially an islanded natural gas market. Several import
                                    facilities line the coasts, and these are understandably lightly utilized. However, there are a
                                    number of projects proposed to convert these import terminals into export facilities to take
                                    advantage of the wide disparity between US and overseas prices (Figure 5). While only one
                                    export facility has been fully approved so far and is under construction, several others have
                                    lined up export contracts and stand ready to commence development upon regulatory
                                    approvals from the US Department of Energy (DOE) (Gas and Power Kaleidoscope: Sail
                                    away, February 19, 2013). We expect the DOE to make decisions on the first applications in
                                    line over the coming months. With off-take contracts lined up and the credit markets ready
                                    to provide financing, final investment decisions on several facilities could be reached in a
                                    relatively short time. This could bring a larger amount US LNG exports to reality in 2017-20.

                                    We expect prices to average $3.90 per MMBtu in 2013 and $4.10 in 2014. Longer term,
                                    upside risks to prices are capped by the ability of producers to deliver rapid growth of
                                    supply. We believe natural gas prices at $4.50-5.00/MMBtu are high enough to motivate
                                    enough gas drilling to meet projected demand: a healthy recovery from recent $2 prices,
                                    but still low enough to preserve a cost advantage in the US relative to other manufacturing
                                    economies.




16 May 2013                                                                                                                     15
Barclays | US shale energy: Modest economic and equity market effects set to grow over time


US EQUITY STRATEGY

                                               US Equities: Expect a modest impact from US shale
Barry Knapp                                    • In the near term, we expect a modest effect on US equities from shale. Lower energy
+1 212 526 5313                                   costs create competitive advantages for select industries (e.g., refiners and
barry.knapp@barclays.com                          chemicals), but the decision to relocate the bulk of global manufacturing should be
BCI, New York                                     driven by non-energy factors.

Eric Slover, CFA                               • We     prefer capex beneficiaries—major service companies and pipeline
+1 212 526 6426                                   infrastructure—to more commodity leveraged positions. However, US refiners offer
eric.slover@barclays.com                          attractive risk/reward. At the sector level, US shale participants are predominately
                                                  multinational cyclical and global demand expectations should drive share price
BCI, New York
                                                  performance; we would wait for signs of firming global growth.

                                               • Watch for signposts that might affect equities leveraged to the US natural gas
                                                  markets, including shifts in US LNG export policy, regulation that could limit
                                                  hydraulic fracturing, accelerated coal utility plant retirements or outages, and
                                                  higher-than-expected demand from gas utilities.

                                               • In the coming years, abundant low cost energy, improved manufacturing
                                                  competitiveness and demographics could contribute to a favorable US investment
                                                  environment. Equity risk premiums could decline through dampened volatility and
                                                  lower public policy uncertainty as the US moves toward higher energy independence.


                                               US energy price advantages allow some to compete at the low end of the
                                               cost curve. For US equities in aggregate, non-energy factors should drive
                                               manufacturing location decisions
Energy savings have created                    US-based manufacturing benefits from lower natural gas, electricity and coal prices, but we
competitive advantages for a                   believe much of these savings have been discounted in company earnings. In the near term,
few industries                                 energy prices are biased higher relative to last year, which would point to margin
                                               contraction but energy consumption is a relatively small percentage of US equities’ sales.
                                               However, energy savings have created competitive advantages relative to the rest of the
                                               world for a few industries (e.g., refiners and chemicals).



FIGURE 1                                                                    FIGURE 2
Energy contribution to S&P 500 earnings growth                              The Energy sector is the biggest driver of S&P 500 capital
                                                                            spending

 %                                                                           $Bn
  35                                                                         700
  30
                                                                             600
  25
  20                                                                         500
  15                                                                         400
  10
   5                                                                         300
   0                                                                         200
  -5
                                                                             100
 -10
 -15                                                                            0
            2010          2011          2012         2013E      2014E                   2010           2011          2012        2013E   2014E
                             Energy: Contrib. EPS Growth                                           SPX ex-UTL,ENR          ENR   UTL
Source: FactSet Estimates, Barclays Research                                Source: FactSet Estimates, Barclays Research


16 May 2013                                                                                                                                      16
Barclays | US shale energy: Modest economic and equity market effects set to grow over time


But we believe factors other                   As McKinsey & Company highlight, different factors of production influence companies’
than energy costs will drive                   manufacturing location decisions including energy, labor costs, access to skilled labor,
global manufacturing locating                  markets and supply chain reliability (see Manufacturing the future: The next era of global
decisions                                      growth and innovation, McKinsey & Company, Nov. 2012). And aside from those
                                               companies with competitive advantages from energy, we believe there are other factors that
                                               are far more important. We find only a short list with competitive advantages from natural
                                               gas and other shale benefits.

                                               Manufacturing includes, among other things, food, textiles, autos, chemicals, refined
                                               petroleum products and even pharmaceuticals, and it resides in 7 of the 10 S&P sectors,
                                               with the percent of manufacturing sales ranging from ~20% for Consumer Discretionary to
                                               ~90% for Materials. To estimate US shale’s potential impact on margins, we attempt to
                                               isolate the price of domestic natural gas, its competing fuel (coal), electricity, and natural
                                               gas liquids (NGLs) along with S&P 500 domestic sales. Impacts in aggregate are quite small
                                               and unsurprisingly, the Materials sector (petrochemicals, fertilizers and steel) and Energy
                                               (refining) have the heaviest exposure to these commodities. So, for almost all other
                                               industries, we believe energy will not drive global manufacturing locating decisions.

US petrochemicals are mostly                   However, manufacturing is expected to return to US shores for those with competitive
natural gas–based versus oil-                  advantages. The chemicals industry benefits from lower costs relative to the rest of the
based for most competitors in                  world and finished products that remain linked to global energy prices--US petrochemicals
Europe and Asia                                are mostly natural gas–based versus oil-based for most competitors in Europe and Asia--
                                               allowing them to compete at the low end of the cost curve and providing a competitive
                                               advantage that should persist for some time. Barclays’ US Chemicals analyst Duffy Fischer
                                               notes US chemicals are having the first growth spurt in nearly two decades, with US
                                               greenfield ethylene crackers scheduled for 2016-20. Our North America Fertilizers and
                                               Agriculture analyst Matthew Korn has varying levels of conviction on the 21 nitrogen plant
                                               announcements since last summer. Capital cost inflation is an increasing headwind; larger,
                                               early movers will benefit as supply is unlikely to expand to market expectations.




FIGURE 3                                                                     FIGURE 4
Manufacturing which includes food, textiles, autos,                          Unsurprisingly, the Materials sector (petrochemicals,
chemicals, refined petroleum products and even                               fertilizers and steel) and Energy (refining) have the heaviest
pharmaceuticals, is present in 7/10 sectors in the S&P 500                   exposure of Nat Gas, Electricity and NGLs in domestic sales.
and encompasses ~40% of sales in the S&P                                     But the aggregate impact on the index is quite small

 %                                                                            %
 100                                                                          2.5
           87
  90                                                                                   2.0
                      77                                                      2.0
  80
  70                            62        61
                                                                              1.5
  60                                                                                              1.2
  50                                                                          1.0
                                                    39
  40                                                        35
                                                                                                                                0.3   0.4
  30                                                                22        0.5
                                                                                                                      0.2
  20                                                                                                        0.1                                 0.0
  10                                                                          0.0
   0                                                                                  MAT        ENR       TEC       IND        STA   HLC      DIS
          MAT       ENR       TEC        IND       STA     HLC     DIS              Domestic nat gas, electricity and NGLs as a percent of total sales
                      Mfg sales as a percentage of total sales                      (estimate)

Source: EIA, US Census Bureau, Barclays Research                             Source: EIA, US Census Bureau, Barclays Research



16 May 2013                                                                                                                                        17
Barclays | US shale energy: Modest economic and equity market effects set to grow over time


                                           Companies involved in shale are predominately multi-national cyclicals.
                                           Global demand should primarily drive fundamentals and prices.
It is challenging to express a             Sectors and industries in the S&P 500 directly and indirectly involved in US shale are
pure-play view on US shale at              predominately multinational cyclicals (median ~40% foreign sourced revenue), with
the sector or industry level.              fundamentals and price performance that are leveraged to the economic cycle. From a
                                           fundamental perspective, the impact of US shale can be muted by both international as well
                                           as conventional US operations. It is challenging to express a pure-play view on US shale at
                                           the sector or industry level.

                                           Global demand expectations should dictate share price performance, since many products are
                                           priced against global oil, overwhelming cost benefits. Leading indicators of global demand
                                           remain weak and our economics team expects further weakening in the US in the 2nd half. In
                                           certain instances, valuations reflect global weakness, but our bias is to wait for signals of a
                                           turnaround in global growth, which should lift the commodities complex as well as stocks
                                           leveraged to the cycle. We would favor Energy over Materials, which are most leveraged to
                                           China and EM, but these preferences have more to do with global growth and less to do with
                                           US shale.


                                           We would look for sub-industries and single names, particularly where the
                                           shale story is misunderstood. We favor capex beneficiaries with lower
                                           commodity exposure. US refiners offer an attractive risk/reward.
For the major service                      We think the US shale story is better expressed through sub-industries or single names,
companies, E&P spending                    rather than a whole sector, particularly where the accepted shale story is misunderstood.
equates to revenue                         For the major service companies, which developed much of the technology that make the
                                           shale revolution possible, E&P spending equates to revenue (45% is North American
                                           sourced). In the US, a shale well is 3-5x the cost of a conventional well, according to our U.S.
                                           Oil Services & Drilling analyst James West and most North American rigs were built in the
                                           early 1980s or earlier and are becoming obsolete. New equipment is required to meet higher
                                           temperature and pressure unconventional drilling.

Existing pipeline infrastructure           Existing pipeline infrastructure is insufficient to move oil and gas from supply (producers) to
is insufficient to move oil and            demand (e.g., refiners), creating significant price discounts in regional and global markets
gas from supply                            (location differentials) that provide strong incentives for continued build out of midstream
                                           pipeline. Barclays Pipelines and MLP analyst Rick Gross notes that the increase in gas, NGLs


FIGURE 5                                                                 FIGURE 6
S&P 500 sectors directly and indirectly involved in US shale             …with fundamentals and price performance are leveraged
are predominately multinational cyclicals …                              to the economic cycle

  Foreign Sales/Total Sales, median %                                     Index                                                                    Index
 60                                      TEC                               2.6                                                                       75
                                                                                                                                                     70
                                                                           2.4
 50                                                   MAT                                                                                            65
                            HLC      SPX                                   2.2                                                                       60
 40                                                                                                                                                  55
                                               IND         ENR             2.0
                    STA                                                                                                                              50
 30                                DIS                                     1.8
                                           FIN                                                                                                       45
                                                                           1.6                                                                       40
 20
                                                                                                                                                     35
                                                                           1.4
 10                   TEL                                                                                                                            30
              UTL                                                          1.2                                                                       25
  0                                                                              04   05    06     07     08     09     10     11        12   13
      0.0            0.5           1.0               1.5         2.0                             Rel. Perf: Cyclicals / Defesivies (L)
                             Beta 3y, median                                                     ISM New Oders (SA, R)
Source: Barclays Research                                                Source: ISM, Barclays Research


16 May 2013                                                                                                                                          18
Barclays | US shale energy: Modest economic and equity market effects set to grow over time


FIGURE 7                                                                        FIGURE 8
For major service companies, E&P spending is revenue. A                         Existing pipeline infrastructure is insufficient to move oil and
shale well is 3-5x the cost of a conventional well                              gas from supply (producers) to demand, offering support for
                                                                                full valuations.

 y/y % chg                                                                       Multiple
  80                                                                             16
                                                                                 15
  60
                                                                                 14
  40                                                                             13
  20                                                                             12
                                                                                 11
   0                                                                             10
 -20                                                                              9
                                                                                  8
 -40
                                                                                  7
       02    03     04    05     06     07     08     09     10       11   12
                                                                                  6
                     E&P: North America Capex                                         02    03    04    05    06     07    08    09    10        11   12
                     Big Four Service Co: North America Sales                                                  MLP: EV / Adj Fwd EBITDA
Note: Big Four include Baker Hughes, Halliburton, Schlumberger and              Note: Barclays Research MLP Universe. Source: Barclay Research
Weatherford Source: Barclays Research, U.S. Oil Services & Drilling


                                              and oil requires significant infrastructure in pipelines, gathering, and storage predominately
                                              from MLPs. Broad MLP indices are fully valued compared to historical metrics, but are an
                                              attractive alternative in a yield-starved environment, offering a ~6% yield and ~7% growth,
                                              according to Barclays Pipelines and MLP research team. Utilities with operations in shale
                                              gas regions can also add gas distribution and pipelines, according to our North American
                                              Utilities analyst, Dan Ford. Railroads have also stepped in to transport oil. U.S. Integrated Oil
                                              and Refining analyst Paul Cheng notes that crude-by-rail is now a significant force in
                                              bringing oil from producer to refiners and rail economics may impact prices more so than
                                              pipeline transportation economics. Barclays Air Freight and Ground Transportation Brandon
                                              Oglenski sees railroads benefiting from inbound drilling materials as well.




                                                  Shale oil and gas beneficiaries
                                                      Oil Service Companies: E&P capital spending is revenue for the service companies
                                                      and a shale well is 3-5x the cost of a conventional well in the U.S. With service
                                                      capacity and equipment acting as the bottleneck at various points, the service
                                                      industry is well positioned to gain from the transition to shale and unconventional
                                                      drilling.

                                                      Midstream infrastructure: Existing pipeline infrastructure is insufficient. Significant
                                                      regional and global price discounts create strong incentives for continued build out
                                                      from pipeline companies and MLPs.

                                                      Refiners: Barclays expects crude price differentials to remain wider than market
                                                      expectations, preserving global competitive cost.

                                                      Chemicals: Cheap natural gas and natural gas liquids feedstock, a large portion of
                                                      production costs, provide a long-term global competitive advantage. Capital cost
                                                      inflation is an increasing headwind; early movers will benefit the most as supply will
                                                      likely not expand to market expectations.




16 May 2013                                                                                                                                                19
Barclays | US shale energy: Modest economic and equity market effects set to grow over time


FIGURE 9                                                              FIGURE 10
Barclays expects refining spreads to remain wider than                Petrochemicals and fertilizers should have the longest-term
expectations and believes US refiners offer a very attractive         competitive advantage due to cheap natural gas and natural
risk/reward.                                                          gas liquids feedstock.

  Discount to Brent, $/barrel                                          Ratio
 25                                                                     70

 20                                                                     60

                                                                        50
 15
                                                                        40
 10
                                                                        30
  5
                                                                        20
  0                                                                     10

 -5                                                                      0
                LLS              WTI Cushing           Bakken                04   05     06     07     08    09    10    11     12   13
                      2012 Avg      Barclays long-term forecast                               Brent Crude / Natural Gas Futures HH
Source: Barclays Research                                             Source: Bloomberg, Barclays Research


Location differentials create            These location differentials create significant competitive advantages for US refiners—who
significant competitive                  convert crude oil into intermediate products such as gasoline, diesel fuel and jet fuel—and
advantages for US refiners               benefit from lower feedstock costs (US sourced oil) and natural gas fuel costs, allowing
                                         them to compete at the low end of the global cost curve. While regional spreads should
                                         narrow, our US Integrated Oil and Refining analyst Paul Cheng expects these price
                                         differentials to remain wider than market expectations and believes US refiners offer a very
                                         attractive risk/reward.

Petrochemicals and fertilizers           Petrochemicals and fertilizers should have the longest-term competitive advantage due to
should have the longest-term             cheap natural gas and natural gas liquids feedstock, which makes up a large portion of
competitive advantage                    production costs. We think end market demand will dominate and capital cost creep limits
                                         expansion to large well capitalized multinational first movers. We remain cautious on
                                         chemicals given heavy leverage to emerging markets, which aren’t expected to turn soon.

                                         The drop in gas prices provided some of the most interesting shale-related
                                         equity trades in 2012. Watch for signposts that might affect equities
                                         leveraged to the US natural gas markets.
                                         From a macro view, in 2012, we think the knock-on effects of the sharp drop in natural gas
                                         were the most interesting shale-related trades in the equity markets. Natural gas and coal
                                         compete on price for electricity generation, which is 35% of gas and 93% of coal demand.
                                         The fuels compete as well on emissions and dozens of coal plants are slated to close
                                         through 2016. In 2012, in its fall to under $2 (from $13 in 2008), natural gas exacerbated
                                         coal-to-gas switching as natural gas displaced coal plants, contributing to higher coal
                                         inventories, lower prices and production cuts, which further impaired the coal mining
                                         industry and had implications for mining machinery and railroads.




16 May 2013                                                                                                                               20
Barclays | US shale energy: Modest economic and equity market effects set to grow over time


FIGURE 11                                                                 FIGURE 12
Natural gas and coal compete on price for electricity                     In 2012, in its fall to under $2, natural gas exacerbated coal-
generation, which is 35% of gas and 93% of coal demand.                   to-gas switching as natural gas displaced coal plants.

 %                                                                         %
 100                                                                       60
  90                                                                       55
  80                                                                       50
  70                                                                       45
  60                                                                       40
  50                                                                       35
  40                                                                       30
  30                                                                       25
  20                                                                       20
  10                                                                       15
   0                                                                       10
                     Nat Gas                          Coal                      03    04     05     06     07   08   09   10    11   12      13
              Electricity    Industrial   Resi/ Commercial   Other                     Coal as a % of US Pwr Gen          Nat Gas         Nuclear
Source: EIA, Barclays Research                                            Source: EIA, Barclays Research


We would look for signposts of              Some of last year’s trends are expected to reverse this year. Increased gas fired demand is
changing trends in the US                   expected to support prices, but gas production at higher prices as well as ample coal
natural gas market, which                   stockpiles should contain power prices. Our North American Utilities team views electricity
could disrupt power balancing               usage of coal and gas as very flexible (see Appendix), depending on the price of the two
                                            commodities. Already this year, when natural gas prices were up ~90% off the 2012 lows,
                                            March data from EIA pointed to switching back to coal from gas, so thus far market forces
                                            are balancing as expected. We would look for signposts of changing trends in the US
                                            natural gas market, including shifts in US LNG export policy, regulation that could limit
                                            hydraulic fracturing, accelerated coal utility plant retirements or outages, and higher-than-
                                            expected demand from gas utilities, which could disrupt this balance, perhaps pushing gas
                                            prices higher and at the margin change the outlook for coal and gas demand.

                                            Longer term, potential for improved investment environment and lower
                                            equity risk premiums
Equity risk premiums could fall             In the coming years, perhaps extending through the decade, as the benefits of abundant
through dampened price                      low cost energy begin to shift from suppliers to the demand side, this factor, along with
volatility                                  improved manufacturing competitiveness and demographics, could contribute to a
                                            favorable investment environment in the US. Further, equity risk premiums could fall
                                            through dampened price volatility, which would provide better visibility to corporate profits
                                            and perhaps lessen energy price spikes, as well as through lower public policy uncertainty
                                            as the US takes steps toward energy independence.




16 May 2013                                                                                                                                   21
Barclays | US shale energy: Modest economic and equity market effects set to grow over time


APPENDIX
Power coal to gas switching
We view electricity usage of coal and gas very flexible. Depending upon the relative prices of the commodity, we see up to 9 bcf/day and 275M tons of coal demand, which could switch to balance
their respective markets.

FIGURE 1
Power Coal to Gas Switching




                                                                                                                                            2012:
                                                                                                                                            $3.69/MMBtu
                                                                                                                                            $3.64/MMBtu
                                                                          100%                                                              2011:
                                    100%
                                                                           80%                                                              $3.96/MMBtu
                                     80%
                                                                           60%   2012:                         2012:                        $3.72/MMBtu
                                     2012:                                 40%   $2.15/MMBtu
                                     60%                   37%                                  12%            $2.83/MMBtu
                                     $2.39/MMBtu                           20%
                                                                                 $2.02/MMBtu
                                     40%                                                                       $2.61/MMBtu
                                     $2.16/MMBtu                            0%
                                     20%    1%                                   2011:                         2011:
                                     2011:                                -20%           -6%
                                      0%                                          -13%
                                                                                 $2.08/MMBtu
                                    -20%
                                                                          -40%                                 $2.90/MMBtu
                                     $2.36/MMBtu   -8%                           $1.90/MMBtu
                                    -40%                                                                       $2.69/MMBtu
                                     $2.20/MMBtu




                                                                                                                    2012:
                                                                          100%                                      $4.09/MMBtu
                                                                           80%
                                                                           60%
                                                                                                                    $3.75/MMBtu
                                                                           40%                  23%                 2011:
                                                                           20%                                      $4.11/MMBtu
                                                                            0%                                      $3.72/MMBtu
                                                                          -20%    -4%    -7%
                                                                        2012:
                                                                          -40%
                                                                        $2.54/MMBtu
                                                                        $2.14/MMBtu
                                                                        2011:
                                                                        $2.29/MMBtu
                                                                        $1.86/MMBtu                     Henry Hub gas price that
                                                                                                        competes with 10% of
                                                                                                        coal in region

                                                                                                        Henry Hub gas price that
                                                                                                        competes with 20% of
                                                                                                        coal in region
Source: Barclays Research
Figure 1 shows the price at which 10% and 20% switching occurs based on the Henry Hub gas price reference. The majority happens in the East where there is a higher concentration of
Appalachian coal burned.


16 May 2013                                                                                                                                                                                   22
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In relation to our respective sections we, Helima Croft, Barry Knapp, Dean Maki, Kevin Norrish, Biliana Pehlivanova and Eric Slover, CFA, hereby certify (1)
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