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Modest economic and equity market effects set to grow over time
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 firstname.lastname@example.org 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 email@example.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 firstname.lastname@example.org • 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 email@example.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 firstname.lastname@example.org 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 email@example.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 firstname.lastname@example.org 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. email@example.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 firstname.lastname@example.org 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 email@example.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 firstname.lastname@example.org 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 email@example.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 Analyst Certification In relation to our respective sections we, Helima Croft, Barry Knapp, Dean Maki, Kevin Norrish, Biliana Pehlivanova and Eric Slover, CFA, hereby certify (1) that the views expressed in this research report accurately reflect our personal views about any or all of the subject securities or issuers referred to in this research report and (2) no part of our compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this research report. Important Fixed Income Disclosures: Barclays Research is a part of the Corporate and Investment Banking division of Barclays Bank PLC and its affiliates (collectively and each individually, "Barclays"). For current important disclosures regarding companies that are the subject of this research report, please send a written request to: Barclays Research Compliance, 745 Seventh Avenue, 17th Floor, New York, NY 10019 or refer to http://publicresearch.barclays.com or call 212-526-1072. 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 Barclays may have a conflict of interest that could affect the objectivity of this report. Barclays Capital Inc. and/or one of its affiliates regularly trades, generally deals as principal and generally provides liquidity (as market maker or otherwise) in the debt securities that are the subject of this research report (and related derivatives thereof). 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