MISSION ACCOMPLISHEDU . S . E N E R G Y I N D E P E N D E N C E A N D “ S A U D I A M E R I C A ” – M Y T H O R R E A L I T Y ?
We strongly disagree with a chorus of predictions, which have grown during the last year, that the United States will become energy independent either in the near- or intermediate- term. We also doubt the United States will sustainably surpass crude oil production levels in Saudi Arabia and/or Russia over the long-term and become the world’s top crude oil producer.
The United States has a number of characteristics and situations that proponents say support a move toward energy independence. These include our abundant hydrocarbon resources, our massive oilfield equipment and oil service infrastructure, and ongoing development of technologies needed to unlock the resources. Add to the mix the still-high global oil prices that encourage development of several U.S. “unconventional” liquid-rich basins and the favorable odds spurring a concerted effort by U.S. oil and gas companies to drill and complete wells at an aggressive pace to boost U.S. output (particularly of crude oil). However, based on our analysis of the fundamentals, we contend that although the United States will ramp up production of hydrocarbon liquids, it is unlikely the United States will boost crude oil production enough to sustainably rival Saudi Arabia’s and Russia’s crude oil output. We therefore strongly urge investors to view such optimistic oil and natural gas production forecasts with a healthy dose of skepticism but also recognize that forecasts (and their effects on conclusions) can change quickly and dramatically. U.S. ENERGY INDEPENDENCE: IS IT POSSIBLE? U.S. presidents have promised since the early 1970s that the United States would seek to become energy independent. Nearly 40 years later, those promises remain unfulfilled. The Rise of Unconventional Oil In 2012, the continuing positive impact of horizontal drilling and multi-stage hydraulic fracturing on natural gas production, and subsequently on liquids production, prompted a number of respected institutions to boldly announce optimistic forecasts for U.S. energy independence. However, we believe prognostications for future U.S. crude oil production that use the International Energy Agency (IEA) forecasts as the baseline are highly misleading largely because the IEA’s predictions include all liquids, creating an apples-to-oranges comparison with other data sources. Therefore, the United States might challenge Russia and Saudi Arabia in producing total hydrocarbon liquids, which include crude oil, condensates and natural gas liquids, but not in crude oil. Furthermore, even though condensates and natural gas liquids will be the primary intermediate growth areas, they do not go into the transportation market – the dominant source of demand for crude oil.
July 2013 Northern Trust Global Investments 50 South La Salle Street Chicago, Illinois 60603 northerntrust.com Jackson Hockley, CFA Senior Energy Analyst Jh31@ntrs.com
The Rise of an Overly Optimistic U.S. Production Outlook A number of research papers and news articles published during the last year proposed and promoted the idea that the United States could become energy independent and take the world’s top position as an energy producer.
• In June 2012, a Harvard University fellow and international oil company executive, Leonardo Maugeri, released his paper, “Oil: The Next Revolution.” It stated that horizontal drilling and hydraulic fracturing would allow the exploitation of U.S. tight geologic oil formations and make the Western Hemisphere energy independent by 2020.
• Five months later, the IEA in its World Energy Outlook 2012, reiterated the theme by stating that, “By around 2020, the United States is projected to become the largest global oil producer (but not overtaking Saudi Arabia until the mid-2020s) as we begin to see the impact of new fuel- efficiency measures in transport. The result is a continued fall in U.S. oil imports, to the extent that North America becomes a net oil exporter around the year 2030.”
• On November 12, 2012, a Financial Times article, “U.S. to be World’s Top Energy Producer,” referenced the World Energy Outlook and further amped up chatter about an optimistic U.S. energy production outlook.
In addition to an anticipated significant increase in U.S. crude oil production, three other key factors in the energy independence thesis are: 1) major gains from energy efficiency, 2) the increasing use of biofuels/renewable energy sources (primarily solar and wind) and 3) fuel switching. CONSERVATION: THE DECLINE IN U.S. ENERGY USAGE One of the two critical pillars to the U.S. energy independence story is the expectation that U.S. energy usage per unit of gross domestic product (GDP) will decline at a steady, meaningful pace. Chart 1 from the U.S. Energy Information Administration’s 2013 Annual Energy Outlook shows the massive reductions in energy intensity expected over the next 30 years. History shows that a 50% reduction in energy intensity occurred over the past 40 years (1970 to 2010) as the United States transitioned from a manufacturing-based economy to a service-based economy. Japan and several Western European countries experienced similar declines in energy consumption. It is important to note that these countries had mature economies, and manufacturing was shifting gradually to lower- cost developing economies. We are wary of forecasts calling for a similar 50% reduction in U.S. energy intensity over the next 30 years, as they generally give few solid reasons to expect a continued decline other than affixing a ruler to the past trend and extending it into the future. One must ask why energy intensity would
2
decline further, and whether future reductions in energy intensity will be tougher or easier to achieve now that energy intensity has already been halved. We believe the energy efficiency advocates must supply credible, detailed analysis sourcing the origins of these expected efficiency gains. Chart 1 U.S. Primary Energy Consumption per Real Dollar GDP
Chart 2 shows some of the key sectors of the economy and the expected future energy intensity of each. The greatest reductions are expected to come from the U.S. industrial and transportation sectors. As shown, the largest efficiency gain is projected to come from the transportation sector where total intensity is expected to drop by 47% from 2005 to 2040. The modest intensity declines experienced since 2005 are in part explained by the impact of the 2008 to 2009 recession and its after effects. The steepest portion of the curve runs from roughly 2015 to 2030. While the bold goal of a 47% decline over roughly the next 30 years — and with the largest gain coming in the next 15 years — is commendable, we believe it may not be achievable. Chart 2
It might be a coincidence that the largest expected efficiency gains (or reductions in energy intensity) are expected in the transportation and industrial sectors. These are the sectors of the economy most exposed to the price of oil and imported oil volumes.
3
Chart 3
Chart 3 illustrates the key sources of U.S. energy. Chart 4 shows U.S. primary energy use by sector, the largest of which is electric power. However, in terms of achieving energy independence, electrical power is not germane to the discussion because virtually all of the fuel that is used to produce electricity is domestically sourced. The two next-largest sector users are transportation and industrial, both of which consume large amounts of crude oil. According to the Energy Information Administration (EIA), the U.S. end markets for crude oil and refined products are transportation (71% of demand) and industrial (23% of demand). Residential and Commercial, as well as electric power, are relatively minor consumers, accounting for only 5% and 1%, respectively. But the importance of oil is actually much greater than end market destinations suggest. Looking instead at the dominance of crude within those markets reveals that the U.S. economy is truly “addicted” to oil. In the transportation market, crude oil holds a 93% share of the market, with distant competition from renewables (4%) and natural gas (3%). In the industrial market, crude oil also holds a critical position at 40%, only slightly below the 41% market share held by natural gas. Chart 4
4
To truly break the hold that crude oil has on the transportation market will require a serious alternative fuel – one that is so far not apparent. Clean Energy to the Rescue? Another major factor in the U.S. energy independence theory is the anticipated meaningful growth coming from renewable energy sources. While environmental groups will continue to pursue a green agenda, the momentum behind the solar, wind and biofuels programs seems to be losing steam. The solar landscape is littered with bankruptcies. The wind industry is faced with growing claims of associated health issues and opposition from environmental groups due to the potential danger to wildlife. Biofuels continue to hold promise, but mandated U.S. ethanol usage (blended with gasoline) seems to have hit a snag as car makers fight a federal proposal to increase the blend of ethanol in gasoline to levels exceeding 10%. And today, there are more hints about possible cuts in government subsidies to all segments of the renewable fuels industry. Fuel Switching: Fact Check Finally, speculation abounds that the United States can wean itself off oil by switching to cheap, abundant domestic natural gas in the transportation market. To explore this, we first must identify the sources of our imported crude oil. The answer, illustrated in Chart 5, might prove surprising. Chart 5: Leading Sources of U.S. Crude Oil Imports
Source: EIA Annual Energy Review 2011 Contrary to popular belief, Canada and Mexico are two of the largest crude oil suppliers to the United States. In fact, the quantity of U.S. crude oil imports from Saudi Arabia, Russia and Iraq combined does not equal our imports from Canada alone. Turning back to fuel switching, we have argued in the past that reality will probably differ vastly from the vision that cheap natural gas can take market share from crude oil in the U.S. transportation market. In our opinion, investors should strongly question whether natural gas can be the “end all, be all” for domestic energy, especially without causing a price rise. Natural gas is currently the fuel of choice in the U.S. electric power-generation market and is expected to increasingly displace coal and nuclear as old plants close. Additionally, there are forecasts that the United States is on the verge of becoming the world’s largest liquefied natural gas (LNG) producer, but these optimistic prognostications overlook the fact that the United States does not yet have one operational natural gas liquefaction facility. There also is an increasing call to force
5
U.S. businesses and consumers to switch to natural gas in the form of compressed natural gas (CNG) as a transportation fuel. If all these potential markets shift to natural gas, or even just increase their use of natural gas, then natural gas prices could potentially soar as demand increases. To put some numbers around the prognostications, the additional demand for natural gas from just the LNG and transportation markets would cause demand to skyrocket to potentially upwards of 120 billion cubic feet per day (Bcf/d) from current U.S. total natural gas demand of just under 70 Bcf/d. The “high-side” estimates (which we think are likely unrealistic) of potential incremental demand from LNG and transportation translate into 50 Bcf/d in new U.S. natural gas consumption. More than 20 proposed U.S. LNG export facilities, if built, could soak up nearly 30 Bcf/d of natural gas – LNG export facility applications received by the U.S. Department of Energy currently total 28.67 Bcf/d. T. Boone Pickens (CEO of hedge fund BP Capital and author of the Pickens Plan) says conversion of the 8.0 million heavy-duty trucks in the United States would boost natural gas demand by 15 Bcf/d – 20 Bcf/d (article in Business Week – posted at www.businessweek.com on April 17, 2013). In addition, some also project that CNG will become a force in the passenger car market. Certainly, one can’t rule out the possibilities that 1) natural gas as LNG could become a major U.S. export and 2) that natural gas in the form of CNG could transition into a significant U.S. transportation fuel. But we think the odds do not favor such outcomes unless there is a long-term disruption in global crude oil supplies that leaves no place else to turn and likely would boost natural gas prices. “SAUDI AMERICA” – FACT OR FICTION? Forecasts about the United States becoming a “Saudi America” assume that the world’s oil and oil reservoirs are the same everywhere. Nothing could be further from the truth. There are many factors that determine whether an oil-bearing formation can be developed economically. These include the quality of the reservoir rock; the type and mix of the resource in the reservoir; the size of the resource; the porosity and permeability of the geologic structure and variations across the formation; the ultimate recovery of resources in place; the shape of the decline curves; and so on. Those forecasts also typically assume we have massive natural resources and that new technologies, such as extended reach horizontal drilling and multi-stage fracturing, will overcome challenges to unlocking and producing oil. Our caution concerning the outlook for U.S. oil production growth and sustainable output centers on several factors that we believe some forecasters have overlooked. While we acknowledge projections that the United States could soon rival Russia and Saudi Arabia in terms of total oil production, we remain skeptical it will occur. Under the right circumstances – soaring oil prices and aggressive drilling/completion activity – the United States could grow its oil production. But with current relatively high and stable oil prices ($90-$100/barrel), we do not believe the United States will, on a sustainable basis, surpass Russia and Saudi Arabia or rise long- term to the “top-of-the-class” producer category. In fact, we think the most disturbing omission in the hoopla around the concept of “Saudi America” is the importance of oil prices. Chart 6 shows estimates of average necessary oil prices across the primary U.S. oil basins to achieve a 10% rate of return. While other companies may calculate slightly different oil and natural gas price estimates needed to generate satisfactory returns, the
reality is that oil prices will need to remain high or rise further to justify continued investment in U.S. unconventional tight oil basins. Chart 6 U.S. Oil Basins: Average Price Needed to Achieve 10% Rate of Return
Source: Canaccord Genuity Research, July 2013 In other words, even with the widespread use of newer techniques such as long-extended reach horizontal drilling and multi-stage completions (fracking), the key driver in U.S. oil production growth still is high crude oil prices (chart 7). Chart 7
Production History: Saudi Arabia vs. United States Chart 8 shows that Saudi Arabia has produced more than 9 million barrels per day (mmb/d) since the early 1990s. During the Arab Oil Embargo (1973) and the Iranian revolution, oil prices spiked to more than $36 per barrel (/b) from roughly $3/b. As a result, global demand for crude oil from Organization of Petroleum Exporting Countries’ (OPEC) contracted as energy conservation took hold, nuclear plants replaced oil in the electric power generation market, and production increased from new oil fields in the North Sea, Alaska and the Gulf of Mexico. By the mid-1980s, after years of cutting production to keep world oil prices high, Saudi Arabia abandoned its role as global swing producer and began boosting production again. When Saudi Arabia again opened the taps, crude oil prices collapsed.
7
Chart 8 Chart 9
The U.S. production story is relatively lackluster (chart 9). Since peaking in the early 1970s, U.S. output has struggled to stave off decline. Although U.S. production crept higher from the mid-1970s to the mid-1980s, volumes dropped again until around 2005 when the impact of rising oil prices plus developing technologies helped reverse the trend. The question now is whether the current upturn will produce a secular change or a short-term reprieve in U.S. production. Chart 9 also shows U.S. oil output is near 10 mmb/d and within striking distance of Saudi Arabia. However, confusion arises from differing definitions of what constitutes “crude oil.” Many times the definition includes all liquids (including crude oil, condensate, and natural gas liquids), as Chart 9 shows. On the other hand, when looking at the composition of U.S. liquids production, (Chart 10), it is clear that U.S. crude oil production is not nearly on par with Saudi Arabia’s 10 mmb/d output level. Chart 10
As of June 30, 2013
8
How Big is Your Tank? One of the more curious omissions in the Saudi America thesis is the size of the economically recoverable oil resource base. Ultimately, oil companies must make a profit and generate excess cash flow to keep pouring investment dollars into an oil field. A large part of the “oil economics” question revolves around the size of the resource base that drilling a well taps and which is a main factor determining how much oil a country can produce. The primary problem with the “Saudi America” thesis centers on simple mathematics. First, Saudi Arabia’s proven “conventional” reserve base dwarfs that of the United States (Chart 11). At the end of 2012, British Petroleum’s Statistical Review of World Energy (June 2013) reported that U.S. proved reserves were 35.0 billion barrels, only 13% of the proved reserve base of Saudi Arabia (265.9 billion barrels). Chart 11
Second, much of the enthusiasm around the “Saudi America” theory emanates from unconventional “tight oil” plays that horizontal drilling and multi-stage fracturing completion methodologies unlocked. However, Table 1 shows the EIA’s estimate of U.S. tight oil potential is 33.2 billion barrels. Combined with the proved reserves, the U.S. has almost 65 billion barrels of technically recoverable reserves. Yet this still leaves the U.S. recoverable reserve base significantly lower than Saudi Arabia’s. We think that increased drilling activity and increased application of constantly evolving oilfield technologies will boost output from “unconventional” tight oil reservoirs. But we also believe it would be a stretch to expect the United States to rival Saudi Arabia’s resources over a sustained period of time.
9
Table 1
Source: EIA Annual Energy Outlook 2012 Table 1 also shows that more than 200,000 wells will need to be drilled to produce crude oil from unconventional tight rock formations -good news for the oil service industry over the long-term. What Is the Speed Setting on this Treadmill? We also must consider the output-per-well, as well as the number of wells that must operate to keep the oil flowing. Once again, available data show that Saudi Arabia has the upper hand. Table 2 shows the number of producing wells in the OPEC member countries. According to OPEC’s Annual Statistical Bulletin, Saudi Arabia had 3,245 producing oil wells in 2011. We cannot confirm these numbers but think that number looks low. In fact, our discussions with industry followers suggest that Saudi has a strategy of producing roughly 2,000 barrels per day from approximately 5,000 oil wells (choked back so current output is significantly below capacity) with the idea that the wells will hold near current restrained volume levels for 20-plus years.
10
Table 2
Source: OPEC, Annual Statistical Bulletin 2012 Contrast the situation in Saudi Arabia (where approximately 5,000 wells generate 10 mmb/d) with the United States, where more than 500,000 wells are needed to produce 6.5-7.0 mmb/d (Chart 12). The chart also shows that productivity per well in the United States (dashed line) has steadily declined since the early 1970s and, even after recent improvement, still is running at slightly more than 10 barrels per day. Chart 12
11
For the United States to maintain its production, the industry must drill a large number of wells each year and perform a significant amount of maintenance on existing oil wells. The addition of high- decline rate unconventional “tight” oil wells will shift the drilling treadmill into an even-higher gear. Chart 13 depicts the normal decline rates in the Bakken and shows that the first-year decline rate is upwards of 75% – much steeper than the decline rates historically seen in conventional oil fields.
Chart 13
Source: Apache Corp. Not only will the industry need to drill a lot of new wells to develop the unconventional oil basins but it will also have to keep drilling aggressively to offset high production decline rates. Yes, drilling two-mile-long horizontal laterals and performing 30, 40, 50 or more stage fracs per well are unlocking oil from tight formations. However, the reality of unconventional tight formations is that these plays have low permeability. Even though the formations may be saturated with hydrocarbons (in the form of oil, natural gas, condensates and natural gas liquids) they do not easily flow through the rock. Hence, producers must fracture the rock to open tiny pathways through which the hydrocarbons can flow. The result is flush production initially after the well is fracture treated and a very rapid decline in production thereafter. Consequently, we believe that if the United States wants to boost oil production, there is only one solution – Drill Baby, Drill! Bakken – The United States Tight Oil Play Example/Anomaly The tight oil play that has garnered the most interest is the Bakken field in North Dakota, currently credited with potential recoverable resources of 5.37 billion barrels (Chart 11) and one of the fastest U.S. production growth basins in the past five years. Oil production growth from the Bakken has been truly impressive and is cited as the baseline expectation for other basins in almost all bullish forecasts of the United States’ future production growth. Chart 14 shows the crude oil output ramp and the number of wells drilled in the field since the beginning of 2009. The upward-trending well count and crude oil production volumes have mirrored each other since 2009.
12
Chart 14
It is interesting to note, however, that while the well count and crude production have continued to grow (chart 15), the Bakken’s well productivity (average production per day) has flattened over the past three years. (The late-2010 to early-2011 decline resulted from severe weather in North Dakota.) This signals that although the industry continues to increase drilling and completion efficiency and has seen initial production rates rise, improvements are offset by high decline rates and the larger number of wells. Chart 15
The lower 48 states have a number of attractive basins (keep in mind that Figure 1 maps all the major unconventional basins – crude oil and natural gas). It is worth noting that the United States has many more unconventional natural gas basins than oil basins, which to some extent limits the United States’ sustainable upside crude oil production potential.
13
Figure 1
Geology also differs not only across basins and countries but within basins, which can greatly affect the volume of crude oil production even in basins considered “liquids rich.” The Bakken is truly different from the other U.S. unconventional oil/liquid- rich basins. As Table 3 shows, the Bakken is primarily an oily basin with oil output accounting for 82% to 85% of volumes. Table 3
14
The next most-leveraged basin is the California Shale, which is hampered by environmental opposition. The Eagle Ford play has also gotten a lot of press for its impressive oil production growth but, as Table 3 shows, across the entire basin the crude oil share of output ranges from 30% to 50%. Thus, we think investors should be wary of the “Saudi America” forecasts that use the “oily” Bakken as the baseline and remember that most exploration and production (E&P) companies are focusing their activities on the sweet spots of the several liquid-rich U.S. basins, resulting in the recent jump in U.S. oil production. We think this production growth should continue in 2013 and perhaps into 2014 as E&P companies continue to focus on those oily sweet spots, activity that does not expand the overall size of the play. United States Isn’t Destined to Become “Saudi America” Although the United States is among the world’s leading oil producers and has potential to boost production in the next few years, the reality is that this nation lacks the resource base or high-quality rock (conventional oil formations) to compete on a sustained basis with Saudi Arabia. This does not mean that the United States could not for a short period of time boost crude oil output to close to 10 million barrels per day. However, the known technically recoverable resource base (which factors in the current oil price) in the United States does not support an outlook of sustained high production. We believe a period of aggressive drilling and completion activity will primarily benefit selected oil service companies that will supply the equipment, personnel and technology the E&P industry will need in its efforts to extract the maximum amount of oil from U.S. oil basins. We strongly urge investors to become informed about the facts around U.S. crude oil production rather than being swayed by overly optimistic predictions. Based on the data, we firmly believe it is highly unlikely the United States will see both “cheap” and “plentiful” supplies of domestically produced crude oil for any sustainable period of time. The United States will not become “Saudi America” anytime soon. FOR MORE INFORMATION To learn more, please visit northerntrust.com or contact your Northern Trust relationship manager. Important Information There are risks involved in investing including possible loss of principal. There is no guarantee that the investment objectives of any fund or strategy will be met. Risk controls and models do not promise any level of performance or guarantee against loss of principal. This material is directed to eligible counterparties and professional clients only and should not be relied upon by retail investors. The information in this report has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. Opinions expressed are current as of the date appearing in this material only and are subject to change without notice. This report is provided for informational purposes only and does not constitute investment advice or a recommendation of any security or product described herein. Indices and trademarks are the property of their respective owners. All rights reserved. Information intended for use with institutional investors only. Not to be distributed to or relied upon by retail investors. Past performance is not necessarily a guide to the future. Index performance returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an
15
index. Index performance is based upon information provided by the index providers. Indexes and trademarks are the property of their respective owners, all rights reserved. There are risks involved with investing, including possible loss of principal. For Asia Pacific markets, this material is directed to institutional investors, expert investors and professional investors only and should not be relied upon by retail investors. This information is provided for informational purposes only and does not constitute a recommendation for any investment strategy or product described herein. This information is not intended as investment advice and does not take into account an investor’s individual circumstances. Opinions expressed herein are subject to change at any time without notice. Information has been obtained from sources believed to be reliable, but its accuracy and interpretation are not guaranteed. Asset management at Northern Trust comprises Northern Trust Investments, Inc., Northern Trust Global Investments Ltd., Northern Trust Global Investments Japan, K.K., The Northern Trust Company of Connecticut and its subsidiaries, including NT Global Advisors, Inc., and investment personnel of The Northern Trust Company. Northern Trust Global Investments Japan, K.K. is regulated by the Japan Financial Services Agency. The Northern Trust Company has a branch in China mainly regulated by the China Banking Regulatory Commission, People’s Bank of China and State Administration of Foreign Exchange. The Northern Trust Company of Hong Kong Limited is regulated by the Hong Kong Securities and Futures Commission. In Singapore, Northern Trust Global Investments Limited (NTGIL), Northern Trust Investments, Inc. and The Northern Trust Company of Connecticut (NTCC) are exempt from the requirement to hold a Financial Adviser’s License under the Financial Advisers Act and a Capital Markets Services License under the Securities and Futures Act with respect to the provision of certain financial advisory services, and fund management activities. In Australia, NTGIL is exempt from the requirement to hold an Australian Financial Services License under the Corporations Act 2001 in respect to the provision of financial services. Issued by NTGIL. NTGIL is authorised and regulated by the Financial Services Authority under UK laws, which may differ from Australian laws. IRS CIRCULAR 230 NOTICE: To the extent that this message or any attachment concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law. For more information about this notice, see http://www.northerntrust.com/circular230.
IMPORTANT INFORMATION: This material is for information purposes only. The views expressed are those of the author(s) as of the date noted and not necessarily of the Corporation and are subject to change based on market or other conditions without notice. The information should not be construed as investment advice or a recommendation to buy or sell any security or investment product. It does not take into account an investor’s particular objectives, risk tolerance, tax status, investment horizon, or other potential limitations. All material has been obtained from sources believed to be reliable, but the accuracy cannot be guaranteed.
PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. Periods greater than one year are annualized except where indicated. Returns of the indexes also do not typically reflect the deduction of investment management fees, trading costs or other expenses. It is not possible to invest directly in an index. Indexes are the property of their respective owners, all rights reserved.
No bank guarantee | May lose value | NOT FDIC INSURED
16
IRS CIRCULAR 230 NOTICE: To the extent that this message or any attachment concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law. For more information abou...
No bank guarantee | May lose value | NOT FDIC INSURED