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Oil and Gas reality check 2012A look at 10 of the top issues facingthe oil sector

Energy & Resources

Contents

Foreword 1

1. The future of oil production: Libya and Iraq are now part of the equation 3

2. Join the game: The global development of shale gas assets 5

3. The decoupling of oil and gas prices: Where and when? 7

4. The new NOCs: The emergence of non-traditional consuming national oil companies 9

5. Just because shale is in doesn’t mean conventional is out: New exporters come to market 11

6. China is an upstream game, not just a consuming black hole 12

7. WTI and Brent: Will the price gap close or stay at an abnormal divide? 14

8. The new cool kid on the block: The American tight oil industry 15

9. At a crossroads: Brazil’s challenge to distribute oil wealth while encouraging investment 16

10. The people equation: Canadian oil sands industry to face tough labor issues 18

Contacts 20

Oil and Gas reality check 2012 A look at 10 of the top issues facing the oil sector 1

Foreword

Welcome to the 2012 Oil & Gasreality check.This is the third year Deloitte Touche Tohmatsu Limited’s Global Energy & Resources’ Oil & Gas group has publishedits annual Oil & Gas Reality Check for the year ahead.

2011 gave us all reasons to pause and think. From political uprising, unstable financial markets and the Japanesenuclear disaster, to the abundance of natural gas, rethinking of the nuclear emergence, and the rise of theconsuming national oil companies (NOCs), 2011 was full of surprises. The speed of which the past year’s eventsunfolded and the impact they had could hardly be predicted nor mitigated. The uprising in Libya and the renewedproduction in Iraq did little to stabilize the world oil markets. The sudden loss of supply from North Africa may havecaused Brent and West Texas Intermediate (WTI) prices to diverge even more than they would have based on NorthAmerican inventories only. Despite economic uncertainty, global oil prices remained stubbornly buoyant and areexpected to remain so in the upcoming year, according to both the U.S. Energy Information Administration (EIA)and the International Energy Agency (IEA)

This report is not a predictive statement of the future of what the oil and gas sector will experience. It is, however,a story of the important and unfolding trends that may influence our way forward in the year ahead. As 2011taught us, predictions are bound to be wrong unless luck is on our side. In this document we explore the trendscreated by the events of the passing year and the impact they may have in the upcoming year. Amongst these arethe conventional and unconventional natural gas revolution, the ultra-deep exploration, the globalization of theconsuming NOCs, and the economic realities that a growing array of energy independent countries will face.

Natural gas found in locations closer to the demand centers such as North America, Western and Eastern Europe,Eastern Mediterranean, Africa, and North Asia established confidence in the possibilities that more countries thanbefore will be less dependent on Middle Eastern and Russian reserves. Furthermore, the abundance of such finds isgiving rise to a new breed of net exporting countries and is reversing the direction of liquefied natural gas (LNG)shipments rushing to gain from West/East price arbitrage. As a result, the traditional exporting countries may find anincreasingly competitive market for their reserves as many of the new net natural gas exporters eye the East as theirtarget market.

Asian NOCs representing the largest and fastest growing markets scour the world looking for natural reserves tomaintain their economies’ growth and secure long term supplies. Funded by governments and focused on long termsupply security, the consuming NOCs have grown into a powerful group of global oil and gas companies. While atthe same time, the traditional producing NOCs are becoming more efficient and independent. Brazil’s newfoundwealth of pre-salt light sweet crude allows Petrobras to establish itself as a leading oil and gas company withsufficient funding and a highly trained technical staff. The entrance of the consuming NOCs into a field that waspreviously populated with producing NOCs and international oil companies (IOCs) is leveling the playing field whichwill give rise to an increasing cooperation between the NOCs and an increasing collaboration in the exploration,production, and marketing of the reserves and the refined products.

The 2012 Oil & Gas Reality Check represents the views assembled from our partners, clients, and industry experts.It represents the combined views of practitioners that serve the industry, manage the companies, and study it alongthe various components including the largest oil and gas companies, oil field services, energy traders, and othersinvolved in this sector. I am hoping the reader will find this informative, credible, and insightful.

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As we conclude the report this year, we must start assembling our views for the next one. For that purpose, I wouldwelcome any input and advice as to what we might have missed in this report, new items that could be included inthe next report, and overall comments on the industry. Please do not hesitate to reach out to any of our sectorleaders named in the back page of this report or send me an email directly.

I would like to thank our contributors for providing their insight and expertise.

Adi KarevGlobal Head – Oil & GasEnergy & ResourcesDeloitte Touche Tohmatsu Limited


LibyaWith nearly 47 billion barrels of oil, Libya holds thelargest oil reserves in Africa and undoubtedly hasthe potential to be an oil superpower. Before therevolution, the oil-rich nation was producing 1.66 millionbarrels per day (bpd) and exporting 1.5 million bpd,compared with August of this year when only 60,000bpd were produced. This is a huge economic blow for acountry whose government relies on oil and gas for80% of its revenues. Additionally, this had a major effecton global oil supply and none more so than in Europe.Nearly 86% of Libya’s oil was exported to EU countries,and although Saudi Arabia tried to compensate for theloss of supply and stabilize prices, it could not providethe same light-sweet crude that Libya produces.

The end of Muammar Gaddafi’s rule gives rise to twoquestions: 1) what is the real potential of the Libyan oilindustry, and 2) how long will it take to get productionback to pre-war levels and beyond? Before Gaddafiseized power in 1969, Libya was producingapproximately 3 million bpd, nearly double pre-revolution output.

A return to this level of production could have a majorimpact on the global supply of oil and, not surprisingly,is making IOC eager to return to, or to enter, the market.

The second question, however, is much more difficultto address due to the many uncertainties that lie ahead.Although Gaddafi is gone and change undeniablyawaits Libya, it is still unclear how unified the differentrebel factions will be once the construction of a newgovernment commences, and if they will be able toagree on how to divvy up the oil proceeds. Additionally,no one quite knows the extent of the damage to thecountry’s current oil infrastructure. Many wells were leftunmaintained for an extended period of time andothers were simply not shutdown properly which mayresult in the need for major infrastructure repairs.

Nonetheless, there have been some positive signs. Initialestimates had Libya producing 500,000 bpd by the endof 2011, a number that was reached by early November.The IEA revised its estimates to 700,000 bpd by the endof 20111, 800,000 bpd by the end of the first quarterof 2012, and 1.17 million bpd by the end of 2012.Furthermore, the IOCs that previously had contractsunder the Gaddafi regime are expected to return assoon as possible, with some already trickling back in.However, to return to the pre-Gaddafi production levelsof 3 million bpd, Libya will need the new governmentto provide incentives so international players areencouraged to make the necessary investment.The current revenue split is 90% for the governmentand 10% for the oil companies, but to encourageexploration and production, one analyst believes itshould be closer to a 70-30 ratio.2

1. The future of oil production: Libyaand Iraq are now part of the equation

1 “Update: Libya oil outputresuming far faster thanexpected – IEA.”ShababLibya.org,10 November 2011

2 Reed, Stanley andStephen, Chris. “Libya:Can it become an oilsuperpower?” BloombergBusinessWeek,24 August 2011

Over the past year, uprisings and revolutions throughoutthe Middle East and North Africa (MENA) have started apolitical shift in the region that could very well have alasting effect on the rest of world not only politically buteconomically as well.

IraqIraq’s oil industry, like Libya’s, never reached itspotential due to a regime that would not allow it to.Arguably, the security and infrastructure situation in Iraqis much worse than in Libya. While Iraq has 150 billionbarrels of proven oil reserves and possibly another150 billion of unproven reserves, higher than SaudiArabia, it currently only produces 2.7 million bpd whichis its highest output in the past 20 years. Of course,much of that has to do with the Gulf War of 1991 andthe hostilities in 2003, but that is not the only factor.Under Saddam Hussein, Iraq was never able to reach itscapacity potential due to aging infrastructure.

However, with increased stability in the country andsteadily decreasing rates of violence, the currentgovernment is attempting to reverse this trend. Whilemany analysts believe it to be unfeasible mostly due toinadequate and aging infrastructure, the governmenthas set a goal to produce 10 million bpd by 2017which would rival Saudi Arabia, the Organization of thePetroleum Exporting Countries’ (OPEC) leading oilproducer. Even though Iraq may not reach this goal, itsends a message to the world and to IOCs that showsits commitment to increasing output to the country’sfullest potential.

Key to reaching this objective is at long last thegovernment’s agreeing to let private companies assist inthe process. In 2009, China National PetroleumCorporation (CNPC) and BP signed a deal to ramp upproduction in the Rumaila field in the south.3

Undoubtedly Iraq’s largest field with an estimated 17.7billion barrels of oil, production reached nearly 1.2million bpd by the end of 2010.

There are some setbacks to the government’s ambitiousproduction goals. Firstly, the capacity currently does notexist to increase its production by nearly a factor of 4.Current production levels are pushing the infrastructureto the brink and without caution there could be majorleakages or breaks in the pipelines. Some analystspredict that Iraq could reach 4.5 million bpd by the endof 2013 in a best case scenario, but old pipelines mustbe replaced before capacity can be increased.

Additionally, wells and pipelines remain a target forterrorist attacks. In October, two bombs exploded atthe Rumaila field timed with a visit by the Iraqi OilMinistry, demonstrating political tension still exists.The blasts caused production to fall to 530,000 bpdfrom 1.24 million for a few days before returning tonormal levels.

Our viewIn Libya, damage to refineries and wells still need tobe assessed and safety will continue to be a concernfor foreign workers coming back into the country.Any incident where foreigners might be harmed couldseriously hinder investment in the short-term.Most importantly, a new government needs to beestablished for regulations to be set, allowing IOCs toknow what their operating environment will look like.In Iraq, major upgrades to infrastructure are neededbefore its ambitious goals of 10 million bpd can befeasible, and as with Libya, security and geopoliticaluncertainty continues to be a threat.

Iraq and Libya will undoubtedly play a major role in theglobal oil industry, but both countries have obstacles toovercome that will make it unlikely for them to have amajor impact on the market in the year ahead. It isexpected that an increase of output by non-OPECnations will compensate for the rising demand in 2012.

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3 “China begins oilproduction in Iraq.”Gulfnews.com,24 July 2011


It is no secret that shale gas has transformed the energyindustry in the United States by turning a down-hillmarket into a thriving self-sufficient industry. Half adecade ago, natural gas production was on a steadydecline making the United States more reliant onimported natural gas than ever before. Technologicalbreakthroughs completely changed the game, and now,the United States is on track to become an exporter ofthis valuable resource. In 2001, 1% of natural gasproduction came from shale compared to 20% today.4

As a result, prices have plummeted which, in turn,appears to be having a positive effect onmanufacturing, specifically the steel and petrochemicalsindustries, by reducing the cost of operating factories.

Now, the rest of world is starting to follow suit.In Europe, Asia, and South America, there is a strongpush towards shale gas exploration and production.A recent study on shale gas potential conducted in32 countries by the U.S. EIA estimates that global basinscontain approximately 5,760 trillion cubic feet (tcf) ofshale gas reserves (not including the 862 tcf in theUnited States) which adds 40% to the world’s gasvolume.5 However, all countries outside of the UnitedStates are still in the infancy stages and are at least fouryears from material production. Additionally, mostcountries will need the expertise of the IOCs that havesubstantial footprints in the U.S. shale industry to helpdevelop their respective industries.

As always when discussing the topic of shale gas, oneof the biggest hurdles is the potential environmentalimpact. There is still inconclusive evidence on the effectsthat hydraulic fracturing – the process used to extractthe gas from the tight rock formations using a mixtureof water, sand, and chemical lubricants – has ongroundwater resources. Therefore, every country hasapproached shale gas production differently.

In Europe, Poland and France have the largest amountsof recoverable shale gas according to the EIA study with187 tcf and 180 tcf, respectively. The development ofthe shale industry in Poland could completely shift thenatural gas landscape across the continent. 187 tcf isenough to provide Poland with gas for domesticconsumption for the next 300 years. As a result, thegovernment fully expects to maximize shale gas’spotential by not only becoming self-sufficient, but also,by becoming a major exporter to the region. As for the environmental concerns, the economicbenefit seems to far outweigh the potentialenvironmental hazards especially when compared tocoal generation, which accounts for 85% of Poland’selectricity generation.6 Therefore, the government hasalready given four large U.S.-based companies that haveoperations in U.S. shale basins exploration rights to helpjumpstart the industry.

If Poland truly does hold as much shale gas as predictedin the EIA study, it may have a big impact on Europeand most notably, Russia. Not only will Russia likely losea large export market, as currently two-thirds ofPoland’s annual gas consumption is imported fromRussia, but it will have a new competitor in the regionand will inevitably drive prices down. This, however, willnot take effect for several years due to Poland’s industrybeing in its earliest stages, and the required investmentto build pipelines and LNG stations for export purposes.Nonetheless, change to the natural gas market inEurope is inescapable, and Russia should be revising itsstrategy by finding new markets.

Although France has potential for a substantial shaleindustry, it has opted to not develop its basins. Theyhave placed a moratorium on hydraulic fracturing in thecountry until the environmental consequences are moreevident. With nuclear power being France’s main sourcefor generating electricity, the government is not aseager to enter the shale industry.

In China, the potential for shale gas is extraordinarilyhigh with the EIA’s study estimating that 1,275 tcf oftechnically recoverable shale is available which wouldbe more than any other country’s reserves, includingthe United States. The Chinese National EnergyAdministration has even commissioned a shale gasdevelopment plan. While there is an optimistic outlookfor the shale industry in China, there are somedrawbacks as well.

2. Join the game: The globaldevelopment of shale gas assets

4 Blair, David. “Search forUK shale gas resourcesbegins.” Financial Times,31 August 2011

5 Katusa, Marin. “New EIAreport says shale gasboom could go global.”Forbes, 27 June 2011

6 Cienski, Jan. “Polandhopes to tap big reservesof shale gas.” FinancialTimes, 9 August 2011

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Firstly, the Sichuan province’s farms supply China with7% of its rice, wheat, and other grains and one-tenthof the country’s pork, all of which are staple foods.While water is abundant in the area, it is unevenlydistributed and needed by farmers. An emergenceof the shale gas industry will undoubtedly create astruggle for water rights due to the high amountneeded by both industries.

Secondly, there are technological constraints.Historically, China has not been very open tointernational oil and gas companies, but if there is hopeof jumpstarting the shale industry quickly, the expertisewill surely be needed. There are signs, however, thatthe government will be more open to IOCs for thepurposes of shale development. Royal Dutch Shell is theonly major Western producer to sign an agreement inChina with PetroChina resulting in the drilling of thefirst horizontal well in the region in March. U.S.-basedExxonMobil, Chevron, ConocoPhillips and Halliburtonare also in talks with China regarding its policies.7

However, even if China changes its policies, there is stillno indication of how much they will change and whatthe incentives for the IOCs will be.

Lastly, coal accounts for 70% of China’s electricity whilenatural gas only accounts for 4% of its energy needs.Even though natural gas emits less CO2 emissions thancoal, it is unlikely that China will stray too far from coalsince many of their modern coal-burning plants havebeen built in the past five years. However, theproduction of shale gas could prove to be cheaper thanimporting LNG from Qatar and Australia.

Shale gas will be a way of the future for China, but justlike other countries, it is still years away fromcommercial production. In the meantime, China willneed to rely on developing supply contracts with gasexporting countries such as Qatar, Australia, and Russia.Additionally, unlike in parts of Europe and the UnitedStates, China’s growing energy demand will likelyovershadow the possible environmental concerns ofextracting shale gas.

In South America, Argentina has the highest potentialfor shale gas with the EIA study estimating that 774 tcfexists within its borders, but production of the resourceis at least half a decade away if not longer. ExxonMobiljust agreed to invest US$120 million to explore gas inArgentina.8 However, even when gas will be ready toproduce, the incentive currently does not exist forcompanies to invest into the market due to price capsenforced by the government. The average price ofnatural gas is sold domestically at US$1.96 per millionBritish thermal units (MMBtu), but the governmentbought it for US$7.33 per MMBtu.9

Additionally, the government would discourageproducers from exporting the resource by implementingsteep taxes. With the current reelection of incumbentpresident Cristina Kirchner, the energy subsidies toindustry and consumers are likely to stay in place.

Like China, however, environmental risks will probablynot stand in the way of the shale gas industry in SouthAmerica. If some of the regulatory hurdles can bepassed, this could be an encouraging factor forcompanies looking to invest in shale gas prospects.

There is no question that the shale industry has changedthe energy outlook of the United States and is well onits way to having similar effects globally. However, thereare questions that exist: how long before the globalrevolutions take off, what are the perceived and actualenvironmental consequences of hydraulic fracturing, andwhat is on the technological horizon that may helpsubdue the environmental concerns?

Our viewThe more emerging markets that find shale gas, themore it will have an effect on the global gas industry.Energy demand in emerging economies is on the risemaking energy security a critical priority. Therefore,countries such as China, Poland, and Argentina are lesslikely to be concerned with the environmentalconsequences of hydraulic fracturing. This is especiallytrue for countries in Asia and Europe looking todecrease their reliance on Russian natural gas.

As for countries like Poland and Argentina who havehistorically been net importers of natural gas, shale gascould change their fortunes and make them into netexporters just as many analysts expect the United Statesto be by the end of the decade. This will incentivizegovernments to encourage foreign investment asPoland has been doing.

7 Kirkland, Joel. “Chinabegins to tap its shalegas, despite dauntingtechnological,environmental hurdles.”The New York Times,14 October 2011

8 “Argentina minister seesunconventional gasboom on the horizon.”Dow Jones Newswires,21 September 2011

9 Ibid


Traditionally, there has always been a significantrelationship between crude oil and natural gas prices.Barring an out-of-ordinary event, the price of crude oilper million British thermal units (MMBtu) is almostalways higher than the price of natural gas per millionBritish thermal units. In August of 2005, the price ofgas per MMBtu was actually higher than crude oil perMMBtu after Hurricane Katrina devastated the U.S. Gulfcoast.

The prices of the two resources have historically beencoupled in the sense that when oil prices increased sodid the price of natural gas, although, that seems to bechanging. In 2007, the Baker Institute of Rice Universitywrote a policy paper on the relationship between crudeoil and natural gas prices in which it stated that if theaverage price of WTI is US$70 a barrel, the price atHenry Hub would be US$9.40 per MMBtu.10 However,that has not happened over the past couple of yearswith the price of oil increasing and the price of gasdecreasing. At the beginning of November 2011,the price of oil was US$94 a barrel which is an 11%increase from November of 2010, whereas the priceof gas sat below US$4, a 1.3% decrease from the yearbefore.

In the past, oil and gas prices have decoupledtemporarily but have always recoupled eventually.However, this time around it seems that it could bepermanent for three main reasons:

• The globalization of natural gas.• Companies specializing in all facets of the gas industry.• The emergence of shale gas.

The globalization of natural gasNatural gas had typically been a regional resource dueto the lack of well-developed cross-border andintercontinental pipeline networks. Since oil has alwaysbeen a more globally-priced and liquidly-tradedcommodity than gas, it seemed reasonable to couplethe prices together. Therefore, when gas contracts aremade, the gas price is based on a formula that isheavily reliant upon the price of oil.

However, with the transportation of LNG becomingincreasingly more utilized, the natural gas industry isbecoming more global. Southeast Asia and Europe nowreceive a large amount of LNG from Qatar as well asmany other countries. As examples of this increasingglobalization there are already talks to create an LNGterminal in Mozambique after Eni SpA announced itsbig discovery in October, so there would likely be supplyto the Asian markets. Israel and Cyprus have discussedbuilding LNG terminals on the Cypriot island. Theglobalization of natural gas allows for markets to settheir gas prices based on other gas market prices andnot oil prices.

Companies specializing in all facets of the gasindustryIn the past, oil companies had been the major players inthe natural gas industry. That has changed, however,with more and more companies specializing in gasexploration, production, and transportation. BG Groupis an excellent example of a vertically integrated gascompany that owns assets that are located not onlyglobally but throughout the gas value chain.Additionally, most big oil companies have establishedseparate gas and power divisions dedicated to thenatural gas industry. This has fundamentally changedthe gas market by companies focusing on the entirevalue chain. Companies do not just want to focus onthe production and transportation of the resource butalso want to trade natural gas. With more companiesspecializing solely in the gas industry, there is less of atendency for prices to be coupled with crude oil.

3. The decoupling of oil and gasprices: Where and when?

10 Hartley, Peter, KennethMedlock III, and JenniferRosthal. “Therelationship betweencrude oil and natural gasprices.” James A. BakerIII Institute for PublicPolicy, Rice University,2007

At the beginning of November2011, the price of oil was US$94a barrel which is an 11% increasefrom November of 2010, whereasthe price of gas sat below US$4,a 1.3% decrease from the yearbefore.

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The emergence of shale gasThe shale gas boom in the United States has alreadyshown how it has effectively decoupled oil and gasprices. While WTI has seen a 11% increase in the lastyear, natural gas prices have decreased by 1.3% withan even bigger decrease over the past three years.With the US expected to become a net exporter ofnatural gas because of shale, there will be an influxof new supply into demand markets.

Additionally, estimates show that China, Argentina, andPoland have a high potential for shale gas in eachrespective country. Even though production is still threeto seven years away, this will eventually drive up supplyand competition in Europe, Asia, and South Americawhile pushing prices down or holding them relativelysteady.

Our viewThe price of crude oil and natural gas will likelycontinue to decouple over the next few years.With natural gas markets becoming more localized dueto the latest abundance of resources nearer to thedemand economies, more countries see the potentialof energy independence. As China’s thirst becomes aglobal target for the next exporters, natural gas marketprices are more apt to be determined by local conditionswhereas oil price remains a global commodity withglobal characteristics. While oil demand is likely toremain high keeping oil prices elevated in the long term(with possible market corrections in the short- andmedium-terms), gas prices remain low in the Westand are diverging from the elevated prices in the East.Although there is a possible downward pressure on theelevated prices of gas in the East (mainly due to LNGcompetition), the West’s prices seem likely to remaindepressed.

By no means is the decoupling process of crude andgas prices complete. Many industries that rely heavilyon natural gas, such as petrochemicals, still prefer forgas prices to be linked to crude due to the fact that oilis more globally traded. However, over time, this is likelyto begin to change as well.


NOCs from producing nations have historically held allthe power, especially the members of OPEC. These daysyou can add Russia, Brazil, and Mexico to the list ofimportant oil producing nations. NOCs from thesecountries are powerful because they control themajority of the world’s oil, and in turn, they can controloil prices by determining the supply available to themarket.

This, perhaps, was most evident by the 1973 oil crisiswhen OPEC announced an oil embargo in response tothe United States’ aid to Israel during the Yom Kippurwar. Today, the major oil producers of the world stillhave that effect on the market, whether it is voluntaryor not. The Iraq war that started in 2003 and thesubsequent unrest in the Middle East sent oil pricesupward in a trend that has yet to be reversed and likelynever will be. In 2011, the Libyan revolution nearlyhalted all oil exports from the country causing Brentcrude to hit US$115 a barrel. It is undoubtedly clearthat NOCs from major oil producing nations arepowerful and will continue to be for years to come.

However, the past few years have seen a rise in a newtype of NOC that is proving to be just as powerful in acompletely different way. These national oil companiescome from energy consuming countries, such as Chinaand South Korea, which need to import the majority oftheir energy needs. They are powerful for two mainreasons. Firstly, the consumption of western developednations has been flat or declining in recent years.Therefore, producers are looking more to the East foremerging markets that have a thirst for energy. Sincecompetition is high for these markets, consuming NOCscan drive a hard bargain on the price of which oil andgas is sold to them. Secondly, consuming NOCs havethe financial backing of their respective states whichallows for untraditional loans and investments thatmight not be available from IOCs.

Over the past few years, China has exemplified howNOCs from a consuming nation can be powerful byusing its financial stability to diversify its import partners.In the Middle East, China continues to establish itspresence by striking deals with multiple countries. In2009, China imported 1 million bpd from Saudi Arabiaaccounting for 20% of its total oil imports.11 Thatrelationship has only grown over time. Unlike othercountries, Saudi Arabia does not need China to invest inits upstream operations as it already has the necessaryinfrastructure. However, Saudi Arabia needs otherresources such as textiles and machinery which can beimported from China. The relationship has also recentlyshifted from just crude trade to downstream cooperation.Earlier this year, Saudi Aramco struck a deal withPetroChina to support a new refinery in Yunnan thatwill supply 200,000 bpd from the new Burma pipeline.Aramco struck another deal with Sinopec to partner onthe Yanbu Refinery on the Red Sea coast.12

However, with the uncertain stability in the MiddleEast, China has been looking elsewhere to becomeless dependent on the region. For example, Chinahas invested heavily in Brazil and other Latin Americancountries in recent years. Sinopec investedUS$7.1 billion for a 40% stake in RepsolBrazil.Additionally, the China Development Bank lentPetrobras US$10 billion in exchange for future oilsupplies.13 The deep wallet of the Chinese governmentallows it to secure supplies in a way that othercountries cannot.

China has been able to show its might in recent talkswith Russia. While a pipeline that will send Russian oilto China was completed in September of 2010, themost talked about deal has been a gas agreement thatwould supply China with 69 billion cubic meters of gasa year for the next 30 years. The deal has been in theworks since 2006, but the two sides have been unableto negotiate a price. Russia’s Gazprom has been lookingto expand its export portfolio beyond Europe for sometime now and grows more and more eager to do so astime goes on. As European nations find new sources fornatural gas, imports from Russia will likely decline.However, China is finding new sources of natural gas aswell which has allowed it to drive a hard bargain. Thediscovery of shale gas in China, increased imports fromTurkmenistan to 40 billion cubic meters a year, and LNGimports from the Middle East and Australia has onlyweakened Russia’s position in the deal.

4. The new NOCs: The emergence ofnon-traditional consuming national oilcompanies

11 “Shifting Sands: SaudiArabia’s oil moves eastto China.”Knowledge@Wharton,5 April 2011.http://knowledge.wharton.upenn.edu/arabic/article.cfm?articleid=2649

12 Hook, Leslie. “SaudiArabia and China: moreoil deals to come?”Financial Times,21 March 2011

13 “Brazil Petrobras signscooperation accord withChinese oil companies.”Dow Jones Newswire,15 April 2011

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Other than China, South Korea’s Korea National OilCorporation (KNOC) has been active in securing oilreserves as well. South Korea imports nearly all of its oilneeds making it the world’s fifth largest importer ofcrude oil. This year, KNOC was able to secure a dealwith Abu Dhabi National Oil Company (Adnoc) givingit a guaranteed stake of 1 billion barrels of technicallyrecoverable oil.14 As the region’s fourth largesteconomy, South Korea is constantly competing withChina, India, and Japan to secure energy resources.This deal will raise South Korea’s oil-owned importsfrom 10% to 15%.

Our viewAs energy consumption in the West flat-lines or evendecreases, consuming NOCs will continue to be morepowerful with producers looking to secure exports tonew markets. However, this does not mean thatproducing NOCs are becoming less powerful but rathershows that they are becoming interdependent.Producers need new markets and consumers needthe supply.

However, as consuming and producing NOCs becomemore interdependent, joint ventures are becomingincreasingly common. These JVs tend to be morecomplicated than those between IOCs or even betweenIOCs and NOCs. From Deloitte member firms’experiences, this is true for three main reasons. Firstly,in many cases, agreements are politically driven and theoriginal deals tend to be unsustainable. Secondly, theNOCs are not on the same page due to cultural andlingual barriers. Lastly, most NOCs do not use theAssociation of International Petroleum Negotiators(AIPN) which helps ensure that best practices are usedwhile negotiating JVs. So while both consuming andproducing NOCs are powerful, they still have much tolearn in working together.

14 “South Korea and AbuDhabi in pact to developoil fields.” BBC News,14 March 2011

The deep wallet of the Chinesegovernment allows it to securesupplies in a way that othercountries cannot.


Over the past half-decade, shale gas has consumedmuch of the conversation in the natural gas industry.How much is there? Is it economically recoverable?What are the environmental effects? Slowly, thesequestions are being answered, and there is no doubtthat shale gas will continue to have a major impact onthe natural gas market. However, over the past year,there have been significant conventional gas discoveriesin countries that historically have not been hydrocarbonproducers. These discoveries could change theeconomic outlook of each country and continue tochange the scope of the global natural gas industry.

There have been major discoveries off the coasts ofAzerbaijan, Israel, Cyprus, and Mozambique. Ifproduction goes according to plan, each country, otherthan Azerbaijan who became a net exporter back in2007, should become a net exporter of natural gaswithin the next decade. Russia, the largest exporter ofnatural gas in the world, will likely be the mostimpacted by losing market share to the new breed ofgas exporting nations.

The amount of exports coming from Azerbaijan couldsignificantly multiply since France’s Total discovered alarge gas field off its coast that could hold “severaltrillion cubic feet of gas reserves.”15 This is great newsfor the European Union who is trying to diversify itssuppliers. The EU backed construction of the NabuccoPipeline that would run from Turkey to a major hub inAustria but has had trouble securing supply for the 31billion cubic meters a year pipeline. Gas from the ShahDeniz field is planned to fill some of the pipeline’scapacity, along with the newly discovered offshore fieldonce it is ready for production

Furthermore, Europe could be getting additional importsfrom Israel and Cyprus which would further weakenRussia’s hold on the European market. Historically, Israelhas been one of the few unlucky Middle Easterncountries that have not had significant reserves of oiland gas. However, in the past year, there have beenlarge offshore finds in the Eastern Mediterranean whichmay turn the net importer into a net exporter of naturalgas. The Leviathan field has a potential of 453 billioncubic meters. Cyprus will likely find significant reservesoff its southern coast as its exclusive economic zoneoverlaps Israel’s zone. There are already talks of buildingLNG terminals on Cyprus that would be supplied by bothcountries and exported to Europe.

While there is great potential for the EasternMediterranean, there are also plenty of hurdles. TheU.S. Geological Survey estimates that there are 122trillion cubic feet of gas in the Levant Basin whichadjoins Israel, Gaza, Cyprus, Lebanon, and Syria.Currently, there is much resemblance to the geopoliticalstruggle in the South China Sea. There are alreadydisputes between Lebanon and Israel over maritimeborders and since the two are technically at war, theywill not negotiate directly. Additionally, Turkey has beeninvolved due to the internal struggles in Cyprus and itssupport of the Turkish Cypriots located in the northernpart of the island. Turkey’s relationship with Israel hasalso grown cold since an aid flotilla en route to Gazawas attacked by Israel and eight Turkish people werekilled.

In October, Italy’s Eni SpA announced a large discoveryoff the coast of Mozambique that could significantlychange the economic outlook of the poor Africannation. Eni initially estimated that there is 15 trillioncubic feet of gas but has since raised that figure to22.5 trillion cubic feet.16 There is enough gas off thecoast of Mozambique to sustain construction of a largeLNG terminal capable of exporting gas to China, India,South Korea, Thailand, and Japan. With increasingenergy demands in the East, the added supply providedfrom Mozambique would be welcomed.

Our viewWhile these new natural gas discoveries will eventuallyplay a role in shaping the global gas market, productionis still a few years away since the discoveries were madefairly recently. Instead, the focus should be on Russia’sreaction to recent competition and whether it cansecure new long-term supply deals prior to the influx ofnew supply to Europe and Asia. Additionally, thegeopolitical situation in the Eastern Mediterranean isworth keeping a close eye on especially since thepolitical tension is much deeper and complex than justthe issue at hand.

5. Just because shale is in doesn’t meanconventional is out: New exporterscome to market

15 Gorst, Isabel. “Gasfield discovered offAzerbaijan.” Financial Times, 11 September 2011

16 Gold, Russell. “Big gasfind for Italy’s Eni.”The Wall Street Journal,21 October 2011

It is no secret that China’s energy demands haveskyrocketed in the past decade and will continue to doso to keep up with its fast growing economy. Prior to1993, the country was a net exporter of crude oil, butnow, it imports more than 50% of its oil needs. Manysee China as a consuming black hole that buys energyassets all over the world and imports the majority of itsneeds, but the government is trying to reverse thistrend and develop a formidable upstream game,something which is turning out to be quite difficult.

As of 2010, China had the second largest export surplusbehind Germany which is one of the main contributorsto its rapid economic growth. However, increasingdemands for food and energy imports are starting totake their toll on that surplus. As a result, thegovernment has made the containment of energyimports a part of its 12th five-year plan. Thegovernment plans to invest in the oil and gas industryto increase the amount of fossil fuels produceddomestically and reduce the percentage of overallenergy imports.

In 2009, China’s nine major oil fields produced3.8 million bpd which accounts for 80% of its totaloil output. However, five of the nine fields have seendeclining production figures17 meaning that China mustfind other sources of oil. Investing heavily in energyinfrastructure is part of the 12th five-year plan to helpreverse the trend. In the oil and gas sectors alone, thegovernment plans to build five large-scale oil and gasproducing bases and 150,000 km of oil and natural gaspipelines.18

Additionally, there has been a huge push to startexploration and production in the South China Sea.However, this has been difficult due to the geopoliticaltension surrounding the region. China, Vietnam,Malaysia, Brunei, and Taiwan all lay claim to the areawithout much progress being made to resolve thedispute. Recently, tensions between India and Chinaregarding exploration rights have risen. According toChinese analysts, the South China Sea potentially has200 billion barrels of oil lying below its seabed whichcould help China slowly reverse its rising need for oilimports. U.S. scientists predict the reserves to be muchlower, closer to 28 billion barrels, but even thisconservative estimate significantly help China reach itsgoal of reducing its energy dependency.19

While there will be a continued focus on growing theirupstream oil industry, the real opportunity to help liesin the natural gas sector. The potential lies in threedifferent types of gas: conventional natural gas, coalbedmethane (CBM), and shale gas.

In the last Chinese oil and gas resource evaluation20,it was estimated that there are 784 tcf of recoverableconventional natural gas. 70% percent of those reservesare based in five basins.21 However, as with oil, thedevelopment of the South China Sea could significantlyincrease natural gas reserves in China. According to theU.S. EIA, the South China Sea could hold up to 900 tcfof natural gas reserves which is equivalent to Qatar’sreserves.22

6. China is an upstream game, not justa consuming black hole

17 Deloitte Internal Review

18 Ibid

19 “Q&A: South China Seadispute.” BBC News,19 July 2011


21 Ibid

22 “Q&A: South China Seadispute.”

12

As of 2010, China had the second largestexport surplus behind Germany which isone of the main contributors to its rapideconomic growth.

13

Even though the development of CBM in China hasbeen difficult, efforts are still ongoing. The sector is inits early stages and proven reserves have been small sofar, but the Chinese oil and gas resource evaluationestimated that there are 383 tcf of CBM in China.23

CNPC owns about 70% of the country’s total licensedacreage and has been working to develop the resource.By the end of 2010, CNPC had drilled nearly 1,500wells in four key exploration areas. The biggest barrierto developing CBM is the high cost of production.

While the development of conventional natural gas andCBM will help reduce China’s dependency on foreignsupplies, shale gas has the biggest potential to makethe country a formidable upstream player. In a 2011report by the EIA, China is estimated to have over1,200 tcf of shale gas in the country, surpassing shaleestimates in the United States. The industry is still in itsinfancy, but the government has upgraded thedevelopment of shale to that of a national interest.However, if the government wants to ensure thegrowth of the industry, it will need the help ofinternational companies that have experience withshale gas exploration and development. The Chinesegovernment knows what is at stake. In initialnegotiations with oil and gas companies, thegovernment has been more open to allowing foreignassistance in shale gas development to help jump startthe industry.

Our viewThere are two main benefits to developing bothconventional and unconventional forms of natural gas.Firstly, it will be a major step towards reducingdependency on foreign supplies, ensuring Chinamaintains a healthy export surplus. Secondly, it isa chance to significantly reduce the amount ofgreenhouse gas emissions in China. Coal makes up 70%of China’s current energy usage structure. By increasingnatural gas usage in China, CO2 emissions trends canbe slowed down or reversed, but if nothing is done andthe current path is continued, China’s CO2 emissionswill be more than the United States’, EU’s, and India’scombined by 2020.

It can be expected that there will be a big push to getthe shale gas industry off the ground in 2012. However,due to geological difficulties and lack of technicalknow-how by Chinese state-owned enterprises (SOEs),it will be a relatively slow start for the sector. With thegovernment backing the development of the shale gasindustry, there is one thing that is almost certain: therewill be no lack of capital investment. Once partnershipsbetween Chinese SOEs and large multinationals aredeveloped to help establish technical know-how, it canbe expected that the industry will grow at an increasingrate. Nevertheless, commercial production of shale gasmost likely will not start before 2014.

Through the new 12th five-year plan, China is well onits way to changing its reputation from being an energyconsuming black hole. Planned investments in theupstream oil and gas industries will help China reduceenergy imports, decrease energy costs, and maintain asurplus in its general trade balance.


14

In 2011, oil prices have been out of character.Historically, WTI crude and Brent crude have sold withina couple of dollars of each other. Actually, WTI, onaverage, has sold approximately US$1.00 above Brentprices. This year, however, has been a different storywith Brent prices well above WTI prices. September sawa peak spread of US$26 before the margin dropped toa little over US$16 by the end of October. Thesemargins are unprecedented, and some believe that theyare here to stay.

However, there are four reasons why the market willsee the prices of WTI and Brent narrow in 2012:

• Increased supply from Libya

• Refineries coming back online in the United States

• New pipelines from Cushing to Texas and the Gulf ofMexico

• Increased confidence in the U.S. economy

Increased supply from LibyaThe biggest reason Brent prices have been selling somuch higher than WTI is because of the revolution inLibya. Beforehand, Libya exported nearly 1.5 millionbpd of light sweet crude to Europe, but in March, thatcame to a halt. Even though Saudi Arabia made up formuch of the supply lost from the North African nation,Saudi crude is heavier, making it harder and moreexpensive to refine causing Brent prices to increasedramatically. While our view is that Libya will likely notreturn production to pre-war levels of 1.6 million bpd,supply will nearly reach 1.2 million bpd by the end of2012 and ease pressure on Brent crude prices.

Refineries coming back online in the UnitedStatesIn 2011, there was an unprecedented amount ofrefineries undergoing maintenance work causing abacklog of oil supply in Cushing. Therefore, supplyeasily met the demand from online refineries causingWTI prices to depreciate. As these refineries come backonline in the coming months, demand for WTI willincrease and import demand will decrease which willraise WTI prices and narrow the gap.

New pipelines from Cushing to Texas and theGulf of MexicoIn addition to refineries undergoing maintenance,the backlog of oil is due to insufficient pipelines leadingfrom Cushing to the Gulf of Mexico. There have beenseveral projects announced by Houston-basedcompanies to build pipelines to Houston and Gulfrefineries which will increase demand. Additionally,if the government approves the Keystone XL pipeline,that will also increase the amount of oil flowing torefineries in the Gulf of Mexico. This, again, willincrease demand and narrow the price gap.

Increased confidence in U.S. economyIn recent months, there had been fears of a double-diprecession in the United States causing the stock marketto dip, including WTI stocks. However, even as fearscontinued over the debt crisis in the Eurozone, thirdquarter economic statistics showing an increase of2.5% in GDP growth in the United States eased fears ofa double-dip recession. As the U.S. economy continuesto grow and fears in Europe linger, WTI prices willincrease while Brent prices will likely stagger.

Our view2012 will likely see a slow shift back to normalcy as WTIand Brent prices narrow throughout the year. This willhappen due to a slight increase in Libyan exports,increased demand in the United States once refineries arelive again, new pipelines from Cushing to Texas and theGulf of Mexico, and the continued growth of the U.S.economy. In fact, by the end of 2012, it is possible thatWTI prices will be selling above Brent crude once again.

7. WTI and Brent: Will the price gapclose or stay at an abnormal divide?

As the U.S. economy continues togrow and fears in Europe linger,WTI prices will increase whileBrent prices will likely stagger.

15

Due to technological advances that allow for theextraction of gas from shale rock formations, the UnitedStates has reversed its natural gas outlook and is oncourse to becoming an exporter of this key commodity.Although shale gas production in the United States willcontinue to be a focus for oil and gas companies, tightoil, also known as shale oil, will increasingly becomejust as essential over the years ahead.

Whereas shale gas predominately lies in the NortheastUnited States, tight oil has been discovered in westernNorth Dakota, eastern Montana, and south Texas. Eventhough analysts have known that oil existed within theshale rock formations, they did not realize its abundance,and even if they had, it was not economical to extractthe oil until recently. In 2008, the U.S. Geological Surveyestimated that there are 4.3 billion barrels of recoverableoil in the Bakken formation in North Dakota andMontana alone.24 In 2005, 3,000 bpd were beingproduced from the Bakken formation.25 Today, thatnumber is 400,000 bpd26 and production could reach1 million bpd by 2020.27

In southern Texas, the Eagle Ford formation is currentlyproducing 100,000 bpd with estimates rising to450,000 bpd by 2015. Nearly 3,000 wells were drilledin the region from May 2011 to June 2011.28 A recentstudy by IHS CERA shows that shale oil formationscould hold as much as 17 billion barrels of oil. This newaccess to oil has helped increase the United States’ oilproduction for the first time in years29, and by thedecade’s end, we could see oil production increase by25% or nearly 2 million bpd.

Just as the shale gas revolution, smaller independent oilcompanies have led the way in the tight oil boom.However, bigger multinational oil companies see themarket potential and are beginning to invest in theseunconventional oil reserves. In 2010, Royal Dutch Shellacquired assets in the Eagle Ford region in Texas. ChiefExecutive of Shell Peter Voser said that he wanted tomake sure that they entered the game early instead ofacquiring matured areas.30

With much of the land already taken in the Bakkenformation, the potential for M&A activity is high.Statoil ASA was one of the first big integrated oilcompanies to acquire an independent, and in turn, gainaccess to tight oil assets in North Dakota. In October2011, Statoil acquired Brigham Exploration Companyfor US$4.4 billion and received 375,000 acres of land inthe Bakken and Three Forks formation. This has beenthe most expensive deal to date.31

Other than the large quantities of oil, big multinationaloil companies may be more enticed to acquire assets intight oil producing regions as the cost of hydraulicfracturing decreases. Over the past 10 years, Exxon’sfinding and development costs of conventional oilhave increased tenfold to US$14.21/bbl. However,Oklahoma-based Continental Resources’ costs arecurrently US$9.63/bbl. Additionally, the productioncosts in the Bakken region is US$55/bbl while oil pricesare approximately US$90/bbl.32

Our view While there is considerable potential in the U.S. tight oilindustry, there may also be some drawbacks. As withshale gas, extracting tight oil requires hydraulicfracturing, a process which could possibly have negativeenvironmental effects, especially on ground watersupply. So far, the opposition to tight oil operations inTexas and North Dakota has not been as stringent as inthe northeastern United States concerning shale gas.It is worth noting that analysts believe the economicbenefits far outweigh the environmental effects.

Furthermore, the lack of infrastructure in North Dakotais causing a couple of problems. Firstly, there has beena large influx of workers into the Bakken region whichdoes not have sufficient housing to accommodatethem. Many people are sleeping in dorm-styleaccommodations, and in the most severe cases, someare sleeping outside. Secondly, the lack of pipelinesmakes it difficult to transport the oil to other parts ofthe country. As the tight oil sector continues to growand develop, investment is needed to ensure that theseissues are resolved.

8. The new cool kid on the block:The American tight oil industry

24 Lachapelle, Tara andPolson, Jim. “Bakkenturns Oasis into targetas fracking costs slide:Real M&A.” Bloomberg,19 October 2011

25 Hargreaves, Steve.“Billions of barrels ofuntapped U.S. oil.”CNNMoney.com,9 March 2011.http://money.cnn.com/2011/03/04/news/economy/oil_shale_bakken/index.htm

26 Krauss, Clifford. “Shaleboom in Texas couldincrease U.S. oil output.”The New York Times,27 May 2011

27 Hargreaves. “Billions ofbarrels of untapped U.S.oil.”

28 Krauss. “Shale boom inTexas could increase U.S.oil output.”

29 Gold, Russell andDezember, Ryan. “It’sofficial: ‘Age of Shale’ hasarrived.” The Wall StreetJournal, 18 October 2011

30 Crooks, Ed. “Shell TargetsNorth American ‘tightoil.’” Financial Times,22 September 2011

31 LaChapelle and Polson.“Bakken turns Oasis intotarget as fracking costsslide: Real M&A.”

32 Ibid

16

Over the past half-decade, Brazil’s budding oil industryhas been of much interest to nearly everyone, whetherit is big international oil companies or energy thirstycountries looking for a new source of supplies. Much ofthe buzz comes from the discovery of potentially largeamounts of oil in Brazil’s offshore pre-salt blocks. It isestimated that there are over 50 billion barrels ofreserves33 in the region off the coasts of Rio de Janeiroand Espirito Santo with some estimates in the 120billion barrel range.34 In addition to having a lot of oil,it is also high quality light sweet crude which is evenmore enticing.

However, with this newfound wealth, there has beenmuch controversy and debate. Everyone wants a piece ofthe pie: the federal government, the states, the majoritystate-owned oil company Petrobras, and the IOCs. Sincethe potential of the pre-salt fields was recognized, theBrazilian government has been trying to figure out howto maximize profit from them. In fact, the governmenthas not held any bidding rounds for offshore blocks since2007. However, the government must be careful not todeter foreign investment by raising taxes and royaltiestoo much especially since billions of dollars will beneeded to develop the deep-water fields.

Last year, former president Luiz Inacio Lula da Silvasigned a new production-sharing agreement (PSA) intolegislation that has been a big topic of discussion.The PSA only affects future agreements on pre-salt and“strategic” blocks sold by the government. The mostnotable piece of the legislation is that Petrobras musthold at least a 30% stake and operatorship of eachblock. Other companies, including Petrobras, can bid onthe remaining 70%.35

Giving Petrobras a mandatory 30% stake andoperatorship ensures more oil reserves and revenues forthe government. However, some analysts believe thatthe responsibility could be too much for the company.Petrobras may not necessarily want a stake in all blocksplus the company has to pay the government for theirstake just like every other company. While this couldbackfire on the Brazilian government, it will most likelymean Petrobras will increase efficiency to ensure theymake a profit.

Additionally, each bidder will be selected based on thepercentage of “profit oil” given to the governmentunder the new PSA. Profit oil is defined as the amountof hydrocarbons produced in excess of the sum of thecost of investment by the company plus royalties.Furthermore, the government will receive an oil outtake(which did not exist in prior agreements) equal to theoil profit agreed upon and a 10% cash royalty.36

The first bidding rounds for the pre-salt blocks underthe PSA have been scheduled for the second half of2012, but there are still some uncertainties. The mainsetback has been due to unclear distribution ofroyalties. Currently, the federal government and the oilproducing states – São Paulo, Rio de Janeiro, andEspirito Santo – reap the most benefit from theroyalties. The remaining 24 states are arguing that theoil belongs to all Brazilians, and the resulting wealthshould be used to improve the country as a whole.On the other hand, stakeholders from the threeproducing states argue that since the oil is producedthere, their states should reap the benefits.

9. At a crossroads: Brazil’s challengeto distribute oil wealth whileencouraging investment

33 “Brazil oil royalty planpasses one hurdle.”Reuters, 19 October 2011

34 Greenblatt, Alan. “Brazilhopes to add oil wealthto booming economy.”NPR.org, 7 September2011

35 Deloitte Internal Review,“Global Oil & Gas Taxnewsletter.”

36 “Brazil implements aproduction-sharing modelfor new pre-saltconcessions.” Vinson &Elkins¸ 3 December 2010

It is estimated that there are over 50 billionbarrels of reserves in the region off the coasts ofRio de Janeiro and Espirito Santo with someestimates in the 120 billion barrel range.


In October, current president Dilma Rousseff sentlegislation that calls for royalties to be distributed moreevenly among all states to Brazil’s Senate. It passed inthe Senate, but it will have a much tougher timepassing in the lower house of Congress. Currently,the federal government receives 30%; Rio de Janeiro,Espirito Santo, and Sao Paulo split 26.25%, and theremaining 24 non-producing states share 1.75%.The new legislation introduced by Rousseff would havethe following effects: the federal government’s sharewould be cut by one-third to 20%, the producingstates’ share would be reduced from 26.25% to 20%,the other 24 states would initially divvy up 20% withan increase to 27% by 2020, and the remaining 40%would be divided by municipalities. The chart belowgives a breakdown of how royalties are distributed inthe current system and how that would change underthe proposed plan.

Even if the new legislation passes in the lower house,the fight will not end there. The oil-producing statesvow to sue to block the legislation.37 However, therehas been talk of raising the special participation tax oncompanies to make up for lost revenue by the federaland producing states’ governments.38 Analysts believethis would affect current agreements which many thinkwould deter foreign investors from deepening theiroperations in Brazil due to fears that future contractscould be altered. Additionally, Petrobras claims it willbring forth a lawsuit to prevent such legislation.39

Other countries with newly found oil and gas reservesare also reexamining their oil and gas fiscal policies,but also face the challenge of enhancing revenues whileencouraging investments. After the discovery of theLeviathan field, the Israeli government appointed aspecial committee to reexamine the oil and gas fiscalpolicy. The committee recommended, and ultimatelylegislated, a fiscal policy imposing progressive taxes onpetroleum profits, rather than raising royalty rates.40

The Obama administration in the United States is alsoconsidering revising royalty payment process in a waythat the industry fears would increase royalty values.41

The Alberta government in Canada is finalizing royaltylegislation for new shale wells with the intent ofencouraging exploration and development. Asunconventional plays mature, revisions to oil and gasfiscal policies will reappear especially if nationaleconomies, particularly OECD countries, continue toface slow growth.

Our viewOne thing clear about the situation is that Brazil cannotmove forward with the planned bidding rounds, whichcould lead to billions in lost revenues, until this issue isresolved. While the federal government wants to ensurethe highest possible revenue for all its states, it shouldproceed cautiously when it comes to increasing taxes.

The federal government realizes that billions of dollarsof investment is needed to develop the fields, so itwill not do anything to put off potential investors.That does not mean that new taxes will not beimplemented, but they would not apply to currentcontracts. Furthermore, if new taxes are implementedat all, they will not be high enough to keep investorsaway. Ultimately, the outlook for the Brazilian oilindustry based on the amount and the type of lightsweet crude it potentially has, the opportunity is toogood to miss. Similarly, other countries will bechallenged to create a favorable fiscal environmentfor undeveloped oil and gas resources while raisinggovernment revenues.

Source: Law-Now.com

37 Colitt, Raymond andBrian Ellsworth. “Insight:Brazil’s oil future hingeson bill to share wealth.”Reuters, 3 October 2011

38 “Brazil oil royalty planpasses one hurdle.” Reuters, 19 October 2011

39 Ibid

40 Dor, Noy and MenachemDanishefsky. “A legalvacuum filling up withgas: Israel’s newregulatory environment,”Offshore Magazine,1 September 2011

41 Tracy, Tennille. “Oil, GasCompanies Fear HigherRoyalty Payments UnderObama Effort,” Nasdaq,17, November 2011

Oil Royalties Current 2012 2020

FederalGovernment

30% 20% 20%

ProducingStates

26.25% 20% 20%

ProducingMunicipalities

26.25% 17%4%

AffectedMunicipalities

8.75% 3%2%

Non-ProducingStates

1.75% 20%27%

Non-ProducingMunicipalities

7% 20% 27%

18

The oil sands industry in Canada is one of greatpotential with maybe even greater hurdles. Over thenext 10 years, the industry will invest at leastUS$200 billion to double oil output from this uniqueand highly coveted unconventional hydrocarbonreserve.42 Currently, Canada produces 3.3 million barrelsper day of crude oil, of which 1.8 million is from oilsands. By 2020, oil sands production will reachbetween 3.5 million and 4 million bpd, illustrating theindustry’s immense potential.

However, realization of that potential will begin withreliance on two short-term factors. Firstly, the marginalcost of producing oil from the sands is higher than themarginal cost of producing oil by conventional means.Therefore, WTI prices must stay at or above US$60 abarrel for production to be economical.

The second and more pressing obstacle to oil sandsgrowth is the shortage of a skilled workforce, whichhas already driven up labor costs – a key input to therelatively high marginal cost. A workforce short innumbers and required skills takes longer to completea given task, with greater levels of rework, increasingproject time lines and labor unit costs. Unlikeconventional crude oil, the extraction of oil sands doesnot use the traditional drilling and wells method, butinstead requires surface mining and in situ techniquesthat are much more labor intensive. Therefore, it isimportant for companies and government alike todevelop a well thought-out strategy to mitigate theeffects of these four labor related issues:

• Demographic transformation• Employee migration• Substitution of technology for labor• Immigration policy

Demographic transformationCurrently, the oil sands industry is seeing a demographictransformation of its workforce from the Baby Boomersto Generation Y (Gen Y) as an increasing number ofBoomers enter retirement. With this shift, a wealth ofskills and knowledge is at risk of being lost. Companiescan alleviate some of this risk by promoting betterinternal communication and knowledge exchangebetween employees. Additionally, creating mentoringand training programs can go a long way to ensuringthat skills and knowledge are passed down from olderto younger employees.

This transformation also has a cultural dimension.Gen Y workers tend to be more technologically savvyand exhibit non-traditional social behaviors andexpectations. Companies will be challenged to createcultures where incoming Gen Y feels accepted andvalued, as well as willing to collaborate with, and learnfrom, older employees.

Employee migrationThe Canadian oil sands are located in a relatively remotearea in the province of Alberta. Historically, in similarworking conditions, it was not uncommon forcompanies to transport employees to and from thework area from across the country. In many cases,the fly-in/fly-out (FIFO) system continues to be the bestoption due to expected short project lengths, whichmake infrastructure development (roads, towns)uneconomical. However, this system continues to beused even for expected long-term projects, whichsignificantly drives up costs.

But it is most important to retain talented workers,and employers are encouraged to ensure that incentivesfor families to relocate are in place, such as qualityschooling and health-care. Companies should alsoconsider investing in permanent infrastructure andhousing to reduce transportation costs.


10. The people equation: Canadianoil sands industry to face toughlabor issues


Substitution of technology for laborOne way to alleviate the demand for human laborcould be through technological developments. Sincesurface mining is one of the ways to extract oil fromthe sands, many lessons can be taken from traditionalmining companies. One suggestion is to follow theAustralian mining industry’s use of automatedmachinery. Many companies use remote controlledtrucks to haul ore from mine face to processing.

Remote-sensing equipment is another technologicaladvancement that will not only eliminate the need forhuman deployment but would eliminate the need forvehicle deployment as well. It would help generate datathat is often better integrated with wider systems, suchas geographic information system (GIS) modeling andanalysis. GIS is a particularly useful application fortracking industrial operations in boreal and ecologicallysensitive regions, which in turn fulfills key monitoringfunctions that can aid in both regulatory complianceand in earning the broader social license to operate.These types of technological advances can free uphuman capital for more challenging and value-addedemployment.

Immigration policyCurrently, Canada’s immigration policy is considered tobe more restrictive compared to most countries, whichhas stymied influx of skilled labor that the oil sandsindustry needs. However, the election of a majoritygovernment in 2011 is seen as an encouraging step inthe right direction. But the Canadian government mustbe cautious when proceeding on this issue because it isa politically delicate subject nationally. Additionally, on aglobal level, Canada’s reputation as a society that hassocially sensitive values could be damaged if radicalpolicy changes are made.

Our viewLabor shortage issues will continue to be a problemfor the oil sands industry for years to come, even ascompanies attempt to diversify Canada’s crude oilexport capabilities to countries other than just theUnited States. Asian countries, especially China, areeager to gain access to Canadian oil, but the necessarypipelines currently do not exist. A proposal to build theEnbridge Northern Gateway Pipelines, connecting thecoast of British Columbia with the oil sands in Alberta,would allow Canada to export oil to Asian countries,and is currently seeking approval from the Canadiangovernment. The main objection to the project is thatthe pipeline would run through aboriginal land.

Additionally, a decision on an expansion proposal to theKeystone Pipeline, called Keystone XL, that would runto the Gulf coast, has been delayed a year by the U.S.government. The pipeline was planned to run throughNebraska and consequently through the Ogallalaaquifer, which is a concern to environmental groups.Furthermore, environmentalists oppose the use ofCanadian oil sands because its extraction purportedlyreleases more carbon emissions than conventional oilextraction.

Canada’s plans to expand its export capacity willundoubtedly mean that oil output will increase in theyears to come, especially if both the Gateway andKeystone XL pipelines projects are approved. Therefore,companies must look to implement effective laborstrategies now to help soften the labor issues of thenear future and ensure the industry’s continued capacityto grow.

One way to alleviate the demandfor human labor could be throughtechnological developments.

20

Global Leadership

Carl D. HughesGlobal Head – Energy & ResourcesDeloitte Touche Tohmatsu Limited+44 20 7007 [email protected]

Adi KarevGlobal Head – Oil & GasDeloitte Touche Tohmatsu Limited+852 2852 [email protected]

Dick CooperGlobal Leader – Oil &Gas ConsultingDeloitte Touche Tohmatsu Limited+1 403 261 [email protected]

Julian SmallGlobal Leader – Oil & Gas TaxDeloitte Touche Tohmatsu Limited+44 20 7007 [email protected]

Regional Leadership

Adi KarevRegional Head – Asia PacificDeloitte China+852 6838 [email protected]

Ricardo RuizRegional Head – South AmericaDeloitte Argentina+54 11 4320 [email protected]

Ken McKellarRegional Head – Middle EastDeloitte Middle East+971 2 676 [email protected]

Russell BanhamRegional Head – CIS+7 495 787 0600 ext. 2107Deloitte CIS

Country Oil & Gas Leadership

Stephen ReidDeloitte Australia+61 3 9671 [email protected]

Carlos VivasDeloitte Brazil+55 (21) 3981 [email protected]

Chris LeeDeloitte Canada+1 403 267 [email protected]

Adi KarevDeloitte China+852 2852 [email protected]

Elena LazkoDeloitte Russia+7 495 787 [email protected]

Bill PageDeloitte East Africa+256 (0) 414 343 [email protected]

Jorge CastillaDeloitte Mexico+52 55 5080 [email protected]

Anton BotesDeloitte Southern Africa+27 (0) 12482 [email protected]

Julian SmallCountry Head – UKDeloitte United Kingdom+44 (0) 20 7007 [email protected]

Gary AdamsDeloitte United States+1 713 982 [email protected]

Olufemi AbegundeDeloitte West Africa+234 1 [email protected]

Industry Support

Anne SchotDirector, Global Clients, Asia Pacific+852 2852 [email protected]

Mark L. Robinson, PhDGlobal Marketing Leader, Energy & Resources+1 703 251 [email protected]

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