evolving business models in the natural gas shales · natural gas to consumers. chesapeake, for...
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Evolving BusinEss ModEls in thE natural gas shalEs
AUTHORS
Bob Orr Alexander Roinesdal
While depressed natural gas prices in the US are creating significant
difficulties for pure-play natural gas producers, larger and more
diversified players are raising their stakes in shale gas plays. Driven
by a long-term view of the natural gas market and drawing on their
experience in other business segments, the new players are exploring
innovative business models to create more sustainable natural gas
operations in the shales. To stay competitive, pure-play operators will
also need to adapt.
Oil & Gas | Energy
Copyright © 2012 Oliver Wyman 1
The last year has been rough for US natural gas producers. After suffering from lower
than expected spot prices in 2011 – mostly hovering in the $4.00-$4.50 range – producers
watched prices plummet in early 2012, in part because of the mild winter, but also because
of their high production rate. (Many players are locked into production requirements from
acreage lease agreements, joint venture agreements, and supply contracts.) The resulting
gas glut pushed prices below $2 in April 2012 before beginning to rebound. Despite the
recent uptick, prices remain below breakeven for many shale gas producers.
Consequently, cash-flow pressure on pure-play natural gas producers is intense. The capital
costs required to produce in the shales are high, and with fewer dollars coming in for every
unit produced, or lowered production while waiting for higher prices, many players are feeling
the squeeze. That’s especially true for the most ambitious operators, which racked up both
acreage and debt at a ferocious pace during the shale boom. Not surprisingly, the markets
have rewarded operators that have most effectively managed their cash-flow to debt levels;
companies with the worst projected cash-flow to debt ratios have lost value since 2007.
LARGE PLAyERS GROWiNG ShARE
Larger companies – with more diversified revenue streams – are better positioned to outlast
this current price trough. Recognizing the long-term potential of shale gas, international and
National Oil Companies (iOCs and NOCs) have spent billions to acquire attractive positions
in the shales. in fact, many majors, which had largely left the US, are taking a close look
at domestic onshore upstream opportunities for the first time in years. While ExxonMobil’s
ExhiBiT 1: SAMPLE ShALE iNvESTMENTS By iOCs AND NOCs
US $ MILLIONS
2008 2010 2011
SIZE OF INVESTMENT
BP
1,900
Statoil
3,375
Total
2,250
Shell
4,700
CNOOC
2,160
Chevron
4,300
Statoil
4,400
bhpbilliton
15,400
Statoil
1,300
2009
ExxonMobil
41,000
Source: industry journals and press clippings
Copyright © 2012 Oliver Wyman 2
$41B acquisition of xTO is by far the largest, nearly all the other majors and several NOCs
have made sizeable investments in the US shales (see Exhibit 1.)
A secure domestic energy source, shale gas provides long-term predictability, which is
essential if industries are going to retool their infrastructures to utilize this abundant energy
supply. As infrastructure changes, demand for shale gas will increase and drive up prices, as
will the likely export of Liquid Natural Gas (LNG) to other continents where natural gas prices
are significantly higher. however, these market changes will take time, and shale asset holders
need to position themselves now to fully reap these projected benefits.
The arrival of iOCs and NOCs in the shales will impact the way all shale players operate.
At the most basic level, the larger firms will continue to drive the industry toward low-cost
operations. These diversified companies are already experienced process optimizers, so
they are applying their operational best practices across all shale assets to most efficiently
produce natural gas. Because the production process is largely repeatable across the various
shale plays, scale amplifies the cost savings. Some operators have even explored Lean Six
Sigma techniques, typically used to optimize processes in manufacturing and plants, in their
shale operations. Achieving cost leadership will be a key component of success in the shales
in the next phase of development.
Large shale operators are also exploring other ways to innovate their business models
to improve production efficiency, to spark long-term demand, and – to prevent service
providers from encroaching on their margins – to control more of the value chain. These
changes are being felt upstream, midstream, and downsteam in the natural gas value chain.
ExhiBiT 2: ChANGiNG BUSiNESS MODELS
E&PExpanded Midstream Model
E&P
Core business focusSecondary business segments
Opportunistic Customer
E&PIntegrated Oil & Gas Company
BUSINESSMODELS NATURAL GAS VALUE CHAIN OBSERVATIONS
E&PShale E&P Specialists
E&P Midstream Marketing
Midstream Marketing
Midstream Marketing& Trading
Utilities/ Industrial Consumers
OilfieldServices
Integrated Natural Gas Company
Most early entrants in the shales were focused on drilling and producing as soon as possible, with limited attention to price risk or cash flow diversification.
Some shale E&P operators, such as Chesapeake, have sought to take a bigger role in marketing gas directly to consumers to increase demand. Some have also brought oilfield services and midstream assets in-house to control costs.
Integrated companies are growing their presence in the shales and can take advantage of their trading and marketing arms to secure more stable cash flows.
Midstream asset owners can take advantage of cash-strapped E&P companies to assume favorable supply positions and use their storage and logistical assets to seek arbitrage opportunities.
Large natural gas consumers, such as power generation and industrial companies, could take advantage of small E&P companies’ current need for cash flow to lock in favorable long-term supply deals.
Source: Oliver Wyman
Copyright © 2012 Oliver Wyman 3
UPSTREAM iMPACTS: vERTiCAL iNTEGRATiON WiTh OiLfiELD SERviCES AND MiDSTREAM OPERATORS
As part of the effort to control costs, some of the larger operators are pursuing a greater degree
of vertical integration of the value chain. As large amounts of natural gas come on-stream in
unconventional fields, operators will need substantial new infrastructure to gather the gas
and transport it to where it can be commercialized. The costs associated with this midstream
segment will have a sizeable impact on the breakeven price and commercial viability of the
natural gas being produced. Taking full or joint ownership of the midstream assets can be
an effective way to control midstream costs. While many smaller E&P operators lack sufficient
capital to play a significant role in the midstream game, the larger operators do not.
The trend toward vertical integration may also emerge in oilfield services, though to a more
limited extent. high-tech drilling rigs, a requirement for directional shale drilling, as well
as other service equipment, such as for fracking, are now in high demand. Shale operators
have been funneling more of their margins to the oilfield service companies for the use of
this equipment. To control costs, some operators have brought oilfield services partially in-
house. for instance, Chesapeake Energy, the second largest natural gas producer in the US,
acquired Bronco Drilling and its 22 drilling rigs for $315 million in April 2011. Chesapeake
ExhiBiT 3: GAS GLUT ShifTS DOMESTiC DRiLLiNG TOWARD OiL
Unprofitable economics have led E&P companies to shift their drilling operations toward shale oil and liquid plays. in
April 2011, the number of rigs drilling for oil in the US surpassed the number drilling for natural gas for the first time
since the mid-1990s. in May 2012, fewer than 500 rigs were drilling for natural gas – the lowest amount since 2002.
1,000
800
1,200
1,600
1,400
200
400
600
Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Aug 12
Oil Rigs
NaturalGas Rigs
0
1,800
ACTIVE US DRILLING RIGS
Source: Baker hughes North America Rotary Rig Count (August, 2012)
47% Decline since the end of October 2011
Copyright © 2012 Oliver Wyman 4
already owned 95 rigs through a subsidiary, and also owns an oilfield services company. it
seeks to maintain roughly two-thirds of its oilfield service use in-house.
Moving service costs in-house may be tempting when utilization levels and day-rates are high,
but it adds significant risks in downturns—when the service assets are less valuable, or even
idle. The majors have withstood these painful experiences with offshore rigs in past cycles, and
that experience will likely limit how aggressively they pursue a similar strategy in the shales.
DOWNSTREAM iMPACTS: PARTNERiNG WiTh CUSTOMERS AND ThiRD PARTiES TO DRivE DEMAND
in an interesting twist to the traditional onshore E&P model, which focuses primarily on
finding and getting gas out of the ground, some shale producers are also taking steps to
integrate downstream. Realizing that ending the natural gas glut caused by the shales
requires demand growth, certain shale companies are stepping up their efforts to market
natural gas to consumers. Chesapeake, for instance, is partnering with GE and valero to
install hundreds of Compressed Natural Gas (CNG) stations to fuel vehicles. Chesapeake
also partners aggressively with large fleet operators to encourage switching from gasoline
to natural gas to take advantage of the significant price differential. Other natural gas
producers, such as EOG and Cabot Oil and Gas, are converting their fleet vehicles to run
on CNG and installing filling infrastructure in their local areas. The integrated majors with
large shale gas positions, such as ExxonMobil and Chevron, could potentially leverage
their existing gasoline site and marketing networks to market CNG directly to consumers.
The near-term impact of these initiatives on demand at a national level will be limited (vehicular
use accounted for less than 0.2% of US natural gas consumption in 2011). But impressive
concentrations of CNG filling infrastructure are emerging in certain regions, such as gas-rich
North Texas and Oklahoma. These are encouraging, albeit early, signs for long-term demand.
in the near and medium term, however, the largest demand drivers will be industry and power
generation. While the traditional shale E&P business model focused almost exclusively on
extracting natural gas, newer business models recognize the importance of developing
relationships with large customers to help secure demand. Relationship building is key
for players hoping to convince their biggest customers to switch from coal and other fuel
sources. if operators can offer long-term natural gas supply contracts at a predictable price,
customers’ fears about price volatility (which pushed many consumers away from natural
gas in the 2006-08 period) will be alleviated. Large operators will also continue to prod
regulators for natural gas incentives, emphasizing the environmental benefits relative to
coal and oil.
The flip side of this long-term contract dynamic is that current circumstances provide
midstream companies and large natural gas consumers the opportunity to capture value
by taking advantage of the cash-strapped natural gas producers, particularly those that
are smaller and less diversified. Utilities or industrial companies, for instance, can offer
Copyright © 2012 Oliver Wyman 5
7654321
Eagle Ford (Gas)
Fayetteville (2.8 Bcf)
Jonah
Woodford (Arkoma)
Wattenberg (Core)
Uinta (Shallow)
Picenace (Highlands)
Raton (CBM)
GOM Shelf
Alberta Shallow Gas
Warwick (W. Texas Overthrust)
Barnett (Tier 2)
BREAKEVEN NATURAL GAS PRICE ($/MCFE)
BREAKEVEN NATURAL GAS PRICE BY BASIN
Marcellus Wet (Core)
Pinedale
Marcellus Dry (Core)
Fayetteville (3.4 Bcf)
Granite Wash (Horizontal)
Huron Shale
Deep Bossier (E. Texas)
Eagle Ford (Condensate Zone)
Cana-Woodford (Core)
Piceance (Valley-Core)
Barnett (Tier 1)
Appalachian-CBM
Haynesville
Marcellus Dry (Tier 2)
Apr. ‘12 Sept. ‘12 Sept. ‘13
0
ExhiBiT 4: SLOW hikE BACk TO BREAkEvEN PRiCiNG
With spot prices below $3/MMBtu for much of 2012, producing natural gas from the shales has in many
cases been unprofitable. Just four years ago, when many players made investments in the shales, prices
were above $10. Many producers won’t break even until prices top $4 again.
PaSt, Current and future natural gaS SPot PriCeS
July 2008 $11.09
april 2012 $1.95
september 2012 $2.85
Futures price september 20131 $3.99
1 As of October 17, 2012
Source: Company data, Morgan Stanley Research, EiA, CME Group
Copyright © 2012 Oliver Wyman 5
Copyright © 2012 Oliver Wyman 6
producers a stable cash flow to help service debt in exchange for a long-term supply of
natural gas at a favorable price. Going one step further, adding both risk and upside, they
could seek to take equity stakes in gas-producing assets, with the goal of capitalizing on the
current market environment to lock in supply through partial backward integration.
MORE SOPhiSTiCATED BUSiNESS MODELS ENSURE LONG-TERM POSiTiONiNG
The window of opportunity is closing on the most favorable of such deals, as iOCs and
NOCs operating in the shales are ushering in business models that are better suited to
manage cash flow and liquidity during downturns. Large players don’t rely on natural gas
as their only revenue stream, and they are also likely to do a better job of hedging and
managing their gas cash flow through in-house trading operations. While small pure-play
E&P companies typically have very limited in-house marketing capabilities, the small iOCs
and NOCs maintain large trading desks and sales operations to secure off-take of their
product and hedge price risks.
The natural gas glut ensures that companies are no longer rewarded for simply acquiring
as much shale acreage as possible and drilling it as quickly as possible. Managing through
the cyclical natural gas business requires a smarter business model, with economical
drilling operations and a more sophisticated approach to marketing and cash flow
management. Larger operators are leading these business model changes, bringing
valuable expertise from their other business segments. While the challenges of the current
cycle will weed out some operators, those that successfully navigate the current price
environment will be well-positioned to reap long-term value from the natural gas shales.
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