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Strategizing for the Future

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Booz & Co. Provides 2013 Oil & Gas Industry Perspective

By Chris Click, John Corrigan and Scott Sharabura

The past year brought new clarity on the direction of oil and gas prices. With it came the bracing but undeniable conclusion that energy companies will have to work harder to earn their profits in the year ahead.

Neither $150 (USD) per barrel oil nor $7 per thousand cubic feet (mcf) natural gas is likely to return anytime soon to rescue the industry’s profit margins. Thus, executives cannot expect rising prices to offset inefficiencies in the industry value chain, as they have in the past. If they want to expand, oil and gas companies will have to do so on their own — by building more efficient business models, and by developing their own set of differentiating capabilities that allows them to create real value and earn superior returns. As more companies focus on what they do best, and leave the rest of the industry’s work to others, we will see an acceleration of the past year’s most significant trend: specialization across the industry. In 2013, generalists will be left behind.

Industry analysts at Booz & Co. have assembled a detailed report on the oil and gas industry, and what energy producers and pipeline companies can expect for 2013 and beyond.

Beyond Easy Money

Energy companies still adjusting to the prospective end of “easy oil” — the peaking fields of accessible light oil in places like the Arabian Peninsula, Libya and Venezuela — now face the end of easy money. Just as new deposits have become harder to reach, companies will find it more difficult to extract profits as prices stabilize at levels well below boom-era highs.

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The factors driving global energy supply and demand points to an extended period of moderate prices for oil and natural gas. Demand is under pressure as growth slows in China, Europe tips into recession, the U.S. economy continues to waver and U.S. fuel economy standards are pushed higher.

Trends in oil show an increase in supply, though the amount of the rise hinges on a wide range of variables. Geopolitical contingencies, such as the possibility of regional warfare in the Middle East or unilateral action by Iran to block the Strait of Hormuz, could crimp the flow of oil to industrialized markets. On the other hand, a return of Iraqi production to pre-war levels could swell pipelines. Similarly, a resolution of the standoff over Iran’s nuclear program could lift the economic sanctions blocking Iranian oil exports, bringing another 4 million barrels per day back into oversupplied global markets virtually overnight. In the Americas, meanwhile, rising output from U.S. shale formations and Brazilian deepwater fields pushes potential oil supplies even higher.

Predicting oil prices is always difficult, particularly over the long term. Small changes in global economic growth rates affect demand dramatically, while unpredictable political events can have a similar effect on supply. But a recent Booz & Co. analysis of the fundamental economics of oil shows that supply is rising faster than demand, a reversal of the trend that lifted prices and fueled industry profits over much of the past decade. Although oil prices can still vary widely, the most probable scenarios — based on an analysis of current trends — indicate a long-term range of $70 to $90 per barrel by 2020, down significantly from the levels of just a few years ago.

As for natural gas, the well-known expansion of supply in North America continues, ensuring that gas prices will stay low for the foreseeable future. They appear likely to stabilize around $4 to $5 per mcf, as an uptick in demand from coal-fired power plants switching to natural gas and expanding liquefied natural gas export infrastructure absorbs some of the excess supply.

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The success of unconventional resources has created a need to vastly expand the pipeline infrastructure of North America, but the high-cost nature of these resources raises concerns about their longer-term economic viability.

Notwithstanding the uncertainties, it’s clear that oil and gas companies should prepare for a period when prices level off. This means changing some practices that took root when prices were rising, and it was accepted that costs would rise accordingly. Now the cushion that supported those expenses appears to be disappearing.

Producer and Production Impacts

The tepid price outlook for oil and gas creates greater uncertainty in upstream investment programs as producers struggle with low gas prices and softening crude prices. How are producers responding to these difficult conditions? Although many North American producers first responded by shifting investment to liquids-rich or oil plays, this move has not protected them from the fact that unconventional oil and gas are at the higher end of the cost curve. More advanced players are addressing the cost and margin issues by focusing on core areas — divesting themselves of far-flung and incoherent portfolio elements, including midstream assets. Concurrently, these companies have crafted strategies around their differentiating capabilities: their unique set of related processes, skills, knowledge, tools, systems and human capital. They devote more investment, management attention and other resources to activities that support these chosen capabilities, and less to unrelated activities. This selectivity has led some producers to focus on production costs, others on down-hole productivity, and still others on marketing effectiveness and asset monetization.

Implications for Pipeline Companies

For pipeline companies, the success of unconventional resources is a mixed blessing. On the one hand, it has reinvigorated the supply side and caused tremendous shifts in flow dynamics, creating a need to vastly expand the pipeline infrastructure of North America. On the other hand, the high-cost nature of these resources raises serious questions about the longer-term economic viability of these plays and producers.

Pipeline companies are now in a position where they must make significant bets on the success of some of these unconventional plays and players. Although long-term contracts with primary shippers offer some comfort to pipeline developers, the Rockies Express (REX) pipeline story presents a tale of caution that a pipeline’s fortunes can change overnight. The REX contracts will certainly support the line’s debt service and some return over the primary term, but the residual value of the line is at serious risk. The concern for oil pipeline developers is similar: If I build a pipeline to bring oil from an unconventional play, will a new play or cheaper supply diminish the inherent value of my asset?

One answer lies in the certainty of demand. Unfortunately, the picture here is unclear. North American petroleum demand is under pressure as a soft economy, a push for energy independence, emerging alternative fuels (i.e. natural gas and electricity), and increasing constraints from the U.S. Environmental Protection Agency (EPA) all work together to soften demand. These questions about the drivers of demand are not likely to resolve themselves in advance of required decision dates for most projects. The export markets are another alternative, but they also have their challenges, including environmentally sensitive terrain, export regulations and competition in the global markets.

Strategies for Pipeline Companies

Given the opportunities and inherent risk in today’s market, pipeline companies should focus on two strategic elements. First, pipelines must determine where their differentiating capabilities reside and how they use them to develop, operate and manage their asset portfolio. Second, within this context they will need to syndicate their market risk because many of these large-scale projects are based on market assumptions that are highly variable.

Understanding where value is created and monetized across the pipeline lifecycle, from development to disposition, is crucial to pipeline company success, especially success relative to peers. The pipeline development capabilities of market sensing, customer origination and contracting, permitting and construction are quite different from the skills needed to operate efficiently and safely, which are different still from optimizing the commercial value of under-used capacity or incremental expansions. Although most pipeline companies will operate across the life cycle of the asset, companies should focus their resources and place their bets where they truly excel. This type of focus improves rates of return and informs operating model decisions, which lead to further improvements in efficiency and effectiveness of capital. Thus some companies excel at greenfield development, whereas others extract value through acquisition of existing assets and cost management, and some others may acquire and optimize existing assets through commodity basis differentials.

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The well-known expansion of supply in North America continues and will ensure low gas prices for the foreseeable future, but increased demand and expanding export infrastructure will absorb excess supply.

Even pipelines that are focused on a set of assets and development that align with their capabilities set are subject to market risk. This is particularly true in today’s market, where oil and gas prices are near the break-even point for some of the largest unconventional plays. And although it is difficult to avoid broad market risk, individual project market risk can be syndicated. The most common means of dispersing this risk is through alliances or partnerships. Geographic and market diversity can significantly improve the risk/return dynamics of pipelines and provide an opportunity for companies to extract value for their areas of expertise while partnering with firms that are strong in other areas of the value chain or asset life cycle.

Pipeline companies will need to view these alliance and partnering relationships strategically. First, they must ensure that portfolio risks are being truly diversified and not merely spread across separate projects. Second, alliance design and management should be structured and executed to extract value from complementary capabilities. This second element is where many firms struggle because they did not adequately consider the upfront structuring of the transaction and internal capabilities during the negotiation process.

“Given the opportunities and inherent risk in today’s market, pipeline companies should focus on two strategic elements. First, pipelines must determine where their differentiating capabilities reside and how they use them to develop, operate and manage their asset portfolio. Second, within this context they will need to syndicate their market risk because many of these large-scale projects are based on market assumptions that are highly variable.”

What’s to Come

The next five years will present a host of opportunities to pipeline companies. Changes in product flows and increases in continental production will offer potential for expansion and new builds for many players. However, the relatively high cost of the new production in a period of low demand growth creates a market risk for these new investment opportunities. Developing coherent strategies that leverage a firm’s differentiated capabilities and diversifies market risk is crucial to successfully navigating these markets.

Chris Click is vice president of Booz & Co.’s Energy, Chemicals and Utilities Practice, based in Dallas; John Corrigan is vice president of Booz & Co.’s Energy, Chemicals and Utilities Practice, based in Dallas; and Scott Sharabura is principal of Booz & Co.’s Energy, Chemicals and Utilities Practice, based in Calgary, Alberta.

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