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US shale: A of choices

A report by the Center for Solutions About the authors

John England, a vice chairman at Deloitte LLP, leads Deloitte LLP’s US and gas practice and also serves as the and enterprise risk services leader for Deloitte & Touche LLP’s US energy and practice. In these roles, England steers Deloitte’s overall of a broad range of , from integration and operational consulting to human capital offerings and services, as well as financial advisory offerings and attest services. England is a frequent speaker on issues and trends, as well as all aspects of energy trading and risk . England serves on the National Council, the Department Advisory Board of Stephen F. Austin , the board of directors for the Southeast chap- ter of the Alzheimer’s Association, and the advisory board of the University of Oklahoma—Price College of Business Energy Institute.

Anshu Mittal, of Deloitte Support Services Pvt. Ltd., is an oil and gas research manager on Deloitte’s Insights team. Mittal has more than 10 years of experience in financial analysis and strategic research across all oil and gas subsectors—upstream, , oilfield services, and downstream. Before joining Deloitte in 2005, Mittal worked with Rating Information Services of India Limited (Crisil), a subsidiary of Standard & Poor’s, as a lead industry researcher in and petroleum sectors. His recent Deloitte publications are The rise of the mid- stream—shale reinvigorates midstream growth and Oil & gas reality check 2014. Contents

The changing rules of the game | 2

2006–2010: Ante up or sit out | 4

2011-2013: Betting on profitable liquids or inexpensive gas | 6

2014: New cards on the table | 8

Dealing the new cards | 10

Building a winning hand | 14

Playing all hands together | 17

Coming up aces | 21

Glossary of terms | 22

Endnotes | 24

Acknowledgements | 26

Contacts | 27 US shale: A game of choices

The changing rules of the game

The US shale boom began quietly, but when its time came, it grew quickly. After almost two decades of experimentation in a field in North Texas, the industry underwent a full-blown revolution in just a few years.

ECORD levels of investment flooded into ones in the . As a result, select Rwhat many had considered one of the companies have decided to sell their marginal world’s most mature energy markets, US liquids-rich shale assets to offset corporate oil and gas multinationals (supermajors and capital constraints.4 international exploration and production com- These ongoing, hard-to-predict changes panies) back to the United States and boosting in the US shale market have not only made the country’s oil and gas by almost 40 decision making complex, but also upended percent from 2006 to 2013.1 Seeing the United the conventional business strategies of oil and States’ success, countries such as , gas companies operating in the region. For , and have started exploring their example, BP recently decided to form a sepa- shale potential.2 rate business to manage its onshore oil and gas The boom, surprisingly, changed course assets in the United States, which, according to when US (“gas”) prices plummeted the company, have “unique characteristics.”5 to historic lows in 2012. Gas-oriented compa- The lack of predictability in the US shale nies generated weaker-than-expected returns, environment has put several questions in front and a series of multibillion-dollar asset write- of oil and gas companies and their stakehold- downs followed.3 With gas in a slump, all eyes ers. How will the shale boom unfold over the turned to liquids (crude oil, condensates, and next few years? How will the evolution in shale natural gas liquids). Although US West Texas progress across the energy chain and Intermediate (WTI) crude prices remained shape the industry’s structure? How can com- above breakeven levels, intense panies refine their approach and play to their and the problem of excess also gripped the US segment level and cross-segment strengths? To liquids market. WTI continues to at a answer those questions, companies will need discount to North Sea Brent, despite reversals to consider the evolution of the US shale game of existing pipelines and the opening of new and the resulting impacts.

2 With the rapidly “evolving (shale) environment, our (BP) business has become less competitive. The new business (the US onshore business unit) will have separate government, processes, and systems designed to improve the competitiveness of its portfolio. —— BP CEO Bob Dudley ” Source: BP, Investor update 2014, March 4, 2014.

3 US shale: A game of choices

2006–2010: Ante up or sit out

OMESTIC exploration and production resulted in a sharp increase in their reserve D(E&P) companies cracked the code for additions. The US reserve replacement rate large-scale shale gas extraction by 2005, offer- (RRR) of select domestic E&P companies aver- ing the promise of growth in the United States. aged between 300 to 500 percent (represented As the shale revolution was unfolding at home, by the light blue dots in the top right quadrant multinationals remained focused on mega of figure 1) from 2006 to 2010.7 Seeing the projects in the , Africa, , US growth of these domestic E&P companies, Gulf of , and —in part because of select supermajors and many international the uncertainty around the potential and eco- E&P companies bought significant shale acre- nomic viability of US shales. age and reserves in 2009 and 2010, making Thanks to the innovative develop- them attain RRR of above 100 percent in the ment efforts of domestic E&P companies, US United States (represented by the dark blue shale began delivering on its promise: Shale and green dots in the bottom right quadrant of gas production more than quadrupled to 3.5 figure 1). trillion cubic feet (Tcf) from 2005 to 2009.6 Select oil-heavy supermajors, however, Just as the production boom began to catch largely chose to sit out and remained focused the attention of multinationals, however, a on deepwater offshore fields. Their purchases decline in prices due to economic slowdown in US shales—less than $6 billion each—were and the non-readiness of new demand made not substantial relative to their size and not them wary. These companies faced a dilemma: significant enough to arrest the fall in their US Invest in shale or risk being sidelined during a oil and gas reserves. They therefore recorded domestic boom. Like a card player approach- low RRR in the United States (represented by ing the table, they had to decide whether to the dark blue dots in the bottom left quadrant “ante up” or “sit out” what was becoming the of figure 1). In sum, nearly all domestic E&P hottest game in the industry. companies anted up early, while multinationals Domestic E&P companies anted up. They entered late and were divided in their US shale entered early by investing organically, which strategy from 2006 to 2010.

4 Figure 1. US oil and gas reserve replacement rate (2006–2010)

500% Sit out Ante up

Companies invested organically in US shales 100% US organic RRR

Companies bought into US shales 20% 20% 100% 500% US total RRR

Supermajors Top 5 international E&P Top 10 domestic companies (US origin) E&P companies

Notes: 1. The above US oil and gas reserves include both conventionals and unconventionals, but the growth is largely attributable to unconventionals. 2. US organic RRR = (total reserve additions + production – net liquids and gas reserves acquired)/production 3. International E&P companies are those with more than 25 percent of their reserves or production outside the United States and a presence in multiple regions/countries. Sources: SEC filings and Deloitte analysis.

Graphic: Deloitte University Press | DUPress.com

5 US shale: A game of choices

2011-2013: Betting on profitable liquids or inexpensive gas

Y 2011, the US natural gas market had margin mix, but also their midstream - Breached a level that surprised almost ing and their end users’ profile. Select oil-heavy everyone in the industry. In just two years’ supermajors that had chosen to “sit out” the time from 2009 to 2011, production of shale first round added less liquids reserves (figure gas had more than doubled, reaching 8 Tcf. 2). The result was a rare dichotomy: Gas prices As companies scrambled to adjust their fell as oil prices rose. The oil-to-gas price ratio strategies, a flurry of acquisition activity increased to 24 in 2011 from 16 in 2009.8 ensued. More than 16 million undeveloped This decoupling of prices dealt oil and gas shale acres changed hands—almost 70 per- companies a new hand, and with it, a choice: cent of it in oil and liquids-rich shale plays. Switch to -priced liquids or invest Deal values topped $35 per proved barrel of in inexpensive shale gas for the term. oil equivalent (BOE) in select shale oil fields, This second round of choices, coming just five compared with the highest deal value of $22 years into the boom, created a conundrum for per BOE in 2008.10 many oil and gas companies. They either had Although the players raised the stakes, to change their operating —especially their profits remained far behind their growth. gas-heavy companies switching to liquids—or Like what happened with domestic gas, the “double down” on gas, where prices did not sharp increase in supply started depressing justify expenditures, and forego potential prof- liquids prices relative to prices in international its from shale oil. markets. This fall in the domestic gas prices Like players shuffling their cards in the and discounted liquids weighed on companies’ middle of the game, oil and gas companies premium purchases and led to multibillion- altered their strategies. Between 2011 and dollar write-downs in 2013, even forcing some 2013, gas-heavy domestic E&P companies such companies to sell their marginal liquids-rich as EOG Resources and Chesapeake Energy assets to cover for capital constraints.11 For shifted their drilling and production focus example, BHP Billiton decided to sell roughly toward liquids, which accounted for nearly 100 half of its less promising liquids acreage in percent of their reserve additions.9 This shift west Texas.12 to liquids changed not only their revenue and

6 Figure 2. US liquids production and reserves additions (2011–2013)

100%

Switch to oil Relative to their gas-heavy production, these companies added more of liquids reserves

50%

Grow in gas Relative to their oil-heavy production, these companies added less of liquids reserves US liquids reserves addition shares

20% 0% 20% 40% 60% 80% 100% US liquids production share

Supermajors Top 5 international E&P Top 10 domestic companies (US origin) E&P companies

Sources: SEC Filings and Deloitte analysis. Graphic: Deloitte University Press | DUPress.com

7 US shale: A game of choices

2014: New cards on the table

HE evolution of the shale game can be encouraged others to invest in gas despite price Tillustrated by drawing decision lines across weakness (“ante up”). As the game evolved the production and price curves for oil and gas and prices decoupled, from 2011 to 2013, the (figure 3). The game started in 2005, when oil lowest gas prices in a decade pushed the early and gas prices were in equilibrium at a 6:1 ratio entrants in shale gas to switch to liquids-rich (the common starting point in figure 3). In the plays, while the companies that sat out in the first round of the game, from 2006 to 2010, first phase moved to take advantage of the situ- the relative strength of oil prices discouraged ation by buying into inexpensive gas. Due to some from investing in low-priced natural the steep fall in gas prices, average deal value in gas (“sit out”), while rising shale gas volumes gas plays fell by nearly 50 percent, from about

Figure 3. Strategic choices for oil and gas companies in US shale

High 2 1 Switch 3 Sit out (Move to oil) (Do not invest in ? low-priced gas)

2011-13 Prices 2005 2006-10 2014

Price equilibrium (6:1)

Ante up ? (Invest in gas) Grow (Buy into gas) Low Low Production High

Crude oil Natural gas Decision periods

Sources: Energy Information Administration (EIA) and Deloitte analysis. Graphic: Deloitte University Press | DUPress.com

8 $2 per proved thousand cubic feet equivalent (Mcfe) in 2008 to $1 per Mcfe in 2012.13 THE HARP OF SHALE STRATEGIES Companies must now plan for the next set The evolution of the shale game resembles a harp, a of choices, given the flip in prices and produc- multi-stringed (pictured on the right). tion. Because of rising shale oil supplies and weak global demand, oil futures are in back- • The first and shortest string on a harp makes wardation—December 2014 WTI oil futures the highest or pitch, akin to ’s are about 2.5 percent lower than August high expectations from players that chose to be in US shale from 2006 futures—and the Brent-WTI price gap remains to 2010. above $5 a barrel despite the start of new pipe- lines from Cushing, Oklahoma.14 In contrast, • The role of the middle domestic gas prices have bottomed out and the strings is to vary the forward curve is in contango, as the growth pitch, similar to the decision of the majority rate in production has moderated. of players to switch In the US onshore liquids value chain, oil to liquids from 2011 upstream will continue to remain the preferred to 2013. choice. Although the US oil downstream, or oil refining, is currently running at record levels, • The last and longest the probability of seeing large new refineries in string creates a longer- lasting, amplified the country is low because of stricter environ- sound, analogous to the mental , a mature domestic demand impact that oil and gas base, uncertainty about crude oil exports, companies’ decisions in the next set of choices and rising competition from new low- will have on the industry’s structure. refineries worldwide.15 On the gas side, a new choice is emerg- ing—one that is not limited to gas producers or the gas upstream segment. Although the recent upward price movement suggests that 400 percent from 2012 to 2013.17 As of July gas prices bottomed out in 2012, they are still 31, 2014, more than 35 LNG export applica- only at one-third of their peak levels and are tions were on file with the US Department of projected to remain below $5.25 per million Energy for approval, and almost 150 chemical British thermal units (MMBtu) until 2025 in projects have been announced in the United real terms (2012 dollars).16 This continued States—highlighting the extent of the growth weakness in gas prices has shifted profits from opportunities and margin migration toward the gas upstream segment to the gas down- the gas downstream.18 stream segment: or buyers of (liqui- In sum, the kink in price and production fied natural gas [LNG] and petrochemicals, curves suggest the coming of a third set of from an oil and gas industry perspective). choices for oil and gas companies operating in This margin migration is evident in the the US onshore market—shale oil upstream or rise in total shareholder returns of the gas the gas downstream. Given the competition downstream segment. The Standard & Poor’s for capital in the oil and gas industry and the (S&P) Composite Chemicals index outper- need to prioritize each dollar, the investment formed the S&P Composite E&P index by decisions companies make in 2014 will likely almost 25 percent, and the stock price of the be key to the industry’s long-term profitability largest stand-alone US LNG exporter rose by and business model.

9 US shale: A game of choices

Dealing the new cards

HALE oil is the fastest-growing resource in and associated natural gas liquids (NGLs) Sthe United States because of the advantaged production will depend on large-scale invest- oil-to-gas price ratio. However, this fast growth ments in “the” US gas downstream. According will likely make the shale oil market more frag- to the EIA, 33 percent of the increase in US mented and less differentiated—much like the shale gas and 85 percent of the growth in US current domestic shale gas market. Consider NGLs will be driven by the growth in LNG the effect of more than 500 independents drill- and petrochemicals, respectively, from 2011 to ing for the same oil in the same market.19 The 2025 (figure 4). The price differential between competition in this market will intensify over global oil (or oil-linked global gas) and US gas the next few years as the growth rate slows is projected to remain far above the equilib- down and turns negative because of the deple- rium price level of 6:1, ranging between 18:1 tion of “sweet spots”. Deloitte MarketPoint LLC to 26:1 until 2040. According to Sasol’s CEO, estimates that US produc- the company’s proposed new cracker in tion will peak by 2020 at about 4.5 million can afford for the ratio to go as low barrels a day (MMbbl/d).20 as 16:1.22 This will continue to provide the US Domestic E&P companies are generally best and LNG export industries a suited for these conditions because of their profound and sustainable competitive advan- smaller , which supports lower tage for the foreseeable future. profits per barrel and enables them to move The cost to produce (the base swiftly across emerging drilling prospects. petrochemical ) in the United States is Select E&P companies, for example, also have a now the second-lowest in the world because proprietary database for all hydraulic fractur- of low prices for feedstock, , and , ing specifications for more than 5,000 wells, which constitute 65 percent to 85 percent of which they will continue to “slice and dice” to the production cost.23 The fact that more than find the new bottom of the cost curve. $100 billion in investment is finding its way On the other hand, US shale gas production into the US petrochemicals segment is a testa- is projected to revive after 2016 and double ment to the value and affordability of America’s to 20 Tcf by 2040.21 This strength in shale gas shale gas and ethane supplies.24

10 The other half of the US gas downstream Figure 4. US gas downstream (LNG exports and petro- segment, the LNG business, shares a posi- chemicals) demand growth as a percentage of upstream supply growth (shale gas and NGLs) tive outlook similar to that of petrochemicals. The LNG business benefits from not just the advantaged gas price but also the lower capital US shale gas vs. US LNG exports (Cumulative growth, 2011–25) associated with the conversion of exist- 10.0 ing terminals. In contrast to 8.0 costly greenfield international LNG projects, 6.0 US brownfield conversion projects are 1.5 to 2.5 times cheaper. The conversion also pro- Tef 4.0 vides timing, , and operating 2.0 33% cost advantages over new projects, which are 0% plagued by cost inflation.25 0 In sum, the gas downstream segment is (2.0) poised to be the US oil and gas industry’s 2011 2013 2015 2017 2019 2021 2023 2025 biggest long-term advancement since the Shale gas supply LNG exports development of shale gas. However, unlike the shale oil market, where pure-play E&P companies would continue to lead develop- US NGLs supply vs. petrochemicals feedstock (Cumulative growth, 2011–25) ment, the gas downstream segment will likely 0.8 have a diverse set of industry participants. For 0.6 example, supermajors, domestic pure plays 85% (like Dow Chemical and LyondellBasell), and 0.4 international chemical companies (like Sasol and Formosa ) will likely compete for 0.2 Quadrillion Btu 0% the sizeable growth opportunities in the US 0 petrochemical industry. On the other hand, the US LNG export market will have a new set of (0.2) 2011 2013 2015 2017 2019 2021 2023 2025 competitors for upstream players—midstream companies, domestic utilities, and foreign diversified entities, which together represent NGLs supply Petrochemical feedstock more than 85 percent of the proposed US LNG Note: Petrochemical feedstock includes liquefied petroleum gases (ethane, , export capacity. Knowing that each participant ) used for producing base petrochemical products and generating power and will aim for a competitive lead, it will be inter- fuel in the bulk . esting to see how they seize these opportuni- Sources: US DOE/EIA 2013 and 2014 Annual Energy Outlook (AEO). ties, deal with each other, and shape the US oil Graphic: Deloitte University Press | DUPress.com and gas industry.

11 US shale: A game of choices

PETROCHEMICALS: A COMPETITIVE UNITED STATES Oil-based is projected to remain the prime feedstock for the global petrochemical industry, and hence will continue to be the ethylene price-setter. These oil-linked product (ethylene and its derivatives) prices and the cost of gas-linked feedstock (NGLs) will keep the competitiveness of the US petrochemical industry intact for the foreseeable future.

–– Price makers are high on the cost curve: Global ethylene prices are largely set by oil-based crackers in Asia and , which represent more than 65 percent of global ethylene capacity. The proportion of US ethane-based crackers would remain less than 27.5 percent, even if all of the proposed 12.5 MMTPA of low-cost ethylene capacity is added in the United States and no capacity expansion is considered worldwide. –– A significant price cushion is available to US ethane-based crackers: The ethylene costs of US ethane-based crackers are nearly one-fourth of those of global naphtha-based crackers. For the cash costs of both to be equal, ceteris paribus, US ethane prices would need to increase by 4 to 5 times over July 2014 price levels.

Figure 5. Ethylene production cost curve (cents/pound, 2013)

80 Ethylene Ethylene price makers price takers 70

60 Ethylene price 50

40 Northeast Europe Asia Naphtha Naphtha 30

20 Ethylene cash cost (cents/pound) Middle US Ethane East Ethane 10

0 0 20 40 60 80 100 120 140 160

Cumulative ethylene capacity (MMtons)

Sources: Deloitte analysis; adapted from , “Yet another potential ethane cracker announced,” January 21, 2014, and LyondellBasell, “JP Morgan industrial conference,” March 2014. Graphic: Deloitte University Press | DUPress.com

12 LNG: ADVANTAGE TO THE UNITED STATES The landed cost (including a 15 percent before-tax internal rate of return) of US natural gas in is estimated to be $10 to $11 per thousand cubic feet (Mcf), $1 to $2.50 lower than Australian and Canadian exports despite higher shipping costs via the .

–– Lowest downstream capital cost: Brownfield LNG projects in the United States provide a significant downstream cost advantage over their brethren in and . US LNG projects cost around $800 per million metric tons per annum (MTPA) of LNG capacity, compared with $1,500 to $1,700 per MTPA in Australia and $1,000 to 1,500 per MTPA in Canada. –– Reducing upstream supply cost: Among the three regions, Australia has the lowest upstream supply cost because of large offshore fields that reduce the number of wells required. However, the large-scale development and adoption of new in the United States has increased the economic ultimate recovery (EUR) of shale plays such as Marcellus to more than 10 billion cubic feet (Bcf) and reduced the cost to drill and complete a well to less than $7 million.

Figure 6. Integrated LNG supply cost (landed cost in Japan)

$15.00 $11–$13.50/Mcf $11–$12.50/Mcf Capital $12.00 $10–$11/Mcf cost range

$9.00 LNG capital cost $/Mcf

$6.00 Shipping cost

Midstream and liquefaction cost $3.00 Upstream supply cost

$0.00 US Gulf coast Western Australia West coast Canada (Brownfield) (Greenfield) (Greenfield)

Note: US upstream supply cost is representative of large E&P independents’ activity in the Marcellus shale play.

Sources: Deloitte analysis; adapted from RBC Capital, “A new dawn for North American LNG,” May 2013; Chesapeake investor presentations.

Graphic: Deloitte University Press | DUPress.com

13 US shale: A game of choices

Building a winning hand

ITH the coming of the gas downstream or a refining unit could easily dispose of and Wsegment, or the emergence of the full buy supplies in the open market. A refiner now gas value chain, the United States could be one typically pays the same price whether it buys of the few countries holding a “royal flush,” from its own upstream unit or from outside with advantages ranging from a worldwide the company. As a result, a standard addition competitive in oil and gas upstream to only offers marginal benefits—primarily sav- refining, LNG, and petrochemicals. However, a ings from the common use of selling, general, simple addition of all the segments would only and administrative costs, which is only 1 to 3 bring “standard” benefits. percent of many companies’ .27 This and A standard addition links multiple seg- the perceived benefit of focus and market pref- ments primarily through product transfers erence for pure plays explain why a number (figure 7). These transfers were once consid- of integrated companies are segregating and ered essential for the industry. Paul Frankel, becoming pure-play specialists. often referred to as the father of petroleum The US gas market is still in “adjustment” economics, argued in his 1946 Essentials mode because of transportation bottlenecks, of Petroleum that these transfers maximize demand-supply imbalance, and price variance profits, reduce risk, and create stability between shale plays. Although in the current in an intrinsically unstable and non-self- situation, there could be a case for owning the adjusting industry.26 full gas chain and capturing the total margin or The development of a free and actively price arbitrage, the market, similar to oil, will traded spot market has undermined the likely self-adjust in the medium to long term. benefits of product transfers—especially for An interconnected network across shale plays, primary, easily transported oil products such increased tradability of gas products, and a as crude oil, , and distillates. These number of highly competitive pure plays across changes meant that an upstream oil producer each segment would marginalize the benefits of gas integration, at least for investors.

14 These pure plays are what investors often This instability may further increase want in order to take advantage of the volatil- because there are now multiple sources, mul- ity and market disruption that occurs between tiple grades, multiple processes, multiple end segments. However, multiple shale factors uses, and multiple fuel prices in the United in play are likely to drive unforeseen margin States. The US shale boom is now spread over migration between segments, raising the risk of 20 active shale basins producing multiple overinvesting in one while negating the growth grades of crude and variable ethane/propane prospects of the other. In 2006, for example, mix, unlike the standard grades of the past. large shale-heavy oil and gas producers in the Small-sized such as crude oil topping United States reported operating margins of units, propane dehydrogenation plants, and about 45 percent; by 2012, typical margins had condensate splitters are gaining traction and dropped to about 20 percent. On the other offering new downstream opportunities. hand, the margins of typical US petrochemical (gas and in power, NGLs and naphtha in producers nearly doubled, shifting investments chemicals, gas and in refining, diesel from upstream to downstream. But in the and natural gas in transportation) are becom- first six months of 2014, a rally in gas prices ing substitutable and prices are fast decou- of about 30 percent over the 2013 average, pling, making fuel switching rampant among primarily due to extreme winters, reversed end users. some of the gains of the gas downstream. Such Considering these changes, integrated com- imbalanced growth and volatile prices create panies that simply add value chains, or pure disequilibrium in the industry, leading to an plays that pursue stand-alone strategies, may unstable industry scenario. end up creating a parallel and underutilized

Figure 7. Standard addition of oil and gas value chains

Existing Emerging Standard (oil chain) +=(gas chain) addition

Crude oil Refining and Chemicals Natural gas LNG

Product flow

Source: Deloitte analysis.

Graphic: Deloitte University Press | DUPress.com

15 US shale: A game of choices

Figure 8. Construct of a business ecosystem , skewing investments to only one segment, stretching balance sheets, and sinking returns during rough price cycles. In Ecosystem other words, such behavior may repeat the Interactive problems of surplus witnessed in the first two of value chains rounds of the game. To overcome these challenges, oil and gas companies need to come together to build an Value chain interactive community of value chains—an Standard addition of end-to-end segments ecosystem—that maximizes the benefits of a rapidly evolving shale market by synchronizing the growth of all interdependent segments of Segment the industry. A strategic ecosystem can retain Group of competing companies the flexibility of being an investor’s favored pure-play structure and simultaneously har- ness cross-segment operational synergies— Company focusing more on reaping benefits through Basic unit of an collaboration and less on owning the value industry performing a business function chain, allowing each company to do what it does best (figure 8). How can companies build this kind of stronger oil and gas ecosystem? How can Source: Deloitte analysis. industry participants exploit the opportunities Graphic: Deloitte University Press | DUPress.com in shale together?

THE THREE FS: THE BUILDING BLOCKS OF AN ECOSYSTEM A standard value chain is characterized by product transfers, incremental value addition, and limited intersegment synergies. But a strategic ecosystem can be defined as a network of segments that maximizes (financial) value for segments; connects processes, creates new products, and provides supply (feedstock) flexibility; and unifies the disjointed asset base (facilities) of the industry—the “three Fs.”

Three Fs Value chain (standard) Ecosystem (strategic)

Incremental one-way value Interactive networking across segments to maximize end- Financial addition across segments to-end business value

Product flows across segments through Collaborative feedstock planning and personalized Feedstock typical supplier-customer product yields to optimize intersegment synergies relationships

Sharing resources such as real estate, facilities, talent, and Independent operations technology Facility and limited dependency Synchronized operations and flexible configurations across between facilities segments

Source: Deloitte analysis.

16 Playing all hands together

HE transition from standard value chain Oil and gas companies can create this web Taddition to a strategic ecosystem requires of interlocked assets by following a capex-light, establishing beneficial dependencies between flexible investment strategy that encourages segments. These dependencies are not just collaboration. Rather than each company about developing product flows, but creating owning and creating a parallel infrastructure, a web of optimized processes, technologies, oil and gas companies can form marketing transportation and storage, , alliances, share technology and infrastructure, talent, real estate, and capital project delivery enter into offtake and agreements, solutions across all segments. connect inputs and yields of facilities, and

Figure 9. Architecture of a strategic ecosystem

Standard addition Strategic of value chain ecosystem

Crude oil Refining and retail Chemicals Natural gas LNG

Product flow Resource sharing

Source: Deloitte analysis.

Graphic: Deloitte University Press | DUPress.com

17 US shale: A game of choices

Figure 10. Expanded view of a strategic ecosystem

Crude oil Natural gas

Unifying acreage management Integrating well information and surface transportation Sharing midstream and processing infrastructure

Co-developing NGL processing units Optimizing process chains (e.g., convert- Entering into long-term profit sharing ing crude directly into Dynamic feedstock (NGLs) and fuel (natural chemicals) gas) contracting Integrating multi-stage cooling and feed splitting Chemicals processes Crude blending and flexibility Exploring new supply and gas marketing agreements solutions Co-owning LNG facilities Co-developing mini-refineries and condensate splitters Reconfiguring pipeline networks

Optimizing support functions such as logistics, power generation, procure- ment, and materials management Real estate and site integration Partnering and developing export Co-creating new products and optimizing terminals, storage facilities, berths, products through collaboration and other ancillary functions Sharing utilities, storage, and terminals LNG Refining

Leveraging existing gasoline retail network for selling LNG Sharing export infrastructure and optimizing support functions

Joint ventures Strategic alliances Relational agreements

Graphic: Deloitte University Press | DUPress.com

18 safeguard supplies and margins through strate- gic and joint ventures. This type of collaboration would yield results if it is primary to a company’s decision making and adopted industry-wide, rather than being ancillary or limited to a few compa- nies as it is currently. Fortunately, the addition of the gas downstream segment has presented Crude oil Natural gas many avenues for collaboration and incented more participants to establish new linkages across all industry segments (figures 9 and 10). Unifying acreage management A chemical unit, for example, could col- Integrating well information and surface transportation laborate with a light crude processing unit or Sharing midstream and processing a mini-refinery to absorb the latter’s naphtha infrastructure output and enhance the associated production Co-developing NGL processing units Optimizing process of chemical feeds such as propylene. Similarly, chains (e.g., convert- Entering into long-term profit sharing contracts ing crude directly into Dynamic feedstock (NGLs) and fuel (natural NGLs processors could increasingly enter into chemicals) gas) contracting dynamic ethane/propane supply agreements Integrating multi-stage cooling and feed splitting with chemical companies, allowing the latter Chemicals processes Crude blending and grade flexibility Exploring new supply and gas marketing agreements to switch between ethane and propane in real solutions Co-owning LNG facilities time depending on the market and price con- Co-developing mini-refineries and condensate splitters ditions of its products. Reconfiguring pipeline networks Midstream companies could take a larger role in interlocking upstream and downstream Optimizing support functions such as logistics, power generation, procure- assets, due to their larger size and reach across ment, and materials management shale plays. Apart from shouldering the capex Real estate and site integration Partnering and developing export Co-creating new products and optimizing terminals, storage facilities, berths, burden, they could offer contracting and feed- products yield through collaboration and other ancillary functions stock flexibility to upstream and downstream Sharing utilities, storage, and terminals companies. Further, midstream companies LNG Refining could configure their offering—creating “pseudo crudes”—by blending new crudes in real time with the help of an upstream company and providing “grade on demand” flexibility to refiners. Similarly, the NGLs Leveraging existing gasoline retail network for selling LNG extraction from natural gas and LNG lique- Sharing export infrastructure and optimizing support functions faction share multi-staged cooling and feed- splitting processes, offering an opportunity Joint ventures to midstream and gas downstream segments to collaborate. Strategic alliances Upstream participants and supermajors can progressively enter into a or subscription Relational agreements contract for midstream and utility companies’ US LNG capacity. Shell and ’s agreement to modify the existing Elba Express Pipeline and Elba Island LNG Terminal is an

19 US shale: A game of choices

example of such cross-segment collaboration. companies. By doing this, they can benefit Under this agreement, the Kinder Morgan from the growing trade of LNG in the spot group will own 51 percent of the entity and market. In 2012, the spot and -term LNG operate the facility. Shell will own the remain- market reached 31 percent of total volumes, up ing 49 percent and fully subscribe the lique- from less than 5 percent in 2000.29 This shift faction capacity. The project will use Shell’s toward the spot market is likely to increase as innovative small-scale liquefaction unit, which US companies begin exporting LNG, more will be integrated with the existing Elba Island buyers seek destination flexibility clauses, facility and enable rapid construction, allowing trading desks are established, and re-export of Kinder Morgan to derive new value from its LNG increases worldwide. existing asset base.28 In sum, the potential benefits of this new Supermajors and international E&P style of collaboration are limitless. It may not companies could widely market their global only drive growth across all oil and gas seg- re- terminals, swap interest in ments, but also help to make America’s energy global LNG projects, and offer their global sup- industry stronger. ply and trading experience to US midstream

20 Coming up aces

HE US shale boom has opened the by investors while simultaneously harness- Tdoors for growth across the two primary ing cross-segment operational synergies of segments of the oil and gas industry. This an integrated structure. In other words, they growth started in oil and gas upstream busi- could toward creating a resource-centric ness through the development of shale gas oil and gas ecosystem in which assets, opera- and shale oil, and it is now moving to down- tions, talent, and support functions interlock stream petrochemicals and LNG . across businesses. This new gas-heavy face of the downstream Such an ecosystem can help the US oil and segment will feed on advantaged domestic gas industry to sustain its competitiveness even gas and its co-products, less-pricey conver- if the current hydrocarbon price or feedstock sion and expansion of existing facilities, and cost advantage starts narrowing or ceases to price arbitrage between the United States and exist. Together, ecosystem participants can also international markets. withstand the unforeseen margin migration With growth comes increased competi- between segments, which will likely become tion—especially given that the United States common as players in the United States free has many pure-play specialists operating themselves of the “one source, one grade, one domestically and integrated companies with process, one end use, and one price” mindset. global operations—and a need to prioritize Luckily, the promise of the gas downstream scarce capital. Foreseeing this challenge, US oil segment and its addition to the existing oil and gas businesses could work toward estab- value chain has presented new opportunities lishing a capex-light ecosystem that retains the for collaboration to shape this ecosystem in the flexibility of the pure-play structure favored United States.

Deloitte offers audit and enterprise risk, tax, consulting, and financial advisory services to companies across the oil and gas industry. Specialty services include resource evaluation and advisory services, capital projects services, merger and acquisition services, and services from dedicated groups including Deloitte Energy Advisors, Deloitte MarketPoint, the Petroleum Services Group, and Vigilant by Deloitte. Reach out to the contacts listed in this report for more information or read more about our oil and gas industry practice on www.deloitte.com/us/oilandgas.

21 US shale: A game of choices

Glossary of terms

Associated natural Associated gas refers to the dry natural gas extracted as an additional product while gas production drilling for oil or NGLs.

Condensates refer to light liquid hydrocarbons recovered from lease separators or field facilities at associated and non-associated natural gas wells, mostly pentanes Condensates and heavier hydrocarbons, which normally enter the crude oil stream after production.

Cracking is the process whereby complex organic molecules are broken down into Cracker simpler molecules.

Downstream companies include facility-based businesses engaged in the Downstream conversion of raw hydrocarbons into finished products (here, refining, chemicals, and LNG).

Estimated ultimate Estimated ultimate recovery (EUR) is an approximation of the quantity of oil or gas recovery (EUR) that is potentially recoverable or has already been recovered from a reserve or well.

Ethane is a straight-chain saturated (paraffinic) hydrocarbon extracted predominantly from the natural gas stream, which is gaseous at standard Ethane temperature and pressure. It is a colorless gas that boils at a temperature of -127 degrees Fahrenheit.

Feedstock refers to any unprocessed material used to supply a Feedstock process.

Hydraulic fracturing, commonly known as fracking, is the technique of creating fractures in rocks and rock formations by injecting fracking fluids into the cracks to extract petroleum, natural gas, or other substances. The method is widely used in shale gas production in the United States.

Independents are companies in the upstream part of the energy value chain Independents engaged in exploration and production of oil and natural gas.

To move natural gas across oceans, it is converted into (LNG), Liquefaction a process called liquefaction. LNG is natural gas that has been cooled to –260° F (–162° C), changing it from a gas into a liquid that is 1/600th of its original .

Liquids-rich shale plays are shale formations that contain natural gas with high Liquids-rich NGLs content. The NGLs content of liquids-rich shale plays ranges from 2.5 to 5.3 shale plays gallons per Mcf.

22 Midstream refers to companies involved in the gathering, processing, transporting Midstream via pipelines, and storage of natural gas and liquids.

NGLs are higher hydrocarbons such as ethane, propane, butane, and natural NGLs gasoline (pentanes plus). NGLs typically have higher energy content and are denser than dry gas.

At regasification terminals, liquefied natural gas delivered by LNG tankers is Regasification returned to the gaseous state.

The reserve-replacement ratio measures the amount of proved reserves added Reserve replacement to a company’s reserve base during the year relative to the amount of oil and gas rate (RRR) produced. A rate of above 100 percent suggests a net addition of reserves, while a ratio of below 100 percent means a net depletion of reserves.

Shale gas is natural gas trapped within shale formations (a fine-grained, Shale gas sedimentary rock). Shale gas has become an increasingly important source of natural gas in the United States over the past decade.

Tight oil refers to the light crude oil trapped in shale, , and sandstone Shale oil/ formations characterized by very low porosity and permeability. It may also be called light tight oil (LTO), tight shale oil, or even shale oil.

A set of known or postulated oil and gas accumulations sharing similar geologic, Shale play geographic, and temporal properties, such as source rock, migration pathway, timing, mechanism, and hydrocarbon type.

Specialists Specialists refer to companies operating in one segment.

Supermajors is a name used to describe the world’s five largest publicly owned, Supermajors integrated oil and gas companies with operations worldwide.

Sweet spots Sweet spots refer to the highest-producing shale plays/fields.

An umbrella term for oil and natural gas that is produced by means that do not Unconventionals meet the criteria for conventional production. This primarily includes , shale oil, and shale gas.

Upstream companies are those engaged in the exploration and production of crude Upstream oil, natural gas, and natural gas liquids.

23 US shale: A game of choices

Endnotes

1. US Energy Information Administration, 10. PLS/Derrick Petroleum Services, data Crude oil and natural gas production, on oil and gas M&A deals in the United accessed on March 10, 2014. States (maximum $/boe is based on 2. Reuters, “Shale 2.0, going global,” deal values greater than $1 billion), November 15, 2013, http://www. accessed on January 15, 2014. reuters.com/article/2013/11/15/ 11. Ibid. shale-idUSL5N0J02ZJ20131115. 12. Ibid. 3. Tara Patel, “Total reports first writedown 13. PLS/Derrick Petroleum Services, data on oil on value of US shale gas assets,” Bloomberg, and gas M&A deals in the United States (based October 31, 2012, http://www.bloomberg. on average deal values greater than $10 million com/news/2012-10-31/total-reports-first- in gas-heavy plays), accessed on April 23, 2014. writedown-on-value-of-u-s-shale-gas-assets. html; “BHP Billiton writes down shale gas 14. Data from FactSet, WTI futures as of March 4, assets by $2.8bn, chief Marius Kloppers forgoes 2014. bonus,” Telegraph, August 2, 2012, http:// 15. US Energy Information Administration, annual www.telegraph.co.uk/finance/newsbysector/ and monthly operable refinery utilization rate. industry/9448474/BHP-Billiton-writes- 16. US Energy Information Administration, down-shale-gas-assets-by-2.8bn-chief- Annual Energy Outlook, 2014. Marius-Kloppers-forgoes-bonus.html. 17. Data from FactSet. 4. Reuters, “UPDATE 1-BHP plans sale to trim down west Texas shale assets,” 18. American Chemistry Council, “US chemical October 22, 2013, http://www.reuters.com/ investment linked to shale gas reaches article/2013/10/22/bhpbilliton-permian- $100 billion,” February 20, 2014, http:// idUSL5N0IC3BX20131022; Eduard www.americanchemistry.com/Media/ Gismatullin, “Shell begins sale of US PressReleasesTranscripts/ACC-news-releases/ shale assets following charge,” Bloomberg, US-Chemical-Investment-Linked-to- September 30, 2013, http://www.bloomberg. Shale-Gas-Reaches-100-Billion.html. com/news/2013-09-30/shell-begins-sale-of- 19. Data from Bloomberg and Hoovers, based on u-s-shale-assets-following-charge.html. listed US-origin E&P companies and non- 5. B P, Investor update 2014, March 4, 2014, US E&P companies with operations in the http://www.bp.com/en/global/corporate/ United States, accessed on February 7, 2014. investors/investor-presentations/ 20. Deloitte MarketPoint reference case investor-update-2014.html. “Factors driving world oil markets.” 6. US Energy Information Administration, 21. Ibid. Natural gas production by source, 1990-2040. 22. US Energy Information Administration, 7. SEC filings and FactSet. Annual Energy Outlook, 2014; Lisa Steyn, 8. US Energy Information Administration, “Sasol cracks major US fracking deal,” monthly WTI and natural gas price data. & Guardian, September 20, 2013, http://mg.co.za/article/2013-09-20-00- 9. SEC filings and annual reports (2011 and sasol-cracks-major-us-fracking-deal. 2012), Chesapeake and EOG Resources.

24 23. American Chemistry Council, Economics 27. Based on SG&A as a percentage of & Statistics Department, “Shale gas, sales of , Murphy competitiveness, and new US chemical Oil, and ConocoPhillips prior to their industry investment: An analysis based spin-off of downstream businesses (data on announced projects,” May 2013. from FactSet and company filings). 24. Ibid. 28. Shell, “Shell and Kinder Morgan announce 25. Ross Kelly, “Cost of Chevron’s Gorgon LNG plans to export LNG from the United project rises to $54 billion,” Wall Street States,” January 28, 2013, http://www. Journal, December 11, 2013, http://online. shell.com/global/aboutshell/media/ wsj.com/article/BT-CO-20131211-712957. news-and-media-releases/2013/shell- html; Matt Chambers, “LNG projects face and-kinder-morgan-announce-plans- more delays, blowouts: IEA,” The Australian, to-export-lng-from-the-un.html. June 21, 2013, http://www.theaustralian. 29. International Gas Union, “World LNG com.au/business/-energy/lng- report—2013 edition,” 2013, http:// projects-face-more-delays-blowouts-iea/ hcbcdn.hidrocarburosbol.netdna-cdn. story-e6frg9df-1226667134309#. com/downloads/online_version_world_ 26. Paul H. Frankel, Essentials of Petroleum lng_report_2013_edition_original.pdf. (New York: Frank Cass and Company, 1946 [first edition] and 1969 [revised edition]).

25 US shale: A game of choices

Acknowledgements

The authors would like to acknowledge Jim Balaschak, principal, Deloitte Services LP; Gregory Bean, director, Deloitte Consulting LLP; and Annette Proctor, senior manager, chief of staff, Deloitte Center for Energy Solutions, for their extensive review, feedback, and suggestions through- out the drafting process.

Special thanks to Parthipan Velusamy, senior analyst, Market Insights, Deloitte Support Services India Pvt. Ltd. for his research and analysis support.

Thanks are also extended to the following Deloitte professionals for their consistent support and contributions to the paper:

Janelia Tse, senior manager, oil and gas, Deloitte Services LP Suzanna Sanborn, senior manager, oil and gas, Deloitte Services LP George Given, senior manager, oil and gas, Deloitte MarketPoint LLC Junko Kaji, acquisitions editor, Deloitte University Press, Deloitte Services LP Mindy Porter, marketing manager, Deloitte Services LP Mangesh Hirve, director, Derrick Petroleum Services Ramani Moses, editor, Eminence, Deloitte Support Services India Pvt. Ltd. Noopur Kapoor, assistant manager, Deloitte Support Services India Pvt. Ltd. Deepak Shah, senior researcher, Deloitte Support Services India Pvt. Ltd. Amit Sudrania, senior analyst, Deloitte Support Services India Pvt. Ltd.

26 Contacts

John England Curt Mortenson Vice chairman, oil and gas leader Oil and gas consulting leader Deloitte LLP Deloitte Consulting LLP +1 713 982 2556 +1 713 982 2607 [email protected] [email protected] @JohnWEngland

Jeff Kennedy Paul Horak Oil and gas financial advisory services leader Oil and gas audit leader Deloitte Transactions and Deloitte & Touche LLP LLP +1 713 982 2535 +1 713 982 3627 [email protected] [email protected]

Coleman Rowland Jeff Wright Oil and gas advisory leader Oil and gas tax leader Deloitte & Touche LLP Deloitte Tax LLP +1 713 982 2948 +1 713 982 4940 [email protected] [email protected]

27 US shale: A game of choices

About the Center for Energy Solutions

The Deloitte Center for Energy Solutions (the “Center”) provides a forum for , thought leadership, groundbreaking research, and industry collaboration to help companies solve the most complex energy challenges. Through the Center, Deloitte’s energy and resources group leads the debate on critical topics on the minds of executives—from the impact of legislative and regulatory policy, to operational efficiency, to sustainable and profitable growth. With locations in Houston and Washington, DC, the Deloitte Center for Energy Solutions offers interaction through seminars, roundtables, and other forms of engagement, where established and growing companies can come together to learn, discuss, and debate.

www.deloitte.com/energysolutions @Deloitte4Energy

For further reading

Deloitte Center for Energy Solutions, The rise of the midstream: Shale reinvigorates midstream growth, Deloitte, November 2013, https://www.deloitte.com/assets/Dcom-UnitedStates/Local%20 Assets/Documents/Energy_us_er/us_er_RiseOfTheMidstream_Nov2013.pdf.

Economist Intelligence Unit (EIU), “Canada/US: Terminal decision,” December 19, 2013, http:// www.eiu.com/industry/article/291357413/canadaus-terminal-decisions/2013-12-19.

Shell, “Shell boosts its leadership in global LNG with the completion of S.A. LNG deal,” January 2, 2014, http://www.shell.com/global/aboutshell/media/news-and-media-releases/2014/ shell-boosts-leadership-global-lng-completion-repsol-deal.html.

28

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