With Fortunes to Be Made or Lost, Will Natural Gas Find Its Footing?

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1 Executive Agenda With Fortunes to Be Made or Lost, Will Natural Gas Find Its Footing? The U.S. shale gas market is out of balance with production outstripping demand. But when the glut ends, how will the market shake out? All signs point to a rebalance by 2020, when the free market kicks in. 1

2 Despite all the talk about shale gas development the potential environmental consequences of hydraulic fracturing, the potential to replace coal with gas for generating electricity, the potential for the United States to export liquefied natural gas (LNG) none of it addresses the bigger picture: The market is structurally out of balance, and it can t stay this way. The technological triumph of shale gas has led to production that far outstrips demand, and if this were a normal market, price and demand shifts would have already delivered a quick rebalancing. But shale gas is not a normal market and a rebalancing is not likely in this complex ecosystem where a wide array of players have diverging incentives and investment horizons. Over the past 20 years, gas prices have fluctuated between $2 and $15 per million BTU. At the low end, the producers are not viable, and at the high end, potential users of gas cannot afford to use it. Will we face more years of such fluctuations before achieving balance, especially since numerous decisions affecting that balance are still up in the air? And yet, bets must be placed now. Infrastructure must be built. With fortunes to be made or lost, these decisions must be as informed as possible. A Quest for Balance The hydrocarbon business is all about balance. Balance among production, refining and converting, and marketing has been a vaunted but elusive goal for more than a century, as Daniel Yergin chronicles in The Prize, a Pulitzer Prize-winning history of the global oil industry. An investment in one industry sector (for example, upstream exploration and production) may be useless unless paired with appropriate investments in other sectors (such as downstream selling and marketing). In the oil industry, factors encouraging balance include vertical integration global companies that control everything from exploration to delivery and regulation of production, either overtly through organizations such as OPEC or more naturally through high barriers to entry. In the gas industry, those factors are lacking. So the relevant questions are not so much Is the shale gas boom real? Or Is it here to stay? (The short answer is yes.) The question companies should be asking is How will the natural gas glut rebalance in the long term? As an analogy, consider the U.S. deregulation of natural gas wellhead prices in Was it real? Was it here to stay? Yes, but after a brief period of sustained low prices in the 1990s, the industry has been plagued with volatility. Prices have bounced up and down, sometimes benefitting producers, sometimes end users. The problem has been balance. When prices were low, up went the infrastructure of gas-fired power plants and pipelines. After the investments were locked in, all that demand sent gas prices so high that much of it could not be used. Will the same thing happen again? We can t say for sure because the factors are different and some of them are yet to be determined. But we can say this: The industry is still not structured to achieve win-win scenarios. It is not integrated, which means that big trends in one area can go almost unnoticed in another. Understanding what s going to happen requires first understanding who all the players are. An Uncoordinated Set of Actors The U.S. shale gas ecosystem comprises a set of players with different incentives and investment horizons that have grown up mostly independent of each other and are generally not inclined to understand the motivations of the other players. The shale gas family includes a variety of actors: 2

3 Independent producers focus on short-term plays and have an investment time horizon of just a few years. They are not afraid to take risks, have few barriers to entry, and can bring on capacity quickly and inexpensively. But if gas prices stay below $4 per million BTU, many players with predominantly dry gas portfolios will continue to struggle and possibly go out of business. Super majors and global producers take a longer view on their investments and can afford to delay investment in certain parts of the world if local conditions are not favorable. Midstream players have a longer view on investments, but they take advantage of geographic and capacity-based market differentials to invest in pipelines, gas processing, and fractionation. Gas exporters are eyeing liquefaction facilities on the coasts that could competitively export LNG and take advantage of high prices abroad if the price spread between the United States and overseas markets stays above $5. Although 4.5 trillion cubic feet of capacity has been proposed, these facilities could cost up to $10 billion per trillion cubic foot and take a minimum of five years to permit and build. Chemical companies are looking at natural gas liquids (NGL) as feedstock. Low-cost ethane (as a substitute for byproducts of crude oil refining), for example, makes polyethylene cheaper to produce in the United States than anywhere in the world except the Middle East. So the industry could build eight to 10 (or more) new gas crackers at approximately $2 billion apiece, including some downstream investments, but it would need confidence in ethane prices being competitive for 10 or more years. Instead of asking Is the shale gas boom here to stay?, we should be asking How will the natural gas glut rebalance in the long term? Power generators want low-cost gas to generate electricity. Before the shale boom, existing gas plants were operating at less than 50 percent of capacity. However, they can ramp up quickly and squeeze out other forms of power generation, primarily coal. If power generators knew gas prices would stay below $6, they could begin replacing existing coal plants with gas plants that take just two to three years to build. The advocates of new uses such as T. Boone Pickens, Chesapeake, and GE will look at compressed natural gas (CNG) to fuel cars and trucks if gas prices are low compared to oil. Such plans will require huge investments over long timeframes to build CNG infrastructure, fueling stations, and vehicle fleets. Some of these players are already pairing up. Chemical companies are signing long-term ethane supply agreements with shale NGL producers and midstream companies. LNG companies are doing the same with their suppliers and their customers. Others are staying single for now, at least until there is more (or a narrower range) price certainty and fewer wildcards. 3

4 Five Possible Futures, One Likely Scenario If supply and demand were stable and investment cycles were shorter, it would be easy for market forces to align them. But the U.S. market for natural gas and NGLs is driven by several diverse and unpredictable variables: the global economy, oil prices, energy and environmental policies, a rise in the global gas supply, or technological advances that are still unknown (see sidebar: Predicting the Unpredictable). Although these variables could interact in any number of permutations, our analysis finds five scenarios that could capture a range of potential outcomes. The most likely scenario, which we call free markets, involves the least dramatic changes from current conditions. In this scenario, GDP growth is modest, oil prices remain within current trading ranges, LNG export becomes a reality, and no major global natural gas production or technological advance affects the balance of forces seen today. We believe the price of natural gas in the free-markets scenario will find equilibrium by 2020 in the $6 to $7 range. Any lower than that and production from dry-gas wells would not be profitable and would not increase sufficiently to meet demand; any higher and demand from power plants will wane. But in this range, demand is high in all major sectors, leading to high margins for producers and strong capital investments. Predicting the Unpredictable If supply and demand were stable and investment cycles were shorter, it would be easy for market forces to align them. But the U.S. market for natural gas and NGL is unpredictable, with several diverse and volatile factors. There s the global economy. Global growth will drive demand for energy and materials. If the recovery gains momentum and global gross domestic product (GDP) rises by 3 to 5 percent annually, demand will be high. But if global GDP stagnates and global trade drops, lower demand for electricity, chemicals, and natural gas in other markets could drop prices across the board. Oil prices are also unpredictable. At the current price spread between oil and natural gas, chemical production from NGLs is attractive. But if oil prices drop to $60 per barrel and are forecasted to remain there, gas production falls and chemical companies delay investments in gas crackers. Energy and environmental policies could upset industry dynamics. Environmental policy on hydraulic fracturing will drive the cost of drilling and completion of wells and could stop it altogether if there are major incidents. Or the United States could restrict LNG exports to foster energy independence or to support jobs and economic growth through a cost-competitive energy advantage, or it could allow LNG exports in a more free-markets policy. Also, environmental regulators concerned about greenhouse gas emissions might impose carbon taxes, air quality restrictions, and carbon dioxide emission regulations that make coal-fired options more expensive, pushing power generators to substitute coal with natural gas. Increased gas supply, with rapid development of gas in other countries could halt the U.S. shale gas advantage, making LNG exports less attractive. And if the new shale plays are rich in NGLs, U.S. chemical company exports will suffer. Finally, we don t know where the next technological advance will come from. Will it be in exploration technologies to unlock stranded resources such as gas hydrates or to further lower production costs of existing plays? Will it be in breakthrough innovation that will alter the economics of processes such as gas-to-liquid conversion? It is hard to predict, but if the next advance is in solar, wind, oil, or coal carbon capture and storage, one of those competing energy sources might leapfrog gas and gain advantage. 4

5 Although the free-markets scenario is the most likely in our analysis, the outcome of global events and governmental actions could lead us down other paths. There are four other possible scenarios: Troubled times. A geopolitical event triggers a disruption in oil supply, sending oil prices up and the global economy into a double-dip recession. Natural gas demand collapses to 20 percent below the free-market scenario level. Limited export. The U.S. government decides to limit natural gas exports and provides support for other fuels in an effort to achieve energy independence, thus depressing natural gas demand. Global gas competition. Other major economies are successful in developing wet shale plays. As a result, demand falls for both LNG exports and ethane-based chemicals from the United States, challenging the overall economics of shale gas plays in North America. High output. Robust global GDP growth and lack of global shale developments lead to the highest level of U.S. natural gas demand. These scenarios represent a combination of various, and sometimes drastic, supply and demand discontinuities. Nevertheless, the resulting gas prices are spread across a surprisingly narrow range of $5 to $8 per thousand cubic feet (mcf) (see figure). We believe market trends point to a strong future for natural gas and its ability to pull prices up structurally, with upstream production economics determining the floor price and competition between coal and gas defining the ceiling price. Figure Natural gas 2020 price scenarios Natural gas price ($/MMBtu) $12 $11 $10 Global economies collapsing Demand for natural gas slowing Natural gas restrictions increasing to stimulate domestic economy Global gas development putting pricing pressure on NGLs and U.S.-based chemicals Competition from coal-fired power generation Domestic demand moderating at high NG prices $9 $8 $7 $6 $5 $4 $3 $2 $1 $0 Gas more attractive than coal Supply being rationalized to eliminate wasteful production Troubled times Gas more attractive than coal Modest global GDP sustaining NGL prices Supply being rationalized Demand for NGL falling, forcing more supply rationalization GDP sustaining domestic demand Gas equaling coal Demand for natural gas rising as LNG is exported and global shale development falls GDP rising Supply being rationalized CO 2 regulations favoring gas No major global shale developments GDP growing New demand channels emerging for GTL and CNG Limited export Global gas Free markets High output competition Notes: MMBtu is one million British thermal units, GDP is gross domestic product, NGL is natural gas liquids, LNG is liquefied natural gas, GTL is gas to liquids, and CNG is compressed natural gas. Source: A.T. Kearney analysis 5

6 Finding Balance One of the biggest difficulties in looking forward is knowing when a current trend represents lasting change and when it is merely a bump in the road. Shale gas represents lasting change, but every change has many paths to balance. And on the road from here to long-term balance, there will undoubtedly be many short-term irritations a mild winter, a Middle East crisis that will send some analysts to wrong conclusions. In our free-market scenario, the price of natural gas finds equilibrium by 2020 in the $6 to $7 range. The regulatory certainty and more balanced pricing reflected in the free-market scenario could provide a foundation of stabilized demand on which to build investments. That s a likely path to long-term balance, but even it would be filled with both short-term bumps and more serious detours caused by players with different incentives. Because of those bumps, prices during the transition will be volatile. When they are low, some producers may be forced out of the market. When they are high, capacity investments may be delayed. Disruptive events such as an oil-price collapse or a safety or environmental incident may dramatically reduce supply. Any one of these detours could be devastating to an individual player. If bigger than expected, one or more could transform the industry in unexpected ways, leading to a different path and a different result. But the same could be said about any unexpected event. More fundamentally, we can say that in the long run, despite temporary blips, the natural gas industry will find balance. The path to get there will take advantage of the reduced costs and expanded supplies resulting from shale gas. It will also take advantage of the smart investments of well-informed players throughout the complex industry ecosystem. Authors Patrick Haischer, partner, New York patrick.haischer@atkearney.com Andrew Walberer, partner, Chicago andrew.walberer@atkearney.com Herve Wilczynski, partner, Houston herve.wilczynski@atkearney.com 6

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