Who Will Lose if Natural Gas Prices Keep Falling?

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1 March March 2013 Who Will Lose if Natural Gas Prices Keep Falling? By Tony Danova A drop in prices would have uneven effects across the supply chain, with those farthest down the chain presenting the least risk to investment banks. Turning a high profit will become increasingly difficult for extractors and distributors The energy sector provides investment banks with a substantial amount of activity each year, with natural gas firms providing a particularly enticing prospect for merger and acquisition (M&A) activity, underwriting opportunities and other services that investment banks offer. Recently, though, US natural gas firms across in the supply chain have been grappling with rapidly falling natural gas prices, due to a heavy supply in combination with somewhat static demand. From 2010 to 2011, the wellhead price of natural gas in the United States fell from about $4.48 to $3.95, according to the US Energy Information Association (EIA). To boost prices, some natural gas firms have attempted to limit the supply by cutting back production volume. The plan has been somewhat successful; the EIA reports that the Henry Hub spot price in natural gas has grown from a low of $1.95 in April 2012 to about $3.33 in January Still, natural gas production volume is at an all-time high in the United States. According to a September 2012 report from the Natural Gas Supply Association, high natural gas production in the United States can be attributed to various factors. For example, the Marcellus Shale boom and other recent $ per thousand cubic feet World price of natural gas Year discoveries of untapped natural gas deposits have led natural gas extraction companies to ramp up production. Historically, the United States has produced roughly 30 trillion cubic feet (TCF) of natural gas each year. Many analysts have concluded that the Marcellus Shale field holds almost 50 TCF of extractable natural gas. On top of the vast amount of natural gas production, skyrocketing crude oil prices have also aided in keeping natural gas supplies high. Generally, drilling of crude oil produces an associated gas as a byproduct. Barclays research estimates that 75.0% of all natural gas production during 2012 was from gas pumped as a 18 SOURCE: info@ibisworld.com

2 March Baselinevs.scenario Baseline2012 Baseline2014 Scenario2014 Industry Overall Structure Growth Sensitvity Overall Structure Growth Sensitvity Overall Natural Gas Distribution Oil Drilling & Gas Extraction Coal & Natural Gas Power SOURCE: byproduct of oil drilling. According to an April 2012 article from Bloomberg Businessweek, crude oil regularly traded above $100 a barrel throughout the early stages of These sustained high oil prices facilitated an opportune time for oil drilling companies to ramp up crude oil production. Still, though many natural gas production firms have pulled back rigs in order to reduce output, the EIA reports that natural gas storage reached roughly 8.9 million cubic feet (MMcf) in November 2012 (latest data available), compared with roughly 8.2 MMcf a year prior. This 8.5% increase in storage space may ultimately further subdue natural gas price growth in the United States going forward. In contrast to the domestic landscape, the world price of natural gas has been steadily rising over the past five years. This driver, which is manipulated in the IBISWorld model, has been propped up by heavy natural gas price growth in Europe and Asia because it is a benchmark price from the weighted averages of Russian natural gas border price in Germany, Indonesian liquefied natural gas price in Japan and the natural gas spot price at Henry Hub in Louisiana. Nonetheless, the World Bank reports a steady decline in Russian natural gas border prices and static performance in Indonesian liquefied gas prices in Japan over the past six months. However, IBISWorld expects the world price of natural gas to increase substantially during 2013, by an estimated 15.7% to $10.00 per thousand cubic feet (tcf). Still, with US prices also continuing to fall, what would an actual decrease in the world price of natural gas to $8.00/tcf mean for the three key US industries throughout the supply chain of this commodity? Moreover, how would these effects flow through to investment banking activity within these key natural gas industries? Natural gas price model In this study, IBISWorld profiles the Oil Drilling and Gas Extraction, Natural Gas Distribution, and Coal and Natural Gas Power industries in the United States, and discusses the implications that falling natural gas prices may have on profitability, revenue growth, demand and other aspects within each industry. Using IBISWorld s Industry Risk Rating Model 1, IBISWorld has dropped the weighted average of the three natural gas price benchmarks (Germany, Japan and US) to $8.00 per tcf from the baseline of $10.04 during 2013, with the end goal to 1 A joint effort with RMA with roots in the work of Michael Porter, the model is based on data from the highly granular five-digit North American Industry Classification System (NAICS). The precise theoretical underpinning is a marriage of Porter s Five Forces and a traditional macroeconomic-style top-down approach.

3 March show the change in IBISWorld risk-rating scores for the three industries during 2013 and To calculate the overall risk score, IBISWorld assesses the risks pertaining to industry structure (structural risk), expected future performance (growth risk) and economic forces (sensitivity risk). Risk scores are based on a scale of 1 to 9, where 1 represents the lowest risk and 9 the highest. The three types of risk are scored separately, then weighted and combined to derive the overall risk score. In the figure above, the model shows that, over the next two years, two key upstream industries within the natural gas sector will experience significant growth in their associated risk scores, while a downstream industry will become less risky. These industries rely on natural gas in different ways, and a fall in the price of the commodity will have varying effects. Oil drilling and gas extraction Firms in the Oil Drilling and Gas Extraction industry operate and develop oil and gas field properties and engage in natural gas exploration. Other industry operations include mining, extraction of oil from oil shale and sands, and exploration and production of crude petroleum. Crude oil accounts for roughly 58.4% of all extraction revenue within the industry, with natural gas consuming the remaining 41.6%. Given its higher prices, crude oil has increasingly dominated the industry s landscape during the past five years. Compounding skyrocketing oil prices with the falling natural gas price, the share of revenue derived from natural gas extraction has fallen from about 51.0% during Higher crude oil prices and falling natural gas prices, within this IBISWorld scenario, would lure oil drilling and gas extraction firms away from natural gas fields, despite an abundant supply of the commodity. If firms increase crude oil output and demand for crude oil falters, this would create a marked decline in industry revenue. While this fall could be buoyed by natural gas, the recent decline in natural gas prices has limited the ability of the natural gas segment to make up for a fall in crude oil revenue. A further decline in natural gas prices would exacerbate this trend, increasing the industry s overall risk score by a significant mark of With one end of the industry lagging the other, larger corporations may shy away from any sort of merger and acquisition (M&A) activity, particularly concerning firms focused primarily on natural gas extraction. Additionally, opportunities for new natural gas extraction firms to enter the industry likely will diminish as the market becomes more saturated. These factors will lead to less potential investment banking opportunities due to lower demand for M&A advisory services and fewer new entrants raising capital. Natural gas distribution Firms in the Natural Gas Distribution industry operate gas distribution systems consisting primarily of gas mains and meters that transport natural gas to end users. Many are also gas marketers, which buy gas from the well and sell it to a distribution system, while others are gas brokers or agents, which arrange for gas to be sold via distribution systems that they operate. Because natural gas distributors are in the middle of the supply chain, they carry a strong interest in natural gas prices because these prices are the most significant and the most direct determinant of industry profitability and revenue growth. Therefore, the Natural Gas Distribution industry would be significantly affected by a sustained fall in the price of natural gas, as its overall risk score would to grow by a steep In general, continually falling prices in natural gas would put immense downward pressure

4 March About IBISWorld Inc. Recognized as the nation s most trusted independent source of industry and market research, IBISWorld offers a comprehensive database of unique information and analysis on every US industry. With an extensive online portfolio, valued for its depth and scope, the company equips clients with the insight necessary to make better business decisions. Headquartered in Los Angeles, IBISWorld serves a range of business, professional service and government organizations through more than 10 locations worldwide. For more information, visit or call Contact: Savannah Haspel VP, Public Relations IBISWorld Phone: savannahh@ibisworld.com on the industry s bottom line, potentially forcing firms to increase sale prices in order to pad margins. This trend could potentially weaken demand and subdue the industry s revenue growth potential. With lower profit and slow revenue growth, firms may be reluctant to enter the industry or expand, limiting investment banks opportunities for underwriting and other services. Coal and natural gas power The Coal and Natural Gas Power industry operates fossil fuel-powered electricity generating plants that are used to power turbines. These turbines generate electricity for households, the commercial sector and industrial firms. Currently, gas-fired electricity makes up about 33.6% of revenue for the industry and has grown significantly over the past five years in light of its availability and affordability. As electricity generated by natural gas becomes even more affordable due to falling natural gas prices, this segment will expand further. Like the Oil Drilling and Gas Extraction industry, consumer demand for gas-fired electricity would have the biggest implication on this industry s risk score, which would decrease substantially by 0.28 in 2013, according to the IBISWorld model. If natural gas prices continued to fall, the industry would benefit from growing consumer demand for gas-fired electricity, helping to push up revenue growth and pad industry profit margins. Additionally, lower natural gas prices have spurred investment into natural gas power plants, a trend that has also benefited investment banks, creating more activity for underwriting and helping new plants raise capital. Mixed results In the IBISWorld risk scenario model, the ability of each industry to remain less risky than anticipated hinges on each industry s capacity to increase consumer demand for its products if natural gas prices continue to fall. The supply of natural gas is there, but the most important aspect for firms is to survey the market and meet consumer needs for natural gas in industrial and commercial markets. Additionally, firms must consider the market for heating, electricity generation and other uses of natural gas in the residential market. The United States has been afforded a rich new supply of oil thanks to the discovery of previously untapped reserves and a high volume of natural gas byproduct from crude oil drilling. Nonetheless, natural gas firms up the supply chain may ultimately be bearish about the prospects of their sector should natural gas prices continue to plunge. For investment banks and thrifts, the natural gas sector proves to be a bit of a mixed bag. Based on the IBISWorld risk model, firms further up the supply chain -- those engaged in production and distribution -- have been struggling recently and will emanate greater associated risk as a result of the falling natural gas prices. On the other hand, firms supplying natural gas for consumer end-use have benefited from a glut in supply by being able to offer their customers a cheaper, more widely available product. Despite greater associated risk as a result of the falling gas prices, expanding consumer use has facilitated heavier investment into this sector. Though falling natural gas prices have made these industries inherently riskier, investment banks should look to those whose demand stems primarily from end users. While revenue growth may slow, and profitability may be squeezed initially, the potential for widening use of natural gas at the consumer level will attract new firms to enter, or others to expand. This will provide ample opportunities for M&A advisory, valuation, underwriting and other specialty services.

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