Strategies to Maximize Value in the Global Oil and Gas Industry Value Chain

Strategies to Maximize Value in the Global Oil and Gas Industry Value Chain Betty J. Simkins, Ph.D. Williams Companies Professor of Business & Professor of Finance Oklahoma State University Email: betty.simkins@okstate.edu Phone: 405-744-8625 Webpage: http://spears.okstate.edu/~simkins Betty Simkins, PhD

The Energy Value Chain Natural Gas Production Processing Transportation Marketing Chemicals Crude Oil Exploration Upstream E&P Production Transportation Storage Midstream Refining Marketing Downstream R&M and Chemicals Chemicals 2

Understanding Value Creation in the Energy Value Chain: Analysis, Strategy and Competitive Benchmarking Type of Comparison Example 1. Comparison between companies Compare Sales Growth for OSU with sales growth for OU. Sales Growth Sales Growth 2. Comparison over time Compare OSU this year with last year. 2012 2011 3. Comparisons to Industry Compare OSU s level of risk with the average degree of risk for the entire Big 12 Conference. Company Risk Industry Risk 3

Energy Value Chain Strategies: Jeopardy Style 1825 Date of first natural gas well drilled in the U.S. 27 Depth of well in feet Fredonia, NY Location 1857 First staged, artificial frack 8 Pounds of gunpowder used for frack

Energy Value Chain Strategies: Jeopardy Style 1859 First commercial oil well drilled in U.S. Titusville, Pennsylvania Location

Energy Value Chain Strategies: Jeopardy Style 1929 First true horizontal oil well in Texon, Texas 1944 First horizontal oil well in Marcellus Region in Venango County, PA

History Up to This Point Shale deposits were discovered throughout the U.S. Some limited production was established in NY, Michigan, Pennsylvania Two major hurdles to widespread development Thickness: Shale deposits cover broad area but thin (300 feet or less thickness) Getting hydrocarbons economically: Difficult to develop commercial production with traditional vertical drilling and shale rock does not give up hydrocarbons easily Did not respond well to traditional well stimulation approaches

Jeopardy Lots of Oil is Left in Shale When was this said? 8

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History 40 Years Ago 10

History Even Just 4 Years Ago and Now! plans for the end of the fossil fuel economy are now being laid. Now! 11

Upstream Strategies to Unlock Value: How? Technology Directional (Horizontal) Drilling Horizontal drilling has been the norm for almost two years. For both oil and gas, a horizontal well means higher initial production accompanied by faster decline rates. PDC Bits (Polycrystalline diamond compact) Fracturing And the brain! 12

Zombie oil wells coming back to life! 13

Recent Trends and Strategies: The World is Not Running Out of Fossil Fuels! Technological advances are a paradigm shifter that is still evolving; impacting energy companies globally. U.S. undergoing an energy renaissance for oil and natural gas Advances have made it possible to recover oil and natural gas from shale and tight formations economically; previously not possible Stimulated a rebirth of the U.S. petrochemical industry Creating a job renaissance for U.S. manufacturing World is not running out of oil any time soon World consumes about 226 million (mm) barrels of oil equivalent (BOE) per day. About 80 mm oil, 66 mm coal, 55 gas, 12 nuclear, and 14 hydro (BOE) 14

We are not running out of fossil fuels. 15

Comparison of the Prices of Crude Oil and U.S. Natural Gas on a Btu Basis Conversion: 1 barrel of oil is equal to 6 mcf of natural gas on a btu basis, on average. So, we use the conversion 1 BOE = 6mcfe to create exhibits like this where BOE stands for barrel of oil equivalent. Mcf stands for thousand cubic feet and mmbtu stands for one million btu. 1mcf=1mmbtu. 16

Source: Energizing America, API report, May 2013 17

Future US Energy Demand Forecast (Source: EIA) Source: Energizing America, API report, May 2013 18

Land area of oil field, solar farm, wind farm, and corn field needed to replace the 2,000 MW of power produced by San Onofre Nuclear Generating Station in Oceanside, CA. Additional reading: Twenty First Century Snake Oil: Why the United States Should Reject Biofuels as Part of A Rational National Security Energy Strategy by T.A. Ike Kiefer, U.S. Air Force Air War College 19

Jeopardy: Important New Strategies for Downstream 2011 U.S. became net exporter of petroleum products 2016 U.S. will export LNG 20

Jeopardy: Important New Strategy for Downstream 2011 U.S. became net exporter of petroleum products 21

U.S. to Export LNG Starting in 2016 Source: Deloitte 22

Strategy Every business seeks a competitive advantage. How? Unique products and/or services that provide better customer value for equivalent cost differentiation or Standardized products and/or services that provide customer value for a lower cost cost leadership Crude oil, natural gas, NGLs, and refined products are commodities How can you make them unique and add new features? How can you add value to a commodity?

Trends in Mergers, Acquisitions, and Divestitures IOCs are focusing on maximizing value because of a wave of activists in the industry. Activist proposals at Hess. Hess selling off Bakken assets. Does this hurt the LT viability of the company? Is this in the best interests of Hess? Puts fear in companies that are laggards. Occidental has been a laggard and is now trying to transition from international assets. CEO now in position to create value. Occidental is known to be a good operator but some investors have lost patience with laggards. Has Apache been a laggard of late? Selling some assets to fund growth projects. ExxonMobil is the largest onshore natural gas producer in the US. They can handle the low prices because they are so big. Shale plays Some are financially and operationally in a weak position. For the weak operator, how long can you keep your head above water? Low natural gas prices have hurt the natural gas plays in the US. 24

Trends in Mergers, Acquisitions, and Divestitures 2 In North America, small to mid size companies are paying high prices to acquire assets. Most transactions with implied proven reserve values above $40 per BOE (S&P research) Selling to mitigate risk Disposition of low return assets Asset sales to fund liabilities (e.g. Chesapeake Energy; Anadarko Petroleum) Redeploying capital We are seeing foreign investment in US shale. MLPs (Master Limited Partnerships): Value creating measures: Receive preferential tax treatment and garner higher multiples because of this; Results in high yield.

Trends in Mergers, Acquisitions, and Divestitures 3 There are fundamental reversals of strategies that have been in place for 20+ years. Four key points: 1. There is a shared strategic focus on aggressive volumetric growth 2. From a strategic perspective the two key tools fueling growth are (1) acquisitions (including JV alliances) and (2) grass roots operations. 3. A mix of conventional operations (onshore and shallow water) and other major asset types will drive growth; complexity is increasing. 4. North America and other OECD countries will play an extraordinarily large role in future growth in oil and gas output. 26

Foreign Investment In U.S. Shale PetroChina/Encana $12.1 B BHP Acquired Petrohawk in 2011 Reliance/Atlas ITOCHU/MDU Resources CNOOC/Chesapeake Statoil/Chesapeake BG/EXCO BHP/Chesapeake Statoil/Talisman Reliance/Pioneer BG/EXCO CNOOC/Chesapeake 27 KNOC/Anadarko

Trends in Mergers, Acquisitions, and Divestitures 4 Downstream: Is it vertically challenged? Integrated operating model for oil companies has been the predominant and most successful operating model of the 20 th century. Logic for integrated model was belief of a natural hedge. Integration would allow a company to optimize the energy value chain. Midstream and downstream could be seen as source of long term cash flow and financial stability to balance risky upstream activities. Integration balanced segments reducing risk and volatility Recent trends are seeing this model being challenged and new models emerging. Players focusing on specific industry segments. Has it created value so far? Let s look at three examples. 28

ConocoPhillips Spin off of Phillips 66 (effective date May 1, 2012)

Williams Companies Spin off of WPX (effective date January 3, 2012)

Marathon Oil Spin off of Marathon Petroleum Company (effective date June 30, 2011)

Total Returns from these Spin offs through June 25, 2013 versus the S&P 500 Return

Let s Look at the Impact on Chemicals Industry: World Ethylene Cash Cost Comparison U.S. Moves from High to Low Cost Provider 33

Added value of Petrochemicals

Global Ethylene Chemicals Cost Curve Source: Deutsche Bank, CMAI 35

Location, Location, Location! WTI and Brent Abnormal supply conditions at Cushing has caused WTI to no longer be an accurate barometer for oil prices in the US and globally. Brent crude from North Sea can be shipped just about anywhere in the world. WTI Cushing can only be absorbed by refineries in the US Midwest. Seaway Pipeline reversal has reduced the differential between Brent and WTI to weaken. Spread peaked at $28 and currently less than $6. Keystone XL Pipeline status? 36

Cost Leadership in Energy Value Chain Efficient manufacturing facilities keep cost low! Learning curve and technology Control costs and overhead Access to capital to build big efficient operations. Industry is capital intensive. Manage costs in research, sales force, and advertising crucial for commodity products Best to be the low cost producer in a commodity business You never want to be the high cost producer in a commodity business Process engineering improve efficiencies and reduce costs Low cost distribution networks pipelines, etc. Strive to use the lowest cost transportation when possible.

The Six C s of the Energy Value Chain Crude oil and natural gas prices drive the business! Cash flow is the blood of the business. Available cash determines operating strategy (not vice versa!) Cyclical This is a boom and bust business Cost control Primary way to achieve long term success Capital intensive Industry requires large investments throughout the Energy Value Chain. Need good and dependable sources of financing. Crazy You have to be a little of this to work in this volatile yet very important business

Rules for Oil Price Forecasting Never mention a price & a date in the same talk If you can t forecast well forecast often If you are ever lucky enough to get it right, don t let anyone forget it

Thank you! 40