Evolving BusinEss ModEls in thE natural gas shalEs · natural gas to consumers. Chesapeake, for instance, is partnering with GE and valero to install hundreds of Compressed Natural

Evolving BusinEss ModEls in thE natural gas shalEs

AUTHORS

Bob Orr Alexander Roinesdal

While depressed natural gas prices in the US are creating significant

difficulties for pure-play natural gas producers, larger and more

diversified players are raising their stakes in shale gas plays. Driven

by a long-term view of the natural gas market and drawing on their

experience in other business segments, the new players are exploring

innovative business models to create more sustainable natural gas

operations in the shales. To stay competitive, pure-play operators will

also need to adapt.

Oil & Gas | Energy

Copyright © 2012 Oliver Wyman 1

The last year has been rough for US natural gas producers. After suffering from lower

than expected spot prices in 2011 – mostly hovering in the $4.00-$4.50 range – producers

watched prices plummet in early 2012, in part because of the mild winter, but also because

of their high production rate. (Many players are locked into production requirements from

acreage lease agreements, joint venture agreements, and supply contracts.) The resulting

gas glut pushed prices below $2 in April 2012 before beginning to rebound. Despite the

recent uptick, prices remain below breakeven for many shale gas producers.

Consequently, cash-flow pressure on pure-play natural gas producers is intense. The capital

costs required to produce in the shales are high, and with fewer dollars coming in for every

unit produced, or lowered production while waiting for higher prices, many players are feeling

the squeeze. That’s especially true for the most ambitious operators, which racked up both

acreage and debt at a ferocious pace during the shale boom. Not surprisingly, the markets

have rewarded operators that have most effectively managed their cash-flow to debt levels;

companies with the worst projected cash-flow to debt ratios have lost value since 2007.

LARGE PLAyERS GROWiNG ShARE

Larger companies – with more diversified revenue streams – are better positioned to outlast

this current price trough. Recognizing the long-term potential of shale gas, international and

National Oil Companies (iOCs and NOCs) have spent billions to acquire attractive positions

in the shales. in fact, many majors, which had largely left the US, are taking a close look

at domestic onshore upstream opportunities for the first time in years. While ExxonMobil’s

ExhiBiT 1: SAMPLE ShALE iNvESTMENTS By iOCs AND NOCs

US $ MILLIONS

2008 2010 2011

SIZE OF INVESTMENT

BP

1,900

Statoil

3,375

Total

2,250

Shell

4,700

CNOOC

2,160

Chevron

4,300

Statoil

4,400

bhpbilliton

15,400

Statoil

1,300

2009

ExxonMobil

41,000

Source: industry journals and press clippings


$41B acquisition of xTO is by far the largest, nearly all the other majors and several NOCs

have made sizeable investments in the US shales (see Exhibit 1.)

A secure domestic energy source, shale gas provides long-term predictability, which is

essential if industries are going to retool their infrastructures to utilize this abundant energy

supply. As infrastructure changes, demand for shale gas will increase and drive up prices, as

will the likely export of Liquid Natural Gas (LNG) to other continents where natural gas prices

are significantly higher. however, these market changes will take time, and shale asset holders

need to position themselves now to fully reap these projected benefits.

The arrival of iOCs and NOCs in the shales will impact the way all shale players operate.

At the most basic level, the larger firms will continue to drive the industry toward low-cost

operations. These diversified companies are already experienced process optimizers, so

they are applying their operational best practices across all shale assets to most efficiently

produce natural gas. Because the production process is largely repeatable across the various

shale plays, scale amplifies the cost savings. Some operators have even explored Lean Six

Sigma techniques, typically used to optimize processes in manufacturing and plants, in their

shale operations. Achieving cost leadership will be a key component of success in the shales

in the next phase of development.

Large shale operators are also exploring other ways to innovate their business models

to improve production efficiency, to spark long-term demand, and – to prevent service

providers from encroaching on their margins – to control more of the value chain. These

changes are being felt upstream, midstream, and downsteam in the natural gas value chain.

ExhiBiT 2: ChANGiNG BUSiNESS MODELS

E&PExpanded Midstream Model

E&P

Core business focusSecondary business segments

Opportunistic Customer

E&PIntegrated Oil & Gas Company

BUSINESSMODELS NATURAL GAS VALUE CHAIN OBSERVATIONS

E&PShale E&P Specialists

E&P Midstream Marketing

Midstream Marketing

Midstream Marketing& Trading

Utilities/ Industrial Consumers

OilfieldServices

Integrated Natural Gas Company

Most early entrants in the shales were focused on drilling and producing as soon as possible, with limited attention to price risk or cash flow diversification.

Some shale E&P operators, such as Chesapeake, have sought to take a bigger role in marketing gas directly to consumers to increase demand. Some have also brought oilfield services and midstream assets in-house to control costs.

Integrated companies are growing their presence in the shales and can take advantage of their trading and marketing arms to secure more stable cash flows.

Midstream asset owners can take advantage of cash-strapped E&P companies to assume favorable supply positions and use their storage and logistical assets to seek arbitrage opportunities.

Large natural gas consumers, such as power generation and industrial companies, could take advantage of small E&P companies’ current need for cash flow to lock in favorable long-term supply deals.

Source: Oliver Wyman


UPSTREAM iMPACTS: vERTiCAL iNTEGRATiON WiTh OiLfiELD SERviCES AND MiDSTREAM OPERATORS

As part of the effort to control costs, some of the larger operators are pursuing a greater degree

of vertical integration of the value chain. As large amounts of natural gas come on-stream in

unconventional fields, operators will need substantial new infrastructure to gather the gas

and transport it to where it can be commercialized. The costs associated with this midstream

segment will have a sizeable impact on the breakeven price and commercial viability of the

natural gas being produced. Taking full or joint ownership of the midstream assets can be

an effective way to control midstream costs. While many smaller E&P operators lack sufficient

capital to play a significant role in the midstream game, the larger operators do not.

The trend toward vertical integration may also emerge in oilfield services, though to a more

limited extent. high-tech drilling rigs, a requirement for directional shale drilling, as well

as other service equipment, such as for fracking, are now in high demand. Shale operators

have been funneling more of their margins to the oilfield service companies for the use of

this equipment. To control costs, some operators have brought oilfield services partially in-

house. for instance, Chesapeake Energy, the second largest natural gas producer in the US,

acquired Bronco Drilling and its 22 drilling rigs for $315 million in April 2011. Chesapeake

ExhiBiT 3: GAS GLUT ShifTS DOMESTiC DRiLLiNG TOWARD OiL

Unprofitable economics have led E&P companies to shift their drilling operations toward shale oil and liquid plays. in

April 2011, the number of rigs drilling for oil in the US surpassed the number drilling for natural gas for the first time

since the mid-1990s. in May 2012, fewer than 500 rigs were drilling for natural gas – the lowest amount since 2002.

1,000

800

1,200

1,600

1,400

200

400

600

Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Aug 12

Oil Rigs

NaturalGas Rigs

0

1,800

ACTIVE US DRILLING RIGS

Source: Baker hughes North America Rotary Rig Count (August, 2012)

47% Decline since the end of October 2011


already owned 95 rigs through a subsidiary, and also owns an oilfield services company. it

seeks to maintain roughly two-thirds of its oilfield service use in-house.

Moving service costs in-house may be tempting when utilization levels and day-rates are high,

but it adds significant risks in downturns—when the service assets are less valuable, or even

idle. The majors have withstood these painful experiences with offshore rigs in past cycles, and

that experience will likely limit how aggressively they pursue a similar strategy in the shales.

DOWNSTREAM iMPACTS: PARTNERiNG WiTh CUSTOMERS AND ThiRD PARTiES TO DRivE DEMAND

in an interesting twist to the traditional onshore E&P model, which focuses primarily on

finding and getting gas out of the ground, some shale producers are also taking steps to

integrate downstream. Realizing that ending the natural gas glut caused by the shales

requires demand growth, certain shale companies are stepping up their efforts to market

natural gas to consumers. Chesapeake, for instance, is partnering with GE and valero to

install hundreds of Compressed Natural Gas (CNG) stations to fuel vehicles. Chesapeake

also partners aggressively with large fleet operators to encourage switching from gasoline

to natural gas to take advantage of the significant price differential. Other natural gas

producers, such as EOG and Cabot Oil and Gas, are converting their fleet vehicles to run

on CNG and installing filling infrastructure in their local areas. The integrated majors with

large shale gas positions, such as ExxonMobil and Chevron, could potentially leverage

their existing gasoline site and marketing networks to market CNG directly to consumers.

The near-term impact of these initiatives on demand at a national level will be limited (vehicular

use accounted for less than 0.2% of US natural gas consumption in 2011). But impressive

concentrations of CNG filling infrastructure are emerging in certain regions, such as gas-rich

North Texas and Oklahoma. These are encouraging, albeit early, signs for long-term demand.

in the near and medium term, however, the largest demand drivers will be industry and power

generation. While the traditional shale E&P business model focused almost exclusively on

extracting natural gas, newer business models recognize the importance of developing

relationships with large customers to help secure demand. Relationship building is key

for players hoping to convince their biggest customers to switch from coal and other fuel

sources. if operators can offer long-term natural gas supply contracts at a predictable price,

customers’ fears about price volatility (which pushed many consumers away from natural

gas in the 2006-08 period) will be alleviated. Large operators will also continue to prod

regulators for natural gas incentives, emphasizing the environmental benefits relative to

coal and oil.

The flip side of this long-term contract dynamic is that current circumstances provide

midstream companies and large natural gas consumers the opportunity to capture value

by taking advantage of the cash-strapped natural gas producers, particularly those that

are smaller and less diversified. Utilities or industrial companies, for instance, can offer


7654321

Eagle Ford (Gas)

Fayetteville (2.8 Bcf)

Jonah

Woodford (Arkoma)

Wattenberg (Core)

Uinta (Shallow)

Picenace (Highlands)

Raton (CBM)

GOM Shelf

Alberta Shallow Gas

Warwick (W. Texas Overthrust)

Barnett (Tier 2)

BREAKEVEN NATURAL GAS PRICE ($/MCFE)

BREAKEVEN NATURAL GAS PRICE BY BASIN

Marcellus Wet (Core)

Pinedale

Marcellus Dry (Core)

Fayetteville (3.4 Bcf)

Granite Wash (Horizontal)

Huron Shale

Deep Bossier (E. Texas)

Eagle Ford (Condensate Zone)

Cana-Woodford (Core)

Piceance (Valley-Core)

Barnett (Tier 1)

Appalachian-CBM

Haynesville

Marcellus Dry (Tier 2)

Apr. ‘12 Sept. ‘12 Sept. ‘13

0

ExhiBiT 4: SLOW hikE BACk TO BREAkEvEN PRiCiNG

With spot prices below $3/MMBtu for much of 2012, producing natural gas from the shales has in many

cases been unprofitable. Just four years ago, when many players made investments in the shales, prices

were above $10. Many producers won’t break even until prices top $4 again.

PaSt, Current and future natural gaS SPot PriCeS

July 2008 $11.09

april 2012 $1.95

september 2012 $2.85

Futures price september 20131 $3.99

1 As of October 17, 2012

Source: Company data, Morgan Stanley Research, EiA, CME Group



producers a stable cash flow to help service debt in exchange for a long-term supply of

natural gas at a favorable price. Going one step further, adding both risk and upside, they

could seek to take equity stakes in gas-producing assets, with the goal of capitalizing on the

current market environment to lock in supply through partial backward integration.

MORE SOPhiSTiCATED BUSiNESS MODELS ENSURE LONG-TERM POSiTiONiNG

The window of opportunity is closing on the most favorable of such deals, as iOCs and

NOCs operating in the shales are ushering in business models that are better suited to

manage cash flow and liquidity during downturns. Large players don’t rely on natural gas

as their only revenue stream, and they are also likely to do a better job of hedging and

managing their gas cash flow through in-house trading operations. While small pure-play

E&P companies typically have very limited in-house marketing capabilities, the small iOCs

and NOCs maintain large trading desks and sales operations to secure off-take of their

product and hedge price risks.

The natural gas glut ensures that companies are no longer rewarded for simply acquiring

as much shale acreage as possible and drilling it as quickly as possible. Managing through

the cyclical natural gas business requires a smarter business model, with economical

drilling operations and a more sophisticated approach to marketing and cash flow

management. Larger operators are leading these business model changes, bringing

valuable expertise from their other business segments. While the challenges of the current

cycle will weed out some operators, those that successfully navigate the current price

environment will be well-positioned to reap long-term value from the natural gas shales.

ABOUT OLivER WyMAN

Oliver Wyman is a global leader in management consulting. With offices in 50+ cities across 25 countries, Oliver Wyman combines deep industry knowledge with specialized expertise in strategy, operations, risk management, and organization transformation. The firm’s 3,000 professionals help clients optimize their business, improve their operations and risk profile, and accelerate their organizational performance to seize the most attractive opportunities. Oliver Wyman is a wholly owned subsidiary of Marsh & McLennan Companies [NySE: MMC], a global team of professional services companies offering clients advice and solutions in the areas of risk, strategy and human capital. With 53,000 employees worldwide and annual revenue exceeding $10 billion, Marsh & McLennan Companies is also the parent company of Marsh, a global leader in insurance broking and risk management; Guy Carpenter, a global leader in risk and reinsurance intermediary services; and Mercer, a global leader in human resource consulting and related services. for more information, visit www.oliverwyman.com. follow Oliver Wyman on Twitter @OliverWyman.

Oliver Wyman specializes in helping clients develop and realize customer-focused, market-tested business designs to capitalize on new customer opportunities, defend against emerging competitive threats, and ultimately grow value. Our consultants have deep expertise across the oil and gas value chain and have worked with leading international and domestic oil and gas companies operating in the Americas, Europe, Asia, Africa, and the Middle East.

for more information about Oliver Wyman’s perspectives on oil and gas business models, please contact your account representative or one of the following partners:

David hoffmanPractice Leader+1 617 424 [email protected]

Bob OrrPartner+1 713 276 [email protected]

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Evolving BusinEss ModEls in thE natural gas shalEs · natural gas to consumers. Chesapeake, for instance, is partnering with GE and valero to install hundreds of Compressed Natural