CIO WM Research 26 June 2014

US equitiesNorth American energyindependence: reenergized

• Rising production from "non-conventional"oil and gas reservesleads us to expect North America will achieve energyindependence by the end of the decade; and the US willbecome a net exporter of natural gas.

• Relatively inexpensive natural gas creates a competitiveadvantage for the US and will bolster energy intensiveindustrial operations, especially in the petrochemical andmaterials sectors. Natural gas will be used increasingly to fueltransportation and electric power generation.

• We see benefits across multiple industry sectors. We updateour list of recommendations for investors looking foropportunities as progress continues towards North Americaenergy independence (see page 6).

SummaryThe energy extraction techniques of horizontal drilling and hydraulicfracturing – combined with a structurally high relative price of crudeoil – has encouraged widespread development of America’s energyresources. Natural gas, the cleanest fossil fuel, has become abundant;while domestic oil production has turned around from a previouslydeclining trend. Today, natural gas in North America costs about afourth of the cost of oil on an energy-equivalent basis. We believethis will prompt fuel switching to natural gas, providing economic andenvironmental benefits.

Robust drilling activity for oil and natural gas, infrastructure build-out, and widespread availability of reliable and affordable energysupplies have been driving growth in many sectors of the US economy.Abundant natural gas supplies have pushed US prices to low levelscompared to other major gas consuming regions of the world wherereliance on imported gas keeps costs higher (Fig.1). This provides acompetitive advantage to the US - one that could persist well into thefuture, as US natural gas reserves are vast.

We see investment opportunities extending far beyond the energyindustry, to companies in energy-intensive industries such aschemicals, utilities and steel, among others, benefiting from low-costand reliable supplies of natural gas.

Nicole Decker, Sector Strategist, UBS FSnicole.decker@ubs.com, +1 212 713 4743

David Lefkowitz, CFA, strategist, UBS FSdavid.lefkowitz@ubs.com, +1 212 713 3739

Source: Getty Images

Fig. 1: Advantaged natural gas price in the USNatural gas price in USD per million British thermalunits

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Source: Bloomberg, DataStream, NomuraUK NBP = United Kingdom National Balancing Point,one benchmark for European natural gas prices, as is USHenry Hub for the US and Japan LNG imports for Japan

A version of this report is available withspecific security recommendations for USonshore investors. For a copy, please consultyour UBS Financial Advisor.

This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosuresthat begin on page 9.

Trends are well-establishedProduction is rising. Shale oil drilling activity remains brisk, as highoil prices support healthy returns and profitable production. Rapidgrowth in production of oil in the US (Fig. 2) and western Canada hascreated infrastructure bottlenecks. More transportation, processingand storage capacity is needed as well, particularly in new productionareas such as the Bakken in North Dakota and the Marcellus in Penn-sylvania.

Fuel efficiency and conservation. Meanwhile, persistent histori-cally high oil prices, as well as policy initiatives such as CAFE Standardshave led US consumers to conserve and to use fuel more efficiently.Domestic consumption of refined products, such as gasoline, is in themidst of a structural decline (Fig. 3).

Advantaged fuel price. While low natural gas prices have rendereddevelopment of many gas shale plays in the US uneconomic, oper-ators in low-cost natural gas resource plays continue to invest andgrow. Abundant and affordable supplies of natural gas are providingbenefits to North America-based industrial and electricity consumers.Natural gas consumption in these sectors is rising (Fig. 4).

Liquefied natural gas. By 2016, we project the US to be a naturalgas exporter, with the completion of the first liquefied natural gas(LNG) export facility. We expect several more LNG facilities to beapproved for construction in the next twelve months, providing apotential new area of growth. Longer term, we believe LNG exportsfrom the US will be supportive of natural gas prices. In our view, thiswill decrease the likelihood that prices revisit their recent lows overthe intermediate term.

Energy security. North America’s newfound energy abundanceoffers the US an opportunity to wean itself off oil supplies frompotentially politically unstable countries. The benefits from enhancedenergy security are difficult to measure. However, as geopoliticalissues has intensified in some of the world's major oil producingregions, we are reminded of the importance of a stable and reliablesource of energy supply. We believe that increased domestic supplyhas reduced the level of uncertainty that businesses and householdsacross the US would otherwise be feeling.

Diversification of the fuel base. America’s oil and gas revolutioncomes at a time of stagnant energy demand growth in the US, butimportant market-driven shifts are underway to diversify the fuel mixaway from oil. While economics will likely dictate this shift, not energypolicy, improved energy efficiency and sustainability will be essentialin order to reap full advantage. Through conservation and efficiencygains, oil consumption will decline. We also project diversification ofthe transportation fuel base, which is predominantly oil-based (Fig. 5).Longer term, we believe natural gas will be used increasingly in fleetvehicles. Together with greater use of renewables, the US will movefurther along the path to greater energy security and self-sufficiency.

Fig. 2: US oil production turns aroundUS crude oil production in thousands of barrels per day

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Fig. 3: Energy demand for transportation pro-jected to declineUS light-duty vehicle energy use in mboe/d (millionbarrels oil equivalent per day)

Note: Shaded area indicates projectionsSource: Energy Information Administration

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Investment conclusions - the decade aheadAs North America continues to achieve greater energy independence,we project a variety of investment opportunities for investors. If thisdecade truly marks the beginning of a long-term shift to a more stableand sustainable energy future in the US, then we believe the outlookis good for those in and around the domestic energy business as wellas energy consumers. This bodes well for investors who can home inon the key beneficiaries, which may include the following:

• Growing North American energy producers;• Energy delivery, distribution and processing infrastructure and

other service providers;• Companies that make equipment that will allow for more effi-

cient production and use of energy;• Companies that can exploit supplies of lower cost natural gas and

natural gas-derived feedstocks;• Those that can rise to the environmental challenges, including

water supply and waste management, environmentally-friendlyfracking fluids, emission-related solutions;

• Innovators for the next generation of renewable fuels.

On the other hand, a shift in the way the US satisfies its energy needsmay pose challenges for some of the incumbents:• Producers and service providers for the coal industry for instance,

may see fundamentals deteriorate as new environmental regula-tions take effect;

• Manufacturers and operators who use coal as a fuel source willbe confronted with decisions on how to meet new environmentalstandards;

• In refining, manufacturers of traditional oil-derived fuels for thetransportation sector may continue to see less demand for theirproducts in the US as fuel efficiency rises and alternatives becomeavailable. That said, US refiners are exploiting a feedstock priceadvantage by becoming large exporters of refined products.

One task for investors is to sort out the near-term and longer-termopportunities. Clearly, emerging technologies in renewable energyare compelling; but many are still in a young, unproven phase,which increases long term risks for investors. That said, momentum isunderway in the several sectors. including transportation, to capitalizeon low natural gas prices (Fig. 6), or to increase fuel efficiency on tra-ditionally powered vehicles through the use of new technologies.

In addition, new extraction technologies and techniques are beingtested by domestic oil and gas producers, which is adding to reservelevels and lifting returns, particularly for operators in the highest-quality resource plays such as the Bakken, Eagle Ford, Niobrara orPermian (Fig. 7).

Finally, several early movers in the materials and industrial sectors,have already begun to expand US operations to take advantage oflow-cost natural gas, increasing their competitive position versus theirglobal peers. This has been particularly true in the chemicals business,where natural gas consumption is high (Fig. 8). Many more plants areunder construction or in the permitting phase, and will continue tocontribute to the revival in US manufacturing (Fig. 9).

Fig. 4: Natural gas demand in the industrial andpower sectors is trending higherUS natural gas consumption by sector in million cubicfeet

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Fig 5: Petroleum powers transportationEnergy consumption by major sector and fuel source,in quadrillion British Thermal Units

Note: Electricity retail sales to ultimate customersreported by electric utilities and other energy serviceproviders. Total electricity system energy losses are cal-culated as primary energy consumed by the electric powersector minus the energy content of electricity retail sales.Source: Energy Information Administration, UBS

Fig. 6: Natural gas is inexpensive relative to oilOil (WTI) and natural gas prices in USD per boe/d (barrelof oil equivalents per day)

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Source: FactSet, UBS

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Outlook for the year aheadThe road to North America energy independence is a multi-yearjourney. New challenges and opportunities will arise along the way,occasionally altering our near-term outlook. As such, we review andupdate our list of recommendations periodically in order to assurethat each selection is appropriate under current market conditions.Our outlook for the year ahead is for continued strong US oil and gasproduction growth, supporting ongoing strength within the energysector.

We also project that abundant natural gas supplies will keep gas priceslow relative to oil prices and to gas prices elsewhere in the world, withongoing benefits to consumers in the industrial sector. We believe thatgeneral growth trends in energy transportation, storage, processingand infrastructure build-out may slow in 2014, but capacity remainstight in several regions, including the Northeast, Mid-continent andCanada.

New areas of growth could emerge. For instance, we believe thatinfrastructure and support services for liquefied natural gas (LNG)could become a new growth area in the near term, as the US movestowards becoming an exporter of natural gas. We expect several liq-uefaction plant projects to be approved by the US government in2014 and 2015.

Our recommendations for investors in this theme for the year aheadinclude companies in the following sub-sectors.

Energy - Exploration & ProductionWith shale oil and gas production now well established, investors havethe ability to identify companies with strong operating track records.We believe investors should focus on operators with strong executionskills, healthy balance sheets, and a high-quality asset base. The estab-lished plays in which operators are the most profitable include theBakken shale in North Dakota, the Eagle Ford in South Texas, thePermian in West Texas and New Mexico, the Niobrara in Colorado,and the Marcellus shale in Pennsylvania. In the next year, we projectthe Permian will see the highest pace of growth in activity.

Energy - Services and equipmentWhile growth rates for the oil and gas services sector in North Americahave stabilized, development activity remains robust and we seeongoing opportunities. In the US, services providers are working withoperators to refine extraction techniques, leading to higher produc-tivity for the operators, and higher margins (due to increased technicalintensity) for the service providers. Importantly, we believe that shaleoil and gas exploration will expand globally, and we expect operatorswith strong international brands to see additional opportunities forgrowth.

Fig. 7: Improvement in recovery techniques isenhancing well productivityFirst month average production in barrels per day

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Read example: improvements in recovery techniques haveincreased the production in the Bakken by 50% fromMarch 2013 to May 2014 in the first month of productionof a field (followed by - not visualized in the graph - adecline which extends out further)

Fig. 8: Chemical sector the biggest natural gasuserNatural gas use by US manufacturing sectors, in %,2010

Chemicals33%

Petroleum andcoal products

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Food10%

Paper8%

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5%

Other17%

Source Energy Information Administration, UBS

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Energy - InfrastructureEnergy infrastructure expansion has played an important role in theNorth America energy revolution. In general, companies that buildand operate oil and gas pipelines, processing and storage facilitiesin the US are structured as MLPs. The sector has seen extraordinarygrowth, both operationally and in terms of the number of partici-pants. More infrastructure is needed in the US; and while we believethe pace of growth is likely to slow, we continue to believe that thereare investment opportunities in this space.

Liquefied Natural Gas (LNG)We believe exports of liquefied natural gas is one of the upcominggrowth areas in the evolving North America energy story. The US ispreparing to export natural gas, which we believe will be supportiveof natural gas prices in the US over the intermediate term and gives anoutlet for further production growth. The construction of export facil-ities and LNG provides opportunity for engineering and constructionfirms, as well as a visible growth path for the facilities' owners.

Materials - Chemicals and steelThe widespread availability of natural gas has heralded a materials“renaissance” in the US. The US chemical industry has historicallybeen one of the largest consumers of natural gas. The impact ofcheaper and more plentiful natural gas for the domestic chemicalindustry is significant. Not only is it a cost-effective fuel in an energyintensive industry, but natural gas is also used as a raw material.The natural gas boom has greatly reduced the production costs fordomestically produced ethane and its greater availability pushes theUS petrochemical industry down the global cost curve. This gives USa competitive advantage over global commodity chemical companiesusing naphtha – a now more expensive, oil-derived feedstock.

Fig 9: Projected growth in US manufacturing jobsdue to unconventional drilling activityNumber of workers

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Source: National Association of Manufacturers, IHS Eco-nomics

Note: The direct and indirect contributions, when com-bined, represent all of the production, marketing, andsales activities required to bring primary products tothe marketplace in a consumable form. The inducedeconomic contributions represent changes in consumerspending as incomes change.

Recommended further readingUBS research focus:North America Energy Independence: Reen-ergizedpublished June 2012

Top Themesupdated monthly

UBS House View Playbookupdated monthly

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Appendix: Shale oil and gas - the basicsIn the US, shale production began over 10 years ago in a natural gas play called the Barnett in central Texas (see Fig. 13).As those techniques were applied to other shale gas plays, the US saw a sharp ramp-up in natural gas production.

In shale oil, the same new drilling techniques were first applied in the Bakken shale, located in the Williston Basin in NorthDakota in the second half of the last decade. Most of the US onshore oil production growth in the past five years hascome from this region and from the Eagle Ford in Texas. However, other shale oil plays, particularly the Permian in WestTexas and the Niobrara in Colorado, are now contributing to the growth. Other plays continue to be evaluated and tested;most of them are smaller, and some with positive early results.

Exploration and production of shale oil and gas resources is not only costly, but challenging from an environmental per-spective. Much progress has been made, but there is room for improvement. The primary objective of the US oil and gasindustry is to safely and efficiently extract oil and gas from shale resources in an environmentally conscientious manner.

Efficient extractionHorizontal drilling and hydraulic fracturing (commonly called “fracking”) are now widely used in the shale plays. How doesit work? In the past, wells were drilled vertically into a target zone. This suffices when the oil or gas in the zone can flow, asoperators have a variety of techniques to coax the resource to flow to the wellbore. In shale plays, the oil and gas is trappedinside shale rock. It does not flow, so only a small amount of oil and gas can be produced with a vertical well (see Fig. 13).

If you think of the earth’s subsurface geology like a multilayer cake, imagine that one of those layers is shale rock withoil and gas embedded in it. To increase the physical contact of the wellbore with the shale rock, the industry developeddirectional drilling, or in this case, horizontal drilling (see Fig. 11). Still, only a limited amount of oil and gas comes in directcontact with the wellbore, and it will not produce enough to justify the cost of the technically complex horizontal well.

Fracking solves the problem by increasing the exposure of the wellbore to the shale rock. Once the horizontal portion ofthe well is drilled, the rock surrounding the wellbore is fractured, so that the oil and gas trapped in the rock can escapethrough the cracks. The rock is fractured by pumping a mix of sand, water and chemicals into the well at very high pressure(pressure pumping). These wells can be highly productive.

In general around the US, shale operators can cover their costs and earn an acceptable capital investment return whenprices are above USD 70-75 per barrel for oil and USD 4-5 per million British thermal unit (mmbtu) for natural gas. Costshave been trending lower. The industry continues to work to improve the process to further increase productivity andreduce the high cost of extraction.

Environmentally responsible operationsPublic debate over the environmental effects of fracking has been focused on three primary issues.

First, some of the chemicals that have been used in the fracking process are toxic, and drilling occurs near sources ofdrinking water supply. Fracking fluid has turned up in drinking water supplies in a few locations around the US. Stateofficials now monitor and regulate the chemicals that may be used in the fracking process. Many operators have moved toa mix of organic-based, non-toxic fracking fluids. It remains unclear as to whether drinking water contamination occurredin the fracking process. Numerous studies have been conducted without turning up conclusive evidence that fluid canmigrate through several layers of rock to the water table. Another possible explanation is that fracturing fluids weremismanaged on the surface. Just before a well begins production, the used fracturing fluid is cycled back up the well andis either stored on the surface for reuse or disposed of in deep underground wells. Today, strict regulations have tightenedstandards for water management and disposal under the Clean Water Act and by the Safe Drinking Water Act.

The second concern is about water usage. Each well drilled requires as many as 10 million gallons of fresh water – far morethan traditional vertical wells. As shale drilling occurs in many of the country’s agricultural centers, local water suppliesare stretched. Water demands for fracking are at odds with the needs of the farmers. The problem will escalate as activityrises, but improvements have been made. Some of the water is now recycled for use in several wells, reducing averageper-well water usage at some sites. Techniques to reduce or eliminate water usage are also being tested.

Third, natural gas recovered during shale oil production is sometimes flared, releasing greenhouse gas into the atmosphere.Normally, a small amount of natural gas, called associated gas, is produced from an oil well. This gas is separated, processedand transported through pipelines to be sold into the market. In certain shale oil plays, such as the Bakken in NorthDakota, infrastructure to process associated gas is lacking. The amount of gas produced is relatively small, but rising oilproduction has made the cumulative amount of flared gas more significant. The problem can be solved over time as moregas processing plants and transportation capacity are built.

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SafetyOil and gas drilling is hazardous, but the risks rise when done in populated areas. Blowouts are rare, but they can occur.In addition, drilling operations require outsized equipment and a large amount of supplies, much of which is brought inby trucks. In some regions, such as the Bakken and Eagle Ford, some of the oil is transported to storage or pipelines bytruck. All this activity causes wear on roads and increases the risk of accidents. As pipelines are completed, the oil trucktraffic will diminish. But movement of equipment is part of the process. The industry must maintain high standards forthe people they hire to ensure safe and responsible handling of equipment.

The US Geological Society (USGS) has conducted research that links deepwell fluid injection, a process which is used todispose wastewater from hydraulic fracturing, with the triggering of earthquakes. The agency finds that earthquakes mayoccur when the injected fluid reaches a critically stressed fault. The deepwell fluid injection process entails injection ofwastewater from the fracking operation, back into the Earth for storage. USGS is researching the factors that control thegeneration of injection-induced earthquakes, and monitors the potential earthquake hazards associated with deepwellfluid injection. The Environmental Protection Agency is responsible for the regulation and permitting of water injectionwells, though additional regulations are imposed on the state level.

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Fig. 13: North American shale oil and gas resources

Source: International Energy Agency, UBS

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Appendix

Chief Investment Office (CIO) Wealth Management (WM) Research is published by UBS Wealth Management and UBS Wealth ManagementAmericas, Business Divisions of UBS AG (UBS) or an affiliate thereof. CIO WM Research reports published outside the US are branded as ChiefInvestment Office WM. In certain countries UBS AG is referred to as UBS SA. This publication is for your information only and is not intended asan offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis contained herein does not constitutea personal recommendation or take into account the particular investment objectives, investment strategies, financial situation and needs ofany specific recipient. It is based on numerous assumptions. Different assumptions could result in materially different results. We recommendthat you obtain financial and/or tax advice as to the implications (including tax) of investing in the manner described or in any of the productsmentioned herein. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis and/or may not be eligible for sale to all investors. All information and opinions expressed in this document were obtained from sources believedto be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness (other thandisclosures relating to UBS and its affiliates). All information and opinions as well as any prices indicated are currently only as of the date of thisreport, and are subject to change without notice. Opinions expressed herein may differ or be contrary to those expressed by other business areas or divisions of UBS as a result of using different assumptions and/or criteria. At any time, investment decisions (including whether to buy,sell or hold securities) made by UBS AG, its affiliates, subsidiaries and employees may differ from or be contrary to the opinions expressed inUBS research publications. Some investments may not be readily realizable since the market in the securities is illiquid and therefore valuingthe investment and identifying the risk to which you are exposed may be difficult to quantify. UBS relies on information barriers to controlthe flow of information contained in one or more are as within UBS, into other areas, units, divisions or affiliates of UBS. Futures and optionstrading is considered risky. Past performance of an investment is no guarantee for its future performance. Some investments may be subject tosudden and large falls in value and on realization you may receive back less than you invested or may be required to pay more. Changes in FXrates may have an adverse effect on the price, value or income of an investment. This report is for distribution only under such circumstancesas may be permitted by applicable law.Distributed to US personsby UBS Financial Services Inc., a subsidiary of UBS AG. UBS Securities LLC is a subsidiary of UBS AG and an affiliateof UBS Financial Services Inc. UBS Financial Services Inc. accepts responsibility for the content of a report prepared by a non-US affiliate whenit distributes reports to US persons. All transactions by a US person in the securities mentioned in this report should be effected through aUS-registered broker dealer affiliated with UBS, and not through a non-US affiliate. The contents of this report have not been and will not beapproved by any securities or investment authority in the United States or elsewhere.UBS specifically prohibits the redistribution or reproduction of this material in whole or in part without the prior written permission of UBS andUBS accepts no liability whatsoever forthe actions of third parties in this respect.Version as per May 2014.UBS specifically prohibits the redistribution or reproduction of this material in whole or in part without the prior written permission of UBS andUBS accepts no liability whatsoever forthe actions of third parties in this respect.© UBS 2014. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved.

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