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Take 10: Oil & Gas, Energy, and Chemicals in 2020

What will 2020 look like for the oil and gas, energy, and petrochemical markets? Here are 10 observations from ADI Analytics.

1. Crude oil markets are finally preparing for a “lower for longer” outlook. Crude oil price averaged $57/bbl in 2019 during which price volatility was quite low—within $20—reflecting the increasing sentiment that the oil and gas industry was no longer growing. There has been talk of oil demand slowing for many years but, at 1.3 to 1.5 million B/D, actual growth has consistently surprised analysts. 

Oil producers, who never read the “slowing oil demand growth” memo, are now paying heed as investors are signaling an end to the party. US oil production growth will slow down by as much as 50% in 2020, even as some new offshore projects that have been commissioned recently pick up the slack coupled with the remarkably disciplined production cuts that OPEC and Russia have delivered in the past couple years.

Would the promise of newfound supply discipline suffice or will demand growth actually slow down as forecasted? How impactful will electric vehicles, fuel economy standards, mobility apps, and renewable fuels be? Where will new crude supply grow and how will that impact the quality mix? These and other questions will challenge crude markets even as the industry tries prudence and discipline.

2. Natural gas offers nothing to write home about. The commodity that started the shale boom and transformed North American and global energy landscapes is now a victim of its own success. Capital spending by E&P companies focusing on natural gas is expected to continue declining in 2020 and substantially so at 25% relative to 2019. Even so, production will rise due to associated gas production from oil wells. Demand will also continue to rise but primarily through exports via LNG and pipelines. 

Although there is little new to write home about, there are several very interesting near- and long-term questions on natural gas. Can innovation push natural gas demand in industrial, residential, and commercial sectors beyond incremental volumes? Will natural gas demand be halted by renewables in the long term and fugitive emissions in the short term? How much more US LNG will the world want? Finally, how do we make money in the natural gas value chain?

3. Shale and its flight to scale. After oil prices collapsed the week of Thanksgiving in 2014, they have been stubbornly low for more than 5 years now, evaporating Wall Street’s interest in funding new exploration or wells for the sake of growth. Equity investors’ focus on profitability instead has forced shale operators to cut capex, opex, and now sales, general, and administrative (SG&A) expenses, which are about 50% lower with larger companies than smaller players. 

As a result, energy majors such as ExxonMobil and Chevron have increased their Permian production by more than 70% and 30%, respectively, in the past year even as they’ve sought out acquisitions. Acquisitions will, however, be difficult as Chevron discovered with Anadarko. There is no dearth of acquisition targets in shale today but quality continues to be scarce. On the other hand, quality shale producers demand high valuations that public equity or debt markets are often reluctant to support or reward as Oxy and Anadarko have come to find out.

Private equity (PE) has aggressively funded a lot of shale growth in the past few years and PE-backed E&Ps have often accounted for the highest production growth over public E&P companies. However, poor valuations and shrinking buyer pools are forcing several PE companies to start preparing to hold on to their portfolio companies for longer duration than expected. Several oil- and gas-focused PE firms are now hiring geoscientists, reservoir engineers, production specialists, and ESG (environmental, social, and governance) experts to build deeper operating capabilities, which is often far more difficult than investors realize. 

Therefore, unconventional oil and gas observers are concerned around several uncertainties and related questions. How will capital spending evolve through the next few years? What kind of production growth can be expected on a realistic basis? For plays outside the Permian, will there be sufficient midstream investments to support production growth investments? Finally, what happens to the long tail of smaller E&Ps floated with the assumption that there will be a steady stream of buyers waiting for them to sell?

4. Upstream offshore lives another day. Evidence that shale is not the only game in town came again recently when Apache (and Total’s) announcement of a significant oil discovery off the coast of Suriname drove its share price up 25%. This discovery builds on ExxonMobil’s successful find in offshore Guyana, which has rapidly developed into a major offshore growth platform for the company.

If shale crashed and burned the offshore oil and gas projects party from the 2000s, the former is contributing to the latter’s resurgence now. Cost-reduction strategies perfected in the craft of shale resource development are now being deployed to improve the cost competitiveness of offshore oil and gas projects. That, coupled with new entrepreneurial companies, is helping bring new offshore oil and gas projects to fruition.

Even so, longer-term concerns around climate change will continue to cloud billion-dollar investments in offshore oil and gas. Similarly, as the recent experience in Brazil has demonstrated, government auctions can fall significantly short, lacking sufficient incentives for developers to pursue new projects. Finally, investors have to grapple with environmental and safety concerns especially with projects designed with lower capital cost targets.

5. Midstream has built it, but will they keep coming? “If you build it, they will come” was the commandment that worked for Kevin Costner in the Field of Dreams, and midstream companies so far. But midstream is wondering if they will keep coming. Midstream companies have invested significant capital—nearly $40 billion by the top 25 midstream players in 2019 alone—building gathering lines, interstate pipelines, processing plants, fractionators, and storage capacity for oil, gas, natural gas liquids, and water to support the shale revolution. A lot of this was on demand from E&Ps and in recent years some of it was done quite prudently by diversifying risk through joint ventures with other midstream companies, acreage commitments with E&Ps, and private equity and other alternative financing mechanisms. 

The midstream shortages for production out of the Permian drove a lot of frenzied growth across the midstream value chain over the past 18 months. That coupled with growing crude oil exports supported by a nice differential between the price of West Texas Intermediate and Brent crude oils led to new investments in crude oil exports infrastructure. All this was expanding upon the extensive infrastructure built to support natural gas production and exports as well as other related midstream investments. 

However, in an outlook where production growth is likely to slow down, and significant consolidation has altered the landscape of players in key plays, how will midstream companies renew transportation contracts is a key question. Changes in the taxation landscape has already forced several midstream companies to reconfigure themselves out of master limited partnerships (MLPs), impacting returns for some investors. Will the traditional, non-MLP structures incentivize new investments in midstream? Finally, consolidation and renewed value chain focus in midstream has created larger players who face growing scrutiny around ESG and related issues. 

6. LNG races toward commoditization. If you think 10 years is a short period of time, LNG is a good commodity to study. Ten years ago, LNG prices were indexed predominantly to oil and there was barely a spot market. Today, LNG is rapidly headed toward commoditization, thanks in large part to shale gas in the US, followed by small measures of technology and business model innovation, rapid demand growth, and black swan events such as Fukushima, which expanded the LNG market almost overnight.

LNG pricing today is under a lot of pressure driven to a large extent by an oversupply in the market. We anticipate LNG supply and demand to balance in the next few years, but it is difficult to reconcile that expectation with the long list of new LNG export projects that have been announced not just within the US but globally. Gas discoveries have proliferated around the world, and LNG is the preferred gas monetization option driving up LNG export project announcements. 

Having said that, LNG demand has continued to surprise analysts. China’s rapid adoption of LNG followed by promising uptake in other Asian and even some Middle Eastern and Latin American markets has occurred at a faster pace than anticipated. Lower LNG prices and spot markets have helped illustratrate nicely the value of price-demand elasticity. Going forward, one has to keep this historical context in mind and be more optimistic about demand growth, which is often far more difficult to forecast than adding up new capacity announcements.

7. Refining and an upcoming sugar high. After a few years of intense speculation around the International Maritime Organization’s (IMO) rule limiting sulfur in marine fuels starting 2020, refining markets enter the new year with a lot of optimism. Diesel crack spreads at $18/bbl are 35% higher than historical averages, while the discount on Canadian crude is 40% higher. In other words, refiners with the necessary processing complexity are relishing the prospect of higher margins driven by significantly cheaper crude oils and diesel fuels at their historical highs. 

IMO may, however, turn out to be a short-term sugar high given how margin expectations driven by historical regulatory transitions have turned out. Eventually, refiners will have to begin contending with medium- to longer-term challenges associated with peak demand for hydrocarbon fuels, growing share of alternative fuels including ethanol and renewable diesel, and business model shifts to find new export markets or protect local markets for their refined products.

8. Petrochemicals’ growth horizon clouded by plastic waste.  Petrochemicals are a bright spot of robust demand growth in the global hydrocarbon landscape otherwise dotted by peak demand concerns. Against this demand backdrop, cheap supply of NGLs—ethane, in particular—has repositioned the US on the lower end of the petrochemicals cost curve. 

That cost competitiveness is likely only going to improve further in the next few years as Y-grade NGL fractionation and ethane recovery capacity increases. Even so, ethane rejection in North America will only increase further, reflecting the deep structural advantages North American petrochemical production will enjoy for decades to come. 

As a result, US chemical majors have invested heavily in ethylene derivative capacity with emphasis on polyethylene destined for exports to Asia and Latin America. However, trade disputes with China and competing capacity investments in Asia and Middle East depressed petrochemical margins in 2019. Although a resolution of the trade dispute with China has been claimed, there are lingering concerns about the long-term reliance on export markets. 

In addition, and more significantly, growing consumer backlash against plastics and polymers—especially single-use applications—pose significant challenges. While demand is unlikely to be impacted, growing resistance to plastics in consumer markets does not bode well for a sector whose growth outlook is underpinned by rapidly growing middle class consumers.

9. Power markets advance with an all-of-the-above strategy. No energy market is in as much flux today as global power markets. In the US, natural gas-fired power continues its seemingly inexorable march upward primarily at the expense of coal-fired power. This is notching up significant carbon emission reductions. For example, carbon dioxide emissions in 2019 fell by 10%, all due to replacement of coal-fired power plants with those powered by natural gas. 

Globally, however, it’s not such a straightforward picture with more of an all-of-the-above strategy when it comes to choice of technologies in the electric power sector. And these global trends should give cause for US gas and power stakeholders to think about what the future might look like.

In China, the country is on track to install almost 150 gigawatts of coal-fired power capacity over the next few years, and similar investments in coal for power generation are underway in other Asian economies. Even so, all of these economies along with those in Latin America continue to invest heavily in renewables and auction data show that renewables are as, if not, more competitive than gas-fired power. But some of these renewable power investments continue to be tied to incentives and subsidies whose sustainability is under growing uncertainty. For example, Mexico has recently initiated rules that will most impact private participation in renewable power. Finally, rapid innovation in renewables, batteries and energy storage, energy efficiency, and nuclear continue to advance a wide range of technologies in the power sector.

10. There’s a lot more to innovation than digital. It’s difficult to drive past the Energy Corridor in Houston without noticing several billboards advertising the benefits of “digital” technologies including artificial intelligence, machine learning, Industrial Internet of Things, and data analytics. Some of the leading consulting firms now can’t seem to publish anything that doesn’t extol the benefits of “digital.” In fact, what can “digital” not do—from finding new oil to improving pipelines to reducing fugitive methane emissions. Reading these reports one can’t but wonder about the miracle of the oil industry coming along so far all these decades without using “digital.”

However, on a due diligence engagement, when our team asked operators, investors, and vendors, “Who’s making money in digital,” we found few good answers. Candid responses include “no one” and “conference producers.” While digital has a good and important role to play, we feel confident in saying that its proponents are overstating its case as an innovation lever in the oil and gas landscape. 

Instead, real and sustainable innovation that is delivering hard dollars in benefits is not quite getting its due. A short, nonexhaustive list includes advanced drilling and completion tools, oilfield electrification technologies, low-bleed valves and long-lasting compressor parts, renewable biofuels, CO2 and hazardous gas adsorbents, micro-measurement devices, and sulfur-reduction catalysts. In addition, the industry has pursued a number of operational and business model innovations that deliver critical competitive advantages.

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