Top Trends in the Oil and Gas Sector

Deloitte's fourth annual Oil & Gas Reality Check presents five trends affecting the oil and gas industry globally and discusses the direction these trends may follow.

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The past 12 to 18 months witnessed the oil and gas sector drifting away from the rule of certainty and the return of uncertainty. Uncertainty required more focus, deeper analysis, and operational determination. Deloitte’s fourth annual Oil & Gas Reality Check identifies five trends and delves into the fundamental characteristics of each trend: the supply, demand, macroeconomic, regulatory, cost, price, and competitive behavior factors.

Given the rise of shale gas resources and with new countries entering the ranks of net energy exporters, some are proclaiming that a global revolution is at hand with fundamental shifts in energy geopolitics because of newly found energy independence. A closer examination of the development progress of countries with major shale gas resources reveals a vastly different picture. Countries that can commercially produce unconventional and conventional gas seek higher returns by exporting or planning to export liquefied natural gas (LNG) to Asia Pacific countries that have historically agreed to long-term purchase contracts at oil indexed prices. The expected increase and diversity of LNG supply is spurring transition away from oil price indexation, and the rise of gas hub and hybrid price indexation.

The discovery of new resources across various geographies coupled with the technical challenges of developing those resources are softening governments’ resource policies—an indicator of the degree of resource nationalism. As production efficiency rates and capabilities improve, will resource nationalism surge or will it pale in comparison with the competitive rise of national oil companies (NOCs)? How companies react to and deal with this uncertainty is changing the notion of a singular business model and giving rise to different business models.

Each of these questions and the five trends are discussed below:

1. Shale gas: A global or regional resource?

The success of North American shale gas has created interest in duplicating the results in other countries. An April 2011 study by the US Energy Information Administration estimated that world shale technically recoverable resources outside the United States were 5,760 Tcf, sparking widespread interest in international shale. However, the presence of shale gas in the ground does not guarantee the unearthing of a fortune.

Given the greater technical challenge of shale gas and higher development costs, exploitation of shale resources is not easily replicable in other markets. While some countries are making progress, over the next 1 to 3 years it will remain a largely regional resource with an uncertain impact on the global market beyond this timeframe. Four countries with major shale gas reserves are representative of the distinct phases of resource development:

  • Poland is struggling to maintain its nascent shale industry because of a recent reduction in the estimated size of its shale resources, as well as declining company interest resulting from poor initial results.
  • China is working diligently to provide an investment environment conducive to shale development, but given rising domestic demand and a challenging exploration environment, it is unlikely to become a shale exporter.
  • Argentina experienced positive production results and is aiming to scale up production, bringing new shale basins online.
  • The United States is home to the shale gas revolution and poised to globalize its shale resources through exports of LNG, assuming favorable exporting regulation and permitting.

The US shale gas revolution was 3 decades in the making with incremental progress through multiple stages of development. Although other countries want to replicate this success, there is a long road ahead before they can begin to see the gas volumes and supporting infrastructure needed to dramatically lower domestic natural gas prices and create export opportunities.
While countries may enter into partnerships with shale-experienced companies, limitations such as low reserves per capita and steep demand curves can constrain countries from becoming shale exporters. Apart from the US’ pending exports of LNG, the reality is that shale will continue to be a regional resource with limited impact on the global market over the short term.

2. LNG pricing: The end of oil indexation?

The prospect of the US globalizing its shale gas resources through LNG exports has many observers (especially in Asia) hopeful that US LNG indexed to Henry Hub prices will also be exported, eroding the hold of long-term LNG contract price formulae indexed to crude oil. Anticipation has been heightened in light of recently announced Henry Hub-linked contracts, which could see Japan’s import prices in the range of USD 10 to USD 12 per MMBtu compared with USD 14 to USD 16 per MMBtu for oil-linked contracts. Rather than signaling a complete switch from oil to gas hub indexation for long-term LNG contracts in Asia Pacific, these recent developments reflect a transition toward a pricing spectrum in which oil indexation is one of several pricing mechanisms used.

As diverse supplies enter the LNG market over the next 12 months and beyond, the dynamics of supply competition will drive transition away from contracts purely indexed to oil prices and at high oil-price parity in the Asia Pacific region. There will likely be a mixture of contract pricing approaches—prices set lower from oil price parity, hybrid indexation, and full gas hub indexation. Oil indexation will likely remain the predominant pricing approach because of concerns over gas and oil price volatility risk, and also because suppliers are able to offer value through nonprice terms, such as quality flexibility, supply security, and equity stakes in upstream projects.

US LNG exports will be a major catalyst for the transition away from oil price indexation. It is important to stress that not all US-sourced LNG will be indexed to Henry Hub prices, and pricing will be dependent on project economics, buyers’ price sensitivity, and the relative competitive landscape. On the other hand, even limited US LNG export volumes indexed to Henry Hub will be sufficient to spark competitive pricing among existing and up-and-coming LNG suppliers (Fig. 1). For Asia Pacific buyers, supply competition and diverse pricing approaches are welcome new developments.

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Fig. 1—Projected prices vs. oil price parity (real 2012 USD/MMBtu).

3. Resource nationalism: Entering a period of low tide?

The recent discovery of new resources and burgeoning demand in developing countries have produced a new crop of supply and demand centers, making industry players sensitive to a potential rise in resource nationalism. We define resource nationalism through types of government resource policies and fiscal regimes. A country’s resource policy is either protective (no equity participation to low equity stakes in production sharing contracts) or open (concession contracts).

Our analysis highlights the partnership opportunities between international oil companies (IOCs) and NOCs, moving beyond the adversarial aspects that colored IOC/NOC relationships in the past. Not only are we seeing beneficial, mutually dependent relationships between IOCs and NOCs, but NOCs themselves are playing a quasi-governmental role in terms of infrastructure development and transference of technical expertise to smaller players in the value chain. This interplay has, in some cases, benefited IOC partners by deepening relationships in the countries where they operate and better assist them to withstand resource policy& changes.

Resource nationalism should diminish in the short term until producing countries advance in resource development, bringing a rise in restrictive resource policies in the long term.

The US, Canada, and Australia—leading the development of unconventional oil and gas resources—will continue with concession contracts and a stable taxation regime in the near term, but are already indicating a future direction of restrictions on exports and foreign direct ownership.

China, Argentina, and Brazil seek foreign partnerships to support development of newly found resources, balanced with the need to build local technical capacity and capabilities. The countries will likely change contracting terms to extract a higher share from their resources, as new technologies mature and infrastructure is built.

Traditionally dominant producing countries, such as Russia, Libya, and Nigeria, will seek foreign investment and expertise to reverse declining rates of production in the short term, but they will likely shift toward majority government ownership as economic production and cash flow improve in the long term.

4. NOCs: Capturing the playing field

The rise of NOCs as competitors of IOCs is a persistent narrative. NOC acquisitions reached an all-time high of USD 112.6 billion in 2012, representing 225% year-on-year growth, and constituting 45% of total exploration and production (E&P) mergers and acquisitions by value. NOCs are taking larger risks by buying undeveloped acreage and fields and initiating large acquisitions in countries such as the US, Canada, and Mozambique, showing that NOCs are taking the long view and globally expanding for local resource development and technical capacity building.

A deeper look shows that NOC expansion is differentiated by oil vs. gas. Oil has been the predominant target of investment and E&P efforts, but this will shift to gas in the long term because of changes in end-use demand, resource availability, and price. Understanding how NOC expansion is differentiated by oil vs. gas will help define how IOCs and NOCs compete and collaborate.

In the short term, NOCs will continue to dominate production in the conventional oil sector, and in the long term will increase investment in the gas sector, especially in offshore gas, shale gas, and LNG. Not only do these developments impact IOCs, but also oilfield services majors that are emerging as important partners for NOCs, even as some NOCs are starting their own oilfield service subsidiaries. Overall, the industry will benefit as NOCs continue to invest heavily in research and development, expand in services capability, and transfer technical expertise to local development of resources.

5. Managing market complexity: Revolution of the play, evolution of the player

It is no secret that, in recent years, oil and gas companies have been forced into more challenging operating environments and become subject to more volatile and complex market conditions, rendering the term “business as usual” obsolete. Vertical integration was traditionally seen as the winning business model, but the industry has become more fractured with diverse business models and nontraditional players, debunking the notion of a singular winning business model.

The types of business models employed by oil and gas companies also differ between sectors. The gas sector, which is dominated by growth in unconventional resources and LNG, is facing greater vertical integration, while the oil sector is undergoing disintegration and specialization for smaller players.

In the past few years, four US integrated companies announced or completed spin-offs of their downstream businesses; supermajors saw profit increases in their downstream segments because of asset rationalization and growth in chemicals; and NOCs continued to expand their global refining capacity. These varying paths show that vertical integration as the winning business model in the oil sector is far from becoming a market certainty. Instead, vertical integration largely depends on aligning company strengths and strategy with local and global market conditions.

In the gas sector, marked by growth in unconventional resources and LNG, the entrance of nontraditional players, downstream players moving upstream, and large integrated companies expanding throughout the value chain seem to show that vertical integration is the winning business model. In the oil sector, vertical integration works for companies with significant economies of scale especially considering the high capital intensity for unconventional E&P and LNG projects.

Overall, the industry has evolved to where market complexity is best managed through diversification of companies, partnerships, and flexible business models.

The full report that served as the basis for this article can be found at www.deloitte.com/energy.