North American energy independence: reenergized 19 July 2016 CIO WM Research Nicole Decker, Equity Sector Strategist, nicole.decker@ubs.com; David Lefkowitz, CFA, Senior Equity Strategist, david.lefkowitz@ubs.com We published a UBS research focus report in June 2012 entitled North American energy independence: reenergized. Here, we provide an update on our outlook for the thesis underlying North American energy independence. We also review our list of recommendations for investors in this theme; we have made revisions that we believe will best position investors for the coming 12 months. Outlook We project North America will be energy independent by the end of this decade; and that the US will no longer be reliant upon imported oil from OPEC nations. Our thesis centers on three primary tenets: 1) higher US oil production; 2) rising crude oil imports to the US from Canada; and 3) efficiency, conservation, and diversification away from oil and other non-renewable energy resources. Source: UBS A version of this report is available with specific security recommendations for US onshore investors. For a copy, please consult your UBS Financial Advisor. In the four years since we introduced our thesis, the trends have been supportive; and despite weaker oil and natural gas prices, we continue to believe that North America can be energy independent by the end of this decade. We see investment opportunities around North America's emerging energy independence. The oil price downturn has been deeper and longer than expected, and the operating environment for North American oil and gas operators remains challenging. However, we see oil market fundamentals improving and in time, growth opportunities in all phases of the oil and gas business. We believe the US competitive landscape favors the stronger operators. Meanwhile, we expect energy consumers to continue to enjoy the benefits of reliable and lower cost energy supplies. Alternative energy suppliers and developers of technologies to consume energy more efficiently should also continue to experience growth. This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosures that begin on page 6.
Oil price setback has not derailed our thesis Rising production of oil and gas in the US has been possible through new extraction techniques that enable operators to exploit vast onshore shale oil and gas resources. In the early years of the shale revolution, production of these resources was relatively expensive requiring above mid-cycle oil prices. At current commodity price levels, one might conclude that US onshore production is no longer viable from an economic perspective. But this is not the case. Industry operators have continued to refine their drilling techniques - incorporating more efficient processes and applying increasingly sophisticated technology. The result has been a surge in well productivity. Unit operating costs have plummeted. Today US operators are not only competitive on the global energy stage, but perhaps even advantaged, as the short drilling cycle of a US onshore well enables operators to be nimble and responsive to fluctuations in oil prices. Our analysis shows that production in the core areas of several major shale oil plays is profitable with oil prices at USD 55/bbl or below (Fig. 1). We maintain our positive view on the US onshore oil industry. We project growth in production to resume once oil prices recover, though we do not anticipate the same pace of growth as seen in the three-year period ending in 2014, when average annual production growth exceeded 1 million barrels per day. We expect consolidation of weaker and less-efficient operators. Thus, the strongest US operators will emerge from the downturn in a better competitive position than prior to the commodity price slump. Progress towards energy independence growing more evident Since the beginning of the decade, North America has grown increasingly energy independent. Oil imports to the US from OPEC nations declined by over 40% in 2010-2015 (Fig. 2). Further, the US in the past two years has transitioned from being a large importer of refined product to a large exporter of refined product. The US is also an exporter of coal; and in early 2016, it became a natural gas exporter. Costs for wind and solar development continue to decline, increasing their ability to compete in the US power generation business. While still representing just a small part of the total US energy resource base, the rate of growth in consumption of these resources has exceeded any other in the US in the past five years. Wind and solar accounted for approximately 5% of all power generation at utility-scale facilities in the US in 2015, up from 2% in 2010. Natural gas plays an important role in US energy The US has long been self-sufficient when it comes to natural gas. However, early last decade, existing fields were maturing and the US was preparing to become an importer of liquefied natural gas (LNG) a high cost source of gas supply due to processing and shipping. Today, ample supplies of natural gas from onshore US plays should be sufficient to satisfy US demand for several decades. This alleviates the need to import gas, and ensures plentiful and reliable supply at an affordable price. Fig. 1. US shale basin breakeven oil prices Figures assume a 20% rate of return In USD/bbl 120.00 100.00 80.00 60.00 40.00 20.00 0.00 Source: Company reports; UBS estimates Fig. 2. Imports to the US from OPEC Down by over 40% since 2010 In thousands of b/d 5000 4500 4000 3500 3000 2500 2000 1500 1000 500 0 2010 2011 2012 2013 2014 2015 Source: Energy Information Agency Fig. 3. Natural gas prices in major consuming markets US gas consumers enjoy a price advantage due to abundance of domestically-produced supply In USD/mcf 20 15 10 5 0 May-11 Aug-11 Nov-11 Feb-12 May-12 Aug-12 Source: Bloomberg, UBS Nov-12 Feb-13 May-13 Aug-13 Nov-13 Feb-14 May-14 Aug-14 Nov-14 Feb-15 May-15 UK NBP Japan LNG US Henry Hub Aug-15 Nov-15 Feb-16 UBS CIO WM Research 19 July 2016 2
What's more the US, who is the largest consumer of natural gas in the world, benefits economically from a cost advantage versus other large natural gas consuming nations (Fig. 3). Most natural gas-consuming nations around the world are at least partially reliant on supplies of higher-cost LNG. This cost advantage has helped spawn a US "manufacturing renaissance", whereby industrial consumers that had moved operations offshore to take advantage of low-cost labor are returning to the US to take advantage of low-cost energy. This has been most evident in energy intensive sectors such as petrochemicals, where natural gas is also used as a feedstock. Reliable and affordable natural gas supplies have emboldened consumers to shift away from more costly and carbon-intensive fuels such as coal and oil. The US has reduced the use of coal for power generation, and we expect the trend to be ongoing. In addition, many municipal fleets - public transportation, garbage removal, mail delivery - have converted to natural gas, helping the US to diversify away from oil as the sole transportation fuel. Long-haul trucking fleets are also converting to natural gas. Use of electric and hybrid cars is rising, powered with electricity generated increasingly from natural gas, wind and solar. Despite an upward trend in activities such as manufacturing, vehicle miles traveled, and air travel capacity in the US, CO2 emissions have begun to trend lower (Fig. 4). In 2015, US CO2 emissions were an estimated 10% below the 2007 peak level. Conservation and diversification of energy resources A key tenet of our thesis for North American energy independence, conservation and diversification of our energy resource base, parallels UBS' research on sustainable investing (please see report entitled Adding value(s) to investing, dated March 2015.) In the discussion on opportunities in energy, the report cites energy efficiency improvements, which yield both energy savings and reduced carbon dioxide emissions. In recent years, stricter regulation with a view to protecting the environment and securing the supply of energy has been a powerful driver, boosting efficiencies in buildings, autos and power generation. Energy efficiency addresses a whole range of issues, such as the sought-after reduction in the use of fossil energy sources and the lack of storage technologies for renewable energies. Companies manufacturing energy efficient equipment benefit from this trend. While development of sustainable energy is still in the early stages, we expect this to become a growing component of our North American energy independence investment thesis. Outlook and investment conclusions Since we introduced our thesis for North American energy independence in June 2012, significant progress has occurred. Current volatility in oil prices does not derail our thesis, though the current operating environment remains challenging. With the decline in oil prices, US and Canadian operators have sharply reduced drilling UBS CIO WM Research 19 July 2016 3
activity. As a result, US oil production has been declining (Fig. 5). Production declines will likely continue through late 2016, contributing to the rebalancing of the global oil markets. We believe oil market fundamentals will improve over the next 12 months. However, even as global oil supply and demand reaches equilibrium in early 2017, a substantial inventory overhang could hold oil prices at or below mid-cycle levels for several quarters. We believe the lowest cost onshore US operators will be advantaged in this environment, given their ability to ramp up profitable operations in a short period of time. In our view, now is a good time for investors in the North American energy independence theme to add to positions. As investors in this theme, we focus on North American oil and gas producers, oil and gas services, and energy infrastructure, where we see value among those with high-quality acreage, and geographically-positioned service providers. Despite more challenging operating conditions in the near term, there are a number of North American operators that we believe can continue to thrive and grow, even in a prolonged submidcycle oil price environment. Over time, we believe oil prices will need to rise to mid-cycle levels (mid USD 70's per barrel) in order to stimulate adequate new supply to satisfy ongoing global demand growth. Meanwhile, lower oil prices and an advantaged natural gas price are beneficial to North American energy consumers, and we look for those able to exploit this advantage in the industrial and materials sectors. We also look for opportunities in renewable technologies, and technologies that target efficiency, providing new approaches to satisfy energy demand. In many cases, the technology for development of a more sustainable energy future remains immature; though we expect investment opportunities to emerge and to become a larger component of our recommendations for investors in our thesis for North America energy independence. Positioning for the coming year The North American energy independence theme is long-term in nature, but new challenges and new opportunities arise as progress continues, and as macro conditions evolve. We monitor the trends in search of the best opportunities for investors in this theme. Below we highlight some sectors that we believe will benefit from trends relating to North America's emerging energy independence in the coming 12 months. Fig. 4. US CO 2 emissions The report from which this data was extracted notes that 2015 was the sixth year in the last decade in which the US has led the world in reduction of carbon emissions. In million tons carbon dioxide 6200 6000 5800 5600 5400 5200 5000 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Source: BP Statistical Review of World Energy, June 2016 Fig. 5. US oil production US oil production has declined by approximately 1 million barrels per day from its 2015 peak. 9,200 8,600 8,000 7,400 6,800 6,200 5,600 5,000 2010 2011 2012 2013 2014 2015 2016 Source: Energy Information Administration Fig. 6. Sector allocation Our recommendations include energy producers and service providers, energy infrastructure, industrial companies, and alternative energy providers Alternative energy Industrial Oil & gas. We believe activity levels in North America are approaching a bottom. The industry remains challenged by low energy commodity prices, and we target the strongest oil and gas operators and service providers. Energy Infrastructure Oil and gas Energy infrastructure. While the pace of growth in this subsector will unlikely return to levels of the recent past, infrastructure providers play a vital role in storing, processing and transporting crude, natural gas, and other energy products throughout North America. Source: UBS UBS CIO WM Research 19 July 2016 4
Industrial energy consumers. Consumers in the industrial and materials sectors will benefit from affordable energy supplies. For natural gas consumers, we believe benefits will be ongoing, as certain chemical, fertilizer and other large consumers of natural gas continue to expand their US operations to exploit the advantages of low-cost and reliable energy supplies. Renewable and alternative energy. Diversification of our fuel base is a key element of our thesis for North American energy independence. We see investment opportunities beginning to emerge as the technologies mature into competitive and growing alternative energy resources. UBS CIO WM Research 19 July 2016 5
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