JUNE 2016

THE EXECUTIVE PUBLICATION FOR THE OIL AND GAS INDUSTRY

RUSTYBRAZIEL’SBASE OILTHEORY SPECIAL FOCUS:

FINANCE & INVESTING SHALE UPDATE

CYBER SECURITY

INVESTING IN MEXICO

AN INTERVIEW WITH E. RUSSELL “RUSTY” BRAZIEL OF RBN ENERGY

DON STOWERS, CHIEF EDITOR – OGFJ

PHOTOS BY SYLVESTER GARZA

THE WINNERS ARE THOSE THAT POSITION THEMSELVES IN THE BUST CYCLE TO RIDE THE NEXT BOOM UP.

Shale Econ 101

EDITOR’S NOTE: Rusty Braziel is president and principal consultant for RBN Energy, which

provides advisory services specializing in strategy, acquisitions, and divestures. He is an

authority in the field of energy information and markets, with an extensive background

in energy marketing, trading, and data services. Over the past 20 years he has worked in

an executive-level capacity with a major producer (Texaco), a major pipeline (Williams), a

leading software company (Altra Energy), and a leading energy analytics and information

company (Bentek Energy). A consultant, author and speaker, Braziel has written for numer-

ous publications and is a frequent speaker at industry conferences. He recently published

The Domino Effect, a best-seller on Amazon that examines the transformative effects of the

Shale Revolution. He also serves on the editorial advisory board for OGFJ.

OIL & GAS FINANCIAL JOURNAL: What is the most important question facing the oil and gas industry today?

RUSTY BRAZIEL: Depends on your timeframe. Right now, the big question is – How will the industry adapt to today’s price environment? Up until the crude price crash, there was a general expectation of sustained high prices that would support continuing investment as

AN INTERVIEW WITH E. RUSSELL “RUSTY” BRAZIEL OF RBN ENERGY

far out as the eye could see. After two years in the school of hard knocks, it is now clear that these markets will be much more treacherous. Some companies will figure out how to thrive in this environment. Some won’t.

But that is not really the most important question. Our much larger challenge is that public sentiment continues to shift toward a view that over the long term our industry should be phased out. Momentum behind this view seems to be building. Whether such a momentous shift could happen in 30 years or even 100 years is not the issue. The fact that our industry will be facing a large movement that wants it to happen is now a permanent fixture of oil and gas markets. We have to deal with that reality – not assume that somehow it will go away.

Your book, The Domino Effect, examines the Shale Revolution and how it is changing energy markets, including the economics around that. Can you explain what you mean by the “domino effect?”

BRAZIEL: The book is about understanding energy markets, what has been happening to energy markets over the past few years, and a framework for anticipating what is coming next. The idea is that everything in these markets happens for a reason – one event triggers another, triggering another. That’s the dominoes. For example, 10 years ago, shale technologies first came to gas markets, which became oversupplied, which crushed their prices, which prompted producers to move their rigs to drill for wet gas that contained high volumes of NGLs. Soon those prices were crushed, too. It was inevitable that the same thing would happen to crude oil. In the book, each one of these developments is a domino. There have been 30 dominoes since the shale revolution started. And there are a lot more getting ready to topple right now.

Ten years ago, everyone was talking about “peak oil.” It was widely thought that we were running out of oil. National Geographic magazine famously ran a cover with the headline – “The End of Oil.” People in the industry said, “No, it’s not the end of oil – it’s the end of cheap oil.” As today’s oil prices attest, both were wrong. Will “lower for longer” be the new norm? What is your take on oil supply and demand going forward?

BRAZIEL: The shale revolution is a fundamental shift to a market we have not seen before. We know where the oil is. We can produce it, if the price is right. In other words, there is a base level of production in North America that can come on line within months of a sustained price signal over some level, let’s say $55/bbl. This base level of production does not disappear at lower prices, it is simply put on hold, waiting for a signal from demand. Prices will increase when demand grows, but the increases will only be temporary.

Why do you say that?

BRAZIEL: Oil markets are locked into a price trading range for

a long time to come. Sometime over the next few months, demand may grow or production may be cut, resulting in price increases. But those prices won’t hold up. That is because of the economics of shale production.

At today’s prices there are a lot of shale wells that don’t make economic sense to drill. But if prices go up, that changes. At higher prices, then it does make economic sense to drill those wells. So the additional wells get drilled. Production starts growing again, and prices will come right back down. The Peak Oil Theory has been replaced by the Base Oil Theory. That base level of production that can come back on when prices are right. It’s all about that base.

Will low oil (and gas) prices have a lasting impact on the Shale Revolution?

BRAZIEL: The Shale Revolution and low oil and gas prices go hand in hand. Because the initial production rates of most shale wells are so much higher than conventional wells, the per-unit cost of production is lower, even though the wells themselves are more expensive. In other words, each barrel of crude or each cubic foot of gas from a shale well costs less, because the volume produced per dollar of invested capital in the well is greater. And it is this lower cost that makes these wells profitable even at low prices. Now that lower prices are a part of the landscape, producers are finding ways to drop those costs even lower – more efficient drilling, lower services costs, even higher initial production rates. As costs continue to drop, the pressure on prices will continue.

The petroleum industry has a history of boom and bust. What lessons should we learn from current and past experience?

BRAZIEL: The obvious lesson is that nothing lasts forever. This, too, will pass. But the more important lesson is that the winners are those that position themselves in the bust cycle to ride the next boom up. The natural tendency in a bust cycle is to hunker down, and to some extent all must do that. But if a company can align its opportunities with what the next market is likely to bring, it can be hugely successful, regardless of when that next cycle happens.

If prices have bottomed out and we’re starting to see the beginnings of a recovery, where will we see it first – on the oil/liquids side of the business or on the natural gas side?

“There is no doubt that the industry will come back stronger than ever, because the survivors will be those companies that learn how to adapt to today’s market realities. In fact, lower prices are already driving a new round of creative technolog-ical innovation that will keep the turmoil coming. Strap on your seat belt.” – Rusty Braziel

RBN’s School of Energy is a genuine classroom situation with students learning the fundamentals of the natural gas, crude oil, and NGL mar-kets,and the interrelationships between those markets. The course-work is characterized by an extensive series of hands-on model exer-cises, with Excel analytical models students learn and then take with them. RBN holds two or three School of Energy sessions each year.RBN photo

AN INTERVIEW WITH E. RUSSELL “RUSTY” BRAZIEL OF RBN ENERGY

BRAZIEL: Well, whether we are seeing beginnings of a recovery or not depends on your definition of recovery. If recovery means back to $100/bbl oil, I think that is a long way down the road. If it means that prices below $30/bbl are behind us for a while, probably so. Perhaps not forever if you buy my Base Oil Theory. But, regardless, recovery however you define it is much more likely on the oil side than gas. Oil is a global market, influenced by global conflict, currency values, chaos in certain producer countries, and of course – global demand, which over the long run will increase. For now, gas in North America is still isolated, and the continent has the capacity to produce far more supply than can be consumed here. It will take a few more years before more gas-fired power generation, LNG exports, and exports to Mexico increase to the point where supply and demand move more closely into balance.

What impact do you think LNG exports will have on the natural gas industry? Will the US eventually export enough LNG to make a difference for producers?

BRAZIEL: LNG exports will definitely be good for natural gas producers. Anything that increases demand for your product by 10% or so has got to be good for prices. And that demand is likely to be somewhat less spikey than the weather-driven demand cycles experienced by markets in North America today. There is

a good chance that enough export facilities will be completed so that LNG exports will make a difference for producers, particularly if crude oil prices move higher relative to gas prices – which, as we just discussed, is pretty likely. The problem is that the difference for producers is still a few years away. The supply surplus that we are living with today will continue to be around for a while until those facilities are completed.

The US was on the verge of rebuilding a lot of aging midstream and transportation infrastructure when the downturn hit. Where are we now? Do we still need to build and replace a lot of pipe?

BRAZIEL: Actually we did rebuild a lot of aging midstream and transportation infrastructure. Scores of new gathering systems, processing plants, pipelines, storage facilities, rail terminals, docks, you name it – have been built out over the past few years. Consider just the rail terminals. Our company has tracked 99 new or expanded loading terminals and 79 unloading terminals built since 2009. That’s huge. And projects are still coming on. Even after the completion of several new and reversed crude pipeline projects, another seven major projects are in the works right now. On the gas side, 34 natural gas pipeline projects to bring on about 27 Bcf/d of incremental capacity are either under construction or on the drawing boards – mostly to handle Marcellus/Utica volumes. The

AN INTERVIEW WITH E. RUSSELL “RUSTY” BRAZIEL OF RBN ENERGY

big question now is whether we built too much infrastructure. Many of the facilities were built under the assumption of continued growth in production. Now production is falling, and that could be a problem for midstream developers.

The petrochemical industry seems to be a beneficiary of low fuel prices. How significant is this for US manufacturing? Is this a long-term trend? What other industries have benefitted from low fuel prices?

BRAZIEL: The petrochemical industry is benefiting from low fuel prices, but even more so from low feedstock prices – cheap ethane, propane, and butane relative to where things were before the Shale Revolution. As gas production ramped up, so did the production of natural gas liquids. And when NGL supply finally exceeded demand, prices crashed. The catch is that the petrochemical industry looked at those low prices and said – “Let’s build more plants to use those cheap NGLs.” Lots more plants. Those new plants are under construction right now. At the same time, several international petrochemical companies looked at cheap US ethane and wanted to get a piece of the action. So they have contracted for new export facilities and ships to export barrels to Europe and Asia. Put all that together and you’ve got a huge increase in demand coming in the next couple of years.

There is no doubt that NGL prices will be on the rise. That will not be good news for any of those petrochemical companies.

Last year, about 150 US oil and gas companies filed for bankruptcy under Chapter 11. More are expected in 2016. This includes E&P companies, oilfield service companies, and midstream companies. Is this nature’s way of culling out the herd, sort of petroleum Darwinism? Will the industry come back stronger and leaner than ever?

BRAZIEL: I would not characterize what is happening as nature’s way. Instead, we are witnessing the impact of creative destruction, right out of Econ 101. The Shale Revolution shifted the cost curve, making the per-unit cost of producing oil and gas cheaper. The impact on prices was right out of the textbook. And the impact on companies that were unprepared for the shift was also right out of the textbook – economic destruction. There is no doubt that the industry will come back stronger than ever, because the survivors will be those companies that learn how to adapt to today’s market realities. In fact, lower prices are already driving a new round of creative technological innovation that will keep the turmoil coming. Strap on your seat belt.

Getting back to LNG, the reason that companies like

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AN INTERVIEW WITH E. RUSSELL “RUSTY” BRAZIEL OF RBN ENERGY

Cheniere decided to convert their import terminals into export facilities was the huge price differential between cheap natural gas prices in the US and the price utilities and end-users were willing to pay in Asia and Europe. Will this huge price gap continue indefinitely? If so, won’t that prompt US companies to continue to find a way to export shale gas?

BRAZIEL: That gap between cheap US gas and LNG prices in Asia and Europe has already eroded significantly. So much so that after the cost of liquefaction, terminaling, shipping, and regasification, it would not make much economic sense to export much LNG from the US today. That price differential shrunk mostly due to the collapse in crude oil prices, which are a big influence on international LNG prices. Assuming crude prices move up faster than US gas prices – which is a pretty good bet – then LNG export economics will start looking better again, hopefully as some of the new terminals are completed. But don’t forget that there are other LNG producers out there – Australia for instance. US LNG plus more volumes from other countries will keep supply growing. So it is no slam dunk that LNG exports will ever realize the highly attractive economics that many of the export terminal developers expected three years ago.

Following up on the pre-vious question, do you expect “gas plays” like the Haynesville, Barnett, Fayetteville, etc. to make a comeback?

BRAZIEL: There are huge gas reserves in all three of those basins. All have breakeven prices that will not encourage much drilling until prices get back above $3.50/MMbtu or so on a sustained basis. That will happen someday. But when it will happen is unknown. And when it does happen, then supplies from those basins will rush back into the market, potentially driving prices back down. It is one more example of my Base Oil and Gas Theory – the overhang of potential productivity will act to keep prices capped.

Long term, if you are an investor in the US, do you put your money in oil or gas? Or is it not that simple?

BRAZIEL: As a general statement, oil prices are more likely to increase in the near term than are gas prices. For that reason, if you are investing today, oil is a better bet. But several gas producers in the Marcellus/Utica plays are developing wells with huge initial production rates, that can be incredibly profitable – especially if all those pipeline projects we discussed earlier get built and LNG exports, Mexico exports, and new

gas-fired power generation happens on que. From an investment perspective, I tend to favor diversification. Don’t put all your eggs in one basket. Because no one really knows what is going to happen. An investment portfolio that includes both oil and gas is the best bet, no matter what the market conditions.

We have witnessed the effect that an oil cartel (OPEC)

can have when it decides to ramp up or withhold production from the world market. We first saw this in the oil embargo of 1973, and we’re seeing it now. Yet there are a lot of major non-OPEC producers, including the US and Russia. Some people say that OPEC’s influence is waning, yet that doesn’t seem to be true just yet. What role do you think OPEC will play in the future – the same or a diminished role?

BRAZIEL: I believe that OPEC has, for the most part, lost its control of the market. Let’s say the OPEC countries reduce their

production. What’s going to happen next? No doubt, prices would increase. But then what? Base Oil Theory, right? US producers would jump back in there, drilling would ramp up, and US production would start growing again. And when that happens, prices drop right back down. So, OPEC would end up with less market share and low prices. Why would they do that? Of course, they wouldn’t. Now the market is in control. That is a radically different world than most governments of the world expected, including our own.

If an oil cartel can be successful, how about a gas cartel?

LNG is a global commodity. Do you see LNG expanding significantly in global markets if shale development continues in the US, Canada, and elsewhere?

BRAZIEL: Well, as we’ve been discussing, I think the days of a successful oil cartel are behind us. A future LNG cartel is even less likely to be successful for two reasons. First, because most of the supply growth will be coming from countries unlikely to join a cartel – US, Australia, maybe Canada. And second because the LNG market is so much more dependent on long-term commitments because liquefaction infrastructure is so expensive.

In your view, what role will renewable energy play in

the global energy scene? Although we’re seeing increased used of wind, solar, and biofuels to generate electricity, hydrocarbons are still the major fuel source for transportation. Do you see this coming to an end? Any battery breakthroughs on the horizon?

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AN INTERVIEW WITH E. RUSSELL “RUSTY” BRAZIEL OF RBN ENERGY

BRAZIEL: As we discussed in your first question, a lot of folks look forward to the day when wind energy, solar energy, and other renewables become cheap enough – and ubiquitous enough – to wean the world off hydrocarbons. That could take a very long time and is certainly fraught with a lot of uncertainty. A technology breakthrough could change things – whether it is batteries or something else. If and when such breakthroughs happen are in the realm of the unknowable.

Finally, Rusty, what conclusions have you drawn after 40 some odd years of involvement in nearly all sectors of the energy industry?

BRAZIEL: Hmm, that’s a tall order. Let’s go for three big conclusions.First, all our markets are connected. Back when I was trading

oil, gas, and NGLs, you could really understand one of those markets without knowing much about the others. Those days are gone forever. For example, the only way to make sense of the gas market now is to understand crude. The only way to understand the NGL market is to understand gas. And so on. That premise is what The Domino Effect is all about, and has to count as one of my conclusions.

That’s really why I wrote the book. Second, this industry may seem from the outside to be

about technology and infrastructure. To some extent it is, but the real industry is about people. This is a great industry with good people trying to do the right thing. It is the talent, innovation, and team spirit of the industry that can make something like a Shale Revolution happen, in an industry that many had written off as dead. That is our true strength and will be with us as far into the future as any of us can imagine.

Third, and somewhat more philosophically, don’t take yourself too seriously. This is a serious business, but it can also be exciting, dynamic – even fun. Years ago, we adopted a rock-and-roll theme for our Daily Energy Post – what a lot of people call the RBN blog – and found out that tens of thousands of folks enjoy learning about energy markets with an upbeat, conversational and entertaining spin. What this industry does is important, challenging, and difficult work. But it doesn’t have to be boring. We have fabulous opportunities ahead. If there was ever a time to go for it, the time is now.

On that cheery note, thanks for talking with us, Rusty.

Standing L to R: Heather Wallace, Sandy Fielden, Jeremy Meier, Noel Copeland, Rusty Braziel, Rick Smead, Scott Potter, David Braziel, Omilla SinghAhamad; Sitting L to R: Paige Hambric, Ashley Braziel, Christine Groenewold, Brenda Brown, Sheetal Nasta, Kelly Van Hull, Callie Mitchell