Is the Kingdom at a Shale Crossroads?

John Dizzard, FT

"After buying production for over 20 years, hopefully I know the characteristics of great wells (flat decline curves, low operating costs, large production), and as you know, the shale plays have none of these. The herd mentality into the shale will eventually end possibly like the subprime mortgage did. In the meantime it is very difficult to sell any kind of prospect that is not a shale play." Anglo Geologist

"We have a supply of natural gas that can last America nearly 100 years.  (Applause.)  And my administration will take every possible action to safely develop this energy.  Experts believe this will support more than 600,000 jobs by the end of the decade." President Obama

I've written several pieces on North American shale mania over the last year, but I have yet to write anything focusing on how this boom has impacted the region and more importantly what could happen if this boom turns to a bust. So, I figured now that Chesapeake has officially declared an end to the North American Shale Gas wildcat era now would be a good time to tackle this issue.

It's all about Saudi…….

Saudi is the big story in the region, and there are big changes taking place. The Kingdom's Petchem and Fertilizer companies have, for the better part of the last decade, been sitting on a license to print money. You can't buy a piece of Saudi Aramco, but you can buy Sabic and Safco and their subsidized $.75 mm/btu feedstock. Add in the volatility in North American Gas and booming demand from Asia, and it is no surprise that plants in North America couldn't compete and were shutting down while investment and capacity additions in the region were surging. As far as most global investors were concerned, it didn't get any easier than buying listed MENA petchem or fertilizer plays. You could just sit back and relax as Asian manufacturing growth and food demand rained money on your portfolio. I can remember spending hours on conference calls with hedge funds that wanted to talk about nothing other than potash, urea, ethylene, propylene, and phosphate .Then just when you thought you had it all figured out, along came shale gas, the crisis, quantitative easing, Opec quota cuts, and the Arab Spring to completely flip the script. So, let's begin by looking at Saudi Arabia, and the shifting petchem landscape they are facing.

The first thing any investor looking at the Saudi Petchem needs to ask himself is where did all the abundant cheap Ethane go.

Looking at the market fundamentals two things jump out at you that should help answer this question....

1) Supply is Down

Feedstock shortages are now a serious concern in Saudi, and an increasing problem across the rest of the Gulf.  Saudi's reduced oil production quotas mean the country must sacrifice associated gas production which has been the historical source of cheap ethane for crackers to defend oil prices. This is further complicated by the fact that the Kingdom's oil fields are getting more mature, and thus are no longer as rich in wet gas(ethane).

2) Demand is Up

Population growth, rising domestic energy consumption, and increasing investment in regional petchem projects has been the norm. Not exactly a good combo when you are facing supply pressures, and Saudi has been hit particularly hard because of rising power investments and increased electricity demand. For example, this year Saudi power plants are expected to burn 1.2mln b/d of crude to offset their lack of access to natural gas.

But this is far from just a supply and demand story.

It is also about…..

1) Domestic Politics Political pressures are leading to a surge in socially driven domestic government spending, and consequently reduced budgetary flexibility.

The Arab Spring has caused Saudi to ramp domestic spending to the point that it needs $85 oil to break even on its budget.  This leaves little room for subsidies, and strengthens the case for shifting resources away from the export heavy petchem sector towards domestic price sensitive sectors.

2) Strategic Goals  The Arab Spring has also led the Saudi government to shift focus more directly to job creation and the domestic economy and away from attracting investment in the petchem sector via providing a sizable global cost advantage. Simply proposing building another subsidized feedstock cracker won't cut it any more as Saudi is looking to climb the value food chain, and thus rationing resources for projects that assist in meeting these goals like more specialized chemicals plants that create higher value jobs.

3) External Factors Shale Gas has had a profound impact on the petchem industry. Henry Hub Nat Gas is now trading closer to $2.5 mm/btu which basically means the US has gone from a high cost marginal producer to the 2nd lowest cost marginal producer on the planet. The net result of all of this is that petchem capacity is coming online in North America, and the region is now attracting significant investment because of the current global cost advantage over naphtha based crackers. So, if the US is becoming more attractive place to build crackers and downstream complexes; the marginal benefit of providing subsidies to attract investment in your petrochemical sector diminishes. And that is only half of the story here. Despite the US significantly closing the cost gap with region, they have lost significant market share to MENA exporters in the key Chinese market. MENA and South East Asia(with MENA leading the way at up 70%) are the only regional exporters who have seen their polyethylene volumes into China significantly increase over the last two years. NAFTA, North East Asia, and Europe have all declined significantly with US PE exports to China falling by 50% over the last two years. So, despite the US becoming a much more attractive place to invest in petchem capacity, Saudi is still gaining market share in the most important export market for petchem producers because of strategic alliance with the Chinese. And this is in an environment in which China's Sinochem keeps investing in increasing production despite weakening global demand, falling imports, and decade low operating rates across most of the European based producers.

Put these three factors together and you understand why the petchem industry in region is in for some changes. The natural investment incentives that support subsidization in the industry are not there, the supply/demand balance is not there, the political social/agenda is not there, and the immediacy threat from shale is also presently not there thanks to close ties with the Chinese. Combine this with the fact that ethylene capacity in the United States is projected to grow by a third over the next 45 years, and you can see why the time may have come to take a second look at your models and the key assumptions that you are making. And this assuming the shale mania experiment does not spread to Europe and China.

So, what will Saudi do?

Well, considering the aforementioned factors, it should come as no surprise that Saudi Aramco is now focusing its attention on ramping nonassociated gas production. The Karan and Wasit projects are perfect examples of this strategy. Aramco needs to find more natural gas to meet rising demand, and this gas isn't going to come cheap. Breakeven costs on these sour gas projects should be north of $4mm/btu, and thus are not exactly something for petchem investors to get excited about. Diversifying to other liquids like propane and naphtha is another way for a company like Sabic to handle the challenges of the road ahead, but that is still not going to solve the diminishing cost advantage and pressure on government oil export revenue problem.

And it is not like Saudi is the only country facing these challenges. Kuwait has feedstock issues, Qatar which is rich in gas currently has a moratorium in place on further development of its northern field, and Iran which is facing external sanctions just recently raised the prices on domestic feedstock to $2 mm/btu.

Now, back to Shale………

With a river of ethane out there the petchem industry has gotten pretty excited about building out capacity to take advantage of the new found feedstock advantage. Debottlnecking announcements, and greenfield ventures are now all the rage. Chevron Phillips Chemical is building a new 1.5mln/tonnes a year cracker in Texas, and adding 1mln tonnes/yr of PE capacity. Formosa Plastics is also building  new cracker in Texas. There have also been capacity expansion announcements out of Westlake, Dow, Lyondell, and Williams. Shell is supposedly looking at  Marcellus cracker. There is even talk that South African based Sasol is completing a feasibility study for a $4billion worldscale cracker. Start adding everything up and you are talking a couple hundred million b/d of new ethane capacity coming on line over the next several years. Will the demand be there for all of this? Or better yet, will the ethane? Add in gas cars, gas trucks, and the supposed end of dirty coal in North America and the demand projections go up even more. Then of course you have nitrogen fertilizer mania. Orascom Fertilizers ( soon to be spun out of OCIC…hopefully this gives IQCD some ideas on QFERT and QAFCO) is now looking to take advantage of some federal stimulus related cheap financing to make $1.3billion investment in a new nitrogen greenfield facility in Iowa. This comes on the heels of a 50% stake in an idled Texas based methanol/ammonia plant, and a $3billion jv investment in a massive urea/ammonia complex in Rio. When all this capacity comes online, Orascom will have gone from not producing any nitrogen fertilizer to being just behind Yara and on par with CF industries in global nitrogen fertilizer capacity in a couple of years.(not a bad way to hedge your bets on egyptian feedstock prices) And I have not even gotten to the methanololefins technology Sabic and Sinochem plan on employing in their recently announced $5billion Trinidad and Tobago venture. Yes, the boom times are here again, and why shouldn't they be. If ethane remains as cheap as it is now or gets cheaper you are talking about a few $100 million dollars a year in margin advantage for North American cracker operators over naphtha based ethylene producers in Europe and Asia. Though one does wonder if that is going to hold up with gasoline demand in North America on the decline, and Chinese demand nowhere close to filling the void. Also, Shale Oil has much better economics than shale gas, and exploration in the space is still ramping. Consequently, domestic US Oil production is still increasing, and thus should continue exert downward pressure on oil prices. Basically, you need to ask yourself what happens to crude when the financials market stop fretting about Iran and Quantitative easing.(Take a look at how far Bakken Shale oil prices at Clearbook plummeted earlier this year due to overproduction and inadequate transportation infrastructure) Maybe an oil price collapse is not such a farfetched scenario despite all the talk of $200 crude due to Iran related geopolitical factors. Though I am not as interested in that scenario as I am in the potential natural gas price shock that would follow a true shale gas bust.

The way I see it investors need to focus on three potential scenarios:

Scenario One Shale gas turn out to be more of a bubble than a panacea.

With Nat Gas prices now depressed producers no longer have the luxury of being able to sell forward future production at $6$7 per mm/btu while they explore/promote shale basins and play the flip leases land game. Instead, they are starting to curtail production at just about the exact time that US energy demand trends are starting to shift heavily in favor of natural gas. This combination of the two should lay the foundation for a rebound in natural gas prices. But will it just be a gradual rebound or could this turn into a natural gas price shock? If you come from the school of thought that believes once the capital investment vacuum that has been driving shale slows down, and well longterm fundamentals become the key driver of gas supply you favor the latter. With steep production declines being the norm for shale gas wells, and most noneconomic new well drilling activity ceasing without land economics and hedging providing support; prices could violently snap back. In this scenario, North American crackers and assorted downstream investments will end up being big losers at right about the time MENA natgas supply issues have become less of a problem. This of course would be great longterm news for MENA players as they would benefit from the shale boom and bust cycle as long as they have not been sucked into major North American investments.

Scenario Two Shale Gas is for real, and only getting started.

In this scenario demand picks up and production issues pressure supply, but you assume the production declines don't end up being nearly as severe and that significant new capacity can absorb the balance shift without a major price shock. You would also assume that shale gas gains momentum in other markets like China and Europe. The outcome of this will be that naphtha based plants are more likely to be exposed for weaker economics down the road( which really hasn't been a big problem so far), and many should be forced to close. This should by the way lead to reduced oil demand over time, and ultimately downward pressure on crude prices. At the same time, petchem prices should eventually start feeling the weight of huge capacity additions, and this will impact margins of producers globally with the lowest cost producers in the region bearing the brunt of this hit. This scenario also would not bode well for Russia as they would probably start to lose the firm grip they hold over European gas.

Scenario Three Shale Gas is for real, and Shale oil will be even better.

This is a worst case scenario for the Gulf because it would involve significant decline crude oil prices to go with much more competitive globally competitive petchem market. Basically, the region loses market share to the rest the world thanks to a shale energy renaissance that leads to major production spikes in traditional export markets. If this transpires, the whole thing won't sort itself out till crude falls far enough to cripple the shale producers. This would require OPEC to continue to pump at peak production as prices start to decline simply to ensure they can take back market share.

So, pick your poison for the next five years and let me know what you think. But no matter the scenario, there will be some clear winners. Jobs will created in the US, shale focused services companies will continue to perform well, midstream companies should benefit, and the E&C players in North America should thrive.