North American Natural Gas

Fundamentals and Market

Based Long-term Pricing
Tommy nglesby and Ankush Kumar
McKinsey & Company, nc.
November 16, 2007 Houston
Baker nstitute/CEE Energy Forum
2007 McKinsey & Company, nc. No part of this report may be circulated, quoted, or
reproduced for distribution without prior written approval from McKinsey & Company. This
material was used by McKinsey & Company during an oral presentation, it is not a complete
record of the discussion. The views expressed herein are based upon assumptions as to
marketplace evolution and dynamics, and other factors which are inherently uncertain and are
subject to change. There can be no assurance that all such assumptions will in fact be borne
out, and, in fact, it can be anticipated that the assumptions will be subject to change over time.
1
PERSPECTIVES ON NATURAL GAS PRICES
Gas price fundamentaIs: What you would need to believe to see a
sustained gas price linkage to petroleum conversion capacity
Questions
Market based perspective on gas price: Estimating long-term gas price
and probability distributions based on commodity and capital markets
2
NYMEX Henry Hub (naturaI gas) price
$/MMBtu
HH spot
Historical forwards
CONSENSUS ESTIMATES INDICATE A SHIFT IN LONG TERM GAS PRICE
PROJECTIONS
GII
EEA
SEER
EIA
HistoricaI Futures Industry estimates
for 2015-2030
1995 2007 2013
Current forward
* EEA = Energy and Environmental Analysis, G = Global nsight, nc., SEER = Strategic Energy and Economic Research, EA = Energy
nformation Administration
Source: NYMEX, EA, Team analysis
Average market price
$, MMBtu 2015-2030
6.08 EA
7.70 EEA
6.68 SEER
6.72 G
Wide range of future
gas price range
0
5
10
15
Previous futures range
3
0
1
2
3
4
5
6
7
8
9
10
Asset vaIue
$ Billion
LONG LIVED E&P ASSET VALUATIONS PROVIDE THE CAPITAL MARKETS
PERSPECTIVE OF LONG TERM GAS PRICE -
EXAMPLE DEAL
Gas price assumptions Production profiIe
Transaction value
($2.2 Billion)
Long-term
price
8.00
5.50
6.75
Reserve risk factor
Drilling profile
Well production costs
DeveIopment and operation
costs estimates
0 40
Long-term price
for 5+ years
Forward
curve for
first 5
years
0
100
200
300
400
Production profiIe
Mmcf/d
0.6 tcf of proven reserves
1.4 tcf of unproven reserves
Reserves
8.00
5.50
6.75
0
ImpIies an embedded
Iong tern gas price of
$6.75/MMBTU
0 2036
Source: McKinsey Analysis
4
SIMILAR VALUATION OF OTHER LONG LIVED GAS EXPOSURES
INDICATE LONG TERM GAS PRICE RANGE OF $6.50-7.50/MMBTU
Long Iife E&P
Transactions
ImpIied Iong-term price
$/MMBTU
Deal 1
Deal 2
Deal 3
ImpIied Iong term price
$/MMBTU
Narrow range
of long term
implied gas
prices
mplies a long
term gas price
6.50 to 7.50
$/MMbtu
$ Millions
7.50
7.00
6.50
7.25
6.75
E&P Company A
E&P Company B
E&P Company C
E&P Company D
Company
Utility
Asset vaIue
$ Millions
790
2,200
945
Enterprise vaIue
$ Millions
4,000
7,500
8,000
4,500
45,000
7.25
6.75
7.00
Source: McKinsey Analysis
5
MARKET OBSERVATIONS CAN BE COMBINED TO ESTIMATE GAS PRICE
PROBABILITY DISTRIBUTION
Expected Price
Near term :
Forward prices
Mid- Iong term:
Fundamentals
combined with
long term price
embedded in
E&P company
valuation
Option implied
volatilities combined
with mean reversion
from price history
Price voIatiIity
SimuIated naturaI gas price* distribution
$ / MMBtu
Stochastic simuIations
with market based
inputs inputs
$0
$5
$10
$15
$20
$25
2007 2009 2011 2013 2015 2017
<5% probabiIity
of gas price being
below 3.50
$/MMbtu in 2018
<5% probability of
gas price being
above 13 $
/MMBTU in 2018
Source: McKinsey Analysis
6
PERSPECTIVES ON NATURAL GAS PRICES
Gas price fundamentaIs: What you wouId need to beIieve to see a
sustained gas price Iinkage to petroIeum conversion capacity
Questions
Market based perspective on gas price: Estimating long-term gas price
and probability distributions based on commodity and capital markets
7
0
2
4
6
8
10
12
14
16
1992 1994 1996 1998 2000 2002 2004 2006
US GuIf Coast gas and energy NYMEX prompt month prices*
$/MMBtu
Natural gas priced between
resid and coal
Refining margins were tight
Natural gas priced
between resid and
distillate
Refining margins
were wide
* Converted at EA heat content of 6.287 for No. 6 low sulfur and 5.825 for No. 2. Coal prices shown as delivered spot prices to Northeast. Does not
include estimate NOX and SOX costs
Source: Bloomberg; McKinsey Analysis
SINCE 2000, NATURAL GAS PRICES HAVE TRADED WITHIN THE BAND
OF A RESID FLOOR AND A DISTILLATE CEILING
#2 Distillate
Natural gas
#6 Resid
Coal
$10+
Crude Iinked
Do gas prices
stay Iinked to
resid in a high
crude price
environment?
$6-8
Gas on gas
Do gas prices
faII to gas or gas
competition / or
crude prices
decIine
significant?
8
SIGNIFICANT GENERATION INVESTMENT WILL SOON BE REQUIRED;
IF NUCLEAR AND COAL PLANTS CANNOT BE PERMITTED,
CCGT BECOMES THE &%CHOICE
Capacity to meet minimum U.S.
power reserve margin of 15%
GW
0
10
20
30
40
50
60
0 2 4 6 8 10 12 14
Natural gas
(CCGT) favored**
Coal (SCPC)
favored***
Nuclear
favored
By 2020 225
125 By 2015
* All plants use 9% WACC and 30-year life
** CCGT at 7,000 Btu/kWh heat rate; $800/kW nominal greenfield Capex; 90% capacity factor; 3-year time to build
*** Coal at 9,100 Btu/kWh heat rate; $2,100/kW nominal greenfield Capex; 92% capacity factor, 4-year time to build; $75/MMBtu coal
Source: EA; McKinsey
Economic fueI choice*
CO
2
price
$/ton
NaturaI gas price
$/MMBtu
9
73
98
7
12
2.5-4.0
2-3
1 November 2005 to October 2006 EA reported demand for US
2 EA estimate of 1.6% growth in US, 2.4% growth in Canada
3 Assumes historical capacity creep for nuclear and coal capacity and utilization, with 30GW new coal build. Assumes renewable growth to 50 GW of capacity (7% of US power consumption). Remaining demand met by new CCGT at
7000 Btu/kWh Heat rate. Assumes 75% increase in gas-to-power demand growth met by capacity creep and new CCGT.
4 Assumes accelerated growth as Oil Sands development to 6.6 MMBd of production by 2020, utilizing 13 cm per barrel of oil
5 Assumes US achieves 20 BGY ethanol standard by 2015, growing to 30 BGY by 2020 results in incremental 2 bcfd of natural gas demand by 2015 and 3 bcfd by 2020.
Source: EA Annual Energy Outlook (2006); National Energy Board of Canada; MMS Deepwater forecast; Renewable Fuels Association; BP Statistical report 2006; press clippings McKinsey analysis
A SIGNIFICANT GROWTH IN GAS DEMAND CREATES A SIGNIFICANT
SUPPLY GAP THAT MUST BE MET
2006
1
Traditional growth
2
Power
3
Oil sands
4
Ethanol
5
2020 demand
2006 production
New demand drivers acting on top of traditionaI growth
engines.
Power
OiI Sands
EthanoI
High demand growth (1.8% per year)
Difficult to permit new builds for nuclear
and coal plants
Growth in power demand met almost
entirely by gas through higher utilization of
existing CCGT gas plants and new gas
fired plants
Rapid increase in oil sands production
(projections of 3-5 million bpd by 2020)
Production requirement of 0.75 mcf per
barrel of oil
North American ethanol demand assumed
to reach 15 billion gallons by 2015 and
grow to 30 billion gallons by 2020
Production requirement of ~1 cm of gas
per gallon of ethanol
Demand
SuppIy
.increase demand growth, impIying a potentiaI
suppIy gap of ~37.5 Bcfd by 2015
70
28
2015 supply gap
Bcfd
10
THE INCREASING SUPPLY GAP WILL DRIVE SIGNIFICANT E&P ACTIVITY
AND REQUIRE ATTRACTING ADDITIONAL LNG VOLUMES FROM EUROPE
NA NaturaI gas suppIy requirements
Bcfd
Gap to be fiIIed by
new resources and
LNG
Existing onshore** prod
New prod from
existing onshore fieIds
Offshore***
Canada production
* Yet To Find
** Assumes hyperbolic decline from HS 2006 survey
*** Estimate from EA/MMS
Source: EA Annual Energy Outlook (2006); Wood Mackenzie; MMS Deepwater forecast; McKinsey analysis
30,000
2006
70,000
2015
+10%
E&P activity wiII increase dramaticaIIy
Number of new wells drilled per year
Rigs
Average
rig count
Within ten years, over 60% of the production wiII come from
new weIIs in existing and YTF* fieIds as weII as LNG .
1400 2550
High US prices required to attract LNG:
Limited LNG liquefaction capacity
worldwide; NA plus Europe demand
LNG regas capacity to exceed
liquefaction capacity
US gas prices will likely be above oil
parity (Europe prices) to attract LNG
cargos
0
20
40
60
80
100
120
2006 2008 2010 2012 2014 2016
Net NA Natural
gas demand, ~3% CAGR
11
0
2
4
6
8
10
12
14
30 40 50 60 70 80 90
L
N
G

I
m
p
o
r
t
s
(
c
o
m
p
e
t
i
t
i
v
e
)
2012 North American NaturaI
gas suppIy and demand curve
$/MMBtu
ndigenous supply
marginal lifting costs
North American gas voIumes
Bcfd
L
N
G

m
p
o
r
t
s
(
f
i
x
e
d
)

n
d
i
g
e
n
o
u
s

p
r
o
d
u
c
t
i
o
n
Non-
switching
demand
Distillate switching
Power dispatch
switching
Resid switching
OiI-Iinked pricing band
LLUSTRATVE
Source: McKinsey
LNG PRICES IN A SHORT ENVIRONMENT RISE TO THE VALUE IN
ALTERNATE MARKET - IN THIS CASE EUROPE
If Demand stays
robust and US suppIy
not sufficient to push
LNG back into the
AtIantic, the marginaI
price setter for the US
becomes LNG
competing with
Europe
12
PERSPECTIVES ON NATURAL GAS PRICES
Gas price fundamentaIs: What you would need to believe to see a
sustained gas price linkage to petroleum conversion capacity
Questions
Market based perspective on gas price: Estimating long-term gas price
and probability distributions based on commodity and capital markets
13
UNUSED SLIDES
14
0
2
4
6
8
10
12
J
a
n
-
9
1
J
a
n
-
9
2
J
a
n
-
9
3
J
a
n
-
9
4
J
a
n
-
9
5
J
a
n
-
9
6
J
a
n
-
9
7
J
a
n
-
9
8
J
a
n
-
9
9
J
a
n
-
0
0
J
a
n
-
0
1
J
a
n
-
0
2
J
a
n
-
0
3
J
a
n
-
0
4
J
a
n
-
0
5
J
a
n
-
0
6
IN EUROPE, NATURAL GAS CONTRACTS INDEX PRICES TO LOW
SULFUR FUEL OIL PRICES
* Monthly prices. Gas prices average for Spain, Belgium, Netherlands, Germany, taly, France & UK . 6-month lag compared to oil (Brent) and LSFO
** Assumes 6.287 MMBtu / Bbl for LSFO, FCC is marginal refining unit in Europe, and an average of narrow and wide light / heavy differentials (modeled)
Source: Platts; World Gas ntelligence; EA; McKinsey GGM; McKinsey refining equilibrium pricing model
$ / MMBtu, 1991-2006 Q3
40 $/bbl ($5.25/MMBtu)**
30 $/bbl ($3.90/MMBtu)**
20 $/bbl ($2.50/MMBtu)**
Cost of Russian
imports (full cost)
OiI-Iinked gas border price* compared to Brent and LSFO prices
Oil-linked gas prices reflect long-
run marginal cost of Europe's next
alternative supply (Russia)
Growing price gap to gas
cost as oil prices
increase and stay high
50 $/bbl ($6.65/MMBtu)**
Brent
Oil-linked gas price (WG)*
Low Sulfur Fuel Oil (LSFO)
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06
15
LIQUEFACTION ACROSS THE ATLANTIC IS CONSTRAINED AND WILL
NOT BE SUFFICIENT TO FILL US REGAS CAPACITY
Natural gas delivered
into Europe currently
prices at a residual
fuel oil linked contract
price
f the US prices below
resid, then more
majority of excess
LNG should divert to
Europe
f US is pricing at a
premium to resid it
becomes the
advantaged market
* Assuming end-of-year in-service dates. Regas projects shown only in operation and under construction. 47.6 Bcfd facilities approved by FERC. Liquefaction
assumes projects operating, under construction and in development. ncludes Middle Eastern projects with expected delievries to Atlantic Basin based on
investing partners or signed contracts
Source: LNG Asian demand Dr. Fesharaki, FACTS nc., September 2005; McKinsey Energy Practice; McKinsey analysis
5 5 5
6
7
7
8
10
12
15
15 15 15 15 15 15
2
2
3
3
4
4
5
8
11
14
17
18
19 19 19 19
0
5
10
15
20
25
30
35
40
2000* 2002 2004 2006 2008 2010 2012 2014
Europe
North America
AtIantic basin
Iiquefaction
AtIantic Basin Liquefaction and regas capacity*
Bcfd