The Surge and Impact North

American Unconventional Gas

2011 Annual Meeting & Forum Natural Gas Trends

Ed Schneider and Mike Juden McKinsey & Company, Inc.
Houston December 7, 2011

CONFIDENTIAL AND PROPRIETARY

Any use of this material without specific permission of McKinsey & Company is strictly prohibited

Summary of key trends

Focus of Todays
discussion

Outside of North America natural gas markets are tightening, increasing

competition throughout the value chain
With indigenous supplies unable to keep up with demand outside of North
America, LNG will be a high growth supply source especially in Asia
Traditional buyers are concerned about acquiring longer-term supplies as LNG
markets are expected to tighten
However, in this environment there are real risks moving forward especially
with a potential near-term LNG surplus in Europe, even with Asian tightening

In North America we expect oversupply to persist for at least the next 3-5
years. We see significant challenges to unlocking a step change in demand
Supply has driven down gas to the coal floor, creating 2-3 Bcfd of demand
Sufficient supply is available at $6/MMBtu or less to support ~10 Bcfd of
additional demand
Outstripping this supply will require large infrastructure investments (power,
chemicals, commuter vehicles, GTL) that required belief in 10 yr+ gas prices or
are challenged even at todays low prices
Value creation potential is shifting from resource access to operations and
supply chain
Midstream plays, and gathering and processing in particular, have attracted
significant investment interest
McKinsey & Company | 1

U.S. gas has fallen back to coal-to-resid pricing after

an extended period of being linked to residual fuel oil

Natural gas (Henry Hub)

Distillate - Gulf Coast #2 (LS diesel)
Residual Fuel Oil (gulf 1% sulfur #6)
Central Appalachian coal 2

Price
$/MMBtu1

35
Resid to Distillate

30
25

Gas supply shortage leads to

high prices competing with
the residual fuel

Transition
period

Coal to Resid

Futures

Gas over supply

leads to low prices
competing with coal

20
15
10
5
0
2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

1 Futures as of Nov 18 , 2011; Converted at heat content of 6.02 for Gulf Coast RFO; 5.72 for Gulf Coast No.2; 26.45 MMBtu/ton for Central Appalachian Coal
2 SOx, NOx or CO2 costs not included; CO2 costs not included; Adjusted for 20% efficiency gap between CCGT and coal plant

SOURCE: Bloomberg; McKinsey analysis

McKinsey & Company | 2

Gas production has continued to grow even as the number of gas directed
rigs has dropped significantly
L48 Dry Onshore Gas
Production2
Bcfd

Onshore gas
directed active rigs1
Count per month
1/07-9/11
CAGR: 8.8%

60

2,000

1/98-12/06
CAGR 1.4%

US has demonstrated added 2.3 - 3.1

Bcfd of incremental supply per year
Dry Onshore L48 gas production
growth
Bcfd

1,800

50

3.1

1,600

2.7

1,400

40

2.3

1,200
30

1.31.5

1,000
800

20

1.0

600

Horizontal
rigs
400

10

0.2

200

Vertical rigs
0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

2006 07

08

09

10

2011
(est)

1 Rig count updated until Sep 16, 2011

2 Includes associated & dissolved gas (L48 onshore)
SOURCE: STEO; NPC; PGC; USGS; Baker Hughes; McKinsey analysis

McKinsey & Company | 3

In the 1990s, producers destroyed significant value by continuing to drill

despite low gas prices
Wellhead Gas Price
$/MMBTU

Independent E&P Average TRS 1990-1999

Median =0.6%

Active gas drilling rigs

4.00
# of U.S. E&Ps
in 1990

700

211

Folded or merged
by 1999

122

Wellhead
price

Gas rigs

3.00

600
500
400

43

Avg. TRS <0%

2.00
Avg. TRS 0-5%

Avg. TRS 5-10%

300

18

200

1.00

12

100

SOURCE: EIA, Baker Hughes, McKinsey Corporate Performance Analysis Tool

Jan-00

Jan-98

0
Jan-96

0.00
Jan-94

18% of survivors
created value

Jan-92

16

Jan-90

Avg. TRS >10%

McKinsey & Company | 4

Drilling effectiveness continues to improve even as rig efficiency plateaus

Well efficiency

Rig efficiency

1st Year production from L48 onshore wells

MMcfd

Gas wells / gas rig month

Wells / Rig / month

0.86

0% p.a.

1.9

19% p.a.

2.0
1.9

1.9

2.0
1.9
1.7

0.62

0.41
0.36

0.35

2005

06

07

0.44

08

09

20101

2005

06

07

08

09

10

2011

1 Based on Jan Mar 2010 wells so that full year production can be calculated
SOURCE: EIA; HPDI; Team analysis

McKinsey & Company | 5

NA gas supply has the potential to increase 4-5 bcfd at todays prices
Ability of gas market to meet demand growth

Price required to create

supply/demand
$/MMbtu

Potential for increased supply at

current drilling activity levels and
current gas prices by 2015

6.3

6.0

6
5.0

5
4.0

4
3.0

3
2
1

2.0

2.0

1.9 bcfd

0.6
bcfd

1.4 bcfd

3 bcfd

2.7 bcfd
2.2 bcfd
1.7 bcfd

0
0
1000 rigs
will
replace
annual
declines

2
Gas
from
liquids
basin1

Other
assoc
gas2

4
Drilled
and not
completed
(one time
Prodn
increase)3

6
Rig and well
efficiency
(by 2015)4

8
Switch back
to coal at
$5.00 gas5

10

12

Rig return
at $6.00
gas6

14

Oil competition
with rigs7

Volume of available gas supply

to meet demand growth (2015-2017)
Bcfd

1 Associated gas from new liquids/oil plays including Bakken & Niobrara
2 Other Associated gas (excluding liquids/oil plays). EIA estimate for growth from Anadarko, Permian, Arkoma (likely underestimated)
3 Assumes 1,700 wells drilled but not completed at average NA well productivity
4 Additional production based on current total gas rig count and projected increase in rig & well efficiency (assumes additional 20% increase by 2015)
5 Based on estimated 2.7 bcfd of coal switched to gas currently at current forward curves
6 Return to gas directed drilling activity (horizontal rigs) in 2009 ($6/MMbtu)
7 Return of 200 gas rigs from oil directed plays to gas assuming current forward oil prices. Breakeven economics of oil directed rigs in conventional oil plays v.
incremental rigs in Marcellus, Eagle Ford, Haynesville

SOURCE: EIA; NA Supply model; Analyst reports; Energy Velocity; Baker Hughes; Team analysis

McKinsey & Company | 6

To date the only demand response has been from the power sector but
could we be entering a decade of demand
HH Spot, nominal
$/MMBtu

Gas Demand (Delivered to consumers)

Tcf

4.31

Vehicles

21.5
0

Power

5.2

Industrial

8.1

8.86

4.50

21.4
0

22.0
0

6.7

7.0

6.7

7.0

5.05 EIA
25.1
0.7
6.7

Potential drivers of
demand growth

Coal plant

retirements?

CO2 regulations?
Power demand
9.4

growth?

Industrial

renaissance?

Commercial

3.2

3.2

3.2

3.5

Transportation

Residential

5.0

4.9

4.8

4.8

LNG exports/GLTs?

2000

2008

2011E

2020E
EIA

SOURCE: EIA

switching?

McKinsey & Company | 7

NE, Appalachia and Midwest linked after

REX III in-service to single market

Chicago Citygates

TCO

Demarc

TETCO M2

Henry Hub differentials1 $/MMBtu

Dominion South

TGP-Niagara

West and North Appalachian

basis differentials

2.0

Lebanon
Some Northeast points fly-up
In winter months

1.5
1.0
0.5
-0.5

Broad basis shifts

and downward
pressure on hub
prices expected

-1.0

Continued collapse

-1.5
-2.0

Midwest and Appalachian

markets linked after REX III
in-service date;
AECO influenced but not
linked

-2.5
-3.0
-3.5
-4.0
Jan07

In-service REX II

Jul07

Jan08

Jul08

Jul09

Jan- Jul10
10

Renewed Mid-

continent blowout
(~2014)

Pressure on hub

In-service REX III

Jan09

of Appalachian
bases

(base) price

Jan- Jul11
11

1 Based on average weekly prices; Price at pricing point less price at Henry Hub yields Henry Hub differential
SOURCE: Ventyx Energy Velocity from ICE and NGX; McKinsey analysis

McKinsey & Company | 8

Life in a gas long North America

FOR DISCUSSION

Continued growth in liquids and oil plays as producers seek higher returns
Steady gas supply despite continued pressure between low gas prices
and escalating services
Majors and large independents continue to invest through cycle based on
long-term view and desire to retain organizations
Small independents invest based on cash flow

Potential for industry consolidation driven economic hardship and

continued interest by majors and NOCs in accessing unconventionals in

90s consolidation did not result in a decrease in activity

Limited investment in infrastructure required for a meaningful increase in

demand driven by complications of low power prices and concerns over gas
prices 2015+

Midstream returns exceed upstream returns for new investments

McKinsey & Company | 9