2010 ends with an industry in flux

The future of offshore drilling regulations following the spill in the Gulf of Mexico (GoM), the volatility of oil and natural gas prices, and rocky financial markets have created an unprecedented level of uncertainty and risk for the oil and gas industry. By the time this is published, we will know the outcome of the midterm elections, and that will be one less unknown for an industry in the midst of incredible change. 

There are many factors that are contributing to the transformation of the industry: 
• The changing dynamics of oil demand following a period of sustained high prices; 
• An abundance of natural gas due to advances in hydraulic fracturing, horizontal drilling, and an influx of new operators causing supply to outpace demand; 
• Excess capacity in the downstream sector; 
• The geographic shift for oilfield service companies as projects in Latin America and Asia Pacific as well as major development projects in Brazil and Australia begin; 
• Increasing momentum with respect to transactions, however tempered, as companies reevaluate their operator and non-operator liability in each deal following the GoM spill; and 
• Last but certainly not least, regulatory uncertainty, not only as it relates to offshore drilling, but just as importantly in connection with hydraulic fracturing, a key component for the recovery of oil and gas resources. 

Policy 
A changing environmental and regulatory landscape is at the forefront of the list of unknowns as the year draws to a close. While efforts are under way to create regulations for enhancing the safety of offshore operations, the industry is 

Marcela Donadio is the Americas Oil & Gas Sector leader at Ernst & Young. She directs industry initiatives and leads Ernst & Young’s oil and gas partners and professionals across the Americas. (Image courtesy of Ernst & Young LLP). She directs industry initiatives and leads Ernst & Young’s oil and gas partners and professionals across the Americas. (Image courtesy of Ernst & Young LLP)

anxious to have a comprehensive energy policy that provides some certainty, including clarifications around the direction of any new regulations related to hydraulic fracturing, which would enable it to plan and grow to meet the energy needs of consumers.

Ernst & Young hosted a debate on energy policy between Howard Dean and Ed Gillespie at the end of August. During the event, Dean called for the need for the industry to be an active collaborator in developing new rules and policies. Transparency around the future of energy policy would go a long way toward helping companies adapt and respond to this period of transformation. The industry and regulators should work together to create policies that benefit the nation’s economy and account for energy security. 

On that note, the industry is working fervently to have a voice in new regulation. 

For offshore producers, the hope is that the operational and liability requirements will be fair and continue to provide an even playing field for companies of all sizes while accomplishing the goal of improving safety. A continued delay in a return to normal operations and increased regulatory barriers will reduce the number of operators in the GoM and could hamper supplies, which might lead to oil price increases in the medium to longer term. In the shorter term, these conditions will present a great risk to the offshore industry and the thousands of industry employees that work in the GoM. 

With the moratorium being lifted a little more than a month ago, the industry still is in limbo waiting to see how the Bureau of Ocean Energy Management will issue new drilling permits. Meeting new federal safety requirements will take time for oil companies. High liability caps and onerous regulations stand to restrict the ability of smaller companies to operate offshore. 

On another policy front, increased regulations with respect to hydraulic fracturing might have a dampening effect on the recovery of both conventional and unconventional oil and natural gas reserves. Regulators and other legislative bodies should pay attention to this fact. 

Oil 
A major change is under way, not only in the way fuels are produced and the kinds of fuels used, but also in consumption patterns. In the wake of the supply and price shocks created by hurricanes Katrina and Rita in 2005, and with more conservative spending habits developed in the US in response to the banking crisis of 2008, America might have forever changed its oil consumption patterns. In addition, with businesses working to reduce carbon footprints, less oil-intensive economies are emerging. 

On the flip side, developing nations such as China and India are requiring more fuel as their economies continue to grow. These sharp differences in economic strength among regions have changed consumption dynamics. Advanced countries’ continued low demand is attributable primarily to the economic recession, but gains in efficiency could be permanent. However, this decrease in demand might be offset by growth in the emerging countries, such that oil demand inevitably will increase in the future. 

Natural gas 
With the North American unconventional gas boom and new LNG capacity coming online, natural gas supply remains strong, and storage levels remain high. As more of the majors move into the shale space and validate the unconventional gas strategy, there should be continued growth in supply. 

A supportive public policy could go a long way toward increasing demand for natural gas and midstream infrastructure for processing and distribution. Further, as a result of the fuel’s low emissions and ample domestic supply, the long-term outlook is positive. 

Advanced countries’ continued low demand is attributable primarily to the economic recession. (Source: International Energy Agency)

In other parts of the globe, China’s untapped shale gas supply seems to have huge potential. In addition, China is investing heavily in many different regions across the globe, including its most recent investment play in Texas. South Africa also is placing high bets on shale gas being its next big play to help offset oil imports. With these new plays in the US and elsewhere on shale gas, Russia, once the leader in the natural gas supply, could see its market share threatened further. Overall, in the race for energy resources, natural gas might just be the fuel of the future. 

Downstream 
In 3Q 2010, refining margins largely retreated to pre-boom levels as a result of modest use in the US and Europe, sluggish demand, and relatively high crude prices. In addition, while spare capacity abounds, new capacity is coming from the Middle East and Asia, which will strain margins further. There are ongoing questions as to the prospects for sustained transportation fuel growth in advanced economies and possible public policy shifts resulting from the GoM spill to greater use of alternative fuels. All of this creates a very difficult operating environment and uncertainty for refiners. 

Oilfield services 
Global upstream spending declined by 25% in 2009 but is expected to be up 15% to 20% in 2010. While the GoM moratorium has created sharp downward pressures on rig use and day rates, new opportunities in South America and offshore Africa are emerging. The boom in unconventional oil and gas drilling has resulted in rising service intensity and has fed the demand for new, high-complexity rigs. Enforcement of “Idle Iron” regulations – which will require full decommissioning of wells, platforms, and pipelines that are no longer producing or providing operational support – will provide opportunities for some oilfield service companies. 

Transactions 
Continued loosening of credit markets, strong oil prices, and evidence of a financial recovery, though somewhat mixed, have driven an uptick in upstream transactions over the past few quarters. With gas prices depressed, investors are looking for gas plays with high liquid content. The GoM spill also has impacted the transactions landscape. In addition to potential oilfield services consolidations, many companies are reexamining how they structure deals. 

Looking ahead, it is safe to assume deals will be structured differently, with more stringent reporting requirements and assessments of liability. These structures stand to decrease the pace of the transaction process. At the same time, if liability caps are placed as high as some fear, an acquisitive market could emerge as smaller operators will be unable to continue offshore operations. 

Final thoughts 
Uncertainty and change provide new opportunities. Heightened concerns around offshore safety and environmental protection are ushering in an era of community and collaboration for GoM operators. If this concept can be extended to energy policy, improving collaboration not only with oil and gas industry peers in fossil fuel development but also with alternative and renewable energy companies and with regulators, the oil and gas industry can make a difference for the future of the industry and the nation. This is an industry that has seen its share of rough waters and always has weathered the storm, emerging stronger on the other side. 

The views expressed herein are those of the author and do not necessarily reflect the views of Ernst & Young LLP.