Uncertainty is clouding the energy trading outlook

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UNCERTAINTY IS CLOUDING

THE ENERGY TRADING OUTLOOK

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INTRODUCTION THE GLOBAL ENERGY MARKETS ARE UNDERGOING AN UNPRECEDENTED PERIOD OF NEAR UNRELENTING CHANGE, AS TECHNOLOGY INNOVATIONS, REGULATION AND GEOPOLITICAL UPHEAVAL ARE SHIFTING THE FULCRUM UNDER THE ENERGY SUPPLY AND DEMAND BALANCE. FOR ENERGY COMMODITY PRODUCERS, TRADERS, AND CONSUMERS THE IMPLICATION OF THESE CHANGES IS A PROLONGED PERIOD OF MARKET UNCERTAINTY.

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s the United States continues to rapidly grow its production of oil and gas from shale, and Canada increases production from its oil-rich tar sands, these new volumes are helping to support world oil markets as crude production outside the US declines due to increasing conflict in the Middle East and North Africa. Should these conflicts widen, the global markets will be increasingly volatile as supply disruptions outpace the growth in North American production.

Though US natural gas production has not yet impacted the global market space via LNG exports, there is no doubt that those exports will happen. While the impact on US prices is unclear at this time, these exports will be yet another variable with which to content in a US market already unsettled by increasing regulations that will, by design, reshape the US energy mix.

Dealing with this uncertainty will require increasing market vigilance, with a constant view on both the near and longterm energy outlook, and supported by a commodity trading and risk management solution that facilitates analytics, market visibility and regulatory compliance, such as Eka Energy.

Uncertainty is Clouding the Energy Trading Outlook

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THE CHANGING NORTH AMERICAN ENERGY ECONOMY North America, and more particularly the US, has in the last 5 years seen a dramatic shift in its energy economy, moving from a country that had been increasingly reliant on imported oil (up to 45% in 2004) to one that is rapidly displacing those imports with newly found domestic production. This energy renaissance has been fueled by advances in horizontal drilling and hydraulic fracturing technologies have opened new and abundant sources of natural gas and crude oil that were once tightly locked in shale and tight sand deposits.

The increase in energy production is unprecedented and has moved the US up to the second largest oil producer in the world, trailing only to Saudi Arabia.

Though US oil demand is expected to continue to outstrip domestic production for the foreseeable future, increasing tar sands production in Canada is expected to contribute to increased supplies from that country, further reducing US reliance on imports from volatile Middle Eastern and South American countries.

Since 2007, natural gas production from shale fields has increased from about 3 BCF per day to more than 28 BCF per day, with total US production increasing from 55 BCFD in 2007 to an estimated 72 BCFD in early 2014. Oil production from shale reserves has helped push US crude production from slightly more than 5 million barrels per day in 2008 (a more than 50 year low), to almost 8 million barrels per day in 2013 (a twenty-plus year high). © Commodity Technology Advisory LLC, 2014

While these new production sources have helped the US reduce its reliance on foreign sources of oil and have brought about a boon in economic growth in many parts of the country, incorporating the increasing volumes of shale gas and oil has not been without issue. Given that much of this new production has been found outside the reach of the traditional production and transportation infrastructure, the industry is facing a number of significant challenges to move those supplies to market.

These challenges include lack of adequate pipeline capacity in proximity to the new fields, the disruption of historical supply patterns, and increasing price uncertainty as these new fields continue to ramp volumes into areas that are increasingly oversupplied and bottlenecked.

Uncertainty is Clouding the Energy Trading Outlook

In particular, areas such as the Bakken Shale in North Dakota and Eagle Ford Field in South Texas have proven especially challenging as the huge increases in oil production have overrun crude pipeline capacity, necessitating alternative means of transport in order to move that crude to the refining centers in the Midwest and along the Gulf Coast.

For the Bakken, the best alternative to pipe transport has been via rail, with up to an estimated 700,000 bbls/day being transported via train, accounting for about 60% of the state’s total oil production.

While pipelines are generally considered the preferable choice in transportation given their lower costs and perceived lower operational risk, delays in permitting and construction of new pipes have increased reliance on rail transport; and increasingly, producers are recognizing the advantages offered by rail, including more flexible routing that allows for delivery to the most lucrative markets, and potentially rerouting should market conditions change while the volumes are in transit. While there are a number of proposals for new crude pipelines to provide additional capacity to move oil production to refineries in the east and south, given the significant investment that has been made in new rail lines and equipment in the area, and combined with environmental concerns related to pipeline construction, it’s unclear if and when this new capacity will be built.

The Eagle Ford Field in South Texas is located relatively near the production and transportation infrastructure that services the long established Permian Basin. However, the huge increases in oil production from the

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field in the last three years (growing from 123,000 bbls/day in 2009 to more than 1 million bbls/day in December 2013) have required a massive development program by producers and midstream operators. New pipelines have been built and new capacity added to existing facilities to move oil and condensate east to Houston-area refineries and processing plants, and south to Corpus Christie for loading on barges and ships for delivery to refineries in Louisiana and points further east.

This re-plumbing of the transportation infrastructure in south Texas will continue as drilling expands more widely in the oil rich areas of the field and later as gas production increases when prices improve.

The Marcellus Field in the Northeast US, though located along established pipeline routes, is having a dramatic and unprecedented impact (with up to 32 tcf of proven reserves1) on the natural gas markets from New England to the Gulf Coast. As Marcellus natural gas production continues to rampup, increasing from less than 2 BCFD in 2009 to more than 14 BCFD in early 2014, basis differentials between the Gulf Coast and Midwest supply points and the Northeast markets have tightened, often making transportation uneconomic and reducing the flow of gas from the south. As producers in the south find their once lucrative markets being taken up by Marcellus gas, they are increasingly forced to seek out alternative markets in the southern US and Midwest, often realizing much lower prices and forcing many to reduce their exploration and production budgets for gas projects.

In order to address the growing surplus of gas in the southern US, pipeline operators are seeking to expand their pipeline networks in the southern states, reaching new or underserved markets and, in the process, improving utilization of their long-haul systems. While these new facilities will help to reduce some of the backlog of gas, industrial expansion in the region and the developing LNG export facilities are the best hope for improving prices and profitability for producers in the region.

1| www.eia.gov/naturalgas/crudeoilreserves/pdf/uscrudeoil.pdf © Commodity Technology Advisory LLC, 2014

Uncertainty is Clouding the Energy Trading Outlook

A ComTech Advisory Whitepaper

US OIL PRODUCTION SUPPORTING GLOBAL MARKETS Though the US will certainly continue to be a net importer of oil for the foreseeable future, the share of imports from outside of North America will continue to fall, reducing the country’s reliance on increasingly unstable or potentially unreliable sources in the Middle East and South America.

With increasing production, the US has been able to effectively return about an average of about 1 million barrels a day (volumes that otherwise would have been imported) to the global markets over the last three years, helping to ensure a stable global oil price even in the face of global supply disruptions (Libya, Iran, Iraq, and others) that have oc-

curred during the period. Nonetheless, as long as the US is a net importer of oil, the country will continue to be exposed to a global price and the impact of any prices shocks that could occur should supply interruptions occur in the Middle East or South America.

Ongoing geopolitical unrest in the Middle East and Africa producing regions continues to be a cloud over the oil markets, with the potential loss of several millions of barrels a day should countries such as Libya and Iraq fall into turmoil.

Should this happen, and despite the increasing production in North America, shortages would occur if swing producers, particularly Saudi Arabia, are unable to offset the losses and prices could spike well above the recent three year average around $110/bbl (Brent).

WHAT WILL BE THE IMPACT OF US NATURAL GAS? With the increases in US natural gas production, and the prospects for even greater volumes to enter the market over the next decade, increasing attention is being paid to the prospects for large scale export of LNG from the US. Though only a single facility is currently under construction (Sabine Pass operated by Chenier) and the volumes to be exported from that facility are relatively modest (initially 2 BCFD), more than a dozen new facilities are in the permitting process and though many of those may not be ultimately built, the potential for much © Commodity Technology Advisory LLC, 2014

greater exports does exist. However, given that the US is geographically disadvantaged in servicing the lucrative Asian and European markets versus competitors in eastern Russia, Australia and North Africa, domestic US prices will ultimately determine the competiveness of US LNG.

Further clouding the outlook for LNG development in the US, the EPA announced in late spring 2014 new CO2 emissions standards intended to reduce greenhouse gas emissions from coal generation by 30% from 2005 levels, by the year 2030.

These new regulations, if implemented as proposed, will force the early retirement of significant amount of coal fired generation capacity, with much of that lost capacity necessarily replaced with natural gas-fired generators. While the exact mix

Uncertainty is Clouding the Energy Trading Outlook

of new gas-fired versus renewables facilities is not yet clear, natural gas will certainly be a significant contributor and gas burns for power generation could increase by several BFCD beyond otherwise “normal” demand growth by 2030.

In early 2014, US natural gas prices began to recover from several years of depressed prices brought on by oversupply. With prices driven-up by a slowing of drilling for natural gas and increased demand brought about by a very cold winter and a gradual economic recovery, the prospects for large scale LNG export look somewhat less likely. However, should the European economy recover from years of economic recession, and growth in China and the Asia Pacific region accelerate,

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large amounts of US LNG could find a market, particularly in Europe, given the increasing concerns related to the reliability of Russian gas supplies.

Should LNG producers’ plans come to fruition and LNG exports do increase in-line with those plans, gas exports combined with increased domestic consumption and increasing pipeline-based exports to Mexico, could result in demand growing by as much 15-20 BCFD over the next decade, an increase of more than 20% over current US production. While it’s not clear how much excess delivery capacity currently exists in the system, there is no doubt that such a dramatic increase in demand will require huge investments in new drilling and natural gas infrastructure, and will most certainly result in higher prices and growing price volatility as excess capacity is quickly taken up and producers scramble to meet demand.

REGULATIONS IMPACTING ENERGY TRADING The financial crash of 2008 ushered in a new era of regulation, one that has seen the G10 countries commit to higher levels of regulatory oversight and intrusive control over energy trading markets. The resulting market regulations -- in the form of Dodd-Frank in the U.S. and EMIR/REMIT (among others) in Europe -- continue to unfold, and their market impacts are continuing to evolve.

The primary targets of the new regulations, large banks and affiliated financial institutions that trade commodities and financial derivatives, have over the last decade invested heavily in energy trading and have often become the primary facilitators of liquidity in © Commodity Technology Advisory LLC, 2014

many physical and financial energy markets. As a result of the new regulations, and combined with low returns due to low volatilities and prices, many of these banks have decided to exit the energy markets entirely, closing trading operations and selling assets to non-bank entities. The potential loss of market liquidity associated with the departure of these large trading groups could increase price volatilities and risks for all market participants in Europe and North America.

For non-bank energy trading companies, the impacts of the new regulations are increasing the cost of doing business requiring greater cash reserves to meet margin requirements, increased investments in technology and personnel to address trade reporting requirements, and increasing the risk of running afoul of regulators who can, and have, assess fines in the millions of dollars. These new and evolving regulations are further impacting commercial decision-making as traders must balance growth with increased regulatory exposure and costs.

Uncertainty is Clouding the Energy Trading Outlook

The technology implications of the new regulations are substantial, as compliance requires a constant recording of all commercial activities, including data and information that may have influenced or supported a trade de-

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cision. As a result, energy trading companies must accurately capture, collate, transmit, store and retrieve massive amounts of data from numerous disparate systems, including ETRM systems, phone, IM, exchanges, data feeds, and even social media.

DEALING WITH UNCERTAINTY Given the rapidly changing energy supply patterns and resultant market imbalances in the US and globally, wholesale energy traders are having difficulty remaining abreast of the ever-changing landscape and adapting to the new physical market dynamics.

In order to profitability operate in this environment, energy traders must maintain a long view of the market, one that allows them to position themselves to take advantage of opportunities that may arise in the coming year or years. But, more importantly, they must maintain a vigilant eye on near-term developments that can impact the supply or delivery of energy commodities and ensure they are properly positioned to address the risks in an uncertain market.

As market conditions evolve with the ever-changing supply and demand balance, and oversight becomes more intense and invasive, visibility across all aspects of your business must improve:

Market visibility / market awareness driven by data with a vigilant eye on macro trends. Strategies must be formulated around macro trends and managed on market data and real-time or near real-time analysis.

Internal visibility / profit is made or lost on daily decisions. Accurate and timely position management, risk management and business intelligence support is key to ensure opportunities are optimally exploited and risks addressed. © Commodity Technology Advisory LLC, 2014

Regulatory visibility /regulators will be quick to move and once on their radar, you will be a target of scrutiny for a very long time. Developing a culture of compliance and visibility for regulators is key to avoiding punitive attention and actions.

Your chances of succeeding in this market will be, in large part, dependent upon the quality of your technology infrastructure. No company can operate profitably and in compliance with regulators without the appropriate technology systems and tools. Your IT infrastructure must be able to immediately and accurately capture the commercial activities of your business, provide near real-time feedback as to positions and exposures, aggregate data from many disparate sources to assist in identifying near and long-term opportunities, and finally, ensure that information for all those sources is accurately captured, maintained, and communicated appropriately to ensure regulatory compliance.

The core of that IT infrastructure should be a comprehensive, multi-commodity energy trading and risk management (ETRM) solution, such as Eka Energy. Eka’s “Smart Commodity Management” product is a fully integrated multi-commodity (ETRM) system covering the entire transaction life-cycle from capture through confirmation, operations, settlement and risk management. With Eka’s smart commodity management strategy, analytics have become the core of the solution’s capabilities, providing the requisite tools to optimize positions, limit risk and ensure compliance in an increasingly unsettled market.

ABOUT Commodity Technology Advisory LLC Commodity Technology (ComTech) Advisory is the leading analyst organization covering the ETRM and CTRM markets. We provide the invaluable insights into the issues and trends affecting the users and providers of the technologies that are crucial for success in the constantly evolving global commodities markets.

Patrick Reames and Gary Vasey head our team, who’s combined 60-plus years in the energy and commodities markets, provides depth of understanding of the market and its issues that is unmatched and unrivaled by any analyst group.

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www.comtechadvisory.com

ComTech Advisory also hosts the CTRMCenter, your online portal with news and views about commodity markets and technology as well as a comprehensive online directory of software and services providers. Please visit the CTRMCenter at:

www.ctrmcenter.com

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