American Energy Research

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ab

Wealth Management Research

June 2012

Energy self-su ciency boosts US economy and manufacturing competitivenessTransport and utilities evolving to make greater use of cheap natural gas

US to end dependence on OPEC and transition to renewables

UBS research focus

North American energyindependence: reenergized


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ContentsNorth American energy

independence: reenergized

01 Editorial

02 Highlights

04 Introduction

05 Chapter 1 Americas new energy diet: lean and green

16Chapter 2 Energy supply: too much is never enough

23 Chapter 3 Americas energy opportunity

30 Conclusion

31 Appendix

35 Glossary

Please see important disclaimer on the back page.

2 2011 Outlook

Publication details

PublisherUBS Financial Services Inc.

1285 Avenue of the Americas

New York, NY 10019

This report has been prepared by

UBS Financial Services Inc. (UBS FS).

Please see important disclaimer and

disclosures at the end of the document.

This report was published on

12 June 2012.

Authors(in alphabetical order)Ron Barone (UBS Investment Research)

Jerey Birnbaum (UBS Investment Research)

Nicole Decker

Joseph Kenol

Maryam Khan

George Lambertson

David Leowitz

Kurt Reiman

Christopher Sighinol (UBS Investment Research)

Andrew Sutphin

Jon Woloshin

EditorMarcy Tolko

Desktop PublishingGeorge Stilabower

Cognizant Group Basavaraj Gudihal,

Srinivas Addugula and Virender Negi

Project ManagementPaul Leeming

North American energyindependence: reenergized

Pipes at a natural gas processing

plant in Colorado signal expansion of

infrastructure and a boon to the US

economy.


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North American energy independence: reenergized June 2012 1

Dear readers,

The surge in crude oil and gasoline prices during the rst quarter of this year angered

consumers and politicians and served as an unwelcome reminder of our dependence on

energy. With no immediate relief available, US motorists had to dig deeper into their wal-

lets. However, a positive trend emerged: the sharp decline in the price of domestically pro-

duced natural gas enabled American households and businesses to save on their electricity

and heating bills.

The same technology that has unleashed an abundance of natural gas has also unlocked

previously unrecoverable supplies of crude oil throughout North America. For the rst time in

decades, the US has actually reduced its dependence on foreign energy sources a trend that

will likely continue.

This movement toward greater energy independence and use of inexpensive natural gas will

yield numerous advantages for the US economy, particularly as it boosts domestic manu-

facturing competitiveness and slows the ow of dollars overseas to pay for imported oil.

Moreover, the enormous infrastructure development needed to adequately service this evolv-

ing energy landscape should li investment spending and hiring in the oil and gas sector and

in other peripheral industries.

US natural gas is not only cheap relative to crude oil, it is also much less expensive than elsewhere

in the world. We expect power utilities, petrochemicals companies and eventually the transporta-

tion grid to use more natural gas. As high pump prices continue to crimp consumer spending,

Americans will shi to more fuel-efcient, electric and other alternatively powered vehicles.

But while dependence on foreign oil shrinks, energy security will remain out of reach as long

as renewables comprise such a small share of US energy consumption. However, we believe

greater energy self-sufciency and more aordable fuels also set the stage for further transi-

tion to renewable fuels down the road.

This edition of UBS research focus explores North American energy independence both the

obstacles and the opportunities. In an accompanying UBS research focus recommendations

report, we outline how sectors and companies could be aected by a move toward energy

independence. In addition to identifying investment opportunities for your portfolio so you

can capitalize on this theme, we also highlight the practical benets of greater energy self-sufciency on our daily lives, so the next oil price spike doesnt cause as much pain.

Editorial

Mike Ryan, CFAChief Investment Strategist

Head, Wealth Management

Research Americas

Kurt ReimanHead, Thematic Research

Wealth Management

Research Americas

Mike Ryan

Kurt Reiman

Nicole Decker

Nicole DeckerAnalyst


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2 June 2012 Themes

North America will likely achieve energy inde-

pendence by the end of the decade. The

American energy extraction techniques of hori-

zontal drilling and hydraulic fracturing com-

bined with a structurally high relative price of

crude oil has encouraged widespread devel-

opment of Americas energy resources. Natural

gas is so oversupplied in the US that develop-ers are curtailing production, while domes-

tic oil producers are working to circumvent

infrastructure bottlenecks to transport their

supplies to reneries. As a result, natural gas

in North America costs less than a h of the

cost of oil on an energy-equivalent basis.

Over the next several years, we expect:

Americas newfound energy resources

to provide a much-needed boost to US

economic activity, as the country con-

tends with the eects of widespread debt

deleveraging. UBS economists project a

roughly 0.5 percentage point intermediate-

term boost to US real GDP. The drivers

behind this growth spurt include explora-

tion, development and infrastructure invest-

ment, direct and indirect job growth from

energy extraction, and the windfall that will

likely accrue to households and businesses

from relatively lower-cost fuels.

Relatively inexpensive natural gas to

create a competitive advantage for the

US. This is another key factor supporting

our view that the US economy will experi-

ence a manufacturing renaissance through

the repatriation, relocation and expansion of

energy-intensive industrial operations. This

trend is especially powerful for the petro-

chemical and materials sectors.

US oil consumption to continue to

decline, as the comparatively high price of

oil will likely prompt drivers to switch to more

fuel-efcient vehicles and alternative pow-

ertrains, such as hybrids and electric vehicles.

Increased use of natural gas at power

plants that have long relied on coal. Naturalgas will also nd its way into the transpor-

tation fuel mix through use of compressed

natural gas and other natural gas technolo-

gies in eet vehicles, as well as through the

wall outlet for plug-in electric cars.

Demand for renewables to hinge on

government subsidies, which may come

under pressure in an age of heightened

austerity.

Intense pressure on the global energy

industry to keep pace with demand. The

Energy Information Administration projects a

58% increase in energy demand by 2035 on

account of rising consumption in emerging

market countries. Despite an increase in the

use of renewables, fossil fuels still account

for over 80% of the global energy mix; and

energy producers must race to even more

remote locations to secure supplies. In the

case of oil, many of these supplies are in the

hands of national oil companies, which evenfurther hinders supply security for countries

dependent on oil imports.

The US to eventually wean itself o

OPEC imports, through a combination of

lower oil demand, greater domestic pro-

duction and additional Canadian imports.

Not only will North America achieve greater

self-sufciency and energy independence,

North American energy

independence: reenergized

Highlights

2 June 2012 UBS research focus


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Reengergized

Energy June 2012 3 North American energy independence: reenergized June 2012 3

conict in the Middle East, will also encourage ashi away from imported oil from the region.

Fossil fuels will not go the way of the dinosaur

anytime soon, however. The US must continue

to pursue eorts to develop technology and

increase the availability of renewables in the

nations fuel mix to ensure maximum energy

security. True energy independence means con-

sumers can no longer be held hostage to either

the fuel suppliers or the supplies. To truly break

free of its tried-and-no-longer-true energy-

inefcient ways and means, the nation mustembrace renewable fuels the next step on the

path to complete independence.

but we expect the US will also become a netexporter of natural gas later this decade.

A lower structural trade decit to result

from a moderation in oil imports and an

acceleration in natural gas exports. Some of

the US dollars previously shipped overseas for

imported oil will now be spent on domesti-

cally produced energy or be freed up for

other spending because of inexpensive natu-

ral gas and expected efciency gains.

The trends we discuss in this report are pri-marily a function of market-based incentives

to change behavior. Energy policy, especially

eorts to reduce harmful pollutants, lower

greenhouse gas emissions and raise fuel ef-

ciency, will also spur changes in the fuel mix

away from oil and coal and toward natural gas.

Geopolitical events, especially the potential for



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4 June 2012 UBSresearch focus

The North American energy landscape has

been irreversibly transformed. Whereas US oil

and gas production once lay at the fringe of

the energy discussion, it now takes its place

right at the center. For the rst time in over a

decade, US energy production is rising thanks

to the formerly untapped potential of shale oil

and gas reserves.

New drilling techniques are behind a spec-

tacular rise in onshore activity all around the

US. The advent of horizontal drilling and

hydraulic fracturing has heralded a modern-

day gold rush of sorts. The number of hori-

zontal rigs at work in the US illustrates the

point. According to Baker Hughes, there

are 1,177 horizontal rigs currently working

onshore in the US. At the beginning of the

last decade, there were 48.

The shale revolution began with natural gas

early in the last decade. Where shale gas pro-

duction accounted for just 2% of the total US

natural gas production in the early 2000s, it

now represents more than 30%. The US had

been preparing to import more natural gas,

building several new port facilities along the

coasts. Now it looks as though the direction of

natural gas will reverse as the US transitions to

an exporter of natural gas.

For how long has US dependence on oil sup-plies from the Middle East been an American

pet peeve? The US is on track to eliminate

Introduction

Kurt Reiman, Head, Thematic Research Wealth Management Research; Nicole Decker, Analyst

imports from the Middle East by the end of

this decade. Oil production in the US has

risen by over 1 million barrels per day (b/d)

in the last ve years virtually all of this

from onshore production in the lower 48.

Surprisingly, North Dakota is now second on

the list of top oil producing states behind

Texas but ahead of Alaska.

All of this is good news for the US. But like any

story about energy, this one has its fair share

of caveats. Environmental concerns are chief

among them, but they are all surmountable.

America also heavily relies on fossil fuels. That

said, abundant supplies of shale gas now chal-

lenge the coal industry and raise the economic

bar for renewable technologies.

America is now reenergized. It is a story worth

following.

Due to the technical aspects of this

story, weve provided an informative

glossary of terms used in this report

starting on page 35.


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Addicted to oil

Since the early 1950s, the US has had to

increasingly rely on imports to meet its steadily

growing appetite for energy (see Fig. 1.1).

Nowhere has this been truer than in transpor-

tation: Although the US is mostly self-sufcient

in the energy used to power industrial, com-

mercial and electricity generation facilities,

Americas transportation network is over-

whelmingly dependent on imported oil to

shuttle around suburban commuters, fuel

larger cars and accommodate more drivers

and airline passengers.1 The reason: The vast

majority of US energy imports are in the form

of crude oil, and the nations vehicle eet is

almost entirely dependent on oil for power

(see Fig. 1.2 and Fig. 1.3).

Americas oil addiction has yielded numerous

disadvantages over the years. Most painfully,

Americans must once again contend with

higher prices at the pump an unwelcome

Americas new energy diet:

lean and greenAmericas newfound abundance of oil and natural gas comes amid

sharply higher global energy demand and structurally elevated oil

prices. As a result, important shifts are under way to diversify the US

fuel mix and improve e ciency. As transport becomes leaner, oil

consumption will decline. Meanwhile, eet vehicles will steadily use

more natural gas, as will power plants. Together with increased use

of renewables, the US is moving along the path to greater energysecurity and self-su ciency.

Kurt Reiman, Head, Thematic Research Wealth Management Research; Nicole Decker, Analyst

Note: Primary energy includes fossil fuels, nuclear electric power, and renewables.

Source: Energy Information Administration, UBS

Production

Consumption Net imports

Fig. 1.1: US energy deficit beginning to shrink

US primary energy balance, in quadrillion British thermal units (Btu)

100

80

20

0

20

40

60

120

1950 1960 1970 1980 1990 2000 2010

Source: Census Bureau, UBS

30

25

20

15

10

5

0

5

35

2000199019801970 2010

Other

PetroleumCoal

Natural gas

Fig. 1.2: Energy imports primarily in the form of petroleum

Net imports of various fuel types, in quadrillion Btu

Chapter 1


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burden when households are trying to burno mountains of debt accumulated during

the real estate boom (see Fig. 1.4). With plen-

tiful domestic reserves of cheap natural gas

and now-viable sources of oil, Americas reli-

ance on imported oil, especially from volatile

sources, seems all the more absurd. Therefore,

Americas energy challenge is to use this new-

found oil and natural gas as an opportunity to

achieve greater energy self-sufciency.

A conuence of powerful forces

But how? Many believe that the US can onlyachieve energy independence through a coher-

ent mix of energy policies and regulations. We

disagree. Although policies are important for

changing behavior and moving the country in

a new direction (see box on page 15),we think

economic and market-driven forces are the

primary catalysts behind America further capi-

talizing on its domestic energy resources. In

addition to economics and policies, geopoliti-

cal forces will also play an important role.

Economic and market-driven forces

Continued worldwide growth in energy

demand will deepen ongoing supply chal-

lenges. Rising emerging market oil consump-

tion, together with declining output growth,

has kept the oil price elevated. This dynamic,

which we expect will persist, bolsters the

development of costlier crude oil reserves to

meet rising global demand (see Fig. 1.5).

Onshore US energy reserves are transform-

ing the domestic energy industry. NorthAmerican energy resource discoveries and

advances in drilling technology, spurred by

structurally higher oil prices, have yielded

economically viable domestic and regional

supplies of oil and natural gas to meet a

larger share of the US long-term energy

needs.

Development of domestic energy reserves

creates jobs directly, but the deployment of

30

25

20

15

10

5

0

40

35

TransportationIndustrialCommercialResidential Electric power

Note: Electricity retail sales to ultimate customers reported by electric utilities and other energy

service providers. Total electricity system energy losses are calculated as primary energy

consumed by the electric power sector minus the energy content of electricity retail sales.


Nuclear

Petroleum

Electricity retail sales

Renewables Electricity system

energy losses

Coal

Natural gas

Fig. 1.3: Petroleum powers transportation and little elseEnergy consumption by major sector and fuel source, in quadrillion Btu, 2011

Note: Inflation-adjusted US city average retail price.


Fig. 1.4: Gasoline prices near generational highs

Real motor gasoline prices, in US dollars per gallon including taxes

4.5

4.0

2.5

2.0

1.5

1.0

0.5

0

3.0

3.5

5.0

1976 1980 1984 1988 1992 1996 2000 2004 2008 2012

Source: UBS

059 12011010090807060 120+

Cost of a marginal barrel of oil, in US dollars

Deepwater

Conventional

Oil sands

LNG & Gas-to-liquids

US shale oil

Unconventional gas/heavy oil

Fig. 1.5: Oil thirst prompts costlier reserve development

Oil production, in million barrels of oil equivalent per day, 2012

50

40

30

20

10

0

60


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Americas new energy diet: lean and green

relatively inexpensive natural gas (see Fig.1.6) oers a potential cost advantage to US

industrial and manufacturing businesses,

which would also indirectly support job

creation.

Not only is the US dependent on foreign

energy imports, Americans also have a rela-

tively higher dependence on energy in their

daily lives than people in other developed

countries.2 Continuing to improve energy

efciency in transportation, business and

household consumption is perhaps impera-tive in a debt-constrained economic envi-

ronment as a way of controlling costs and

maximizing income and productivity.

Policy forces

Deleveraging of balance sheets in the US,

and the resulting slow-growth environment,

shis the discussion toward policies that

promote jobs and investment in the natu-

ral resources sector, as well as policies that

appropriately weigh both the costs and ben-

ets of environmental concerns.

Central banks are likely to keep monetary

policy accommodative for as long as pos-

sible during this era of deleveraging, which,

all else being equal, could bolster the price

of oil and other commodities. In addition to

supporting the development of unconven-

tional reserves in North America, structurally

high oil prices promote enhanced efciency

measures and advances in renewables

technology.

The US has shouldered a gaping trade decit

for decades the principal components of

which are decits with China and oil-export-

ing countries (see Fig. 1.7). To the extent that

a persistent and large trade decit is seen as a

weakness, policymakers may support eorts

to bring the trade decit closer to balance

through reduced imports of crude oil and

exports of natural gas.


West Texas Intermediate crude oil

Henry Hub natural gas

20

15

0

5

10

25

Fig. 1.6: Natural gas inexpensive relative to oil

Natural gas and crude oil prices, in US dollars per million Btu

1997 2000 2003 2006 2009 2012

Source: Bureau of Economic Statistics, UBS

China goods trade balance

Oil trade balance US goods balance

1

2

7

5

6

4

3

0

20021999 2005 2008 2011

Fig. 1.7: US trade deficit remains uncomfortably wide

US trade deficit and its constituents as a share of US GDP, in %

Source: BP Statistical Review of World Energy 2011, UBS

0

20

15

10

25

5

France

Canada

Germany

Japan

India

Russia

US

China

Brazil

Fig. 1.8: Substantial energy demand growth in China and India

Share of global primary energy demand for selected countries, in %

1990 2010


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Chapter 1

Geopolitical forces A geopolitically sensitive period highlights

the need for greater energy self sufciency

(see the July 2010 UBS research focus,

Geopolitics: the blind side). Geopolitical

instability and concerns about supply inter-

ruptions, particularly in the Middle East,

have added to the price pressure and vola-

tility in oil markets, which are likely to per-

sist.3 Although there is no practical way to

completely insulate the country from these

shocks, since oil prices are set in global mar-kets, reduced dependency on volatile supplies

would likely soen the economic impact if

crisis erupts. Therefore, North America has an

incentive to become energy independent and

bring new reserves onboard.

The US faces structural competition for

energy resources from fast-growing, highly

populated emerging market countries, espe-

cially China and India (see Fig. 1.8). Both the

Energy has been plentiful and cheap for so

long, especially compared to human eort,

that we now take it for granted. Not only do

we use it in ways that are highly inefcient,

we assume that producers will supply more

of it consistently over time to meet our needs.

However, there are no guarantees that future

energy supplies will be available in sufcient

quantities and at an aordable price. Aer all,

only about 13% of global energy consump-

tion in 2010 was renewable, according to

ExxonMobil (see Fig. 1.9).4

The amount of energy the world consumes

today is simply staggering. Putting this amount

of energy in a way that can be easily grasped

is a difcult exercise. But perhaps the following

examples can help:

To show just how far society has departed

from early civilization, we calculated how

long it would take for people to generate

the equivalent of todays annual energy con-

sumption. Scientists have estimated that the

average person produces energy at a sus-

A growing global appetite for energy

Biomass/Waste 9.1%

Hydropower 2.3%

Wind/Solar/Geothermal/Other 1.3%

Source: ExxonMobil, UBS

Fig. 1.9: A small slice of energy demand is renewable

Renewable energy share of global final energy consumption, in %, 2010

Nuclear 5.5%

Fossil fuels 81.8%

Renewables 12.7%

12.7%

8 June 2012 UBS research focus


11/40




tained rate of one-tenth of a horsepower.5

We estimate that it would take the worlds

4.3 billion working-age people almost 250

years to produce the amount of energy con-

sumed globally in just one year.

Global consumption of fossil fuels (coal,

natural gas and crude oil) is equivalent to

approximately 210 million barrels of oil per

day.6 It would require the daily oil produc-

tion of 19 Saudi Arabias the worlds larg-

est oil producer just to reach one day of

the worlds oil demand.

The Alaska National Wildlife Refuge (ANWR)

holds 10.4 billion barrels of oil (the midpoint

estimate of recoverable oil reserves).7 This

resource would be depleted in just over a

month and a half by the worlds energy

demand. In other words, if taken in isola-

tion, the global energy industry would needto discover a eld the size of ANWR every

50 days just to meet the worlds energy

needs as expressed in oil terms.

Despite the already enormous appetite for

energy, most forecasts call for a sustained

increase in worldwide energy demand over

at least the next decade. The US Energy

Information Administration (EIA) projects

global primary energy demand will growSource: Energy Information Administration, UBS

800

700

600500

400

300

200

100

0

1990 2000 2008 2015 2020 2025 2030 2035

OECD

Non-OECD

Fig. 1.10: An insatiable appetite for energy

Global primary energy consumption, in quadrillion Btu

53% between 2008 and 2035.8 Importantly,

the appetite for energy among developed

countries is poised to level o while energy

demand in emerging markets will likely grow

strongly alongside rising incomes and growing

populations. The question is more about just

how fast energy demand will grow in emerg-

ing markets. For now, the EIA expects energy

demand within Organisation for Economic

Co-operation and Development (OECD)

countries to expand by only 18%, whereas

consumption is forecast to grow 85% in non-

OECD countries (see Fig. 1.10).

US and China will seek to secure energyresources from overseas, and also look to

develop domestic resources, whether they

be renewable or traditional fuels. Since both

are so heavily dependent on foreign suppli-

ers, greater energy security for both nations

would not only limit the potential for geo-

political conict, but could pave the way

for more stable global economic growth. In

fact, Chinas thirst for energy could present

an opportunity for cooperation if US compa-

nies were able to license their shale oil andgas extraction technology to enable Chinas

domestic production.

US energy independence?

Has Americas energy decit grown so large

that US energy independence is simply out

of reach? Probably, but another strain of this

theme North American independence

seems attainable. The path involves some com-

bination of the following:


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Chapter 1

Reduced crude oil consumption throughthe development of substitute vehicle pow-

ertrains and fuels, improved automotive ef-

ciency and less overall demand

Increased domestic production of crude oil

and natural gas

Improved infrastructure for the transport and

use of North American natural gas and crude

oil in the form of reneries, pipelines and lling

stations, as well as changes and improvements

to electricity generation and distribution, suchas the build-out of smart grids

Increased use of renewable fuels through

technological advances and cost reductions

Before diving into the supply side of the

energy equation, we will rst take a look at

how demand shis can enhance US energy

self-sufciency.

A leaner, greener path lies ahead

US demand is likely to remain anemic over the

next several years, thanks to a protracted phase

of domestic debt deleveraging, slowing popu-

lation growth, improved auto fuel efciency,

increasingly efcient industrial operations, and

structurally high oil and gasoline prices (see Fig.1.11). In fact, aer years atop the global energy

consumption charts, the US slipped to second

place in 2010, with China overtaking the number

one spot (see Fig. 1.12).

Weaker US energy demand growth makes North

American energy independence all the more

possible, while strong emerging market demand

makes it all the more necessary. In our view, the

demand channels that will have the greatest

eect on improving US energy security are

Energy substitution from both oil and coalto natural gas, as well as from fossil fuels to

renewables

Energy efciency

Energy substitution: oil to natural gas

The transportation sector oers the greatest

potential for oil-to-natural-gas substitution.

Although low natural gas prices and high gaso-

line prices make this an obvious candidate for

switching, relatively few customers have made

the transition (see Fig. 1.13). While competi-

tive on the basis of price, natural gas demand

within the transportation grid is unlikely to take

o without distribution networks, refueling

facilities and vehicle engine retrots.

Fig. 1.12: China surpasses US as worlds largest energy buyer


Primary energy consumption, in quadrillion Btu

100

80

60

40

20

0

120

US

China

1965 1980 1995 2010

Fig. 1.11: Much less growth in US energy demand than in the past

Note: Shaded area indicates EIA forecasts.


10-year change in US primary energy consumption, in %

50

40

30

20

10

0

10

60

10-year change

Historical average

1960 1990 20001970 1980 2010 2020 2030


13/40



Geopolitical

instability and

concerns about

supply interrup-

tions, particular-

ly in the Middle

East, have addedto the price pres-

sure and volatil-

ity in oil markets,

which are likely

to persist.

For now, most of the oil-to-natural-gas vehicle con-version activity is taking place among companies and

municipalities that can refuel vehicle eets at a central

location. Still, the cost to convert a garbage truck or

a bus to run on natural gas is high, and the payback

period might run up to seven years at todays prices.

The federal government proposed oering tax credits

for eet vehicle conversion in the Natural Gas Act of

2011, which the Senate has not yet approved.

We expect the trend to cleaner-burning, lower-

cost natural-gas-powered vehicles to continue.

Infrastructure development will bring wideracceptance. In anticipation of a more compre-

hensive refueling network, some car manu-

facturers have begun to roll out vehicles that

run on natural gas. The economics are better

on new cars. While they cost more than their

gasoline-powered counterparts, the dierence

in price, about USD 5,000, is less than it would

cost to retrot an older vehicle.

Looking ahead to the potential oil demand

impact, if 10% of the nations car and truck

eet is converted to run on natural gas, we esti-

mate this could reduce oil consumption by one

million barrels per day (b/d), or 5%, based on

average 2011 US oil demand.

As we wrote in The Decade Aheadin February2011, one of the virtues of electric cars is that

they can tap into a much more diversied fuel

mix, including natural gas, and some are even

able to run on conventional gasoline. It remains

to be seen if the electric vehicles will coexist

with natural-gas-powered cars, or whether one

will win out. In these early days, we expect car

companies to continue rolling out models in

both formats, as each appears to be growing in

acceptance among consumers.

Energy substitution: coal to natural gasUS natural gas use has been growing steadily

in electric power generation (see Fig. 1.14).

This increased demand comes at the expense

of coal, another domestic fuel source (see Fig.

1.15). The drivers of new demand for natural

gas in the utility industry will be a conuence of

economic and political forces.

As prices have declined, natural gas has

become more cost-eective to burn than coal.

Because coal tends to compete with natural

gas as the marginal fuel to produce electric-

ity, run-times at coal plants have declined in

favor of more cost-eective natural-gas-red

generation.

Fig. 1.13: Alternative vehicles a small share of US fleet

Source: Alternative Fuels and Advanced Vehicles Data Center,

Bureau of Transportation Statistics, UBS

Alternatively powered light vehicles by fuel source, in % of total

0.4

0.3

0.2

0.1

0

0.5

Liquefied petroleum gases

Liquefied natural gas

85% ethanol (E85)Compressed natural gas

Electricity

Other

1996 1998 2000 2002 2004 2006 2008 2010


Residential

Industrial

Commercial

Electric power Transportation

6

4

2

0

810

12

200019901980197019601950 2010

Fig. 1.14: Power generation a growing consumer of natural gas

US natural gas consumption by sector, in trillion cubic feet


14/40


Chapter 1

This shi, commonly called coal-to-gas switch-ing, has hurt coal demand in the US, particu-

larly in the Eastern US. Generally, coal-red

plants in the East consume Appalachian

coal, which is more expensive than other

coals. Burning coal for power generation has

become uneconomic versus natural gas at

many plants in the Eastern US. In the Western

US, power generation plants tend to burn

Powder River Basin (PRB) coal, which is lower

quality but less expensive and, as a result,

more competitive with natural gas. Assuming

xed prices (including delivery costs) of USD83 and USD 35 a ton for Appalachian and PRB

coal, respectively, we estimate that gas-red

plants will continue to win market share at

the expense of coal plants when gas prices are

below USD 4.50 per million British thermal unit

(mmbtu), whereas PRB coal-red plants can

remain competitive as long as gas prices stay

above USD 3.00/mmbtu.

In addition to economic signals, changes

to the utility fuel mix are also policy-driven.

Environmental Protection Agency (EPA)

rules, particularly the Mercury and Air Toxics

Standards, will require coal-red power plants

to install costly environmental retrots by

2015. For some older, inefcient plants, the

useful lives and run-times of the facilities will

not be long enough to recover the costs ofthe upgrades, which will force operators to

close roughly 3% to 5% of the existing US

power supply. The gap will likely be lled by

natural gas plants, boosting its share of the

energy mix.

The EPA has also proposed new-construction

performance standards, which aim to limit

carbon-dioxide emissions from new fossil fuel

generators. While it has not been nalized,

and natural gas economics have essentially

achieved it already, the rule eectively preventsany new construction of coal-red plants.

We project coal demand to decline in the US,

albeit at a slower pace than we have seen in

the recent past. With natural gas prices argu-

ably having bottomed, the majority of the

coal-to-gas switching has already occurred.

In the future, the shi will likely be dictated

by environmental mandates and occur more

gradually.

Worldwide, coal will remain an important

energy resource for the foreseeable future, as

it plays a prominent role in meeting demand

for the emerging economies. Despite its envi-

ronmental shortcomings, coal is abundant,

aordable and safe. Therefore, in a supply-

Source: UBS

Natural gas

Coal

Wind Other

Nuclear Hydropower

30

20

10

0

40

50

60

2015

UBS forecast

201020052000 2020

Fig. 1.15: Natural gas to displace coal in power generation

Share of electric power generation capacity by fuel type, in %

Source: World Bank Commodity Price Data (Pink Sheet), UBS

Europe natural gas

US natural gas Japan liquified natural gas

1614

12

0

4

2

10

8

6

18

1980 1990 2000 2010

Fig. 1.16: US has a comparative advantage in natural gas

Natural gas prices, in US dollars per mmbtu


15/40



constrained world, it is a necessary energysource until a viable alternative becomes avail-

able. Natural gas economics outside of North

America are far less attractive, with consumers

in Europe and Asia Pacic paying three to four

times the North American price per unit (see

Fig. 1.16). Coal demand will likely grow world-

wide through the end of this decade, though

growth in demand may be slower than in the

past due to increased use of renewables such

as wind, solar and in some regions, nuclear.

Energy substitution: from fossil fuels torenewables

When it comes to energy independence, the

key advance for renewables will be a type of

biofuel that nally succeeds in displacing crude

oil used in transportation.

Federal policy sets required levels of biofuel

to be blended into the conventional gaso-

line pool. First introduced in the 2005 Energy

Policy Act, the 2007 Energy Independence and

Security Act introduced standards for two cat-

egories of renewable transportation fuels: one

standard for the total volume of renewable

fuels, and a second standard for advanced bio-

fuels, such as cellulosic ethanol. The standard

renewable fuel, ethanol, is primarily used as a

blendstock in the national gasoline pool. It cur-

rently represents approximately 10% of the US

gasoline pool, and is now bumping up against

a blend wall, where car engines must be

altered to run on gasoline with a higher etha-

nol component.

The Environmental Protection Agency (EPA)

currently allows up to 10% ethanol, which will

cap growth in the use of ethanol in the gaso-

line pool. While the EPA has been petitioned

by the ethanol industry to raise the allowable

ethanol level to 15%, which was granted on

a limited basis for use in newer vehicles, many

retailers are unequipped to dispense the higher

blend. Most automobile manufacturers war-

ranties cover use of blends of up to 10%. For

now, we expect limited growth in the use ofstandard renewable fuels within transport.

Researchers continue to hold out hope for a

breakthrough in advanced biofuels production.

These fuels would be derived from sustain-

able feedstocks, such as low-nutrient, high-

yield crops or waste from the agricultural and

forestry industries. However, the technology

remains immature, and advanced biofuels are

not yet commercially viable.

Energy efciency: policies and fuel costs sup-port more efcient transport

According to Energy Information Agency (EIA)

data, US gasoline demand has declined by

over 500,000 b/d from peak 2007 levels (see

Fig. 1.17). Much of this decline is attributable

to a higher level of unemployment, with fewer

people driving to work, and other factors

related to soer economic activity. However,

we believe some of this demand destruction is

also attributable to higher efciency standards

and consumers growing preference for fuel

economy in the face of high and volatile gaso-

line prices.


8

7

6

10

9

2005200019951990 2010

Fig. 1.17: Steady decline in US gasoline demand

US motor gasoline supplies, in million barrels per day

Weaker US

energy demand

growth makes

North American

energy indepen-

dence all the

more possible,

while strong

emerging mar-

ket demand

makes it all the

more necessary.


16/40


alone, if all vehicles on the road were sub-ject to 2016 standards, we estimate the rules

would reduce consumption by approximately

one million b/d, or 5%, based on 2011 US

oil demand. If the proposed rules for future

years go through, the estimated reduction in

oil consumption would rise to over two million

b/d by 2020, or nearly 11%.

All energy sources needed to meet future

demand

As global energy demand continues to grow,

the world will face ongoing energy challenges.Planning for this eventuality is therefore critical.

From a practical perspective, the only viable

way to ensure a secure and sustainable energy

future is to diversify away from what is now a

predominantly nonrenewable, hydrocarbon-

based energy supply pool.10

The US is relatively well-positioned for the

near term, thanks to new supplies of oil and

natural gas. However, now would be the

time for the US to secure its long-term energy

needs by investing in clean, aordable and

sustainable fuels. This is paramount if the US

is to make a more sustainable transition to

true energy security.

Americans love big cars and light trucks. Butwhen fuel prices are high in the US, there

is typically a shi from large, gas-guzzling

vehicles to more fuel-efcient ones. Indeed,

according to data published by The Wall Street

Journalfrom market analysis website, Motor

Intelligence.com, in the year-to-date through

May, sales of large cars in the US are down

89%, while small and midsize car sales have

risen 21% and 17%, respectively, compared

to the same period in 2011. Likewise, sales of

large sport utility vehicles (SUVs) have fallen

by 2%, while small SUV sales are up 29%.However, it remains to be seen if these trends

are permanent.

Federal mandates also support more fuel-

efcient cars and trucks. Corporate Average

Fuel Economy (CAFE) standards are a sales-

weighted average fuel economy, measured

in miles per gallon (mpg), of the passenger

cars or light trucks in a car manufacturers

eet (see Fig. 1.18). Current CAFE standards

require that vehicles meet an average 29.8

mpg in 2012, rising to 34.1 mpg by 2016

(formerly 2020).9 Beyond 2016, proposed

standards would be increasingly stringent, ris-

ing to 38.8 mpg by 2020 and 49.6 by 2025.

These rules will reduce the amount of gasoline

Americans consume. In the 2012-2016 period

Note: Shaded area indicates projections.

Source: International Council on Clean Transportation

California

US

EU

Canada

Japan

Australia

South Korea

China

40

30

20

50

60

70

20202015201020052000 2025

Fig. 1.18: Countries pushing improved automotive efficiency

Miles per gallon for light-duty vehicles, normalized to US CAFE test cycle

Chapter 1


17/40



Broadly, there are two approaches that policy-

makers can use to alter the energy mix: Make alternatives more aordable and

accessible

Discourage demand for conventional fuels

We believe the most eective energy policy is

one that borrows from both approaches, but

it needs to be carefully managed. It is unpro-

ductive and even detrimental to make one

particular resource unaordable if there is no

alternative choice, and vice versa.

Policy to increase the supply of alternativefuels and technologies

Market-driven change is inuenced by price,

which determines demand. For policymak-

ers, the temptation is to subsidize alternatives

so that they are economically competitive

with the prevailing infrastructure. Today, wind

power, solar photovoltaic and electric cars

are all subsidized and none are yet cost-com-

petitive. While the intention is to wean these

businesses o subsidies as technical progress

is made, this is easier said than done. There is

less urgency for businesses and consumers to

improve processes and lower costs so long as

they are protable. Meanwhile, the govern-

ment becomes stuck in a trap, as pulling sub-

sidies prematurely would cause prices to rise,

which would hurt consumers.

Direct government support for research is

another route, leaving it to the business com-

munity to determine how to compete in the

marketplace. However, this requires a high

level of commitment from the government,particularly since funding for these types of

projects can oen come under pressure when

there are budget cutbacks.

Policy to dampen demand for

conventional fuels

As the adage goes, The best source of new

supply is conservation. In this regard, there is

a lot of low-hanging fruit in the US.

One way to reduce energy demand is through

programs that promote energy efciency andconservation, such as the CAFE standards

discussed earlier. Energy-efcient appliances

and light bulbs are now mandated as well.

However, it is curious, especially given that

high energy costs periodically reduce house-

hold discretionary income, that forced

conservation seems to be the only proven

long-term eective way to get most Americans

to conserve.

A far more controversial policy to lower

demand is to impose taxes, fees and mandateson certain fuels. Such is the case, for instance,

with the EPAs coal mandates, which require

expensive upgrades to coal plants to avoid

costly penalties. It was also the idea behind

the recently proposed carbon dioxide cap-

and-trade system, which did not get passed

because of concerns that trading schemes can

be complex, bureaucratic tools for social engi-

neering that may also cause unintended eco-

nomic hardship.

For this reason, some policymakers favor a at

tax. Gasoline and diesel fuel taxes are a type of

at tax. Though not a popular idea, some poli-

cymakers in the US favor a higher gasoline tax

to curb demand and fund alternative research.

In Europe, consumers paid roughly USD 5.87

per gallon for gasoline in 2010, which included

USD 3.80 in taxes, versus the average price

in the US of USD 2.84/gal, which included a

combined state and federal tax of an average

USD 0.45.11 The US federal tax is only USD

0.184/gal and has not been increased since1993. The implications are obvious: US drivers

pay among the lowest taxes for the developed

world and drive cars with low fuel economy,

whereas Europeans drive smaller, more fuel-

efcient cars.

How policy can alter the energy equation


18/40


Energy pursuits: access, technology and

knowhow

The energy industry has steadily evolved

through innovation and ingenuity. Technical

improvements have enhanced environmental

protection, and production has grown more

efcient to optimize available reserves. The

2010 BP disaster was a sober reminder of the

risks and dangers of oil and gas exploration.

However, in the early 1900s, oil gushers, such

as the famous Spindletop well in Texas, were

routine. They coated the countryside with mil-

More energy: an intense challenge

For decades, Americans have taken energy for

granted. This is changing as oil prices remain

well above historical averages, partly reecting

sti competition for supply from developing

economies.

The increase in price is an unwelcome

reminder that oil and gas resources are neither

renewable nor recyclable. For every unit of

oil and gas consumed, another unit must be

found to replace it. Not only are the quantities

already enormous, but the world consumes

more energy year aer year.

The challenges appear greatest in the oil

markets. We have heard the phrase:All the

easy oil has been found. It is true. Oil produc-

ers have had to extract resources from pro-gressively difcult-to-reach places to satisfy

rising demand. This has increased the costs

of extraction which are, in turn, passed on to

consumers. We estimate the marginal cost of

a barrel of crude has risen from USD 22 per

barrel (bbl) 12 years ago to at least USD 80/

bbl today (see Fig. 2.1).

Energy supply: too much is

never enoughRevolutionary extraction techniques will raise US oil and natural gas

production at a time when the world faces structural energy supply

challenges. Higher domestic oil production and greater imports from

Canada can help end Americas dependence on unstable suppliers.

Although America will remain dependent on fossil fuels throughout

the decade, the US will continue to pursue eorts to increase the

availability of renewables in the nations fuel mix.

Nicole Decker, Analyst

Chapter 2

Note: Marginal costs include exploration, development, production, taxes, transportation,general and administrative; and estimated gross up needed for operators to earn a 10% rateof return.

Source: UBS

50

40

30

20

10

0

60

80

70

2000 20022001 2010 2011 2012E2008 20092006 20072004 20052003

Fig. 2.1: Extracting difficulties drive up marginal cost of oil

Estimated marginal cost of worldwide oil production, in US dollars per barrel


19/40


Energy supply: too much is never enough

unied voice on oil industry issues. As the USbecame a net importer of crude oil in the early

1970s, OPEC had gained a dominant position

in world oil markets and an ability to inuence

oil prices (see Fig. 2.3). Sometimes it exercised

its inuence in ways that undermined global

growth. For example, in October 1973, OPEC

initiated an embargo (to protest US and other

Western nations support of Israel during

the Yom Kippur War). In a matter of weeks,

world oil prices tripled. In 1979, the Iranian

Revolution ravaged many of Irans produc-

ing elds. Until 2008, this was the highestlevel ever for oil prices in real terms. Since that

time, the US has sought to reduce its depen-

dence on OPEC oil supplies.

OPEC has moved away from the role of a car-

tel to that of the worlds swing producer.

The organizations self-appointed task is to

alter production through a quota system to

balance world oil supply and demand (see Fig.

2.4). However, the aw in OPECs stated mis-

sion is that it conicts with an economic moti-

vation to optimize the revenues generated by

its resources.

Most OPEC nations have little industry other

than oil, and are dependent upon oil revenues

lions of barrels of oil, wasting natural resourcesand causing long-lasting environmental dam-

age. The invention of the blowout preventer in

the 1920s was an important technical develop-

ment for the industry and remains so today.

Oil exploration now entails sophisticated sub-

surface imaging, elaborate calculations and

highly specialized equipment that help uncover

resources in increasingly remote and precarious

places. Still, the worlds proved oil reserves rep-

resent less than 50 years of supply, based on

current oil demand levels.

Whats more, oil reserves in most of the

Organization of the Petroleum Exporting

Countries (OPEC), as well as some other large

non-OPEC suppliers are o limits to interna-

tional exploration and production companies.

Approximately 70%-80% of current world

reserves are controlled by national oil compa-

nies or sovereign-owned companies (see Fig.

2.2). As a result, a large portion of the worlds

oil supply is tightly controlled by countries

whose interests are not necessarily aligned

with that of energy consumers.

OPEC: supply constraints

OPEC was formed in 1960 to provide a large,

Note: Excludes Canadian oil sands.


Libya3.4%

Nigeria2.7%

Venezuela15.3%

Iran9.9%

Iraq 8.3%Kuwait7.3%

UAE7.1%

Saudi Arabia19.1%

Angola1%

Algeria0.9%

Qatar1.9%

Non-OPEC22.8%

Ecuador0.4%

Fig. 2.2: OPEC holds the lions share of current world reserves

Share of total proven crude oil reserves by country, in %, 2010

Note: Shaded areas represent supply shocks.

Source: BP Statistical Review of World Energy 2011, Energy Information Administration, UBS

Inflation-adjusted crude oil price, in US dollars per barrel (rhs)

Annual change in global oil supply, in million barrels per day (lhs)

0

1

4

3

2

5

43

2

1

6

0

100

80

60

40

20

120

1970 1980 1990 2000 2010

Fig. 2.3: Supply shocks induced oil price spikes

Annual change in global oil supply Inflation-adjusted crude oil price


20/40


where oil and gas have not been previouslyexplored for or produced. These hard-to-reach

places include Arctic regions, deep below salt

layers (subsalt) and oshore in ultra-deepwa-

ter. Just as in the past, we believe this next

generation of exploration could be crucial to

future world supplies. The difculty and high

cost of extracting this oil will likely keep global

oil prices elevated, and this oil will only be

exploited if prices are high.

Oil: ending OPEC imports

Given all the constraints on global oil produc-tion, we think Americas shale oil and gas revo-

lution is truly a game-changing development.

In particular, we think the development of this

energy resource will free the US from reliance

on OPEC crude oil by 2020 and enable the

nation to become a net exporter of natural gas

even sooner. While the decline in oil consump-

tion discussed in Chapter 1 provides the US

with some additional energy security, there are

two supply-related trends that will likely con-

tribute to independence from OPEC:

Rising US oil and natural gas production

Increased oil imports from Canada

Imports of 8.9 million b/d accounted for 59%

of the total crude that the US input into its

reneries in 2011. Of this, Canada and Mexico

to fund social and government programs. Asa result, most OPEC nations and other sover-

eign-run oil companies tend to underinvest

in their own oil industries to preserve their

resources investing only enough to support

production that will satisfy internal govern-

ment funding needs.

Failure to maintain a comfortable cushion in

spare capacity has caused the market to lose

condence that OPEC is able to raise produc-

tion to meet rising global demand. This con-

cern is exacerbated when civil unrest, such asthe uprisings in Libya and Nigeria, and poten-

tial military action, such as in Iran, threaten

to remove millions of barrels of production

and capacity from world markets. With spare

capacity already depleted at 3.1 million barrels

per day, a major event would nearly wipe out

OPECs spare production capacity.

Beyond OPEC: another technological leap

under way

Even the best oilelds can only produce for

so long. Many of the world-scale basins that

have served for decades, such as the North

Sea, are mature, and production is now taper-

ing o (see Fig. 2.5). With limited access to

new resources because of nationalization,

operators are turning to frontier regions

Chapter 2


Brent crude oil price, in US dollars per barrel (rhs)

OPEC crude oil production, in millions of barrels per day (lhs)

33

31

25

27

29

35

37

80

60

0

20

40

100

120

140

20102006200219981994

Fig. 2.4: Oil prices sensitive to OPEC production

OPEC crude oil production Brent crude oil price


3

2

1

0

6

5

4

7

200520001990 199519851980 2010

Norway

UK

Fig. 2.5: North Sea oil production in steady decline

Oil production in Norway and the UK, in thousand barrels per day

Given all the

constraints

on global oil

production, we

think Americas

shale oil andgas revolu-

tion is truly a

game-changing

development.


21/40



as exploration continues in other plays, includ-ing the Permian Basin in Texas, the Monterrey

shale in California and the Denver-Julesburg

Basin in Colorado.

We believe the Gulf of Mexico has been over-

looked as activity was halted by the drilling

moratorium following the tragic Macondo

accident in 2010. Oil production in the Gulf

of Mexico declined by 15% (234,000 b/d)

in 2011. The moratorium has been lied, as

regulators and operators have stepped up

standards to help ensure safer operations. Thepermitting process has resumed, and explora-

tion and development activity is expected to

reach pre-incident levels by the end of 2012.

Production has turned upward in 2012 to date

(see Fig. 2.8). With subsalt exploration in the

Gulf of Mexico only beginning, new supplies

from the Gulf of Mexico could surprise to the

upside, in our view.

Oil imports from Canada. Canada is already

the single-largest source of imported oil for

the US, and over 97% of Canadas exports

ow to the US (see Fig. 2.6), accounting for

nearly one-quarter of total US imports. Canada

has large deposits of heavy crude oil that are

now economically recoverable, thanks to new

technologies. According to the BP Statistical

supplied 3.3 million b/d (see Fig. 2.6).1

OPECsupplied 75% of the crude oil from outside

of North America. Among the OPEC nations,

the US imports the most from Saudi Arabia,

Venezuela and Nigeria. However, supplies from

all three of these countries have been threat-

ened by civil unrest and other geopolitical

issues, highlighting the instability of the US oil

supply base.

US oil production. By the end of this decade,

the Energy Information Administration proj-

ects domestic oil production to rise to 6.7 mil-lion b/d, up 22% from 2010 levels. However,

the EIAs oil production estimates are con-

servative, in our view. Already, only a few

months aer the projections were published,

US oil production is over 6 million b/d, above

the EIAs projections for 2012 (see Fig. 2.7).

Production has risen by over 600,000 b/d in

the last year. We believe that US oil produc-

tion could rise by at least another 2 million

b/d to over 8 million b/d by 2020.

Onshore shale oil accounts for most of the

recent sharp increase in US oil production. We

estimate that production in the Eagle Ford and

in the Bakken alone has risen by over 700,000

b/d in the past three years. We believe shale

production in the US is only in the early stages

Note: Lighter shade denotes imports from OPEC.


0

20

15

10

25

5

Canada

SaudiArabia

Mexico

Venezuela

Nigeria

Iraq

Colombia

Angola

Russia

Brazil

Kuwait

Ecuador

Algeria

Fig. 2.6: Canada is the largest source of US imports

Crude oil imports to the US by country as a share of total imports, in %, 2011


Projected production

Production

4

5

6

3

0

1

2

7

2006 2008 2010 2012 2014 2016 2018 2020

Fig. 2.7: Production exceeds cautious EIA forecasts

US crude oil production and projections, in million barrels per day


22/40


eral approval. This would be a lower proleway to bring incremental crude production

from Canada to the US.

New oil supplies from the US and Canada clear

the path to energy independence in North

America. OPEC oil exports to the US could fall

to zero by 2020 (see Fig. 2.10). There are chal-

lenges, we know; additional hurdles will arise.

But much has already been accomplished,

and only a continuation of the momentum

that has already begun is needed to achieve

independence.3

Natural gas: supply outpaces domestic

demand

Hydraullic fracturing and horizontal drilling

technology (commonly called fracking)

has resulted in such rapid growth in natu-

ral gas production that the US is experienc-

ing a supply glut, forcing natural gas prices

to low levels. (See appendix on page 31 for

a more complete discussion of shale oil and

gas techniques and environmental consider-

ations.) Shale gas production in the US grew

at an annualized rate of 32% between 2000

and 2010 (see Fig. 2.11). Most of the recent

growth comes from the newest and largest of

the US shale gas plays: the Marcellus in the US

Appalachian Basin.

Review of World Energy 2011, Canadas com-bined conventional oil and oil sands reserves

top 175 billion barrels, which places it squarely

in the top ve in the world (see Fig. 2.9). The

Canadian Association of Petroleum Producers

2011 report forecasts oil production in Canada

will rise to 4.2 million b/d by 2020, from 2.8

million b/d in 2010.2

There has been some question as to whether

new supplies from Canada will be sold to

the US. Controversy centers around the envi-

ronmental eects of oil sands production,processing and rening. In addition, ofcials

have delayed construction of the proposed

Keystone XL pipeline, an infrastructure proj-

ect that would transport additional Canadian

crude oil to the US. The project is held up

in a lengthy permitting process on concerns

about the spill risks near drinking water sup-

plies and other environmentally sensitive

areas. Absent US support, some Canadian

producers have begun to look at export

markets accessible from the Canadian West

Coast, though pipelines over the Canadian

Rockies could be difcult. However, there are

a number of smaller pipeline projects that

could connect to preexisting cross-border

infrastructure, which would boost capacity to

transport oil to the US and not require fed-

Chapter 2


0

300

200

100

400

600

500

1980 20001990 2010

Fig. 2.8: Gulf production rebounded despite disasters

Gulf of Mexico crude oil production, in million barrels

Note: Lighter shade denotes OPEC reserves. Canadian reserves include conventional oil andoil sands.


0

250

200

150

300

100

50

SaudiArabia

Venezuela

Canada

Iran

Iraq

Kuwait

UAE

Russia

Libya

Kazakhstan

Nigeria

US

Qatar

China

Brazil

Angola

Algeria

Mexico

Ecuador

Fig. 2.9: Canadian oil sands among top world reserves

Largest proven oil reserves, in billion barrels, 2010


23/40



Coal: marginalized but not going awayThe US holds estimated coal reserves that

would last upwards of 200 years, based

on current demand levels. Coal represents

approximately 20% of the energy consumed

in the US, the third-largest energy resource

behind oil and natural gas. Most of the coal

consumed in the US is used to generate

electricity. As power-generation economics

move in favor of cleaner (at least to burn) and

cheaper natural gas, coal producers are turn-

ing to export markets.

The future of coal in the US goes beyond

aordability and supply. With new competition

from natural gas, the case for coal is aord-

ability of clean supply. A major research eort

is under way to develop clean coal technology,

but thus far, the feasibility of clean coal tech-

nologies remains unproven. Given its prevalent

market share of the US energy resource base,

it will not be possible to eliminate the use of

coal any time soon. However, using less of

it marks an important step toward a cleaner

energy base.

Seeking long-term solutions

A more secure supply of oil and natural gas

is exciting and benecial for the US. And

In the early days of petroleum exploration,natural gas was not considered a useful prod-

uct and was burned o. While the US has

historically been self-sufcient in natural gas,

production had been in a gradual decline

since the mid-1970s, as elds in the Gulf of

Mexico matured. As a result, several terminals

were constructed on the US coasts to receive

imports of liqueed natural gas (LNG) (see box

on page 22). These terminals now essentially

sit idle, and some are in various stages of per-

mitting for conversion to LNG export terminals.

By the EIAs projections, the US will be a netexporter of LNG by 2016.

The EIA estimates technically recoverable shale

gas reserves in the US at 482 trillion cubic feet

(tcf). Total gas reserves in the US would sup-

port current demand for 100 years. US natural

gas production is projected by the EIA to rise

to 25.8 quadrillion Btu by 2020, up 17% from

2010 (see Fig. 2.11). More likely, natural gas

production growth will be dictated by demand

growth and exports for the foreseeable

future. As vast supplies lie in wait, the industry

could accommodate a signicant increase in

demand. Importantly, we believe supplies are

adequate to hold prices well below those seen

in LNG-dependent markets elsewhere.


Rise indomestic

oil production

Increase inCanadian

imports

Offset due togreater

conservation

Fig. 2.10: Independence from OPEC oil

Factors influencing future US crude oil supply, in million barrels per day

10

8

6

4

2

0

OPEC imports

Non OPECimports

Non OPECimports

Fig. 2.11: Shale production poised to accelerate

Note: Shaded area indicates projections.


US natural gas production by resource, in trillion cubic feet

25

20

15

10

5

0

30

Non-associated onshore

Coalbed methane

Non-associated offshoreAssociated with oil

Alaska

Tight gas

1990 2000 2010 2020 2030

Shale gas

OPEC oil

exports to the

US could fall to

zero by 2020.


24/40


ply base will be in an eternal state of evolution.

We say this for three reasons: 1) there is always

a better, more efcient way to use energy; 2)

there will always be a need to increase supply to

accommodate the worlds energy needs; and 3)

we will always nd ways to harness new sources

of energy. As we look at the US, we see that the

evolution has begun. The work must go on, so

that when the time comes, the supply will be

available.

although fossil fuels will likely still compriseover three-quarters of the total US energy

resource base by the end of the decade not

much less than its current share there will be

important shis in the fuel mix toward natural

gas and away from oil and coal.

The US will remain reliant upon hydrocarbon-

based energy until aordable and practical

renewable alternatives are developed. Shale

supplies have granted some time, but without

suitable renewable alternatives, breaking the

fossil fuel habit will be next to impossible.

One non-fossil-fuel-based energy resource

that is viable but unpopular today is nuclear.

Nuclear power is used to generate approxi-

mately 20% of the electricity in the US,

whereas in France it provides closer to 75%.

The administration, once pro-nuclear, has

grown more ambivalent in the wake of the

Fukushima meltdown. However, permits

for construction of four new reactors were

issued earlier this year, the rst approvals since

the partial meltdown at Three Mile Island in

Pennsylvania in 1979. But most utilities have

curbed nuclear plans, due to increased compe-

tition from low natural gas prices, lack of fund-

ing or lackluster demand.

What about other energy alternatives: solar,

wind, tidal, geothermal, biomass and biofuels?

All have their place and all can contribute, but

costs still need to come down. We expect that

the energy resource base of the future will com-prise a wide variety of renewable energies and

technologies. Most likely, the US energy sup-

Chapter 2

What is LNG?

Liqueed natural gas (LNG) is an inno-

vation that allows natural gas to be

more easily transported long distances

by freezing it into a liquid state. A

relatively expensive process, LNG has

become a prevalent source of supply

to markets outside of the US, helping

to explain why natural gas prices are so

much higher internationally than theyare in the US.


25/40


international trade, the US economy consis-

tently generates outsized gains in productivity.

Because of these productivity gains, US labor

compensation has risen by less than many of

its emerging market and advanced economy

peers (see Fig. 3.1).

Increased availability of comparatively cheap

natural gas creates an additional competitive

advantage for the US economy. Secure and

abundant supplies of energy (not to men-

tion another important resource, sustainable

supplies of fresh water) favor the return of

manufacturing, industrial and petrochemi-

Energy as a game changer

The development of domestic oil and gas

reserves holds promise for the US economy

at a time when structural deleveraging head-

winds are tempering enthusiasm about the

long-term economic outlook.

As we wrote in the June 2011 edition of the

UBS research focus entitled, US competitive-

ness: Americas still got talent, the nation

has achieved some of the strongest produc-

tivity gains among developed countries in

recent decades.1 Despite its relatively large

pool of domestic demand and low levels of

Americas energy opportunity

North Americas oil and natural gas revolution represents a boon tothe US economy and underscores our view that America will undergo

a manufacturing renaissance this decade. Oil and gas development

has employment and investment benets, the extraction technology

and fuels have export potential, and companies and consumers have

access to relatively low-cost energy. Importantly, market forces not

energy policy are creating these opportunities.

Kurt Reiman, Head, Thematic Research Wealth Management Research;Nicole Decker; Joseph Kenol; George Lambertson; David Leowitz, CFA; Andrew Sutphin;

Jon Woloshin, CFA,Analysts

Chapter 3

Fig. 3.1: US labor cost competitiveness has improved

Note: Each decade reflects the average of unit labor costs over the period.

Source: Bureau of Labor Statistics

Manufacturing labor costs per unit of output, US dollar index (2002 = 100)

0

40

120

80

160

Canada

US

Germany

France

South Korea Taiwan

Japan Singapore UK

2000s1990s1980s1970s1960s1950s

Fig. 3.2: Hollowing out of manufacturing since World War II

Manufacturing value added as a share of US GDP, in %

10

5

0

35

30

25

20

40

15

45

1940 1950 1960 2000199019801970 20100

5

10

15

20

25

30

1950 1960 1970 1980 1990 2000 2010

Source: Bureau of Labor Statistics, UBS WMR


26/40


energy sources rather than imports is animportant potential antidote to ongoing debt

deleveraging and a sluggish US economy.

At a time when many economic sectors are

either limping along or are in the midst of an

outright decline, employment and investment

in natural resource industries, though small,

could prove benecial to income formation

(see Figs. 3.3 and 3.4). Moreover, indirect

employment gains through associated indus-

tries, such as in petrochemicals, materials,

utilities and autos, could be a multiple of the

direct employment benets.

Americas relatively lower energy costs could

mean more income and prots to reinvest

in research and development, perhaps even

in renewable fuels, which could boost long-

term productivity growth and generate new

technology to propel the next wave of above-

trend economic growth. In addition to secur-

ing natural resources, the country will need to

continue investing in efciency upgrades and

the best available energy technology. Aer

all, advances in productivity and innovation

matter greatly to economic growth over the

long term. In a similar vein, the US will need

to develop untapped resources in a way that

does as little harm to the greater environment

as is possible.

cal activities to the US aer a decades-longexodus (see Fig. 3.2) since these industries are

big energy consumers and would accrue enor-

mous cost savings. Moreover, the extraction

technology is exportable to overseas markets,

as are the fuels.

A June 2012 Q-Series report from UBS

Investment Research concludes that a sustained

relative energy price advantage in the US could

boost intermediate-term US real GDP growth

by around 0.5% per annum.2 According to

UBSs chief US economist, Maury Harris, Therelative decline in natural gas prices on balance,

over the past few years have been dramatic

enough to become a key element in the argu-

ment for a US manufacturing renaissance in

the next half decade and beyond. Moreover, if

there were no osetting stronger dollar eects,

the net eect would be around 0.8% per

annum. Although this additional growth might

not sound like a lot, if it were sustained over

25 years it would add another USD 5.3 trillion

or 40% of 2011 GDP to US economic out-

put relative to a base case of an average 2.5%

growth rate over the decade.

Given the comparative advantage aorded by

vast US natural gas reserves and the potential

for future exports, development of domestic

Fig. 3.3: Small revival in oil and gas investment

Source: Bureau of Economic Analysis, Bureau of Labor Statistics, UBS

Fixed investment, oil and gas extractionvalue added, in %

Mining employment,in %

2.5

2.0

1.5

1.0

0.5

0.0

3.03.5

0.30

0.25

0.20

0.15

0.10

0.05

0.00

0.35

Oil and gas extraction employment as a share of total US employment (rhs)

Fixed investment in mining activities as a share of US GDP (lhs)

Oil and gas extraction value added as a share of US GDP (lhs)

2002199219821972 2012

Source: Federal Reserve, UBS

0

4

2

6

12

10

14

8

2002199219821972 2012

Fig. 3.4: Value added has soared along with prices

Oil and gas extraction value added as a share of industrial production, in %

Chapter 3


27/40


Americas energy opportunity

Natural resource discoveries are not without

potential pitfalls. For example, the export

demand and investment ows that stem from

nding large, previously unrecoverable oil

and natural gas deposits could cause curren-

cies to appreciate, which then disadvantages

the wider non-energy tradables sector of the

economy. Economists refer to this as Dutch

disease,3 the phenomenon in which countries

experience a boom in natural resources, makethem available as exports and then watch their

domestic manufacturing industries decline

under a stronger currency. In our view, the

prospects of Dutch disease infecting the US are

unlikely since the economy is so highly diver-

sied and because exports comprise such a

small share of GDP.

Abundance of domestic energy presents

another risk to long-term US economic growth

since cheap fuel could undermine eorts to

improve energy efciency and clean-tech

innovation. As it stands now, the US already

consumes more energy per unit of GDP and

per person than many developed countries

(see Fig. 3.5). The US also has a low share of

renewable fuels in the overall energy mix (see

Fig. 3.6). Per capita energy use is relatively high

in part because of wide annual temperature

variation and low population densities in North

America.4 However, historically low gasoline

taxes and a prolonged period of cheap

energy also encouraged wasteful behavior,such as a preference for big and inefcient

homes and cars. If energy policy does not con-

tinue to reinforce existing market-driven incen-

tives to upgrade energy efciency and make

advances in renewables technology, access to

inexpensive natural gas could do more harm

than good.

The risks of a resource boom


0

500

400

300

600

100

200

0

10

8

6

12

2

4

Brazil

Turkey

China

Argentina

Israel

Italy

Spain

UK

Germany

France

Japan

Switzerland

Netherlands

Australia

US

Canada

Fig. 3.5: Americans are inefficient users of energy

Primary energy consumption Energy intensity

Primary energy consumption, in million Btu per person (lhs)

Energy intensity, in thousand Btu per 2005 unit of GDP (rhs)

Fig. 3.6: US lags behind in renewables uptake


Renewables share of total fuel mix, in %, 2010

50

40

30

20

10

0

60

70

Canada

Peru

Portugal

Venezuela

Chile

Finland

Ecuador

Spain

Philippines

VietnamU

S

Austria

New

Zealand

Brazil

Sweden

Switzerland

Colombia

Norway


28/40


Chapter 3

ginal cost for the next several years. Naturalgas production in the US is unlikely to grow

as fast as it has in recent years, especially

given demand constraints, but Marcellus shale

operators are advantaged by the plays lower

costs. For oil producers, well-executed growth

could be a key dierentiator. (See our report

dated 18 April 2012 entitled US Oil and Gas

Shale Guide for a list of companies exposed

to this theme).

In the North American oil and gas services

sub-sector, there are concerns that the upturnmay have peaked. However, we believe that

industry leaders will continue to benet over

the long term from robust activity and mar-

gin-enhancing improvements in operating

efciency.

Coal. The long-term outlook for US coal is

mixed, and we are cautious on the industry

for now. If natural gas supplies remain abun-

dant as we believe they will, we expect US coal

demand to gradually decline as environmental

rules that make the use of coal more difcult

take eect. However, demand for coal is robust

outside of the US, driven by steel production

in the developing economies, such as China.

Many US producers, as a consequence, have

turned to the export markets. Producers in the

A wide range of industry benetsIn addition to the boost to the overall US

economy, companies and industry sectors also

stand to benet from the eorts and incen-

tives to make greater use of North American

energy supplies. Energy companies will make

considerable investment in developing new

resource plays, as well as much-needed infra-

structure build-outs and upgrades (see Fig.

3.7). Moreover, the high price of oil both in

absolute terms and relative to natural gas will

likely encourage boosts to energy efciency

and new alternative modes of transportation.What follows is a discussion of how North

American energy independence aects specic

industry sectors. We provide a separate report

that features our views on specic investment

recommendations tied to this theme.

Energy

Oil and gas. We have a positive outlook on

the oil and gas sector and recommend selec-

tive exposure to high-quality operators in

North America. For natural gas producers,

near-term recovery in natural gas prices at

least to breakeven levels would provide sup-

port. Over time, true value creation will come

through superior execution, since we do not

expect prices to rise much beyond the mar-

Source: Baker Hughes, UBS

0

800

600

400

200

1,000

1,400

1,200

1992 1997 201220072002

Fig. 3.7: Horizontal rig count has gone vertical

North American horizontal oil rigs, in thousands

Source: Alerian, Bloomberg, UBS

S&P 500 energy sector total return index

Alerian MLP total return index

1,200

1,000

800

0

600

400

200

1,400

1996 2000 2004 2008 2012

Fig. 3.8: Oil and gas MLPs have significantly outperformed

MLP and energy sector total return indices, index (Jan 1996 = 100)

The develop-

ment of domes-

tic oil and gas

reserves holds

promise for the

US economy at

a time whenstructural

deleveraging

headwinds

are tempering

enthusiasm

about the long-

term economic

outlook.


29/40


Power generation

The emergence of natural gas as a plentiful

energy resource will likely have a signicant

impact on power generation. As an inexpen-

sive, cleaner alternative to coal, natural gas

has become an economically and politically

attractive fuel choice for electricity production,

especially for new power plants. While the

prospects for natural gas are bright, investors

should bear in mind that coal will likely remain

the most widely used fuel in power genera-

tion in the US for at least the next decade,and likely longer. As a plentiful, inexpensive

and cleaner alternative to coal, natural gas

will continue to take share as one of the pri-

mary fuels used in the production of electric-

ity. In spite of the consequent negative impact

on power prices, natural-gas-red merchant

plants will benet as declining prices are oset

by higher utilization.

Because natural-gas-red plants tend to be the

marginal producers of electricity, natural gas

and power prices are highly correlated (see Fig.

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