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Energy: Navigating Through Another Cycle Transition

Energy: Navigating Through Another Cycle Transition. Table of Contents. Cycle Comparisons Page 4 Commodity Analysis Page 10 E&P Spend & Rig Counts Page 28 Sub-Sector Industry Structures Page 37 Equity Investor Perspectives Page 47 Disclosures Page 51.

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Energy: Navigating Through Another Cycle Transition

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  1. Energy: Navigating Through Another Cycle Transition

  2. Table of Contents • Cycle Comparisons Page 4 • Commodity Analysis Page 10 • E&P Spend & Rig Counts Page 28 • Sub-Sector Industry Structures Page 37 • Equity Investor Perspectives Page 47 • Disclosures Page 51

  3. Cycle Comparisons

  4. Oil, Interest Rate, Recession and Energy Stocks (’70-’09)

  5. Global GDP and Crude Oil Demand Source: IEA; IMF; National Bureau of Economic Research

  6. Comparing Cycles: 1974-1975 Oil Prices, Demand & Global GDP Oil demand declined 1.8% between ’74-’75 OPEC spare capacity rose to 4.1mn in 1975 (7% of demand) from 2.5mn b/d in 1974 (4% of demand) Global GDP declined <1% in ’74 & ’75 Oil prices rose from $3/bbl in ’73 to over $10/bbl in ’74-’75 Source: Bloomberg 7

  7. Comparing Cycles: 1980-1986 Oil Prices, Demand & Global GDP Oil demand declined 10% from ’80-’83 Oil prices dropped 72% from ‘81 high to ‘86 low OPEC spare capacity rose to 13.9mn in 1983 (24% of demand) from 3.3mn b/d in 1979 (5% of demand) Global GDP growth averaged +2.0% Source: Bloomberg 8

  8. Comparing Cycles: 1990-1993 Oil Prices, Demand & Global GDP Oil demand increased < 1%/yr between ’90-’93. Oil prices dropped 66% from ‘90 high to ‘94 low. OPEC spare capacity rose to 3.5mn b/d in 1993 (5% of demand) from 1.8mn b/d in 1991 (3% of demand). Global GDP growth over this period averaged +2%. Source: Bloomberg 9

  9. Commodity Analysis

  10. Crude Oil Outlook – Fundamental Recovery in Progress Thesis: • Fundamental recovery in progress. • Oil price bias to the upside. Trends: Global oil demand infers 3.5% GDP growth in 2010. • China leads • US Recovery OPEC supply rises on previous expansion projects. Non-OPEC supply marginally higher. • Russia, West Africa, Brazil offsets Mexico. OPEC spare capacity inches lower. Source: IEA; RBC Capital Markets Estimates

  11. NYMEX Front Month and 12 Month Strip Prices • Spreads blew out late 2008/2009 during credit crisis and economic turmoil. • Spreads have since normalized with market still in slight contango. Source: Bloomberg

  12. Non-OPEC Production Note: Excludes Angola numbers in 2004-2006 for the purposes of comparability. Source: RBC Capital Markets estimates, IEA • We expect Non-OPEC production to be up 0.1% in 2010. The biggest contributors to production growth should be Brazil, FSU, and Asia, which should be offset by declines from Mexico, Africa and Europe • We expect Non-OPEC production to be up 0.5% in 2011. The biggest contributors to production growth should be Brazil, Russia and Asia, which should be offset by declines from Europe and Mexico

  13. OPEC Production Cuts: Listen to the Saudis • Oil prices rallied within 12 months following 11 of the 14 cuts since 1998. • Compliance and cheating are misnomers. • OPEC has followed through on every cut since 1999. • OPEC target quotas are not specific output goals. • Actual production levels match market needs. • OPEC acts logically when share is safe. Source: The IEA and RBC Capital Markets Estimates

  14. Iraq – Back to the Future Iraq Production Where to from here? • Current Production: 2.5 mmbbl/d • Plateau Production of almost 11 mmbbl/d • Industry expectation somewhere in the middle Recent Project Awards Signal Progress • Industry getting more optimistic about the opportunity. • However, stable legal system needed before major investment with be made. Source: International Energy Agency.

  15. China Demand – Structural Trends are Powerful 2009 • Overtakes Germany as World's Biggest Exporter. • Tops US as largest Auto Market. 2010 Est +6-20%. 2010 • Expected to displace Japan as 2nd largest economy. 2030 • On pace to become largest global economy. Source: Energy Directions, Inc, BP Statistical Review, CIA Factbook, Noble Corp., and RBC Capital Markets

  16. China Net Crude Oil Imports / WTI vs. U.S. Trade Weighted Dollar China Net Crude Oil Imports • China’s voracious appetite for crude oil continues Source: Bloomberg WTI vs. U.S. Trade Weighted Dollar • The relationship between WTI and the U.S. Dollar is clear • WTI price outlook factors in for the dollar depreciation in 2010 and 2011 Source: Bloomberg. Trade-weighted average foreign exchange rate includes Australia, Canada, Japan, Sweden, Switzerland, United Kingdom and EURO 11 countries. Base year - 1973

  17. US Gasoline Expenditure Ratio: Best Predictor of Crude Oil Demand History shows 3.5%+ expenditure ratio is trigger point for drop in demand. • 1979-1983 corresponds to 4-yr drop in crude oil demand. • 2008 leads corresponds to 2009 decline in oil demand. Info can be tracked monthly. • Current ratio at $2.81 gal is 3.0% of disposable income. • Peaked in July ’08 at 4.7% when gasoline was $4.16/gal. More timely than the widely used “miles driven” statistic.

  18. Crude Oil: OECD Days of Demand Source: The IEA

  19. Crude Oil: DOE Inventories Source: EIA

  20. The Crude Oil – FX Relationship: Something Radically Changed in ’07 What happened? • Exponential growth in commodity funds. • Increased use of oil by Global Macro and Multi-Strat funds. • Introduction of ETFs. • Use of commodities as an asset class by various institutional investors i.e. pension funds et al. • Weaker dollar makes oil cheaper/spurs demand for emerging growth countries. Source: Bloomberg and RBC Capital Markets

  21. Speculative Interest In Crude Oil • Speculators control about 43% of the open interest in NYMEX crude futures, which has trended down since mid-2008. We estimate that speculators control well over 50% of the trading volume and think the numbers are higher on the unregulated OTC market. • There is currently a net long futures position of 168,000 contracts, which is up 75% from year-ago levels. • NYMEX daily dollar volume now accounts for roughly 38% of world oil trading versus about 20% in previous years. Source: Bloomberg

  22. US Natural Gas Outlook 2010: $5.50/Mcf, downside bias • Record LNG imports. • Production growth by mid-2010. • Demand: Electric generation and Industrial usage. Longer Term • Marginal cost = $5.50-$7.50/Mcf. • LNG imports raise risk profile. • Independents: 3%+/yr growth over next decade. • Private operators struggle to maintain production. • Shale has changed the game. • Majors are now making a play. Source: RBC Capital Markets Estimates, Department of Energy, NOAA, Waterborne LNG Report, Baker Hughes, and Bloomberg

  23. NYMEX Front Month and 12 Month Strip • Spreads widened during global arctic blast late ’09 early ’10. • 12 month strip more relevant than spot in predicting E&P spend and future drilling activity. Source: Bloomberg

  24. Natural Gas Storage • Its not where inventories are but where they will be • Record peak of ~3.8 TCF of natural gas in storage was reached in late 2009 • We expect 2010 to trend above the five year range, but below 2009 levels • Increases in natural gas demand are a key to bringing natural gas storage to normalized levels as U.S. natural gas production remains resilient • The EIA is planning on making downward revisions to its U.S. natural-gas production data

  25. Industrial Natural Gas Usage • Industrial natural gas consumption is closely linked to GDP and commodity prices • >50% of industrial natural gas is consumed by the chemicals, petroleum and metals industries. • An economic recovery is the key to rebuilding industrial gas usage and tightening the current supply/demand imbalance

  26. LNG Outlook • Global LNG production starting a sharp ramp. • Europe likely to diversify supply due to continued issues with Russia. China, India and parts of South America could become vast new markets. • Diversification of industries in LNG countries could keep gas locally. Source: Waterborne, BP Statistical Review, the DOE, and RBC Capital Markets

  27. E&P Spend and Rig Counts

  28. 2010 US E&P Spending Outlook Risks • Scrutiny over hydraulic fracture stimulation • Will producers show capital discipline? • Natural gas prices • Rise in service costs • 50% of US projects uneconomic at $4/Mcf Trends • Access to credit • Hedging • Leaseholds • Solid balance sheets • Focus is on shales where scale provides growth opportunities • Emergence and continued development of oil/liquids-rich horizontal resource plays

  29. Hedging & Commodity Price Sensitivity • The 39 E&P companies covered by RBC account for approximately 40% of all US land rigs. • On average, this universe has hedged 45% of its 2010 natural gas exposure at a price of $6.50/mmbtu and 40% of its crude exposure at $81/bbl. • We identified another 278 rigs operated by majors or large independents that we believe are hedged in a similar fashion. • Including these additional rigs, we estimate that 40% of all US land rigs are not hedged and are at risk to short-term volatility in spot prices. Source: RBC Capital Markets Estimates (Scott Hanold and Chad Potter) and Company Documents

  30. Economic Threshold of the Natural Gas Shales Source: RBC Capital Markets Estimates, Company Reports

  31. US Land Rigs: Rig Count Progression/Mix Source: BHI, Land Rig Newsletter and RBC Capital Markets Estimates

  32. Natural Gas Rig Count Driven by Shale Plays • Horizontal rig count comprises half of the active US land rig fleet, driven by activity in shale plays. • Natural gas rigs will make up the majority of the rigs added in 2010. • Our forecast calls for an additional ~200 natural gas and ~80 oil rigs being added by the end of this year. • Gas rig count is 949, down 41% from the September 2008 peak. • Oil rig count is 502 rigs or 14% above the previous peak in November 2008. Source: BHI

  33. US Shale Activity Source: Land Rig Newsletter and RBC Capital Markets Estimates

  34. Canada • Capacity constraints widespread in 1Q10 for frac services, wait lists the norm and a backlog of well completions being built. • Pressure pumpers are leading the pricing power rebound (spot prices +20% in 1Q10) and margin expansion is accelerating. Source: BHI, CAODC, Nickle’s, EIA and RBC Capital Markets Estimates

  35. International Rig Count Source: BHI, Land Rig Newsletter and RBC Capital Markets Estimates

  36. Sub-Sector Industry Structures

  37. Consumable Service Industry Structure Source: Spears & Associates

  38. Time to Pricing Power We believe that consumables will be among the first to achieve pricing power. In our view, the major inflection point should be a 2011 event, but the industry appears to be on the cusp of pricing power with tightness in certain products/basins. Pressure pumping continues to lead the way, followed by land rigs. 1H10 2H10 2011 1 2 3 4 Now Evolving • Wireline • SLB, BHI, HAL Source: RBC Capital Markets

  39. Pressure Pumping: Industry Structure • Wells in shale plays are benefitting from increasing frac stages per well, driving demand for pressure pumping. • Pressure pumping in shale basins like the Marcellus is more horsepower intensive than in conventional plays. • HAL has #1 market share in North America. Source: Spears & Associates

  40. Land Drillers: US Land Fleet Composition • Tier 1 – Most efficient rigs that can drill in unconventional plays (e.g. AC-driven rigs). • Tier 2 – Can drill same wells as Tier 1 but less efficient (e.g. SCRs). • Tier 3 – Cannot compete with Tier 1 or possibly Tier 2 without upgrades and/or offering significantly lower dayrates (e.g. mechanical rigs). Source: Company documents, RigData and RBC Capital Markets Estimates

  41. Offshore Drillers: Industry Structure

  42. Offshore Drillers: Floater Rates Rolling Over Source: Source: RigLogix; RBC Capital Markets

  43. Offshore Drillers: Jackup Rates Stabilized Source: Source: RigLogix; RBC Capital Markets

  44. Sub Sea Market: Best Secular Growth • In our view, the subsea equipment market has the best secular growth rate (25-30%/yr) of any oilfield service sector. Recent deepwater discoveries support this view. • Subsea orders in 2010 could approach $5bn with subsea revenue ~ $3.0bn. This would translate into YE 2010 backlog of ~$4bn. • We estimate that there are ~10 systems projects with a value > $150mn that could hit this year. Timing is always a risk, but channel checks suggest oil and gas companies are ready to forge ahead. Subsea Market Share Source: Quest Offshore Resources, ODS Petrodata, FTI and RBC Capital Markets Note: Tree unit market share 2007-1H09

  45. Marine Seismic: Industry Structure • International markets grew to 83% of total market from 76%, driven by NOCs and IOCs targeting primarily oil. • Technical advances are bringing new activity. • Increasing demand for seabed seismic data acquisition(Transition Zone, Ocean Bottom Cable and 4D).

  46. Equity Investor Perspectives

  47. Oil Services Sector Perspective Positioned to outpace most energy sub groups Evolving Trends: • Pricing power starting to emerge in various product/service lines. • International markets: 3Q09 marked the low. Uptrend underway. • Service intensity increase driven by unconventional drilling in NAM. • Deepwater infrastructure market poised to show strong secular growth. • NAM land drilling outpacing expectations. Investors leery about nat gas. • Seismic data library first. Marine contract a late 2010/2011 story. Maintain exposure to natural gas and oil-intensive plays We like Services • Higher complexity drilling and completion. • More horizontal wells, multi-stage fracs. • Pricing power evolving. EPS momentum next. We like Deepwater Infrastructure • Best growth rate (25-30%/yr) of any oil service sub-sector. We are warming up to Jackups • Excess capacity gradually being absorbed. We would side-step Deepwater Drillers • Overall pricing band still trending moderately lower. • 5000’ rig demand lackluster.

  48. Oil Services Drivers and Performance at a Glance Source: Wonda Source: RBC Capital Markets Estimates

  49. Stocks Move Prior To Fundamentals…Here’s 2008 – Current • Sentiment as measured by the OSX led: • Crude oil by 2 weeks (upper right). • US land rig count by 28 weeks (lower right). • EPS revisions by about 70 weeks (below). Source: Thomson One and Bloomberg

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