Perspectives. Turner, Mason & Company LUCKY/UNLUCKY 2013? - YEAR IN REVIEW. U.S. Versus International Players

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1 March 2014 Turner, Mason & Company C O N S U L T I N G E N G I N E E R S LUCKY/UNLUCKY 2013? - YEAR IN REVIEW U.S. Versus International Players We begin our review with a comparison of how the stocks of U.S. energy companies performed in 2013 as compared to their counterparts in the rest of the world. Although not perfect, the metric we chose for these comparisons was stock gain (or loss) in 2013 compared to the previous year. Not surprisingly, and due largely to the Crude Boom, the stock performance of U.S. companies in all sectors outpaced their global rivals by this metric, as shown in Figure 1. The averages shown in Figure 1 were taken from the list of stocks used to comprise two Exchange Traded Funds (ETFs); ishares IYE (U.S. Energy ETF) and AXEN (ex U.S. Energy ETF). While stock performance The past three years have been truly amazing in all industry segments. U.S. oil production outstripped the nation s infrastructure for moving crude oil from production areas, which led to price volatility and spread anomalies that were unprecedented. The proliferation of light, sweet crude production comes as the last (at least for some time to come) wave of heavy, sour crude processing projects are completed. So now, the refining industry looks for ways to (of all things) lighten their crude slates. Stagnating domestic product demand has forced refiners to export more products, which has been facilitated by the increased competitiveness from lower crude and natural gas costs. With inadequate take-away capacity on existing pipelines, the industry relied on rail movements in a big way to move this burgeoning production to refineries capable of processing the new super-light crude oils. This new domestic production is replacing higher-cost, international light and medium crudes tied to Brent with significant ramifications to suppliers from West Africa, the North Sea and elsewhere. In this first issue of 2014, Turner, Mason & Company looks back to see how these major changes have affected the performances of the various segments of the industry during 2013; and, we discuss how some major players in each segment have responded to this new supply paradigm. and financial results should ultimately correlate (over the long term) with company performance, they often don t tell the full story, especially in the short term. There are times that despite poor short-term financial performance, companies are poised for significant change; and the market trades more on expected performance or potential. There are also times when a company stock, in spite of a nice quarter or year, trades lower than one would expect due to concern about the repeatability of that performance. With the rapid transformation taking place, we now examine why the U.S. performed better than the rest of the world in 2013, and what this might portend for the future. Inside this issue: U.S. versus International Players 1 Upstream: A Year of Shale 2 Downstream: Regional Disparities 3 About the Firm 5 Turning Point Blog This weekly blog covers a variety of energy issues. The 2014 Crude and Refined Products Outlook AVAILABLE NOW For more information on the 2014 CRUDE & REFINED PRODUCTS OUTLOOK and other OUTLOOK products contact: Shanda Thomas sthomas@turnermason.com John Mayes jmayes@turnermason.com John Auers jauers@turnermason.com

2 Page 2 Upstream: A Year of Shale During 2013, U.S. production companies continued to refocus capital and other resources for sustained growth based on new found opportunities. This refocusing trend began with the split-off of Marathon Petroleum from Marathon Oil in 2011, Murphy Oil s sale of two refineries that same year, and the ConocoPhillips split into separate upstream and downstream companies in In 2013, BP completed the sale of its Texas City and Carson refineries, and Hess Corporation moved to sell off all downstream assets and become a pure play upstream company. Two other prominent trends continued in 2013: (1) a shift toward increased presence in onshore North American tight oil production, and (2) increased focus on liquids rich gas plays in view of the decoupling of gas and oil prices. Oil from the Permian, Eagle Ford and Bakken areas was responsible for the lion s share of production growth, as shown in Figure 2. While deepwater offshore plays can cost billions, allowing only the largest companies to compete, on-shore, tight oil wells cost orders of magnitude less and enable smaller independents to not only compete, but thrive. Unlike offshore exploration and production programs, the shale revolution has included many smaller independent producers. Although there are dozens of these independents spread across shale plays in the U.S., we have chosen to focus on one producer from each of the three largest plays in the U.S. crude oil production boom to illustrate this refocusing and the impact it is having on their individual companies and America s oil renaissance. The Permian Basin has been a significant contributor to domestic crude oil production since the early 1900s. The production decline from this mature area that began in the 1970s continued until fracking and enhanced oil recovery techniques reversed that trend in the last few years. Pioneer Natural Resources (PXD) sold its Barnett Shale and Alaskan assets in 2013 and continued its aggressive pursuit of opportunities in the Permian s Spraberry and Wolfcamp plays. Pioneer s 2013 production from the Permian accounted for slightly less than half of their total production, which was over 160 MBOEPD. Pioneer has touted the Permian as the second largest proved reserves in the world. As shown in Figure 3, Pioneer s Permian production has more than doubled since 2009; and, they plan to double production again by Their ramp-up of drilling rigs from 5 at the end of 2013 to 16 by the end of Q is an aggressive step toward meeting that goal. The Williston Basin, home of the Bakken, was discovered in Production has taken off since 2008, and Continental Resources (CLR) has been one of the leaders in this significant contributor to the tight oil boom. Continental reported 49.6 MMBOE produced in up 39% over As shown in Figure 3, two-thirds of their total production came from the Bakken; and, they plan a 17% increase in 2014, most of which will come from the Bakken. Continental's focus on efficiency and optimizing well design has paid off. Reporting a decline of 13% in cost per well in 2013, Continental projects an additional 6% decline in 2014 driving average well costs down from $9.2 million in 2012 to a target of $7.5 million this year. The Eagle Ford was on few radar screens until a few short years ago when production began to take off, and has continued to outpace even the most bullish estimates. EOG Resources (EOG, formerly Enron Oil and Gas, splitting off in 1999 before Enron s infamous 2001 bankruptcy) is the largest producer in the play. EOG has made significant and consistent production gains with 40% year-over-year growth in crude oil production in They are also a player in the Bakken and are working to transform their developments (Continued on page 3)

3 Page 3 Upstream: A Year of Shale (continued) (Continued from page 2) there to a high-return growth play. As shown in Figure 3, EOG s production in the Eagle Ford has grown from about 10 MBOEPD in 2009 to 175 MBOEPD in This represents over 80% of EOG s total production. Production in 2014 is projected to grow another 27%. The capital markets apparently believe the production growth of these companies is sustainable, as gauged by the year-over-year increase in their share prices (see Figure 4) in Pioneer, who posted a net loss for the year due to a $1.5 billion write-down on discontinued operations, still had the largest year-over-year gain of over 70%. EOG and Continental realized gains of 40% and over 50%, respectively. Even the much larger ConocoPhillips had a 27% year-over-year stock price increase in It is important to point out that investors reward growth and for larger, more mature companies like ConocoPhillips, growth potential is more limited. Not everyone has enjoyed success in these growth areas, however. BP has evaluated options for spinning off its shale assets into a new business to compete with the smaller, more nimble independent producers. Shell has taken it a step farther, backing out of its shale project in Colorado and selling its Eagle Ford shale in Texas. Shell took a $2.1 billion write-down in U.S. shale in Downstream: Regional Disparities The refocusing was not just an upstream phenomenon. The Crude Boom has presented significant new opportunities to U.S. refiners as well. Lower cost crude oil and natural gas has enhanced the relative competitiveness of domestic companies compared to many of their international counterparts. The ability to export refined products has kept utilization rates high. Figure 5 illustrates regional U.S. margin opportunities that existed in 2013 compared to major refining centers in NW Europe, Italy and Singapore, as determined by our proprietary modeling system. Due to their advantaged acquisition costs, Mid- Continent (MC) refiners processing WCS crude benefitted the most with margins above variable costs topping $32 per barrel on average during the year. Additionally, MC refiners running Permian Basin (WTI) and Bakken crudes did very well. With the boom in light crude production leading to a relatively low, heavy-crude discount in 2013, USGC cracking refineries running Bakken, Eagle Ford and LLS had better net margin opportunities than coking refineries running Maya, by our models. USAC refiners running Bakken did significantly better than those still running West African sweets; and even West Coast refiners, running ANS, had significantly larger margin opportunities than European and Far East refineries dependent on waterborne international crudes. The U.S. downstream has seen a growth of independent refiners in the past several years as smaller companies merged, independents picked up assets from majors looking to divest, and majors spun off some refining assets into separate entities. The refocusing included expansion in light crude processing investment as well. In November, Western Refining (WNR) announced their acquisition of the (Continued on page 4)

4 Page 4 Downstream: Regional Disparities (continued) (Continued from page 3) controlling stake in Northern Tier, giving them a presence in the upper Midwest with access to both Bakken and Canadian crude. Light oil expansion projects at Valero and Marathon, Calumet s Great Falls expansion and their Dakota Prairie refinery groundbreaking are other examples of refiners attempts to capitalize on the tight oil boom. The ability of individual companies to capitalize on the margin opportunities from price-advantaged crudes depends on quick acting, creative supply personnel and stable plant operations. Figure 6 shows net income and our calculation of earnings per barrel-day capacity for a select group of independent refiners. As illustrated in Figure 5, inland refineries such as those owned by Western Refining and HollyFrontier (HFC) had an advantage over the Gulf, the East, and especially the West Coast refiners. HollyFrontier and Western Refining were advantaged due to their locations. Western Refining s locations in El Paso and Gallup, NM, provide them with advantaged access to both growing Permian Basin and Rocky Mountain region crude production. Holly- Frontier s refineries in Artesia, Cheyenne, El Dorado and Tulsa place them within reach of inexpensive Bakken, Niobrara, Permian and Canadian crudes. HollyFrontier s refinery in Woods Cross, UT, has access to crudes coming out of the Uinta. Phillips 66 (PSX), the only refiner with a presence in all PADDs, reported 94% advantaged crude utilization in their U.S. refineries up from 67% in They reported a strong profit of $3.7 billion, down only 10% from 2012, and are cur- rently working a rail project in their Ferndale, WA refinery to get access to Bakken. By leveraging these advantaged crudes in high percentages throughout their circuit, they have been able to earn high margins despite their geographic diversity. While stock gains generally correlated with income per barrel of capacity, HFC s healthy stock gain of 14% was the lowest of our group. VLO, MPC, TSO, PSX and WNR each had year-over-year stock price gains between 35 and 65%! Marathon (MPC) completed the acquisition of Galveston Bay (BP Texas City), increasing their total refining capacity 30%, and placing over 60% of their total capacity on the Gulf Coast. Marathon positioned themselves to take advantage of increased product exports with export expansion projects at their Garyville and Galveston Bay refineries. Valero (VLO), with significant capacity on the Gulf and West Coasts, was buoyed by nearly $500 million in profit on their ethanol business in 2013 due to the run up in RIN prices. These dynamics, which led to particularly strong Q4 margins, helped to push their stock higher. Going forward, Marathon and Valero are leading the way in adding to their light crude capacity with a focus on being able to process the very light condensates coming from the Utica and Eagle Ford fields located in close proximity to their refineries. Tesoro (TSO), focused primarily on the West Coast, has been working aggressively to improve its crude cost positions. The West Coast has the biggest logistical challenges to gain access to the price-advantaged tight oil crudes. While that is slowly changing with the rail projects being pushed on the West Coast, there is significant opposition to such facilities. However, both Tesoro and BP have begun the process of moving crude by rail to their West Coast refineries, and Tesoro is working a rail-to-barge JV with Savage in the Port of Vancouver, WA, to supply its California refineries. Valero is actively pursuing a rail terminal at their Benicia, CA refinery as well, but is facing local opposition. Both Tesoro and Holly- Frontier are investing in their Salt Lake City refineries to take advantage of locally available (and difficult to process and transport) Uinta Basin crude. In addition to inexpensive domestic crude, cheap natural gas has helped U.S. refineries by making them more competitive and putting increasing pressure on the European Continent. It is not just the refining sector that has flourished. This is a boon for all U.S. manufacturing, especially petrochemicals. The U.S. now competes with the Middle East in having some of the lowest natural gas prices in the world. With energy costs a fraction of what they are internationally (gas costs as much as 4x higher in Asia, and 2.5x in Europe), domestic petrochemical and refining margins are stronger and have led to rising refinery utilization and increased product exports. This abundant and inexpensive natural gas has attracted Sasol to invest billions in a GTL facility in Louisiana, and for Methanex to relocate two methanol plants from Chile to Louisiana. European majors Shell, Repsol and Total, all reported disappointing 2013 refining results on low margins. With BP s sale of their Texas City and Carson refineries, their U.S. downstream footprint was reduced significantly, although they remain an important player and completed the multi-billion heavy crude expansion at their Whiting, IN plant at the end of the year. The renewables business saved the European independent Neste Oil from otherwise lackluster refining earnings. The story in Asia Pacific was similar with both Caltex and Thai Oil experiencing lower margins. The economic recovery has led to fluctuations which have hurt those who are forced to trade in currencies that have grown weaker to the U.S. dollar, the de facto standard in the global oil markets.

5 Page 5 About The Firm Since 1971, TM&C has provided a broad range of engineering, management and other professional services related to the petroleum industry. Clientele include major, independent and national oil companies, engineering and technology companies, service providers, financial institutions, law firms, government agencies, entrepreneurs and other professionals worldwide. Recent representative engagements include: Release of TM&C s 2014 CRUDE AND REFINED PRODUCTS OUTLOOK for worldwide subscribers; An assessment of the various challenges and bottlenecks, plus a system-wide rebalancing of North American crude oil production from major new light oil production areas through the distribution network and finally through the refining system in the NORTH AMERICAN CRUDE & CONDENSATE OUTLOOK; Studies related to the implications of various possible U.S. crude export policies; Due diligence related to domestic and international renewable fuel producers; Economic and Supply Impacts of a Reduced Cap on Gasoline Sulfur Content prepared for the American Petroleum Institute; Industry-wide study of potential refinery effects and capital requirements for second phase of Tier 3 gasoline regulations; Independent assessments of regional refining developments and forecasts of demand and product movements from other regions to evaluate the prospects for a major pipeline project; Expert consultation in ad valorem tax disputes related to U.S. refineries; Feasibility study for a prospective gas-to-liquids project on the U.S. Gulf Coast; Several engagements related to Bakken quality, pricing and refining economics; Valuation of a large terminal and pipeline network on behalf of a prospective buyer; Independent valuations of the U.S. refining assets for both, integrated oil company clients and financial institutions; and Project management for refinery expansion projects. Turner, Mason & Company consultants have an average of over 25 years experience and most are licensed, professional engineers. Several have advanced degrees in chemical engineering or MBAs. Major contributors to this issue of John Auers was promoted to Executive Vice President effective January 1, John has distinguished himself both within the firm and throughout the industry with his extensive analyses of industry drivers and developments as the leader of our various Outlook publications and the many consulting engagements that come from these activities. His weekly Turning Point blog is read by oil industry professionals around the world. The 2014 Crude Outlook Available September 2014 Rebalances Crude Supply & Demand Worldwide Based on New North American Production Platts Daily Yields combine TM&C Refining Models and Platts Price Assessments to provide crude oil value assessments Ryan Couture joined TM&C as a Senior Consultant in September He comes to us from ExxonMobil. He graduated from the University of Connecticut with a BS in Chemical Engineering (2008) and worked in the downstream division of ExxonMobil. He is experienced in process engineering, wastewater treating, catalyst selection and project/turnaround support. Since joining TM&C, Ryan has become a member of the Outlook Team and contributes to multi-client publications and forecasts, including Outlook and Turning Point publications. Mike Leger is President of TM&C and has led firm activities since He graduated from Louisiana State University in 1971 with BSChE degree. He was formerly with Texaco, Cities Services Company and CITGO Petroleum, Mike also served as President/CEO of a small independent U.S. refining company. Turner, Mason & Company CONSULTING ENGINEERS 2100 Ross Avenue Suite 2920, L.B. 38 Dallas, Texas Phone: Fax: Chairman: President: Malcolm M. Turner, P.E. Michael W. Leger, P.E.