The New Energy Landscape:
How to Navigate the New Normal
Cory Epstein
Commodity Risk Management
Bank of America Merrill Lynch
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Bank of America Merrill Lynch Commodities
Table of Contents
1) Introduction
2) The New Energy Landscape

Crude Oil

US Natural Gas
3) How To Navigate the New Normal

The Case for Hedging Natural Gas

Hedging Strategy
4) Appendix
Bank of America Merrill Lynch Commodities
Introduction
 Commodities prices, more than any other product class, have experienced material volatility over the last
several years. The graph below illustrates relative price performance since Jan09. Notice how 3M LIBOR,
DJIA, and the Dollar Index (DXY) have been relatively stable compared to a sampling of commodities prices.
 Not only have absolute commodities price levels risen, but volatility has as well.
 Volatility across crude oil and natural gas is creating new winners and losers across industries, and even
within certain sectors of the economy.
 How are oil and gas producers responding to
the new price environment?
 What are oil and gas consumers doing to take
advantage of the new price environment?
 While the new energy environment has
created financial losses and other issues for
many companies, it has also created unique
opportunities for those that can understand,
weather, and anticipate the new normal.
350%
Relative Price Performance Since Jan09
300%
250%
200%
150%
100%
50%
0%
-50%
-100%
DJIA
Source: Merrill Lynch Commodities, Inc. Proprietary.
LIBOR
DXY
Cotton
Copper
WTI
Nat Gas
The New Energy Landscape:
Crude Oil
The New Energy Landscape
Crude Oil – How Did We Get Here?
 Oil markets have seen a precipitous decline over the past
few months as global supply has surged on US shale
production and the return of Libyan exports while demand
has waned and perceived geopolitical threats have not
materialized. The biggest declines came after the OPEC
meeting in late November in which the cartel decided not
to cut production as it has done historically in times of
oversupply as individual members fight for market share.
WTI Historical Prices
$140
$120
$100
$80
$60
 The staggering crude oil inventory build in the US – 109
million bbl over 18 weeks – has finally started to slow
down as demand from refiners has picked up seasonally.
Global inventories are still building, but the rate of builds
has started to soften. This factor, combined with
expectations of tighter global oil balances in the longterm, has led to a rally in global crude oil prices since midMarch.
 Weekly rig count statistics, reported by Baker Hughes is
perhaps the single most important lead indicator of where
US oil output goes next. This count has decreased by over
806 since December, a dramatic decline. However,
production is still growing and wells are becoming more
efficient.
1
Source: Merrill Lynch Commodities, Inc. Proprietary (upper), Bank of America Merrill Lynch Research (lower).
$40
Historical Price
Mean - 1 St.Dev
Mean
Mean +1 St.Dev
The New Energy Landscape
Crude Oil – What Can We Expect Going Forward?
 The run-up in prices conceals a stubbornly weak
underlying fundamental balance – Initially, the oil market
surplus was reflected in large increases in crude
inventories, placing downward pressure on crude oil
prices. Now, we can expect to see petroleum products
building as refineries ramp up after maintenance.
 Due to continuing weakness in the fundamental balance,
the BAML Research team sees potential for a double-dip in
prices by the end of 3Q15. The Research team anticipates
a dip in WTI to $50/bbl as refinery maintenance kicks in
again in September before recovering to $57/bbl by yearend.
 We see WTI prices for 2016 capped on increased hedging
activity in North America and maintain our 2016 WTI
crude oil price forecast of $57.
 Many large E&Ps have mentioned delaying rig completions
as the strong contango incentives delays, especially with
cost declines coming in / expected from service areas as
many contracts expire and producers move to spot pricing
(materially lower). With shale value being predominantly
skewed to the first few years of production, management
teams are acknowledging the benefit of deferring wells.
WTI Forward Curves
$100
$90
$80
$70
$60
$50
$40
9 mo ago
2
Source: Bank of America Merrill Lynch Research (upper), Merrill Lynch Commodities, Inc. Proprietary (lower).
6 mo ago
3 mo ago
Recent
The New Energy Landscape:
US Natural Gas
The New Energy Landscape
Natural Gas – How Did We Get Here?
 The US natural gas market has had a phenomenal
turnaround over the past year. In the winter of 2014, a
polar vortex created a yawning inventory gap which
boosted prices above $6/MMBtu. This winter has seen an
inventory glut which has pushed prices below
$2.50/MMBtu.
 Prices are now at levels last seen in 2012 and could see
further weakness going into the summer given high
output, particularly in the Northeast. BAML Research has a
2015 average forecast of $2.85/MMBtu.
 However, the longer term outlook for US natural gas
production is decidedly negative. Associated gas supply in
places like the Eagle Ford is expected to fall as producers
cut capex. Northeast production will decline into year end
in response to the 50% drop in NGL prices. By the end of
2015, the combination falling production and strong
demand growth will likely eliminate the slack in gas
balances. This rebalancing could set the market up for a
meaningful price recovery and we expect prices to average
$3.90/MMBtu in 2016.
3
Source: Merrill Lynch Commodities, Inc. Proprietary (upper), Energy Information Administration (lower).
NYMEX Natural Gas Historical Prices
The New Energy Landscape
Natural Gas – What Can We Expect Going Forward?
(2008-2012) Supply driven bear market
 Large shifts in natural gas supply curve driven by new shale gas supplies
 Limited structural demand growth
 Production growth (~2.4 BCF/D per annum) much greater than structural demand growth (~0.5 BCF/D p.a.)
 Increasing amounts of price-induced fuel switching and declining imports needed to balance the market
(2013-2014) Balanced S&D (Range bound, with volatility)
 YOY supply growth ramps in 2014 with infrastructure build-out and increasing drilling efficiencies
 Structural demand growth emerges; decreasing amounts of price-induced fuel switching needed to balance the
market
 Power burn becomes increasingly elastic in reaction to near term forwards and cash price fluctuations; this is a
temporary phenomenon as incremental coal retirements will reduce switching flexibility
 Short-term, demand induced price spike seen Winter 2013-2014; 30 year winter created large storage hole
placing floor under summer 2014 prices; reveals inelasticity of demand during extreme weather periods
(2015-2018) Rapid Structural Demand Growth
 Unprecedented structural demand growth driven by:
4

New industrial demand (2-3 BCF/D)

Coal plant retirements and conversions to natural gas (2-6 BCF/D)

Transportation fuel demand (1 BCF/D)

LNG exports (2-6 BCF/D)

Pipeline exports to Mexico (3-5 BCF/D)
 Based on current drilling economics, supply should be able to keep pace with demand during this time period at
prices similar to forward curve. However, as winter 13-14 revealed, any increase in inelastic demand decreases
switching ability and creates for higher volatility and price level
The New Energy Landscape
Natural Gas – Increased Demand Drives Higher Prices
 Huge growth in production has not led to huge growth in
inventories.
 LNG export capacity will increase dramatically in coming
years.
 $100+ billion of capital investment in gas-burning facilities
have been announced.
 We expect industrial demand to increase by ~0.5
Bcfd per year for at least the next five years as these
projects are completed.
 New infrastructure and increased Mexican gas demand
will increase exports to Mexico
 Coal retirements will create incremental demand for
natural gas and reduce elasticity of demand
 Electric generation coal capacity has been reduced
in recent years and this trend is expected to
continue over the next few years. Relatively low
natural gas prices and EPA rules such as Mercury
and Air Toxics Standards (MATS) are spurring coal
plant retirements.
 Coal to gas switching Has helped balance the
natural gas market in recent years But going
forward, coal retirements will likely reduce the
market’s ability to balance supply and demand.
5
Source: Energy Information Administration (upper and lower).
The New Energy Landscape
Natural Gas – Wind Generation Hedges Have Flattened the Curve
 Due to positive economics for new wind generation, supported by the Production Tax Credit
(“PTC”) which expired at the end
of 2014, Texas has experienced a large number of filings for development of new wind farms.
 Due to a lack of liquidity in the back of the power curve, BofAML believes that many of the buyers of wind generation are
hedging via gas sales to offset a portion of the risk for their purchased power. This has resulted in pressure on the back of the
gas curve, significantly flattening the curve over the past 2 years.
 A typical wind hedge spans ~10 to ~12 years , beginning in 2015-2017 and represents ~35% of the nameplate capacity.
 Once this hedging pressure is removed, demand side fundamentals should bid the curve in order to elicit a production
response.
6
Source: Bloomberg.
How to Navigate the New Normal:
The Case for Hedging Natural Gas
How to Navigate the New Normal
The Case for Hedging Natural Gas
 The volatility in prices has been staggering. Individual
price spikes can be severe, and financial risk management
provides a means of insulating your business from this sort
of volatility.
 The current environment is very compelling for natural gas
consumers. Many clients are initiating hedging programs
with their first ever trades or adding layers to existing
hedge portfolios. We are also seeing interest in longdated hedges from our clients who consume material
amounts of gas. This activity isn’t confined to just a single
sector. Utilities, municipalities, energy distributers,
chemical companies, fertilizer manufacturers, ethanol
producers, and others who know natural gas very well are
seeing value in the current pricing.
 So, why look at hedging gas now?
Aren’t we the “Saudi
Arabia” of gas with all of our shale production? Yes, our
production has definitely ramped up. In fact, between
2008 and 2012, production grew about 2.5 bcf/day per
annum while demand only grew about 0.5. This is one
reason why prices fell so much; natural gas companies’
exploration and drilling programs outpaced a sluggish US
economy. However, we are finding at least as many new
ways to consume natural gas as we are to produce it. Also,
last winter, the coldest in 30 years, reminded us that no
matter how much gas we produce, we can only store so
much. The fact is that demand growth, combined with
LNG export potential, is catching up with supply.
7
Source: Merrill Lynch Commodities, Inc. Proprietary (upper), Bank of America Merrill Lynch Research (lower).
NYMEX Natural Gas Historical Prices
How to Navigate the New Normal:
Hedging Strategy
How to Navigate the New Normal
Hedging Strategy – Winning or Losing?
 If you are looking at hedging as winning or losing, you are missing the point.
Hedges are not bets. They are
valuable budgeting and forecasting tools. A hedge defines a price, lending certainty where there is none.
 Assume you hedge 50% of your consumption at $3.00
 If the floating price rises to $6.00, you are happy that your hedge is in the money and will gain you
$3.00
that month. Your average cost is $4.50.
 If the price falls to $0.00, you are upset that your hedge is out of the money and will cost you $3.00 that
month. Your average cost is $1.50.
 The point to take away from this is that, whatever happens in the market, you have hedged 50% of your
consumption at $3.00.
8
How to Navigate the New Normal
Hedging Strategy – How Much Do You Hedge?
 In considering how much to hedge, many begin at 50% fixed /50% floating and adjust up or down according to
additional risks or risk mitigants they find in their business.





Leverage – Higher leverage implies greater sensitivity to costs and less margin for error.
Ability to pass on prices – The less you can pass prices fluctuations through, the more you need risk
management.
Budget performance – Past budget surprises may make protection against similar occurrences more
important.
Margins – Thin margins mean less room for price movement.
Price Outlook – What is your outlook for prices? Are you appropriately positioned?
?
100%
Floating
Price
9
RISK CONTINUUM
100%
Fixed
Price
Appendix
Merrill Lynch Commodities, Inc.
BAML Research Forecasts
Forecasts as of May 28, 2015
10
Source: Bank of America Merrill Lynch Research.
Bank of America Merrill Lynch Commodities
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