Energy Predictions 2010

FOREWORD Welcome To The 2010 Energy Predictions Report. This is the first year in which the Deloitte Touche Tohmatsu Global Energy & Resources group has published its predictions for the year ahead.

The volatility of the global economy in 2008 and 2009 and the anticipated challenges ahead for 2010 have made this set of predictions particularly important to compose.

Some have questioned whether predictions are feasible amid such turbulence. How accurate can they be, given the uncertain outlook and many of the unprecedented conditions being experienced today?

Anticipating the course of the next 12 months is likely to be hard. But, in my view, that makes having a considered perspective more crucial than ever.

Predictions, by their nature, are not facts. But properly developed predictions should encompass a diverse array of views and inputs, which can kindle debate, inform possible directions, and even identify potential courses of actions.

The methodology for developing this set of predictions involved in-depth interviews with clients, industry analysts and the most senior energy practitioners from Deloitte member firms. I am most grateful to all of them who offered up their insights and experience at a time when their attention was particularly in demand.

2010 is likely to challenge all of us. But while the energy sector is expected to be impacted by challenging conditions in the year ahead, it should be remembered how important a role energy plays and how its use affects each and every person on the planet.

In short, while global growth may be cyclical, the need for energy is and will remain constant.

I wish you all the best for 2010.

Peter Bommel Global Industry Leader Energy & Resources

A GLOBAL ECONOMIC TURNAROUND WILL BEGIN TO TAKE SHAPE BUT WHAT SHAPE WILL IT TAKE? During the fourth quarter of 2008 and the first quarter of 2009, industrialized economies were contracting at a rate not seen since the Great Depression. Unemployment was rising, corporate profits were decreasing, and consumers were continuing to suffer. Then, policymakers around the world, who had previously been on the sidelines, implemented their economic recovery plans.

Based on several pieces of new evidence, it appears likely that a turnaround – albeit a tepid one – is beginning to take shape in the seven largest OECD nations and several emerging ones. According to forecasts made by the Economist Intelligence Unit, OECD countries are expected to grow on average by 1.5 percent in 2010: more specifically, by 1.2 percent in Canada, .07 percent in France, .05 percent in Germany, 2.7 percent in Italy and the U.S., 2.3 percent in the U.K., and 1.3 percent in Japan.1

The outlook for emerging nations such as China and India is more encouraging. China remains one of the fastest growing economies in the world, even though by Chinese standards, the country is in the doldrums. Economic growth for 2009 is expected to be in the neighborhood of seven percent, down from double-digits in the past,2 but is poised to grow by 8.5 percent in 2010.3 In India too, the fog is lifting. Through much of the early part of 2009, there was a palpable gloom in a country that had previously seen growth above nine percent. Part of the grimness came from the realization that India was not immune to the global economic slowdown. But here too, there is good news. The economy is forecast to grow by 6.3 percent in 2010.4

Bottom Line

A global economic recovery is beginning to take shape, but the question now on the minds of global policymakers and business leaders is: What shape will it take – a "V," a "U," or a "W"?

In a V-shaped recession, the economy suffers a brief but pointed period of economic decline with a clearly defined trough, followed by a strong recovery. A U-shaped recession lasts longer and has a less-clearly defined low point. GDP may shrink for several quarters and slowly return to growth.

What some economists are predicting now is a W-shaped, or "double dip" recession.5 In this scenario, overall economic growth experiences a modest upturn but the economy remains weak in certain segments. Meanwhile, consumers and businesses begin to get squeezed by increasing costs. These conditions lead to another painful trough before a strong recovery appears. This prediction is based on several factors, including the massive influx of stimulus money by governments and the rise in prices of oil, energy, and food. Escalating prices for these key commodities can, in some cases, lead to inflation, further restraining economic growth.

Oil & gas companies, in particular, will have a keen interest in which type of recession and subsequent recovery prevails. In a V-shaped recession, the recovery is strong and more pronounced, thus forcing a quick run-up in oil prices. A U-shaped recovery lasts longer, but eventually promises robust economic growth and increased demand for energy. Oil prices rise as a result; however, if they rise too much, the increase can strain the availability of equipment and labor in the oilfield services sector, further driving up exploration costs. A W-shaped recovery could also result in rising commodity prices, but with more variability and ongoing risk for oil & gas companies struggling to improve cash flow.

A key unknown is the ability of energy measures such as renewables to help drive the shape of the recovery. According to the Carbon Trust, countries could potentially profit by taking a bold new approach to commercialization of renewable energy: making investments through greater technology prioritization and to move away from technology neutrality. It has been predicted that the UK could generate up to £70 billion (US$111.6 billion) for the economy and create almost 250,000 jobs in offshore wind and wave power alone.6 Offshore wind and wave could provide at least 15% of the total carbon savings required to meet their 2050 targets.7

No matter what shape the recovery takes, it is becoming more apparent that "easy does it" should be the watchword: The global economy cannot withstand another extreme rise in oil prices without severely impacting economic growth.

IT'S ACQUIRE OR BE ACQUIRED FOR MANY AS M&A REBOUNDS The 2008 oil price crash and ensuing market volatility left many energy companies in a fog of uncertainty. With limited visibility into the direction of future markets and a worldwide contraction in investment capital, many chose – or in more dire instances, were forced – to conserve cash, cut expenses, and attempt to weather the storm. M&A activity dropped precipitously, declining between 50-85 percent from pre-recession levels, depending upon the region and the specific industry sector.8

Even those with deep pockets have been reluctant to do M&A or they have found there is a limit to what can be accomplished. For example, many of the oil supermajors have been holding on to their cash and/or opting to pay dividends to their shareholders in lieu of pursuing M&A deals. Meanwhile, those that have forged ahead have been impeded by market conditions and a lack of desirable targets. Anglo American rejected a no-premium offer from Xstrata in the mining sector,9 and major players in the European power sector have been constrained by the fact that all of the mid- and lower-tier firms have already been purchased.

With a dearth of suitable acquisition targets, the appetite for M&A between the very biggest firms is likely to remain limited moving into 2010. Many other types of companies, however, may find the conditions favorable for a rebound. The recent oil-price recovery is already putting upward pressure on deal-making activity among independent oil companies, with the number of asset-level transactions steadily increasing. Emerging signs of improving capital markets also point to the likelihood of an upturn in overall energy M&A by mid- 2010, with the possibility of a complete recovery to pre-recession levels by 2011.

While a broad recovery in M&A activity is anticipated, it is likely to play out differently by sector:

Oil & Gas: Independent and junior oil & gas companies have struggled in recent months due to their higher sensitivity to oil prices and tax regime changes. After the oil price collapse of 2008, many leapt into survival mode, implementing enterprise cost management programs, focusing on efficiency and revisiting their planning capabilities. Those that succeeded in freeing up cash are now poised to implement M&A strategies designed to enhance their reserve portfolios while those that remain cash strapped, which is still the vast majority, are likely to be M&A targets.

Mining Companies: During 2009, mining M&A has been led by the junior or mid-level players, which have to consolidate if they want to stay alive and not be swallowed up by the bigger firms. Indeed, many anticipate that the mining sector will continue to consolidate until there are a handful of supermajor firms like there are in oil & gas. Large mining companies will increasingly need to buy rivals and subsequently sell off assets to gain synergies if they are to compete with state-owned companies, particularly those from China. These conditions mirror those encountered by large oil companies a decade ago, when massive consolidation swept the industry in response to the rise of national oil companies (NOCs) such as Saudi Aramco, Gazprom, Petrobras, and others.

Power & Utility: While suitable targets will remain a constraint in some areas of the world, M&A in the power and utility sector will likely trend upward. Mergers and acquisitions are expected to increasingly become a strategic part of companies' plans as they respond to deregulated market opportunities and an improving capital market environment. In some cases, mergers may be necessary to raise capital for necessary improvements and new construction of additional transmission and distribution facilities. Government support, particularly in the U.S., for critical infrastructure improvements and renewable...