Kansas Independent Oil & Gas Association 800 SW Jackson Street - Suite 1400 Topeka, Kansas 66612-1216 785-232-7772 Fax 785-232-0917 www.kioga.org

State of the Oil & Gas Industry Dynamic Challenges Facing Kansas Oil & Natural Gas Industry Edward P. Cross, P.G., M.B.A. President Kansas Independent Oil & Gas Association January 2017

The drastic drop in crude oil prices in 2015 and continuing into 2016 have had a significant impact on the small businesses that make up the Kansas oil and natural gas industry. The Kansas Independent Oil & Gas Association (KIOGA) represents thousands of independent oil and natural gas explorers and producers, as well as the service and supply industries that are significantly affected by the low price environment. In Kansas, small independent producers account for 92% of the oil and 63% of the natural gas produced. The oil and natural gas industry is an important part of the livelihoods of Kansans throughout the state – folks who are significantly affected by the low crude oil price environment. Nationally, independent producers drill about 90% of American oil and natural gas wells; produce about 54% of American oil, and more than 85% of American natural gas. With over 4,200 members, KIOGA is the lead state and national advocate for the Kansas oil and natural gas industry. What Happened to Crude Oil Markets Crude oil prices dropped by more than 60% from mid-2014 through 2016. Several drivers contributed to the fall. The first driver is oversupply. In response to a dramatic increase in U.S. oil production over the last several years, the Organization of Petroleum Exporting Countries (OPEC) decided in November 2014 to dump low-cost oil into the global markets in an effort to drive down the price of oil and punish U.S. oil producers. Another significant driver is the strength of the U.S. dollar. Because the price elasticity of crude oil is low, real dollar serves

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to decrease crude oil prices. Some analyses suggest the strong U.S. dollar was responsible for about 16% of the fall in crude oil prices in 2015 and 2016. The most significant factor contributing to the severe drop in crude oil prices in 2015 and 2016 was the shock that OPEC created in the oil markets through their actions to regain market share at any cost. The only mechanism to stabilize oil prices is the market itself based on supply and demand. While world oil demand remains inelastic, world oil supply is becoming increasingly inelastic. This condition could make world oil prices very volatile. Going forward, we appear to have a crude oil market pricing system with a very fast response time and very slow feedback mechanism (supply adjustments). A steady contraction in production by U.S. producers and a corresponding slide in crude oil inventories fueled modest price rebounds in late 2016. Then on November 30, 2016, OPEC met and agreed to remove 1.2 million barrels of oil per day from global oil production. On December 10, 2016, OPEC members met with several non-OPEC nations including Russia, Mexico, Oman, Azerbaijan, and Kazakhstan. Non-OPEC nations agreed to production cuts totaling 558,000 barrels per day. Saudi oil minister Khalid Al-Falih said during the meeting that it was an absolute certainty that Saudi Arabia will cut production below its OPEC quota in January 2017. World crude oil prices rose by more than 5% on the news. An important note is that Saudi oil drilling activity is up indicating that they fully intend to maintain sufficient spare capacity to crash prices should OPEC and/or non-OPEC quota discipline deteriorate. While OPEC’s deal to curb output may help erode global crude oil supply and lift prices, Chinese imports remain key for a sustained recovery. China is the biggest crude oil buyer in Asia and second largest global consumer after the U.S. Chinese imports grew by 11% to 14% in 2016. However, some analysts see Chinese tax issues and crude oil stockpile challenges reducing the growth in Chinese crude oil imports to 5% to 9% in 2017. Crude Oil Market Structure The crude oil market is a global oligopolistic market mostly influenced by the OPEC cartel. The OPEC cartel is made up of 14 oil producing nations. The OPEC cartel control about 1/3 of the world’s oil supplies and collude to control global crude oil prices. Kansas oil and gas producers, like all oil and gas producers in the U.S., are perfect competitors in an oligopolistic market. That is to say, we are price takers, not price makers. Kansas oil and gas producers have no control of crude oil prices, but can only manage their internal costs. For Kansas oil and gas producers, optimizing internal operating efficiencies is paramount in order to hedge against volatile crude oil price swings.

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IHS recently completed a study on upstream drilling and production activity. The IHS study found that upstream costs in 2016 for onshore plays were 25% to 30% below their 2012 levels, when per-well costs were at their highest point the past decade, and 16% to 20% lower than the average of the past five years. Although some drilling costs have increased, the resulting performance benefit per well more than offsets those increases, leading to an overall decrease in cost per BOE produced. The unit cost concept does not, however, factor in the market value of oil and gas produced from these wells, which is important for calculating net present value of profit or loss. More efficient fracturing and service providers, and decreased drilling times have all contributed to cost savings. Since oil prices started falling in mid-2014, reduced demand for drilling services has also enabled operators to renegotiate contracts with service providers, resulting in lower costs for drilling and well completions. Sales of oilfield services in Kansas and across the nation are down over 60% from 2014. The less efficient and most highly leveraged providers of those services have or will eventually leave the market. If demand for those services started to rise as oil price improves, the price of those services would rise with it. The oil and natural gas industry is displaying a lot more discipline in 2016 after learning some tough lessons from the experience of the last couple of years. However, the oil and natural gas industry has a history of destroying capital as commodity prices improve. Moderate growth of oil production in the U.S. might best serve the industry by reducing the risk of a repeat of 2015. The oil and natural gas industry is near the point where the U.S. starts to reverse the decline in production. The gains will be modest but the growth rate should improve throughout 2017. If crude oil prices rise above $60 the rate of growth in U.S. production could once again pose a threat to OPEC’s market share. Crude oil prices received by Kansas oil and gas producers are a result of several factors. The New York Mercantile Exchange (NYMEX) price is set daily by an open auction. The price is based on global supply/demand factors. West Texas Intermediate (WTI) is the benchmark price for crude oil produced in the U.S. WTI crude oil produces more gasoline per barrel of oil than any other crude oil, not only in the U.S., but in comparison to almost any other crude oil produced in the world. WTI prices today are about even with NYMEX prices. Kansas Common crude oil contains more contaminants and produces less gasoline per barrel than WTI and, as a result, is priced about $10-$11 lower than WTI.

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Figure 1 Figure 1 illustrates how OPEC is able to manipulate that crude oil market to control crude oil prices. When supply (S) is raised from S2 to S1, price (P) decreases from P2 to P1.

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Figure 2 Figure 2 illustrates the microeconomic impact of OPEC manipulation of the broader crude oil market. The D/S equilibrium point of the market becomes a demand/marginal revenue (D,MR) curve for the oil and gas firm. The D,MR curve combined with output determines revenue. Individual firms must keep their average total cost (ATC) at a minimum to optimize financial performance. Marginal cost (MC) is the incremental cost of one more unit of output (e.g., the cost to produce one more barrel of crude oil). Financial performance for the firm is optimized at the production level where MC = D,MR.

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Figure 3 Figure 3 illustrates how the oligopolistic market structure requires the perfect competitor players to optimize their operating efficiencies in order to minimize losses or maximize profits. When market supply is increased from S1 to S2, the price falls and the D,MR decreases from D1,MR1 to D2,MR2. The perfect competitor firm’s average total cost (ATC) and marginal cost (MC) remains the same. The result is a macroeconomic decrease in crude oil prices with microeconomic loss in profits or even losses for individual perfect competitor firms.

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Figure 4 Figure 4 illustrates the potential effect on world crude oil prices from world oil supply becoming increasingly inelastic.

Impact of Crude Oil Price Collapse Crude oil prices dropped by more than 60% since 2014. As a result, Kansas lost over $730 million in oil and gas output since 2014. This aligns with the roughly $1 billion cut in capital expenditures (capex) in Kansas over the same period. To understand this better, let’s look at capital expenditures (capex) which are Funds used by companies to maintain or increase the scope of their operations. This kind of spending is very good for an economy. It builds infrastructure, it creates jobs, and is an investment in the future. Companies make these investments because they believe they will get a good return on those investments. Unfortunately, when the price of oil crashes those investments become unprofitable and capex gets cut ($69.2 billion cut nationwide in 2015 and $89.6 billion cut in 2016). Kansas crude oil prices dropped below $20 per barrel in early 2016 as a global glut of production drastically dropped prices. The drop in crude oil prices triggered over 100 oil and gas producer bankruptcies across the nation since the beginning of 2015 that involve over $34.3 billion in cumulative secured and unsecured debt. This is having a profound impact on the oil and gas service sector where we are seeing large job cuts ~ 240,000 direct industry layoffs and about 1 million indirect industry layoffs nationwide. Many oil and gas companies in Kansas and elsewhere cut capex by 75%-80% in 2016. Kansas oil and gas companies invested about $300 million in 2016, down from $1.3 billion invested in 2014. Kansas oil and gas companies have invested over $1 billion annually in 8 of

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the last 11 years. Companies have deferred well completions and many high-cost marginal wells are being temporarily shut-in. As a result, royalty payments to Kansas oil and gas royalty owners dropped by about $400 million in 2016. In Kansas, much like the rest of the nation, some oil and gas service companies have layed off as much as 55%-60% of their workforce and reduced wages by as much as 20%-25% and some producers have layed off as much as 20%-25% of their workforce. As a result, family income has dropped by about $341 million across Kansas. Direct oil and gas employment loss in Kansas since 2014 is over 3,100. When you add in indirect jobs, employment losses in the Kansas oil and gas industry jumps to over 6,100. The oil and gas industry agonizes over losing their workforce. Tough choices have to be made. Oil production in Kansas fell by 8.1% in 2015 and by 14.25% in 2016. Oil production decline generally lags oil price collapse as producers work to maintain production and improve operating efficiencies. Many oil and gas producers across Kansas and elsewhere are working to optimize supply chain relationships, improve operational efficiencies, reduce and refocus capex, and examine acquisition and divestiture opportunities. Operators are high-grading and drilling only the best prospects. In many cases, improved productivity is less about improved technology and more about better application of existing technology.

Figure 5A Figure 5A illustrates the trend in Kansas oil and natural gas production over the last 10 years.

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As a result of low oil prices, tax collections to the State of Kansas and Kansas counties have also declined dramatically. Oil and gas severance tax collections by the State of Kansas declined by 40% in 2016 and have declined by nearly 75% since 2014. Property tax collections by counties declined by 41% in 2016 and have declined by nearly 69% since 2014.

Figure 5B Figure 5B illustrates the impact of falling oil prices on oil and gas severance tax collections and property tax collections in Kansas.

Figure 5C Figure 5C illustrates oil and gas activity in Kansas from 2014-2016. The industry experienced a 76% drop in drilling rig count and an 83% drop in drilling permits issued in the 2014-2016 period.

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The ripple effects are everywhere. If you think about the role of oil in your life, it is not only the primary source of many of our fuels, but is also critical to our lubricants, chemicals, pharmaceutical, plastics, and many other items. If you think about the law, accounting, and engineering firms that serve the industry, the pipe, drilling equipment, and other manufactured goods that it requires, and the large payrolls and their effects on consumer spending, you will begin to get a picture of the enormity of the oil and gas industry. And these are good paying jobs that comfortably support middle class families. The longer oil prices remain low, the oil and gas industry will continue to constrict. In turn, considering the economic impact of the oil and gas industry, that would be detrimental for the economy as a whole. Clearly, lower oil prices do not compensate for the loss of capex and rising unemployment in the U.S. and Kansas economy. The crude oil market has exited the “survival phase” and is now in the “inflection phase”, in which producers restructure and sell assets. Some companies and private equity firms are waiting to scoop up assets. Some public traded companies have taken on huge debt to keep wells pumping to generate cash for interest payments. Opportunistic buyers are waiting for bankruptcies so that debt is wiped out and oil and gas fields can be acquired at a steep discount. Some buyers are waiting for signs of an improving oil market to acquire oil and gas properties at steep discounts. Recently, buyer activity has increased tremendously. The buyer/seller value gap is closing. Several oil and gas companies are looking at the lower 10%15% of their portfolio to see if some efficiencies can be created by divesting and then redeploying capital into better assets. The production rollover has happened sooner than many anticipated. Many analysts underestimated how quickly oil production would fall when industry capex is drastically cut. Production decline rates accelerate when capital is taken away. Low oil prices have accelerated production declines and a faster-than-expected rebalancing of supply and demand is occurring. Despite forecasts of a tighter oil market in 2017 due to declining U.S. production and planned OPEC and non-OPEC output cuts, oil prices experienced downward pressure in December 2016 in wake of a rise in U.S. interest rates. In December 2016, the U.S. dollar neared a 14-year high against a basket of other currencies after the U.S. Federal Reserve raised rates and hinted rates could rise more quickly than anticipated in 2017. Crude oil prices fell by 1.2% on the news. However, many market analysts suggest the strong U.S. dollar does not change the underlying oil market fundamentals. The U.S. dollar was up about 2% in December 2016 while U.S. oil production was down about 2%.

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What are companies doing? For the second consecutive year, oil companies worldwide produced more oil and natural gas than they added to their proved reserves. This is not necessarily an indication of fewer available resources, but rather that at current prices, there are fewer resources that can be turned into proved reserves. In 2016, capital expenditures in the oil and gas industry declined 35% from 2015, suggesting continued reductions in exploration and development investment. The reserves replacement ratio, the ratio of proved reserves added during a given year to production for that year, indicates the extent to which a company is replacing its produced reserves. Generally, companies had a reserves replacement ratio of approximately 100% in 2012 and 2013, and around 75% for 2014, 2015, and 2016. However, many small onshore oil and gas producers added more reserves than they produced in 2016. Many companies are refocusing capex and strategizing their way out of this downturn. These companies are optimizing operating cost structures to achieve more efficiency gains and becoming more specialized regarding their core producing assets. Many Kansas producers are focusing on the most resilient short-cycle projects and concentrating on their core competencies and smaller producer advantages. Many Kansas producers are high-grading and drilling only the best prospects. In many cases, improved productivity is less about improved technology and more about better application of existing technology. Expenditures for exploration and development constitute most of a company’s upstream capital investment. When calculated on a reserve addition per barrel basis, these expenditures represent the cost of finding and developing a barrel of oil. Studies have indicated finding and development costs declined by $10.23 per barrel since 2014. Other Key Challenges In addition to low oil prices, the oil and gas industry continues to address many challenges. Despite the strategic importance of oil and gas production to the U.S. economy and even its national security, the Obama administration’s energy policy was to overregulate, pick winners and losers in the marketplace, and make American energy increasingly expensive and uncompetitive. President Trump’s administration has an opportunity to reset the harmful energy policies of the last administration. From 2000-2012, the oil and natural gas industry spent more on low and zero carbon technologies than the federal government and nearly as much as all other industries combined. According to the EPA, oil and gas methane emissions account for only 3.63% of total U.S. greenhouse gas emissions. Methane emissions from the oil and gas sector declined by 3.8% last year, marking the 4th consecutive year of decline.

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Yet EPA continues to pursue new regulations that impose unnecessary barriers to development with very little concomitant benefit. Studies have shown that proposed EPA methane rules would reduce global warming by 4 one-thousandths of one degree (0.004) by the year 2100. The fact is our nation’s 21st century oil and gas renaissance has made domestically produced oil and gas economical and abundant. This market-driven success has helped our nation to achieve significant emission reductions. The oil and gas industry played a significant role in reducing U.S. greenhouse gas emissions by over 20% over the last decade. U.S. carbon emissions are now near 27-year lows. The men and women of the oil and gas industry reject the stale mindset of last century’s thinking peddled by some that oil and gas production and environmental stewardship are not compatible.

Figure 6 Figure 6 illustrates the significant decline in U.S. greenhouse gas emissions over the last decade.

When looking at energy policy it is important to know that our nation has left behind decades of energy scarcity and has become a worldwide leader in energy production. With the right energy policy, we can now move forward and build upon our nation’s new era of energy abundance, self-determination, and global energy leadership. We need tax reform solutions that don’t compromise our ability to grow the economy and create jobs. We need regulatory reforms that don’t add unnecessary layers of compliance burdens on top of existing protections. We encourage everyone to listen to the facts when it comes to energy policy discussions and focus on what’s important: American jobs, American energy security, and American global energy leadership.

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Going Forward Low crude oil prices are not the long-term story or trend. The price of crude oil will recover in the future and the oil producing characteristics of Kansas uniquely positions the State for a bright energy future. What powers the U.S. today? In recent years, market forces have spurred massive amounts of new energy production. Oil and natural gas production in the U.S. has increased 10 times more than wind and solar production between 2012 and 2015, even as wind and solar energy producers received billions of dollars in subsidies. After nearly eight years of President Obama, the most pro-clean energy president in American history and one who handed out billions of taxpayer dollars to green tech companies, the slice of the electricity market powered by renewables has increased from 4% to slightly-less than 7%. That’s a lot of time and money for very little progress.

Figure 7 Figure 7 illustrates U.S. energy consumption by source. Oil and natural gas supply 65% of U.S. energy consumption today. Add in coal, and fossil fuels supply 81% of U.S. energy consumption today.

What will power the U.S. in the future? The Information Administration (EIA) estimates that 25 years from now fossil fuels will account for 80% of our country’s energy consumption. According to the EIA, even under the best-case scenario for alternative fuel use, fossil fuels still account for 78% of our energy needs. The International Energy Agency (IEA) projects that by 2040, world energy demand will increase by 45% and nearly 60% of that demand will be supplied by oil and natural gas. Oil is expected to remain the number one source through 2040 followed by natural gas and coal. Solar, wind, and biofuels are expected to grow briskly and

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could approach 4% of global energy demand by 2040. Most wind and solar installations are not cost-effective on the open market, necessitating subsidies. As long as subsidies exist, taxpayers have to support industries that are not economically viable on their own. Funding underperforming assets often comes at the cost of starving productive assets.

Figure 8 Figure 8 illustrates U.S. energy consumption by source through 2040. Oil and natural gas are projected to supply 62% of U.S. energy consumption in 2040. Add in coal, and fossil fuels are projected to supply 80% of U.S. energy consumption in 2040.

By producing the most abundant, affordable, reliable energy in the world, the oil and gas industry makes every other industry more productive. And it makes every individual more productive giving them an opportunity to pursue happiness that previous generations never dreamed of. The oil and gas industry makes our environment far safer and creates new resources out of raw materials. The energy we get from oil and natural gas is particularly valuable for protecting ourselves from the climate. The climate is inherently dangerous and is always changing, whether we influence the change or not. In the last 80 years as CO2 emissions have risen from an atmospheric concentration of 0.03% to 0.04%, climate related deaths have declined by 98%. Clearly, oil and gas make the planet dramatically safer.

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Oil and natural gas have also made the planet dramatically richer in resources. Until the Industrial Revolution, there were almost no energy resources. Oil and natural gas are not naturally resources. Those who first discovered how to convert oil and natural gas into energy weren’t depleting a resource, they were creating a resource. The world is a better place for it. Life is all about taking materials in nature and creatively turning them into useful resources. And by creating the best form of energy resource, the oil and natural gas industry helps every other industry more efficiently create every other type of resource, from food to steel.