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A Double Infusion of Extra Energy

By David Yang
Industry Analyst
IBISWorld
Santa Monica, CA

Favorable oil and natural gas prices have helped the manufacturing sector recover from the recession. Historically, domestic crude oil and natural gas prices have matched international prices, because energy resources are globally traded commodities. However, since the late 1990s, innovative extraction techniques, such as hydraulic fracking, have helped stimulate domestic fossil fuel production, which, combined with infrastructure pipeline shortages that constrained international energy trade, resulted in a glut of natural gas and crude oil in the US. This situation introduced divergent trends in domestic and international energy prices, where domestic crude oil and natural gas prices fell considerably Shale as a % of total natural gas withdrawalsbelow their international counterparts, which have been rising. Low energy prices on average reduced operating costs for the manufacturing sector, improving the global competitiveness of domestic firms. Exports flourished as a result, and fueled the recovery of the manufacturing sector.

Over the next five years, low energy prices will continue to provide domestic manufacturers with a considerable advantage on world markets, especially as the manufacturing process becomes more automated and energy intensive. Continued advances in technologies like robotics and computer-controlled production lines will make labor a less pertinent factor to overall manufacturing costs. Instead, manufacturers must focus on obtaining the most effective technology, cheap fuel and electricity, and access to efficient transportation and distribution infrastructure. These factors will help US manufacturing return to growth in the coming years.

New Extraction Technologies
Shale gas has stimulated the natural gas boom in the US over the past five years. Shale gas is natural gas reserves trapped under rock, clay and mineral formations. Historically, shale reserves were more difficult, and therefore more costly, to tap than other natural gas resources. As a result, shale gas extraction had been limited for most of the 20th century. However, over the past three decades, collaboration between the Department of Energy (DOE) and the energy industries has yielded fruitful breakthroughs in natural gas extraction technology, particularly hydraulic fracturing.

Hydraulic fracturing, commonly known as fracking, is a process where pressurized fluid is used to drill into rock formations to extract fossil-fuel reserves. Similar technology has been in use since the 1860s, although its first major commercial applications occurred in the 1950s. Nevertheless, shale gas extraction via fracturing remained costly and inefficient compared to tapping into conventional natural gas reserves. Since then, steady government research grants and subsidies supported more effective fracturing technique development, culminating in Mitchell Energy establishing the first economically viable shale gas well in 1998.

Directional (horizontal) drilling is another technique that has contributed to the emerging feasibility of shale gas in the US. According to the DOE, horizontal drilling can increase the accessible fossil-fuel reserves of a well 2%. Using current Energy Information Administration (EIA) estimates on total petroleum reserves, an increase of 2% results in an additional 465.3 million barrels of accessible crude oil. In comparison, the US produced 2.4 billion barrels of crude oil over 2012. However, the main benefit of directional drilling is that it provides access to hard-to-reach fossil-fuel reserves. Directional drilling creates curved wells, allowing gas extraction firms to access gas reserves located under lakes, railroads, protected areas, shale formations and other geographic obstacles that a drilling rig cannot easily reach. In addition, directional drilling improves the overall efficiency of the drilling process. Over the past two decades, energy firms have increasingly used directional drilling to extract shale gas resources. The EIA estimates that since the early 1900s, horizontal wells have grown from about 9% of total wells drilled to over 50% in 2010.

Surplus Production
Over the past five years, shale gas production in the US has skyrocketed due to technological development in hydraulic fracturing and horizontal drilling. According to latest data Us and international natural gas prices have been diverging sharply since 2009.from the EIA, natural gas extracted annually from shale gas reserves increased from about 2.0 trillion cubic feet (TCF) in 2007 to 8.5 TCF in 2011, which represents an average annual growth rate of 43.8%. Over the period, natural gas extracted from shale gas grew from 8.1% of total natural gas production in the US to 29.8%. Since 2003, the US has had a surplus of natural gas, and the production boom in recent years has further widened the surplus. EIA 2012 data shows that the US produced 4.3 TCF in surplus natural gas, compared to 1.6 TCF in 2007.  

As a result of surplus production, domestic natural gas prices have plummeted. From 2007 through 2012, natural gas prices in the US declined from $6.3 per thousand cubic feet (MCF) to $2.7. Over the same period, international natural gas prices increased from $6.8 per MCF to $8.7, representing a complete divergence from domestic prices. According to the EIA, domestic natural gas prices are expected to increase to $3.4 per MCF in 2013, still far below the estimated international price of $10.0 per MCF.

Similar to natural gas, crude oil prices were significantly lower in the US than on the international market. Domestic crude oil production has grown strongly over the past five years, as advances in horizontal drilling techniques bolstered well output. According to data from the EIA, US crude oil production increased from 5.1 million barrels per day (bpd) in 2007 to 6.5 million bpd in 2012. In particular, hydraulic fracturing fueled a surge in production from the Bakken Formation in North Dakota. From 2007 to 2012, crude oil production in the state achieved fivefold growth, increasing from 124,000 bpd to 662,000 bpd. In 2013, US domestic crude oil production is expected to continue to increase, totaling 6.8 million bpd. 

While crude oil output growth helped lower prices, infrastructure shortages were the most important driver behind cheap crude oil in the US. The bulk of Bakken crude oil was shipped to Cushing, OK, a major oil hub that stores oil shipped from as far away as Canada. Since the Bakken boom, the inflow of crude oil has far outstripped Cushing’s outflow pipeline capacity, creating an overabundance of crude oil in the region. As a result, West Texas Intermediate (WTI), the price benchmark used for crude oil in the region, has plummeted. The downward trend represents a divergence from Brent prices, the crude oil price benchmark on international markets. In 2011, WTI prices per barrel totaled $94.9 compared to $111.3 for Brent crude, representing about a $16 price differential. As infrastructure investments picked up, the gap narrowed. In 2013, WTI is estimated to decline to $87.8 per barrel, while Brent is expected to fall to $96.8, lowering the difference to $9.0. Nevertheless, domestic manufacturers were able to access relatively cheap fossil fuel over the past two years. 

Energy Price Outlook
In the five years to 2018, investments in pipeline infrastructure, such as the under-construction Cushing MarketLink pipeline by TransCanada, will further narrow the price differential between domestic and international fossil-fuel prices. Surging energy consumption from emerging economies such as China and India will particularly drive up the price of crude oil and natural gas. According to the most recent EIA forecasts, WTI prices will converge on world crude oil prices over the next five years. By 2018, WTI crude oil is projected to reach $110.2 per barrel, compared to Brent prices of $113.0. Nevertheless, the US will still enjoy relatively cheap crude oil in the coming years because the convergence is projected to be slow. 
On the other hand, domestic natural gas prices are anticipated to remain considerably lower than international natural gas prices. Although pipeline projects will stimulate natural gas exports, the US will still maintain the technological advantage of hydraulic fracturing and shale gas extraction techniques, which will keep domestic natural gas prices relatively low. In the five years to 2018, the EIA projects domestic natural gas prices to increase at an average annual rate of 5.6% to $4.42 per MCF. Over the same period, the world price of natural gas, calculated using spot prices from Russian natural gas border prices and Indonesia liquefied natural gas prices, is anticipated to increase at an annualized rate of 4.1% to $12.3 per MCF. 

Impact on Manufacturing
According to the National Association of Manufacturers, the domestic manufacturing sector contributes about $1.8 trillion to the US economy each year, representing about 13% of the entire economy and supporting about 17.2 million jobs. Low natural gas prices and relatively low crude oil prices benefit the manufacturing sector. In particular, low energy prices in the US improve the competitiveness of domestic manufacturing industries globally. Other benefits associated with cheap energy include reduced transportation costs, allowing domestic businesses to bring their goods to market more quickly.

Although the manufacturing sector comprises many diverse industries with different operating characteristics, the performance of two particular sectors should provide a glimpse into the potential impact of cheap energy on US manufacturing. 

Chemical Manufacturing
The chemical manufacturing sector is an important indicator of overall US manufacturing performance. Chemicals are used in nearly all manufacturing industries. Increasing demand for chemicals indicates that the manufacturing sector is growing. The Chemical Activity Barometer, an index of the overall chemicals sector created by the American Chemistry Council, is a leading indicator of the industrial production index. In particular, the Inorganic Chemical Manufacturing industry (IBISWorld report 32518), the Organic Chemical Manufacturing industry (32519) and the Petrochemical Manufacturing industry (32511) are critical suppliers to the manufacturing sector.

Chemical manufacturing is a highly energy-intensive process. Crude oil is used as an input and electricity is used to power a variety of machinery and equipment. Plummeting natural gas prices bolstered a surge in natural-gas-generated electricity over the past five years, which helped lower the price of industrial-use electricity. In the coming years, cheap natural gas is projected to keep electricity prices anchored, stimulating growth and improving profitability for chemical manufacturers. In the five years to 2018, inorganic chemical manufacturing revenue is forecast to grow at an annualized rate of 4.1% to $45.2 billion, due to growing domestic manufacturing production and low energy prices. Over the same period, organic chemical manufacturing revenue is anticipated to expand an average 4.5% per year to $163.5 billion, and petrochemical manufacturing revenue is projected to increase 3.5% per year on average to $98.9 billion. 

Auto Manufacturing
The automobile manufacturing sector, which includes firms that manufacture all related parts and components, struggled in recent years with a slow recovery from the recession. However, the economic recovery and low energy prices will help auto manufacturers return to growth over the next five years. Automakers were some of the earliest adopters of industrial robots, and continued advances in robotics, combined with cheap electricity, will allow manufacturers to further expand energy-intensive automation technology. In addition, the rise of fuel-efficient vehicles and hybrid engines, along with slow-growing oil prices, will significantly lower fuel costs for new cars, providing an incentive for consumers to purchase new vehicles.

In the five years to 2018, revenue for the Automobile Engine and Parts Manufacturing industry (IBISWorld report 33631) is anticipated to increase at an annualized rate of 3.0% to $35.2 billion, due to low energy costs and growing consumer demand. Other auto sector manufacturers, such as the Automobile Transmission Manufacturing industry (33635), the Automobile Interior Manufacturing industry (33636) and the Automobile Metal Stamping industry (33637) are also forecast to recover strongly. On average, IBISWorld forecasts that automobile sector revenue, including motor vehicle manufacturers and vehicle parts manufacturers, will grow at an annualized rate of 2.6% over the next five years. The auto sector’s share of total domestic manufacturing is anticipated to increase from 8.1% in 2013 to 8.2% in 2018. 

Manufacturing Outlook
In the five years to 2018, IBISWorld forecasts that the domestic manufacturing sector’s revenue will grow at an annualized rate of 2.4%, reaching prerecession levels by 2014. Firms will be able to invest in energy-intensive machinery and equipment, such as automated production lines, robotics, computer systems and other labor-saving technologies. As a result, domestic manufacturers can remain profitable while competing on price in international markets. In addition, emerging economies will likely continue to grow strongly, bolstering their per capita disposable income levels. Demand for US exports will subsequently increase, fueling revenue growth for domestic manufacturers.  

High Energy Price Scenario
While energy prices are projected to remain anchored in the coming years, there are always risks stemming from geopolitical events. For instance, escalating tensions in the Middle East may cause spikes in oil prices by limiting global supplies. Additionally, oil and gas extractors located in the US and Canada have accelerated pipeline construction in an attempt to alleviate the flood of crude oil in Cushing, OK. Currently, TransCanada’s Cushing MarketLink pipeline is scheduled for completion in 2013. The company’s Keystone XL pipeline is awaiting final federal approval, although it is currently scheduled to be in service in 2015. Although the exact effects are difficult to forecast, given the unpredictability of energy prices, an expansion of pipeline infrastructure will likely result in higher energy prices. Domestic gas and oil extractors will be able to export fossil fuel at international prices, lowering the excess of crude oil and natural gas in the US. Finally, environmental concerns regarding hydraulic fracturing may lead to increased government regulations, heightening extraction costs and raising energy prices.

What are the implications of higher energy prices, given the manufacturing sector’s reliance on energy? In this scenario, IBISWorld assesses the effects that higher-than-expected energy prices will have on the risk scores of domestic manufacturers. An industry’s risk score includes structural risk, growth risk and sensitivity risk. Structural risk accounts for the impact of fundamental characteristics common to all industries, such as international trade and competition. Growth risk measures an industry’s projected revenue growth, while sensitivity risk accounts for external factors affecting industry performance. The risk score is measured on a scale from one to nine, where a lower risk score indicates a less risky industry. 

The scenario assumes domestic natural gas and crude oil prices will converge to world prices by 2018, representing a faster rate of growth than current EIA forecasts. In this scenario, natural gas prices are anticipated to increase 14.8% in 2014, while crude oil prices are projected to grow 4.5%. The growth rates were applied to natural gas and crude oil prices in IBISWorld’s database, with the results shown in the following table.  

Automobile manufacturers would experience a small 0.1 increase in overall riskiness, due to sensitivity risk stemming from higher crude oil prices. Consumer demand for automobiles can be constrained by high oil prices, which negatively impacts the long-term growth of automobile manufacturers. Chemical manufacturers would exhibit a more significant growth of 0.2 in overall riskiness, because these firms rely on fossil fuel as an energy source for machinery and as an input. Higher energy prices would reduce the efficiency of chemical manufacturers by limiting their machinery use. Additionally, higher input costs would squeeze profitability. Nevertheless, on average, higher energy prices would have only moderate effects on individual automobile and chemical manufacturers because the recovering domestic economy and export markets would be strong enough to support industry growth under this scenario. 

However, although the absolute increases in risk were small, higher energy costs can increase risk levels across entire supply chains. In particular, higher energy costs for chemical manufacturers will result in higher chemical prices, which translate to greater costs for paper manufacturers, pharmaceutical manufacturers, cleaning supply manufacturers, metal product manufacturers and other industries that use chemical products. Higher operating costs, combined with an appreciating dollar as economic growth picks up, can erode the competitive advantages domestic manufacturers have gained over their international counterparts during the past five years. Exports and profitability will decrease, limiting the growth of US manufacturing.

The Bottom Line
In the coming years, energy will play an even bigger role in manufacturing. Manufacturers have already implemented automated production lines during the previous five years, and this trend will only continue through 2018. According to McKinsey Global Institute, the research arm of consultancy McKinsey & Co., labor costs will play an increasingly smaller role in overall manufacturing costs. Rising labor costs in China and other countries will reduce the effectiveness of labor-arbitrage, where manufacturers relocate to countries with cheap labor. Instead, manufacturers must focus on transportation, technology, regulation, energy and other costs associated with the manufacturing process. Consequently, government energy and environmental policies will be especially important for manufacturers. In particular, policies regarding the Keystone XL pipeline and hydraulic fracturing will have a major impact on energy prices and manufacturing costs in the US.


Published Date : 11/1/2013

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