As oil prices have plunged, shareholders, employees and the public at large want to know how energy leaders will respond. Here is a reminder of the path we have been on and the strategic options ahead.
The last ten years. One simple idea has underpinned oil and gas businesses since the
early 2000s: easy resources are tightly held in politically risky or closed countries, and hence only the technically difficult resources are available to meet rising global energy demand. Let’s consider what strategies have been pursued, and how well they worked.
- Go upstream. Underpinned by the belief that there is more value from finding and producing oil than there is in refining it, companies sold down their refining and marketing assets and redeployed the capital to extract more production. This trend was accelerated by weakening demand for transport fuels in the West and by the impact of the recession on demand for refined products and chemicals.
- Mega-project developer. By far the most popular strategy for exploration and production companies. This involved gearing up and investing increasing amounts of cash flow into hugely complex drilling and engineering projects, often in remote or extreme environments. The supermajors reached levels of $30 to $35bn of capital investment per year, and shareholders generally saw value eroded away by costs rising faster than oil prices.
- Frontier explorer. AKA the “gamblers strategy”. Excited by some big wins in India and Africa and the availability of cheap money, smaller explorers went chasing oil and gas finds in politically risky and technically demanding areas. The winners were those that quickly sold on those assets to larger E&P companies. For those companies still holding low quality assets when the money stopped in 2014, their shareholders have suffered. Under this strategy, it is those management teams and financiers with local and geological knowledge that generally win over time.
- Take the unconventional path. Encouraged by the rapid success of the US shale pioneers, larger international companies awakened to the attraction of politically risk free energy resources in North America. Many paid too much for poor quality acreage and struggled to acquire know-how through joint ventures. Nevertheless, so many companies “cracked the code”, opened up new resources and drove down costs, that shale gas and shale liquids production shot up and depressed prices of gas and oil to eight-year lows. The winners were those who paid the least for their shale resources: early pioneers and NA-based oil and gas firms who had held onto “legacy assets”, unaware of the huge potential from the shale sitting within them.
- Build new provinces. Many international companies, worried about declining production in their legacy basins and a shortage of future supplies, made the leap into new regions and aimed to build competitive positions in new basins. This often meant taking non-operated positions in countries and projects where they had little knowledge and influence, and relying on a good partner and operator to make it work. Unsurprisingly, good partners were in short supply and in many cases were in too deep themselves. This made it hard to find the right opportunity and partner without overpaying. Relationships and knowledge have separated the winners from the losers.
The next five years. With so much uncertainty around the oil price, many oil and gas companies are currently unwilling to fundamentally change their strategy. While they wait for clearer signals, they are cutting back on capital investment, and shrinking their staff numbers to deliver a smaller activity set in the next year or two. At the same time, they are aiming to maintain optionality to restart projects and exploration should the oil price rise. Let’s assume, however, that the oil price will stay low for longer. As well as simply stopping activities, companies are considering what actions, ranging from the tactical to strategic, they can take to deliver more value to investors and to create wealth for host countries at a lower price range.
- Renegotiate. While not necessarily available to all companies, the tactic of renegotiating terms with host governments is an important one. A re-allocation of risk and reward between parties can stimulate new investment and drive efficiencies which, with the right conditions and a bit of luck, lead to value growth for the company and host country over time. Obvious negotiation points are around the costs and incentives for new exploration and the tax take on newer fields, compared to “easier” legacy fields, as well as requirements to use a certain supplier base and fund other government projects. However, too much change is unhelpful. Investors and companies value stability, and frequent changes undermine confidence in making long-term investments.
- Go shopping. When the oil price falls far enough, in theory it becomes cheaper to add reserves through acquisitions rather than exploration. But this is not always so in reality. Companies often underestimate the additional cost to integrate a major acquisition, and overpay for the – still to be developed – upside when in a competitive bidding situation. Synergy value – from infrastructure, technology, adjacent projects, skills, relationships – needs to be real, rather than hoped for. Having a genuinely advantaged financial structure or exploration capability can make for a better parenting advantage than simply an overlapping portfolio. The recently announced acquisition of BG by Shell, described by many as “bold”, will be watched closely and stimulate further acquisition activities.
- Go digital. Although “digital” is being used as a panacea, in oil and gas it is essentially about improving operating efficiency, by connecting up physical and human components of the production system and delivering more productivity from existing kit (wells, equipment and infrastructure). With a low oil price, the promise of higher productivity is alluring. However, the structure of the industry makes it difficult to introduce standard digital systems across different fields. To date, efforts have focused on remote operations centres. These allow scarce expertise to be shared across high-value operations. This illustrates the challenge of “going digital”: no-one has yet demonstrated how to bring real efficiency, rather than simply create more demand for skills in an industry that is already short of talent. The promise is there, and the prize is high, but the path is not yet clear. Marakon has been helping companies develop clear focus on the specific needs and opportunities, and build more confidence in the business case.
- Collaborate more. The word stewardship is increasingly being used in the context of oil and gas basins, as governments and operators worry about leaving resources undeveloped. Although collaboration within a project is high (to share risks), companies compete intensely to access, install and control critical technologies and infrastructure. This creates higher barriers and rent for rivals, but also increases costs for everyone. So planning and contracting more holistically and centrally makes sense as it brings costs down and means a bigger pie for everyone to share. Making it happen is harder. The benefits are a long time coming, and the temptation to revert to self-interest when the oil price starts to rise is high. But, it is increasingly being done within large companies, and lessons are being learnt on how and where to collaborate across the whole industry. In Marakon’s experience, it is critical to build collaboration into the operating model, starting at the top. That avoids the raft of “initiatives” that are often seen as a luxury and in many cases treated cynically by employees.
- Improve and enhance recovery from existing fields. When it comes to investing capital in additional volume growth, proponents of improved oil recovery (IOR) and enhanced oil recovery (EOR) frequently find themselves left out of the process. At first it is hard to understand why. Adding IOR technology is standard practice to most new oil and gas fields. Retrofitting it to older fields to recover another 10 to 30 percent of the oil or gas seems obvious. EOR goes after the next 5 to 10 percent using more expensive technology, but is often still cheaper than alternatives. The reasons it is often ignored are that it is “hidden”, incremental and complex. But it works most of the time, and the economics look good even at lower oil prices. You need the talent, technology and a good story for investors to make it more compelling than chasing the next big new development project.
- Re-shape the portfolio. Taking a long hard look at the portfolio mix and re-shaping it around more predictable value creation is an increasingly relevant option for many oil and gas companies. This is different from simply high-grading the portfolio, which is usually about “chopping-off” the more-expensive-to-develop and riskier projects from the budget. Many oil and gas companies have ended up with an opportunity-driven mixture of asset types after 10 years of strategies based on shortage of supply. They rarely had the luxury of asking “what mix do we want and why”, as the focus has been on “what is available and can we get it”. Redistributing resources can create an asset mix that performs better in a lower oil price world, as long as you have the confidence in that outlook. Marakon’s experience of working with executive teams on portfolio strategy is that ‘alignment’ is at least, if not more, important than ‘analysis’. (More details on our approach are discussed in a previous Marakon Commentary "Redefining Winning in E&P".)