E&P Companies Meet the Future, and Many Don’t Like it!

2007 saw the progressive overturn of many conventional wisdoms, while affirming others even more basic. Among them: even after five-plus years of higher oil prices, non-OPEC supply remained largely inelastic, whereas demand for oil was elastic; a “barrel is a barrel”, long since incorrect, has resulted in a difference in net income per “boe” produced in North America compared to some Gulf States of $20 versus $1, and government take in some countries crept upward of 94% (see Libya); $70 to $100/bbl oil prices did not necessarily represent happy days for IOCs or NOCs—in part because a falling US dollar eroded returns in non-dollar denominated currencies.

Old adages which were affirmed included the importance being able to execute large projects on time and on budget, and that the oil business was a “people business.” Project execution capability became a coveted “strategic differentiator” as operators wrestled with technical challenges, rising costs and limited experienced staff. But this rare remaining value proposition for the large IOCs took further hits in 2007 as costs continued to mount, and project schedules began to appear like suggestions. Moreover, for decades oil companies (both state-owned and privately-owned) stated that “ours is a people business,” but they never behaved that way. The cost of this strategy reached new highs in 2007. The demographics of the OECD workforce resumed their statistical march downhill whereas, in the non-OECD world, many older experienced staff (often working for NOCs who had built their respective sectors) ‘retired’ from low government wages into higher pay positions with other companies leaving behind organizations of young, but untrained, technical staff. Those NOCs with the ability to raise salaries to world-scale exacerbated the staffing challenges of those NOCs who could not. Technical staffing challenges and capacity constraints contributed to an uneasy triangular dance between NOCs, IOCs and ISCs (the international service companies) as they competed with each in a global market place for trained technical staff and service sector capacity, with due caution for the impact on corporate relationships and understandings.

Contractual issues, direct and indirect, dominated the affairs of many in companies and governments in 2007. Widespread dissatisfaction with Production Sharing Contracts was expressed on both sides; for governments, carrying the burden of rocketing costs with less return in the near to medium term was less and less politically viable; and for publicly-traded companies, the difficulty of reporting comparative value in terms of volumes became more problematic as entitlement barrels shrank with higher prices.

NOCs were not immune to owner/contractor squabbles as many continued to seek and amass global portfolios. At the same time, it became increasingly clear that not all NOCs are created equal. The differences include, but go far beyond, resource endowments and can be largely explained by governments’ allowances for strategic and operational autonomy. More than ever, NOCs struggled between optimizing themselves for commercial operations versus the need to act as development companies for the state capacity-building that so many governments sought. These NOCs also faced competition within their own ranks as new micro-NOCs (province or state-owned governments, or other governmental interests) and local/regional players emerged onto the playing field, spawned by political, economic and industrial development.

The large (and medium sized) IOCs have found opportunities for quality, conventional assets to be scarce; those that they can capture often comprise more difficult reservoirs to exploit economically, or they entail an acceptance of harsher fiscal terms than in the past. In addition, the competition from NOCs for these assets has evolved. Exploration costs have soared - deepwater or arctic wells can cost $50 to $150 million putting the net present values of even large-volume finds at risk. This in turn has increased the attractiveness of unconventional resources—the opportunity for long-life reserves and production profiles has been captured by all major IOCs.

The larger IOCs appear to be converging in terms of their strategic responses to the access challenge, making it harder to differentiate them in terms of their E&P asset portfolios alone. Their strategic differentiation increasingly turns on their ability to execute, and other offerings in terms of technology, market access, integration and partnering structures.

In the 1990s, many IOCs envisioned a lower price world and the privatization of government assets as a means of access to large E&P assets. This kicked off another round of challenge to NOCs when many governments questioned their abilities and looked beyond them for additional solutions. That pressure accelerated the evolution of many NOCs (which held them in good stead five to ten years later).

But then oil prices changed (as did other factors). E&P businesses now face a widening gap between their current portfolios which deliver returns of 25% to 35%, and the new material investments which offer only 8% to 15%. The possible future: oil prices ranging from $70 to $120/bbl, but with returns less than 15% as costs and government-take remain high; as a result, the base portfolios of many producers will migrate to lower return assets and domiciles. Those IOCs and NOCs which can survive and develop an effective response to this strategic dilemma would be ahead of the game in the post-2015 period.

Key Messages:

Not all NOCs are created equal, but neither are IOCs who will have to adapt. High oil prices will not result in higher returns or more supply (which may be difficult to explain to consumers) and E&P businesses will be forced to plan on the basis of projected E&P margins, not oil prices per se (as is done in refining & marketing). The cost pressure on service sector returns will come back with a vengeance as national oil sectors launch new competitors and operators attempt to force more competition. In this world, which is emerging and will gain pace in 2008, NOCs and IOCs will be forced to determine when their current strategies will encounter a “strategic ceiling” (created by various combinations of access, staffing, government demands, cost and capabilities, external challenges) and will be driven to consider new business models. Some will not react in time.

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Jerry Kepes is a Partner and Head of the Upstream Practice. For further information on this article contact Enews_jkepes@pfcenergy.com.