Upstream Downturn: Time for Change?
My fellow baby boomers in the upstream oil & gas industry will be all too familiar with the recent pattern of oil price drop, fewer discovered resources being developable above breakeven, cost reductions to protect dividends or balance sheets, inevitably leading to retrenchment and layoffs. Those of a certain age have seen this pattern play out quite a number of times. Indeed, this downturn feels similar to the one in the mid- to late-eighties in terms of severity, duration and impact. And it’s easy to predict a slower recovery this time, with laid-down equipment rusting on the sidelines and a lot of those laid-off people not intending return to the industry. Thus the recent retrenchments by companies enable survival, at least for some, but a vicious cycle is maintained. But is it avoidable? At least in part? I believe so.
It is understandable why upstream operators and service suppliers are reducing their work forces. Many projects are no longer economic at today's prices. Even better projects struggle to attract capital when cash flows are constrained and balance sheets are burdened with debt. If capital is no longer being spent on projects and drilling, there isn’t, quite bluntly, work for all those people to do. One effective register for this effect is US rig count, depicted above from zerohedge.com against WTI price lagged by 3 months. The correlation between rig count decline and price decline is obvious, and behind it is the equally obvious decline in people numbers, be they operators on the rigs, or engineers and scientists supporting the work.
To make matters worse, with boom time cognitive bias at work (who’d have thought 3 years ago OPEC would have transferred the role of swing producer to north America?), heavy investment at high oil prices focused on volume growth did indeed grow US domestic oil production, but also led to heavy borrowing and rising cost of supply due to inflation in the services sector. Now companies are burdened by debt (or dividend commitments), vastly reduced cash flows, and a devalued resource base.
Looking at the Rystad chart published in oilprice.com in February 2016, it’s interesting to observe how producing fields average at $29/bbl cost of supply and that non-producing north American shale oil has an average cost of supply of $68/bbl, more than double. This is supported by anecdotal evidence from operators of the best parts of shale plays looking for $40 to $50 oil prices to get back to work.
So what is the antidote, even if only partial, to this upstream boom and bust cycle? There’s no getting away from our industry being vulnerable to the global supply and demand picture, but here are three measures for the industry to adopt now, turning this particular crisis into an opportunity for the longer term.
Focus more on margin, less on volume – what if we adopted the business mindset, whatever the current price, of “how do we drive down costs, i.e. lower cost-of-supply as well as drive up volume, without comprising safety or long term reliability?” What if an investment case for a new project posited at high prices demands breakeven at prices closer to bottom cycle, or at the very least requires a trajectory of lowering breakeven as part of the project? A important sensitivity is to test if the project, bottom cycle prices, say $30/bbl, can deliver a positive NPV at a discount rate even that is the cost of the investor's capital. This business mindset would be different from the "gold rush" mentality of rapid capital deployment at high prices with less regard for the economics being highly vulnerable to price. This should lead to businesses actively improving all drivers of their economic engine, improving returns in the top of the cycle and making the business more resilient to the bottom of the cycle. Maybe the industry could be a better performer in the long term delivery of returns on capital employed than its bottom quartile position now.
Industry collaboration to avoid repeat mistakes, multiple learning curves and other value leakage – many leaders in the upstream business believe it’s really the explorers and their driller colleagues who win the value; thereafter projects and operations people are really about the safe and efficient of the value to the market. Hence I assert that operators would be better off to collaborate more on shared problems in the post-appraisal parts of the value chain in hydrocarbon basins rather than compete or not share common issues and solutions. In the deep water symptoms of lack of collaboration are repeated problems on technologies such as downhole valves and completion failures and inefficient utilization of logistical and maintenance resources. In the onshore, witness competitive demand for equipment driving up schedule inefficiency as well as unit cost. For example, new completion technologies should be sought to drive down rig time (costs) as well improve productivity of the well. Of course for this to be an industry mindset, suppliers and operators are going to find a balancing point where both are incentivized for more efficient use of fewer units or technologies. Note that there is a strong technology component to this measure: not just about new technologies to enable more efficient and greater recovery of discovered resources; but also requiring collaboration to make existing technologies work better in a less expensive, more predictable manner.
A new capability for the upstream – operational excellence – needs to be deeply embedded in our industry from this point forward. It’s much more than past experiences like taking pride in continuously improving performance on drilling rigs, but a major transformation in mindset, skills, experiences and organization, right across the value chain. Operational excellence could have a fundamental impact on mature field management, but I believe that green field construction and operation could also benefit. I have come across several exceptions to prove the "rule" that this isn't something upstream has traditionally done. Hess are one of the standouts - particularly in their onshore activity in the Bakken shale. Manufacturing and process industries know this subject well and can give the upstream a leg up in the required transformation by pointing the way on requisites such as leadership, organization, culture, skills and processes that are best suited to improve both volume and cost of supply. There will be very beneficial side effects such as increasing reliability and improved operational integrity and hence reduced risk of harm to people and the environment.
The benefits from such an industry shift could be multifold and enormous. Imagine how global energy security might look if new north American shale could be developed and produced at a cost much closer to producing fields. Consider how people could be confident of their future if their organizations are aiming to be competitive in both boom and bust conditions. And wouldn’t those people have a different skill set, more transferrable to other industries? Think about the stock price of an energy company that is able to make decent returns with a pipeline of capital projects even at $30 oil.