The Final Frontier: E&P's Low-Cost Operating Model

Acknowledgments

I wish to thank the many people with whom I have had the pleasure of working over the past many years, for kindly providing the impetus, expertise, and resources to produce this book, especially my former partners and colleagues from Booz, UBS, and Stern Stewart & Co. I would also like to thank my previous editors, including David Champion, Don Chew, Art Klein, and Krista Pettit, for teaching me not to write like a scientist.

However, the views expressed herein are solely my own. Moreover, any errors or omissions are strictly my own.

I also wish to thank my IHS colleagues, including Ulviyya Abdullayeva, Ruslan Anisimov, Kurt Barrow, Stephen Beck, Ryan Carbrey, Andrew Day, Erik Darner, Jean Dugan, Blake Eskew, Steve Fekete, Philippe Frangules, Bob Fryklund, Etienne Gabel, Mark Griffith, Tim Hemsted, Mark Jelinek, Ed Kelly, Jerry Kepes, Chris Kiser, Roger Kranenburg, Mike Kratochwill, Nick Lowes, Fernanda Machado, Michael Marinovic, Paul Markwell, Michael Muirhead, Gil Nebeker, Charlie O'Brien, Alastair Reid, Darryl Rogers, Jamey Rosenfield, Senjit Sarkar, Ed Scardaville, Grigorij Serscikov, Nick Sharma, Curtis Smith, Leta Smith, James Stevenson, Dale Struksnes, Jim Thomas, Rodrigo Vaz, Dan Yergin, and Tim Zoba.

Finally, I wish to thank the many clients who have challenged and entrusted me with their needs and encourage them to please continue to do so!

Abstract

This book guides the reader through the redesign elements for the internal operating model of an enterprise in the oil and gas sector—including integrated oil companies (IOCs), majors and independents, national oil companies (NOCs), and services companies in the upstream supply chain. For simplicity, this book references these companies as Exploration and Production (E&P) companies.

A culmination of disruptive forces and evolutionary change in the oil and gas industry has conspired together to make the case for a new low‐cost operating model. The industry has experienced tremendous evolution in terms of: our understanding of the underlying global resource base, the nature of its ownership and principal stakeholders, technologies and methods for resource development, and economics and business models. While companies have been very focused on cost and productivity, beyond incremental accommodations to change, there has been little effort to redesign and transform internal enterprise operating models. Moreover, unlike other industries that have undertaken operating model transformations in response to disruptive industry forces, upstream companies rarely undertake operating model change on a systematic or enterprisewide basis, except post‐merger integrations.

The industry has made great strides, but now must sort through:

What different to do

How to do it differently

Operating models and operational excellence must now be on everyone's agenda—changes can yield profound cost savings and operating efficiencies. However, change is much easier to plan than to implement, and operating model redesign is rarely executed on an organizationwide basis.

CHAPTER 1

Introduction

A culmination of disruptive forces and evolutionary change in the oil and gas industry have conspired together to make the case for a new, low‐cost operating model. The industry has experienced tremendous evolution in terms of our understanding of the underlying global resource base, the nature of its ownership and principal stakeholders, technologies and methods for resource development, and the economics and business models.

The industry was focused on cost and productivity even before the 2014 collapse in oil prices, but beyond incremental accommodations in response to change there has been little effort to redesign and transform internal enterprise operating models. Unlike other industries that have undertaken operating model transformations in response to disruptive industry forces, upstream companies rarely undertake operating model change on a systematic or enterprisewide basis.

A VITAL INDUSTRY

Notwithstanding tremendous advances in renewable energy, hybrids, and electric vehicles (EVs), and agreement among our world leaders to make great strides on behalf of climate change, oil and gas companies are, and will continue to be, an important contributor to the world's energy needs and to the world's economy. Most forecasts, even under aggressive growth trajectories for renewables, still call upon the upstream for one‐half or more of our energy in 20 years.¹

In the United States, natural gas and petroleum have played an important role in our energy mix for more than 100 years.² With the benefit of more than $1.5 trillion over the past 10 years, accounting for about one‐third of all new power generation capacity, renewables now represent a small but important source of energy (see Figure 1.1). Wind and solar provide 5 percent of all electricity consumed in the United States (nuclear power accounts for 63 percent of all non–carbon‐dioxide emitting power sources—the National Review estimates that it will take more than 100 years for solar to replace the electricity currently obtained from nuclear plants).³ Even with the tailwinds of government support at federal, state, and municipal levels, including regulations, tax credits, and direct subsidy, the US Energy Information Administration (EIA) expects fossil fuels will provide more than three‐quarters of US primary energy in 2040.

Figure 1.1 World Primary Energy, by Fuel (million tonnes oil equivalent)

Source: BP Energy Outlook 2035

WHAT NOW?

Oil and gas companies have been focused on cost and productivity since before the 2014 collapse in oil prices. Upstream operators have made enormous efforts through massive vendor concessions, capital project deferrals, reductions in force, and high‐grading drilling and completion activity to the most productive acreage.

For example, in 2016, one dollar of US onshore capital yielded twice the output (i.e., BOE/D) that it did in 2014, due to lower costs and higher productivity.

WHAT NOW?

For those asking, Are we there yet? sadly, the answer is no. For most in the industry, free cash flow is inadequate or even negative. The question to be asking is, What now?

The industry has experienced tremendous evolution in terms of our understanding of the underlying global resource base, the nature of its ownership and principal stakeholders, and the methods and technologies for resource development. And business models have evolved considerably with these changes, including the adoption and growth in usage of drilling promotes with a carried interest, farm‐outs, and other nonoperated ventures (NOVs), an industry supply chain with a wide array of field services companies, many forms of collaborative ownership and operation through joint ventures (JVs), state ownership and control of natural resources through national oil companies (NOCs), the adoption of corporate shared services models, experimentation with business processes offshoring and/or outsourcing, and much greater use of big‐data analytics and digital solutions within the core operations.

But beyond direct accommodations in response to each of these changes, there has been very little effort to redesign and transform internal enterprise operating models. Moreover, unlike other industries that have undertaken operating model transformations in response to disruptive industry forces (e.g., retail), the upstream rarely undertakes operating model change on a systematic or enterprisewide basis. The notable exception has been event‐driven situations, such as post‐merger integration (PMI) programs where promises of synergies may trigger fundamental reviews of upstream operating models, and major divestitures such as a sale or carve‐out/spin‐off, and initial public offering (IPO) preparation.

Upstream operators were already struggling to earn adequate returns before prices fell, but now face difficulties generating sufficient cash flow even to cover their basic needs—they do not generate enough cash flow to cover operating costs, capital projects, overhead expenses, debt service, dividends, and so on. With oil and gas prices remaining low, hedges rolling off, and sources of cash falling short of uses for cash, the upstream requires fundamental gains in cost and productivity. Many of the largest (and easiest) cuts, like vendor concessions, will not be sustainable over a full cycle. Furthermore, some of the biggest gains thus far are not scalable. And the future supply gap beyond 2020 requires a significant investment to find, develop, and produce resources that are very likely to be relatively expensive barrels.

There must be considerably more work, and more difficult work, to reduce upstream costs. The industry has made great strides for sure, but now the more difficult (but more valuable) task is to sort through:

What different to do (i.e., setting the strategic agenda)

What to do differently (i.e., defining the operating model)

The first question (i.e., the what) establishes a strategic agenda, and relates to choices in terms of the corporate and business unit strategies, asset portfolios, and business models. Setting the strategic agenda demands choices about what businesses to be in and what assets to own. Perhaps more importantly, the strategic agenda must establish in which key capabilities to invest and which activities to in‐source. It is impossible to be world‐class in every capability—every aspect of activity of the business and therefore critical choices must be made.

The choices about what not to do are often more important than the choices about what to do. Most upstream oil and gas enterprises have a portfolio of too many businesses, too many assets, too many geographies, too many resource types, and too many opportunities, all of which are competing for too little capital, not enough expertise, and too limited a talent pool. Therefore, the most important strategic choices are what not to do. Moreover, these choices require an iterative process to reconcile between the following three critical elements of the upstream enterprise:

Aspirations, goals, and objectives for the business

Opportunities and needs of the underlying resource portfolio

Organizational capabilities of the enterprise internal operating model and talent pool

The second question (i.e., the how) sets the enterprise operating model, and relates to the internal architecture of the company, its operation, and its governance. Defining the operating model—choices regarding the internal architecture, performance metrics, systems, processes, and culture has a profound impact on the performance of an enterprise. An operating model is effectively the blueprint for the internal architecture of an enterprise, its operation, and oversight.

Now, most research and experience with low‐cost operations tends to focus on innovation in business models (rather than enterprise internal operating models) to lower the costs of acquiring and serving customers and enhance the customer experience, often with digital platforms.⁴–⁶ Where there is research and experience with low‐cost operating models, it tends to be in consumer‐facing industries, with examples such as Costco, Dell, Southwest Airlines, Walgreens, Wal‐Mart, E*Trade, and IKEA rather than B2B industries, or specifically, the upstream oil and gas industry.⁷,⁸

INDUSTRY EVOLUTION

Over the past century, the oil and gas industry has experienced a significant evolution in terms of our understanding of the underlying global resource base, the methods and technologies involved in its development, and the nature of its ownership and principal stakeholders. In conjunction with this change, there has been considerable evolution in business models—but so far, the accommodations made to enterprise internal operating models have been largely incremental (see Figure 1.2).

Figure 1.2 Upstream Evolution

Source: IHS Energy

What began in the early days of the twentieth century as a largely entrepreneurial effort quickly evolved into big business, in part due to the scale of its requirements, in terms of capital and expertise—in the 1960s, oil supply was safe and abundant and not a constraint on economic growth, with excess capacity exceeding demand by about 20 percent of the free world's consumption.⁹ This fueled the corporatization and professionalization of the industry and facilitated tremendous growth in functional expertise, especially geological and geophysical roles, engineering, and other technical functions. The growth era of 1972–1981 drove large‐scale expansion. While the 1980s were characterized by low prices, layoffs, and consolidation, they also gave rise to innovations in 3D seismic, commercial beginnings for both horizontal and logging while drilling, and many new technologies and service companies.¹⁰

While the breadth and depth of technical capabilities flourished, so, too, did the opportunity for specialized field services companies to provide such expertise on an intermittent or as‐needed basis. Similarly, business model adaptations such as nonoperated ventures (NOVs) and joint ventures (JVs) enabled companies to participate in resource development and production activities beyond the reach of their core ownership holdings or core capabilities. These vehicles also facilitated a pooling of financial capital and technical expertise, which were often in short supply, while also syndicating the project risk—which was often considerable.

As oil and gas became big business, many host countries recognized the opportunity to retain a greater share of their resource sector's bounty and control through the adoption of state‐led national oil companies (NOCs)—another variation in the sector's business models. Consolidation among the largest integrated players (mega‐mergers) facilitated consolidation—affording large economic gains in the downstream refining and retail segments of the industry and a consolidation of conventional upstream business. Many companies adopted corporate shared services models for centralized procurement and other business roles.

Consolidation of the world's lowest‐cost conventional resources under NOCs and state ownership caused international oil companies (IOCs) and independent operators to venture further afield into new international frontiers and a growing array of resource types—including ultra‐deep‐water, the arctic, shale gas, tight oil, and the Canadian oil sands. These ventures generally represent much higher cost resources and require even more specialized expertise.

In the aftermath of the collapse in oil and gas prices, efforts to offset the effects of cost inflation and capital constraints have included the sale of many midstream and downstream assets, with many upstream operators exiting these parts of the value chain to focus their efforts (and limited resources) on the needs and opportunities of the upstream. Within the enterprise, this has generally included a migration toward asset team organizations, and investments in key capabilities such as enhanced subsurface capabilities, with improved data processing for 3D seismic, greater use of geomechanical modeling and reservoir engineering, enhanced recovery (EOR), and new applications for digital and big data analytics.

Despite this evolution—our understanding of the resource base, methods and technologies for its development, ownership and stakeholders, business models—there has been little effort to redesign and transform enterprise operating models beyond incremental accommodations. Unlike industries that have undertaken operating model transformations in response to disruptive industry forces (e.g., retail), the upstream rarely undertakes operating