How upstream exploration economics are recovering

Oil and gas exploration economics were broken, even while oil prices were above US$100. Our new research shows that the upstream exploration sector is poised to emerge from the current slump leaner, more efficient and more profitable. Here we look at how they're changing their approach, and what that means for the future.

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The oil price downturn has been a catalyst for the industry to fix exploration economics. Rising costs, reducing returns combined with high-risk exploration strategies meant that the sector could not continue to operate in the same manner.

Where does the industry go from here?

Our research shows that the majors have started to look at exploration differently, and they've cut investment more drastically than other sectors. As the industry readjusts, there are now fewer wells being drilled. It's not that there's less oil to find – they're simply investing in less-risky operations. A lot of recent discoveries were not getting commercialised. And the economics of exploration were already broken back in 2014, when oil was at $100 per barrel.

One of the positive findings that we have seen from the majors changing the way they approach exploration is improved returns even at lower prices.

Click the chart to view full screen:exploration economics

Focussing on high-yield options

Dr Andrew Latham, Vice President of exploration research at Wood Mackenzie says: "The new economics of exploration mean that rather than pursuing high-cost, high-risk exploration strategies – elephant hunting in the Arctic, for example – the majors have become more conscious of costs. Smaller budgets have required them to choose only their best prospects for drilling, including more wells close to existing fields. The industry now has in prospect a different – and potentially more profitable – future."

We've identified five ways that explorers can recover:

1. Focussed investment
Reduced exploration investment has forced only the best-quality prospects to be drilled.

2. Focus on returns and value over volume
A shift towards lower-cost locations, more emphasis on tax shelters against existing production, more focus on near-term opportunities and generally less above and below ground risk.

3. Redirecting investment
Focussing on areas where government support and fiscal terms are most appropriate.

4. Reduce costs
Ongoing efforts to reduce the costs of developing discoveries through project re-design, standardisation and innovation.

5. Lower-cost renewals
Longer-term acreage inventory renewals at a low cost.

Lower costs and more targeted investment

To achieve these aims, the majors have started to change the way they operate. They've cut conventional exploration spend by 53% in 2015 vs 2014. But the number of exploration wells completed fell by just 11% compared to the average of the previous four years. The average spend per well is back down to levels not seen since 2008. They've also refocused exploration on proven basins, nearer to existing production infrastructure, and reduced activity in high-risk frontiers.

Click the chart to view full screen:Exploration IRR trends

Conventional versus unconventional spend

As the majors trim spend and refocus, they will discover smaller conventional volumes. This will lead to them relying more on other renewal options – unconventionals, discovered resource opportunities, enhanced recovery and M&A. We estimate that only 50% of production will be replaced by conventional exploration. This means that unconventionals are now attracting over 15% of exploration spend and have outperformed returns from conventional exploration since 2013. The end result will be a leaner, more fit-for-purpose sector, and will see the majors and the rest of the industry returning exploration to profitability at US$60 oil price.

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