Five issues keeping executives awake at night

We all have those little worries in the back of our minds that never seem to go away.  Did I turn off the stove?  Did I lock the front door?   Most of the time after rushing back to the house and checking, you realise that you did indeed shut off the stove and lock the door - whether you were conscious of doing it or not. 

Well we've gone through the worry for you. 

Upstream executives have had a lot on their minds the past few years. So we've taken it upon ourselves to come up with a list of concerns plaguing even the best of us that - if left unresolved - will consume leadership and erode shareholder value. 

1. Lack of strategic clarity

"Fuzzy strategy" makes it difficult to focus organisational behaviour. A clear, competitive strategy is an important element of the capital allocation process. It sharpens thinking about where, when and how the company should spend capital. Clear strategy also helps keep high-value employees from working arduously on projects and work streams that were destined to get a "no" from the start.

With a clear strategy comes a well understood competitive framework to march on, including clarity around barriers-to-entry and competitive advantage, market forces, market evolution and relative competitive positioning.

But to really be successful, you need to understand how to "win". Whether it's winning through scale economy, as a first mover or early entrant, through technical differentiation or cost leadership.

One uncertainty is the energy transition underway - which you can read more about here. There are wide ranging views of what the future looks like for hydrocarbons. Issues include how the transition will unfold and over what time frame. We are only just beginning to see some Majors start to articulate a strategy for the transition; most of the industry is still on the starting blocks.

The other uncertainty is unconventional oil and gas. How long production will continue to grow – and at what cost of supply? Unconventionals in the US have generated a surprising surge in supply, resulting in price disruptions felt globally. Going forward, cost of supply will determine how long production can grow. Overall, it is too early to tell with confidence. The answer is critical for strategy both in terms of how it affects price; but also the commitment any company should make to tight oil or shale gas.

2. Inability to grow production

Lack of production growth, over time, breeds stress in the executive suite. A lack of growth options, organic or commercial, can take years to be recognised by leadership – and worse, years to fix.

Companies that disappeared over the last 25 years tended to be plagued by weak portfolios and stagnant growth. Examples included Mobil (merged into Exxon), Amoco and ARCO (merged into BP), Texaco and Unocal (merged into Chevron), Elf and Fina (Merged into TOTAL), BG (merged into Shell) and Union Pacific Resources and Kerr-McGee (merged into Anadarko).

In almost every case, management ran out of options to grow production and eventually "capitulated". Their portfolios had plateaued, and efforts to acquire or explore their way out proved unsuccessful. Sometimes management accelerated the decline by spending on low value-destructive opportunities, and by incentivising deal making over value creation – believing that it would fix the production profile. Along the road to capitulation, Boards had to be convinced that the company was worth more in "someone else's hands". Uncomfortable conversations and sleepless nights are part of this process.

3. Poor capital allocation

The upstream poses capital allocation challenges throughout the cycle. Oddly, these challenges are exacerbated at the top of a cycle, when prices are high, rather than at the bottom.

Why? Because financial discipline is less prevalent during a cycle top.

In a cycle bottom (e.g. 2015 to present), there is restraint on capital spending. Lower prices don't support as much investment. It's easier to be disciplined – culling projects, assets and staff. It is much easier in a cycle downturn to get buy-in on tough decisions.

During cycle tops, high price outlooks manifest a false sense of optimism about the future – a "this time it's different" mind-set. (By high price, think of the recent $110 oil/$8 gas). This is where the big spending mistakes occur. Mistakes of grossly overpaying for acquisitions or delivering projects that are significantly late and significantly over budget.

This sentiment has been illustrated numerous times when share prices have leapt when E&P has cut its capital budget. Going forward, producers have become more capital disciplined, doing more with less, getting clever at taking cost out of the system.

Example: Statoil – who had allowed itself to forget the fundamental cyclical nature of the industry. Statoil's strategy to deliver cost reductions during this downturn have been based on three disciplines – simplification, standardisation and industrialisation. Statoil has reworked design solutions and improved efficiency, reducing break evens from $70 to $21 on 3.2 billion boe of future production. One success has been Johan Sverdrup, where project costs have been cut by more than 50% (~85% from structural re-design, and ~15% from lower cost-of-supplies) while increasing the field recovery factor. The Company admits that the ultimate test of its new behaviours will be the response of costs during a price recovery.

4. Cycle bottoms

Cycle downturns shake the industry and are fatal for some companies as prices fall by 50% and more. Severe oil-price downturns date back to the 19th Century, to John D. Rockefeller's "good sweating" practices. In more recent times, downturns occurred numerous times, in 1986, 1998, 2008 and 2014 on the oil side, and 2008, 2012 and 2015 on the gas side. These big price slides impact everyone including producers, service companies and suppliers.

With each severe downturn come a number of "near-death experiences" for weaker producers. Few escape significant value destruction during these periods, with some producers forced into bankruptcy – or being acquired at an advantageous price.

Majors, who don't usually hedge, focus on low cost production and the downstream. Integration – refining and chemicals – gives them a natural hedge in a cycle bottom. Independents, on the other hand, are forced to hedge in order to protect funding for capital programs and preserve cash. Either way, nobody sleeps well during a price collapse.

The bottom of the cycle can also be a galvanising moment.

We’ve already seen a massive turnaround from a bloated spending mess in 2014, to many different examples of survive and adapt – and ultimately we've ended up with an industry that’s more fit for the future.

5. Failures

Health, Safety, Security and Environment (HSSE) failures pose the greatest threat to a company's license to operate. Poor HSSE performance has derailed some notable careers so it gets the full attention of senior leadership – with highest priority.

Lower upstream activity in the downturn might be expected to lead to better stats on HSSE. But at the same time, the low price environment and focus on margin raises concerns that cutting cost and corners might increase the risk of accidents, big and small. Ageing infrastructure and facilities in mature areas are another factor. The industry recognises that technology, digitalisation and automation are part of the way forward.

So there you have it – the 5 issues that keep executives awake at night.  Hopefully this reminder will help prevent some of you from falling into these traps.  Don’t say you haven't been warned!