Maximising upstream value in the long term
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Life’s good again in the upstream sector. All the hard work through the downturn is paying dividends, literally. Brent over US$70/bbl means everyone is in the money given the sector’s cash flow breakeven of US$53/bbl.
Pleasing as it is to see fortunes turn for the better, few, WoodMac included, would argue that it’s onward and upward from here. The oil market is still oversupplied, and downs – as well as ups – lie in wait in the months and years ahead. Nor can oil and gas companies lose sight of significant long-term challenges ahead.
The energy transition isn’t going to go away, and structural decline seems inevitable at some point certainly for oil demand.
European Majors are diversifying into the power value chain, from renewables generation through to customers. So far, it’s about sowing seeds for the future – new energy units won’t amount to much for years yet.
Meanwhile, core upstream is where the money is. So how to get upstream ’fit for future’ – to prolong oil and gas production at the company level, make it as profitable as possible, and maximise value? Here are some thoughts on how to prepare for eventual decline, however distant in the future it may be.
First, adapt the portfolio. We’ve already seen more portfolio rationalisation by the Majors than in any previous down cycle. Strengthening finances has been a driver; but so, too has high grading – reducing exposure to higher-cost and high–carbon intensive assets, and shedding late-life and geographically stranded positions.
An overarching future theme will be increasing focus around advantaged positions defined by materiality, long life, low costs, higher margins and growth potential. Low carbon intensity needs to be at the top of the agenda, favouring investment in gas and lighter liquids.
Portfolio fitness is not like training for a one-off charity marathon run. It has to be a constant, ongoing process to maintain competitiveness.
The Majors, with big, diversified portfolios, have much still to do. Internationalising Asian NOCs, big accumulators of assets pre-2014, have been reluctant to high grade and need to grasp the nettle. Independents may typically be less diversified, but some have already proved nimble in adapting.
Second, get down the cost curve. The low-cost producer wins. Competition is currently fierce among IOCs and NOCs to win exposure to big, low-cost, long-life resources, whether discovered or high-potential yet-to-find. Business development activity has ratcheted up for the prime opportunities, among them Brazil, Mexico, the Permian, discovered resource opportunities in the Middle East and pre-FID LNG projects.
Not every producer can be in the bottom quartile on the curve. Thematic specialists will emerge, aggregating assets to cut central costs and high grade development. Recent consolidation among domestic specialists of high-cost Canadian oil sands is a lead indicator.
Third, manage for margin. This mantra of the downturn needs to become entrenched – running the business at the lowest cost and capturing the maximum margin as a price-taker. Industry costs have been reset, but the pressure must be kept on even as margins improve. The really big test of margin resilience may be yet to come.
Technology is increasingly important, with digitalisation the big new thing. Big data opens up opportunities to reduce costs through automation, robotics and predictive analytics, streamlining processes from wellhead to refinery.
We think US$30 to 40 billion per annum of operating costs could come out – 10% of the global total. The more bullish in the industry reckon 20 to 30% in the next five years. An even bigger prize may be in subsurface, through digitalisation’s potential to boost reserves and reduce failure rates.
Fourth, retain financial flexibility. Production growth will become the preserve of the few, and shrinking, the norm. Performance metrics will be financial – margins, ROCE, cash generation, dividend-paying ability. Those with financial flexibility will be in a position to lead an inevitable consolidation of the industry, prolonging their viability at the expense of the weak.