Returns will improve with lower costs and tighter focus

Oil and gas companies are trying to balance playing a short game and a long game. The dominant strategic theme is strict capital discipline; higher risk investment is off the agenda.

But at the same time, there’s a need to sow some seeds for future growth. The Majors have stepped up acquisition of new frontier exploration acreage in 2017 – it’s classically counter-cyclical. But does the economic case stand up to scrutiny? The simple answer is no, if recent evidence is the guide.

The average full cycle return on exploration is a mere 6% over the last decade.

And returns have been consistently poor – the industry has failed to achieve the bare minimum acceptable return of 10% from exploration in any year of the last ten. Had oil companies expected future oil prices to be US$50/bbl, they would never have spent a cumulative US$0.7 trillion on exploration over the last decade.

The poor performance has dulled the appetite at board level.

Absolute spend on exploration globally has halved from US$95 billion per annum pre-crash, to around US$40 billion currently. The status of exploration in resource-capture strategies has also been diminished relative to other growth options as companies weigh up the comparative risks and returns.

There’s a more balanced approach nowadays with spend more evenly spread between conventional exploration, unconventionals (for those who have it), M&A, and discovered resource opportunities. Exploration’s share of the pie has halved.

Fund managers, too, have deprioritised conventional exploration exposure in portfolios, put off by the higher risk, low returns and the cash-strapped nature of most Independents. Equity capital, the traditional source of funding the sharp end, is just not available.

Anadarko, one of the most successful explorers globally in the last decade, still embraces conventional exploration on a reduced scale. But the stock market’s exultant reception of last month’s return of capital suggests investors prefer any surplus cash to come back to them rather than put at risk with the drill bit.

This gloomy environment opens the door for counter-cyclical players.

Andy Latham, Head of Exploration Research, reckons those taking a longer term view are on the right track.

First, building a portfolio in the down turn doesn’t cost much and acreage can usually be acquired with low commitment.

Most governments recognise that for them it’s about winning investment and generating activity rather than cash up front – rare is the ‘hot block’ that attracts a big signature bonus. The Majors are able to acquire huge tranches of acreage in under-explored frontier basins, and after extensive high grading, drill only the very best prospects.

Second, exploration returns will improve.

It’s not quite happening yet – average returns in 2016 dipped to a derisory 3% even on our price deck of US$65/bbl real long term, the lowest in recent history and in spite of lower costs. It may turn out to be just a bad year; alternatively returns for 2016 may improve over time as more reserves come to light. Time will tell. But we think that the industry’s intensifying focus on prospect quality, reducing exploration and development costs and improving project execution will pay off.

Third, exploration is not really about averages.

Capital is mobilised for the big wells – the needle movers – and some of these are still coming in. ExxonMobil’s latest find, Turbot-1 in Guyana with Hess and Nexen (CNOOC), brings commercial reserves in this brand new province to 2.5 billion/bbl, with an NPV,15 project breakeven of US$52/bbl.

The series of discoveries the group has made ticks a lot of the boxes that define frontier exploration success – big oil fields, good reservoirs, scope to phase development to accelerate production. Plus – and it’s a big plus – the Guyana tax regime is one of the more attractive around. More of these please!

Not all the acreage picked up in the down turn will work out.

But getting in at low cost is half the battle in making money in any endeavour. Those explorers that have a clear strategy to get into the most promising basins at low cost are the ones that will have the best chance of turning the economics around and getting returns back up into double digits.