The Oil Industry’s Era of Austerity

As the major oil companies struggle with how best to boost their profitability in an era of rising oilfield costs, business models are being adjusted. The changes are a reflection of managements’ attempts to change the culture of their organizations. The most popular theme is to split a company’s business into separate units with different investment and operational characterizations. For example, a popular way to split an integrated oil company is to put the most capital-intensive businesses – refining, petrochemicals, transportation and marketing – all in one basket, while the exploration and development business sits in another. That approach was popularized a few years ago by Marathon Oil (MRO-NYSE) and ConocoPhillips (COP-NYSE). The strategy was recently criticized by Archie Dunham, former CEO of Conoco at the time of its merger with Phillips Petroleum. His reasoning for disagreeing with this structure was that the capital-intensive businesses generated large cash flows that helped fund the capital needs of the E&P business.

Lately, a new business model is being promoted. That model involves splitting off the shale resource portion of a company’s E&P operations into a separate unit in an attempt to mimic the structure, and presumably the operations, and hopefully the profitability, of an independent oil and gas company. The thinking behind this move is that the philosophy driving successful shale exploiters is quite different from that needed to exploit conventional oil and gas plays. For the major international integrated oil companies, this rationale may prove successful. What it takes to be successful in hunting for and developing elephant-type fields in deepwater and remote regions of the world is considerably different from success in the domestic shale basins where the emphasis is on finding the optimal drilling and completion techniques and then repeating them over and over and over again with a goal of driving costs down. The strategy is the equivalent of buying bespoke goods versus mass produced items.

The two major oil companies who have recently embraced this new business model include Royal Dutch Shell (RDS.A-NYSE) and BP Ltd. (BP-NYSE). It remains to be seen how long it takes for each company to establish these new business units. In the back of the minds of many observers is the question of whether these moves are initial steps toward completely severing ties, i.e., selling or spinning off the entities. Our question with this business model structure is whether a corporate culture can be redesigned to achieve a different goal?

Exxon Mobil Corp. (XOM-NYSE) attempted a culture shift when it purchased XTO Energy a few years ago. At the time the deal was announced, observers questioned how ExxonMobil would be able to retain the key XTO managers who were used to a high degree of freedom to experiment, which is often found in smaller, independent oil and gas companies, as opposed to the monolithic and highly structured enterprise of its new parent. ExxonMobil’s approach was to retain XTO’s offices and management and to move ExxonMobil’s shale staff in. So far this shale investment has yet to financially pay off as envisioned by ExxonMobil’s management. Fortunately, the company has avoided the embarrassment of having to write down the value of its shale investment despite continued low natural gas prices and CEO Rex Tillerson’s lament in 2012 that the company was “losing its shirt” in shale gas. The fact ExxonMobil has not taken an asset impairment charge as many of its peers have caused the Securities and Exchange Commission (SEC) to question the company about how it was able to avoid that fate.

According to a Wall Street Journal blog in early February, the company responded to the SEC inquiry stating that placing a value on wells that pump oil and gas for decades requires considering many factors, including future events. For example, the company has had approved a liquefied natural gas (LNG) export terminal that once in operation could lift the value of its domestic natural gas resources above the current price and, importantly, future prices as suggested by quotations in the futures market. Whether that reflects true conviction or significant leverage over the company’s auditors is difficult to know.

Another way in which producers are addressing their reduced profitability is to attack their cost structures. Royal Dutch Shell says it plans to begin using cheaper Chinese oilfield equipment in order to lower operating costs. This would be a significant cultural adjustment as oil company purchasing departments are mandated to find the lowest cost equipment as long as it meets industry and company specifications. If the company has not been using Chinese equipment, the question is why?

This Chinese equipment strategy reminds us of Shell’s “Drilling in the Nineties” program designed to cut E&P costs. The approach was that oilfield service companies needed to bundle all its drilling and completion offerings into a single package and then price the entire package cheaply. The problem was that Shell’s drilling engineers, responsible for the success of wells and fields, wanted to make sure they could get the best equipment and services to ensure their success. If the service company that won the contract only had, for example, the number three ranked drilling fluids needed, the Shell engineer would arrange to purchase the number one product from a different service provider.

We will never forget a discussion we witnessed dealing with Shell’s program that occurred at an early 1990s annual meeting of the International Association of Contract Drillers (IADC). At the end of the back and forth among the drillers about the pros and cons of Shell’s program, one elderly gentleman, the president of a long-time West Texas contract driller, stood up and said, he didn’t understand what all the fuss was about since this approach had been going on for decades – it was called turnkey drilling! Everyone laughed and as if a light bulb went on, the discussion ended. Drilling in the Nineties eventually disappeared only to be replaced by “Best in Class” in which the producer or driller selected the best vendor in each supply category.

The battle over price versus quality of drilling and completion equipment and services has always gone on and the winner depends on the relative tightness of the market. The tighter the market, the better it is for service companies. Likewise, the looser the market, the better it is for producers. The common thread of all the various drilling and service contracting initiatives tried in the industry was how they fostered consolidation within the oilfield service industry. That may be the same outcome this time, too.

RIGZONE

9 Comments on "The Oil Industry’s Era of Austerity"

Davy, Hermann, MO on Thu, 17th Apr 2014 2:36 pm 



This process will accelerate once the financial correction hits high gear with a reduction in capex liquidity and a hike in the cost of money. It is a matter of time just be patient

Makati1 on Thu, 17th Apr 2014 3:07 pm 



Soon all the lies will not be enough to keep the suckers … er … investors in the game. The parents are selling their children as reality becomes too obvious to hide anymore. Couldn’t happen to a better band of thieves.

rockman on Thu, 17th Apr 2014 3:27 pm 



“The thinking behind this move is that the philosophy driving successful shale exploiters is quite different from that needed to exploit conventional oil and gas plays.” I’m sorry but I have no idea what that means and I’ve worked for Big Oil and Little Oil for 4 decades. For the public companies (Big or Little) the philosophy has always been the same: add more reserves this year then you produced this year. And it made no difference at all if it were done with conventional or unconventional reservoirs or if even if it were done with acquisition of another company. Management didn’t care how the goal was achieved…they just wanted it done.

Likewise the non-public companies I’ve worked for 9like my current owner) didn’t give a crap if we replaced reserves or not as long as the wells drilled were profitable. And they didn’t care either what the nature of those projects were.

The problem Big Oil has with plays like the shales has always been there: lack of personnel. Go research the numbers: Big Oil has often bragged in the past about how much oil/NG they find per technical employee. Which has always been true: ExxonMobil may have the same number of hands developing a 300 million field as I would have working on a 3 million bbl field. Which is a nice brag until you realize that for XOM to develop one hundred 3 million bbl fields they’ll need to hire 100X the number of staff they had working that one big project.

A possible example of what happens when they load to boat too much: Shell Oil paid $1 billion for leases in the Eagle Ford Shale play and very quickly drilled 185 wells. They took great advantage of the deep pockets. And how well did they staff handle the rush: while other companies have been reporting high initial flow rates guess what was the AVERAGE initial flow rate of the Shell wells: 79 bopd. Obvious they were drilling on a not very sweet spot in the EFS (assuming theye were actually drilling/frac’ng properly). Some whether long before the drilled 185 wells (several $billion worth) someone at shell should have called a time out. But I can tell you from my experience with big oil that once management has made The Big Call on a project you won’t find many middle managers jumping up to say they were wrong. Not very good for your career path. LOL.

I imagine most here already understand how labor intensive the shale play is for the companies involved. You can’t sit back and drill 60 shale wells this year and then coast for a few years when those wells slowly deplete: you keep poking holes like there’s no tomorrow. Because if you stop poking holes there will be no tomorrow. I’ve worked on DW GOM projects were the part of the company’s staff spent 3 years working on a single well before it was drilled. And how did that go with the last well I was involved with: a $154 million drill hole. Opps…we need to spend another few years to generate the next prospect. And that has always been the one big advantage of Big Oil besides deep pockets: the ability to wait years to see cash flow generated for the generation efforts. Little Oil can’t spend 3 years waiting to drill their next shale prospect.

I don’t play the shales but know lots of geologists/engineers that do. If you asked them how concerned Big Oil will swoop in and take the shale plays away from them they would look think you’re nuts. Even in the DW GOM Big Oil isn’t considered the Big Competition. They are just one more player.

Richard Lyon on Thu, 17th Apr 2014 5:52 pm 



Interestingly, the fiction that the US has somehow become an energy exporter has been sustained by drawing down its winter storage to 50% of the 5 year low – so low, in fact, that it’s not clear they can be recharged by next winter. They’ve exported it to drive up domestic gas prices and secure higher European gas prices. And they’ve compromised their winter supply because fractured gas economics are so deranged. This article seems to corroborate that.

shortonoil on Thu, 17th Apr 2014 7:15 pm 



In 2005 conventional crude Peaked, and the world changed. We might not have noticed it, except through a more austere life style, but it changed. The world’s oil markets went form a buyers market to a sellers market. Before 2005 all the light sweet that the market wanted could be supplied, after 2005 that was no longer true. Light sweet is very special because it provides an “energy window” that other hydrocarbons can not provide. It gives the “best bang for the buck” that can be found anywhere in the world of energy. Prior to 2005, if the market wanted more light sweet the oil companies got out their drilling rigs, pounded down a few more holes, and whammy, more light sweet. That day has come to an end!

Now the oil industry has found that their century old business model is broken. So they are going to sack a few VIP, restructure their divisions, re-asses their options; all in hope of improving their faltering bottom line. But the bottom line is that banging down of a few holes no longer leads to instant riches. The oil industry has been changing chairs for a century to get a better view of the shuffle board game. They are still changing chairs; above the game is painted a sign, the emblem of Majesty, the unsinkable – Titanic!

http://www.thehillsgroup.org

Northwest Resident on Thu, 17th Apr 2014 7:42 pm 



It must be really tough for oil execs today, knowing that they are presiding over a doomed industry, and that the near-royalty status they and their predecessors have enjoyed will not be handed down to the next generation. Despair and a sense of inevitability must hang like a thick cloud in the once-might halls of the oil majors executive headquarters.

rockman on Thu, 17th Apr 2014 8:40 pm 



Richard – Actually very little US NG goes to Europe. Almost all of the export goes to Mexico and Canada and has been heading that way for many years. But overall the US is not a NG exporter: 7% of our NG consumption is imported. So the US consumer is actually driving up the price of NG for those consumers in the countries we import from.

Feel better now that you know we’re screwing someone else in the NG market? LOL

shortonoil on Thu, 17th Apr 2014 10:06 pm 



“It must be really tough for oil execs today, knowing that they are presiding over a doomed industry, and that the near-royalty status they and their predecessors have enjoyed will not be handed down to the next generation.”

For petroleum to have a market it must be of value to the end user. That value can be measure in energy terms, and/or $ terms. Since conventional peaked at the end of 2005, or the beginning of 2006 [as our graphs show] the value of a unit of petroleum to the end user has been declining. At the same time the cost of producing it has been increasing. The petroleum industry is between a rock, and a hard place. Declining end user value, and rising cost of production. This divergence will become critical over the next decade as end user value falls by almost 50%, and production cost increase by 20%.

Some where out there, no too far away, is a breaking point. The FED will keep printing in an attempt to stop up the hole, and the consumer will continue to tighten their belt. Everyone will wonder what will be in store for the next generation!

http://www.thehillsgroup.org

Kenz300 on Fri, 18th Apr 2014 12:20 am 



The cost to find and develop fossil fuels keeps on increasing…………..

The costs of alternatives keep dropping……..

Oil companies need to change their business models and become energy companies. They would do themselves a favor by investing in alternative energy sources and diversifying away from fossil fuels.

Give a boy a hammer and everything needs to be hammered. The fossils running the fossil fuel companies can not see past their old methods of doing business. The world is changing and the their old business model is dying. The days of large centralized energy production are coming to an end. Local, distributed energy production is the future.

Every landfill around the world can now be converted to produce energy, biofuels and recycled raw materials for new products. The inputs to the process are inexpensive since they are already being collected.
This does not fit into the old business model of the oil companies so it will take new energy companies like Waste Management and others to lead the way.

The oil companies will change as their cost continue to rise and the competition continues to get cheaper.