As E&P, oilfield services and drilling companies report more optimism for the industry in 2017 and beyond, the model for tomorrow’s energy company also has shifted to reward specialization and excellence in core offerings.
Examples of this shift can be found in the uptick in mergers and acquisitions, asset sales and divestitures, especially in the Permian Basin. As noted in PwC’s latest deals report, fourth-quarter 2016 deals volumes were 30% higher than in third-quarter 2016 and 45% higher year-over-year. Additionally, the rate of bankruptcies and restructuring filings is decreasing, especially for E&P companies, according to PwC’s business recovery services practice.
These deals show that energy companies are winding down on prioritizing cost-savings initiatives and ramping up on strategically repositioning their portfolios for growth to better compete in a stabilizing commodity environment.
What’s driving the change?
Prior to the nosedive of oil prices in second-half 2014 cost efficiencies and cash flow typically came second to making fast production gains and delivering strong returns on investment. At more than $100/bbl, companies dealt with inefficient supply chains and logistics, high costs for labor and materials, and need for innovation or effective use of technology because profits were much easier to come by at that price level. The rising commodity price also covered up that some parts of these companies were average and was further exacerbated by the conventional industry wisdom of the time to maintain the status quo because that’s what the industry has always done.
After the crash, however, energy companies had to take a hard look at their stressed balance sheets and make the courageous decisions to prioritize cost cutting as well as lean into the areas of their businesses where they saw the best opportunities for stability and growth through portfolio rationalization and strategic transactions. Essentially, energy companies had to develop a mindset that fosters a strategic nimbleness to focus on where they are exceptional and have the honesty to acknowledge where they are average.
As is currently being witnessed through the recent flurry of deal activity in the industry, today’s smart energy companies are divesting business segments or assets that no longer add value to their model for a leaner, more specialized company and are buying up assets that complement or beef up their current exceptional capabilities. They’re determining where they have the capabilities to win when the market is favorable as well as when it isn’t and have realized that an up market can potentially skew performance measures while a down market can reveal unpleasant truths. They’re looking beyond their own industry and drawing inspiration from automotive, biomedical and aerospace to improve both technical and financial performance, including more investment in R&D to shorten development cycles or go-to-market technology launches, reduce capital spending and decrease labor costs.
In one example of this phenomena, on recent yearend earnings calls a specialty chemistry company announced the divestment of two of its four operating segments in drilling and production technologies to focus more on its energy chemistry and consumer chemistry technologies segments, where it has seen the greatest success and where it generates the most value for its unique expertise in prescriptive oilfield chemistry. The market rewarded this company with a 15% stock jump post-earnings and praised the leadership’s forward-thinking vision.
Another well-known E&P with assets in the Permian Basin has seen success by allowing its geoscientists and engineers to have greater flexibility and independence in pursuing research and identifying opportunities for asset development. This notion of allowing the company to be led by science and ideas to come from those closest to the asset rather than by industry norms has positioned them as one of the most innovative E&P companies in one of the hottest shale plays. This company also included profit targets in its bonus plan rather than just production growth.
Even the major oilfield services companies have realized one of their greatest strengths lies in their historical database, where they’ve worked with multiple E&P companies across the globe to optimize their wells and can more easily bring their regional and global experience to bear, having already solved similar problems elsewhere among thousands of wells. Smaller independent operators are then able to take advantage of these oilfield services’ deep banks of experience in well optimization and instead focus their efforts on where they bring the most value. This also allows smaller E&P companies to do a lot more with just a couple dozen people who specialize in specific areas of excellence such as geology or reservoir management.
Rise in partnerships and cross-collaboration
As each of these examples demonstrate, specialization is key to creating a differentiated and more competitive business, but it also requires more collaboration and partnership with other peers, academics or government entities. No one company, university or government has all the expertise required, and collaboration is proving increasingly essential to innovation.
Leveraging one another’s strengths not only differentiates individual competitive edges, but it also strengthens the industry as a whole to operate more efficiently. Economists call this the law of comparative advantage, where mutually beneficial results occur as a result of partnering with others who have exceptional capabilities that are complementary to one’s own unique capabilities.
Along with more cross-collaboration and specialization, tomorrow’s energy company will also be more geographically streamlined, having consolidated inventory, labor and logistical distribution to key targeted growth markets instead of managing a wider spread with pockets of either understocked or overstocked inventories and overutilized or underutilized employees. This swap from breadth to depth effectively lowers costs related to inventory, labor and logistics and relies on suppliers to complete the ecosystem. However, it takes a conscious decision and strategic vision to begin to integrate technologies, workflows, services, disciplines and organizations that have long been segregated or merely bundled.
Historically, production sharing agreements or contracts (PSAs or PSCs) have been used by predominately developing regions that lack the necessary capital or experience to develop their own natural resources, such as in the Middle East, South America and Central Asia, and they agree to PSCs with foreign players to fill this void. The foreign oil company usually agrees to bear the mineral and financial risks of exploring, developing and producing the field while the country’s government takes a share of the profits.
In today’s landscape PSAs between E&P companies and oilfield services companies are becoming more commonplace as a way to share profits and reduce costs, with some agreements having cost reductions built into contracts.
For example, an independent oil and gas company headquartered in the U.K. recently agreed to a 50% net revenue PSA with an oil and gas consulting firm based in St. John’s, Newfoundland, to produce onshore assets in western Newfoundland, Canada, with the consulting firm covering 100% of the funding and ongoing operations.
Overall, to improve operator margins, the industry must rethink the fundamental ways in which it does business. The days of being average, of being all things to all people, of being a jack-of-all-trades but a master of none, are all but written in the history books. By forming strength-based strategic relationships with best-in-class oilfield services and drilling companies, E&P players can remove costs, get access to partners’ deep knowledge and experience in areas in which they might have only been average and boost returns on invested capital. Market conditions and the industry are now ripe for embracing this new model of tomorrow’s energy company.