IOCs need new business models

The energy industry has been facing challenges — extreme price volatility, decline of “easy oil,” commoditization of technologies, talent shortage, pressure to reduce the carbon footprint, emergence of global national oil companies (NOCs), and a surge in petronationalism. These last two challenges have put the current business model of the international oil companies (IOCs) in question, possibly as dramatically as the shift from the concession model to the current production-sharing agreements (PSAs) did in the late 1960s and early 1970s.

Petronationalism is not new, but it has regained major significance because IOCs that traditionally were the only significant players in the international arena are now being squeezed by two competitors — large state-owned NOCs and oilfield services providers.

By 2007, reserves fully accessible to IOCs were reduced to 6% from 85% in the 1960s.(Image courtesy of Arthur D. Little)

Traditionally, IOCs have managed to cope with the threat of independent producers by leveraging their deeper pockets to replace reserves through low-risk acquisitions instead of high-risk exploration activities. However, the coupling that is occurring between increasingly capable NOCs and assertive oilfield services providers is a more vital threat that is compounded by the growing expense and risk of exploring and developing fields in hostile environments (such as the Arctic or in ultra-deep water), which puts the financial position of the oil companies under pressure.

A new business model
In the 1960s, 85% of global oil and gas reserves were open to IOCs, 14% were held by the Soviet Union, and NOCs controlled about 1%. By 2007, reserves fully accessible to IOCs were reduced to 6%. And today, the renewed surge in petronationalism is challenging the long-term business continuity of major IOCs, limiting their access to new reserves and lowering equity stakes in current production in mature assets.

The growing coupling between NOCs and oilfield service companies will not make IOCs and independents redundant. NOCs and host countries will continue to rely on IOCs for exploration, development, and production. However, they will make use of new contract formulas, shifting from PSAs to service agreements. This shift is forcing IOCs and independents to rethink their business model.

Rethinking the business model requires IOCs and independents to address three sets of issues: processes and control, competence planning, and company valuation.

Getting down to business
Industrial risk management is a major concern in this new contractual environment. During the bidding phase with the host country, IOCs commit themselves to challenging targets with limited knowledge of the technical challenges ahead and little time to evaluate the costs of possible solutions. One typical example is the service agreements with Iran, where a buyback scheme is used under which the IOC establishes a contract with the host country to develop a new asset according to a turnkey formula, and at the end of the development the asset is handed over to the host country. Another example is service agreements in Iraq, where the development and production service scheme is used, with very low fixed fees per barrel.

In both cases, the main industrial risks occur in the first phases of the asset lifecycle.

Ideally, IOCs would refrain from bidding until the front-end engineering design is done and they are ready for the final investment decision (FID). In practice, bidding takes place earlier. To bid properly, IOCs have to anticipate the FID by the end of the concept phase. As a consequence, they should reinforce cost-estimating capabilities significantly, standardize designs, and put rigorous project control processes and tools in place. IOCs could improve performance in these domains by learning from successful EPC contractors.

Another major risk occurs at commissioning and handover, especially with buyback schemes. The different operational doctrines of the developer and the operator can lead to non-acceptance and delays. Success requires reinforcement of operations readiness and assurance (OR&A) culture and practices to secure seamless integration between developers and operators.

In the case of technical service-providing schemes within the service agreement contractual framework, competence management is the key to success. First, IOCs should become more effective so they can compete with leaner and cheaper EPC contractors in the service-providing arena. Second, they should secure the availability of skilled local resources.

IOCs and independents also should secure the right mix of competences required for the new contractual environment. They should be ready to deal with initiatives where they have limited control of the reservoir, which means they have to reinforce some competence areas in production.

Service agreements typically imply an increased reliance on local resources, which should require clear boundaries and obligations for the host country — agreed upon at contract signature — in terms of training and availability of skilled resources. Structured and realistic national resource plans are of paramount importance.

At the same time, IOCs have to regain their lost position of undisputed technological superiority. They can attain technology leadership through more intense internal development efforts —through proprietary technology development, through a fast-follower strategy leveraging academia, or by acquisitions. IOCs and independents also should secure the right mix of competences required to work in the new contractual environment.

The traditional key drivers for evaluating oil companies are proven reserves, reserves replacement cost, and daily production. Unfortunately, when an IOC establishes an otherwise attractive service agreement, none of these parameters is affected. As a consequence, service agreements hamper IOCs’ ability to improve their market value and increase financial leverage. They are forced into a corner where they have to act as a bank for some of the service agreements themselves and bear increasing financial risks as well as the burden of exploring and developing in extreme conditions.

To ensure proper valuation of the company in a new contractual environment, IOCs may have to make a clear-cut separation of their traditional PSA-based and service agreement-based businesses.

Such separation would be beneficial in many respects:
• The separate company or division can be valued and leveraged on the basis of new parameters such as risk exposure and financial earnings;
• The company can define specific fit-for-purpose lifecycle management rules to support the different business requirements and related decision-making processes;
• The company can refocus its competence planning and development actions to serve the new business requirements;
• The company can create fit-for-purpose compensation policies to support the new resource base; and
• Separation accelerates the cultural fit related to the OR&A required to service external customers.

Separation leads to a new culture that helps to integrate a growing number of local resources.

Insights
Until now, IOCs have not been able to rethink their business models fundamentally to address the challenges resulting from the shift occurring in the industry. Future returns on investment will likely decrease while oil business risks increase considerably.

This shift represents an unparalleled opportunity for all players in the industry. NOCs can partner more effectively with reserve- and production-hungry IOCs and independents to increase production effectiveness and to extend outside their national borders. Independents can leverage their predisposition to higher risk and their less threatening appearance toward host countries to enter the arena of big oil. And service providers can move out of their traditional EPC contractor position in the value chain and join the arena of producers.

IOCs can continue to thrive provided they rethink the present business model, redefine the interface and integration with host countries, and rekindle the technology strategy to regain leadership and create truly differentiated results compared with those achievable by the coupling of NOCs and service providers.