Why Upstream Profit is Going South?

This is not a secret that the upstream oil and gas has been steadily disappointing the investment community over past few years (see Booze & Co review). The sector is and will be crunching bigger and more challenging projects such as LNG, offshore deep-water and unconventional projects – oil sands, shale gas/oil – which demand higher capital intensity (est. upstream spending in 2013: $678m). This issue is referred to as mountain of capital.

The math is simple. Despite the forecast of $104 /b (WTI) for crude sales in 2014, market foresee declining in net profits for upstream. The operators will be sharing a big chunk of the net margin with oilfields service companies, construction, and EPC sector. It is tough for the upstream operators to keep up with the expected dividends and make the investment community happy in this environment.

When would this trend bottom? Well, the North wind to the upstream profits may blow again sometime in next 2-3 years horizon, but the sector needs to do more to come back to the 20-25% rate of return that investors recall earlier this decade. In short term, the commodity prices will stay under pressure; the market sentiment is that the oil price may even decline in short term (Q4’13). The push comes from slower than anticipated global demand growth, and inventories being almost at balance (business insider). Individual investors may find the oilfield ETFs a better choice for price gain over next 1-2 years.

What upstream sector is doing to mitigate the risk? Every penny counts, so companies started optimizing their portfolio to improve the overall value in short term. The majors and independents actively source required funding through divestment of non-core assets. They recognize the need for strategy around their core competencies and aim for higher operational and execution efficiency (OEMS). Some already adapted to the strategy of value over volume, while focusing to untapped 10% volume through operational excellence and innovation (Bain, 2013).

What else? Any strategic area to focus on? In addition to the massive effort that the sector is making on rationalizing the portfolio and cost-cutting considerations in project execution to improve the financial performance, there may be few strategic areas that could help to mitigate the impact, and to stage for a fast recovery when at bottom. It is impressive that how few of the operators have taken the crisis as the opportunity to transform the organization towards higher efficiency to improve the value creation capabilities.

Leadership – The leadership is the most critical item in getting the organization through crisis (McKinsey’s survey). Leaders need to ensure that the leadership, accountability, and the need to improve the competitiveness is promoted in all layers of the organization. The leaders should aim to make more leaders, specially in the mid and lower ranks. The senior leadership need to be seen as change agents and truly lead the change (and not to leave it to a memo and a town-hall). As change agents, the senior leadership should share their vision, outline the strategy, be patient and persistent, ask tough questions and lead by example to gain everyone’s trust. See more on CEO’s Role in Transformation.

Effective communication and a real plan – Not all operators have taken the issue of the performance gap serious enough. Some E&P companies are more proactive than others in taking the advantage of the market forces to enhance and improve their competencies. Nevertheless, addressing the issue demands a proper strategic planning and effective communication to the organization. A proper plan would affect many departments and business units, therefore a holistic approach in developing a plan and a well-orchestrated execution is required to warrant closing the gaps.

Culture – Talking to my network in downtown Calgary and other places, I learned that few of the majors have already initiated campaigns promoting value-added culture, financial discipline (how would you spend it if it was your money?), shortening lengthy execution and decision processes and other improvements to cut work cycles and avoid waste. This component is an important part of any strategy reset to make sure that the proposed changes in the vision, processes, and short-medium targets are supported by all the employees. Let’s admit that being cost-conscience is not in the DNA of many the oil and gas E&P companies.

Technology – The need to focus on technology is more than ever. With increasing share of unconventional assets in the production and reserves among the majors and independents,  substantial value improvement could be realized if few of the critical technologies reach to the commercial stage. Oil sands segment for instant can benefit from technological advancements which can improve the SOR, capital intensity and environmental impact. All these areas could lift up the financial performance of the oil sands assets. Operators should not see investment on technology projects as a cost-center in their strategic map.

Procurement and supply-chain – Since vast majority of the mountain of capital will be spent on purchasing services, equipment, engineering, and construction, the role of the supply-chain management is super critical. The Strategic Sourcing is one single area that has been overly underestimated and under-capitalized by many operators until very recently (McKinsey, 2013). Read more on this in my other post.

 

So there is hope at the end of the tunnel. But the length of the tunnel would depend on how proactive and effective we could revisit our strategies, plan, and act. 

 

More to read:

Operational excellence: The imperative for oil and gas companies

Building superior capabilities for strategic sourcing

What “good” looks like: Creating an operational excellence management system

4 comments to “Why Upstream Profit is Going South?”

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  1. E&P at times can be very risky; at times that cost reductions have to weighed vs. exposure. I.e. BP’s decision not to run a cement log in the recent blowout a couple years back in the gulf. Some sort of analysis would have to be done to determine what the savings would have on the operational productivity and safety.

  2. If indeed “the upstream oil and gas has been steadily disappointing the investment community over past few years”, it can only mean one thing: the risk/reward ratio (among other factors) should be improved in comparison to other sectors to give said investment community an opportunity to change its mind, risk perception and mitigation included. Ways to succeed in that task exist for those able/willing to listen more carefully to the investment community.

  3. Thanks for sharing your thoughts on this JC. Interesting point. There has been a shift in market dynamics over past 10 years or so. What are the upstream risks in your opinion, that did not exist 10 years ago, or were not as serious as they are today? From investor’s point of view, is this a riskier industry to invest now versus 10 years ago?

  4. Thanks Mike. Yes, the upstream industry strives to accelerate the project execution cycles to improve the profitability. Unfortunately there are incidents that makes observers believe that time to time the corners are cut short, even by the leading operators. I learned that after the BP Macondo incident many majors revisited their HSSE and Drilling/Completion practices.

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