2013 Oil and Gas Industry Perspective
by Christopher Click, Andrew Clyde, and Scott Sharabura
Originally published by Booz & Company: December 13, 2012
Energy producers had to work harder for profits in 2012. As supply rises and demand levels off, the winning companies are narrowing their focus.
The past year brought new clarity on the direction of oil and gas prices. With it came the bracing but undeniable conclusion that energy companies will have to work harder to earn their profits in the year ahead. Neither US$150 per barrel oil nor $7 per thousand cubic feet (mcf) natural gas is likely to return anytime soon to rescue the industry’s profit margins. Thus, executives cannot expect rising prices to offset inefficiencies in the industry value chain, as they have in the past.
If they want to expand, oil and gas companies will have to do so on their own—by building more efficient business models, and by developing their own set of differentiating capabilities that allows them to create real value and earn superior returns. As more companies focus on what they do best, and leave the rest of the industry’s work to others, we will see an acceleration of the past year’s most significant trend: specialization across the industry. In 2013, generalists will be left behind.
Energy companies still adjusting to the prospective end of “easy oil”—the peaking fields of accessible light oil in places like the Arabian Peninsula, Libya, and Venezuela—now face the end of easy money. Just as new deposits have become harder to reach, companies will find it more difficult to extract profits as prices stabilize at levels well below boom-era highs.
Our analysis of the factors driving global energy supply and demand points to an extended period of moderate prices for oil and natural gas. Demand is under pressure as growth slows in China, Europe tips into recession, the U.S. economy continues to waver, and U.S. fuel economy standards are pushed higher.
Trends in oil show an increase in supply, though the amount of the rise hinges on a wide range of variables. Geopolitical contingencies, such as the possibility of regional warfare in the Middle East or unilateral action by Iran to block the Strait of Hormuz, could crimp the flow of oil to industrialized markets. On the other hand, a return of Iraqi production to prewar levels could swell pipelines. Similarly, a resolution of the standoff over Iran’s nuclear program could lift the economic sanctions blocking Iranian oil exports, bringing another 4 million barrels per day back into oversupplied global markets virtually overnight. In the Americas, meanwhile, rising output from U.S. shale formations and Brazilian deepwater fields pushes potential oil supplies even higher.
Predicting oil prices is always difficult, particularly over the long term. Small changes in global economic growth rates affect demand dramatically, while unpredictable political events can have a similar effect on supply. But a recent Booz & Company analysis of the fundamental economics of oil shows that supply is rising faster than demand, a reversal of the trend that lifted prices and fueled industry profits over much of the past decade. Although oil prices can still vary widely, the most probable scenarios—based on an analysis of current trends—indicate a long-term range of $70 to $90 per barrel by 2020, down significantly from the levels of just a few years ago.
As for natural gas, the well-known expansion of supply in North America continues, ensuring that gas prices will stay low for the foreseeable future. They appear likely to stabilize around $5 per mcf, as an uptick in demand from coal-fired power plants switching to natural gas and expanding liquefied natural gas export infrastructure absorbs some of the excess supply.
Notwithstanding the uncertainties, it’s clear that oil and gas companies should prepare for a period when prices level off. This means changing some practices that took root when prices were rising, and it was accepted that costs would rise accordingly. Now the cushion that supported those expenses appears to be disappearing. Companies will need a cost-disciplined approach, centered on the distinctive capabilities that give them a competitive advantage.
Capabilities hold the key to profits. The tepid price outlook for oil and gas exposes the weaknesses of the highly integrated, diversified business models that have characterized the industry for decades. This business model, built for an era of rising prices, is too inefficient to produce returns that cover the cost of capital when prices retreat. The solution for many companies will involve specialization: emphasizing one group of distinctive capabilities and pulling back in other areas.
The companies that have already gone in this direction have demonstrated its value. Starting in 2009, for example, Devon Energy determined that its key strengths lay in onshore North American assets that required horizontal drilling and fracking techniques. It divested offshore and international assets, and cultivated the technological, human resources, and capital management capabilities needed to maximize its essential advantage in this sector.
ExxonMobil made a similar move when it stepped back from retailing to focus on managing a global exploration and production portfolio, in which it drives higher returns through distinctive capabilities in asset evaluation, capital discipline, and facilities management.
These companies have crafted a strategy around their differentiating capabilities: their unique set of related processes, skills, knowledge, tools, systems, and human capital. They devote more investment, management attention, and other resources to activities that support these chosen capabilities, and less to unrelated activities.
A capabilities-driven strategy can drive returns higher even as prices fall. You will discover that profits rise when you cultivate these key strengths, rather than trying to play every role.
Preparing your company for growth during lean times. Resist the temptation to shore up profits by ordering across-the-board cost cuts, which can weaken your ability to compete and make you more vulnerable to labor shortages, regulatory compliance problems, and other uncertainties. Instead, it is possible to cut costs while growing stronger. There are three components to what we call the Fit for Growth approach.
The first step is to make basic choices—if you haven’t already made them—about where to focus your capital investments and your expenses. Analysis of the returns your company can expect, based on current trends, will almost certainly show that you cannot generate superior returns in more than one or two areas. Reassess the strategic value of your company: In doing this, think in terms of capabilities to be developed, not assets to be bought or sold.
When energy companies focus on a type of commodity, they are vulnerable if the price drops. But an investment in capabilities can often be shifted from one sector to another. The capabilities needed for shale gas and shale oil, for example, are far more similar than those needed for shale oil and deepwater oil. Better to focus on capabilities like understanding shale geology, executing complex mega-projects, or profitably operating mature assets than on a particular commodity or set of assets.
Identify the business models where your unique capabilities create value in ways competitors can’t. Some energy companies are better at making big greenfield discoveries, while others excel at buying assets on the cheap or applying new drilling technologies. But even these categories may be too general. A more refined analysis is needed to zero in on the truly unique attributes that can form the basis of a coherent capabilities system.
Once you have decided where to focus, look to exit or outsource activities that don’t fully align with your core capabilities. This emphasis on strategically relevant activities is evident in BP’s recent sale of refineries in Los Angeles and Texas City to Tesoro and Marathon Petroleum, respectively. The deals underscore BP’s strategic focus on upstream operations, while bolstering the buyers’ position as refining specialists.
The second step is to reduce operating costs. With commodity prices unlikely to rise, energy companies’ profits will depend on efficiency. Despite its history of wide price swings, the industry has allowed inefficiencies to fester up and down the value chain, from exploration, drilling, and project delivery, through production and marketing, to refining and distribution. The vertically integrated companies that have dominated the sector often lacked the focus and organizational controls to drive efficiency through their far-flung operations.
The many opportunities include an intense focus on operational excellence (to reduce costs and improve reliability); renegotiating contracts with vendors that have passed along rising costs over the years; getting the maximum benefit out of large information technology investments; and instilling more sophisticated megaproject management so there are fewer cost overruns. Companies that adopt this type of frugality are automatically more resilient; they can manage price downturns more easily, and reap a larger benefit from price increases.
Finally, the third step is to form more joint ventures—and make them more effective. As companies become increasingly specialized, they will be compelled to partner more frequently with other firms that bring complementary capabilities. However, the industry has a spotty record in forming joint ventures that work.
A few leading energy companies are beginning to distinguish themselves through cross-company collaborations. Some firms are thinking very carefully about selecting the right joint venture partner, to ensure that they share a common vision for the asset and compatible ways of doing business. Other companies are collaborating much more intensely with their vendors, reducing the inefficiencies that can arise.
These collaborations are not easy to manage well. They require a cooperative and trusting work culture, and careful attention to governance mechanisms, work processes, and informal flows of information. But getting it right is crucial; collaborations will be central to the success of the more specialized oil and gas companies of the future.
In short, with an understanding of the pressures facing the oil and gas sector, you have the rationale you need to chart a path toward strategic coherence.
Most companies won’t get good returns from a broadly diversified approach to the market. Now is the time to identify the capabilities that can differentiate your company from rivals and create premium value for your shareholders.
We hope you find these thoughts helpful as you consider your strategy for 2013. We have helped many leading oil and gas companies address these challenges, and we would be happy to discuss our perspectives with you in further detail.