December 12, 2010

Big Oil and the Natural Gas Bonanza: Dual Operating Required

Natural gas demand is set to rise by at least 100 billions of cubic feet per day and natural gas prices are expected to rise steadily from 6$ per MMBtu to 8$ per MMBtu by 2020.The oil majors hope to make major money in natural gas, but this will require that they learn to operate two distinct types of businesses under one roof. Previous attempts a dual operating have generally failed. Can the oil majors succeed?

Today, natural gas is abundant virtually throughout the world, thanks to new so-called unconventional reservoirs (sometimes called unconventional reserves) discovered in the U.S., China, and Europe. At the same time, increasing concerns about carbon emissions have made natural gas, which generates only half the carbon emissions of oil, a relatively clean option for some of the world’s largest energy users. For some countries, gas has become a placeholder for running trucks, buses, and power plants until renewable energy sources such as solar and wind power and advanced battery technologies become cost-efficient. “The U.S. Energy Information Administration forecasts prices reaching upwards of $8 per MMBtu by 2020; the breakeven price for many unconventional wells is $4 to $7 per MMBtu. Stronger demand will drive higher prices: According to Booz & Company forecasts, demand should grow at an annual rate of approximately 2 to 3 percent globally through 2020 as the world economy improves, as gas-fired plants replace relatively dirty coal plants for power generation, and as new policy rules, such as the proposed energy bill in the U.S., encourage and mandate increased use of natural gas for transportation,” said George Sarraf, partner Booz & Company.

But as the green-energy geopolitics surrounding natural gas continue to be well documented, another equally intriguing phenomenon is playing out: The unexpected revival of natural gas is quietly precipitating a fundamental shift in the oil and gas industry—a shift that few companies were prepared for but that may determine the industry’s overall future makeup. “The revival of natural gas pits the major oil companies against the independents, which have plied the unconventional reservoirs doggedly over the last seven to 10 years. And it raises questions about whether the oil giants can become big players in this new unconventional gas business. To do so, they will have to develop dual operating models under one roof—one, a traditional high-risk, corporate-led exploration model, and the other, a nimble, efficient, and decentralized operation. However, in other industries (notably airlines), such two-headed strategies have generally failed,” said Raed Kombargi, partner Booz & Company.

Dual Operating Models

In order to compete in unconventional assets, oil majors will have to embrace a dual operating model—in essence, pairing traditional operations with separate and more agile business units modeled after the independent gas firms, with flatter organizations, simpler governance structures, and an emphasis on efficiency and innovation. These attributes are necessary to reduce operating costs, as well as to allow the firms to quickly adapt new well designs, source local contractors and materials, and secure labor as needed. An energy giant can attempt to gain these capabilities in two ways.

The First Is Through Acquisition
“An oil major can buy a natural gas company with the proven talents to exploit unconventional assets. ExxonMobil took this approach with its $41 billion purchase of XTO Energy in late 2009. But it’s an open question whether large, brand-name companies have a high enough tolerance for the economic risks inherent in unconventional gas exploration. Only time will tell if such a model can succeed,” said Sarraf.

The Second Is Through In-house Development
“An oil major can choose to develop the natural gas expertise organically in-house, perhaps after gaining capabilities through a joint venture. Royal Dutch Shell was the first major oil company to attempt this, with its $4.7 billion acquisition of East Resources in May. But it’s too early to tell whether Shell will be successful,” said Kombargi.

Success Uncertain

History has shown that industry dual operating model successes are rare. Indeed, the oil companies’ success in capturing the potential of unconventional natural gas reserves will depend on how well the entry strategy is executed. An acquisition approach will require that the oil company maintain the targeted natural gas firm’s decentralized operating model, while gingerly introducing elements of its own capabilities that add incremental value—such as an integrated supply chain to minimize procurement complexity. The goal should be to improve the natural gas company without destroying its culture, which in large part lets it thrive in the unconventional environment.

An organic approach will require openness to external ideas. The oil major must actively seek out new operational concepts suited to unconventional gas operations, by participating in industry conferences, hiring experts and specialists as advisors and teachers, and setting up internal training mechanisms. Above all, management will need to ensure that existing processes and structures do not discount these fresh ideas because of a “not invented here” bias. If a joint venture is part of this approach, the company will need to develop a plan that allows it to learn from the arrangement, by creating formal and informal governance mechanisms to promote the transfer and dissemination of knowledge.

If designed and managed appropriately, either strategy could be successful, but history suggests that most of the oil giants will struggle to make dual operating models coexist. Though it may not seem obvious today, many of these companies are likely to find that the technical hurdles of unconventional reserves are relatively minor. Far tougher, and ultimately out of reach for some, will be the challenge of changing behavior and culture.