Oil and gas companies have survived the worst of the downturn. Now it’s time to begin thinking about growth — and developing a strategy to produce higher returns over the long term.
A key expected strategy for surviving in a “lower-for-longer” price environment is portfolio optimization — shedding assets that do not fit a specific geographic strength, technical capability or risk profile. During the recent downturn, many oil companies migrated from cost reduction to portfolio rationalization. Several companies even optimized to the point of a single basin focus, consolidating drilling activity to reduce costs, most often by retreating to the predictable returns available in onshore unconventionals.
But with the downturn now in its fourth year, it might be time to begin rethinking the upstream portfolio — this time, with an eye toward optimizing for growth and consistent cash returns.
Divesting higher-risk assets was a smart move for many companies when prices fell quickly. But history shows us that prices are unpredictable. If prices were to rise over the next 10 years — perhaps due to geopolitical issues or even an unexpected increase in global demand — it makes sense to have a broader reserve base available for exploration and production.
By focusing on a smaller number of plays, companies may have limited the option value potential for strong returns down the road. Keeping less expensive assets and properties in the portfolio today for longer-term development is one way to shorten the runway for growth in the future, should prices rebound.
Unlocking future opportunities
An example of how some companies are keeping their options open can be found in Mexico’s deep-water auctions, the first of which took place in December 2016, with the second round scheduled for January 2018. This strategy does not require significant immediate capital, and companies can hold acquired blocks for a decade, waiting for the right time to move forward. This is just one way to create a low-cost option to expand the base in North America, with a potentially higher payout in the future.
Why add reserves now? Even in a downturn, growing reserves are critical for long-term success. Recent analysis based on the EY US oil and gas reserves study found that, over the past five years, top-performing oil and gas companies — those with a return on capital employed (ROCE) between 8% and 22% — grew their reserves by an average of 16%, while companies in the bottom tier did not grow their reserve base at all.
Our analysis also found that top-performing companies grow organically. For the top tier, nearly 90% of gross reserve additions came through extensions and discoveries rather than acquisitions. And unsurprisingly, top-performing companies kept their reserves through the downturn, selling just a little more than 10% of their starting reserves over the past five years. In contrast, middle-tier companies sold more than 20%, and bottom-tier companies — driven by economic survival necessity — sold almost 35% of their reserves.
Consequently, strong companies are now in a much better position to capture portfolio expansion opportunities and can quickly ramp up production if market conditions make it advantageous. That puts even more pressure on the competition to make smart portfolio decisions today.
Looking outside upstream
Reserve additions are just one option for companies that want to prepare for future growth. Another viable strategy could be vertical integration, especially for large independents. Given their position in the marketplace, they face the most significant challenge going forward, since the supermajors are already integrated and small independents can be profitable with a highly tailored portfolio.
Thus, independents with access to capital and the scale to handle an acquisition might benefit from the addition of midstream or even downstream assets to capture more of the hydrocarbon value chain. Strategic acquisitions can provide a boost to earnings, generate natural and low-cost hedge positions to lower risk, and allow large independents to capitalize on changing market conditions.
Growth, regardless of price
Because predicting future prices is impossible, there is no way to know how long this downturn will last. Although we may never see a US$100 barrel of oil again, at some point, oil and gas companies must think about more than survival and position themselves for growth and cash flow returns to investors in an energy marketplace that is more competitive than ever.
The challenge, therefore is to continue to drive cost containment and operational excellence today, while developing a portfolio that creates a platform for growth and higher returns in the future. Those who achieve this balance will find success — both today and tomorrow.