Managing Oil and Gas Companies-I Opportunities Await U.S. Independents Willing To Change

James C. Henry
Henry Petroleum Corp.
Midland

The trends reflect the advanced stage that the U.S. has reached in the production cycle of its petroleum resource. Mature production means that:

• Major oil companies have sold off many of their low-return properties and shifted their financial resources and human resources to core properties.

• Major oil companies are shifting assets from the U.S. to other producing countries at earlier stages of production.

• The operating divisions of major oil companies in the U.S. are becoming more like independents.

• Independents are filling the void left by major oil companies.

• These independents are either exploitationists or depletionists.

These trends are changing not just business practices but the positions independent producers take on long-running political issues.

A mature resource

Oil production in the U.S. Lower 48 fits a profile predicted in 1956 by M. King Hubbert (Fig. 1 [18278 bytes]). The prediction is holding up very well.

Hubbert accurately predicted production would peak in 1970, a rather remarkable accomplishment. He was able to make this prediction because the curve was past the inflection point-where it changes from concave to convex. Also, the amount of reserves found each year had peaked a few years before he made his prediction.

Hubbert said that the production life of a depletable, known, geographic area, such as the Lower 48, follows a normal distribution, or bell-shaped curve. He predicted ultimate recovery in the Lower 48 of 150-200 billion bbl of oil.

Hubbert's prediction was challenged with vigor at the time he made it. Forty years later, there are still people who refuse to believe there is a finite amount of oil in the U.S.

No one can predict the future, but with this degree of accuracy in matching the last 76 years, you have to place some credibility on Hubbert's prediction.

The decline rate now is 4%/year. Most fields decline faster-at something over 10%/year. Technology has made the difference, particularly waterflooding.

One factor that could make Hubbert's prediction wrong is crude oil prices. If oil prices would go up and stay up, the production decline would level off and reserves would increase. We can produce more oil at $40/bbl than at $20/bbl.

But will the price go up and stay up? I don't think so.

I am a disciple of Ed Capon. He was a research engineer with ARCO who said oil is a commodity and therefore never increases or decreases in real value.

Fig. 2 [13083 bytes] shows that oil prices over the last 100 years in constant 1993 dollars have been relatively flat except for the run-up in the 1970s and '80s caused by the oil embargo and the Middle East war.

Over this period of time, the median price has been $15/bbl, which is the horizontal line on the graph. In 1996 dollars, the median price is $16/bbl.

There are periods of 10-20 years where the price may stay up or stay down. I think we are currently in one of those periods where the price is going to average more than $16/bbl for a number of years; there is now very little excess capacity to produce oil.

Three ages

Using the Hubbert curve, I have divided the life of the oil industry in the U.S. into three ages (Fig. 3 [17720 bytes]). Each age lasts approximately 35 years. The first age, when the oil industry was "young," lasted from 1918 to 1953. The industry's "middle age" lasted from 1953 to 1988. The "mature" stage will last from 1988 to 2023.

The approximate location of the inflection point, where the curve goes from concave to convex, is 1953. Another inflection point occurs at 1988.

In 1996 we are some 8 years, or one fourth of the way, into the "mature" age and 27 years away from the end of that period, when production drops all the way down to 1 million b/d of oil. Advancements in technology may extend the end of the mature age, but in 1996 production has already dropped from its high in 1970 of 9.4 million b/d to 5 million b/d in 1996-a drop of almost 50%.

In the Permian basin, waterflooding began at about the same time that the U.S. oil industry, based on Lower 48 oil production, entered middle age-1953. Fig. 4 [17188 bytes] shows the results of waterflooding on the Texas side of the basin. It also shows the effects of exploration, which helped sustain primary production. Without exploration, the decline in total production since the mid-1970s would have been much steeper than it has been.

The cumulative decline rate for primary production plus secondary recovery with waterflooding in the Permian basin is slightly greater than the total production decline of the Lower 48-50% since the peak of 1973 vs. 46% since the peak of 1970 in all of the Lower 48.

Fig. 5 [15384 bytes] adds the effect of carbon dioxide flooding to the primary-plus-waterflood curve. CO2 flooding is making a significant difference (16%) in the oil production rate. But, of course, it is not making anywhere near the contribution that waterflooding did-at least not yet. Even with CO2 flooding, production is still declining.

From ages to stages

The production life of the Lower 48 can be divided into three stages corresponding to the industry's ages.

The first, exploration, coincides with the industry's youth. This stage favors the major oil companies, with their vast financial and human resources. The main players are geologists and geophysicists. During this stage, large risks are taken.

The stage coinciding with the middle age is exploitation, when the large fields discovered during the exploration stage are waterflooded. Again, it favors the major oil companies because they own the large fields and have the financial and human resources to install and operate large waterfloods. The principal players in this stage are engineers. Large risks are taken during this stage, but not as large as risks of the exploration stage.

The depletion stage occurs during the mature age. At this stage, current fields are worked on by plugging back or deepening wells to new producing zones, and by infill drilling. Fields smaller than the discoveries of the exploration stage are found, and waterfloods begin in fields smaller than those waterflooded in the exploitation stage.

Depletion is a stage of innovation, where many ways are found to do things cheaper and more efficiently. During this stage we see the widespread application of new technology such as 3D seismic, horizontal drilling, and CO2 flooding.

This is the first stage that does not favor the major oil companies. Their large financial and human resources are better adapted to exploring for and exploiting large fields. Depletion favors independents, with their much lower overhead. And it favors two types of independents: the exploitationist and the depletionist.

Independent types

The exploitationist has a full staff of engineers, geologists, landmen, and accountants. He is familiar with and has participated in most of the new technology: 3D seismic, horizontal drilling, CO2 flooding, and so forth. In addition, he is capable of drilling wells very cheaply and has very low overhead.

I like to think that my company, Henry Petroleum Corp., is an exploitationist. The exploitationist is willing to take some risks but does very little pure exploration.

The second type of company, the depletionist, is much different from the exploitationist. A depletionist has virtually no technical staff. With his low overhead he is able to operate wells much cheaper than either the major oil companies or the exploitationist. He will nurse wells along and pay close attention to them but does not have the technical staff to operate waterfloods and CO2 floods or to conduct 3D seismic. The depletionist is risk-averse.

Independent operators must decide whether they will be exploitationists or depletionists. There is little room for compromise between the types. You can be either an exploitationist with a large technical staff or a depletionist with very little, if any, technical staff; you can't be both.

For either type of operator, this is the golden age for independents. For the first time we don't have to compete with the major oil companies. In fact, the majors are helping us by selling some of their smaller, less-profitable, fields.

Back in the 1970s, I was attempting to lease some acreage in Martin County, Tex. Before I knew it, a major had leased the acreage along with half of Martin County.

The majors change

For major oil companies with operations in the U.S., changes are occurring rapidly.

ARCO has divided into several autonomous regional companies. These smaller regional companies are hybrids; they have the financial resources of a major oil company but the flexibility of an independent. Shell and Amoco are forming one regional, autonomous company from both of their sets of properties in the Permian basin. Other companies are shifting their human and financial resources toward their core properties and operating them with skeleton staffs-or selling them.

As oil production in the Lower 48 continues to age, what is happening to the major oil companies? Are they still growing? The answer is yes, but most of their growth is overseas.

Some exploitation independents will be joining the majors in the move overseas. They will be working on smaller fields the majors can't afford to spend time on. Oil and service companies based in the Permian basin are already operating in many countries outside the U.S.

When the Permian basin-based companies compete overseas for projects, they will have an advantage over other companies because the Permian basin is the applied technology capital of the world. We have more waterfloods and more CO2 projects than any other area in the world.

Worldwide production patterns show effects of the shift away from the U.S. From 1970 through 1992, production in the U.S. decreased by 4 million b/d. At the same time, production in Western Europe increased by 4 million b/d, and production in Asia-Pacific increased 5 million b/d (Fig. 6 [13863 bytes]). The oil industry in Western Europe and Asia-Pacific appears to be in its middle age. I believe those regions are past their young age because they are past the inflection point of the production curve.

The production slopes of Western Europe and Asia-Pacific are greater than the slope of the U.S. in its young age. One explanation for the Western Europe slope is that the exploration and exploitation stages have been compressed into one age: Some sort of pressure maintenance program begins soon after a field starts to produce.

Fig. 7 [10234 bytes] shows how the average size of fields discovered in the Lower 48 has decreased over time. The trend is a reason the majors are going overseas.

Operating small fields

We can't operate a smaller field the same way we do a large field. With a small field we must reduce operating expenses.

Fig. 8 [23223 bytes] shows how cutting expenses can extend the economic life of an oil field with a typical decline curve. Without cost-cutting, income equals operating costs in about 15 years, and the field is shut in. Cost-cutting extends field life by 8 years. It also increases reserves and net income.

How do we make this change? One way is to reduce the personnel directly assigned to a smaller field, reassigning these people to core properties. This has a direct effect on the profitability of the field. Another way is to sell the field to a company with lower overhead and operating expenses.

This is happening in the Permian basin. Fig. 9 [11744 bytes] shows how one major oil company has reduced the number of properties it operates in the region. Although the number has diminished by about 80%, the company's reserves associated with those properties has declined by only 20%. The company is able to concentrate on the remaining 20% of its fields.

Property sales resulting from such strategies of the majors have created unusual opportunities for independent oil producers to grow. Their garbage is our gold. Their uneconomic field is our bonanza.

Changing political views

Cutting costs isn't the only way to adapt to a mature age. Another way is to increase oil production through waterflooding and CO2 flooding. But a diminishing field size makes this difficult. And a developing problem is fractionalization of working interest and royalty interest owners.

A field with 10 owners in 1953 may have 100 owners today. That makes unitization very difficult. Generally, a field must be unitized before it can be flooded.

The Permian Basin Petroleum Association is looking into legislation for state-assisted unitization. Under such a law, agreement by 75% of the working interest owners and 75% of the royalty interest owners in a field to unitize for a waterflood or CO2 project would force the remaining 25% into the unitization agreement under the same formula as the other interest owners. Texas is the only producing state that doesn't have some form state-assisted unitization.

Independents are unitizing more and more of the oil fields in Texas, and the majors are unitizing less and less. In fact, in 1995 there was not one unitization application by a major oil company (Fig. 10 [12944 bytes]). Twenty years ago, the Permian Basin Petroleum Association helped kill state-assisted unitization because of independents' fear of being unitized by a major oil company. Now independents need it.

Unitization was fairly easy in the 1960s because fields were larger and it was easy to justify the time spent on unitization. Fig. 11a [33421 bytes] shows one of those large fields. The light area is owned by several oil companies that want to unitize and waterflood the field. The dark area is owned by a company that doesn't want to unitize. Since this field is rather large, it is a simple matter to do away with the injection wells close to the dark area and flood the remaining part of the field.

In a smaller field typical of the 1990s, refusal of the same company to join the flood makes the project uneconomic (Fig. 11b [33421 bytes]). It would block drilling of the three offset injection wells plus the one on the refusing company's property. Although the hold-out owns only 17% of the field, it can stop the other 83% from recovering their secondary oil for their own property. I call this "the tyranny of the minority."

This apparent change in political position is an appropriate response to major trends affecting the business of independent producers. It's the type of change independents must make in order to prosper in their golden era.

The Author