Achieving profitable growth in E&P: New strategies, business model

Panos Cavoulacos
Booz Allen & Hamilton
Washinton, D.C.
Etienne Deffarges
Booz Allen & Hamilton
San Francisco

Major changes in the oil and gas environment during the last decade and a half have necessitated significant course corrections in upstream business strategies. Exogenous factors such as privatization and the opening of new opportunity areas have caused significant shifts in company strategies to drive growth, while lingering low commodity prices have applied continuous pressure to reduce costs.

Successful upstream players have changed their strategies-from frontier exploration to development/production new ventures and on to gas and power plays-and built the capabilities necessary to achieve profitable growth (Fig. 1). Moreover, these companies have adopted a new business model, an organization paradigm based on process-driven networks of business units, accountability and pay-for-performance, empowered multidisciplinary teams, and best practice sharing.

Frontier exploration focus-1980s

During the 1980s, the upstream world had a very clear footprint.

Development of existing proven undeveloped reserves in the U.S. continued to occupy significant mindshare and resources of top E&P companies while very definite boundaries existed internationally to determine where to explore for growth. The focus of efforts during this period was on frontier exploration via the drill bit, with exploration of potential "elephant" plays representing the primary vehicle for growth.

This "elephant hunting" mentality was driven by four major factors:

Relatively high oil prices and projections of higher future oil prices as OPEC started to reassert its power
"Major resource holders" mostly closed to western (American) investment
Low reserve replacement rates in mature basins, accompanied by relatively high finding costs and high overall tax rates (government take)
Improvements in technology, i.e., 3D seismic and MWD.
The result of this "elephant hunting" mentality was substantial investment in a focused number of prospect areas and countries (Table 1) that were, at that time, open to new exploration and development and represented, essentially, the geologic frontier. These efforts were enhanced by the availability of the latest technological developments that enhanced the probability of success of pursuing these strategies:
Surface evaluation techniques
Sophisticated 3D seismic techniques
Harsh environment (deepwater, arctic) drilling and production technology
Faster and more accurate directional drilling and MWD capabilities
High resolution, high speed logging and testing tools
Subsea completion/multiphase flow technology
Enhanced secondary and tertiary recovery techniques.

When successful, "elephant hunting" expeditions are very attractive; they reward oil companies with higher profits/BOE and net margins relative to those in the U.S. lower 48 states, higher wildcat success ratios, reserve additions on the scale of those in the Persian Gulf, higher production rates and, ultimately, higher rates of return.

However, executing this strategy successfully not only required a number of technical capabilities but, more importantly, also implied a significant culture and mindset change within the old E&P corporate mentality. In short, to be successful, E&P companies had to adopt a "venture capital" mentality focusing on investment rather than management of earnings. This situation was very different from the old E&P culture and required comfort with long odds as well as ability to manage risk. Investment focus revolved around highgrading of opportunities, not diversification, and relied less on hard facts and more on good ideas and informed instinct. This mindset change was by far the biggest obstacle to becoming a successful "elephant hunter."

Facing tremendous cultural as well as technical challenges, execution of this strategy proved to be daunting, with only a few players demonstrating clear success.

New opportunities emerge-1990s

Around 1990, new value creation opportunities emerged in the E&P business.

While the necessary technical capabilities remained the same, the upstream geographic scope broadened. At that time, substantial quantities of identified, proven but undeveloped reserves in the Former Soviet Union, Persian Gulf, Latin America, and Northern Africa started becoming available to western companies (Table 1). A number of factors led to this new "open" attitude by host governments and their national oil companies to foreign investment:

Access to much needed funds for further E&P investment
Technology transfer and exposure to latest technology
Experience with latest management thinking and processes
Risk diversification through quicker monetization of current reserve base
Opportunities to diversify globally through enhanced cooperation/alliances.
E&P strategy has shifted from frontier exploration to development/production new ventures. These ventures still involve exploitation of oil and gas reserves and thus require all the technical capabilities needed to succeed in the previous era. However, the transaction-intensive nature of the strategy requires developing or acquiring new and complementary capabilities-primarily initiating and closing deals.
New business development processes must be developed to ensure access to deals before they become public bidding auctions.
Existing relationships and negotiated arrangements must contribute to increase both deal flow and the number of opportunities captured.
Strong political risk management capabilities, including the ability to structure innovative deals with creative financing, become crucia.l
The ability to react quickly and make timely decisions-creating a "nimble" organization-is key in this deal-making environment.
Maintaining flexibility and adopting "non-traditional" arrangements where management control is shared and influence is more important than authority will undoubtedly differentiate successful players.
Therefore, the new E&P strategy requires upstream players to focus on innovation and opportunism, whereby value can be created by quickly identifying and capturing market-driven opportunities through systematic deployment of advantaged capabilities (such as creative financing, gas marketing, production technology, etc.) and/or optimal monetization of existing assets.
One such market-driven opportunity that has become a prominent part of many E&P companies' strategies is the drive towards new ventures in the gas and power industries. Indeed, major changes in these industries have created substantial growth opportunities.
Skyrocketing demand for power generation capacity in rapidly developing economies such as Brazil, China, India, Indonesia, and Thailand
Deregulation and privatization of power generation
Availability of natural gas, previously uneconomic on a stand-alone basis but now able to benefit from quicker monetization via power projects ("Gas by wire")
Technical developments in gas turbine/combined cycle technology.
Distinct and independent businesses are evolving from the previously integrated regulated electric utility business as a result of deregulation of the power industry. Each of these new businesses offers substantial value-creation opportunities to oil companies (Fig. 2), although the strategies and key factors for success-and thus core competencies-will differ depending on the segment of the power market that oil companies target (Fig. 3).

Growth and cost control

Throughout this last decade, oil prices have remained stable but low. In this environment, with industry financial performance falling short of capital market expectations, oil companies have applied continuous pressure to reduce costs.

Upstream management teams are constantly reviewing operations to improve processes and productivity throughout the upstream business. As a result, E&P players reduced headcount per barrel of gross operated production by 6-8%/year in 1991-94 (Fig. 4); there is every reason to believe that recent upstream productivity trends will continue.

Much of this cost re-examination has come in the form of a core competency analysis, focusing on those capabilities vital for success and on those internally developed institutional skills that can truly differentiate companies from their competitors.

Cost control implies outsourcing noncore processes or tasks; after a period of initial resistance, this approach has now been institutionalized by most major oil companies. Indeed, casting a critical eye and challenging existing paradigms constantly will allow oil companies to minimize costs even in periods of growth.

Going forward, both growth and cost strategies will continue to be emphasized by majors worldwide. It is important to note that, while value-creation growth initiatives have changed over the years, they are not mutually exclusive. Rather, new growth strategies tend to be cumulative, with companies adding new plays to their portfolio as opportunities arise. In addition, while each company may prosecute similar value-creation strategies, specific tactics will differ widely depending on starting points, key capabilities, emerging opportunities and timing-being in the right place at the right time and being ready to act upon the opportunity (Fig. 5).

The key question then becomes: "Are all major oil companies pursuing the same generic upstream strategies?" We believe that the answer to this question is: "Yes, they are all pursuing the same portfolio of generic strategies-albeit emphasizing different specific opportunities."

In the past, following the first oil shock and expropriation by host governments, companies carved out very specific regional strategies to maximize investment returns. Today, low oil prices, openness to western oil company investment, and demanding growth targets have redirected every oil company to the pursuit of market-driven opportunities. The upstream oil and gas business has once again become truly global.

New upstream business model

The new strategic environment and the twin objectives of continued growth and improved profitability have led many E&P companies to adapt not only these generic strategies, but also their organizational structures and processes to achieve superior performance.

These efforts started as early as 1990, and different companies pursued these initiatives for their own specific reasons. However, we now observe that a significant number of successful players have reorganized and that ideas first discussed 2 or 3 years ago have been implemented and operationalized. Consequently, we believe that a new upstream organization paradigm has now emerged (Fig. 6).

Company structure

Unsatisfied with their poor performance in the early 1990s, several oil companies reorganized into less-hierarchical, activity-based networks of business units.

Business units are defined as collections of identifiable assets of significant scale forming an individual unit. The business unit management team will generally manage its own operating resources, make its own business decisions, and be accountable for results.

Business units are different from affiliates because virtually all resources are available locally, all decisions (within limits of authority) are made locally, and managers are held accountable for their performance.

Business units are defined on the basis of either process (exploration, production, non-operated assets), geography (U.S., North Sea, etc.) or business (gas, power).

These new organizations have pushed executive authority and responsibility closer to the front-line. Executive vice-presidents overseeing the upstream sector are generally responsible for creating synergies across business units, setting performance targets at appropriate levels, appointing, coaching, and developing the next generation of leaders, and facilitating best practice sharing; they have neither the responsibility nor the staff to make day-to-day decisions or manage monthly P&Ls. This day-to-day executive authority has now been pushed down to the business unit management level.

Business unit organizations are now very common in the E&P industry; however, two companies have pushed the concept further. One reorganized into a federation of about 40 asset-based teams, with no team having more than 500 staff members. Asset managers report directly to the head of E&P, asset teams have full P&L responsibility, and decisionmaking authority is pushed to the lowest possible levels of the organization. Each asset team and its management is held accountable to a set of key operational and financial measures, thus linking the performance of the asset base to management compensation.

At another upstream company, top management replaced the traditional E&P organization with separate growth and operations organizations; there is no longer a head of E&P, and the new ventures group-focusing on energy solutions, not exploration-has become the cornerstone of the growth organization. New ventures VPs pursue market-driven energy solutions in target countries through multidisciplinary teams with capabilities in exploration, reserve acquisitions, gas, power, etc. Both the growth and operations groups are supported by virtual teams, who are the repositories of competencies in E&P technology and negotiations.

Accountability, pay-for-performance

The cornerstone of the new upstream organization is the performance contract between the business unit management team and its top management. This contract establishes objectives and determines compensation.

One company uses, in addition to personal management objectives, a few key metrics to drive the contract; these include reserve and production growth, acreage additions, production costs, finding costs, operating cash flow per barrel, and return on capital employed (ROCE).

This company pays variable cash bonuses on the order of 18% for middle managers, and much higher (50%+) for senior executives; its incentive system is meant to provide employees with significant, direct rewards for superior performance.

Another E&P organization reinforces value creation targets by a culture of increasing accountability, performance measurement, and "pay for performance" compensation. Highly variable cash bonuses (with a significant non-discretionary component) and stock options are used to reward performance; for example, no cash bonus is paid if the company's ROCE does not exceed 10%. On-the-spot cash bonuses are used to recognize key contributors, in the form of $5,000 checks presented to team members making significant contributions.

Key business processes

For example, one major oil company is now pursuing a market-driven strategy, focused on target countries, with cross-business coordination based on global strategic imperatives. Target countries represent major opportunities where resources from all sectors (upstream, downstream, and chemicals) are harnessed and deployed.

Exploration activity has been substantially refocused through a value-based worldwide prospect portfolio, managed through a centralized unit. Consistency and discipline in E&P processes is ensured by peer reviews and post mortems.

Gas strategy has been globalized and is now driven by customer needs and market analyses, rather than by available company natural gas resources. A global gas coordination team is responsible for making decisions about new gas projects, resolving conflicts, and facilitating opportunity capture, while regional teams focus on market evaluation and tactical business decisions.

Another oil company has decided to concentrate only on the execution of those core activities that lead to a sustainable competitive advantage. Activities that are not part of its core business, or where it cannot create value, are outsourced or drive cooperative alliances and partnerships with contractors and other oil companies.

This company captured operating cost savings of over 30% in a core producing area through outsourcing and partnerships with contractors.

Multidisciplinary teams are the privileged organizational vehicle in a third upstream competitor. The CEO reinforces this culture with visible support through his own team and with high authority levels. As a result, empowered teams in the field have been the source of significant technical innovation and cost reduction, leading to the lowest worldwide lifting cost in the industry.

Processes decentralized to business units (e.g., exploration) are supported by peer reviews to ensure common prospect evaluation and portfolio optimization. For example, teams in a core producing area have reduced drilling time for standard 10,000 ft wells from 40 days to 8 days and cut costs from $4 million/well to under $1 million.

This company extends the team concept to its contractors and empowers and rewards them for reducing costs. The successful completion of standard 10,000 ft wells in under 192 hr results in contractors getting paid 25% of the time saved, of which 25% must be paid to rig personnel.

Skill deployment

Empowered and accountable teams cannot resolve everything; in particular, a skill deployment mechanism across teams is necessary so that the organization becomes more than the "sum of its teams."

One company uses both formal and informal processes to deploy skills globally. It has developed and implemented a worldwide electronic bulletin board that serves as a transparent career management system. Job openings are posted worldwide through the computer network. Employees can self nominate after 2 years in a position and, before being selected for the short-list, must get approval from their supervisor to proceed through interview process.

While 45% of the jobs are awarded to preferred candidates identified prior to posting, roughly 55% of positions are filled by individuals identified through the self-nomination process. This process takes 4-6 weeks (from posting to filling job), much faster than previous methods.

In several companies skills are increasingly deployed in an informal, "fish net" fashion, with ad hoc teams gathered temporarily for a specific project and returning to their original positions afterwards. Technical discipline managers fulfill the roles of chief geologist, geophysicist, and production/reservoir engineer and help recruit, train, and manage careers.

Best practice sharing

More generally, beyond skill deployment, best practice sharing is a key challenge for these new organization structures; consequently, innovative mechanisms, sometimes called networks of excellence, have been put in place by several oil companies to encourage the transfer of knowledge.

These networks are groups of 5-15 people with expertise in particular areas who come together to deal with various technical issues to build and share specific core competencies and knowledge across the company; networks may cross sector boundaries. Most networks have loosely defined charters and goals and small budgets; executives (champions) sponsor the networks and guide their work. Increasingly, electronic mail and groupware tools (such as Lotus Notes and intranets) are used to link the community of participants.

Although no such company exists, an E&P company organized under the new business model (Fig. 7) would consist of several business units, with growth (business development) separated from operations. Gas marketing and power would be distinct businesses, and a separate structure would be set up to manage non-operated properties.

A culture of increasing accountability and cost control would be enforced by the use of empowered teams and pay-for-performance programs extending to the front line. Consistency and discipline in E&P processes would be ensured by peer reviews and post mortems. State-of-the-art information technology would facilitate communication and exchange of information. Bulletin-board systems would be used to deploy skills, while systematic capability assessment would ensure that the necessary resources are available to implement strategies. Finally, mechanisms would be built to share best practices across business units.

Conclusions

Despite a continuously changing environment characterized by privatization, opening of new opportunity areas, low commodity prices and pressures to reduce costs, successful upstream players have been able to grow profitably during the last 15 years.

Their success has been based on their ability to change strategies in a timely fashion, to build the capabilities required to sustain profitable growth, and to adopt a new business model driven by business unit networks, accountability and pay-for-performance, empowered multidisciplinary teams, and best practice sharing. Moreover, their track record suggests that these players are uniquely positioned to capture the rewards of new opportunities arising in the upstream.

The Authors 9521jcaa.eps Cavoulacos 9521jcab.eps Deffarges

Panos Cavoulacos is a principal in Booz Allen and Hamilton Inc.'s energy practice, based in Washington, D.C. He focuses on strategic, organizational, and business/market development issues in the petroleum and power industries.
He has led major initiatives for oil companies in exploration and production, marketing, and staff support services, both in the U.S. and in Europe. Before joining Booz Allen, he was business development and planning manager at GE Industrial & Power Systems. He holds bachelor and masters degrees in nuclear engineering as well as a masters in management and a PhD in energy economics, all from MIT.
Etienne Deffarges is a vice-president and partner in the San Francisco office of Booz Allen & Hamilton. He heads its global energy and chemical practice, which serves major oil companies, electric and gas utilities, chemical firms, and pharmaceutical groups worldwide. He specializes in strategy development, organization analysis, and business process re-engineering for international oil and gas companies.
He was graduated with high distinctions as a Baker Scholar from the MBA program at Harvard Business School. He holds an MS in civil engineering from the University of California at Berkeley and a BS/MS in aeronautical engineering from the French National School of Aeronautics & Space.