Can the E&P industry avoid future shock?

David Murphy, Chris Friedemann, Ricardo Castro
McKinsey & Co. Inc.
Dallas

The recent burst of energy in the oil and gas exploration and production business marks a stark contrast with just a few years ago when the industry was hit by the oil price collapse, which destroyed $400 billion in value during 1987-92.

The players are fighting their way back, but the industry is clearly in a state of flux and the outcomes are uncertain.

During the next decade, we believe industry participants will have enormous opportunities not just to survive but to prosper.

Emerging trends, however, suggest that the paths to success will be very different from the past.

To win, players will need to stay in tune with those trends and configure themselves in new ways to capitalize on them.

Emerging trends

To illuminate what's happening now, it's helpful to look briefly at the pre-bust past.

Prior to 1986, participants played fairly well defined roles in the E&P business system. National oil companies (NOCs) held significant reserves and looked to the majors to help them expand the oil and gas industries of their countries.

Major oil companies (MOCs) provided most of the equity, developed the assets, acted as project integrators, and provided high-end technical services.

Independents targeted niche opportunities, mostly in the Lower 48.

Oil field service companies (OFSs) focused on providing discrete, commodity-like services, such as shooting seismic or drilling and completing wells.

The E&P world of today is no longer so orderly and is likely to become even more chaotic during the next decade.

NOCs are becoming increasingly sophisticated customers-and, in some cases, competitors-posing a new set of challenges for the MOCs and OFSs.

The lines between what MOCs and OFSs do are blurring dramatically, potentially putting them on a collision course. Independents and "petropreneurs" have capitalized on MOC divestitures to build their assets and capabilities and are now setting their sights on emerging international niche opportunities.

Each of these trends is worth some elaboration, because they signal an oil industry very different from the past and the need for new strategies and capabilities to succeed.

Changing NOC status

NOCs will continue to exert enormous influence over the industry's evolution.

They have been and will continue to be the gatekeepers to most of the world's oil reserves. Today, the 10 largest NOCs control access to more than 70% of the world's reserves; by contrast, the 10 largest MOCs control less than 2%.

Moreover, NOCs now have a 75% share of upstream profits (vs. 50% in 1970); the MOCs' share has shrunk to 15% from 40% since 1970.

What has changed to shift the balance of power to the NOCs?

First, NOCs now can pick and choose from an array of funding options. That was not the case in the 1970s and 1980s. Then, geopolitical and economic turbulence in the reserve-rich countries made direct equity investment from the MOCs the only financing alternative. With liberalization and privatization, however, many NOCs now operate in more stable and less risky environments.

Concurrently, global capital markets have become more accessible, and new financing vehicles such as project finance and asset-backed securities have emerged. As a result, more investors (including independents, OFSs, other NOCs, and nontraditional players such as GE Capital) are willing and able to invest in projects around the world; many NOCs are securing funding sources on their own; and MOCs are advantaged capital providers only for the largest, riskiest, and earliest life-cycle projects.

Second, NOCs today can choose from a much broader set of players capable of providing or obtaining needed technical, commercial, and project management talent. Independents such as Anadarko and Apache increasingly are targeting the international arena for growth. OFSs such as Halliburton and Schlumberger are willing to assemble integrated service packages for their customers. Some NOCs such as Statoil, Petronas, and Petrobras are no longer content to stay at home but aspire to move beyond their borders to offer capital and services to other NOCs.

Third, NOCs are changing their operating models and developing capabilities to do more of what they used to rely on others to do. Since the 1950s, NOCs have moved from an almost total reliance on the "passive" royalty/taxation model to a much broader array of creative fiscal terms.

Recently, for example, the Colombian NOC adopted such innovations as sliding-scale terms, automatic triggers for NOC buy-ins, and explicit external developer termination clauses.

In addition, with capital, technology, and resource development expertise increasingly available on the "open market," many NOCs are developing the ability to pit providers against each other and to act directly as the project integrator. In Mexico, for instance, Pemex acts as project integrator for its largest field, Cantarell, but relies heavily on external parties such as Western Atlas, Bechtel, and Netherland & Sewell for key technical services.

Fourth, with more capital providers and resource developers to choose from, NOCs are in a position to extract even more economic "rent" from their reserves-with a corresponding squeeze on outsiders' profits. Since the 1950s, government takes around the world have grown from about 50% of operating cash flow to more than 85%. A simple "back of the envelope" calculation illustrates the squeeze on external developers (MOCs, OFSs, and others): If you assume $10 in operating cash flow from every $20/bbl of oil, outsider takes have plummeted from $5/bbl to $1.50/bbl.

MOC, OFS roles converging

Against this backdrop of increasing NOC power, the roles of MOCs and OFSs are blurring.

At issue is whether the convergence will slow or stop, continue amicably, or put MOCs and OFSs on a collision course.

In the aftermath of the oil bust, MOCs took drastic action to restore profitability. They terminated 372,000 employees during 1985-95. They cut their R&D budgets at a compounded annual rate of almost 5% during 1990-94. They restructured their portfolios around core businesses and assets. They divested more than $10 billion in non-core E&P assets during 1989-95 to buyers like Newfield and Apache (which thus gained a platform from which to launch future international assaults).

Along with these cuts, the MOCs began outsourcing and forming alliances with OFSs to provide services they used to provide internally. A few statistics illustrate the remarkable shift toward integrated services. Today, industry sources estimate that nearly two-thirds of all North Sea drilling is done on an integrated basis. Worldwide, the estimates range from 20% to 40%.

The future could bring more of the same. A 1997 Salomon Bros. survey of 228 oil and gas companies showed that the number of companies using integrated OFS services jumped from less than 5% in the late 1980s to 30% in 1996. Moreover, more than 50% of the companies were interested in using more services, compared to less than 20% in the late 1980s.

As the MOCs drew back to their core assets and businesses, the OFSs began expanding capabilities to fill the void. They pursued acquisitions, joint ventures, and product alliances to expand their service offerings. They reorganized to offer integrated services (one-stop shopping) to their customers and to reduce their operating overhead. They increased R&D spending at a compounded rate of almost 7% during 1990-94 to take advantage of technology advances that would differentiate their products and services and allow them to develop integrated information management systems.

As a result, OFSs now are playing roles in the E&P business system that formerly belonged solely to the MOCs (Fig. 1 [31,289 bytes]). Along with providing traditional "commodity-like" services, they are delivering high-end technical services and, increasingly, playing the project integrator role. Going forward, MOCs and OFSs will be in the interesting position of cooperating on some projects and directly competing on others.

Other more recent trends will be worth watching-partly to see whether they put MOCs and OFSs on even more of a collision course and partly to see how the NOCs respond. Some OFSs are forming subsidiaries or reorganizing to take equity positions. Reading & Bates, for example, has agreed to share in the risks and upside of offshore drilling by assuming a direct equity interest in certain deepwater Gulf of Mexico wells.

Simultaneously, many MOCs are beginning to redesign their organizational approaches so that they can be more flexible and entrepreneurial in responding to customer needs in different geographies. They also seem to be edging closer to an "unbundled" approach, which allows them to offer specific products or services (such as capital provision or field redevelopment) in a separate rather than fully integrated package. While it is difficult to predict how far either side will go, the beneficiaries of increasing competition and customer focus will be the NOCs.

Petropreneurs' growing role

The rise of the petropreneurs-including such companies as Apache, Enron, Newfield-is old news now, but still an amazing story.

McKinsey tracked the performance of 20 U.S. petropreneurs (both publicly traded and privately held) during 1991-96. Collectively, the group created shareholder value that exceeded the S&P 500's by an estimated $17 billion-often with assets divested by the MOCs. They grew at an average annual rate of more than 20% (vs. 2% for the MOCs) and captured almost $40 billion in new revenues.

Until recently, petropreneurs generated most of their growth in the U.S. Now, several petropreneurs-including Triton, Anadarko, and Newfield-are beginning to compete internationally with MOCs and OFSs for opportunities. Triton, for example, has business relationships in Colombia that are on a par with British Petroleum's. Anadarko is parlaying a string of world-class discoveries in Algeria into a solid regional and global growth platform. Newfield's recent acquisition of Huffco's international interests in China and West Africa launches the company onto the global stage from its traditional base of operations in the Gulf of Mexico.

The trends of the last several decades have set the stage for a dynamic E&P business going forward. NOCs have increased their power and sophistication. The lines between traditional players are blurring. All industry participants are looking beyond their traditional core businesses for both domestic and international growth opportunities.

The fundamental question is whether all participants can peacefully and profitably coexist or whether the E&P environment is once again destabilizing and driving all towards the next upstream shock.

Future trends, player strategies

Will the 2000s be the era of shared success or future shock?

No one has a crystal ball, but a few themes seem highly probable.

NOCs will establish themselves even more firmly in the driver's seat. Resource developers will be forced to stretch far beyond where they are now to deal with the challenges and capture the opportunities that lie ahead. A select few will position themselves for a high-payoff "end game."

Collectively, NOCs will drive the industry's evolution. Each NOC, however, will play roles and build or seek capabilities that are consistent with its country's desired level of control over reserves, attitudes toward competition, economic requirements, and regulatory mandates. As is true today, NOCs will have three "macro" choices for managing resource development in their home markets: remain closed, encourage an open market, or foster a hybrid of the two.

We expect many more NOCs to move to the hybrid or open model in the decade ahead. Which NOCs and how fast they move are the big unknowns. Once an NOC decides, however, the conversion could occur virtually overnight-as illustrated by the recent transformations in Thailand, Venezuela, and Argentina.

As they convert, the NOCs may change their buying behavior in several ways. The common "industry view" is that NOCs will match a specific project "one-to-one" with the advantaged resource developer and service provider.

That is, NOCs will pick the largest MOCs for big, complex, early life-cycle projects that need lots of capital and have significant country or project risk. Examples include developments in the Caspian or Sakhalin regions of the former Soviet Union.

NOCs will tap the best independents for projects in proven basins and underexploited areas, such as Malaysia, where much of the development infrastructure is in place and the capital requirements are more modest. They will turn to large, integrated OFSs for projects in mature basins with low geologic uncertainty and minimal need for capital infusion or vertical integration. Examples might be field redevelopments in Venezuela or Argentina.

We think a more intriguing model is already being pioneered by several NOCs, including Statoil and Petronas. These NOCs are beginning to unbundle each project into separate elements and, based on an array of criteria, to pick the best MOCs, OFSs, and petropreneurs for each element. If this model plays out, we could envision a future in which every project involves multiple preferred providers: a specialty firm like Edge or a proven "elephant finder" like BP providing exploration services; a Shell, Mobil, or Schlumberger providing primary reservoir development and project management services; a Halliburton or Statoil providing operations services; a Newfield or Renaissance providing exploitation services; and an Enron Capital & Trade or a unit of Goldman Sachs providing any supplemental project capital.

As the key resource owners, the NOCs will drive the industry's evolution. They will be increasingly capable and sophisticated customers. The choices they make will clearly influence the fortunes of traditional and nontraditional E&P competitors, creating great opportunities as well as substantial challenges for those who wish to play the game.

Customer focused providers

If you were looking at a future in which your destiny was going to be heavily influenced by more powerful and sophisticated customers, how would you be positioning yourself to respond?

Some MOCs, OFSs, and petropreneurs are already beginning to configure themselves for this new future. In some cases, their strategies are strikingly similar.

MOCs and petropreneurs have at least three strategic options, each of which is based on what they would have to believe about the future evolution of the industry (Fig. 2 [32,201 bytes]). Currently, few participants appear to favor the "status quo" approach. Instead, most appear to be focusing on a limited number of advantaged E&P roles. They are exiting disadvantaged positions through sale or joint venture, unbundling traditionally integrated service offerings when needed to "win a deal," and partnering with other producers and service companies when their customers require integrated, "full-chain" participation.

To pursue this option, MOCs and petropreneurs must define where and how they are advantaged. In a game that is growing increasingly competitive and fragmented, developing a sense of the "advantaged position" and how to capture it will become a critical requirement for success.

Perhaps the most interesting option is the "total energy solution" strategy, which realistically can be pursued only by MOCs and the larger, broad-based, and commercially minded petropreneurs. These companies would link upstream, midstream, and downstream assets within or across regions to create "competitive space" between themselves and smaller, niche specialists and to capture the vertical integration benefits that still exist in many emerging markets.

A few MOCs-including Unocal in Southeast Asia, Mobil in Asia-Pacific LNG, and Exxon in China-appear to be moving in this direction. We think the best-in-class "total energy providers" will create networks of business units around the world and forge privileged relationships with service companies, NOCs, petropreneurs, and regional specialists to complement their asset positions and capabilities.

OFSs also have at least three strategic options, again based on a set of beliefs about the future (Fig. 3 [30,302 bytes]). In our view, holding the ground is the "minimum bid" for OFS providers. Their ability to do so depends significantly on likely resistance and competition from the MOCs. Many of the larger, broad-based OFSs appear to be positioning themselves to become full-line integrators and asset developers. They are building the skills to play more challenging project management and thought-leadership roles and to participate earlier in the life cycle of a project. Smaller OFSs must develop (on their own or through alliance) the capabilities to compete in a supplier world that is becoming less specialized and increasingly integrated.

Currently, only a few appear interested in or capable of pursuing the most far-reaching option-becoming a "virtual major"-given its significant scale and scope requirements. This strategy would require forging an entirely new set of partnerships with a range of players, including engineering and construction firms, MOCs and/or independents, equity and/or funding partners, and specialist OFS providers.

The emergence of Schlumberger and Halliburton as the "eighth and ninth sisters" could be one outcome of this option. Another scenario is even more intriguing. Imagine Schlumberger and Halliburton having the aspiration and capability to facilitate resource development anywhere in the world by the smallest players. What would happen to the prevailing industry structure-including economic rents and global supply levels-if there were more Seven Seas Petroleums in Colombia, Arakis Energys in the Sudan, and Avalon/Gazprom alliances in the FSU?

MOCs and OFSs will face massive changes in the coming decade. Current players will need to stretch far beyond where they are today to address the challenges and seize the advantage in the local, regional, or international opportunities that will unfold.

High payoff end-game

To get some perspective on the stretch required and on possible end games even further out in the future, we looked for analogs in other industries facing similar discontinuities.

High tech industries-personal computing, software, information systems, and aeronautics-were particularly illuminating.

In each of those industries, a few players emerged to exert a leadership position and set the pace for the way the industry works. We call them "value-added orchestrators" because they forged extensive and complex alliance networks with other industry participants and positioned themselves to capture most of the value created in their industry segment.

Microsoft is perhaps the best example of a value-added orchestrator, and its story is both remarkable and revealing. In 1983, Microsoft was viewed as a provider of a simple operating system to the fledgling personal computer market. By 1996, Microsoft was a force to be reckoned with. Microsoft had a market cap of $72 billion (up from $784 million in 1986), a dominant worldwide market share in PC software and operating system applications, and strong positions in many new environments, including multimedia, cable, and the Internet.

Just since 1990, Microsoft has captured an estimated 40-60% of the market value created by publicly traded computer-related businesses.

How did Microsoft do it? The company didn't have the best technology (Apple's operating system was acknowledged to be superior early on) or the best starting position. What it had was an ability to see an industry discontinuity on the horizon, form a clear view of the end game, and put in place the strategy, systems, and relationships required to win.

Relationships were and continue to be the key. Microsoft forged strong alliances with external software developers (its pivotal service providers) and formed privileged partnerships with such companies as Intel and Compaq. Today, this network of alliance relationships makes it possible for Microsoft to call the tune in the industry; conversely, it's hard for anyone to dance without Microsoft as a partner.

We are convinced that some players will emerge as the Microsofts of the E&P industry. Like Microsoft, they will assume value-added roles as general contractors and thought leaders, form webs of partnerships and alliances to create barriers to entry, and in turn drive the industry structure to their advantage.

What and where they orchestrate is likely to vary. Some may focus on specific parts of the E&P chain in many regions around the world. Others may orchestrate all activities in specific regions. Still others may perform value-added roles across certain opportunities, such as deep water or the gas chain.

Who will orchestrate is obviously uncertain. In other analogues we examined, the orchestrators often "attacked" from outside the industry. An attack by outsiders is possible in E&P, since the orchestrator strategy seems far removed from the current positions and strategic intent of most E&P participants.

At the same time, however, a few incumbents certainly have sufficiently strong leadership positions to succeed-including some MOCs, OFSs, and NOCs. Pursuing such a strategy would clearly be difficult but could yield significantly higher returns at lower levels of capital employed for the select few who can actually pull it off.

To recap, we believe the E&P industry could potentially be on the verge of another discontinuity. The prospects are both challenging and exciting. Whether the future brings shared success or significant shock depends a great deal on the choices each player makes today.

Acknowledgements

The authors wish to acknowledge the assistance of their clients and Mc Kinsey colleagues-including Brad Berkson, Keith Chappell, Carolyn Coughlin, Dave Gee, Allen Soong, Andy Steinhubl, and Diane Taylor-in sharpening the concepts and points of view expressed in this article.

"The trends of the last several decades have set the stage for a dynamic E&P business going forwardellipseThe lines between traditional players are blurring. All industry participants are looking beyond their traditional core businesses for both domestic and international growth opportunities. The fundamental question is whether all participants can peacefully and profitably coexist or whether the E&P environment is once again destabilizing and driving all towards the next upstream shock."