Unconventional resources to keep pivotal supply role

For the past several years, leading major oil companies and independent producers have believed unconventional resources to be key elements of future energy supply. As a result, they’ve poured investment capital into heavy oil, shale gas, tight gas, and coalbed methane. However, the economic crisis and subsequent reduction in financial liquidity in companies worldwide threaten the growth prospects for North America’s unconventional hydrocarbon resources.

In light of the economic climate, leading unconventional gas producers are reducing their capital budgets and, in some instances, shutting in production entirely. For example, Chesapeake Energy, citing wellhead prices “substantially below industry break-even costs,” curtailed a portion of its unhedged Midcontinent production. In just the past few weeks, oil sands producers such as Suncor, Petro-Canada, Nexen, and BA Energy have announced project delays or cancellations.

So, as Canada’s Globe and Mail newspaper has queried, will unconventional projects and jobs be incinerated by the crisis? We believe not. Oil sands and shale gas in particular have become pivotal sources of North American supply growth. A number of elements support the continued development of these resources: the underlying fundamentals of supply and demand dynamics (i.e., as the price decreases, more resources will be consumed); the benefits of gas vs. other fuels for power generation; and the potential for governments to pursue greater energy security.

The recent decline in activity stems from the capital-intensive nature of unconventional developments and the pace at which companies sought to exploit the resources. For example, the Canadian Energy Research Institute’s latest study estimates that capital expenditures of over $300 billion (Can.) will be required during the next 20 years to realize the full potential of oil sands resources. As another example, a Booz & Co. analysis of 10 middle-size natural gas producers found the median company had outspent its operational cash flow by 130% during the past 12 months. Clearly, access to capital is a must-have for unconventional producers.

Now that capital is not readily available, the financial crisis is restructuring the competitive landscape. We hear companies say they need to live within their cash flow as there is little capital available. Because of this cash crunch, it is likely that some of today’s producers of unconventional oil and gas will not be around to benefit from long-term growth. We believe those companies with the foresight to cut spending while identifying and acting on ways to capitalize on market opportunities can secure competitive advantage and prosper.

The potential

Over the past 3 years, strong global demand, robust commodity prices, improved technologies, and readily available capital led some companies to expand production from North America’s unconventional oil and gas reservoirs. Canadian oil sands production reached 1.2 million b/d during 2007, and recent forecasts indicate production will increase to 2 million b/d by 2012.

Unconventional gas production also has shown a surprising increase, especially in light of recent dire predictions regarding North America’s imminent dependence on imported liquefied natural gas. For example, the Barnett shale alone contributed almost 900 bcf to domestic supply during 2007. Based on growth from the Fayetteville and Woodford shales, as well as several tight gas plays in the Rocky Mountains, the Energy Information Administration (EIA) projects unconventional natural gas will represent almost 50% of total US production by 2012.

New uncertainty

Declines in global demand growth and in commodity prices related to the economy represent major hurdles. From a global supply perspective, unconventional resources hold a marginal position. In addition, oil prices have already dipped below the most recent break-even price estimates of $80-115/bbl for new integrated oil sands developments. The story for gas is no different: The projected break-even costs of many emerging basins exceed current prices, as evidenced by several producers’ recent plans to curtail production and capital expenditures.

So is the promise of unconventional resources now a historical fallacy?

No. The underlying fundamentals support continued development of unconventional resources in three ways: First, global supply and demand balances, albeit less aggressively, require continued production growth in the face of maturing and declining traditional supply sources.

Second, major oil companies have fewer opportunities for new developments, as challenging international environments have limited access or unfavorable terms; therefore, the incentive is high through technology and other means to ensure cost, recovery, and other factors keep unconventional resources economically viable.

We expect that rig rates, service costs, and the cost of oil-country tubular goods will decrease during 2009 as activity levels slow down. Other analyst reports suggest that these costs could come down as much as 30% from the 2008 peak. Such a cost reduction would improve the economics of any new investments, including exploration drilling.

Finally, declining oil prices will decrease inflationary cost pressures that have plagued development investment over the past several years and work to offset the impact of declining commodity prices on project economics.

Competitive advantage

Methods of attaining competitive advantage, on the other hand, have changed. Traditionally, access to resources coupled with access to capital drove success in production from unconventional oil and gas reserves. This fact is illustrated by the number of small and medium-size companies that accumulated large leaseholdings and employed leverage to generate short-term success in production growth as well as valuation and share-price performance.

However, it takes more than just a large land position and aggressive drilling to create shareholder value in the face of an economic slowdown. Now that capital is not as readily available, high-quality resources, lower operating costs, and technological advantage will determine which companies have the staying power to capitalize on the long-term opportunity offered by unconventional resources.

There are three steps that companies can take during the downturn to improve their positions over time. These steps are applicable equally to well-capitalized companies and those facing liquidity problems and may actually generate incremental capital or improve liquidity:

1. Companies should look for opportunities to expand their unconventional portfolios through mergers and acquisitions. Large companies with healthy balance sheets will likely find a multitude of opportunities, as some small and middle-size producers will be unable to raise additional debt or equity capital and will be forced to divest assets or consider selling their companies. In recent work with an oil sands producer, Booz & Co. identified a number of attractive takeover prospects whose current market values did not appropriately reflect the inherent value of their project portfolios.

Inorganic growth isn’t just for the cash-rich. Perhaps a wave of mergers of equals akin to what we saw in the late 1990s, when like-sized companies combined operations to form larger entities, is just what the industry needs. This will allow smaller companies to improve their capital positions, increase potential cost savings, and position themselves for market turnaround.

2. Unconventional producers should focus their capital spending on opportunities to advance or create competitive advantage. The nature of unconventional assets vs. conventional resources, including differences in capital requirements, reserves life, and interdependence between midstream and downstream assets, suggests there are unique opportunities for competitive advantage in unconventional developments.

Market leaders will continue, and possibly accelerate, investments that establish and sustain these benefits. Moving forward with the construction of an oil sands upgrader could force a competitor to cancel its plans for a similar project. Expanding gas-gathering and processing facilities in a particular basin could allow a company to dictate the future development of that area. Such forward-thinking initiatives can overhaul competitive conditions.

To make such decisions, companies must examine the near-term potential and long-term option value of their capital portfolios. This will help them set priorities for their investment decisions. Limited capital availability may require divestments, as well.

3. Future unconventional winners will distinguish themselves by demonstrating superior operational and technical capabilities. Unconventional resources benefit from a tailored business model, one that separates simple, easily repeated activities from more complex, customized efforts, in order to realize economies of scale in unconventional plays.¹

Based on recent assignments with unconventional gas producers, we have found that reviewing the surface access process and addressing existing bottlenecks may reduce a producer’s cycle time by 20-30% through relatively simple process revisions. Those companies pursuing such an advantaged model to its full extent—for example, segmenting rig lines by complexity—will ultimately enjoy lower finding, development, and lease operating expenses, all of which will provide incremental capital for reinvestment in production growth.

Here to stay

Production from unconventional resources is here to stay. It is required to meet future demand growth. In addition, the economic fundamentals of unconventional resources, such as the relationship in realized price vs.costs, will adjust to allow unconventional production to participate meaningfully and economically in global supply. Yet not everyone will survive the current crisis. The lack of liquidity among many unconventional producers, as well as the fact that lower prices will spotlight economic disadvantages, will force many companies to exit the market.

Such discontinuities represent opportunity for those who exploit them. Companies pursuing inorganic expansion through mergers and acquisitions can use capital to build advantaged assets and capabilities while instituting operational and technological advantages. Companies that seize the opportunity to expand their unconventional portfolios while improving their operating costs will position themselves for sustained long-term growth. ¿

Reference

1. Steinhubl, A., Klimchuk, G., Wilczynski, H., “Building the E&P Factory: Lessons from Leaders in Other Manufacturing-Based Industries,” Booz & Co., June 2007, www.booz.com/global/home/what_we_think/reports_and_white_papers/ic-display/41901972.

The authors