COMPETITIVE ADVANTAGE KEY TO E&P SUCCESS

Andrew Steinhubi
McKinsey & Co.
Houston

The decade of the 1980s was a tough time for the U.S. exploration and production industry. Average return on assets for the major oil companies' U.S. E&P operations dropped from 19.2% in 1981 to 2.8% in 1988 (Fig. 1), and many independents did even worse. Reserve additions dropped from 2.7 million bbl of oil equivalent (BOE) in 1984 to 1.6 million BOE in 1986 and 1987, with only a modest recovery in 1988. Despite moves to sell marginal reserves, cut back on operating and overhead costs, and reduce capital expenditures, returns on investment programs averaged 6% after tax. Capital investment increasingly moved outside the U.S. An estimated $50 billion in wealth was destroyed, and several major companies-including Gulf, Phillips, Unocal, and Texaco-were targets of takeover attempts.

The next decade does not hold much prospect for an industry turnaround. The U.S. is a less attractive drilling area than many areas abroad. While crude oil prices are likely to experience a cyclical increase at some point in the decade, the price increase will not be high enough or last long enough to bail out the average upstream investment program. The underlying outlook for smaller fields, higher investment requirements per field, and little long-term price relief signals continued decline in average discovery economics. There is considerable uncertainty surrounding the prospects for favorable tax law modification.

With a devastating decade behind it and continued tough times ahead, are all U.S. E&P companies down for the count? We don't think so. Even in the 1980s, at least one fifth of the companies earned compensatory returns (Fig. 2). And, despite the U.S. outlook, we think other companies can join their ranks if they take aggressive steps to change the way they do business.

So far, most companies' reaction to the downturn has been to sell marginal reserves, cut back on operating and overhead costs, and reduce capital expenditures. Successful companies will realize that these steps do not provide the answer. They will abandon the traditional philosophies and related management approaches that were developed when U.S. geological potential was generally untapped. These traditional philosophies grew from the view that profits were driven by external factors (primarily oil prices) and would be the natural result of maximizing reserve positions, having access to technology "as good as anyone else's," and organizing to achieve broad geographic coverage so as to be in the right place at the right time. Competitive advantage was not stressed.

But at every point in the industry's history, some companies were making more money than others. During upturns, although escalating prices have masked the effects of uncompetitive practices, enormous differences in profitability existed. In the last few years, despite price declines and a much more difficult geologic environment, some companies have earned compensatory returns while others have not. The message? Companies-not external forces-determine their financial future, if they focus on developing or exploiting competitive advantages and on making money (creating economic values) rather than on finding and producing oil and gas. And, driven by that new philosophy, the "winning" companies will adopt new operating approaches more conducive to financial success in the challenging times that lie ahead. They will:

Significantly reduce the emphasis on reserves.
Systematically challenge the economic contribution of individual E&P assets and activities.
Adopt "zero-based" organizations, structured around assets and opportunities.

REDUCE RESERVES EMPHASIS

One aspect of the old philosophy has been an overemphasis on maintaining or expanding reserves. Declining reserve positions have been equated with a failed exploration program and an inevitable shrinking of company revenue and staff levels. In the "worsecase" scenario, companies would shrink out of business. Ironically, the emphasis on reserves is having the same effect.

This is not to say that reserve maintenance or growth is inherently bad. Rather, the problem comes when companies pursue that strategy without a fundamental understanding of their competitors' relative strengths or weaknesses and the impact of these characteristics on value creation. Companies that take the time to develop this understanding, however, will focus on two areas: capturing the hidden value of their producing assets and rebalancing and upgrading their exploration-prospect portfolios.

CAPTURING VALUE

Contrary to the conventional wisdom that producing assets and their operators are roughly equivalent, some competitors are-or can become-better at extracting value from particular assets. Our recent survey of U.S. E&P companies, for example, shows that major producers' operating costs (lifting costs, other field expenses, and regional technical support) vary by at least $3/bbl in each U.S. basin (Fig. 3). Companies' overall financial performances also vary significantly across producing segments.

Quite simply, by leveraging superior geologic knowledge, infrastructure position, and/or technological capability, some competitors are doing better than others at extracting value in some basins. Several offshore operators, for example, have outperformed their competitors in managing marine and helicopter transportation costs, which generally represent over 10% of offshore lifting costs. Some onshore competitors have achieved technological breakthroughs, such as drilling reentry through existing well bores, thereby incurring much lower investment for certain development opportunities. On the West Coast, Chevron and Texaco have been leaders in advancing thermal techniques, including the use of hot water and variable quality stream, for heavy oil recovery.

Still others, such as Amoco and Shell, have gone even further. Both companies have long had property acquisition and disposition programs that center on increasing positions in areas of strength and exiting areas no longer offering upside opportunity. This "opportunity-seeking" strategy is yielding much better results than the "get-rid-of-the-dogs" approach that characterizes many current asset disposition programs.

As these examples show, companies that understand their relative advantages or disadvantages in a basin will have an inside track in maximizing shareholder value. Taking into account the upside potential of future undeveloped reserves in an area, winning competitors will take several courses of action. The first is to pursue strategic acquisitions to expand in areas where they are competitively advantaged through factors such as superior production technology, reservoir knowledge, exploration leads, scale infrastructure, or gathering networks.

Companies should also sell properties in areas where they are competitively disadvantaged (e.g., properties that are not part of any substantive segment and thus have a scale disadvantage) and redeploy the funds into areas of strength. Finally, successful players will review competitively neutral properties (those in which the company has no obvious advantages or disadvantages) with an eye toward identifying opportunities to build competitive strengths.

As they decide on the optimum producing asset portfolio, companies need to avoid some of the pitfalls of the past. In the desire to maintain reserve size, companies have typically limited property disposals to small properties or to those with high depreciation (DD&A) levels. Unfortunately, DD&A expense does not provide a solid basis for asset rationalization since it primarily reflects historical events and does not, by itself, suggest either an advantaged or disadvantaged position.

Positive cash flow is an equally unreliable basis for deciding whether to sell or hold a property. The best questions to ask in making this determination are: What is the highest cash flow possible? Is that attainable with my company as the operator?

If the answer to the second question is no, successful competitors will build the skills required to achieve that cash flow or sell the property to someone who can extract greater value from it.

Finally, to maximize asset value, companies must aggressively pursue all investment opportunities within their asset base. For years, producing divisions have postponed high-return development projects in favor of costly exploration programs with lower (and often unacceptable) rates of return but the potential to add reserves to the books. As one executive put it, "Not developing reserves is the same as finding new reserves. Both maintain the integrity of the asset base." After years of underfunding, many producing organizations have almost stopped searching for new opportunities.

The reality is that economic value is created by developing existing reserves as expeditiously as possible. So far, the industry has not done that, creating an estimated $1.60/BOE discrepancy or "value gap" between operating cash flow values and the likely price of underlying assets if they were sold (Fig. 4). That gap is the bait that continues to attract would-be corporate raiders to U.S. E&P companies.

UPGRADING PROSPECT PORTFOLIOS

In the drive to build reserves, most companies have pursued numerous rank exploration prospects across multiple basins. Few have considered whether those prospects meet the conditions for long-term economic success, such as critical mass (land position, drilling), technology advantages (seismic, drilling techniques), and local knowledge or expertise. Estimated find sizes have often dominated the decision to drill under the "bigger is better" rule. Lower-risk and higher-return exploitation and exploration prospects, unfortunately, have often been overlooked. The result? Most companies' exploration programs have earned well below their cost of capital. Additionally, most companies have not earned their cost of capital in the majority of basins in which they participate. Typically, a handful of a company's plays generates 80% (and sometimes 100%) of the economic value (Fig. 5).

As in production, however, some companies are doing better at maximizing economic value. Here, too, the new rules of shrewd competition apply. Throughout the decade, Shell Oil has repeatedly capitalized on "first-strike" technological advantages. The economic success of Shell's bright spot technology in the Gulf of Mexico and the preemptive Michigan area position gained from its seismic technique are just two examples of Shell's institutional advantage. Samedan's success in the Gulf Coast and selected other areas is testimony to the fact that companies can gain a competitive advantage based on local knowledge and expertise.

Other companies can draw important lessons from these examples. The "winners" are and will be those who aggressively work to improve the quality of their exploration portfolios and the prospects within each portion of the portfolio by pursuing three sets of activities:

Increasing their emphasis on exploitation opportunities. Just as with value-creating production opportunities, exploitation opportunities (e.g., on-structure wildcats) should be pursued expeditiously to maximize existing upstream asset values. Companies should also keep in mind that, over the last several years, more oil has been discovered from additional reservoirs within proven fields than from new fields (Fig. 6).
Focusing mature basin grassroots exploration activity on plays where competitive advantage exists or can be created, Companies need to select areas where a seismic technique, production technology, drilling capability, land position, or other competitive edge can be brought to bear.
The key here is to develop a screening process that hones in on places where those skills offer the highest probability of economic success. A good screening process should sequentially assess trends that:
- Have sufficient aggregate reserves and production rates (it can be misleading to use size of discovery as the only criterion; number of discoveries per program should also be considered.)
- Can be leveraged through specific experience, knowledge, or technical skills.
- Contain sufficient land availability and access to gathering systems and lack prohibitive environmental or regulatory factors with which the company has not dealt before.
- Equate to a rate of return in excess of the company's own cost of capital.
Balancing rank or "frontier" exploration within the context of the overall program. The advice to companies considering new rank exploration is to go slow. If total failure of the new rank projects in a given year cannot be absorbed, do not take them on. Over time, all rank exploration must stand alone as an economic value-creating opportunity. A screening process similar to the "mature-basin" process outlined above can be extremely useful in making this determination.

The overall keys to a successful exploration program are to understand and to leverage the skills essential to success in a particular play. Only at the play level can companies assess the full competitiveness of their supportive technology, infrastructure, land position, and local knowledge.

At the play level, companies can also identify fully allocated returns, including full geologic and geophysical and research allocations.

Adding these expenses to projections will often reduce discounted cash flow returns by half, exposing the truly profitable activities.

CHALLENGE ECONOMIC CONTRIBUTION

In the good old days of ever-escalating crude prices, most projects were likely to be profitable as long as minimum technical cost and investment hurdles were cleared. A company typically looked at its own finding and exploration costs in relation to the industry's Lower 48, reviewed earnings and cash flow measures, and conducted incremental economic analyses to determine how it was doing. That approach may have been fine then. It isn't fine now. Given the change in industry economics, companies must be able to screen new projects more carefully, challenge existing assets and activities, and look for clues on how to achieve more competitive levels of performance. To do that, they will need to make a number of improvements to existing systems:

Adopt new measures of investment performance. Exploration performance, for example, should be judged on a full-cycle economic basis, specific to each basin or trend. Traditionally, the industry has used regional finding and development (F&D) costs as a primary measure of investment performance. In reality, however, the same F&D cost can contribute to very different rates of return across different regions or among companies within a region. This is because of variations in the timing of exploration and production investment, initial production, years to depletion, and other factors, The "takeaway" message is that net present value and discounted cash flow rate of return are the likely comprehensive measures of investment performance, unlike pseudo-economic measures such as exploration finding cost.
Compare internal net present value estimates to asset market values. Most companies evaluate the incremental economics of development investment in terms of discounted cash flow. They need to take this analysis one step further. The issue with development spending is not so much "Are we earning an adequate return?" but "Are we identifying and pursuing enough good opportunities aggressively?" Consequently, comparing internal net present value estimates to asset market values is a better approach since it will help companies identify improvement opportunities.
Benchmark performance relative to competition. For several years, many integrated energy companies have gathered market intelligence to evaluate their downstream performance relative to competitors. They need to be similarly diligent in gathering competitive information on upstream performance-particularly on costs-that will help them assess how much they could be earning in an area and challenge themselves to higher levels of competitive performance.
Use available data to look back on the reasons for project success or failure and to assist, before the fact, in making new investment decisions. Most companies acknowledge that current earnings and cash flow measures do not recognize the future value of current decisions and that current period results cannot be separated from historical decisions. Our own review of several companies' performances, in fact, showed that current-year pretax earnings were almost the inverse of the same year's net present value created.

To address this problem, companies may need to upgrade their systems' capabilities. For example, they should be able to capture historical data by project category (within specific basins) that will help highlight deviations between the estimated economics of new projects and the actual results of similar past projects. This kind of analysis will allow them not only to estimate new project economics more realistically but also to look for controllable factors that, if improved, might yield better performance. Routinely comparing actual to projected results can also improve future planning performance.

ORGANIZE BY ASSETS, OPPORTUNITIES

While many companies are much leaner today than they were 3 or 4 years ago, most are still organized to support the "maintain-or-grow-reserves" philosophy. Structurally, they look like pyramids: Staff members are dispersed across many geographic locations, and operations and exploration units typically report through their respective functional vice-presidents to senior vice-presidents of E&P.

Under the new value-creation philosophy, this pyramid structure is likely to be a formidable barrier to success. Maintaining exploration staff everywhere, for example, is unlikely to be economic, particularly onshore, where extensive activity in the 1980s has reduced the number of attractive projects remaining. Excessive management layers (often 10 or more between a production engineer and a senior vice-president) add to costs and contribute to slower decision making. Having common district or division offices responsible for vastly different types of production or exploration activity inhibits the development of superior knowledge or skills in individual activities or about specific geologic trends. To maximize shareholder value, companies will need to restructure their organizations, starting from a zero base. There are three steps to follow here:

Identify the areas offering the greatest potential for wealth creation in production and exploration. Using the process suggested earlier, companies should identify production and exploration opportunities in areas where they can exploit or develop better knowledge, a favorable cost position, superior technology, and/or specific skills.
Determine which functional skills are needed to capitalize on the opportunities. Very mature producing areas, for example, may require only field offices and a centralized engineering support group to maintain existing operations and pursue limited development opportunity. Ongoing exploration and development basins, on the other hand, may require a more decentralized and functionally integrated group of engineers and geologists to pursue emerging opportunities.
Do not overburden the organization with excessive supervision and review. Two general guidelines apply here. The first: Stay lean. Winning companies will regularly evaluate the qualifications and number of people they need to exploit planned activities. The second: Stay flat. To maximize returns from areas with significant upside potential, companies will decentralize authority so that those who know the most about an area make the decisions.

CHANCE TO START FRESH

The U.S. E&P industry needs to put the 1980s behind it. The new decade offers a chance to start fresh, with philosophies and management approaches more in tune with economic, geologic, and competitive realities. The new goal is to maximize shareholder value. The companies that will win, not just survive, in the 1990s are those that make strategic decisions about where to produce and explore, systematically challenge themselves to outperform their competitors, and organize to develop and leverage their unique or superior capabilities.

This change in mindset is essential. The new game is not like golf, where the goal is just to beat the course. It is more like tennis; you have to beat the competition.