Drastic industry changes
As complexity grows, oil and gas companies must focus on capabilities and flexibility
Viren Doshi, Strategy&, a PwC-owned unit
Oil and gas companies-and particularly those with large upstream operations-have always been better at managing day-to-day operational uncertainty than firms in other industries. However, even by those standards, the industry now faces a series of profound structural changes that will create a dramatically more complex environment for the foreseeable future. Upstream companies must operate across a wide range of exploration and production environments, leading to more diverse operations and greater complexity. The recent decline in oil prices complicates this challenge, yet that is a medium-term factor. The more persistent issue is high volatility in oil prices, which increases the level of planning uncertainty and is only likely to get worse in the future.
In this environment, the strategic responses that may have worked for upstream companies in the past are no longer relevant. Instead, companies need to identify and focus on a small number of differentiating capabilities, and then reshape their portfolio and investment decisions accordingly. Perhaps most critically, this strategy must remain flexible enough to adapt to changes in the operating environment.
Growing uncertainty in both supply and demand
Driving the current uncertainty are a number of trends playing out across the industry. On the supply side, the recent growth in oil and gas production has been dominated by unconventional plays in the US, a shift that has primarily benefited a small handful of independent companies. By contrast, many established players have been taken by surprise, requiring them to now rapidly reevaluate their strategic priorities and reshape their portfolios.
Recent changes in exploration have been even more dramatic. New resources have come through major discoveries in previously unexplored regions, notably in Brazil and Africa. Ultra-deepwater plays now account for 40% to 60% of all newly discovered resource volumes, yet the break-even prices to justify bringing such new production on line are far higher than the current crude price outlooks per barrel.
The demand side has been equally uncertain. The recent growth in demand for oil and gas has come almost entirely from emerging markets, particularly China and India. Demand from Organization for Economic Co-operation and Development (OECD) countries has eased due to a combination of higher prices, increased energy efficiency, and alternate sources. Instead of closing refineries in the OECD, however, companies have invested in more complex cracking and coking capacities, exacerbating the surplus of petroleum products in export markets.
In addition to supply and demand factors, oil and gas companies must invest in new technologies such as hydraulic fracturing and enhanced oil recovery and deal with an increased regulatory burden, and an intensifying shortage of critical labor skills, largely due to a maturing of the oil and gas workforce.
Collectively, these issues create a far more challenging environment, and they require that upstream companies change how they chart out their future path. In the past, companies had the luxury of a predictable world, with growing global production and demand, clear growth targets, and an abundance of conventional opportunities. Consequently, many companies could get by with largely similar strategies that emphasized common operational elements, such as managing costs, exploiting technological advances, and securing access to attractive reserves and for exploration opportunities.
The prevailing approach in the past, which was felt to be appropriate as the industry invested in large, long-term, capital intensive projects, was linear. It resembled the way in which a railway operator decides where to lay track and then proceeds with little ability to make changes. The strategy was not just metaphorically "on rails," it was in practical terms inflexible. Today, however, the complexities and uncertainties of the market mean that such strategies are inadequate to the task. Instead, companies that wish to excel need a strategy that is dynamic and flexible. They will need to be able to respond to changes more easily, in the same manner that skilled sailors set a course that they broadly follow but that they can change to accommodate the elements.
The value of capabilities-driven strategy
The most successful players in the future will therefore focus on a small number of differentiating capabilities that make them distinctive in the market. By "differentiating capabilities," we mean the combination of individual knowledge, skills and behaviors, processes, tools, and systems that allow a company to outperform its peers in one specific aspect of the market.
There are many ways in which a company can differentiate itself through excellence in a particular part of the oil and gas value chain. For example, it can manage relationships in an important region, or possess a strength in a particular technology, or have expertise in certain commercial settings. Successful companies also have a portfolio of assets that mesh with their capabilities, driving stronger operational and financial performance.
For example, Occidental Petroleum has a portfolio dominated by mature oil fields in which the company can deploy its expertise in optimizing production and its leading position in enhanced oil recovery. The company leverages strong commercial skills and relationships to access new opportunities through direct negotiations with major resource holders, notably in the Middle East. Recognizing its strengths, Occidental spends significantly less on exploration than its peers. This factor contributes to its industry-leading profit margins.
Another example is Apache Corporation, which has a similarly focused approach and targets discovered fields. However, Apache's capabilities lie in cost reduction, infill drilling, and nearfield exploration. As with Occidental, Apache has been successful in securing assets from super-majors based on its strong relationship management skills and ability to move quickly.
In contrast to Occidental and Apache, many companies - particularly recent entrants to the upstream sector - often have a portfolio of assets in numerous countries, with highly diverse technical and operational requirements. Such portfolios are incoherent, in that they do not align with the companies' capability-systems. As a result, these companies often underperform according to both operational and financial parameters, including experiencing significant safety, environmental, or reliability issues.
The recent trend of a lift in the market value for companies such as ConocoPhillips, Marathon, and Murphy Oil after they separated their upstream and downstream operations reflects, in part, this premium that markets place on focus and coherence around a set of differentiated capability-systems. Indeed, this phenomenon occurs in virtually all other industries as well-Strategy& research has shown that coherent companies are usually rewarded with higher valuation multiples.
Flexibility is critical
The right combination of capabilities and assets will vary from one company to another, yet there is a common thread: strategy must be flexible enough to adapt to changes in the operating environment. In the past, oil and gas companies had the luxury of investing in attractive, long-term opportunities, and then focusing on execution-a linear and inflexible approach. Today, by contrast, success lies in flexibility: wherein capabilities set the broad direction, yet flexibility still affords companies the freedom to anticipate and respond quickly to unexpected events.
In some ways, flexibility is more difficult for oil and gas companies, given the long-term nature of many investments in the sector. Decisions on major capital investments have become increasingly challenging, particularly because of persistent project time and cost overruns. Yet companies can still build significant flexibility into their investment programs.
For companies active in exploration, the right approach might involve taking small stakes in emerging basins in case significant discoveries are made, and by actively managing the exploration portfolio of options. For producing assets, a company can actively consider, and plan for, the different activity sets it would need to conduct under different oil price scenarios. Designing modular field developments that can be scaled up in response to changing market conditions also builds optionality into long-cycle investment projects. This is particularly important for companies in volatile operating environments, such as Iraq.
Conclusion
In an industry beset with increasing uncertainty, diverse technological and operational environments, and intensifying industry-specific skill shortages, oil and gas companies will need to change the way they conduct business. For virtually all players, a dynamic, capabilities-driven approach will help them win in a turbulent market. To get there, companies must identify and focus on a few differentiating capabilities required to win in their chosen areas of operations. They must reinforce their portfolio and investments round those capabilities. Moreover, they must remain agile enough to respond to changes in both internal and external circumstances.
By implementing this approach, companies will position themselves to be able to respond efficiently to changing conditions, and stay ahead of the competition.
About the authors
Viren Doshi is a senior partner and leader of the energy practice at Strategy& (formerly Booz & Company), a unit owned by PwC. Doshi has over 30 years of industry experience in the energy, oil, and gas sectors. Key areas of expertise include managing supply and trading in volatile markets, designing innovative business models, and implementing pioneering strategic transformations and mergers. Doshi holds an MBA from Cranfield School of Management and an honors degree in electronic engineering from Southampton University.