Unconventionals create discontinuity

Witness the unprecedented change which has occurred in the North American natural gas market over the last several years. In the mid-2000 period, natural gas prices climbed upward as demand exceeded dwindling supply, reaching a peak of over $13 per thousand cubic feet (Mcf) and triggering the prospect of growing volumes of imported liquefied natural gas. Yet the same trends drove innovation by a few independent E&P companies that cracked the code on releasing gas from shales, substantially reversing the import trend to exports (See Figure 1).

The rest of industry quickly followed suit and gas prices plunged as low as $2 per Mcf in April, 2012, eventually normalizing around $4 to $5 per Mcf. More recently, the impact of growing industry emphasis on liquids and light tight oil (LTO) have taken hold, with crude prices falling from the $110 per barrel level for Brent earlier this year to less than $80 per barrel level as of early December.

Underlying this pricing rollercoaster has been a parallel tumult in the sector's competitive structure. Early innovators and entrants into the unconventional sector have in many cases given way - either because their business model no longer fits the current environment or because they were not built for the long term - to a second wave of industry players. Many large international oil companies entered during this second wave through the acquisition of independent E&P first-movers.

Profitable growth during the unconventional sector's next stage of evolution is not a given. Participants face multiple challenges. First, the land grab - during which large acreage positions were acquired at relatively low costs per acre - is over. Strategically advantaged positions, the "sweet spots" in the core basins, have largely been secured and their prices bid up. Second, the increased domestic supply of hydrocarbons has put pressure on commodity prices and created discounts that reduce profitability, especially in light of US regulations which limit gas and currently permit no oil exports. Third, the subsurface technical understanding of unconventional assets is still relatively early in its development. Many potential plays will prove uneconomic due to unfavorable geological and geophysical characteristics. Other new plays will emerge as "surprises" from areas with long-standing conventional production, such as the Permian Basin.

Industry players are working to address these price, cost and subsurface challenges. While no clear winner has emerged as yet, patterns are emerging of what capabilities and actions are needed to maximize value. To achieve competitive excellence in unconventionals, organizations must consider:

• Leveraging lean manufacturing techniques, including a rigorous continuous improvement approach, to drive maximum learning and performance in drilling and completions and infrastructure design and delivery;
• Customizing the management system, including strategic and operational planning processes, to more dynamically allocate capital, optimize field developments cross-functionally, and integrate plans with suppliers; and
• Rethinking core value chain activities including how to assure access to premium markets through midstream and marketing integration, as well as availability of scarce equipment and services resources through supply chain arrangements or integration.

Lean manufacturing and continuous improvement

Low prices are accelerating industry efforts to "lean out" their drilling and production operations procedures often through applying the types of lean manufacturing techniques used in the automotive and other manufacturing plant industries. Central to adapting lean to unconventional E&P is the appropriate definition of the rig line(s), which potentially is analogous to a level-loaded factory in manufacturing industries. The performance of the rig line may be monitored, compared to internal and external benchmarks, and thus continuously improved.

Best-practice rig lines rely on pull signals to pace activity and to optimize "inventory" at various stages in the process. For example, permitted well-sites represent inventory for the rig line. The optimal number of land specialists to support the rig line is the number of staff required to supply that amount of inventory given the pace of the line. Any less and the rig line would stall due to a lack of inventory. Any additional and there would be waste in the system. A similar resourcing process should occur in each other operating area such as pad construction, geo-steering, completion crews, and reservoir engineering as well as in administrative support functions such as revenue accounting.

Customized Management System

Historical approaches to management processes (see Figure 2) were typically designed to meet the needs of long lifecycle megaprojects or onshore conventional oil and gas operations, and are not necessarily suited to the characteristics of unconventional assets. Unique characteristics of shale and LTO plays that require adaptation include: the overlap across the exploration, development, and production stages of an unconventional play, the speed of drilling ramp-up (and potentially ramp-down) required - both in light of market changes as well as internal subsurface and project performance learnings, and the large number of small but interdependent cross functional decisions that must be managed.

Perhaps the most difficult change to common management approaches to break is the traditional annual planning and capital allocation cycle. Too often, the annual capital allocation, along with associated budgeted production and cost metrics and forecasts, becomes the de facto operating plan for business units. This approach is neither dynamic enough nor focused enough on the value levers of the Unconventional business.

The field development plan, formulated initially during appraisal activities and updated throughout the asset life cycle, is integral to a more customized unconventional management system. This tool (see Figure 3 for typical elements) addresses the integrated surface and subsurface aspects of how an asset should be optimized when in full development and production. The process brings together specialists from across the company to consider issues and tradeoffs.

The overall planning process becomes more dynamic when asset life cycle plans and associate performance metrics and look backs (also customized to unconventionals by considering non-traditional metrics such as inventories and work/spend in progress, quality metrics such as length of lateral delivered in target zone, and otherwise tailored to drive drilling and completion learning curves) are reviewed regularly, rather than annually, to gauge progress and trigger adjustments to capital and other resources as required.

Rethink Integration

Market interfaces at the wellhead for conventional E&P are typically sufficient and transparent enough to separate E&P from midstream and marketing activity. However, separating E&P from midstream and marketing can lead to value leakage in unconventional. First, the volume and changing schedule of well tie-ins, oftentimes in areas with limited existing infrastructure, challenges hand-offs between the upstream and midstream. Additionally, with the current supply surplus of natural gas and depressed oil prices due to export limitations, the need to maximize returns requires a transparent view, and value capture, from wellhead to end-use market and prices.

Also, several producers have opted to integrate into supply chain activities often outsourced to others in conventional E&P, including ownership and operations of rigs, compression equipment, and sand mines and logistics. Typically, higher returns, as well as the benefits of management focus on core E&P activities, outweighs the benefit of operating such services and assets in-house. However, some producers have argued increased accessibility and higher activity integration needed for unconventional success warrant such investments.

Creating Capabilities Unique to Unconventional

Many companies recognize the need to refine their current business model from that typically deployed in conventional E&P. The largest oil companies, as disclosed publically, have each taken fundamentally different approaches to their transformations. ExxonMobil bought XTO, an unconventional-focused independent E&P company and is employing a sequenced, "arms- length" approach to its integration.

Royal Dutch Shell has formed a separate division within their global upstream business to customize its internal, well-formed E&P core processes to pursue unconventional, and BP recently announced a wholly owned separation of its domestic onshore assets to catalyze a movement to lower cost and more competitive unconventional capabilities. These represent three very different choices regarding how to develop new capabilities, yet each of these highly successful global companies recognize the need to develop capabilities new and specific to the unconventional asset class.

Even those independent E&P companies with significant unconventional experience have been forced to reconsider their historical business and operating models as we enter the next growth wave. As outlined to the investment community, Chesapeake Energy, for example, has pursued a major transformational initiative to achieve two strategic objectives: (1) financial discipline and (2) profitable and efficient growth from captured resources. And EnCana Corporation has also announced a comprehensive restructuring of its organization and realigned its capital program to better align with the company's strategy of being the leading North American resource play company.

The critical challenge that companies face as they seek to develop new unconventional capabilities is that the internal operating model necessary to excel at these activities is fundamentally different from traditional industry models. These differences are extensive and require changes to organizational structure, planning processes, core operating processes, and information management. Hence, the change needs are transformational, versus incremental.

The unconventional resource sector holds the potential to transform the domestic and international energy landscape, but we are still in the early stages of the sector's evolution.

As we enter the third industry phase, there are multiple competitors attempting to secure sustainable, profitable growth, but as of yet there are no clear winners. Ultimate success will require that companies build capabilities that are unique to the characteristics of the unconventional asset class and that are realized through an operating model that is different than traditional models. The prize, today in North America, but ultimately on a global scale, is great for those companies willing to take on the challenge.

About the authors

Andy Steinhubl is the strategy leader of KPMG's Energy and Natural Resources Group. He has over 30 years of energy experience. He previously worked at Booz and Company where he served as the North America Oil and Gas Practice leader and the Houston office managing partner. He holds a BS in chemical engineering from Purdue University and an MBA from Stanford University Graduate School of Business.

Chris Click is a member of KPMG LLP's Oil & Gas Strategic Services Group. He has over 15 years of oil and gas experience. Prior to joining KPMG, led the upstream oil and gas team at Booz and Company. Click received a BBA from Texas A&M University and an MBA from the Kellogg School of Management at Northwestern University.