A Case of Successful Alignment
This case study is part of a continuing series prepared by Pangea Global in its ongoing research project on the business of oil and gas. The project examines the three key business dimensions of performance, People, Strategy and Business Processes for the North American exploration and production industry segment. The case study series illustrates specific sources of high performance within those three dimensions unique to each company. These case studies are used to help companies seeking to improve their performance by illustrating how high performing companies have found their way to success. The case studies are developed from public documents with requested clarification from the companies. As such, proprietary information is never collected and respect for full disclosure is strictly adhered to.
Overview- A Market Value Premium over Fair Value
One of the more interesting stories to emerge from our analysis of the North American upstream sector is Cobalt International Energy. This is a new company operating only since 2005 but has had some significant technical success. Cobalt is pre-revenue and has invested over $4 Billion, about half debt and equity. Since it is pre-revenue, and has invested substantially, Cobalt’s return on Capital is among the lowest in the North American upstream (Figure 1).
At that, it has a market value of about $4.2 Billion, but a Morningstar™ Fair Value of only $2.5 Billion.That means the capital market places a premium of $1.7 Billion on Cobalt despite the lack of revenue and earnings to date (Figure 2).
The $1.7 Billion premium implies the market is supportive of the leadership, strategy and execution . In our opinion Cobalt is a technical success due to alignment of people, strategy and process. Commercial success has yet to be achieved, but looks promising, even in an environment of chronic low oil prices.
Background-An Independent beating the majors at their own game
Cobalt is unique among independents, successfully competing with large international oil companies (IOC) and a few national oil companies (NOC) in deep water, deep horizon, subsalt and pre-salt prospects in the Gulf of Mexico and West Africa. The company has drilled seven wells generally in 5,000’+ water depths and 30,000’+ Total Depth (TD), one over 35,000’ TD. The results have been impressive, encountering in one case over 1000’ of net pay at the Shenandoah discovery in the Gulf. In the Kwanza Basin offshore Angola, Cobalt’s theory has been proven with 5 discoveries including Orca, with an estimated 400-700 MMBO in place. In August, Cobalt sold its Angola assets to Sonangol the Angolan NOC.
Exploration Strategy-A Classic Case of BHAG in Action
While Cobalt is near the bottom of the list of North American E&P companies in return on capital (Figure 1), it is illustrative of the fact that financials do not tell the whole story. It has been claimed that a strategic investment means the numbers don’t work. In the case of Cobalt however, the strategy is working, but the key to the results is execution.
The leaders of the company, both management and directors probably have a focused vision of the potential of the two petroleum provinces chosen. It is also clear they also know what it will take to be successful in such high-risk, high-potential areas. It then follows they designed the strategy based on careful analysis and assembled a plan to implement the vision. This is a classic example of Jim Collins BHAG principle: Big Hairy Audacious Goals.
Critical though is that Cobalt assembled a world class leadership team. Senior management has extensive offshore experience with major oil companies: Amoco, BP, UNOCAL and others. They have the expertise and experience to know how to put together a successful frontier exploration effort. They have the support of a highly qualified, well connected and no doubt active Board of Directors. In addition, the technical team is undoubtedly world class, most of them likely veterans of big projects requiring excellent team work and close integration of multiple disciplines.
From the business process view, Cobalt’s capital allocation is obviously effective generating impressive exploration results. The prospect generation process has brought forth superior opportunities and the management team has made wise allocation decisions. It would be interesting to know which prospects did not make the cut and why. Perhaps one day they will share some thoughts on that topic.
Allocation of capital to production has yet to be tested as Cobalt’s discoveries are still in the evaluation phase. However, the company is planning for development with a standardized development process. While Cobalt is not alone in pursuing standardization, the similarity of their targets suggests that a high degree of repeatability will be possible. Learning and refinement will no doubt be deep and accelerated. While Cobalt has expressed its intent to operate all of its assets, there is a flexibility that comes through in their interest in the value third parties can bring to their business.
Future Challenge-Commercial Success in Complex Projects
Cobalt is at a critical transition point as it now must transform into a development and production company. Cobalt’s management well recognizes this and have no doubt been planning for this transition, since at least their first discovery. Cobalt made a major strategic move in August 2015 with the sale of the Angola assets. The stated intent is to capture the value created, reduce risk and refocus on higher return projects. In our view this is a very smart move and contrary to the wildcatter mentality. Michael Porter is famous for defining the “essence of strategy as what not to do“. This is one example of why Cobalt does and should have a market value that exceeds the fair value of its assets. The sale to Sonangol raises the question of whether an IOC would have paid a higher price. Also, the transaction and final payment of $1.3 Billion is subject to approval by the Government of Angola at no date certain, presenting substantial sovereign risk. Presumably this was mandated a preferential rights covenant in the Licenses. As an aside, it will be interesting to see who assumes operation of field development of the five discoveries. Sonangol may retain operatorship, but there are a number of IOCs operating in the basin. One IOC that is not in Angola is Shell. Recent disappointment in the Artic and poor economics in the Alberta Tar Sands has caused Shell to change its focus to global LNG and deep water high potential areas. Angola may be in its sights. Should Shell acquire blocks 20 and 21 Cobalt with its stellar capabilities may be invited to participate in, if not lead, future exploration projects.
There are substantial opportunities for Cobalt in North America, particularly the Gulf of Mexico. While larger companies will operate most of the current discoveries, Cobalt is operating the North Platte discovery and the Goodfellow exploration project.
Cobalt could definitely be a game changer if the transition to a producer is successful. Designing, financing, building and deploying the massive infrastructure necessary to commercialize these large and complex reservoirs has historically been the province of the IOCs. Very few NOCs have acquired the engineering and project management necessary prowess required by such projects. Petrobras and Statoil are two notable exceptions. Independents that have ventured into deep water frontiers have generally not fared well. The skills required are hard to acquire and very expensive to develop in house. The capabilities to commercialize these apparently massive discoveries are very different than those that got them here.
The IOCs have struggled at times to refine the required systems, and without uniform success. ExxonMobil is regarded as the paragon of big projects. Chevron too is well regarded. Shell has staked its future on large deep water projects. BP does not come to mind as a big project winner. Indeed, most of BP’s successes were made through acquisitions.
Further, in an environment of sustained low oil prices, Cobalt’s exploratory successes are not certain to become commercially successful regardless of how skillful they become. They have several advantages over the IOCs that could make an enormous difference.
Critical Success Factors for Cobalt
First is their ability to integrate multiple disciplines into an effective “exploration machine”. This is clearly a function of great leadership. More than good management, Cobalt’s senior team seems to have sparked a special mix of vision, mission, passion and esprit de corps among the approximately 200 professionals. This is not something one can see reading the Wall Street Journal, but it is evident in the way Cobalt has achieved success in such a short period of time.
Second, sound decision making is a hall mark. Every oil and gas professional learns very soon that no one has all the answers and every day is a learning experience. As good as the senior team may be, they are not omniscient geniuses; that quality does not exist. Where they are geniuses is in putting the right people in the right positions, giving them the tools and empowering them to take prudent risks. What emerges is a rare but highly effective decision making process that surfaces the right opportunities.
Third, the ability to move quickly and decisively without the burden of bureaucracy will serve them well. However, unlike exploration, development and production require an ethic of efficiency and cost containment. Care, caution and prudence are behavioral styles not usually found in cultures that have achieved success through creativity, innovation and thinking outside the box.
Fourth, forging effective teams is something the IOCs and NOCs struggle with. Anyone even remotely close to a large development project will attest to the need for very close coordination and tight integration of multiple skill sets. At its essence, it is about helping individuals with their own behavioral styles, differing value sets, and multiple styles of thinking to mesh those differences to achieve a shared outcome. However they have done it, Cobalt has achieved this elusive goal. Can they sustain it? Can it be grown? Can it be transferred to entirely new processes? Those are the key questions the leadership, with the board’s help, must resolve in the affirmative.
Fifth, a culture of learning is very apparent. Subsalt/pre-salt geophysics has been a major challenge for earth scientists since the early days of seismic data collection and mapping. An early lesson all explorationists learn is that seismic maps are not physical maps. At best they simulate subsurface structure. The varying rock properties that drive reflectance often cause distortions that may result in a false structural feature, either a high or a low. Salt beds are among the least dense of formations and are prone to absorbing seismic energy rather than reflect it. The result is an inability to identify structures below the salt. If as it appears, Cobalt has cracked the subsalt code, it will open a number of plays in other basins to further exploration.
Six, leveraging the capabilities of partners, suppliers and other resource providers is fairly common practice among E&P companies, particularly the independents. Cobalt is unusually open about its use of this practice. While they operate their assets, ensuring control, they make a specific point about using outside resources to complement their own skill sets. The added focus on mission critical processes should facilitate the transition.
Seven, Cobalt has instilled a culture of excellence. Drilling wells seven miles deep in mile deep water to hit a fairly small target is a major technical challenge. Good just doesn’t cut it. Hitting 5 in 10 exploratory wells does not happen without making sure every step in the exploratory process is conducted the best it can. Voltaire is credited with writing that “perfection is the enemy of good”. He also wrote that “good is the enemy of excellence”. Jim Collins opened his landmark book Good to Great with the observation that “we often settle for good government, good schools and good businesses”. For most commercial endeavors good is all that is needed. Consumers typically don’t care to pay for perfection. Often they won’t even pay for excellence. But E&P is very different from other enterprises. It is not forgiving and close is usually an expensive dry hole. Cobalt’s leadership has taken some very specific measures to recognize and reward excellence to coincide with structures and processes in which excellent people do excellent work.
This is a company well worth following as there will be some big lessons learned. In our estimation, Cobalt could be a highly valuable acquisition candidate. However, should a suitor do anything other than provide resources and empowerment, disappointing results may ensue. Cobalt likely has more value as an independent. Impressive as its assets are, Cobalt’s real value is its alignment of people, strategy and process.
Morningstar Fair Value is an estimate of the company’s equity worth at the present time. It is calculated with Morningstar’s proprietary statistical model applied to future cash flow projections developed through independent primary research.
 Pangea has not interviewed personnel associated with the company. Information relied upon is exclusively from public data. All analysis, observations, conclusions are the author’s. Any errors and omissions are solely the responsibility of the author.