The Business of Oil and Gas

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What Should Exxon Do?

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If I were advising Exxon-Mobil’s next CEO what would I recommend?

This is a purely hypothetical question as I am not waiting for the phone to ring. Rather, the intent is to illustrate one view of how a radically new industry structure could unfold. The bottom line is that Exxon should become a technology company.

The Wall Street Journal reported this morning that Darren Woods was named President effective January 1. Similar moves preceded the elevation of past Exxon CEO’s including Lee Raymond and incumbent Rex Tillerson, suggesting Mr. Woods will become CEO upon Mr. Tillerson’s retirement, no later than 2017.

The next CEO will have to steer the company in a time of chronically low oil prices. In my view, this presents both the obvious challenge and perhaps new opportunities. Exxon among all the International Oil Companies (IOC) has options to play the game in new and perhaps more profitable ways.

The IOC’s have been losing control of the international oil market since the 1970’s

This includes the entire value chain, but here I focus on the upstream. The OPEC nations seized ownership of their oil resources by forcing a change from Concession Contracts (CC) to first Production Sharing Agreements (PSA) and then to Service Agreements (SA) and more recently to Joint Ventures (JV) with the host country national oil company (NOC).

A concession contract gives ownership of the resource to the company which develops it at its cost and risk, paying taxes and royalties to the host county (HC). Production Sharing Agreements vest ownership of the resource in the host country. The company takes title to a fraction of the oil as it is produced. Costs are recovered from “cost oil” and “profit oil” is shared according to an agreed formula. The Service Agreement vests title and sales proceeds entirely in the host country. The company is paid a fee for its risk, capital and technical contribution.

Complexity for the IOCs has increased substantially during this evolution, as they must agree to terms upfront and yet take substantial risk over the life of the agreement. In any event, the ability to earn high rates of return is constrained, yet the risk of earning less than cost of capital remains.

Risk and return under all of these agreements has hinged on production. While host countries have increased their potential for higher returns they have also assumed greater risk of production falling short of expectations. Production sharing provides the company with some risk protection while limiting upside. Service agreements provide no meaningful upside and somewhat limited downside if production falls short. Every agreement, like every license block has unique characteristics, but there are common denominators:

  1. Increasing control by the host country,
  2. Increased revenue share to the host country
  3. Increasing reliance on oil revenue to fund national budgets,
  4. Trend to limit company profitability,
  5. More stringent terms in periods of rising prices, more liberal terms in low price periods
  6. Increased political and fiscal risk (i.e. Taxes and Royalties) to the IOCs.

The IOC/NOC/HC relationship

At its most elemental, it has been tense, conflict prone with very narrow commonality of interest save for maximizing revenue. During the last 40 years the leverage has been largely in the hands of the NOC/HC due mainly to a combination of increasing sophistication and diminishing opportunity sets for the IOCs. As long as prices tended to rise, the IOCs were willing to cede control and revenue. As economically driven entities, they may not have liked the trends, but were compliant, even to the point of not contesting expropriation. Returns seemed high enough, particularly in periods of generally rising prices.

A New Industry Structure

Things have changed. Now that oil and gas can be produced from the source rock, shale, the rarity of large highly productive traps no longer confers the leverage it once did. The geologic accident of a few nations possessing these mother lodes has been replaced with widespread shale resources.

Further, oil prices are likely to stay low for an extended period. The ability to bring new production on line at low marginal cost is a new fact of life. True, a new horizontal well may be more expensive than a new vertical well, but multiple laterals in multiple horizons can be drilled from one vertical well bore. The cost of drilling and completing horizontal wells continues to fall.

All of this suggests to me that supply will be abundant. Demand will rise in response, but energy intensity in developed economies has been falling for over 40 years. The scenario that suggests returning to a higher price trajectory is rapid economic growth across all emerging and frontier markets such that Africa exceeds the US and Europe in auto sales. That scenario may playout, but more likely over decades than years.

What does this imply for the international upstream?

Since the market will not offer high prices, more revenue means more production. More production means lower prices. While there is a limit to how low prices will fall, the low cost producer wins. Like the two guys being chased by a bear. The one guy tells the other “We can’t out run the bear”. The other replies “I don’t have to; I just have to out run you!” The survivors will out run the rest.

How do you become the low cost producer? The same way the shale entrepreneurs did, technology. Horizontal drilling and hydraulic fracturing are not new technologies. They are, however newly applied to shale. Further, technology has advanced a long way and even seems to be accelerating with the dual pressures to reduce cost and sustain some earnings growth.

Digital oil field is a relatively new technology, but seems to be gaining traction with the ability to track mission critical activities in real time. Greater bandwidth and methods to capture, display and react to changes allow companies to better seek the Holy Grail, optimizing oil field economics.

Advances in project management tools and practices allow more precise (i.e. tighter) scheduling, reduce slack time, resulting in shorter start to completion times. More complex projects can be undertaken with fewer people, shorter time frames and less risk.

These developments give the company that:

  • masters current technologies,
  • refines emerging technologies and develops new technologies …

…a considerable advantage.

These capabilities will be much in demand by the NOCs under pressure to generate more revenue for the host country. It will allow more of the proceeds be returned to the government and provide some defense of market share.

I would suggest to Mr. Woods that while Exxon’s deep pockets will allow some advantage in competing for new opportunities, technological supremacy is even more powerful. Clayton Christensen’s classic book The Innovator’s Dilemma makes the point that a disruptive technology anticipates customer needs. I would guess that the NOCs don’t yet know what they need, but it is probably safe to assume it can be met with new ways of doing things. That suggests new technologies or new ways of using technology could create a strong, break away competitive advantage for Exxon.

Buy Schlumberger?

How would I recommend approaching the opportunity? It has to begin with a vision of where the company would want to go. But in simple terms, shale is the way of the future. Sustaining and optimizing legacy reservoirs is a host country imperative. Extending those legacies into new production may be attractive, and the host countries may be willing to offer attractive terms in this time of fiscal duress. Offshore deep water, deep horizons continue to offer attractive economics.

People

In broad terms, taking advantage of the talent that has recently become available should be a no-brainer. The service companies are largely the holders of the technology and employed the talent to use it effectively. Many highly skilled people have been released from service of late. It would be a real waste to lose all that skill and knowledge as surely it will as those people find other lines of work. I would be hiring technical people from the likes of Schlumberger, Halliburton and Baker-Hughes.

Strategy

Second, the service companies are rich in patents and patent development. An outright acquisition of Schlumberger would be conceptually the simplest, but the anti-trust howls would be defining. But selective acquisition could be an option. In any event, Exxon already has among the best research infrastructure in the industry, possibly rivaling the service companies. That could be the base upon which to build successive generations of new technology, well in advance of any other player.

Process

Third, Exxon’s balance sheet would allow it to finance just about any project that makes sense. It could cherry pick the best opportunities and finance them on its own. However, in recent years Exxon has found that the best investment is its own stock. That suggests the competition for new reserves has driven out much of the potential upside. I don’t think that is the case now. Exxon could be uniquely positioned to add reserves at a time when terms are likely to be more favorable and competitors are scrambling to reduce CAPEX. A new way of looking at the capital allocation and capital deployment processes could allow the company to run away from the pack.

In any event this post illustrates one way the very strongest could thrive and prosper in a new industry structure. What it further illustrates is that any company, even Exxon, needs the people, the strategy and business processes to shape the battlefield and win.

I would become a technology company. Crazy? Like a fox.

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