Despite years of victories declared over downsizing, portfolio optimization, and process and technology improvements, exploration and production companies still struggle with two things. First, overall E&P costs are near the highest levels of the past decade, although high oil and gas prices have masked rising costs and lower performance among producers of all sizes. Second, contrary to what was seen in previous high-price environments, companies have been cautious about investing, possibly to the detriment of reserves and production in the long term. In this environment, which type of company-major or independent-is best positioned to survive if a price collapse occurs? How will companies compete and what are they doing to ensure success? SAIC's annual benchmarking study attempts to answer some of these questions. Now in its 10th year, it was developed and formerly conducted by Arthur Andersen energy-team employees. It provides a rich source of information on trends in general and administrative (G&A) costs, operating costs and capital spending in particular. Twenty companies participated in this year's study, including four majors and varying sizes of independents with annual Lower 48 production ranging from 2 million barrels of oil equivalent (BOE) to 150 million. The challenges of finding and producing oil and gas in the very mature Lower 48 have led to high (and rising) costs. While margins are up due to higher commodity prices, full-cycle cost is up more than 70% since 2001, and more than three times 1995 levels. Full-cycle cost is defined in this study as the total cost required to find, develop and produce hydrocarbons, as well as the cost to support the corporate infrastructure (defined as the sum of reserve-replacement, operating and G&A costs). From 2001 to 2003, for the group of companies studied, operating costs rose 22%, reserve replacement costs went up 126%, and G&A was up 10%. Given the changing mix of international, political and economic dynamics currently at play, industry analysts and investors are asking questions about the strategic role of the U.S. E&P company. That role may largely depend on the class of E&P company being analyzed. Four company types Based on the analysis, SAIC has segmented E&P companies into four subgroups: majors, superi-independents, diverse independents and niche independents. Each group is marked by a set of distinctive characteristics as well as relatively similar performance. These characteristics include strategic focus, portfolio characteristics, economies of scale and capital spending profile. Majors fall within an obvious historical class of companies that boast enormous reserves, production and market capitalization. They tend to have more international focus and can take on huge, capital-intensive and risky projects. Super-independents are of a new class that emerged in the past few years. Their typical profile is now taking on many of the attributes formerly associated with the majors, including high-grading of assets, pursuing mergers and acquisitions, moving to deepwater plays and expanding internationally. While quite large, they still are not as large as majors. They have a strong U.S.-focused portfolio, although they are venturing into international areas, where their activities make up a smaller, but significant percentage of operations. Niche independents are smaller and have an obvious geographic or asset focus. Or, they may be a U.S. business unit of a much larger E&P company that is leveraging certain core competencies of the parent into particular regions or types of assets (e.g. Gulf of Mexico deep water). Such a company is achieving economies of scale and competitive advantage by limiting itself to a small scope of operations and focusing on excellence given the existing portfolio. Diverse independents are companies that do not fit into the aforementioned categories. They generally lack the scale of the super-independents and lack the particular geographic or strategic focus of the niche companies. Focus on 2003 performance Of the three primary E&P cost components, G&A is probably the best measure of a company's cost management savvy and culture. SAIC's definition of G&A includes all costs above the first-level supervisor in the field, including technical, operating and support G&A. It is largely personnel-related cost and the easiest lever for companies to pull when they need to reduce costs. The historical trend shows G&A costs have been rising since 2000 when commodity prices started to improve. Gone are the days when $1 per barrel was the G&A cost to beat. SAIC's data also show that the idea that independents are lower-cost than the majors is now just a myth and becoming more so every day. A company's G&A tends to be dominated by three factors: asset portfolio, capital investment levels and economies of scale. As such, expected results or targets can be developed for each company by taking its specific factors into account. Results indicate two classes of companies are consistently better performers from a G&A perspective: the niche independents and the majors. Niche players gain their cost advantage from very focused and streamlined portfolios. They demonstrate the benefits that can be achieved when companies focus their operations in areas where they have a strategic advantage. Not only do the niche independents have among the lowest G&A cost structures in the industry, they typically rank the best in overall efficiency. On the other hand, majors derive significant benefit from their high-graded portfolios of offshore assets and their enormous economies of scale. Given those advantages, they have room for improvements in G&A efficiency. The super-independents and diverse independents typically have the highest G&A costs. They have not chosen to specialize in a geography or area, and are actively acquiring assets, often resulting in a poorly focused and under-optimized portfolio. Their relatively higher capital spending also drives up their G&A costs. What about direct operating costs, defined by SAIC as the sum of lifting costs, workovers and property, production and severance taxes? These have increased 22% from 2002 to 2003. Less than one third of the 20 companies studied were able to lower operating costs year-on-year. As would be expected, operating costs varied widely with hydrocarbon mix, well productivity and operating geography. In 2003, the lowest operating cost was achieved in the gas-rich Rocky Mountain region. Driven by high-volume wells, the Gulf of Mexico shelf and deepwater regions also had low operating costs. In contrast, the Texas coast and the Permian Basin had the highest operating costs, driven by the maturity of these areas and low well productivity. The majors tend to have low operating costs, driven by their high-graded portfolios of highly productive wells, their investment in technologies to improve operating efficiencies and their focus on operational excellence. Niche players, especially those in sustain mode, also have low operating costs, in fact, less than the super- and diverse independents. Savvy niche players are able to leverage the knowledge base they have gained over time in their specific regional operations, or learn from the best practices of their corporate parents. As such, they are able to continuously optimize and reduce operating costs. Lower spending Reserves-replacement costs averaged nearly $14 per barrel in 2003, a 6% decrease from 2002. The Rocky Mountain region had the lowest-cost reserve replacement of the regions studied, while the offshore and Gulf Coast regions had the highest replacement costs. The majors reported the highest reserve-replacement cost, skewed by unprecedented reserve writedowns as well as the high costs associated with deepwater activity. Niche independents had the second-highest reserve-replacement cost, driven by their focus on mature basins such as the Permian, or for some, pursuit of new high-cost, long-lead-time reserves such as in deep water. The super- and diverse independents showed the lowest average reserve-replacement cost. A key measure of growth is reserve-replacement percentage. SAIC's data show the median 2003 reserve replacement percentage was 62%, indicating the average company is falling far short of replacing the reserves it produces. Three companies in the study managed to increase volumetric reserve-replacement percentages with less than median capital spending. They were able to achieve volume growth with relatively low levels of investment. Five companies increased reserve volumes, but did so with capex significantly above median spending levels. Seven companies achieved 50% or less reserve replacement while spending up to $35 per barrel of production. This trend of declining reserve-replacement percentages follows in lock step with the trend of reduced capital spending, despite record high commodity prices. Overall, companies' capital investment in the Lower 48 is on the decline, with a median year-on-year reduction in exploration and development (E&D) capital spending of 9%. With all but one exception, majors' E&D spending declined from 2002 to 2003, as these companies use the U.S. to generate cash for more attractive oportunities overseas. Niche independents' E&D capex also declined from 2002 to 2003, possibly indicating their narrower range of opportunities and/or their strategy to milk their assets. With the exception of one company that ramped up capital spending in a core geographic focus area, independents' E&D spending declined from 2002 to 2003. Super-independents' E&D expenditures declined from 2001 to 2002, however, the majority of companies increased E&D spending in 2003. As was the case with E&D capital, across the groups, acquisition spending also declined during the last three years, which is not surprising given the high price environment. Majors' and super-independents' acquisition capex fell from 2002 to 2003. Only two niche independents consistently devoted capital to acquisitions in 2002 and 2003. When viewed as a percent of margin, capital spending declined from 2002 to 2003. All categories of companies invested less as a percent of margin in 2003 as compared with 2002. In part, this change is driven by higher margins in 2003 versus 2002, but that only explains a portion of the year-on-year difference. When viewed on an absolute, per-BOE basis or as a percentage of margin, despite all the hallmarks of an outstanding year for E&P companies, it appears they have deliberately chosen not to invest as liberally as they have in the past. This may boost performance in the short run, but this behavior lays the groundwork for worsening economics going forward. Despite what should be a period of prosperity and growth, the industry is experiencing a particularly negative confluence of factors: increasing operating and G&A costs, increasing reserve-replacement costs, decreasing reserve-replacement percentages, and insufficient capital reinvestment in the U.S. Adding to this mix is the seemingly unstoppable fact that year-on-year production volumes continue to decline. Nearly 70% of the companies experienced a decrease in production versus last year. During a three-year period, fully 65% experienced production declines, including the majority of the super-independents and majors. The bright spot was the niche players with concentrated assets that were able to increase production in their core areas. It is important for companies to recognize that a reduction of capital spending in the short term may boost results as companies invest in a smaller number of more attractive projects. However, in the long run, if companies do not replace their production, they will be on a treadmill of increased cost pressure driving higher costs per barrel. Successful models Despite the grim picture the SAIC study paints, there are ways for companies to address costs and improve performance. The prerequisite for improvement includes a firm understanding of company performance versus external benchmarks, as well as a critical analysis of the activities of the organization. Improvements are possible through cost reduction and redirection of effort toward higher value-added work-and creating "space" or headroom that allows the assets of the organization, its technical and operating personnel, to focus on the fundamentals. Our first example is a basin-specific niche player whose cost-control strategy effectively enabled it to grow production and reserves in arguably the most mature basin in the Lower 48. Company A's operating strategy focused on managing budgets and staffing to the top quartile benchmark as compared with its peers. It used benchmarking as the basis of its annual budgeting process. Company A's cost-control processes facilitated more efficient deployment of capital in strategic basin plays, many times operated by others, which in turn cost-effectively grew reserves and production at base staffing levels. Although wholly owned by a larger entity, Company A was allowed to manage itself with minimal corporate oversight into line management decision-making. Management provided a bureaucratic shield over the day-to-day field operations and forced decision-making and accountability down to the lowest possible level. Management reporting and performance measures were streamlined and standardized based on financial performance rather than production volumes. The company maintained its top status for five consecutive years before its parent was acquired. The second example is a major with significant operating assets across North America. Company B maintained its cost structure at expected levels, based on its asset and operating characteristics, and is a top-quartile performer. Due to economies of scale and significant geographic breadth, it had numerous exploration/exploitation options as well as an attractive set of asset optimization strategies. However, it also had complex and burdensome bureaucratic processes. The legacy of downsizing, aggressive cost control and an aging workforce severely challenged Company B's ability to predict how to deploy its staff to the most promising growth opportunities. To overcoming these hurdles, it created activity-level "space" for its technical and operating staff by streamlining and removing prescriptive administrative and reporting processes. This approach, coupled with data management strategies that focused on built-for-purpose workflows and integration of cross-disciplinary activities, is anticipated to generate 7% to 10% staff efficiency improvements-without headcount reductions. These improvements equated to the work and effort (i.e. value) that 56 to 80 new geologists and engineers could generate. The outlook Given currently high commodity prices, it should be relatively easy for companies to achieve gains in the short term. However, the longer-term effects of constrained capital investment and lower reserve replacement will result in reduced production and consequently higher prices on a per-barrel basis. This is a treadmill that some companies will not be able to endure. Adequate gross margins and free cash flow will become increasingly difficult to maintain, much less increase. As such, the distinct classification of companies emerging in the Lower 48 will continue to become more sharply defined during the next several years. Our experience during the past decade suggests that companies that institute and maintain disciplined cost management, coupled with benchmarking and activity analysis (regardless of whether their strategy is to grow, sustain, or manage the production decline), tend to be the top performers in the industry. It appears the majors and the niche players will be best positioned to withstand a substantial price decline and maintain profitability, while the super- and diverse independents would most likely be unable to sustain profitability at lower prices. Certain diverse independents could be ripe targets for acquisition by super-independents targeting particular areas to gain major-like economies of scale. M Angela A. Minas is a corporate vice president at Science Applications International Corp. (SAIC) responsible for global consulting with the commercial and international business. Glenn A. Klimchuk is vice president, leading SAIC's North American oil and gas consulting practice. M. Bernadette Cullinane is a managing consultant and leads SAIC's E&P benchmarking studies. See SAIC.com.