Unconventional Repositioning

The commercialization of unconventional resources has attracted the attention of U.S. independents, international and national oil companies (NOCs) seeking a new platform for growth. Looking to capitalize on the discoveries of abundant U.S. tight-oil, shale-gas and coalbed methane reserves, energy executives have been adapting their companies’ strategies to position for growth in this space and mitigate threats or risks associated with changes in upstream economics.

It is notable that the “shale rush” happened at a time of historical lows in natural gas prices, while conventional oil production has been providing strong performance results and continued production growth from increased recovery. The International Energy Agency (IEA) estimates the share of shale-gas production will nearly double, to 45% of total gas production, by 2035. However, much of the recent growth has come from the associated gas in liquids-rich plays. Currently, dry-gas shale fields without requisite infrastructure or market proximity are mostly uneconomic, with average breakeven costs per well of $5 to $7 per million Btu for dry gas or $3 per million Btu for liquids-rich plays, according to the IEA.

While the shale plays continue to attract upstream capital dollars, the sustainability of the trend poses concerns for some participants in light of marginal economics. The major integrated companies have been building a presence in the shale space as a longer-term investment, while fine-tuning their capital program toward liquids in the near term. At the same time, for the smaller E&P players that are capital constrained, the key question is how they can stay in a game that may take several years to play out.

To gain an edge in the evolving E&P playing field of unconventional resources, companies need to define their strategy. Key questions include: What is the role of shale plays in their business portfolio and how much capital do they deserve under various market scenarios? Will growth be driven by organic or inorganic activity, and what is the exit strategy? Does the company have the technical capabilities to commercialize these resources?

Companies that have successfully carried out a multi-resource investment program have had a clear strategy.

The “shale rush” happened at a time of historical lows in natural gas prices, while conventional oil production has been providing strong performance results and continued production growth from increased recovery.

Capital spending and portfolio rebalancing

Since the economic recovery took hold, most industry participants have increased E&P capi- tal spending and expanded natural gas portfolios in response to the growing demand for cleaner energy sources. In pursuit of margins amid persistently low natural gas prices, the industry has turned to liquids-rich plays, as evident in the rig count. The decline in unconventional dry-gas drilling has been offset by an increase in the unconventional oil rig count. However, the production reversal has lagged, due to plentiful associated gas in liquids-rich fields continuing to expose many producers to disadvantaged natural gas.

The financial performance of E&Ps that were late in adjusting their portfolios to changes in field-development economics has suffered, and some are still trying to reverse course. Companies must monitor market indicators and stay attuned to industry dynamics to recognize trend shifts and adjust capital spending accordingly. While going against the trend may offer a differentiation strategy, a company should be realistic about its risk-management approach if the industry at large proves correct.

Capital allocation is fundamental to upstream players; investing capital in the most attractive opportunities drives shareholder value creation. Having a strategy in place that responds to changes in market conditions is critical to sustaining these performance results. Two key methods to ensuring responsiveness are scenario-based planning based on market factors, and advanced analytical tools to model portfolio impact and adjust allocation as needed.

Scenario modeling can follow a phased approach to field development to support portfolio-rebalancing decisions. For instance, after funding the exploration program and formation evaluation, a company can consider whether to assume operatorship or to farm out, based on field-prospectivity evidence, attractiveness of economics and adequacy of the company’s technical expertise. Another milestone in deciding whether to stay in the play can occur at the transition from development to production.

In addition to optimizing decisions across the asset’s life cycle, upstream operators need to review their capital-project portfolios in aggregate to achieve the desired asset maturity, production profile and best mix of growth vs. value plays. Whether shale plays are considered a growth engine or a core position, companies should select those with acceptable commercial and technical risks.

Plays’ economics vary, so companies must determine the acceptable threshold for their participation as an operator or a working interest partner. Plays with a higher breakeven cost, like the Bakken and Eagle Ford shales, may not be suitable due to their higher sensitivity to a drop in commodity prices. Selecting the right plays, in conjunction with an appropriate hedging program, aids in withstanding price volatility. Furthermore, to help maintain target profitability, producers should favor wells with high recovery and low decline rates.

The role of A&D

In recent years, high oil prices and relatively attractive regional natural gas prices in Asia and Europe, combined with strong balance sheets, have driven increases in E&Ps’ capital budgets and fueled deal flow. Not surprisingly, recent upstream merger and acquisition (M&A) activity in the U.S. has been weighted toward unconventional plays. U.S. shale resources have also attracted investment dollars from Asian NOCs.

Supplementing their organic growth strategy with inorganic opportunities, domestic and international companies have pursued targeted acquisitions in both unconventional and conventional plays to expand their shale positions and increase exposure to oil. While acquisition activity has softened in pure shale-gas plays, liquids-rich prospects continue to attract the interest of acquirers seeking accretive growth in existing portfolios or entry into new plays.

While most E&Ps transact at the property level, some pursue corporate acquisitions. The right M&A strategy for a given company de- pends on its size and strategic intent. Is it looking for attractive prospects to develop, or is it interested in acquiring the target’s entire asset base, along with its capabilities and technical know-how? Factors to consider include the acquirer’s core competencies, access to capital and integration impact.

In addition to active participation in acquisitions, major oil companies have continued to divest late-life oil fields and nonstrategic assets to high-grade their portfolios. Asset rationalization post-acquisition helps to realize synergies from the combined exploration portfolio and supports the companies’ cash position needed to maintain investment in their core areas. Targeted asset and corporate A&D can be used to shape business and technology portfolios and maintain a strong capital-investment pipeline.

Whether a company is pursuing an inorganic or organic growth strategy, it must balance growth with internal capabilities. Many smaller E&P players and internationalizing NOCs are challenged by their own rapid growth, with increasing investment activity outpacing their organizations’ abilities to handle it. As a result, they are considering or undertaking business transformation efforts.

In recent years, high oil prices and relatively attractive regional natural gas prices in Asia and Europe, combined with strong balance sheets, have driven increases in E&Ps’ capital budgets and fueled deal flow.

R&D alignment

One of the most important areas of organizational capability in the upstream is technology research and development (R&D). It is a critical enabler of commercial field development, particularly in shale-gas and tight-oil plays, which have higher well costs than their conventional counterparts. Hydraulic fracturing, which is transforming the energy balance, underscores the importance of technology as a source of competitive advantage for E&Ps globally.

Companies differ in their approach to technology—whether to develop know-how internally through R&D and experimentation, or to acquire it through transactions or joint ventures. The appropriate strategy depends on the company’s operating model.

U.S. operators continue to look for technology improvements, particularly in drilling and completion, to gain an edge. According to the Department of Energy (DOE) Office of Petroleum Reserves, more than 27 companies have engaged in oil-shale research since 2007. Research efforts have targeted a range of technical challenges, including surface processes and water re-use, among others.

The role of experimentation in applying technology to shale plays cannot be underestimated, and newer entrants may benefit from partnering with experienced producers. One of the Asian NOCs, for instance, joint ventured with a U.S. E&P by buying stakes in the latter’s U.S. shale projects. Partnerships and joint ventures are effective ways to share technology and the risks of field exploration and development in both conventional and unconventional plays.

In addition to considering technology capabilities when making commercial decisions, companies need to review technology strategies in conjunction with their business portfolio. How much of their R&D investment should be directed to unconventionals depends on the relative allocation of these assets in their portfolio.

Whether technology is developed in-house, acquired or transferred, the company’s R&D portfolio should align with its asset portfolio and organizational capabilities. Harnessing technology to create value is key to an E&P’s competitive position, especially at a time of change in industry focus toward unconventional resources.

Competitive implications

Shales are viewed as a strategic area for future reserves replacement and production growth by many E&Ps. The competitive intensity in unconventionals has increased over the past few years as this segment attracted new entrants of various sizes and national origins. Where and how a company chooses to compete in this space, in consideration of its core competencies, will determine the future strength of its position.

The survival of E&Ps in these uncharted waters depends on their ability to stay attuned to market fundamentals and follow traditional principles of corporate strategy and portfolio management. Successful companies are able to identify the right opportunities for their portfolio and effectively seize them to generate profitable growth.

The market is increasingly attributing an upstream company’s value to its capital efficiency—the ability to direct capital to opportunities of highest return to shareholders, while balancing risk. Determining the appropriate mix of resources—conventional vs. unconventional and oil vs. gas—must be done in conjunction with the company’s expertise to commercialize them. The resulting production profile should be consistent with the expected growth and variability of earnings for sustainable shareholder value creation.

To effectively navigate in this dynamic environment, companies must formulate a sound growth strategy. Executives should clearly understand what role unconventional resources will play in their portfolio and how these assets will contribute to their current and future performance. Furthermore, companies have to assess their own ability to create value from these resources and the R&D programs needed to address unique asset challenges. Companies need to build requisite capabilities from strategy to execution to deliver growth in unconventional resources, whether through the drillbit or acquisitions.

Reid Morrison is a principal in PwC’s Houston office and is the U.S. advisory leader for the energy sector ( reid.morrison@us.pwc.com? ). Svetlana Valonis is a manager in PwC’s strategy and operations advisory practice focused on the energy sector.