Oil and Gas Companies Becoming Hyper Specialists, Which is Driving Efficiency and Pleasing Investors, but Making Companies More Vulnerable to Volatility and Unexpected Events, IHS Markit Says
North American shale players are particularly narrowly focused and
exposed to significant risk and fragility
A continuing trend toward greater specialization in the oil and gas
industry is enabling companies, particularly in the North American shale
plays, to achieve greater efficiencies, please investors, and improve
financial results, but new analysis from business information provider
IHS Markit (Nasdaq: INFO) says this corporate strategy is putting many
companies at significant risk to market volatility, fragility, and
vulnerability to unforeseen events.
“Specialization is increasingly driving strategic focus for oil and gas
operators because, for a time, it works, and the market prefers and
rewards specialists,” said Raoul LeBlanc, vice president of financial
services at IHS Markit, and lead author of the new IHS Markit analysis, The
Promise and Peril of Specialization. “When you focus on one play
type or asset, like an athlete who focuses on a single sport, you tend
to get better at it and become faster and more efficient. Investors and
investment banks are the primary drivers pushing this strategy, and
while there is certainly great upside to this approach, there are also
new risks that may not be readily apparent,” LeBlanc said.
For much of the oil and gas industry’s history, bigger was
unquestionably better. This made sense on many levels because the
industry spans the globe and faces a nearly unparalleled array of
political, financial and technical risks. Scale and diversity, it was
argued, was the best buffer against these risks.
That ‘bigger is better’ truism, however, has been supplanted by an
inexorable push towards specialization. The trend started with the
emergence of the shale industry and gathered momentum when those
successes attracted increased spending and exposed the often poorer
risk-reward ratio of many international investments.
“Two new developments accelerated the trend toward onshore
specialization,” LeBlanc said. “First, shale production has grown large
enough to generate significant cash flows, allowing companies to sell
the ‘distraction’ of other asset types, which virtually every large E&P
player has done in their North American portfolio.”
Companies now specialize in shale, offshore assets, CO2 plays, or other
themes. Examples include Encana’s split and Occidental’s spin-off of its
95-year-old California business. Secondly, the maturation of major shale
plays beyond the delineation phase has reduced risk by revealing the
overall quality of acreage holdings. As the industry moved into the
low-risk, high-capital phase of the plays at the same time cash flows
collapsed post-2014, companies focused on their best assets.
Companies that once strived for breadth in technologies and geography
now compete in narrower competitive bands in pursuit of a deeper, more
limited, set of skills. Global producers increasingly focus on countries
or regions, shifting away from international activities to onshore North
America. Within North America, the hypercompetitive environment has
pushed producers to become pure-play companies.
“Within the U.S. upstream segment, the transition from conventional to
unconventionals has been profound,” LeBlanc said. “At the dawn of the
tight-rock era, virtually all companies in the U.S. held portfolios
characterized by conventional oil and gas holdings in multiple regions,
plus some near-field exploration opportunities. As the potential of
shale became apparent, they shifted capital deployment toward those
assets, retaining conventional assets as cash generators to fund early
stage positions.”
The biggest independents – Chesapeake, Devon, Anadarko and EOG
Resources, are examples, IHS Markit said. While their end results turned
out differently, each moved to buy a significant foothold in multiple
plays. The companies understood that some plays fail and that despite
best efforts, their acreage might not be in the “sweet spot” of well
quality. Diversification among the various plays hedged those risks.
Anadarko, Devon, Encana and Pioneer were among independents that led the
retrenchment to the U.S. onshore. Now, even global companies including
Chevron, ExxonMobil and BP, are redirecting significant capital to the
U.S. onshore and in particular, the Permian Basin. Like decathletes,
major companies possessed a breathtaking range of skills and endurance,
but as more specialists dig down on particular technologies and
geographies, the decathletes are finding it hard to compete, LeBlanc
said. “This has been particularly evident in the majors’ struggle to
compete with shale specialists at their own game.”
Specialization narrows a company’s horizons, IHS Markit said. Building
an operation around developing a single or narrow portfolio of assets,
even one as prolific as the Permian, may determine a company’s lifespan.
This has already been witnessed with companies focusing on older gas
plays such as the Barnett or Pinedale, and is even creeping into the
more mature Bakken shale play, where investors have grown concerned
about the dwindling inventory of core drilling opportunities. There are
few companies spanning the shale gas and shale oil divide, IHS Markit
said. “There are no major producers with significant positions in both
the Marcellus/Utica, the top gas play in the U.S., and the Permian
Basin, the top oil play,” LeBlanc said.
Increasingly, companies are becoming pure-play companies focusing on
just one basin, or even subsections of a single basin. Pioneer Resources
is selling its Eagle Ford assets to go “all in” on the Permian Basin,
where it holds a large, market-leading position. “The question becomes
what happens to those single-play specialists when their play is no
longer competitive with other shale basins,” LeBlanc said.
The push toward specialization also risks sapping a company’s ability to
explore new frontiers. “In today’s environment, new ventures investments
are a costly distraction from near- and medium-term objectives,” LeBlanc
said. “The problem will become apparent over time if the company fails
to successfully migrate from its core asset.”
Perhaps the greatest risk of specialization comes from environmental
volatility, the IHS Markit report said. The specialist company is
fragile to unanticipated changes—the kind the corporate giants were
built to withstand. For instance, a sudden public turn against fracking
in the form of a regulatory ban or judicial stay—like that threatening
Colorado’s Wattenberg play, or what occurred with regards to the banning
of deepwater drilling in the Gulf of Mexico following the Macondo
disaster—could spell disaster for a company with no other options in
their portfolio outside of their area of specialization.
Additionally, other options of cheaper supply could undermine the
economics of a single type of asset. A breakthrough in renewables
technology, or more forceful government policy to cut carbon emissions,
could quickly sap value from a company’s portfolio if it isn’t able to
adapt and compete. Investors will be quick to abandon a company that
loses out in these market shifts. This divergence of exposures creates a
gaping wedge between management and shareholders in an era of
specialists, LeBlanc said.
“In the past, investors wanted asset diversification to protect the
company’s long-term viability as an investment,” LeBlanc. “Today,
investors seek diversification through their own investment in many
different companies, so are more focused on a company’s short-term
financial performance, rather than its long-term viability,” LeBlanc
said. “That works for the investors, but it may run counter to the
company’s long-term best interests. With that in mind, it is imperative
for company leaders to assess and understand their specific risks and
then create a strategy to mitigate those risks without sacrificing
short-term growth.”
“Ironically, while the narrower skills sets of specialization do deliver
financial results and we expect the specialization trend to continue,
during the recent prices downturn, the integrated business model proved
its worth,” LeBlanc said. “As falling prices undercut the profitability
of upstream operations, the integrated companies saw their downstream
operations pick up the slack, while the more diversified portfolios gave
them more options to find attractive investment opportunities.”
In the U.S. onshore, every play is in the process of down spacing, IHS
Markit said. The point is that every asset – and especially the
disproportionately small core areas that some operators specialize in,
is finite and will deplete. In the long-term, companies will need to
transition to a new asset, IHS Markit said.
“In addition to exhaustion concerns, specialization in the development
phase (which is where most companies are at this point in
unconventionals), also makes it difficult for companies to add
significant shareholder value,” LeBlanc said. “We see oil and gas
companies typically creating the most shareholder wealth by taking
chances on unproven rocks and delivering big new reserves in the proving
and optimization stages of a play. A company focused on the efficient
manufacturing of shale wells at the mid-life stage must invest the bulk
of the lifetime capital, but enjoys relatively little value-add from
low-risk capital deployment. Opportunities for value creation are
especially thin for later entrants that paid an entry premium for
premier plays like the Permian,” he said.
“The key here is specialization works…until it doesn’t,” LeBlanc said.
“The industry’s rush to focus is exposing companies to systemic and
company-level risks that ‘diversification’ previously reduced.
Specialists would be wise to consider these hidden risks and develop
options to mitigate them.”
To speak with Raoul LeBlanc, contact Melissa Manning at melissa.manning@ihsmarkit.com.
For more information on the IHS Markit analysis, The
Promise and Peril of Specialization, contact clare.fletcher@ihsmarkit.com.
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