The imperative necessity of business model innovation for the upstream oil and gas sector

Current business model

One key element of the business model the upstream oil and gas (“O&G”) companies is maximizing shareholder value (i.e. chasing the share price increase and providing dividends to shareholders). This is a particularly important element as it is based on a computation mechanism which seemed to justify on a scientific basis a key element of their business strategy[1]. The listed companies have to be seen as increasing their shares value because depending on their share price evolution, there are several indicators they are judged upon (e.g. the strength of the company, availability of third parties to partner with the respective company, ability/ conditions to raise capital etc). Last, but not least, some of the top managers do have their performance bonuses linked to the share price evolution.

The traditional business model of the upstream O&G companies is based on the maximization of the bookable reserves[2] and the increase in production (especially, the production has been vigorously chased before the oil price dumped in June 2014[3]).

Another element of the current business model was cost reduction (this should be an ongoing objective of any business model, perhaps less if it relates to an activity of sales of luxury items). After the 1970s, the international oil companies believed that externalizing as much as possible from their non-core/ technological services will lead to competition between the acquiring third party companies and, ultimately, would lower their costs (as beneficiaries of such third party services). Yet, this backfired on them a number of years later when the technological competition exerted by such service companies has taken the international oil companies outside the competitive processes. Moreover, in the last decade, the industry has developed contractual mechanisms (e.g. production enhancement contracts[4]) where only service providers are eligible.

Failure of the current business model

As it has been mentioned[5], there have been signs of the failure of the traditional business model before the oil price drop: most of the upstream actors have failed to increase their reserves, the price evolution of their shares has been negative and the return on capital (despite the rising oil price) has been decreasing.

Apart from the low oil price environment that settled since June 2014, the following may be quoted as causes of the inefficiency of the current business model:

  1. Overestimating results of large CAPEX investment projects
  2. Giving up to the technological and managerial advantage
  3. Progressive fiscal terms imposed by host states
  4. Harder, costlier and riskier access to reserves
  5. Inefficient downstream business
  6. Financial problems.

In addition, a new element surfaced in the last couple of years (culminating with the Paris COP 21 Agreement from December 2015): the strong reduction targets set for global emissions. 

What should companies consider in adapting their business model?

Most of the oil and gas companies have hold onto their business model for more than 40 years. Whenever they have encountered (some of) the above presented difficulties, the O&G companies have found ways to overcome them without changing their business model. Yet, now it is clear such measures can’t prevent the adaptation of their business model.

Some of the obvious measures have already been taken (e.g. reducing costs in order to reach cash flow neutrality). At the same time, it is clear that some elements simply cannot be touched (e.g. chasing shareholder value), but here are a few emerging trends which the O&G companies need to factor into their business model innovation process:

  1. Disruptive technologies

Several possibly disruptive forces that may impact the O&G environment:

  • the CCS (carbon capture and storage) techniques are still in their early phase. There could be ideas[6] (that currently may look like “science fiction”) that could turn into tomorrow’s reality. At present, the fundamental flaw of many of these innovative ideas lies behind their economic viability [yet, all bright ideas need time to (im)prove themselves].
  • huge potential of the electric vehicles (EVs) technology: EVs prices are still high and, therefore, not available to mass markets. But, as it has been mentioned[7], if all currently EVs planned production will eventually materialize (and the EV sale price decreases as forecasted) than the volume of displaced oil (i.e. oil currently used for fueling petroleum based vehicles) may translate into an(other) oil crisis as early as 2023!
  • the renewables’ share in the energy mix will have to be closely monitored (as it is obvious they are on a rapidly rising trend till 2040)[8].
  1. Higher compliance costs/ new legislation on climate change

It is beyond doubt that the upstream compliance costs will rise. The environmental move acting for the reduction of green house gas emissions is gaining momentum: the Paris COP 21 Agreement seems to have laid the foundations for a new global approach (where the voluntary intend – not so much the forceful action – stands behind the states’ actions).

In this context, it is expected that the O&G companies will no longer benefit from the authorities’ clemency as regards their current obligations and that the regulatory (specifically environmental) obligations whose enforcement has been kept in a sort of latent status will be brought to light. It is also clear that see stricter legal provisions will be enacted in order to comply with the Paris COP 21 Agreement.

The accidents witnessed in the last years (especially the 2010 Macondo spill) have led to firmer and stricter legal frameworks. State authorities are now very sensitive to any type of accidents (specifically, the ones involving human injuries). Due to such accidents, new obligations imposing limited functioning life for the offshore platforms and replacement of old equipment have been enacted at EU level (and Romania must transpose them into its legislation).

  1. More mergers and acquisitions (M&A)

When oil price is down, asset values are down[9]. For the companies/ investment funds that have the financial muscle, now it’s time to buy.

In the previous price crisis, there was a wave of mergers as it was believed that purchasing shares in a company was a cheaper way to increase reserves than investing into exploration acreage[10]. In the current environment though, it seems there isn’t much appetite for such mergers: apart from Shell’s huge acquisition of BG and the failed $28 billion Halliburton/ Baker Hughes deal, not much seem to happen on the M&A arena.

  1. Portfolio optimization

O&G companies are now reviewing their portfolio: the promising assets are to be developed with carefully weighted investments, the producing assets (i.e. cash flow generators) must be maintained with limited OPEX, while the low producers/ low potential assets are to be divested.

Some players have already announced their intentions: Shell will concentrate on the deepwater production and will exit from 5 to 10 countries[11]; Statoil decided in 2015 to exit Alaska[12]; OMV Group set up a central special unit to look at its existing portfolio, while Petrom is actively optimizing its portfolio.

  1. Diversification into other energy producing areas

Considering the move towards a cleaner environment, O&G companies will have to work towards that goal as well. The world is still far from giving up fossil fuels, but coal demand has peaked already in 2014 and oil peak seems not that far either. Gas will benefit most from the carbon emissions hunt, but the climate change considerations have to be weighed against the lower economic rent provided by gas[13]. At the same time, since renewables will obviously grow, some of the largest O&G companies have taken steps towards that era: Statoil recently bought stakes in a German wind farm (with projected investment of up to EUR 1.2 bln) and made the decision to build the first floating wind farm[14]; Total (re)named itself the “oil, natural gas and solar company” after purchasing the largest equity stake in the second largest solar power company in the world[15]; BP invested massively over the last three years in its Brazilian biofuels plants [16]; ExxonMobil (through its downstream arm) has portfolio diversification high on its agenda[17].

***

The oil and gas landscape is at a turning point. All O&G companies feel the severe hit of the price crash from June 2014. Before mid 2015 it was believed that prices will recover and this was just another crisis like the previous ones. Yet, now almost everyone understands this is the new reality and they have to transform. Those not willing to engage in such transformation will slowly disappear; those that will manage costs wisely, will re-shape their portfolio and will open the door for cleaner technologies, may come out of such distressed times strengthened and best positioned for the future energy landscape.

[1] Paul Stevens, “International oil companies. The Death of the Old Business Model” – available on https://www.chathamhouse.org/sites/files/chathamhouse/publications/research/2016-05-05-international-oil-companies-stevens.pdf (accessed on 30 may 2016)

[2] Over time, reservoir engineers have developed certain schemes for justifying in front of the regulator higher figures describing the bookable reserves.

[3] Sometimes, the maximization of production was chased so vigorously, that the increase in production was to be achieved even at the cost of negative NPV! Yet, that will no longer be the case as the O&G industry will now look for value instead of volumes.

[4] Production enhancement contracts (“PEC”) are specific to mature fields: the production and the reserves remain with the titleholder/ beneficiary, while the PEC contractor receives a tariff against the production achieved. PECs have been awarded in Romania and Mexico

[5] Paul Stevens, “International oil companies. The Death of the Old Business Model” – available on https://www.chathamhouse.org/sites/files/chathamhouse/publications/research/2016-05-05-international-oil-companies-stevens.pdf (accessed on 30 may 2016)

[6] See for example, the idea of prof. Klaus Lackner (i.e.  the director of Center for Negative Carbon Emissions at Arizona State University) to capture carbon from the air through very high “plastic trees”. For further details, see http://www.bbc.com/future/story/20121004-fake-trees-to-clean-the-skies (accessed on 6 June 2016)

[7] For more details, see https://vimeo.com/156585403 (accessed on 6 June 2016)

[8] For further details on such disruptive technologies, see the Wood Mackenzie’s  Q4 2015 edition of the Global Risk Tracker availanble at http://www.woodmac.com/reports/macroeconomics-risks-and-global-trends-global-trends-risk-tracker-q4-2015-34424211?track=22?goto=http://www.woodmac.com/reports/macroeconomics-risks-and-global-trends-global-trends-risk-tracker-q4-2015-34424211?track=22 (accessed on 17 July 2016)

[9] . Many companies have taken impairments on their upstream assets: see, for example, http://www.romania-insider.com/romanian-omv-petrom-takes-eur-400-mln-hit-due-to-oil-price-drop-may-post-first-losses-since-privatization/164151/ (accessed on 7 June 2016)

[10] Paul Stevens, page 33 under “International oil companies. The Death of the Old Business Model” – available on https://www.chathamhouse.org/sites/files/chathamhouse/publications/research/2016-05-05-international-oil-companies-stevens.pdf (accessed on 7 June 2016)

[11]http://oilpro.com/post/24941/shell-being-transformed-upstream-exit-10-countries-plans-to-doubl?utm_source=DailyNewsletter&utm_medium=email&utm_campaign=newsletter&utm_term=2016-06-07&utm_content=Article_3_txt (accessed on 8 June 2016)

[12] http://www.statoil.com/en/NewsAndMedia/News/2016/Pages/q4-2015.aspx (accessed on 8 June 2016)

[13] Shell seems to be willing to take this bet as it has recently announced (through the voice of its CEO) that it will “see its gas portfolio significantly expanded” – for further details, see http://oilpro.com/post/24941/shell-being-transformed-upstream-exit-10-countries-plans-to-doubl?utm_source=DailyNewsletter&utm_medium=email&utm_campaign=newsletter&utm_term=2016-06-07&utm_content=Article_3_txt (accessed on 8 June 2016).

[14] http://www.statoil.com/en/NewsAndMedia/News/2016/Pages/q4-2015.aspx (accessed on 8 June 2016)

[15] For further details, please see http://www.total.com/en/news/growing-renewables-particular-solar-energy-and-biomass (accessed on 7 June 2016)

[16] For further details, please see http://www.bp.com/en_br/brazil/o-que-fazemos/biocombustiveis.html (accessed on 7 June 2016)

[17]For further details, please see http://lubes.exxonmobil.com/Lubes/sustainability_productsandprocesses_diversification.aspx (accessed on 8 June 2016)

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