Highlights:

• Increased demand, high oil prices and steady production have increased sector confidence, but challenges lie ahead.
• Managing return on capital invested is a major issue for the industry, despite high prices and rising demand.
• Corporates need to keep focused on upstream core assets to increase returns.
• Partnerships, investment in new technology and a focus on quality, as well as scale of production, are fundamentals for the future success of the industry.

Main Article:

The oil and gas sector is changing. Capital Insights explores how corporates are seeking growth by consolidating and innovating.

At first glance, oil and gas companies seem to be doing better than ever. Production is running at near record levels. According to the BP Statistical Review of World Energy 2013, the world produced 86.1b barrels of oil in 2012 — a 15% increase on total production 10 years ago.

At the same time, oil prices have averaged a historically high level of US$111 per barrel for the past two years, according to the US Energy Information Administration (EIA). A decade ago, oil was priced at just US$25 a barrel. The high pricing is a result of growing demand. According to BP, consumption increased to a record high of 89.7 billion barrels last year, a 14% increase on the 78.4 billion barrels consumed in 2002. Strong growth in emerging markets (EM) has driven the increase, with a rise in consumption of 3.3% in countries that are not members of the Organization for Economic Co-operation and Development (OECD).

Oil and gas executives have taken heart from this backdrop of increasing demand, high oil prices and steady production. “For the bulk of the last decade, we have been in an environment where oil prices were rising quite quickly and gas prices were either flat or rising,” says Andy Brogan, Global Oil & Gas Transactions Leader at EY. “Fields that came on stream when prices were still low are economical at those lower prices and are still producing. When the oil price is trading above those levels, the energy companies are making money, and that underpins confidence.”

This is shown by EY’s latest Capital Confidence Barometer, in which 58% of respondents were focused on growth — up from 41% in October 2012.

This underlying industry confidence supported a record year for M&A in 2012.

According to EY’s Global Oil and Gas Transactions Review 2012, deals worth US$402b were closed in the oil & gas sector last year, significantly higher than the US$337b in 2011. There were 92 transactions exceeding US$1b in 2012, compared with 71 in 2011, a further sign of confidence as corporates demonstrated a willingness to invest large sums in long-term projects. Major deals include the acquisition by CNOOC Ltd, a China National Offshore Oil Corporation subsidiary, of offshore group Nexen for US$15.1b.

Despite a falloff in M&A activity in 2013 (as there has been in many sectors due to continued economic uncertainty — for more, see “The big picture”) and a cautious approach to additional investment by corporates, there have still been substantial deals. These include US company Freeport-McMoran Copper & Gold buying offshore driller Plains Exploration and Production for US$10.8b in May, while in April, US company Hess sold its Russian assets to the country’s second-largest oil producer, Lukoil, for US$2b.

“The industry has been blessed with quite a long period of relative stability with the commodity price at reasonably strong levels,” says Jon Clark, UK Leader for Oil & Gas Transaction Advisory Services at EY. “That has helped to build balance sheets in larger companies, but it has also made people feel more comfortable about making long-term capital commitments and investment decisions.”

Capital constraints

However, despite the positives, the industry faces challenges. Managing return on capital is one of the major issues with which the industry has been confronted, even in an environment where prices and demand have stayed high.

A May 2013 Citigroup study, Investing for Commodity Uncertainty, found that the return on capital employed for 30 of the world’s largest oil companies fell to 9% in 2012. Between 2005 and 2008, figures show that return on capital averaged over 15%. That return could drop to 8% by 2015, if Brent crude prices fall below the US$100-per-barrel threshold.

“There is no doubt that it is more costly to produce resources today than it was 20 years ago,” says Kevin Forbes, Partner at specialist oil and gas technology investor Epi-V. “There is a huge cost differential between a relatively simple drilling operation in Saudi Arabia and drilling under 10,000 feet of water in a deep-water project.”

Finding new sources

Discovering and producing reserves in more hostile conditions has been one of the major contributing factors to the pressure on return on capital.

Government-backed national oil companies (NOCs) now control the bulk of the world’s oilfields — according to the BP Statistical Review, countries outside of the OECD now control 85% of the world’s proven reserves. A recent example of the growing strength of NOCs can be seen in China’s CNPC acquiring a 20% stake in Offshore Area 4 in Mozambique from Italy’s Eni for US$4.2b in July 2013. International oil companies, which used to control more than four-fifths of global reserves before the rise of NOCs, have had to look to difficult-to-access, deep-water assets and unconventional sources of energy, such as oil locked in shale and tar sands.

For example, in September this year, US company Ensco took delivery of an ultra-deep-water drilling ship, ENSCO-DS7, which is set to become its fourth rig working in the West Africa deep-water market.

A 2013 Goldman Sachs analysis of Europe’s largest oil and gas companies demonstrates how challenging it has been for some groups to improve return on capital when the sites are so difficult and technical. The investment bank found that 18% of the capital invested by Europe’s largest oil and gas companies has gone on projects that need the oil price to be US$80 or higher just to break even.

 Making the most of it

Even though unconventional and deep-water oil and gas assets are pricier and more challenging to develop, exploiting these resources is essential if the world is to continue meeting the mounting demand for hydrocarbons.

According to the International Energy Agency (IEA), the development of deep-water reserves, oil sands and shale gas is forecast to increase production from outside OPEC to 53 million barrels a day by 2015, up from fewer than 49 million barrels a day in 2011. By 2035, the IEA forecasts that unconventional gas will account for half the increase in global gas production.

Unconventional resources have become key for oil companies, as they provide access to new reserves that are not controlled by the dominant NOCs. Many of these projects can be operated profitably thanks to improvements in technology, and supplies are plentiful. The EIA estimates that the world holds reserves of 345 billion barrels of technically recoverable shale oil and 7,299 trillion cubic feet of shale gas.

This is a significant source of new assets for international oil companies, easing pressure to replace reserves.

“The shale plays have made a very significant contribution to our business. These assets … provide tremendous optionality for ConocoPhillips,” said Matt Fox, Executive Vice President of Exploration and Production at US oil group ConocoPhillips, in its 2012 annual report. “They are resource rich, with years of scalable drilling inventory.”

Brogan adds that another advantage of unconventional resources is that they provide oil companies with greater capital flexibility than plays in deep-water or traditional wells. “If you are in huge offshore assets operated by a consortium, [this] usually means that you are in assets that have very long lead times and very little flexibility about the capital you deploy once you have made the decision to go. Unconventionals are a good alternative to that, because you can scale those up and down quickly,” says Brogan.

The only way is upstream

The focus on return on capital among the oil companies, coupled with moves to make plays for deepwater and unconventional assets, have been the major drivers of oil and gas M&A recently. These priorities mean that the largest growth in investment is in upstream assets (operations involving exploration and production stages), where deal value increased by 68% to US$284b, according to EY’s Global Oil and Gas Transactions Review 2012.

Upstream deals have continued to dominate deal activity in 2013, with Royal Dutch Shell’s US$6.7b buyout of Repsol’s liquefied natural gas (LNG) assets one of the standout deals of the year. Activity in the downstream market (operations that take place after production through to retail), by contrast, has been slower, with downstream deal volumes falling 6% to 162 deals in 2012, and deal values staying flat at around US$42b.

Oil companies have been eager to sell off downstream operations and focus on potentially more lucrative upstream plays. Examples from 2012 include Exxon Mobil selling its Japanese retail, refining and storage division, TonenGeneral Sekiyu, for US$3.9b, Statoil selling a 54% stake in its road-transport fuel retailer to Alimentation Couche-Tard, and BP selling its Carson refinery and Southern California refining and marketing business to Tesoro Corporation. Meanwhile, in September 2013, US oil company Chevron agreed to sell its downstream assets in Pakistan.

“Downstream assets tend to have a lower unlevered return than upstream assets, so you have seen companies selling those assets or, at the most extreme end, completely splitting downstream and upstream,” says Brogan.

The road ahead

In a changing world, corporates in the oil and gas sector need to bear in mind the following factors when trying to compete:

1. Return on capital. Although the oil price is trading at near-record highs and demand is increasing, return on capital is still a key area of focus as resources become more difficult and expensive to produce. “As the rocks that companies are producing oil from become progressively harder to get at or are more remote, and the focus on health, safety and environmental concerns becomes even greater, then the cost of developing them increases. Processes have become more technical and difficult. Deep-water is more expensive than shallow-water, and unconventional resources are more expensive than conventional,” says Brogan.

2. Partner up. Partnerships have always played a large part in the industry, but the fact that many oil and gas fields have become more technically challenging to operate and require large capital investment has prompted an increase in joint ventures (JV) and strategic alliances between oil and gas companies to mitigate risk.

“We are now entering a third era, where cooperation between partners is the key to unlocking the resources found in the most challenging locations,” said BP Chairman Carl-Henric Svanberg in the company’s latest annual report.

A recent example of this is the JV deal announced in June 2013, between Pangean Energy and PetroTech Oil and Gas, which saw the companies enter a contract to buy mineral rights in the huge Bakken shale oil reserves in North Dakota.

3. Upstream deals. The record M&A level in 2012 — particularly in upstream activity —

demonstrates the importance of using acquisitions as a tool for breaking into new geographies and taking control of unconventional resources such as shale or deep-water. And, while 2013 has been quieter for M&A, there is reason for optimism. The second quarter of 2013 saw an improvement in upstream deals — although it was a modest one. According to Derrick Petroleum Services, volumes rose from 117 deals in Q1 to 141 in Q2, with value also rising from US$20.9b to US$24.9b. The indication is that the sector is still focusing on its core activities.

Upstream deals are extremely key to positioning oil companies to achieve the best return on capital. “In an environment where capital is more constrained than in the past, companies have rightly focused on where they can get the best returns on that capital. Traditionally, the upstream segment of the market is where bigger returns on capital are possible,” says Clark.

4. Invest in technology. Advances in technology have been the key enabler for companies developing difficult-to-reach assets. Without technological developments, production on many assets operating today would be impossible. This is set to be an ongoing theme — investing in technology, either internally or through acquisitions, will allow companies to produce with greater efficiency and open up new resources in the future.

“Oil companies are making returns on capital on difficult assets, which they could never have made economical 20 years ago,” says Forbes. “Given the recent technological breakthroughs, there is every chance the industry can continue to open up hard-to-access reserves in the future.”

5. Quality not quantity. Producing as much as possible used to be the main focus for international oil companies. Now, with the focus on return on capital, quality, as well as scale of production, is the priority. “For BP, advantage now comes from exceptional capability rather than exceptional scale. Our future is about high-margin, high-quality production, not simply volume,” said BP’s Svanberg in the annual report.  Indeed, technical ability and high margins are likely to remain crucial, as oil companies rely more on deep-water and unconventional reserves to replace oil stocks and meet the world’s ever-increasing energy needs.