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IHS Markit: Oil and gas companies are becoming hyper specialists

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A continuing trend toward greater specialisation 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 says this corporate strategy is putting many companies at significant risk to market volatility, fragility, and vulnerability to unforeseen events.

“Specialisation 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 toward specialisation. 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 specialisation,” 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 specialise 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 US 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 US held portfolios characterised 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 US onshore. Now, even global companies including Chevron, ExxonMobil and BP, are redirecting significant capital to the US 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.”

Specialisation 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 US, 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 specialisation 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 specialisation 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 specialisation.

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 specialisation do deliver financial results and we expect the specialisation 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 US 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 specialise 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, specialisation 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 optimisation 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 specialisation 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.”

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