The Final Frontier The Final Frontier E&P’s Low-Cost Operating Model Justin Pettit Copyright © 2017 by Justin Pettit All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation You should consult with a professional where appropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002 Wiley publishes in a variety of print and electronic formats and by print-on-demand Some material included with standard print versions of this book may not be included in e-books or in print-on-demand If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com For more information about Wiley products, visit www.wiley.com Library of Congress Cataloging-in-Publication Data is available: ISBN 9781119376545 (Hardcover) ISBN 9781119376576 (ePDF) ISBN 9781119376569 (ePub) Cover Design: Wiley Cover Image: © ImagineGolf/Getty Images Printed in the United States of America 10 To Krista, Trevor, Maddie, and Teddy, for their laughter, love, and patience Contents Acknowledgments ix Abstract x Chapter Introduction A Vital Industry What Now? Industry Evolution Ten Reasons to Update Your Operating Model E&P Needs a New Agenda 19 Notes 20 Chapter The New Agenda 23 Upstream Cost Transformation 24 “Cut Costs and Grow Stronger” 30 E&P Capabilities 34 Resource-Based Key Capabilities 45 Notes 49 Chapter E&P Operating Model Redesign 51 Internal Operating Model 55 Business Delineation and Performance Measurement 56 Organization Structure, Capabilities, and Workflows 66 Operations Management Processes 74 Delegation of Decision Rights 75 Informal Social Norms and Corporate Culture 77 Implications of Industry Evolution 80 Business Model Considerations 83 Notes 85 Chapter PMI and Other Event-Driven Redesigns 87 The Search for a Perfect Ownership Model 89 Preparing to Go Public 91 Key Success Factors 92 Event-Driven Redesign 94 Note 95 vii viii CONTENTS Chapter National Oil Company Considerations 97 National Oil Company Context 98 Sovereign and National Oil Company Strategies 103 Business Model Implications 109 Notes 114 Chapter Collaborative Operating Models 117 Who Uses Joint Ventures? 118 Joint Venture Strategic Intent 122 Joint Venture Value and Valuation 124 Deal Structure 127 Joint Ventures in Practice—The “How” 132 Notes 141 Chapter Financial Implications 143 Financial Strategy and Policy 145 Hedging and Trading 155 Notes 168 Glossary of Terms 171 Other Useful Links 171 Works Cited 172 About the Author 178 Index 179 Acknowledgments I wish to thank the many people with whom I have had the pleasure of working over the past many years, for kindly providing the impetus, expertise, and resources to produce this book, especially my former partners and colleagues from Booz, UBS, and Stern Stewart & Co I would also like to thank my previous editors, including David Champion, Don Chew, Art Klein, and Krista Pettit, for teaching me not to write like a scientist However, the views expressed herein are solely my own Moreover, any errors or omissions are strictly my own I also wish to thank my IHS colleagues, including Ulviyya Abdullayeva, Ruslan Anisimov, Kurt Barrow, Stephen Beck, Ryan Carbrey, Andrew Day, Erik Darner, Jean Dugan, Blake Eskew, Steve Fekete, Philippe Frangules, Bob Fryklund, Etienne Gabel, Mark Griffith, Tim Hemsted, Mark Jelinek, Ed Kelly, Jerry Kepes, Chris Kiser, Roger Kranenburg, Mike Kratochwill, Nick Lowes, Fernanda Machado, Michael Marinovic, Paul Markwell, Michael Muirhead, Gil Nebeker, Charlie O’Brien, Alastair Reid, Darryl Rogers, Jamey Rosenfield, Senjit Sarkar, Ed Scardaville, Grigorij Serscikov, Nick Sharma, Curtis Smith, Leta Smith, James Stevenson, Dale Struksnes, Jim Thomas, Rodrigo Vaz, Dan Yergin, and Tim Zoba Finally, I wish to thank the many clients who have challenged and entrusted me with their needs and encourage them to please continue to so! ix Abstract This book guides the reader through the redesign elements for the internal operating model of an enterprise in the oil and gas sector—including integrated oil companies (IOCs), majors and independents, national oil companies (NOCs), and services companies in the upstream supply chain For simplicity, this book references these companies as Exploration and Production (E&P) companies A culmination of disruptive forces and evolutionary change in the oil and gas industry has conspired together to make the case for a new low-cost operating model The industry has experienced tremendous evolution in terms of: our understanding of the underlying global resource base, the nature of its ownership and principal stakeholders, technologies and methods for resource development, and economics and business models While companies have been very focused on cost and productivity, beyond incremental accommodations to change, there has been little effort to redesign and transform internal enterprise operating models Moreover, unlike other industries that have undertaken operating model transformations in response to disruptive industry forces, upstream companies rarely undertake operating model change on a systematic or enterprisewide basis, except post-merger integrations The industry has made great strides, but now must sort through: ◾ What different to ◾ How to it differently Operating models and operational excellence must now be on everyone’s agenda—changes can yield profound cost savings and operating efficiencies However, change is much easier to plan than to implement, and operating model redesign is rarely executed on an organizationwide basis x C H A P T E R Introduction The Final Frontier: E&P's Low-Cost Operating Model, Justin Pettit © 2017 by Justin Pettit All rights reserved Published by John Wiley & Sons, Inc A culmination of disruptive forces and evolutionary change in the oil and gas industry have conspired together to make the case for a new, low-cost operating model The industry has experienced tremendous evolution in terms of our understanding of the underlying global resource base, the nature of its ownership and principal stakeholders, technologies and methods for resource development, and the economics and business models The industry was focused on cost and productivity even before the 2014 collapse in oil prices, but beyond incremental accommodations in response to change there has been little effort to redesign and transform internal enterprise operating models Unlike other industries that have undertaken operating model transformations in response to disruptive industry forces, upstream companies rarely undertake operating model change on a systematic or enterprisewide basis A VITAL INDUSTRY Notwithstanding tremendous advances in renewable energy, hybrids, and electric vehicles (EVs), and agreement among our world leaders to make great strides on behalf of climate change, oil and gas companies are, and will continue to be, an important contributor to the world’s energy needs and to the world’s economy Most forecasts, even under aggressive growth trajectories for renewables, still call upon the upstream for one-half or more of our energy in 20 years.1 In the United States, natural gas and petroleum have played an important role in our energy mix for more than 100 years.2 With the benefit of more than $1.5 trillion over the past 10 years, accounting for about one-third of all new power generation capacity, renewables now represent a small but important source of energy (see Figure 1.1) Wind and solar provide percent of all electricity consumed in the United States (nuclear power accounts for 63 percent of all FINANCIAL IMPLICATIONS 167 Performance Measurement in Trading Risk-adjusted scorecards and analytical engines play a key role in the successful implementation of risk management strategies Performance measurement in trading is evolving to meet strategic needs, but most trading operations have built systems to monitor performance by counterparty, by segment, by security, and by professional Performance measures must relate returns to their economic risks—such as risk-adjusted return on capital (RAROC) and economic profit (EP) These measures require appropriate resolution of numerous complex performance measurement issues Risk Capital Allocation Economic capital (risk capital) is the amount of equity capital necessary to cushion against unexpected losses (i.e., expected losses are expensed) from market risk, operating risk, and credit risk (i.e., VaR, typically at 95 percent or 99 percent confidence on a one-day basis) However, risk capital may not be additive due to risk-diversifying effects within a portfolio, making any “reconciliation” of top-down and bottom-up capital-based measures very difficult Market-Based Transfer Prices Market-based or arm’s-length transfer prices are needed for fees, commissions, markup, spread retention, and positioning profits, net of funding costs and expected losses Challenges include the triangulation of these prices in vertically integrated or less liquid markets Cost Accounting Indirect expenses may be allocated on an activity-basis, at an account-level detail or using portfolio characteristics, on the basis of routine transaction counts, special handling counts, credit ratings, and inquiry counts, for example 168 THE FINAL FRONTIER House Performance To measure house performance we must isolate the impact of customer facilitation (including captive customer demand) from discretionary positioning Internal trading performance excludes positions taken to facilitate internal or external customer trades (customer order flow execution value, net of customer facilitation costs) The best time to launch a risk management initiative is, of course, in advance of any blow-up At a minimum, companies that have experienced hedging losses, sharp rises in procurement costs, or eroding margins due to currency and commodity volatility should develop a comprehensive inventory of net exposures, evaluate which risks they are strategically advantaged to own or not own, and assess the company’s capacity for risk This process can piggyback onto other initiatives, such as sourcing waves, hedging policy development or rewrites, and enterprise risk management initiatives, to avoid initiative overload and harness natural synergies between efforts NOTES Excludes direct employment from petrochemical facilities Professor Mark J Perry, University of Michigan and The American Enterprise Institute, “Economic Impacts of the Oil and Natural Gas Industry on the U.S Economy in 2011,” PwC (July 2013); (January 8, 2013) See, for example, the case study of Gulf Canada’s oil-linked financing during the Kuwait war, J Pettit and R White, “Citibank Canada Ltd.—Monetization of Future Oil Production” (Richard Ivey School of Business case publication 9-95-B032, 1992) Please refer to Chapter of Justin Pettit, Strategic Corporate Finance: Applications in Valuation & Capital Structure (Hoboken, NJ: John Wiley & Sons, 2007) Ibid., for ladders, gaps, and towers, fixed-floating, swaps, liquidity, and distributions As discussed by Marian Moszoro and Pawel Gasiorowski, “Optimal Capital Structure of Public–Private Partnerships” (December 2007) IMF Working Papers, pp 1–13 Available at SSRN: http://ssrn.com/abstract=1087179 For a good survey of the literature, see R M Stulz, “Rethinking Risk Management,” Journal of Applied Corporate Finance, (1996), pp 8–25, as well as “Risk Management Failures: What Are They and When Do They Happen?” Journal of Applied Corporate Finance, 20 (2008), pp 39–48 See, for example, Antonio S Mello and John E Parsons, “Strategic Hedging,” Journal of Applied Corporate Finance, 12(3) (Fall 1999) The concept of deciding strategically FINANCIAL IMPLICATIONS 169 what exposures to retain is introduced by Kevin Buehler, Andrew Freeman, and Ron Hulme, “Owning the Right Risks,” Harvard Business Review (September 2008) This problem seems to have only gotten worse with the evolution of disclosure requirements, but is evident as far back as Gordon M Bodnar, Greg Hayt, and Richard C Marston, “Survey of Derivatives Usage by US Non-Financial Firms,” Wharton School of Business Paper, 1998 Also published as “Wharton 1998 Survey of Risk Management by US Non-Financial Firms,” Financial Management, 27(4) (Winter 1998) 10 Both quantitative and qualitative methods for evaluating corporate financial strength as a proxy for risk capacity are outlined by Justin Pettit, “The New World of Credit Ratings” (September 1, 2004) Available at SSRN: http://ssrn.com/ abstract=593522 See also Chapter 6, “An Executive’s Guide to Credit Ratings,” in Justin Pettit, Strategic Corporate Finance: Applications in Valuation & Capital Structure (Hoboken, NJ: John Wiley & Sons, 2007) 11 Providing further empirical support, AngloGold, the world’s third largest gold producer (behind Barrick and Newmont), disclosed problems in the autumn of 2010 The company issued $1.4 billion, or roughly percent new capital, in the form of 15.7 million ordinary shares, plus a three-year percent subordinated mandatory convertible bond to cover underwater hedges of about $2.4 billion AngloGold’s hedge book locked the miner into forward gold sales, as far out as up to five years, at an average of roughly $450 per troy ounce at a time when spot was nearly $1,275 per ounce and investors were pulling out of the US dollar and into commodities Gold went on to trade as high as $1,800 per ounce, but this does not mean that gold producers should not hedge, rather that symmetrical hedges are ill-suited to long-dated hedges and/or underlying assets with greater volatility 12 For a more complete discussion of hedge design, see Chapter 11 in Justin Pettit, Strategic Corporate Finance: Applications in Valuation & Capital Structure (Hoboken, NJ: Wiley, 2007) 13 See, for example, A Braas and C N Bralver, “An Analysis of Trading Profits: How Most Trading Rooms Really Make Money,” Journal of Applied Corporate Finance, (1990), pp 85–90, and T R Adam and C S Fernando, “Can Companies Use Hedging Programs to Profit from the Market? Evidence from Gold Producers,” Journal of Applied Corporate Finance, 20 (2008), pp 86–97 Glossary of Terms Please reference Schlumberger’s online glossary: http://www.glossary.oilfield.slb.com/ OTHER USEFUL LINKS American Association of Petroleum Geologists http://www.aapg.org/ BOE Report http://boereport.com BP Energy Economics Data and Tools http://www.bp.com/en/global/corporate/energy-economics.html Energy Now http://energynow.ca/ Federal Reserve Bank of St Louis https://www.stlouisfed.org/ IHS Markit Energy Blog http://blog.ihs.com/ihs-energy International Energy Agency https://www.iea.org/ Oil & Gas Journal http://www.ogj.com/index.html Oil & Gas Financial Journal http://www.ogfj.com/index.html Society of Petroleum Engineers http://www.spe.org/ Social Sciences Research Network http://www.ssrn.com/ US Energy Information Administration http://www.eia.gov/ 171 The Final Frontier: E&P's Low-Cost Operating Model, Justin Pettit © 2017 by Justin Pettit All rights reserved Published by John Wiley & Sons, Inc Works Cited Adolph, Gerald, and Justin Pettit Merge Ahead: Mastering the Five Enduring Trends of Artful M&A (New York: McGraw Hill 2009) Al-Fattah, Saud M “The Role of National and International Oil Companies in the Petroleum Industry.” USAEE Working Paper No 13-137, January 27, 2013 Available at SSRN: http://ssrn.com/abstract=2299878 or https:// dx.doi.org/10.2139/ssrn.2299878 Al-Fattah, Saud M “National Oil Companies: Business Models, Challenges, and Emerging Trends.” USAEE Working Paper No 13-138, January 27, 2013 Available at SSRN: http://ssrn.com/abstract=2299879 or https:// dx.doi.org/10.2139/ssrn.2299879 Baldwin, Richard E “Global Supply Chains: Why They Emerged, Why They Matter, and Where They Are Going.” CEPR Discussion Paper No DP9103, August 2012 Available at SSRN: http://ssrn.com/abstract=2153484 Banerji, Shumeet, Paul Leinwand, and Cesare Mainardi Cut Costs + Grow Stronger: A Strategic Approach to What to Cut and What to Keep (Boston: Harvard University Press, 2006) Behn, Daniel “Sharing Iraq’s Oil: Analyzing Production-Sharing Contracts Under the Final Draft Petroleum Law” (September 17, 2007) Available at SSRN: http://ssrn.com/abstract=976407 or http://dx.doi.org/10.2139 /ssrn.976407 Belleflamme, Paul, and Francis Bloch “Optimal Ownership Structures in Asymmetric Joint Ventures.” Queen Mary & Westfield College Economics Working Paper No 411, April 2000 Available at SSRN: http://ssrn.com /abstract=235306 or https://dx.doi.org/10.2139/ssrn.235306 Bennett, Simon C., John B Gregory, and John S Leggate “Productivity and Profitability from Mature North Sea Fields.” Paper presented at the Society of Petroleum Engineers conference, May 1995, The Hague, Netherlands Bhaumik, Sumon K “Determinants of MNCs’ Mode of Entry into Emerging Markets: Some Evidence from India.” Available at SSRN: http://ssrn.com /abstract=533722 or http://dx.doi.org/10.2139/ssrn.533722 172 The Final Frontier: E&P's Low-Cost Operating Model, Justin Pettit © 2017 by Justin Pettit All rights reserved Published by John Wiley & Sons, Inc WORKS CITED 173 Bodnar, Gordon M., Greg Hayt, and Richard C Marston “Survey of Derivatives Usage by US Non-Financial Firms." 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advisor to the oil & gas industry with 25 years of experience as an oil company corporate development executive, bulge-bracket investment banker, and management consultant Mr Pettit entered the industry in 1992 as a senior business planner with Norcen Energy Resources and went on to a successful career on Wall Street His previous roles include Partner at boutique restructuring and enterprise improvement firm Stern Stewart & Company, Global Head of Strategic Advisory for UBS Investment Bank, and Lead Partner for M&A advisory in the energy and chemicals practice of Booz & Company (and Booz Allen Hamilton) He is the author of two books on capital strategies as well as numerous papers Mr Pettit holds a BASc (Mechanical Engineering) from University of Toronto and an MBA from Western University, with continuing education in Petroleum Geology (TU Delft) and Reservoir Geomechanics (Stanford) He is an active member of the New England Chapter of Society of Petroleum Engineers (SPE) 178 The Final Frontier: E&P's Low-Cost Operating Model, Justin Pettit © 2017 by Justin Pettit All rights reserved Published by John Wiley & Sons, Inc Index A ABC Company 133 Allocations 59 Arbitrage 164 Cost transformation 24 Costing 59 Costs 15 Costs for capacity 61 Cut costs and grow stronger B Big data 71 Bone Spring 28 Book loss 62 British Petroleum (BP) 54 Build, borrow or buy 127 Business delineation 56 Business model 83 Business Unit (BU) versus Headquarters (HQ) 67 C Capabilities-driven strategy 31 Capability area 41 Capital efficiency 15 Capital planning 44 Capital structure 152 Carbonate 43 Cardium 43 Catch-up clauses 136 Collaborative vehicles 118 Completion practice 42 Contract rights 135 Conventional plays 43 Corporate culture 77–78 19, 30 D Deal structure 127 Debt 131 Decision rights 75 Delaware basin 28 Delegation of authorities 75 Demand rights 136 Developers 106 Development drilling 47 Digital Field 65 Discovery Challenges 12 Disruptive forces Dollarize 58 Drag-along rights 136 Drilled but uncompleted (DUC) 26 Drilling and completion (D&C) 48 E Exploration and Production (E&P) capabilities 34 179 The Final Frontier: E&P's Low-Cost Operating Model, Justin Pettit © 2017 by Justin Pettit All rights reserved Published by John Wiley & Sons, Inc 180 INDEX Economic Profit (EP) or Economic Value Added Geotechnical workflows 71 Geosciences 36 (EVA) 65 Energy Information Administration (EIA) Engineering 35 Enron 78 Enterprise operating model Environment 18 Equity 149 Evolving global resource base Exit and termination 137 Exporters 108 F Fading production 13 Field life 41 Field life cycle management 40–41 Field life extension 41 Financial strategy 145 Financing 146 H Hedge horizon 161 Hedge ratio 161 Hedging 155 High-grading 26 Horizontal wells 42 Hybrid structures 149 Hydraulic fracturing 42 I Imperial Chief Executive Officer (CEO) 79 Importers 103, 111 Industry evolution Initial public offering (IPO) 88, 91–92 Internal operating model Intrinsic value 24 International Oil Company (IOC) Iran 43 Financing alternatives 147 Financing strategy framework 146 Fiscal 17 Functional statements 66 J Joint and common costs 60 Joint venture (JV) 110, 118 JV costs and challenges 125 Funding 145 G GAAP treatments 62 Geophysical methods 36 Geophysics 36 Geoscience capabilities 36–37 K Key capabilities 31, 34 Key Performance Indicators (KPIs) 63 Kurdistan 43 Kuwait digital oil field 65 INDEX L Layering 163 Low permeability conventional oil 42 181 P Percentages 64 Performance measurement 56–65 Permeability 42 M Management processes 74 Management-by-email 80 Market-making 165 Mature conventional plays 42, 43 Methane Hydrate 105 Microseismic 37 Midland basin 29 N National Oil Company (NOC) 88, 89, 98 Network optimization 164 Non-Operated Venture (NOV) 131 North Sea 41, 47 O Offshore 32, 44 Oil & gas prices 19 Oil sands 49 Onshore conventional 46 Operated By Others (OBO) 131 Operating model Operating model elements 55 Operating model redesign 20, 55 Operational excellence 20 Organization structure 66 Organizational capabilities 34, 35 Organizational design 66 Ownership structure 153 Permian basin 29 Piggyback rights 136 Porosity 42 Portfolio 32 Portfolio management 32, 33, 44 Portfolio tool 75 Post-merger integrations (PMI) 88 Prices 19 Production growth 58 Profit centers 56, 57 Proprietary trading 163 Public-Private Partnership (PPP) 131 R RACI 75 Real options 135 Regulatory 17, 36 Relevant scale 68, 69 Reserve replacement 58 Reserve growth 41 Ripple effect of unconventionals 11 Risk capacity 160 Risk capital 160 Risk strategy 158 Risk-Adjusted Return On Capital (RAROC) 166 182 INDEX S Sale or dissolution 138 Sandoz 68 Seismic 36 Services 16 Shale gas 8, 11, 48 Social license 18, 35 Social norms 55, 77 The “how” The “what” Tight oil 8, 11, 42, 48 Trading 155–159, 163–168 Transfer of interests 137 Transfer pricing 58 Two-dimensional (2D) seismic 36 Spraberry 28 Standardization versus U Unconventionals 11, 42, 48 optimization 72 Strategic agenda 19, 24 V Strategic intent 122, 124 Strategic risk management 157 Strategy-led cost transformation 29–30 Supply chain 16, 44, 68, 69 T Tag-along rights 136 Take-away capacity 49 Talent 73 Tax treatments 63 Technical capabilities 36 Technology 16, 39–40 Technology development Valuation 25, 56, 125 Vertical wells 42 Virtual scale 68, 124 Vital industry Volumetric measures 58 W Wall Street 78 Well architecture 42 Wolfcamp 27, 28 Workflows 66, 69–72 Z Zagros Field 43 ... (i.e., the “how”) sets the enterprise operating model, and relates to the internal architecture of the company, its operation, and its governance Defining the operating model choices regarding the. .. objectives for the business Opportunities and needs of the underlying resource portfolio Organizational capabilities of the enterprise internal operating model and talent pool THE FINAL FRONTIER The second... than to implement, and operating model redesign is rarely executed on an organizationwide basis x C H A P T E R Introduction The Final Frontier: E&P's Low-Cost Operating Model, Justin Pettit ©