Market volatility dictates a different approach for gas vs. oil. Herve Wilczynski and Al Escher

Transcription

1 The North American gas market is structurally more volatile than the global oil market. While some companies have played the cycles brilliantly, the industry as a whole has much room for improvement. Traditional oil thinking is often the root of the problem. In contrast, leading companies have adopted practices around their capital deployment, internal capabilities and talent management that enable them to achieve better returns than their peers. This paper outlines the various approaches and benefits used by industry leaders to manage the highly volatile North American gas market. Herve Wilczynski and Al Escher Figure 1. Historical spot market volatility for selected commodities Average Annual Volatility, % Natural gas behaves more like agricultural commodities Natural Gas Cotton Pork Bellies Source: EIA, Derivatives and Commodity Futures Trading Commission, SBC Analysis Light Sweet Crude Market volatility dictates a different approach for gas vs. oil The oil and gas exploration and production industry (E&P) is certainly used to cycles, even extreme cycles, in activity. The industry also has become used to oil and gas price variations being somewhat out of phase as oil has become a global commodity and gas remains a regional commodity, and there is relatively little switchable demand. However, looking more closely at the difference between global oil and North American gas, the issue is not simply that the cycles do not always coincide. North American gas follows a fundamentally different kind of dynamic, behaving more like an agricultural commodity than like oil. Certainly the results of the recent gas cycle bear witness to a need to re-think how companies manage their North American gas E&P businesses. We need a bit less oil thinking. The big difference in the cycle for oil vs. North American gas is that gas is much more volatile. Of course, the value of oil used in North America is still much higher than the value of gas, so the oil cycle attracts more attention from the media and even Congress. There were Congressional hearings when gasoline went over $ per gallon in 008, but no similar hearings when natural gas went above $1 per MMBtu. But from a producer s perspective, gas prices are twice as volatile as oil prices, putting gas on a par with commodities like cotton and pork bellies (Figure 1). In comparison, the oil business looks staid and predictable! 1

2 Figure. North American Gas Pricing Mechanics The higher volatility of North American gas markets compared to global oil markets is a long term phenomenon, and seems to be structural. Low cost of entry: Companies can enter, or increase their exposure to the North American gas market for a few million, or a few tens of millions of dollars. In contrast, the cost to enter or ramp up in the global oil market, with its larger, mostly offshore or Arctic investments, is easily in the billions of dollars. So, gas is 100 times easier to enter compared to oil. This attracts more players to North American gas 100 s or 1000 s compared to more like 10 s of major companies in the global oil markets. And it means that the gas market has many players who can respond quickly, for example if prices are above long term averages. Time to add capacity: Capacity to produce North American gas, especially onshore and on the Gulf of Mexico shelf, can move from concept to production in under a year. In contrast, oil-related mega-projects take a decade or more to go through the same process. As a result, the gas market can respond much more quickly when prices are above long term averages. Turndown potential: As we have seen during Q 008 and YTD 009, the North American gas industry can shut down roughly /3 of expansion capacity in a matter of months. In contrast, longer term oil projects will tend to remain funded through price cycles, unless the cycle extends through many years. This means that the gas industry $ per MMBtu can turn down capacity much faster. Further, the higher average decline rates of North American gas wells vs. global oil fields means that production rates will fall even more sharply as drilling activity declines. Industry governance: OPEC has a long term interest in the stability of global oil markets, and has shown the willingness and the ability to add incremental production when prices are high, and the discipline to withdraw production when prices are depressed. There is no corresponding group governing North American gas production. Long run price needed to add capacity Development Costs Short run price needed to keep producing (Lifting Costs) Access to Resources: Much like the agricultural industry can increase planted acreage when prices of, for example corn, are high, the North American gas industry is relatively open in terms of access. Granted there are environmental and other restrictions, but they do not impede the market enough to effectively restrict supply. In contrast, access to oil resources is heavily regulated and restricted by governments. So, companies H1 008 price was unsustainable Note: Henry Hub used for historical spot price. Source: EIA, SBC analysis. can respond to changes in North American gas prices in a way that is much more muted with oil. Technology: Tremendous innovations have affected recovery for both oil and gas. Most innovations affecting oil, like deepwater and subsea systems, and improved reservoir management and pressure maintenance techniques, tend to impact feasibility and long term recovery rates. In contrast, most technological innovations affecting gas tend to impact initial production rates, especially completion and stimulation techniques. This difference creates a stronger link between technical innovation and near-term market prices for gas. H1009 price also unsustainable Other external factors such as alternative sources of gas supplies or changes in taxation can add to price volatility For example, the flow of LNG and associated gas can disrupt the supply and demand balance in North America depending on macro trends

3 such as gas consumption in Europe and Asia, These structural factors increase the volatility especially since LNG shipments to North America of the North American gas market. Gas players will be a last stop for unwanted gas that can take quick action when North American gas be priced at variable cost. Another example of prices are away from equilibrium, driving the possible disruption is the current push from the market back and frequently through an Obama administration to raise fees and taxes for equilibrium point (Figure ). gas producers. The ability of the US government The supply response, especially on the downside, can be dramatic. Figure 3 below shows to artificially dampen oil market investment is much less, as most domestic drilling activity is for that the rig count closely mirrors the gas prices with a short time lag of 3 months, just like gas rather than oil. during Figure 3. Conservative drops in price and activity in North American gas. Price Index, Peak = % 0% Month from Peak 10% 0% % -0% Rig Drop % -0% Rig Drop % -60% Price Drop % Price Drop % Note: 001 gas price peak in April, 008 gas price peak in June Source: EIA, SBC analysis Figure. Typical gas strip price projections $ per MMBtu 5 3 While some companies have played the North American gas cycle brilliantly, overall the industry has plenty of room for improvement. The current overhang of inactive leases in danger of relinquishment and the inventory of drilled but uncompleted wells are evidence of overshooting the peak when prices were high. Even concerns about HSE are linked to the cycle 1. And the long term lack of technical professionals is evidence that market volatility is encouraging individual behavior that is detrimental to the industry, but for which the industry seems to have few answers. Finally, the financial distress of many companies is clear evidence that the industry has not sufficiently factored in the extreme cyclicality of the North American gas markets. Clearly, the industry overall is struggling to deal effectively with this volatility. At least some of these issues seem to be rooted in oil thinking. At one level, this should not surprise us since the ratio in value of oil to gas produced globally is 8-10 (we still call it the oil industry for a reason). So, many processes have been oriented around oil. For example, companies generally maintain a price strip for gas that looks much like an oil price strip (Figure ). This kind of gradual reversion to long term equilibrium is at odds with how the North American gas market has worked in practice. Even the curriculum of petroleum engineering programs, the background of many industry Source: Company interviews; SBC Analysis 3

4 executives, is tilted toward oil. So, how might companies start to re-think their approach to the gas business in light of a product that behaves more like an agricultural commodity? Planning: Oil focused companies can afford to plan in over a time horizon of a year or even many years. In contrast, gas companies need a more dynamic way of allocating capital as rapidly changing economic cycles might dictate different moves (e.g. focus on reserve addition, increase production, fast track development). Often, capital allocation should be revisited several times each year. Capital discipline Alarms: Companies should agree on and monitor an equilibrium range for gas prices, and move away from the herd when prices are outside the envelope. This means slowing activity when prices are above equilibrium and ramping up (land acquisition, for example) when prices are below it. The reasoning behind this is more farm-thinking than oil-thinking. The amount of acreage under gas will expand and contract rapidly, and supply with it. Once management convinces itself of this, high-price periods become times to build cash and low-price periods a time to invest some of this cash for the next cycle. The equilibrium range itself will vary with tax rates and regulation, and with changes in technology. Resilience Lever down the Balance Sheet: Many companies borrowed aggressively over the past few years to build their gas production base. But with volatility more like agricultural commodities, it may make sense for companies to consider levering down their balance sheets. Hedging: Hedging (just as partnering or other risk management tools) is of course a familiar tactic, but is used inconsistently across the industry as hedging levels vary from zero to 100%. Again looking to agricultural producers for a benchmark, about 50% of most commodities are hedged annually. If North American gas companies believed in the farm model they would hedge a healthy portion of production both in good times and bad. Cost efficient and scalable processes: Cost efficiency and business scalability are at the heart of the lean manufacturing management philosophy. This time tested approach has been adopted successfully by a number of industries and has led to more economically resilient organizations 3. It is now successfully adopted by E&P leaders as way to manage the volatility of the NA gas market. The hallmark of the lean application to gas is the adoption of factory-like models where well sites are permitted, constructed, drilled, completed and tied in following a continuous and balanced flow of activities, thus allowing for effective labor and equipment utilization (up to 0% reduction in unit cost) and a significant faster time to production (up to 50% faster). Similarly, adoption of lean practices in conjunction with subsurface optimization can lead to 5 to 10% in production uptakes for producing assets. Simplified technical design: Gas wells typically do not require extensive customization. In fact, experience shows that in some cases 80% of the well design can be standard for a given play. As described in the Schlumberger Business Consulting publication Unconventional gas asset challenge conventional filed development, a wellstructured Continuous Design Improvement process, can focus on the 0% customization that matters to increase the profitability of a play. This can lead to significant reduction in cost (fewer engineering hours, reduced inventory, scale purchases) as well as opportunities to re-use equipment for new wells. De-risk commitments: Lease structure and supply chain are two examples of long term commitments that can be de-risked using novel approaches. For example, building mineral leases that take greater account of volatility would of course require market acceptance. However, the current downturn might be a good time to try terms that, for example, shorten leases during high price times and lengthen them during low price periods. The same is true for supply chain where contract terms can help achieve a more equitable risk sharing system between suppliers and producers, providing stability to both parties during up and down cycles. Accelerating people development: Operating in a volatile environment has far reaching implications for a company s human resources as the profile required

5 puts a premium on adaptability. Getting this right now is key, as the industry is pursuing an aggressive recruiting effort to compensate for talent loss due to the aging population. Traditionally, oil and gas companies spend up to 10 years developing autonomous technical professionals. In a volatile industry where technology innovation unlocks new types of reserves quite rapidly (conventional, CBM, tight gas, shale), being able to build competency fast is necessary. In fact, some leading practices are now capable to develop technical professional capable of making reliable original, non standard decision on their own within 3 to years. Implications While many companies employ some aspect of these tools, applying them systematically for a structurally volatile, ag-like market is less common. Figure 5. Gas versus oil thinking. Levers Capital deployment Internal capabilities Human resource management Gas thinking best practices Frequent planning to adjust to shifting market condition Capital discipline to avoid speculative or overly risky investments Resilient capital structure to make it through cycles Cost efficient and scalable processes to adjust to cycles Simplified technical design to reduce engineering and supply chain complexity De-risked external commitments Information technology focused on rapid operational decision and intervention Deployed against large capital investment Functionally aligned competency model Accelerated on-boarding of new talent to provide autonomy faster Traditional oil thinking Structured around long term bets Concentrated around fewer big projects or assets Traditionally cash rich companies are able to weather short term cycles Rigid processes focused on managing risks associated with large bets Custom technical design to deal with increasing asset complexity Information technology traditionally aimed at automating tasks and managing business data (financials, HR) Flexible competency model for easy redeployment of resources Accelerated on-boarding of new talent to provide autonomy faster The difference between industry leaders and others resides in the fact the former make deliberate, long term, choices around the strategy to deploy capital and the type of internal capabilities they need. Clearly there is not one answer, as various companies elect to follow different paths based on their portfolio, capital structure, and reputation with the financial market. However, looking at a representative sample of companies with a strong focus on North American gas, over the past 10 years top quartile companies typically achieve returns 5 to 10% higher than their peers. These industry leaders share a common characteristic around low cost and scalable capabilities (process and people), allowing them to preserve cash in down cycle and harvest the benefits during boom times. Some have specialized in the application of technology while others have excelled at setting alarms so they tend to buy low and sell high. A common thread is a truly customized gas approach to the business a clear divorce from oil thinking. (Figure 5). The differences between the oil and North American gas markets also have implications for major companies. Companies with a large diversified portfolio need to have different business models for oil and for North American gas. Capital budgeting, internal processes, M&A approach, and treasury, all need to be adjusted according to a different risk profile and market dynamics. They will need this to compete with the more nimble style of independent companies as all players improve their skills in this volatile market. 5

6 Summary Natural gas is a core fuel for the North American economy. This is likely to continue as concerns about carbon emissions and a desire for increased reliance on indigenous sources of energy are playing a larger role in the public debate. In this context, US gas producers have a great long-term opportunity, but the rules of the game can be tricky. Too many factors are in play to accurately forecast North American gas prices. In fact, volatility is likely to be the norm, with alternating periods of prices above and below long-term sustainable levels. Structurally building flexibility in the business model is the safest way to succeed in such an environment. Contacts: Al Escher Director, North and South America AEscher@slb.com Herve Wilczynski Vice President, North and South America HWilczynski@slb.com Schlumberger is the leading oilfield services provider, trusted to deliver superior results and improved exploration and production performance for oil and gas companies around the world. Through our wellsite operations and in our research and engineering facilities, we are working to develop products, services and solutions that optimize customer performance in a safe and environmentally sound manner. Knowledge, technical innovation and teamwork are at the center of who we are. Schlumberger employs more than 76,000 people of over 10 nationalities working in more than 80 countries. Schlumberger Business Consulting is the management consulting arm of Schlumberger. 1 nd Annual IPTC Conference summary, as reported in Journal of Petroleum Technology, February 008 Midwest Market Solutions, a leading agricultural hedging research and advisory firm, January 8, As reported in the March 9, 009 edition of the Wall Street Journal Schlumberger Business Consulting Annual HR survey, 008 6