Open up a in-flight magazine in the US and you could be forgiven for thinking the world has been saved by Unconventional oil and gas. From the New York Times, to the National Geographic, to Foreign Affairs, article after article illustrates the shale revolution. Peak Oil has fallen from the media into ridicule, and the discussion has moved from an impending energy disaster to the implications of US energy independence and its impact on geopolitics.
But this article is not about shale oil. The oil industry isn’t just the Bakken. Conventional oil still supplies over 80% of global daily liquids supply and there’s an interesting & important story hidden behind the shale rhetoric with implications for both oil majors and mid-sized independents. Conventional oil exploration clearly peaked some time ago, and Conventional production may be peaking today. Despite the Unconventional story, this matters.
The Exploration End Game
There’s no way around it, Conventional oil is getting harder to find. In volume terms Peak Discovery was in the 1960s, when geologists & engineers armed with slide-rules, a good idea, & strong coffee were finding multi-billion barrel fields without 3D seismic, MAZ, AVO, or FTG (although I’m sure they had their share of acronyms).
An Industry at the Tail End
Since then the exploration game has been getting ever harder, with more challenging fields, at ever greater depths, and often with smaller field sizes. All in all, for almost every year since 1985 the world has used significantly more oil than the industry has found through exploration… (This does beg the question as to where all the reserves growth has come from*, but that’s not really the point of this article…)
We’ve been using more oil than we’ve been finding since the mid 1980’s…The graph above shows Exploration discoveries minus annual production…
BP Proven Global Oil Reserves
Today, the industry remains in the declining rump of the exploration discovery hump… Fortunes are being spent, made, and lost in the tail of the first chart above. But in fact, the industry has performed a bit better than the thin post-2008 discovery prediction shown above suggests.
In the decade following 2003, when the oil price started to rise in response to an increasingly globalised economy and rapid asian economic growth, the oil industry drilled over 16,000 exploration and appraisal wells, investing a truly straggering 550 billion dollars across the globe**. Annual exploration investment reached $70 billion in 2008, with over 1,800 conventional wells drilled, before stalling through the recession. In 2012 resurgent spending reached $90 billion. It won’t be long before the industry has its first $100 billion exploration year.
Considerable investment in technology and exploration methods ensured that the industry kept the average discovery success rate broadly constant through this surge in activity, with about 40% of exploration wells resulting in a discovery. But what did we get for all this money and effort?
Well, the final result of this staggering investment was an average of 13 billion barrels of oil discovered each year (27 billion barrels of oil equivalent if you include gas). That’s slightly less than the industry found in the 1990s. Or, to put it more starkly, $550 billion and 16,000 wells couldn’t deliver half the oil volumes discovered every year throughout the 1960s.
All that extra investment couldn’t save Conventional exploration from its decline.
During 2012 the world produced ~27 billion barrels of in-the-ground oil (excluding NGL and refinery gain), whilst the exploration industry spent $90 billion and found around 7 billion barrels of oil. All in all, we produced around four times the amount of oil discovered through exploration.
The clear result of spending more and finding less is that oil exploration becomes more expensive on a per barrel basis. If you assume that all the gas found has no value then the aggregate finding cost would be just under $13 per barrel of oil. Of course, if you include the gas then this metric gets better, at ~$3.3 per barrel of oil equivalent. But remember, gas developments are very, very costly and gas value varies regionally… Either way, to compare, in 2003 Exxon’s finding cost was just 58 cents per barrel of oil equivalent. The oil industry is spending more & finding less.
Exploration Gets More Expensive
Conventional exploration has clearly peaked. New frontier basins are very hard to find, risky to explore in, and expensive when you do. The age of cheap conventional oil is genuinely in the past. But how might this affect the future strategies and successes of the majors and mid-sized independents? More thoughts on that below…
Peak Conventional Production?
Ok, so exploration has peaked, but production has gone from strength to strength, and reserves, and reserve-production ratios continue to grow, right?. What’s the issue?
For starters, outwith the Unconventional story, it is not clear that Conventional production has continued to grow. In fact, it has pretty much been bumping along a 73 million barrel daily production plateau since 2005, when headlines like “The End of Oil is Closer Than You Think” were in vogue. The world really has been saved by the North American Unconventionals (plus a bit of refinery gain).
This is clearly great news for the companies fully exposed to the Unconventional plays (at least whilst they can continue to grow production and aren’t affected by the terminal field decline stats), but that’s clearly only a subset of the industry. If Conventional oil is getting harder to find, and we’ve been bumping along a Conventional production plateau for the last decade, what are the implications for the rest of the industry?
Well, you can see from the chart below that most of the oil majors are producing less oil than they used to. Shell, Total, BP, and Exxon are all markedly down, whilst Chevron is just about treading water. This has pushed most companies to change their reporting metrics from volumes to value. They’re basically saying “hey, we might not be finding or producing so much, but given the price, look at the money we’re making!”.
It’s clear that the industry is finding and producing less conventional oil. Investment continues, but at some point, we don’t know when, the industry will enter a value destructive phase. At this point, no matter what the industry does, it will not be able to find enough barrels to justify the exploration expenditure. Shareholders will sigh as their money is thrown away on ever more value-destructive projects. Welcome to the end of exploration.
The End of Exploration?
Conventional exploration can only really end in an Unconventional world. As long as Unconventional production rises to offset any conventional production decline then the oil price will remain broadly static. And it is only in a static oil price scenario that conventional Exploration truly suffers. A falling price scenario would hurt Unconventional producers first. Alternatively, a rise in prices could lead to demand reducing recessions/depressions, or at the very least, conservation (Peak Consumption). So, having been “saved” by the Unconventional operators, who now act as swing producer, the rest of the industry has to navigate their impact on Conventional exploration strategy.
It is likely that the highest cost producers will experience value destruction first. These are most likely to be the majors, who might have the best technology but certainly have the most process and the highest drilling costs. The smartest companies will see the writing on the wall first, astutely realising that they are no longer adding sufficient value through exploration. There are a number of potential responses.
1) Cut costs. If your finding costs are going up, and you simply can’t find more volume, then you need to cut costs. Service inflation has sky-rocketed in recent years and many operating companies are now attempting to push back. Of course, in addition you can look critically at staff costs. Arguably this has started in the international oil sector, with retrenchment at BG and other large firms. Will it become a theme? Firms will need to be careful not to compromise safety, after all, the oil business is a genuinely dangerous one.
2) Cut ineffective programs. Hand in hand with the cutting of overhead costs it would seem prudent to identify the least productive exploration programs on a value basis, and cut these aggressively… (the NPV of arctic projects anyone, where single wildcat wells might cost $500 million?)
3) Admit what you can’t do. The first companies to feel the value pressure will be the high cost companies, the very companies that will also struggle to play in the Unconventional game. These need a new strategy in the new world, and may need to cut process and procedure to compete. BP explicitly recognised this in the restructuring of their onshore US Unconventionals business in 2014, where they formally separated the business into its own NewCo entity, with a unique structure, office, and process. This is a clear recognition that the industry needs to change to compete. Two questions: can this model be applied to other exploration assets, & is it a race to the bottom?
4) Buy rather than explore. If exploration costs are increasing, but with the figures relatively opaque and hidden behind the scenes, there may come a time when barrels are cheaper to buy than to explore for. A kind of arbitrage. The first companies to reach this conclusion will perhaps be able to pick up some reasonable barrels, but late followers will pay higher prices for poorer assets. It’s the beginning of a buyers market right now, is it a good time to buy rather than drill?
5) Phase Change. We’ve been mainly talking about oil. Of course there is a second phase: gas. Getting good at this, and controlling trading and marketing lines, along with possible LNG production and offtake might make good sense. But watch out for those development costs and Unconventional competition in the target market.
6) Mergers and Acquisitions. The natural turn-to response of a company in trouble. Bankers will push this option, and CEOs love the pay-off, but in this new world bigger may no longer be better. In fact, the opposite strategy may lead to a better outcome. The industry needs to be lean and effective. If you need to merge, it might be prudent to cherry pick the result and divest the trash. Mergers to improve rather than enlarge seem a better strategy.
7) De-mergers and radical shrinkage. In the end, this may be the only option. The most successful companies may be those who can keep the technical and financial capacity of the larger firms, but with the rapidity and process of smaller, leaner firms. A poor outcome will be simply selling the pieces off to the highest bidder (likely National Oil Companies with different strategic drivers). A better outcome might be possible – simplified leaner companies, retaining the key skills that make them effective. Or perhaps the majors will effectively become venture capital allocators for smaller diverse outfits?
It’s not clear what the answer is. But at some point the Conventional exploration industry (i.e. most it) will enter an value destructive phase. Are we there today? Maybe not, but we’re closer than we were yesterday. The only unacceptable option is to do nothing. The most successful companies will be those that recognise that value destruction is soon at hand and act decisively upon it.
* the answer is dominantly from oil volumes entering the proven category from within existing fields…
**WoodMac
The View from the Mountain 