1Shale Is Transforming Oil and Gas Priorities

Shale Is Transforming Oil and Gas PrioritiesOil from U.S. shales has flooded the market, adding more than twice the growth in global demand in 2014. While producers keep pumping, hoping to ride out the storm, others are getting serious—reprioritizing to focus on value, margins, and faster returns.

1Shale Is Transforming Oil and Gas Priorities

A Changing LandscapeThe energy landscape is changing. In just four years, oil from U.S. shales surged to 4.5mmb/day. This drove the collapse of oil prices last year—flooding the market, adding more than twice the growth in global demand, even before OPEC opened its taps and added another 1.2 mmb/day. Shales have structurally altered both the balance and basis of supply.

Shale costs have fallen fast, and well productivity has risen by 30 percent since mid-2014. Financing and cost structures vary, but the more productive U.S. shales are now just over half way up the supply cost curve (with breakeven around the $45 to $60 a barrel range)—below most North Sea and deepwater projects (and well below the Arctic or oil sands)—and cash flow returns come sooner.

In just four years, oil from U.S. shales surged to 4.5mmb/day, flooding the market and driving the collapse of oil prices. Shales have structurally altered both the balance and basis of supply.Independent shale operators are able to respond to price signals much faster than those in the capital intensive offshore—in months rather than years. And after the steep price drop at the end of last year and then months of much lower rig activity, we are now seeing signs of U.S. shale output stalling. This ability to respond faster than most long lead-time production is likely to limit emerging price rises.

The world is also awash in gas, with a wave of new LNG coming from Australia over the next three years. Much more is available from shales in the United States and from some big new finds in new basins. A few years ago, the United States was expected to be a big importer. Gas demand for power in many places is being squeezed by cheap coal and subsidized, rapidly growing renewables. Once in place, operating costs of renewables are very low and therefore usually preferable to buying gas. Gas oversupply may last for years. Clearly, the industry has been too successful; we now have more oil and gas than we need.

Low Prices, but for How Long?The oil and gas industry is notoriously cyclical, driven by large long-term investments (see figure 1 on page 2). The OPEC embargoes and oil price shocks of the 1970s helped trigger soaring inflation, high unemployment, stock market crashes, and government changes in Western countries. The steep fall in 1986 was brought on by growth in non-OPEC oil in new basins (such as the North Sea) and six years of high prices that suppressed demand. Twelve years of lower prices followed, punctuated by a spike in 1990 during the Gulf War. Low prices during the deepwater growth years of the mid and late 1990s started a wave of mega mergers, led by BP in late 1998.

2Shale Is Transforming Oil and Gas Priorities

From 2004, rising oil prices were driven by accelerated Asian demand and supply constraints, where nationalism closed access and a perception that “easy oil” was over. This lasted until the 2008 financial crisis and the subsequent rebound to more than $100 a barrel (from 2011 to 2014) driven by soaring Asian demand.

Shale has now altered the balance of power on the supply side, as China has on the demand side. Rising prices will trigger more supply and keep prices capped, and even more so if the constrain- ing ban on U.S. exports is lifted. The current steep fall in prices is looking more like that of 1986.

Since the beginning of 2014, the industry has been producing more oil than we need, with the surplus as high as 2.5 mmb/d this spring (see figure 2 on page 3). The United States increased output by a record 1.7 mmb/d in 2014, and OPEC was producing 1.2 mmb/d more than a year ago. Demand in 2014 grew by 0.8 mmb/d, and oil stored by the OECD alone has reached record levels of about three billion barrels. Oil prices sank again in August amid signs of slowing Chinese demand, uncertain economic growth elsewhere, and the proposed deal with Iran.

Non-OPEC supply is expected to fall over the next few months. As producers adjust to the “lower for even longer” price outlook, producers are cutting high-cost supply from Canadian oil sands, the North Sea, Russia, and some shales, where output has proved resilient with higher productivity, fraclogs, and hedging. Marginal or inefficient fields—where operating costs lead to ongoing losses—are being shut in or are at risk of being abandoned early. Half a million barrels a day or more of non-OPEC supply could go.

But more oil is on the way from big non-shale projects, notably in Brazil, Canada, and the Gulf of Mexico. Currently constrained countries, such as Iran, Iraq, and Russia, are likely to add more oil to the market over the next year or two. More gas is coming too. Australia’s northwest shelf has a wave of new LNG projects coming on over the next three to four years to 2019, just as Asian demand is slowing.

Figure 1Oil prices tend to rise and fall in cycles

$ per barrelNominal Dubai Real Dubai

Note: Oil price is Saudi Arabia Light 34˚ API up to 1984 and Dubai Fateh 32˚ API from 1985 to October 2015, converted to real dollars using the August 2015 U.S. Consumer Price Index.

Sources: World Bank, Energy Information Administration; A.T. Kearney analysis

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3Shale Is Transforming Oil and Gas Priorities

Lower prices should stimulate demand, but the outlook is uncertain. Driven primarily by China, India, the United States and the Middle East, demand will have to rise quite fast to absorb all this new supply.

Supply is coming from new locations, and flows have shifted, particularly to meet the surge of demand in Asia. This means money is moving in new directions, with significant geopolitical implications as the needs of the United States, China, the Middle East, and Russia change. Uncertainties abound and risks of instability remain high, brought on by global conflicts— from the consequences of the Arab Spring and ISIS to Russian tensions and disputes in the South China Sea.

High-cost projects in some OPEC countries are also at risk as some countries are suffering and likely to put pressure on the next OPEC meeting in December.

At the same time, Saudi and some other OPEC producers face a dilemma. Their effective break-even is not driven by oilfield costs, which are very low, but by national budget commitments. Some producers already have huge budget deficits at current prices. Unless oil prices are $20 or more higher, subsidies will eventually have to be cut, which risks significant social unrest among their mainly young populations. But low prices need to last long enough, perhaps into 2017, to cut a good chunk of high-cost output permanently. Otherwise, last November’s move will end up having no lasting effect.

Oversupply is still more than one mmb/day and is hurting returns—while producers keep pumping, hoping to ride out the storm. So until some major disruption creates a spike, oil prices look set to stay low for a while. This will be good for consumers. For the industry, lower prices for a few years will focus minds and drive costs lower. Companies need to change how they operate and radically improve efficiency.

Forecast

Figure 2The industry has produced more oil than needed since early 2014

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Sources: International Energy Agency Oil Market Report, September 2015; A.T. Kearney analysis

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*OPEC production assumed at 31.7mb/d(most recent 3 month average) through forecast period

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4Shale Is Transforming Oil and Gas Priorities

Focus on Costs and Cash FlowCompanies have responded to sharply lower income as expected, cutting drilling and staff, postponing high cost projects, and hoarding cash flow to pay the dividends promised. E&P spending has fallen around 20 percent in 2015 and will fall further in 2016.

Maintenance and ops have been cut less than drilling and seismic. North American onshore drilling and oilfield services have been hardest hit. Mature offshore areas (such as the North Sea) with high costs and low productivity face accelerated decommissioning costs, while business is still booming in low-cost areas such as the Middle East.

Companies have a renewed focus on costs. Like deals, costs often follow prices, but with a lag. Costs cut deep into margins in the later stages of a boom. When prices fall—as in 1986, the early and late ‘90s, and today—deals are an attractive way to grow (see figure 3). Mergers can deliver big overhead cost savings. As activity and demand shrinks, suppliers lose bargaining power while bigger buyers gain negotiating power. Suppliers face intense cost and competitive pressures.

Most companies have tried all the traditional, straightforward procurement levers, some working aggressively with suppliers and others collaboratively. Aggressive negotiations seek pure rate reductions, but—depending on supply, demand, and utilization needs—many field contractors are unwilling to shave off more than 15 to 20 percent. Collaborative negotiations tend to be more successful, for example, rate reductions in exchange for extending a supplier’s contract.

Figure 3Plummeting oil prices in the late 1990s sparked a wave of mergers

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Sources: Energy Information Administration; A.T. Kearney analysis

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$114 inJuly 2015

BP AmocoDecember 1998: BP’s $55 billion Amoco acquisition

TotalFinaSeptember 1999: TotalFina and Elf $54 billion merger

ExxonMobilNovember 1999: Exxon’s purchase of Mobil for $82 billion

BP ARCOApril 2000: BP Amoco’s purchase of ARCO for $27 billion

ChevronTexacoSeptember 2001: Chevron’s $40 billion deal with Texaco

ConocoPhillipsAugust 2002: $18 billion merger of Conoco and Phillips Petroleum

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5Shale Is Transforming Oil and Gas Priorities

With idle capacity, suppliers have to discount their services, which makes outsourcing more attractive to oil companies—providing an opportunity to reappraise what they do in-house and what could be done better or at a lower cost by outside specialists. Good opportunities exist to outsource more non-core activities, IT being one good example. Suppliers often have leaner and lower cost structures, and because they are more specialized, they can build distinct capabilities in their chosen areas.

Adopting new technologies will also significantly lower costs and improve uptime and overall recovery.Oil and gas is now way behind other sectors in cost controls and cash returns. Going forward, operators need to adopt more of a manufacturing mindset, focusing on doing fewer things better and in more efficient, repeatable ways. Typically, 60 to 90 percent of costs are external, bought from suppliers. This needs to go right along the supply chain. A more all-encompassing approach is to look at how specs are set, how services or supplies are sourced and executed, and the interplay between them. Projects can be better planned and paced, use more replicable Lego-like modules and digital technology, and offer more thoughtful incentives to minimize over-specification, late changes, and waste.

Adopting new technologies (such as digital mobile monitoring, remote operation, miniaturization and intelligent automation) will also significantly lower costs and improve uptime and overall recovery. There are big opportunities to simplify, standardize, and streamline—as shales have done, lowering costs and raising productivity so effectively each year.

Shales Are Driving New PrioritiesAs companies look ahead and plan for 2016 and beyond, a more coherent, longer-term response is required. The structural change brought by shales may be the stimulus needed for the industry to reset portfolios, test new business models, and sharpen value propositions.

The volume business model may now be over. Many have been struggling to replace reserves and production, despite spending more. As companies moved into more technically challenging areas, more complex projects were often late and over budget. Margins took a hit, and returns to shareholders were disappointing.

Most upstream and service companies currently cannot fund their capex, debt, and promised dividends from their own cash flow. The majors have a staggering combined cash flow deficit of around $80 billion this year—and will need $50-$60 billion next year. So they are borrowing even more and selling assets.

Producers need to offer investors a better value proposition. They must adapt their business models to focus more on margins, faster returns, and value, and much less on simply growing reserves and production at any cost. This is a model that has not been working well for a while. And it will not bring much success as long as we have more low cost oil, gas, and other energy resources than we need.

6Shale Is Transforming Oil and Gas Priorities

Environmental pressures are growing too. Carbon taxes, hybrid vehicles, more efficient use of energy, and moves to shift investment from fossil fuels to other areas (such as communications or renewables) will reduce the capital available for oil and gas projects.

Investors, spooked by oil’s collapse, will focus more on margins and faster returns. Capital discipline, driven by clear portfolio priorities, will be key. Companies should concentrate on what they do well. Distinct activities such as shale and offshore need distinct business models, different commercial relationships, working styles, and metrics. Cultural and people issues also need care, otherwise key talent will leave.

The next two years may offer a window of opportunity to invest in better projects. Companies that can afford to invest should do so while costs are down and before prices start to recover—which they eventually will as demand overtakes supply with its relentless decline curves.

Deals to Refresh PortfoliosThis is a good chance to rethink and reset portfolios. Shell, for example, recently abandoned its high-cost ($7 billion) Alaskan exploration program. Others are now looking seriously at ways to exit or minimize further investment in loss-making positions in the Canadian oil sands or the North Sea, positions they inherited or, in a number of cases, paid a lot of money for only a few years ago.

Exploring on Wall Street is likely to be a better investment than drilling frontier wildcats, once sellers recognize that a quick recovery is not in sight (see figure 4). Growth from resource led exploration is delivering less value, with returns often stalled for many years. Some oil and gas,

Note: For some large majors, estimated average breakevens for projects are $30 to $40 higher than for their current production.

Sources: Goldman Sachs, May 2015; A.T. Kearney analysis

Expected leverage (estimated 2016 net debt to capital employed)0 10 20 30 40 50 60 70 80

Figure 4Deals will likely increase as the financially strong buy lower breakeven growth

Rice Energy

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Det Norske

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7Shale Is Transforming Oil and Gas Priorities

like coal, may never be produced, just as “the stone age didn’t end for lack of stones.” With so much available, resource owners are now having to compete to attract investment.

Firms with strong balance sheets will be able to buy higher-quality growth assets at a lower cost and with less risk than much of their previously planned megaprojects or new basin exploration. Some companies have already made a move, making deals for growth or renewal.

Shell’s bold $70 billion deal with BG leads the pack. Repsol too, after its Argentinian experience, paid a big premium to secure growth—for more lower-risk OECD exposure—by buying Talisman. The company now has big positions in North American shales and in the mature North Sea, which it will now need to manage carefully to realize value.

Different sectors have different drivers (see figure 5). Majors with strong balance sheets are looking for renewal to add material, higher-margin growth that will move the needle as Shell has with BG.

Independents, such as Noble and Apache, also want to shed their high-cost, aging tails and are pulling back to the United States and focusing on shales with quicker, less risky returns. Noble also strengthened its shale presence by acquiring Rosetta for $3.7 billion. Over the summer, private equity investors bought Encana’s Haynesville gas assets for $850 million. Woodside bid more than $8 billion to add assets in Papua New Guinea from Oil Search, but may be stalled on price.

Source: A.T. Kearney analysis

• How will less activity, lower prices, and thinner margins a�ect various areas and supply chains?

• Where and how will consolidation and exits change competitive dynamics? Where should companies focus to prepare for an upturn?

Oil service companies

• Will falling prices, volatility, and higher perceived risk lead to less investment?

• What asset types and portfolios should be targeted? When is the ideal time to make a move or to exit?

Financialinvestors

Figure 5Oil companies need to adapt their focus and business models to the new realities

• How will a new focus on costs, cash flow, faster returns, and renewed portfoliosimpact companies as they adopt new business models?

• NOCs with limited resources will likely play central roles but with more care and due diligence.

• Forming new partnerships, exploring more innovative deals, and developing new capabilities are all on the agenda. How will this change market dynamics?

• Breakeven costs are falling, but how far will they drop for various business models?

• How will this impact those focused on di�erent asset types? Some win zones are emerging. Will these change when prices rise?

Internationaloil companies

Nationaloil companies

Independents

8Shale Is Transforming Oil and Gas Priorities

In October, Mikhail Fridman’s LetterOne sold its UK gas assets (bought from RWE) to Grangemouth operator INEOS for $750 million—probably at a fair price, at $10 per barrel of oil equivalent, but a steep discount to its share of the overall $5 billion acquisition of Dea. So North Sea firms take heart. LetterOne also announced adding three of E.ON’s producing fields in Norway for $1.6 billion. With Lord Browne as CEO, the company sees plenty of opportunity to grow in Norway and Mexico and in shales all over the world. More deals are likely.

National oil companies have not cut spending as much as others. Some Indian and Asian com- panies are looking hard at now better priced assets. In September, India’s Oil and Natural Gas Corporation acquired a 15 percent stake in Russia’s vast Vankor Field from Rosneft, paying around $1.3 billion. China National Petroleum Corporation may follow, while Thailand’s PTTEP could spend around $1.2 billion on BG’s Bongkot field. Sonangol bought deepwater interests from Cobalt for $1.75 billion. More might buy to secure needed energy supplies, as the Chinese have.

Some deals reflect an optimistic price outlook and will succeed only if oil prices rise above $70 by 2017. If prices remain low, some high-breakeven assets will prove hard to make profitable or sell.Some deals highlight the dangers of growing volume without understanding the implications for margins, returns, and value. But with some, including NOCs, overpaying for assets, perhaps based on limited due diligence, buyers' targeting and evaluation is likely to become much more selective.

Some of the deals so far reflect an optimistic price outlook and will work well only if oil prices rise above $70 to $80 by 2017. This now looks less likely. If prices remain rather lower into 2017, acquiring any high breakeven assets, such as some in the Arctic, North Sea, or Canadian oil sands, will be difficult to make profitable or to sell. New or existing owners will need much lower costs to make these work.

In the service sector, Halliburton bought Baker Hughes to acquire scale and fill some key portfolio gaps. In August, Schlumberger agreed to buy Cameron for its subsea technology offering more than $14 billion. The hefty $5 billion (or 56 percent) premium may yet be covered by expected savings, but Schlumberger will not have found a bargain until oil prices start rising. The supply chain is overpopulated with many small companies. So good potential for more consolidation to improve efficiency, perhaps providing interesting opportunities for companies such as Weatherford and GE.

More assets and potential deals are coming into the market, with nearly 400 already identified. But low and volatile prices and an uncertain demand outlook are undermining confidence. Many sellers still have overly high price expectations, and so far the deal market remains stalled. As sellers expectations of a quick recovery fade and cash flow pressures grow, we expect to see more deals over the next two years.

9Shale Is Transforming Oil and Gas Priorities

Authors

Hugh Ebbutt, associated director, London hugh.ebbutt@atkearney.com

Jim Pearce, partner, London james.pearce@atkearney.com

Adapting to New RealitiesThe energy landscape is changing once again. Environmental concerns and renewables, like offshore wind, are growing; there is greater awareness about the impact of pollution and carbon, and stronger incentives from policy makers—from China to North America. Energy demand has fallen in developed countries as high prices have stimulated more efficient use. The focus is now on diversity of supply, interconnection, smart grids, efficiency, less waste and, increasingly, competitive costs and practicality.

Lower cost, more responsive shale output is transforming the oil and gas markets, forcing com- panies to reassess their priorities and adapt to the new realities. Strategic deals that build on key strengths can reset and strengthen portfolios where most needed. Indian and other Asian NOCs are also looking at lower-priced asset opportunities. Expect more M&A in 2016 and 2017.

Longer term, the shale revolution will gradually spread. New ideas and technology, sometimes from unexpected sources, will change the game again—both in how we use energy and in its supply. To thrive in an increasingly interconnected and unpredictable world, with its many moving pieces, energy companies will need to become much more adaptable, innovative, and agile.

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