Upstream playbook for 2021 & beyond
Capturing profit and unlocking synergy value with a low-cycle operating model
2020 rocked every sector, and the oil and gas industry was hit particularly hard — on numerous fronts. The dual supply and demand shock of the spring followed growing uncertainty on both near- and long-term demand levels. Meanwhile, domestic pressure to ramp up production across OPEC continues to rise as these countries struggle with the global downturn. On top of these challenges are persistent calls to increase environmental, social and governance (ESG) transparency and compliance as activism takes root and is now a prominent issue on CEO and board agendas.
The US will continue to be a dominant producer on the global stage, but pressure for consolidation is swiftly accelerating, and the industry’s structure will likely look much different in 2021 (and beyond).
What will it take to win in this climate?
As sector consolidation plays out, the winners will deliver value to shareholders in the near and long term by successfully navigating the current dual shock and evolving expectations. They will be required to:
Break out of the club
Recognize that peers aren’t just other E&Ps but rather a much broader set of companies. Also, consider that the most dependable, long-term investor remaining for E&P companies seems to be the value investor as growth investors are no longer attracted to the sector and ESG investors remain opposed to it (and are uninterested in the industry’s gravitations toward “going green”).
Deliver steady cash (even at the bottom of the cycle)
The value investor demands a steady dividend yield. In PwC’s recent Energy Investor Study, 80% of both industry leaders and analysts agree that achieving free cash flow (FCF) and return on capital employed (ROCE) were the most important measures of financial performance for oil and gas companies.
Build a platform for acquisition
The most efficient, low-cost producers will be in a position to bring new assets (and companies) into their fold and extract immediate deal value. This will likely occur both nationally at the macro level and at the micro, basin-by-basin and field-by-field levels.
And how will upstream companies do it?
Execute deals rigorously
Unlock greater synergy value from prime targets and well-executed integrations. The use of a “synthetic best-in-class company” model as the marker for deal performance throughout the entire deal lifecycle (strategy, identification, diligence, integration, synergy capture) provides the goal line discipline required for success.
Adopt a low-cycle operating model (LCOM)
Break historical norms and build the business to deliver in the low cycle (e.g., sub-$40/barrel). Ruthlessly prioritize expenditures and allocate relevant tasks to the right teams to carry out this model across the organization.
Re-engineer a balanced and robust portfolio
Evaluate assets to establish a mix of base production with high cash flow (which may require longer-term investments) and short-cycle assets which can capture spikes in the upcoming oil price volatility.
Deal strategy
Deals are happening, and more are coming whether a company is a low-cost operator or already has a portfolio configured for a future volatile price environment. Today’s deals will reshape the industry and position companies to be tomorrow’s winners.
For US producers, a winning strategy is simple and self-perpetuating. First, transition to the low-cycle operating model, demonstrate value creation and create capacity for investment. Then, acquire competitors with higher-cost profiles and assets that fit your portfolio needs. And unlock value by integrating the acquisition into your LCOM platform.
When carried out correctly, the cycle is self-reinforcing, providing additional opportunities to unlock value with each additional acquisition. This value can then be directed to the project of highest return in a discriminating way. Scaled players will have more opportunities and thus will be able to more efficiently allocate capital and achieve higher returns. Furthermore, acquirers in low-price environments achieve disproportionate shareholder value growth.
Those companies that can implement this strategy will be better positioned to simultaneously enhance their operating costs, scale and cost of capital.
Why a low-cycle operating model makes sense now
Low cycle operating model
Adopting a low-cycle operating model (LCOM) requires a mindset shift. Today, it’s imprudent to build company strategies that anchor on “mid-cycle” activity demands under the flawed assumption companies can flex up during the good periods and flex down during the bad. The LCOM instead builds the company to succeed at the “low-cycle” price point and activity demands (e.g., sub-$40/barrel). This creates the capabilities and confidence required to most predictably deliver cash and returns in any market environment.
Profitability of LCOM
Critics argue that a LCOM leaves companies unable to reap the outsized rewards of the boom cycle. While a valid point, a LCOM also hedges against losing capital and promotes steady and predictable year-in, year-out profitability that, over the long haul, creates more cash compared to the industry’s traditional operating models.
Best in class operator
The LCOM can certainly involve trade-offs. Leading operators need to make strategic decisions around which areas of the business are most important to excel in (and which ones are not). Such decisions will naturally differ among operators and the basins in which they operate. Once high-priority capability areas are defined, they need outsized focus compared to the rest of the business – through capital spending, hiring, tools, etc. All other capability areas of the business ought to undergo rigorous cost rationalization.
Tangible impacts of the LCOM are most easily seen in workforce strategy and planning. A LCOM workforce consists of a core set of employees supplemented by a flexible contract labor force and service providers. The workforce mix changes as activity levels (defined by financial constraints and portfolio options) adjust to market conditions.
In addition to providing steady returns, the result is a company that is poised to extend and expand the value of its LCOM platform via deals.
Structure the portfolio to accommodate the next cycle...and beyond
A LCOM should align with the strategic direction of the portfolio of resources a company is developing. Naturally, each resource play can differ markedly. Yet, going forward, the following key characteristics will serve as hallmarks to guide the inclusion of any given resource in a portfolio to support profitability through all cycles:
US shale and its place in the portfolio
Unsurprisingly, Middle-Eastern resources have CapEx efficiency advantages. Offshore resource plays have also made great strides, many of which now only require an investment of less than $3/bbl. This, combined with their proximity to fast-growing Asian demand centers, makes them attractive portfolio resources. Offshore assets still require years of sustained investment before a first barrel flows and thus cannot be brought on or offline quickly to react to demand swings.
In contrast, US shale resources are more capital intensive and less cash-flow producing on average, with resources requiring close to $4/bbl of capital investment. Still, US shale nevertheless holds two important advantages: its cycle efficiency is high, and it is close to a major and mature global demand center. Oil and gas can be brought on relatively quickly — within mere months.
A balanced portfolio that has base production from offshore assets creates steady cash flow and uses short-cycle NA shale as a swing resource. This enables quick ramp-up and ramp-down (despite being more capital intensive) and creates conditions for the profitability and flexibility needed to weather any potential price or economic volatility. Such a portfolio is designed to allow capital to flow toward projects that optimize cash-flow return. Achieving that end will put companies in a favorable position to support dividends and create investment capacity.
Market consolidation and the value of scale
Scale is a pathway to lowering operating costs — particularly in the US shale market — essentially by allowing companies to spread fixed costs and leverage buying power. Scale also frees companies to optimize capital allocation across the portfolio. Finally, when done correctly, it unlocks elements of the LCOM that are less available to smaller operators.
The increase in process and systems discipline (or maturity) required for operations at scale substantially increases workforce leverage — reinforcing the low-cost advantage. Deployment of at-scale industrial internet of things (IIOT) operations, for example, increases reliability of production operations and enhances efficiency of every worker, thereby increasing returns. It also opens up alternative workforce models (e.g., outsourcing, exception-based, contingent labor) that are more difficult to deploy for less mature organizations that are not operating at scale.
Scale and the LCOM, working in tandem, unlock the ability to grow. Establishing resilient low-cycle value creation unlocks the ability to invest and enables companies to participate in deals. Combining scale and the LCOM in today’s market creates an ideal setting for increased deal activity and consolidation. As a result, when commodity prices do recover, there will be fewer companies reaping the rewards.
Accelerating synergy capture
Buyer beware: Only 31% of E&P acquisitions add shareholder value relative to peers...
Realizing the value of a corporate acquisition in the E&P sector is not straightforward. PwC’s analysis of E&P deals over the past decade indicates that less than one in three acquirers outperform their peer set three years after the acquisition, and, on average, the acquirers create less value than their peers on a continuous basis.
...yet, this is how value creators optimize deals
The companies that do achieve value from acquisitions do so by applying a structured and disciplined approach toward deal execution by including the following:
- Screening targets for portfolio fit and synergy opportunities
- Performing systematic due diligence that uncovers portfolio characteristics and also understands the target’s operating model
- Establishing hypotheses early in the process on:
- Integration plan and the end-state operating model
- Size and location of operational and back-office synergies
- Capital plan — optimization of net working capital and CapEx
- Structuring for optimal tax exposure
- Structuring the integration around a rapid transition to the LCOM and capture of scale synergies
Target selection requires balancing the tradeoffs between the portfolio fit and the potential for synergies. The first step in reconciling these twin goals is an outside-in understanding of the opportunities. While many operators have a solid assessment of the asset quality and operational performance of their peers, in many instances the quality of the back-office operations and operating model tend to be more opaque. PwC’s most recent diagnostic survey revealed an overall downward trend in general and administrative (G&A) cost per BOE across US producers. However, a wide disparity between leaders and laggards still remains. The first quartile performers have 43% lower cost basis than their peers. Indeed, it pays to understand whom you are targeting.
The due diligence of the operating model is anchored in understanding the cost profiles of potential targets. Unfortunately, there is ample flexibility in the reporting requirements for the key categories that make up the operating model. For example, while one company may report general and administrative expenses as 10% of revenue, another may report it as 20%. Due diligence efforts should be aimed to uncover the real ranges of the opportunity and then baseline them to the acquirer’s levels. PwC's independent industry benchmarking studies and diagnostics uses data beyond what is publicly available in order to normalize company reporting variances and resolve such apples-and -oranges issues. This will form one of many early hypotheses regarding the value of transitioning the target to the acquirer’s LCOM.
There will be many value hypotheses for deal synergies. In PwC’s experience, in a well diligenced and executed deal, organizational synergies may range between 50% and 80% of the target’s cost base. Capital synergies will depend on the portfolio and development plan, but acquirers should be able to optimize capital allocation by as much as 30% of the combined capital spend base. Opex synergies will range between 15 and 35% depending on the category (e.g., transportation or lifting). And in today’s environment, these optimizations have the potential to be even higher.
Additionally, consolidation in the upstream market will impact oilfield service firms. Upstream firms will rationalize their supplier base ensuring that some oilfield service firms survive (while many will not). While the supplier base may no longer be as diversified, consolidation will improve overall reliability.
Historically, integrating an acquisition was expected to take about two years, but planned synergies are seldom realized over this long a period. In today’s environment, however, companies must move faster. Therefore, accelerated synergy capture is critical for survival in these difficult times. Companies should drive toward synergy capture periods of six to 12 months and be prepared for a succession of deals.
Clearly, the bar for successful deal execution is high. Much needs to be done in an environment when costs are being slashed, workforce is remote and uncertainty abounds. Thus, successful acquirers will build a differentiated M&A capability. Broadly this capability is built on numerous factors, including: a market-sensing and analysis process; an integration playbook; an enabling technological platform that can drive an agile, structured and efficient execution; and a small, dedicated core team that can pull from the broader organization.
In conclusion
The US upstream sector is in a period of evolutionary change. The operators that accept the new climate and evolve to meet the challenges of 2020 and beyond will emerge successfully. They will likely grow their companies. Their business models will be resilient in the face of commodity price fluctuations. And they will continue to serve a vital role in supplying the US and the world with energy.
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