Increasingly, the upstream segment is finding capital sources harder to come by, meaning that a larger share of operators’ development must be self-funded. In lieu of traditional measures like production growth and reserve replacement rates, the investment community is emphasizing segment performance metrics capturing fiscal discipline—return on capital, free cash flow, recycle ratios and overall balance sheet health.
Will the segment continue to prioritize capital discipline if oil prices increase? Or will companies revert to the old habit of chasing production and reserve growth during an up market? At a deeper level, are upstream companies becoming more sophisticated in how they invest for competitive advantage in any market scenario?
In our experience working with E&Ps, those that have strong connections among their asset base, their differentiating capabilities and operating costs are the most successful at both controlling costs and investing—including talent, technology and general and administrative (G&A) investments. The key question that operators have to ask themselves is, “if prices go up and I start spending more, am I spending it in the right places?” Companies undertaking this approach can not only realize cost savings (on average about 20-40%, according to PwC’s analysis), but they can orient spend toward higher-value activities.
Evidence from the proprietary PwC G&A Diagnostic suggests the possibility that, for some companies at least, oil price increases seen in 2016-2017 (Figure 1) may have had the effect of lessening the focus on G&A cost management. Although E&Ps allocated more budget dollars to debt reduction and share repurchases in 2018 than they did in 2017¹, three-quarters of US shale oil companies still report capex in excess of cash flow from operations.² And evidence from a recent Dallas Federal Reserve Bank survey of 100 US E&P executives identifies their primary 2019 goals as growing production (46%) and acquiring assets (13%)—far exceeding the proportion that said their goals were to reduce debt, reduce costs or return capital to shareholders.³
G&A cost has traditionally been measured relative to net production (using barrel of oil equivalents that combine production of crude, liquids and dry gas). When production increases, G&A cost typically does as well, and when production declines, it is natural to expect some decline in G&A cost to occur. How have the rates of increase or decrease in these measures compared over time?
Figures 2a and 2b and the accompanying table display trends in total G&A costs and net production for the 2015-2016 and 2016-2017 periods, respectively. Examining the quadrants in each figure, a notable pattern emerges. In the earlier period, companies whose production declined also almost always saw decreases in G&A cost as well (representing 61% of the overall data, as shown in Table 1). In the latter period, companies with declining production were much more likely to see increases in G&A cost: 22% of the data vs. less than 4% in the earlier period. Moreover, the percentage of companies below the 45° line—those whose percent increases in G&A cost exceeded percent increases in production or those whose percent reductions in G&A were less than their percent reductions in production—increased from 26% to 44% between the two periods.
As a result of the marginal price gains in 2017, we may be seeing a renewed optimism in price and an erosion of G&A cost discipline. This is a phenomenon we’ve dubbed “The Optimism Trap.” There are a number of potential explanations for this pattern:
Those that fall into the Optimism Trap will miss out on the current wave of G&A and corporate function transformation that is currently sweeping across all sectors, not just oil and gas. This transformation is grounded in the new suite of technology tools (automation, artificial intelligence, etc.) and the increasing digital aptitude of the workforce.
This transformation is characterized by:
In missing out on this wave, companies that fall into the trap forgo the incremental margins that can be had in any price environment, and more importantly will miss the opportunity to build the capability and flexibility into their organizations that will enable them to weather the next commodity market storm.
Upstream operators have long known that public data on G&A costs are misleading and not suitable for comparisons across companies, due to different accounting practices and a lack of transparency and consistency in what those companies include in income statement G&A. To fill this void, the PwC G&A Diagnostic has emerged as the industry leading source of truly comparable, consistently defined, peer-based G&A costs and headcount. Data are collected and vetted by component—for both Technical (e.g., Operations, HSE, Land) and Support G&A (e.g., IT, HR, Legal, Finance and Accounting) areas.
Since 2014, more than 60 separate entities operating in the US Lower 48—E&Ps and IOCs alike—have participated in the PwC study. These entities collectively account for more than three quarters of all companies in the IHS global integrated, regional integrated, large and mid-sized E&P US peer groups.