Exploration success isn't just luck. Performance leaders use techniques that make them winners.

In our recent study, "Exploration Strategy and Performance," we examined the different spending patterns amongst the 28 leading oil and gas exploration companies.

Overall we have seen spending on exploration decrease since a peak in 1998. This is particularly significant given the continuous rise in production these companies have achieved during this period.

The proportion of exploration spend coming from the supermajors has dropped notably from around two-thirds of exploration spend to around two-fifths.
The positive impact of this reduction in spending, along with higher oil prices, has been the overall improvement in returns generated by new field exploration in this period, with rolling average returns moving up from around 13% to around 16%.

The downside of the spending reduction has been a drop-off in reserve replacement since a peak in 2000, when there were a number of giant new field discoveries in the form of Kashagan in Kazakhstan and some major gas finds in Western Australia.

In this article we look more closely at some of the trends in spending amongst the different companies that we have studied and identify some of the spending habits of highly effective explorers.

One of the key strategic themes prevalent amongst the most successful explorers has been greater level of focus in their exploration activity and hence in their exploration spending.

The best example of this is BP's "Basin Perfectionist" strategy, which aims to create maximum value from a limited number of highly prospective plays (currently deepwater Gulf of Mexico, Angola, Trinidad and Egypt). BP invests heavily in exploration in these areas to get the best understanding of the basins and drill the highest potential wells. BP's drilling success rate is markedly higher than other companies we have studied.

There is also strong evidence of other companies improving value creation after moving to a similarly focused strategy during the study period.

As focus is an ingredient of success, this leads to the obvious question - How can we measure focus amongst companies?

Figure 1 considers the average amount spent in each country by supermajors (red) and other explorers (blue). The national oil companies have been excluded as their large domestic spend skews the chart.

We can see that broadly the supermajors spend between US $30 million and $60 million per country per year. This masks the fact that the top three or four investments that they make each year will be more than $100 million, and they will have a tail of much smaller investments.
Indeed it is the number of these $100 million-plus investments that appears to distinguish performance among the supermajors (Figure 2).

For supermajors to execute the "Basin Perfectionist" strategy effectively they need to consider two kinds of investment: large scale investment in the plays and smaller investments in unproven basins that have the potential to develop into the high-impact plays of the future.

With respect to the smaller companies quantifying focus is more difficult. In this group leading value creation has come from focusing on core competencies such as leveraging acquisitions, applying deepwater technology and exploiting the strong US gas market.

Country count is less important for these companies than focus on profitability, and it is those that have identified the investments that can deliver profits for their companies that have created the most value.

Focus is not only a matter of spending. The attention of management also needs to be focused on core opportunities.

A number of companies that made major discoveries in the Caspian, West Africa, North Africa and the Gulf of Mexico in the late 1990s have found themselves with major development
projects to be executed in the early 2000s. These have been critical projects for these companies, and attention has been focused on extracting the optimum value from these developments rather than on adding additional reserves through newfield exploration.
However, as a result of this focus on development there is less focus on driving newfield exploration, and as a result reserve replacement for these companies has fallen in the early 2000s.

Another interesting spending habit

is the amount a company will spend before walking away from an investment in a country.
To consider this we looked at the 785 individual country investments that the 28 leading companies made in the years 1995 to 2004.

Of these, 198 investments returned positive value creation, giving total value creation of $224 billion. The remaining 587 investments destroyed a total of $42 billion.

Intuitively we would expect the companies that have created the most value to have the fewest big individual losses, but in fact we find that the opposite is true.

The companies that have the largest single country losses are actually those that have created the most value.

This is consistent with the Basin Master strategy, as this requires companies to make major investments in the core plays that they identify, and if a country proves to be drier than expected, then the losses can be substantial.

This only serves to highlight why it is only the largest companies that can bear the large risks that are inherent in this strategy, as their production base and balance sheet strength will allow them to make enough of these large-scale investments to ensure that the risks are diversified away.

Perhaps the biggest challenge for investment in newfield exploration is that it can no longer be relied upon to deliver full reserves replacement for every company. This means that investments need to be made in other areas such as appraisal of existing discoveries, monetizing stranded gas reserves, heavy oil extraction, tight gas development and accessing brownfields in previously inaccessible countries.

As a result, newfield exploration needs to compete for budget with all of these other activities.
As exploration is relatively high-risk, it needs to provide either higher returns or larger potential upside to justify the investment, and this provides a major challenge (Figure 3).

It is increasingly difficult to see where the potential elephant discoveries for international companies in conventional plays may come from in the coming years.

Where there is prospectivity, such as in Libya or Iran, the competition for opportunities is fierce, and this drives down potential returns as contract bids must be aggressive to succeed.
Other opportunities, restricted to more frontier regions such as in the Arctic or in ultradeep water, present significant technological challenges and increase risks even further, making the need for higher returns more important.

All of this makes it harder to justify investing in exploration, when the cash could alternatively be used in lower-risk activities with significant reserve potential.

Therefore, we expect explorers to have to be even smarter with their spending habits to ensure that the current level of high returns is maintained through focus on the areas with the biggest potential that complement each company's individual strengths.

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