Some oil and gas companies have allowed production goals to divert their attention from shareholder expectations.

In recent times, markets have focused on production targets and delivery as a key measure of an upstream company's success. Failure to meet targets and downgrades of future estimates have been met with reductions in share price, often out of proportion with the potential impact on companies' earnings.
Targets affect the strategies and behaviors of companies, and we believe that excessive focus on production targets in the upstream business is interfering with efficient portfolio management. Companies are encouraged to keep inefficient assets to maximize volumes. We have yet to see the major portfolio rationalizations expected as a result of the "mega-mergers." Companies are unwilling to sell if they cannot replace with equivalent volumes. As a result, assets do not end up in the hands of their "natural owners," leading to suboptimal performance in the industry as a whole.

Relentless pursuit of volumes may also push the industry to take inappropriate development decisions, accepting tough terms and thin margins. Finally, the perceived need to show a rising production profile has encouraged strategic acquisitions at premium prices, which have destroyed value in the acquiring company.

For these reasons, we believe that the excessive focus on production growth targets is adversely affecting total shareholder returns. The industry and the markets need to shift the emphasis away from volume to value.

Production focus

Companies have, to an extent, created the problem themselves by the ambitious growth propositions made to shareholders. Expectations have been unrealistic. Most companies will not be able to grow production at 3% to 7% annually through organic growth. Even to achieve relatively modest production growth while maintaining a constant reserve-to-production ratio requires a good underlying reserve replacement performance. For example, a 3% per annum production growth would require a constant average reserve replacement performance of around 135% to 140%, something that few companies have been able to achieve in recent years.

Production targets are popular because they are simple to measure, transparent and not open to manipulation. They are also independent of oil and gas prices and, therefore, show underlying growth irrespective of the state of the commodity price cycle. However, production growth targets are only proxies for value growth, and by concentrating on this measure in exclusion there is a danger that behaviors will be encouraged that are at odds with value growth considerations.

This focus on production growth also is coming at a time when it is more difficult for the industry to find profitable growth opportunities. Exploration trends for some are disappointing. Many of the large conventional plays are mature or declining. Competition is fierce, and many companies now have very strong balance sheets and financial capability. The internationalization of some national oil companies is producing new and well-funded competitors. Politics are slowing progress in some regions (Brazil, Venezuela, Middle East, Mexico, Russia and the Alaska National Wildlife Refuge), and the political risks of investing in areas such as the Middle East and Russia are high.

In this highly competitive environment, it is important that the measures used by the market do not encourage companies to focus on production growth at the expense of value.

Investor goals

Investors look to total shareholder return (TSR) as the principal success measure. Some companies have specific TSR targets. Others argue that, as TSR is largely driven by share price movements over which they have little control, it is not in itself an appropriate specific target. But even the latter group takes actions to deliver business results that ultimately will deliver an appropriate TSR.

To deliver an appropriate TSR, companies will need to align the overall direction of the business, their strategic themes, their assets, people, cultures, structures and processes. Some of the demands of investors may clash, for example return on capital and growth. However, in the long run, the enterprise value of the company and its ability to pay dividends will depend on it being able to add value through the efficient use of its capital, directly linking TSR to value creation.

Measures companies and investors will use to monitor progress include:

* align with TSR objectives;
* encourage the best investment decisions;
* allow a degree of flexibility in tactics to deliver; and
* provide a balance between short-term performance and longer term business build.

Yardsticks

The key question that any measure should seek to answer is: Are oil and gas companies creating value? The supplementary questions are: Who? Where? How? How much?

The focus on production growth, reserve replacement performance and finding, development and production costs gives an indication of who is finding and developing reserves and at what cost but, crucially, does not address the value of these reserves. The cost element is also a snapshot of the present and not necessarily going to be repeated in the future. Also finding and development costs are distorted by timing issues. Finding costs for example are calculated on reserves booked during the year and may be lowered by the effect of reserve upgrades at fields discovered years earlier.

Cash flow and unit earnings tell us about the current state of the companies but not about their growth potential. Return on capital employed (RoCE) is also a current measure largely dictated by the companies' legacy portfolios and decisions taken in the past with regard to write-downs. Because a company has a high RoCE does not necessarily mean its recent and future investment decisions are going to create more value than those in a company with a lower RoCE. In fact, a period of heavy investment activity, which will lead to future value creation, will act to depress RoCE as the impact of this capital spending is likely to be delayed due to the long lead times of many upstream projects.

In our view, a shift from volume to value and current to future measures would help the industry and its shareholders to identify companies that display superior upstream performance and are set for profitable growth.

We rely heavily on net asset value (NAV) analysis of future project cash flows when dealing with valuation issues. This is, of course, standard practice within the industry when evaluating projects internally. However, the only use of NAV analysis in US Securities and Exchange Commission (SEC) reported figures is to value the companies' proved reserves at year end at prevailing oil and gas prices, a figure companies say does not accurately reflect the value of their upstream assets.

A greater use of NAV analysis is, we believe, to answer the key question: Which companies are creating value for their shareholders? For example, an NAV analysis of the cash flow (actual and predicted) of fields discovered in the past 5 years when compared to a company's exploration spend would clearly show whether value was created in this area.

To be an acceptable measure, there would have to be a greater degree of transparency in the information provided by companies. For example, the underlying assumptions as to reserves and timing of significant exploration successes would have to be provided. Alternatively, this information could be produced by independent analysts.

NAV is a key measure, but it too has its drawbacks. In particular, because of the effect of discounting, it tends to understate the attractiveness of assets with long-term cash-flow profiles. Other cash-flow-based measures could be utilized to indicate both long-term and short-term cash-flow prospects.

Another key measure companies use internally to prioritize and set the hurdle for investment decisions is the internal rate of return (IRR) of the project. If more information was disclosed (or provided by third parties) on the likely returns and planning scenarios for companies' key investment decisions, this would, together with the NAV analysis, highlight the returns that are expected on current investments. While some of this information is commercially sensitive, in these cases, the information could be aggregated at a corporate level. For example, stating the IRR expected on total new field exploration successes over a given period or on assets acquired would provide a clear indication of the success of these activities.

The next step

With the current loss of confidence in production targets, it is now more important than ever to select measures that will align the companies' key objective of long-term profitable growth with market expectations.

Transparency will be critical. As Sir Henri Deterding said in 1934, "Our Royal Dutch-Shell operations would never have succeeded as they did if we had tried to keep any part of our general working policy a secret... there is no better way of winning the confidence of your shareholders than to make them understand as you go along every possible detail of just how any business, into which they have put their money, has been run."

There are two key questions. What are the best measures of performance? And, for these measures, what targets should companies promise the markets? The first will evolve from debate between the industry, analysts and investors and also from industry leadership. The answer to the second will require companies to have a very clear view, inter alia, of their current portfolios, of the key value drivers and of the competitive environment.

BP said recently that it is re-examining its medium- and long-term investment strategies and that the outcome of this review should be ready by February. Other companies are also considering changes. Now is the time for all interested parties to engage in the debate.



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