It’s no surprise that oil prices drive many of the strategic business behaviors of executive teams, investors, directors, analysts and organizations in the upstream industry. Booms and busts happen, and they will most likely continue to happen.

The root causes of these price swings can make for interesting analytical entertainment, but we are more concerned with another issue: the predictably irrational strategic decisions that executive teams make before, during and after these periods of dramatic price fluctuations, and the subsequent collateral damage to their overall health and business performance.

Given the industry’s past response to large price swings, we can predict that the names of the companies that will ultimately earn the rights to that recoverable oil, drill the wells, lift the oil and get it to market will be quite different from the current cast of players. In fact, many, if not most, of the operating companies, service companies and other related businesses in the North American upstream industry will, sooner or later, fall victim to a financial condition necessitating the total or partial sale of their businesses due to decision blunders made at or near strategic tipping points along the pricing continuum. These blunders will spawn outcomes ranging from complete business liquidation to strategic sale or merger with a more viable entity.

As this article was being written, it wasn’t yet clear whether the industry was in the midst of a simple price downturn or a full-fledged price collapse. Rather, we seemed to be in the doldrums.

The most common consequence (and the enduring legacy) of upstream leadership teams’ behavior in periods of booming oil prices is value destruction from hyper-expansion. The most common response before, during and after periods of price busts is a panicked curtailment of operating activity, often followed by a fire-sale liquidation of assets and disgorging of talent. These nearly always culminate in a diminished capacity to achieve future growth and a return to health.

For the sake of brevity, we define industry players according to four classifications, based on expressed or implied corporate strategic intent and vision. Specifically, the segments are:

Sustaining Franchises: These players aspire to maintain a branded entity as a long-term sustaining business (theoretically into perpetuity). Credible sustaining franchises are the main destinations for massive capital investments from the financial communities.

A segment of the investment banking industry works in concert with sustaining franchises to find the next acquisition (which comes from the two other classes of industry players defined below) needed to fuel the ongoing synergy between the largest sustaining franchises and the stock markets, private equity firms, pension funds and large private investors. ExxonMobil, Shell, BP, and Chevron are examples of surviving sustaining franchises.

Builder-Flippers: These entities are born and grow from the vision, will and skill of entrepreneurs, and eventually become fully established enterprises with the help of certain investor entities. The owners often sell out at some point to monetize the business and to create personal wealth. Burlington, XTO, Petrohawk and Chief Oil & Gas are examples.

Pretenders: These players are in the “murky-middle” between the proven franchises capable of sustaining competitive business operations through the various boom-and-bust cycles and the builder-flipper set. Here, we see leadership and investors aspiring to think and act as a sustaining franchise but lacking the talent, resources or assets to be viable over the long term. These companies are part of the M&A food chain that will ultimately belong to the larger sustaining franchises.

Companies exhibit fairly predictable behaviors as commodity prices rise or fall. By monitoring tipping points, they can reduce overreaction to high or low prices.

Sun Oil, Mobil, Amoco, Texaco, Kerr-McGee, Gulf, Getty, and others too numerous to mention have been unable to survive as a sustainable franchise and were gobbled up.

Niche Players: These relatively smaller players have created a mini-version of the sustaining franchise through crafty and highly focused entrepreneurial actions. They have established uniquely valuable assets usually associated with a specific basin or play, but otherwise lack the resources, assets or strategic scope to become a larger, more broad-based player. Many of these companies survive and thrive through boom-and-bust cycles, while others wither and die.

In a world defined by the need to compete for the capital required to fund expensive drilling programs, make strategic acreage acquisitions, and build the facilities and infrastructure needed to get that oil to market, capital providers will always exert extraordinary influence and control over the thinking and decisions of operating upstream companies. Often, those decisions are much too short-term-focused. Worse yet, in response to the need to meet the short-term expectations of investors and analysts, some certifiably terrible decisions can be made, from which it becomes difficult to recover when wildly divergent price swings take place.

What we call Miller’s Principle predicts that significant induced error in the design and execution of business strategies will result in dramatically painful value destruction at two ends of a spectrum. At one end is the boom period; at the other, of course, is the bust period. In the middle range is the mirage of a “stable” price zone, where prices seem to cluster within a settled and seemingly predictable range. It is this much-loved, tranquil space between the polar price extremes of boom and bust that too often lulls leadership teams into a series of faulty decisions based on the assumption of continued reasonably stable prices.

Even in this middle range, induced error (or waste) is significant, due to a variety of factors. Waste is usually measured as a percentage of invested capital. Total induced waste is the sum of all value destruction across the entire value chain. Our experience over the past 40 years indicates that the range of waste in capex investments is typically 15% to greater than 30%, depending on the quality of the operating company. With capital spending in the billions of dollars, waste on the order of 15% or more will quickly become relevant in most precincts.

In boom periods, we see rapid over-expansion, general hyperactivity and the frantic scramble to obtain acreage, contract for rigs, hire personnel, identify drillable locations, search for capital, drill and complete wells to hold acreage, and build the necessary facilities and infrastructure. These actions are undertaken with a heightened sense of urgency to keep pace with the expectations of analysts and investors, all of whom become increasingly opinionated as the expansionist hysteria grips the broader industry. Capital discipline typically becomes sloppy, which promotes waste across the entire value chain as the drive to expand becomes tangled up with inefficient business practices.

Compounding the challenge of navigating boom-bust realities are the commonly flawed price assumptions underlying so-called “conservative” budgets, business cases and planning that become status quo when the industry moves through a period of apparent price stability. During periods of high prices, management can become so hypnotized by what appears to be a smooth glide pattern to a greatly expanded business footprint that common sense is suspended in favor of the pursuit of an illusion.

And, when the inevitable bust arrives, the shock snaps leadership out of its dream world, causing a painful form of whiplash from which it can be difficult to recover. The shock turns to panic as prices slide well below the budget’s conservative price case.

In this period of panic, entire portions of an otherwise excellent business can be liquidated at fire-sale rates. Panic results in an over-reaction, and we see drilling rigs laid down, programs cut or shut down completely, acreage sold, people fired and massive waste of capital realized—again.

Across the continuum from total liquidation to hyper-expansion, there are distinct markers or key indicators that define the upper and lower limits of the middle zone (the mirage of stability, see graphic). These markers will alert executives, investors and analysts with critical early warnings that they have ventured too close to a tipping point. Knowing how to set and then utilize these markers allows management to respond more quickly and more effectively to sudden, significant price volatility with incrementally significant operational course corrections along with considered adjustments to an overall grand strategy.

Good leadership teams know how to define the right markers. The best leadership teams carefully define the right markers and then pay close attention to them, As a consequence, they create more value for all of their stakeholders by significantly reducing waste across their value chain.

James Miller is chairman and CEO of XCEL Partners, chairman and CEO of AOME Engineering, and director of XPST (proprietary subsurface analysis and interpretation), which provide strategic business and technical services to upstream companies. He may be contacted at jm@xcelpartners.com. This article is the third in a series; the first two appeared in the July and September issues, respectively.

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