Does change unfold in evolutionary increments in oil and gas, or does change erupt in revolutionary events that can be described as transformational?
Looked at another way, if an industry event is transformative, how does that event transform the structure of the industry itself?
As noted in last month's Oil and Gas Investor, both the pace and the breadth of the transition to pad drilling has been stunning—from less than 20% of horizontal wells in late 2012 to more than two-thirds of horizontal wells currently. Few industrial sectors experience change that dramatic, or that fast.
Yet those occurrences are commonplace in modern oil and gas, which witnessed a quick move to unconventional shales in the 2005-2007 era and the rapid switch to horizontal drilling in the post-2008 commodity price collapse. Those were important milestones on their own. But the argument today is that pad drilling is transforming how the industry “does” oil and gas.
The rapid move to pad drilling and batch completions illustrates that the industry transitioned in 2013 into the resource harvest mode of the unconventional cycle in most of the major unconventional plays. That transition created transformational pressures on oil services. The most visible evidence has to do with the change underway in the US drilling fleet. It is now apparent that newer pad-capable, highly automated technological rigs are displacing older equipment as the preferred tool for doing business. Rather than additions to the fleet, these new rigs are replacing older units in the fleet.
Newbuild announcements for 2014 hover in the low 60s currently and appear well on the way to an order book between 80 and 100 units. Furthermore, that pace should be sustainable for the next half decade, since the math indicates that half of rigs drilling horizontal wells currently are either older electric rigs or conventional mechanical units. The assumption is that newbuild technology rigs will replace upward of 500 older rigs over the next half-decade as the industry settles into the new era of resource harvest and its attendant emphasis on efficiencies.
In the cases of one sector in oil services, the pad drilling move is, in fact, transformational. But what about the E&P side of the equation? Here is where the question gets interesting. Clearly the skill set in a company embarking on a resource harvest model is different than the skill set that pursues a growth-oriented exploration program. The latter emphasizes an entrepreneurial approach; the former favors planning, execution and supply chain management. Harvesting tight formation resources will contribute the greatest share of production volume growth over the next decade. So the question is, how will the publicly held E&P community adapt following its decade-long entrepreneurial scramble to position itself in resource plays?
The previous industry model, anchored in the heyday of shale gas, implied that the operating community would evolve structurally with the majors and their deep pockets, long-term planning and large-scale project management experience gradually absorbing high-flying public independents that blocked up great unconventional acreage on one end of the E&P spectrum. At the opposite end, the master limited partnerships (MLPs) with their superior execution skills would slowly aggregate the remaining conventional acreage. The public independents were therefore facing a squeeze play.
That model appeared to be unfolding as theorized over the past decade as large integrated oil companies amassed significant positions in unconventional gas. When natural gas prices fell, the unconventional euphoria among the major oil companies evolved into major shareholder dismay. Entities like Shell have since written down significant portions of their North American unconventional portfolio in the face of declining production and lower-than-expected free cash flow.
It turns out the majors aren't necessarily any better than the public independents when it comes to outspending cash flow on unconventional properties in a low commodity price environment. The result for several IOCs has been a shift away from capital-intensive unconventional plays and greater focus on resuscitating production and free cash flow.
So what does this model look like now? The transition from exploration to resource harvest may favor a business approach similar to a conventional MLP where basic operating skills become the means to capture efficiencies and reduce costs with an emphasis on execution and cash generation. This approach works well in conventional oil and gas. It may be that a business model focusing on execution comes to characterize the previously entrepreneurial public independent E&P firms in the future.
Stay tuned.
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