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WORLDENERGY VOL.6 NO.

3 2003 70
T
hree years ago, Barrons Online
wrote: "Wall Street may be
starting to realize that its
difficult for even the largest oil outfits
to generate significant sustainable
growth profits and revenues."
Ominously, the article compared oil
companies today with commodity
producers of chemicals, aluminum or
wood products. Any appreciation in
major oil stocks, it noted, has owed
more to expanding price-to-earnings
(P/E) multiples than to profit growth,
with earnings driven by cost cutting,
not greater oil and gas production.
Since then, the downward spiral
has continued. Major exploration
and production (E&P) stocks have
declined as much as 20 to 30 percent,
despite strong oil and gas prices,
ongoing cost cutting and industry
consolidations. Have the financial
markets finally lost faith in big oil,
scaling P/Es back to those of typical
commodity businesses? To make
matters worse, several large energy
companies have recently missed
their production targets. As a result,
the pendulum is swinging once again,
this time from emphasizing growth in
production to return on capital.
Unless the energy industry wants to
descend into a commodity purgatory,
like paper or chemicals, it needs to
break out of this endless circle.
Id like to suggest a new model
for the upstream E&P industry,
which could avert this downward
spiral and prevent E&P from evolving
into yet another commodity sector
driven by speculation. This model
focuses on value creation through
technical and business innovation,
and is based on the following
observations:
by Robert P.Peebler
President and CEO
Input Output,Inc.
The Downward Spiral
WORLDENERGY VOL.6 NO.3 2003 71
Most shareholder value is
created in the exploration,
delineation and early field de-
velopment phases of the oil
field life cycle, i.e. through
material exploitation activities.
These constitute an E&P
companys core business.
Being a good steward of capital
will be expected of every oil
company, but the materiality
of new opportunities or size of
the prize relative to the size
of the company will be the
primary driver of value apprecia-
tion in the future.
Most E&P companies today lack
stringent enough materiality
hurdles. Therefore, the people
they deploy chase too many
projects to be effective. Eighty
percent or more of a companys
internal staff should be focused
primarily on mission-critical
core activities.
Ownership of proven producing
reserves is a high-cost, low-
margin business. Rather than
monetizing quickly and recycling
cash into higher return projects,
it ties up too much capital in
owning a commodity.
As proven producing reserves
grow, the need to maintain
growing infrastructures diverts
management attention from
corebusiness and into adminis-
tering low-cost, low-margin
"manufacturing"activities.
Rethinking the Core Business
Rethinking what activities are core
to the E&P business is essential to
change. I prefer the definition of
"core" as any activity that could add
substantial value to shareholders
and, ultimately, increase a companys
share price. Through core activities a
company can truly differentiate itself.
"Core competencies," in contrast,
are all activities that a company may
do well. Some of these, though
fundamental to running the business,
will never increase shareholder value.
Poorly executed, they could lower
your stock price. But the market gives
you no credit even when you do them
exceptionally well. These are non-
core. The best strategy is to execute
these efficiently and effectively, but
not to try to differentiate on them.
Unfortunately, most large E&P
companies invest considerable inter-
nal resources in non-core activities,
seriously diluting their focus on core
business. In a typical start-up, some-
thing like 80 percent of activities are
focused on core, only 20 percent on
non-core. In a typical large company,
that ratio is usually reversed. Only
20 percent of all activities are core.
In my proposed business model, the
core activities of an E&P company
should focus primarily on exploration,
delineation, early development and
early adopter phase production
enhancement projects, all of sufficient
materiality to have a significant
impact on future worth. These activ-
ities not ownership and routine
management of producing reserves
will create the majority of a companys
future value. By my definition, once
an asset has matured to the point that
additional exploitation efforts are
unlikely to yield sufficient new
production production that is
material to that companys size and
costs of doing business that asset
can no longer be considered "core."
How, then, does one manage
mission-critical non-core assets
where, for example, you cannot
afford to lose the production? In
these non-differentiating assets, the
company must maintain control but
should disengage its scarce internal
resources. How can that be accom-
plished? Through virtual rather than
vertical integration.
Virtual vs.Vertical Integration
Virtual integration was one of the
most powerful concepts to emerge
during the last decade of the 20th
century. I believe it holds the greatest
potential to improve the way energy
companies organize and operate in
the 21st century.
Fifty years ago, Hollywood produc-
tion companies employed their
own screenwriters, directors, actors,
editors, film crews and set builders.
They even owned theaters in which
to show their movies. Today, they
draw from a vast network of external
talent to assemble "fit for purpose"
movie project teams. Large studios
have evolved from vertically
integrated enterprises to virtually
integrated value chain managers,
performing most functions through
economic alignment of independent
contractors and virtual partners.
They recognize that a company can
execute only a few core activities well.
Another example of virtual inte-
gration is Cisco, a high-tech company
that develops and markets core tech-
nologies while outsourcing most of
its manufacturing to a web of partners.
To interact more effectively with its
partners, Cisco leverages Internet-
enabled information technologies.
In the oil patch, virtual integration
has never really been given the
chance it deserves, especially in the
Unfortunately,most large E&P companies invest
considerable internal resources in non-core activities,
seriously diluting their focus on core business.
WORLDENERGY VOL.6 NO.3 2003 72
aftermath of the "dot-bombs." The
key to success lies in accurately
identifying a companys core activi-
ties, then leveraging advanced
technologies to deal more effectively
with the rest of the value chain
through well-chosen virtual partner-
ships and outsourcing relationships.
To better understand these activities,
consider the four-quadrant matrix
shown in Figure 1.
Mission-Critical Core Activities
Mission-critical core activities, which
should remain in house, include:
Material exploration, delineation
and field development projects
Material exploitation projects in
fields that can add substantial
new reserves and/or production
volumes relative to the size of
the company
Internal technology programs
that can create early adopter
or proprietary advantage in
core activities
Integrated risk/portfolio
management
Core activities, as noted above, are
those that can increase a companys
share price and add significant share-
holder value. One of the primary
drivers of share price is market capi-
talization the markets perception
of a companys potential for long-
term, profitable growth. Why have
large oil company stocks seen little
appreciation, or declined, in recent
years? I believe there are four reasons:
1. First, because oil and gas price
cycles seem to be increasing both
in frequency and magnitude,
the market believes that price
appreciation over time will
be unlikely and that timing of
commodity cycles will be harder
to gauge.
2. Second, company consolidations
and property acquisitions create
little future value unless they
result in material new exploration
and/or exploitation opportunities.
Often, one-time cost reductions
associated with mergers and
acquisitions are offset by declines
in productivity due to more
complex management challenges,
inward focus while sorting out
organizational issues, loss of
corporate knowledge about
acquired assets and risk aversion
created by fears of future job loss.
3. Third, the materiality hurdle for
mergers, or the "size of the prize,"
must be significantly larger as
the size of the company grows.
Will merging two companies
create more new opportunities
than if they were to remain
separate? Unfortunately, these
deals tend to overemphasize
potential cost savings and
underemphasize future value
creation.
4. Finally, the industry focuses
too much on growth by way of
acquisition rather than by way
of the drill bit. With recent high
commodity prices, one would
think that large oil companies
would aggressively reinvest their
huge cash flows in advanced oil-
field technologies that promise
to help find additional reserves,
but this is not happening except
in very high-end projects.
The strategic challenge for the E&P
company of the 21st century, there-
fore, is not how to better manage
its existing business operations, but
how to ensure sufficient mission-
critical core opportunities to support
the growth and profitability targets
required to substantially increase
shareholder value. Organizations must
focus the majority of their internal
resources on the core business while
developing more productive ways of
managing non-core activities.
According to a recent study by
consulting firm Wood McKenzie
(Figure 2), 80 percent of the portfolios
owned by the six largest oil compa-
nies represent only 16 to 28 percent
of total projected value. This suggests
that up to 80 percent or more of
their property portfolios the non-
core assets are not a good place to
invest limited internal resources,
Figure 1: Virtual partners and outsourcing leverage non-core activities.
Organizations mustfocus the majority of their internal
resources on the core business,while developing more
productive ways of managing non-core activities.
Source: Geoffrey A.Moore,Livingon theFault Line
WORLDENERGY VOL.6 NO.3 2003 73
even though, in aggregate, these
assets may still hold enough material
value and remain important enough
contributors to current production
not to divest them yet. Pruning these
tail-end properties by selling some
to smaller firms is still a reasonable
strategy, but it tends to leave a large
portfolio of non-core assets by my
definition.
How much of a typical large
E&P companys management and
employee time and energy are actu-
ally focused on mission-critical
core work? Figure 3 illustrates a
likely distribution of resources. Since
the bulk of assets are non-core and
activities performed in house still
include non-core production opera-
tions and accounting, the majority
of the companys people executives
included are probably deployed on
non-core work. That is the essence
of the value problem in the energy
industry today. Too many decision-
makers are wedded to the belief
that these activities are worthy of
considerable internal effort. Freeing
in-house resources for true core work
will require extensive outsourcing
and partnering relationships that are,
at present, poorly developed.
Mission-Critical
Non-Core Activities
Mission-critical non-core activities,
which I believe should be outsourced,
include:
Routine drilling and completion
operations in core assets
Exploitation activities in
non-core producing fields
Routine production operations
in non-core fields that are
still important contributors to
current production volumes
Geotechnical information
technology infrastructure
development and maintenance
Production accounting
Activities in this quadrant of
the matrix are challenging for most
companies to outsource because
they know that problems here can
seriously impact their base business.
Imagine if Cisco could not depend
on its manufacturing partners to
deliver high-quality products on
schedule. Production operations is
a good example of a mission-critical
non-core activity in E&P. Most
executives of large oil companies
consider production operations one
of their key differentiators. But while
the market expects them to run
efficiently, it is not clear that investors
will pay more for a company stock
just because it has good production
operations.
Thus, one of the challenges facing
the virtual oil company of the future
is how to move beyond standard
outsourcing contracts of the past.
They must begin to form strong
strategic relationships with outsource
partners whose mission-critical
core businesses are excellence in
production operations and other oil
company mission-critical non-core
activities.
Figure 2: The majority of assets owned by the six largest oil companies
accounts for a minority of total company value.
Figure 3: More employees work on non-core than on core activities.
WORLDENERGY VOL.6 NO.3 2003 74
Supporting Core Activities
Supporting core activities, for which
one should engage a partner, include:
External technology partner-
ships that support early adopter
programs
Production operations of core
properties
Supporting core activities are those
that, like the mission-critical core,
are truly key to market differentiation.
The difference is that they require
capabilities that are no longer
feasible for the company to provide
internally. These resources must
come from external partners who
have these capabilities as part of
their own mission-critical core
and are willing to enter strategic
partnerships founded on strong
economic alignment.
The importance of this quadrant
has increased dramatically over the
past decade, as energy companies
have divested many of their internal
technological capabilities. These
now reside primarily in the service
sector of the industry. However, the
culture of most oil companies still
does not lend itself well to building
the partnerships necessary to provide
effective supporting core work.
There has been much lip service
about win-win partnering, but the
current focus on cost control creates
an ever greater chasm between oil
companies and service providers.
I believe the industry is approaching
a crisis in the application of advanced
technologies needed to find and
produce new oil and gas reserves,
largely due to this systemic problem
of ineffective partnering in the early
stages of technology development and
adoption. The supporting core quad-
rant of my proposed business model
will require considerable management
attention, because theseactivities are
fundamental to the health and future
growth in value of every oil company.
Ironically, few oil companies today
seeminterested in makingthis change.
Supporting Non-Core Activities
Supporting non-core activities, for
which one should contract, include:
Back-office IT
Administrative HR
Most accounting
Most legal
While they are not typically part
of an energy companys core business,
in most cases substantial in-house
resources have been committed to
activities in this quadrant. Because
these are areas in which a company
is least likely to gain any competitive
advantage, they are the easiest to
handle through more standard con-
tracts with outside service companies.
The primary objective should be
to obtain the best price and quality
necessary to get the job done
nothing more.
Disengaging from these activities
can be a daunting challenge, because
most companies have invested so
much in gaining internal expertise
and building familiar legacy systems.
Dealing with the emotional and
tactical issues of moving to an outside
contractor can be difficult as well. A
few industry leaders, such as BP, have
made significant strides in the direc-
tion of building appropriate relation-
ships with contractors in supporting
non-core activities, moving the
bulk of these functions outside their
own walls. Although this is work in
progress, I doubt companies that have
made the switch would go back to
traditional ways even if they were
given the choice.
The culture of most oil companies still does not lend
itself well to building the partnerships necessary to
provide effective supporting core work.
WORLDENERGY VOL.6 NO.3 2003 75
The Wake-up Call
Today, most large upstream oil
and gas companies are still on the
"safe" path of growth by way of
consolidation and cost reduction.
Unfortunately for their shareholders
as well as the global economy,
which depends on continually
increasing supplies of energy this
strategy is a zero-sum game. The
wake-up call that current business
models are no longer working can
be heard in oil company share prices
falling or going sideways, even as
commodity prices remain high.
Value creation in the future will
require a much more effective model
in which 80 percent or more of a
companys precious internal resources
are focused on mission-critical
core activities, while economically
aligned strategic partners execute the
supporting core functions. Most, if
not all, non-core activities should be
provided by outsource partners and
contractors who become an integral
part of the new virtual enterprise,
resulting in companies that are much
more flexible and effective and likely
have 50-70 percent fewer employees.
This, I believe, is the only way
large oil and gas companies in the
21st century will be able to reinvent
themselves in Wall Streets eyes,
reverse the downward spiral into ever
lower multiples and unlock substantial
new value for their shareholders.
Robert P.Peebler is president and
CEO of Input Output,Inc.and
chairman of Energy Virtual Partners
(EVP),Inc. Prior to founding EVP
in 2001,he was vice president of
e-business strategy and ventures
for Halliburton Company. Previously,
he had been president and CEO of
Landmark Graphics Corporation
since 1992,and held executive
positions there including chief
operating officer,president of the
seismic products division and vice
president of marketing. Before
joining Landmark in 1989,Peebler
was president of his own marketing/
management consulting firm. He
was also employed by Schlumberger
for more than 18 years in executive
positions,including vice president
of operations for the North America
Wireline Group,and vice president
of global marketing for the Energy
Services group in the New York office
of Schlumberger Limited.
Peebler is recognized as an industry
visionary who has put his unique
ideas into action. He was presented
with the Oil and Gas Industry
Executive Award by World Oilin
October 2002. The award honored
him for breakthrough thinking on
how upstream companies manage
their information. Peebler is a widely
published author and speaker on
information technology trends that
are transforming the exploration
and production industry.
Peebler holds a BSEE degree from
the University of Kansas. He is a
member of the 25-year Club of the
Petroleum Industry,API and the
board of directors of Input/Output.
He also serves on the board of
the University of Houstons Global
Energy Management Institute.
Formerly,he has served on the
boards of directors of Sheltering
Arms Senior Services,Landmark
Graphics Corporation,Drilex
Systems,Inc.,Synetics Technologies
LLC and the Houston Museum of
Natural Science.