In Oil, Bigger Isn’t Always Better
Forty years ago, British economist E. F. Schumacher wrote that “Small is Beautiful” in a famous book by the same name.
The vision championed market approaches that discounted the importance of size to results, a philosophy that contrasted the notion that “Bigger is Better.”
In bringing the idea of his teacher (Leopold Kohr) to a broader canvass and a wider audience, Schumacher began a debate that has revolved around the impact of technology and market size ever since.
Just last weekend, the debate renewed.
Again it was an English environment, but the subject matter would have been quite unexpected only a few years ago. This time the occasion was our annual energy consultations at Windsor Castle outside London. The debate focused on both size and profitability of oil companies in the development of new fields.
The key lesson: During expanding times in the oil business, like today, small is not only beautiful.
It is also profitable.
And it can be for you if you take the time to learn why…
Why Bigger Isn’t Always Better
There is a growing recognition that how big a company is no longer automatically determines profitability. In fact, if current trends are any indication, the combination of operating costs, field specifics, and market potential may actually be gravitating against the bigger players.
Traditionally, size has determined the impact of an oil company. For much of the past 40 years, majors have attempted to gain dominance by expanding operations. This attitude fueled many cycles of mergers and acquisitions.
The M&A activity would focus on developing vertically integrated oil companies (VIOCs). These expanded corporations would oversee operations from the wellhead, through transport and midstream to refining and retail distribution.
The idea appeared straight forward enough.
If the same corporate structure would control major stages in production, processing, and sales, it could maximize return by applying transfer pricing rather than market pricing.
Simply put, moving volume from one part to another of the same enterprise would allow for cheaper costs “within the family,” rather than requiring arms-length deals between two genuinely unrelated providers.
Becoming bigger, therefore, was regarded as a more direct route to improving bottom lines.
However, this began to wane with the rise of two factors.
The first resulted from the increasing costs of new large field projects. The second arose as the vertical companies began experiencing declining efficiency.
The structure of these new huge companies would dictate that they focused upon projects having enough size to justify the carried overhead. In the case of the former factor, therefore, costs would escalate as production dimensions increased. The biggest companies could only pursue the biggest projects. Increasingly, field development would end up being pursued by joint ventures comprised of international majors, each in its own right a VIOC.
In the case of the second factor, the mega companies began experiencing performance problems, introduced by the attempt to provide all major elements in house. That eventually led to the big boys shedding some units, noticeably in OFS. Today, there is not a single VIOC that still does its own field preparation, drilling or well completions.
Two Factors to Consider
With the majors selecting the largest fields and delegating preparation, transport and distribution to others, a new dynamic is emerging in the business. The biggest VIOCs, such as ExxonMobil (NYSE: XOM), BP (NYSE: BP), Royal Dutch/Shell (NYSE: RDS-A), or Chevron (NYSE: CVX), are obliged to focus on the largest fields.
But two factors are opening up opportunities for non-majors.
First, the need to maximize field volume to justify size is leaving more promising fields below the threshold at which a VIOC can have an interest. Even when a major will emphasize a significant basin, more of the field prospects within are relegated to other companies.
This is a result of estimated reserve figures in otherwise promising locations becoming unattractive to large company overhead considerations. Production over cost is not enough. The size of the volume extracted is also decisive.
Second, we are finding more of the fields discovered are smaller in size, containing oil that is heavier, having higher sulfur content (sour crude) or impurities, or presenting geological and reservoir problems. These factors merely add to the size problem in discouraging the bigger operators.
When combined with the move in many parts of the world to unconventional tight (or shale) oil requiring fracking and more expensive horizontal drilling, the universe of what projects become legitimate for the VIOC becomes limited to onshore and offshore mega fields.
Leverage Still Remains Critical
Now there are still enough of those for the majors to pursue.
For example, while the likelihood of multi-billion barrel onshore fields is declining, most estimates now believe the bulk of conventional oil remaining worldwide will be found in deepwater large fields.
However, the locations for much of both conventional and unconventional oil onshore now increasingly appear to be in fields below the interest of the biggest players.
That is providing a profitable opportunity for well-managed, experienced, and focused smaller producers. These companies tend to develop basins with which previous projects have made them familiar. In the process, both production success and profits for investors have resulted.
There is one caveat to all of this. These smaller companies often have less leverage or ability to withstand prolonged declines
in crude prices. In a protracted downward market, therefore, such as the one experienced from the third quarter of 2008 through just about all of 2009, they become prime candidates for takeover or are forced to curtail significant portions of work.
Near term, that is not the situation facing us.
Crude prices will be moving up as the recovery gains footing in the U.S. and a bit later in Europe. That movement will intensify as we move into the summer.
Additional production must come on line. That will set the stage for some nice investment returns from smaller but well positioned companies. Such companies provide two advantages to the investor – they provide return while also becoming takeover targets for the majors.
We’ll be talking more about specific companies as these opportunities arise.