Analyst: Oil and Gas Taking Page from 'Big Pharma' Playbook

Analyst: Oil and Gas Taking Page from 'Big Pharma' Playbook
What do the oil and gas industry and 'Big Pharma' have in common these days?

Activity in the oil and gas industry has been picking up, but there are signs that companies continue to emphasize financial discipline and maintain cost-reduction efforts begun during the latest downturn. Such steps might reflect a broader trend toward improving long-term value for shareholders, and oil and gas firms striving toward greater capital efficiency appear to be paralleling the approach of companies collectively known as “Big Pharma,” according to an analyst with Meketa Investment Group.

“Large pharmaceutical companies have increasingly outsourced early stage drug discovery and [research and development] to smaller niche companies that have demonstrated greater success in advancing products through development and clinical trials in a more cost-effective and timely manner,” said Gerald Chew, principal with Meketa. “Within the oil and gas industry, new and independent oil and gas companies are leading much of the innovation, developing efficiencies, best practices and technologies that are resulting in improved oil and gas exploration, operations and processing.”

According to Chew, a “misalignment between shareholders and company management” that diminished shareholder value was evident during the previous growth period in the oil and gas business cycle.

“Corporate compensation plans that primarily focused on production and reserve growth helped foster a ‘growth at all cost’ mentality and the development of high-cost projects that are only economically viable in a high commodity price environment,” Chew explained. “The surge in supply created an imbalance with demand, resulting in significant amounts of hydrocarbons held in inventory.”

What sort of changes might we see in the oil and gas industry should it continue applying a Big Pharma-esque approach be? Read on for Chew’s insights on that and other questions.

Rigzone: Is there anything particularly different about the most recent downturn, compared to previous peaks and valleys in the oil and gas business cycle?

Chew: The oil and gas sector is very cyclical, with various supply and demand factors influencing hydrocarbon prices. The most recent downturn was primarily affected by lower than expected global demand for oil and significant increases in supply driven by U.S. unconventional production from the shale revolution. Oil held in inventory and storage reached record levels and resulted in an oversupplied market. Whereas in the past OPEC would have typically intervened with a coordinated supply response to bolster prices, inaction by the cartel exacerbated the oversupplied market and kept prices lower for longer. The severity and longevity of the downturn led to significant cost reductions and improved efficiencies across the industry, forcing those unable to adapt out of business.

Rigzone: What’s unique about the current recovery?

Chew: Relative to prior cycles, the removal of oil export restrictions and the significant buildout of liquefied natural gas facilities along the Gulf Coast are expected to transform the U.S. into a major energy exporter and reduce the reliance on foreign oil. Production from the Permian Basin is becoming increasingly important to supply global demand, as large-scale exploration and development projects with long lead times have been shelved or placed on hold.

However, the pipeline systems transporting the oil and natural gas from the Permian to market are becoming capacity constrained. While there are several projects in development to alleviate the capacity concerns, the market needs to be cautious of overbuilding its midstream infrastructure. Additionally, operators should not solely rely on the recent oil price increases when exploring and developing projects and continue to focus on cost reductions and operational efficiencies.

Rigzone: What sort of changes might we see in oil and gas industry operations if more companies emphasize long-term shareholder value instead of “growth at all cost”?

Chew: Significant shareholder value destruction occurred across the upstream energy industry over the past years stemming from excessive use of leverage, pursuit of higher-cost projects and inefficient cost structures. Compensation plans that focused on reserve growth with little regard to acquisition, development and operational costs helped create a misalignment between management and shareholders.

In an effect to improve long-term shareholder value, companies have focused capital on their core assets, selling off non-core projects and reducing overall leverage positions. Cost reductions, drilling efficiencies and improved processes continue to drive down the finding, development and operating costs and improve hydrocarbon recoveries of oil and gas projects.


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