Will Capital Allocation Get More Exciting in 2018?

Will Capital Allocation Get More Exciting in 2018?
Will the upward trend in commodity prices prompt more risk-taking?

“Survival,” rather than “growth,” has been a watchword for capital project spending in upstream oil and natural gas in recent years. As a result, industry investment programs have tended to favor lower-risk, less expensive projects.

“Capital allocation was mainly driven by break-even points, stronger re-use of existing equipment and therefore less on expansion projects,” Patrick Brown, partner with A.T. Kearney and co-author of a recent paper on capital projects, told Rigzone.

Oil and gas companies have been playing it safe with capital spending, but within the past year commodity prices have trended upward. Assuming prices continue to move in this general direction, can we expect companies to include riskier projects in their capital allocation plans next year? Based on insights from Brown and Greig Aitken, principal analyst with Wood Mackenzie, a markedly more aggressive capex trend appears unlikely.

Back to a Future Focus

In recent years, upstream companies have focused on “moving as low down the cost curve as possible and high-grading portfolios,” Aitken told Rigzone. “With costs coming down and oil prices stabilizing, the period of ‘survival’ that we saw in 2015 and most of 2016 is over. This year, companies began focusing on the future again – but a future where oil prices may be lower for longer.”

Aitken noted that increased spending in North American unconventionals – particularly tight oil – has contributed to “a small uptick” in overall capital expenditure levels in 2017 and should continue next year. He said the change in exploration and development reflects a shift to “short-cycle opportunities.”

Brown appears to concur with that overall assessment.

“Given the unchanged oil price levels, we do not expect significant changes from capital allocation in 2017,” Brown said, adding that the emphasis on smaller, less risky projects has led to generally unimpressive capital project performance industrywide.

“This is mainly due to the fact that large oil reserves tend to be in remote areas and at times politically unstable geographies,” Brown explained. “Given today’s technology, they also remain difficult and risky to capture – for instance, Arctic and deep-sea. Again, at the current oil price, those projects would often not have positive break-even.”

Stronger oil price development, greater political stability and technological advancements will help the more challenging, costlier projects come to fruition, Brown noted. Nevertheless, he added that more challenging projects in said regions often face another hurdle: the lack of a skilled workforce.

“In addition, oil and gas is not considered as a career choice by many young graduates and large parts of the old experienced generation is going to retire in the coming years,” Brown said.

‘Value Above Volume’

A greater focus on returns and a preference for short-cycle opportunities bode well for tight oil in terms of capital allocation decisions, remarked Aitken. Companies with strong U.S. tight oil positions have been funding tight oil investment by selling non-core assets such as international and U.S. gas holdings, he explained.

“Projects have been re-engineered to bring down costs and generate cash as quickly as possible,” Aitken said. “Capital allocation decisions are focusing on value above volume.”

Aitken also said that questions remain regarding the speed of growth in tight oil given investors’ growing appetite for more measured – and less cash-intensive – growth.

“‘With oil prices having ticked higher, more companies are looking towards share buybacks and increased shareholder distributions,” explained Aitken “Otherwise, companies are promising more of the same – a continued focus on disciplined growth. But if prices remain higher, there is a question over whether companies will remain disciplined or whether there will be a move back to chasing volume growth.”

The emphasis on low costs and quick returns has not been limited to tight oil.

“We have seen in increase in conventional projects taking final investment decision this year – relative to the past two years – but, in line with this mindset of ‘value-based growth,’ the focus has trended towards brownfield/expansion activities rather than greenfield opportunities,” Aitken said.


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