The End of Hard Oil

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The Era Of Easy Oil Is Over – The Hard Oil Era May Be Over Too

In the late 1990s, a strategic concept arose in the oil sector – the Era of Easy Oil was over for the International Oil Companies (IOCs). It largely turned out to be an accurate assessment – by the early 2000s Easy Oil access was effectively ruled out for these firms.

Today, the replacement Era of Hard Oil may also be coming to an end, with various implications for many oil firms.

Easy Oil first. The theory was simple enough – by century end the huge private oil fields discovered and developed in the 1960s, 70s and 80s were largely depleted, with the remaining giant basins – mainly in the Middle East – owned exclusively by state oil companies.

Slowly but steadily, this led to IOCs having to discover, extract and develop oil and gas from fields in increasingly frontier locations, and requiring increasingly complex technology. To add to this, there was the further complication of needing to do this rapidly to replace the depletion of existing reservoirs – almost all firms having set ongoing production growth (and hence revenue) targets.

For the past decade, the menu of hydrocarbon growth options available to international oil firms typically looks like the following:

  • Arctic Oil
  • Oil / Tar Sands
  • Shale gas
  • Tight Light Oil
  • Ultra-deepwater / High Temperature / High Pressure
  • LNG
  • Coal Seam Gas
  • Gas to Liquids

Most of these, as some of the names suggest, require innovative and novel engineering, commercial and logistical requirements to be viable. Compare this with the portfolios of Saudi Aramco or the National Iranian and Iraqi Oil Companies – an array of vast and well-studied onshore or near-shore oil and gas basins, all in their home country.

Clearly oil and gas is not a manufactured product commodity that works with normal supply-demand forces. The most sophisticated and experienced manufacturers have to produce it in increasingly complicated arenas, whilst the holders of the easiest-to-mature resources are beset by politics and conflicts that disrupt development.

And unlike most complex manufacturing processes, the resultant product cannot be differentiated in any significant way irrespective of its cost to produce – all firms in this market are price takers.

The final strand of the “End of Easy Oil” argument is that, with marginal oil and gas so difficult to produce, there must be a long-term trend toward higher pricing to buttress these high-risk investments.

This is where the logic fails, and its failure mode is crucial to understand what may happen next in the industry.

The “high cost to produce forces high price future oil” argument is based on several foundations. It presupposes an ongoing scarcity of oil and gas, the ongoing requirement for more demanding engineering solutions to access it, and the dearth of any competing (and lower cost) energy source in the near to medium term.

The scarcity of oil and gas molecules is mainly a function of the concentration of the largest oil fields in a problematic political geography – not an intrinsic natural limit. As some of these large fields are exhumed via political change, and come back into production, so oil and gas supply can start toward surplus. The scarcity is largely man-made and can be so altered.

More demanding engineering solutions are indeed required for IOC field developments – but this is not a feature of the industry in general. In the last five years the largest six IOCs have spent collectively over $600-700bn to purely maintain flat production levels – ie zero net increase in global oil and gas output. At the same time the relatively straightforward engineering fracking technology applied in the onshore US, in some of the oldest hydrocarbon basins recorded, have created an extra 5 million barrels per day of oil and gas – the equivalent of creating an ExxonMobil and Chevron from scratch.

But still, the era of Hard Oil can be argued to determine higher future pricing. This follows simple arithmetic: the loss in production from cancelled Hard Oil projects eventually creates a future gap that sends prices upwards to allow producers to invest in high cost projects to increase supply. How long this takes is debatable, it depends on Mid East politics and the appetite for shale oil producers to pile on debt, and so on. But it happens.

This also presupposes that the final element of the Easy Oil case holds – that no alternative energy source emerges to fill future gaps. This may not be correct either.

The industry has been caught out by this paradigm very recently – it did not foresee the growth in shale oil and gas, a gradual subtle addition of 6% to global volumes that caused prices to fall over 70% in 12 months.

Similarly, the growth in power capacity from wind and solar and other renewables outpaced traditional oil, coal and gas fired alternatives for the first time in 2013-14, with the US and China again notable investors. Growth in battery storage technology, and load optimizing software from EU experience is also making the stability of power generation from these technologies viable. Other technologies such as electric vehicles, plus general efficiency and global decarbonisation policy measures are likely to dim demand growth. All of these could render future supply gaps smaller then expected, and keep prices low.

One can debate on the pace and impact of these changes. What is key though, is that a return to the Hard Oil Era engineering model may not be sustainable even if prices rebound. It may now just be too inefficient and risky, and needs to make way for a new performance model of energy development.

Why? The past decade has shown that the frontier engineering model that the Hard Oil era requires is very inefficient, and does not produce any real net gains in energy supply (oil plus gas). By definition it is very high risk, at the edge of industry abilities, and so prone to very larger errors.

Even at greater than $100/bbl the industry could not make a variety of projects viable. A plethora of industry papers indicate that the vast majority of frontier or mega-projects, maybe more than 80%, do not meet cost or schedule targets, and most of those exceed them by a distance – typically over 60%. At this point, most analysis then goes on to suggest that the industry is therefore wasteful, and needs to adopt, for example, better standardization and lean manufacturing techniques, and more technical innovation to improve this performance.

However, the evidence could also indicate that the performance on these projects is a feature of frontier engineering, and not a bug. It’s not that big a stretch of reasoning to assume that very high complexity engineering projects will tend to have a chronic cost and delivery problem against hopeful targets – so much so that the condition even has its own behavioural science label – optimism bias.

Any IOC pursuing a largely frontier engineering strategy will by definition have a portfolio of technically demanding, geographically disperse, and politically testing projects. None of these features easily lend themselves to low-cost, standardized solutions – the converse of the shale plays in the US, where rapid efficiency gains are nurtured in a medium-tech, scaleable environment with a mature commercial jurisdiction.

A frontier engineering strategy is exposed to relatively high supply chain costs (see post Oil Price and Industry Costs), which may be negotiated down to some extent. But along with the straightforward direct input costs of material and labour will be the “softer” costs of managing and coordinating a highly distributed set of supply chains in various countries, with projects and partners harbouring a range of priorities and schedules. None of these characterizes the ability to develop scale, scope and repeatability effectively. Even where sub-scopes, or indeed full scopes of projects, may be repeated, the wider complexity of frontier projects – local content, JV requirements, mobilisation and frontier-establishment investment and so on – reduce or remove the absolute cost improvements achievable.

Put simply, these Hard Oil projects resist the ability to move down typical manufacturing learning curves, and managerial and leadership teams often have to rely on empirical knowledge or develop new procedures themselves. Indeed, no senior executive team in any IOC has broad-based frontier project delivery experience, which makes the firms then further prone to major errors in terms of project selection and execution. The evidence of the past ten years point to exactly these issues.

And these effects are very important – they indicate that frontier-based project portfolios have a natural resistance to cost improvements. Further, they do not lend themselves (easily) to centralization efficiencies or standardization programs. Worse, IOCs who dabble in or try to offset these deficiencies with a limited set of central initiatives may also end up deceiving themselves, and move rapidly into a deep, optimistic, mix of high-risk engineering projects with a resultant unsustainable cost base.

Whilst frontier projects may need to be a part of any IOC asset-base, a portfolio too rich in these will likely remain very high cost in relative terms, irrespective of the actual oil price. They will be continually prone to significant capital over-run, and unlikely to produce stable top line production growth.

IOCs and Independents therefore need to be absolutely honest about the cost nature and extent of their frontier engineering projects – and manage portfolios accordingly, to avoid the trap of assuming costs can be brought under control, when structurally this may not be feasible.

What does this suggest for the future?

A recent FT article painted the relatively bleak options open to large IOCs – and many companion articles suggest nightfall is coming on the traditional model.

What is clear is that IOCs need to recognize that the cost structure of a dispersed and frontier oil project portfolio will never be the cost leader in the industry. They need to be honest and transparent about this, or endless window-dressing attempts at overcoming this fact will cause them to be consistently out of position in the industry whenever oil prices deflate.

The following simple grid indicates the issue –

Slide1

Without a price rebound, any portfolio not adjusted toward a simpler, leaner engineering scope will likely be rapidly unsustainable – break-evens at close to $80-100/bbl are no longer practical.

Even under a price rebound scenario, any IOC pursuing a frontier-rich scenario still runs the risk of being continually exposed to lower cost energy alternatives – they will remain a high cost producer of a commodity in which they are a price taker.

What does that suggest in terms of actions for IOCs and other players to pursue beyond an era of Hard Oil?

Taking the engineering and cost view, it requires a shift in the risk portfolio from frontier-biased, to a broader portfolio mix. This may mean lower profits, and more utility style returns. For a large energy corporation, this is not necessarily a negative outcome. But switching efforts into more cost-effective scopes or portfolio combinations could improve profitability – as frontier projects inherently produce more volatile results and risks of impairment and so on.

At a time of energy price volatility and energy landscape change, there are also other features of portfolio change that can be pursued – from the obvious, to the more step-out:

  • Review the current portfolios using an engineering lens (descope, re-scale, re-phase) or a commercial view (farm-out, renegotiate, exit). In all of this, painfully honest assessments are required, as well as a consistent target of overall production growth.
  • Asses the ability to merge portfolios with lower cost and simpler players: but note that the cultural and skills base may not match, plus various processes eg lean versus customized, preferred standards, level of review and so on – may not mesh. Recent industry history suggests this option has not been successful, but that does not preclude it.
  • Take a broader value chain analysis – remove the portfolio bias from solely engineering and construction to include critical assets eg terminals, end-use supply or trading. Again, this is a switch from core expertise, and is therefore higher risk. But it allows a broader definition of portfolio to potentially emerge.
  • Set a Renewables agenda – even if the plan is to not have one. Five years ago taking a position or not on shale oil would at least have caused IOCs to prepare for its growth proactively. Again with renewables – is the strategy to be an active participant or a non-player; why, and what are the implications?

The era of Hard Oil may compare with the Concorde exit in the airline industry – a structurally high cost product rendered obsolete as many lower cost substitutes became more acceptable. Industry technical skills need to switch to more efficient methods of growth and energy supply, and the industry needs to admit to itself that is has high structural cost profile that cannot be removed with a limited set of standardization and simplification initiatives.

Instead, it will require a broader transformation of skills and capabilities toward cost engineering and leaner scopes, rather than constantly pursing only the edges of innovation, and initiating piecemeal standardization agendas.

More widely, this is a positive development, replacing high-risk, uncertain and slow energy development with a smaller, leaner set of energy growth portfolios, across a range of technological solutions.

The Era of Hard Oil is therefore likely to end relatively soon – the quicker the industry embraces this, the quicker it can take full part in the new energy era ahead.