Current & emerging challenges in Global Oil & Gas Industry

Introduction When oil prices reached a record high of almost $150 per barrel in July 2008, industry stakeholders recognized that prices would ultimately slip. No one however, predicted the speed or severity of the fall. By January 2009, prices dropped to $40 per barrel. Upstream companies that had committed themselves to higher cost found themselves saddles with unsustainable production cost.

As approval for new projects ground to halt, downstream companies also began experiencing the ill effects of global financial crisis. Natural decline rates in existing field average roughly 7 % globally, which reduces annual supply capacity by approximately six million barrels per day. Post- recession resumption in the massive growth rates in countries like China & India promises to quickly reverse the recent drop in global consumer demand. Cost of regulatory compliance remains set to rise, especially in United States, as it steps up plan to reduce greenhouse gas emission aggressively. Retirement rates in oil & gas industry and talent crunch also are some other key challenges which need to be addressed.

To address these challenges, oil & gas companies cannot afford to be side-tracked by short term trends. They must take a long term view as they tackle their cost cutting and process improvement initiatives. More than that, they must identify viable options either to grow or simply sustain their business – from exploring for new reserves and attracting new talent to engaging in strategic partnership, mergers & acquisition. Through this paper, I have tried to analyse the major challenges which concerns the Oil and Gas Industry in current world scenario


Supply shortages due to Global Economic Slowdown

The oil and gas sector requires tremendous and continuous investment to maintain and grow reserves in the face of accelerating depletion rates from the world’s known oil field. While some international and bigger oil companies have the option to finance the projects and exploration through cash flow, mid-tier organizations, independent and downstream ABHISHEK KUMAR Roll -02 PGDM –IB 2011- 13 Page 2

Current & Emerging Challenges in Global Oil & Gas Industry

providers traditionally rely on debt and equity financing. Although this model has worked to the industry’s benefit for years, the global financial crisis is now taking a toll on companies of all sizes. Tighter credit markets are impelling smaller operators to defer expansion or capital projects, limit development and even sell off assets. In the past few years,some companies have failed to raise enough capital through their IPO due to lower oil prices and lower demand due to economic slowdown1. Forty-three companies from the Commonwealth of Independent States (CIS) have postponed or pulled their flotation this year, said PBN, a consultancy with a focus on Russia and the CIS. While limiting capital investment may placate shareholders in the short term, failure to replace resources can result in insufficient production to meet long term demand.

Despite slower growth, the International Energy Agency still forecasts world primary energy demand increases by one-third from 2010 to 2035, with China & India accounting for 50% of the growth (World Energy Outlook 2012)2. The IEA is calling for an energy supply investment of $ 1 Trillion per year through 2030.

The ensuing supply crunch may further raise the oil prices and threaten economic recovery. In recognition to this dilemma, some countries have introduced fiscal incentives to prop up key industry players. Brazil’s national development bank, committed over US $10 Billion to state –controlled oil producer Petrobras. This followed a similar investment by Mexico’s government in its oil producer, Permex, to fund the construction of new refinery.

Figure i- Source – World Energy Report 2012 ABHISHEK KUMAR Roll -02 PGDM –IB 2011- 13 Page 3

Current & Emerging Challenges in Global Oil & Gas Industry

Figure ii: Source Barclays Capital


High operating Cost leading to Lesser Profits

For oil and gas companies across the supply chain, high commodity prices in recent years translated into more than record profits. They also served to stimulate development of higher cost, unconventional crude and gas resources, which, in turn, pushed up the costs of engineering, procurement, construction, equipment, labour, land and other critical inputs.

As a consequence, when price fell precipitously capital was already committed and cost failed to drop as steeply. In response to lower current cash flows and the projected margin squeeze on new investment, companies around the world have begun to delay and cancel projects.3 According to the Canadian Energy Research Institute; investment in Canada’s oil sand is expected to fall by $ 97 billion in a decade. OPEC also announced postponements of 35 of approximately 150 of its upstream, midstream and downstream projects. Declining production combined with higher operating cost pushed up unit operating cost by 10% to 15% year over year. A

ccording to a report by E& Y4 on oil and gas reserve disclosure information as reported by publicly traded companies in their annual reports filed with the United States (US) Securities and Exchange Commission (SEC), production costs climbed 27%, to $50.9 billion in 2011. The higher cost environment associated with high oil prices contributed to a $5.8 billion increase in lease operating costs in 2011, while the increase in ABHISHEK KUMAR Roll -02 PGDM –IB 2011- 13 Page 4

Current & Emerging Challenges in Global Oil & Gas Industry

revenues resulted in a $3.9 billion increase in production taxes. According to a recent report published by HIS5 on Dec 4 2012, the costs of both building and operating upstream oil and gas facilities continued to rise over the last six-month period—albeit at a slower pace—and have reached record highs, according to two cost indexes developed by IHS (NYSE: IHS). The IHS Upstream Capital Cost Index (UCCI) rose one percent over the Q1 2012-Q3 2012 period to an index score of 230, matching its Q3 2008 high. Its counterpart, the IHS Upstream Operating Cost Index (UOCI), rose to 0.5 percent to a new high score of 190 over the same period.

Figure iii: Source Barclays Capital – Global E& P Spending (Excluding US)

Figure iv: Source Infomine ABHISHEK KUMAR Roll -02 PGDM –IB 2011- 13 Page 5

Current & Emerging Challenges in Global Oil & Gas Industry


Regulatory Complexity

With oil and gas reserves scattered in locations from Russia, the Middle East and Africa to North and South America, industry players must adopt a truly global approach to their operations. Yet, as oil and gas companies expand farther afield, they are subject to variable regulations. Companies must do more than comply with divergent health and safety, tax and financial reporting regimes.

They must also factor in the time and cost involved to obtain permits for an exceptional array of activities, from water and land use to environmental clearances. In the environmental space alone governments continue to mandate improved fuel specifications, limits on industrial emissions and, most recently, caps on carbon production. To gain access to the reserves needed to maintain internal growth and meet external demand, oil and gas executives must continue casting their eyes to new exploration and development regions around the world.

As they do, they will also need to strengthen their capacity to ensure on going adherence to the industry’s ever-evolving regulatory frameworks. In recent years, Foreign Corrupt Practices Act (FCPA) has become a focal point of international energy companies.

Most companies have some level of compliance program to train their employees on FCPA as well as auditing behaviour in the fields. Yet antitrust issue continue to grow in importance as the energy sector relies more heavily on JVs and partnerships that requires sharing of information and cooperation among competitors. In UK Oil & Gas industry, the transfer of regulatory power to the EU is an issue facing many industries in the UK. Cameron’s veto back in December was an audible attempt to protect the City of London from potentially damaging regulations.

The regulatory and reporting landscape is particularly complex for oil and gas companies. Not only do they have to conduct operations in a variety of regulatory and tax regimes but they also have big upfront investment needs, which often go hand in hand with great uncertainty about long-term outcomes.

The geopolitical, environmental, energy and natural resource supply and trading environment, combined with often complex stakeholder and business relationships, adds to the complexities oil and gas companies face. In addition, the advent of International Financial Reporting Standards and section 404 of the Sarbanes-Oxley Act for US registrants has added to the challenges. All of ABHISHEK KUMAR Roll -02 PGDM –IB 2011- 13 Page 6

Current & Emerging Challenges in Global Oil & Gas Industry

this demands careful judgement around corporate governance, internal controls and external reporting. According to a report by Oil & Gas Financial Journal published in July 2012. The second-largest oil company in the United States faced financial reporting challenges stemming from the need to manage version control of financial reports coming from 12 different applications and regularly processing 2,000 different reports.


Talent Shortage

In 2004, the American Petroleum Institute estimated that the oil and gas industry would face a 38% shortage of engineers and geoscientists and a 28% shortage of instrumentation and electrical workers by 2009. In the intervening years, the story has become even more ominous. In North America and Western Europe, industry statistics show that more than 50% of the oil and gas industry’s engineers will reach retirement age by 2010.11 Although similar trends do not prevail in India, China and the Middle East, over the next 10 years, portions of the industry are at risk of losing more than 50% of all their experienced talent.

While one might imagine NOCs to be insulated from these issues, this is not in fact the case. As NOCs look to expand, they are increasingly concerned about attracting, developing and deploying the right resources – particularly in environments where they lack the capacity to terminate unskilled staff.

These trends place oil and gas companies in a challenging situation as they consider responses to the current economic crisis. While some organizations are considering trimming their workforces, most recall the lessons of the 1980s, when a wave of layoffs left companies with significant skills gaps. To avoid similar future outcomes, companies must devise strategies for maintaining access to the talent they need over the long term.

According to Schlumberger Business Consulting6 more than 25% of petro technical currently working for E&P companies are older than 50 years of age and the vast majority will retire in the next five years. This is the generation of professionals who joined the industry during the late 1970s and early 1980s at the peak of the oil and gas expansion cycle. From a quantitative perspective, the total number of autonomous petrotechnicals will decrease by about 6% or 5,000 professionals. This is a relatively small loss that hides a much larger outflow of about 27% or 22,000 of the current pool of experienced petrotechnicals and partially offset by the ABHISHEK KUMAR Roll -02 PGDM –IB 2011- 13 Page 7

Current & Emerging Challenges in Global Oil & Gas Industry

inflow of 17,000 younger petrotechnicals who are reaching autonomy. The tight availability of technical talent will become a limiting factor for growth and eventually a risk factor. As experienced in 2006–2008, the market for experienced petrotechnicals is expected to become extremely tight in the foreseeable future, driving up salaries, and reliance on experienced hires to mitigate staffing problems will become a more expensive and risky proposition. In this context, E&P companies need to adapt quickly and improve talent management policies in planning, recruiting, development, staffing and attrition. The potential exists to accelerate people development.


Mergers and acquisitions

With the world’s markets characterized by on-going volatility, the oil and gas sector has slipped into two camps. On the one side are IOC producers, NOCs, government utilities and other organizations that boast strong balance sheets and secure cash flows. On the other side are smaller producers, independents and downstream providers, some of whom find themselves facing severe cash flow and capital shortages as lenders turn off the taps. ABHISHEK KUMAR Roll -02 PGDM –IB 2011- 13 Page 8

Current & Emerging Challenges in Global Oil & Gas Industry

Bringing these two camps together is a narrow window of opportunity that may spark a wave of industry mergers and acquisitions (M&As). The global oil & gas industry registered a total of 1285 M&A deals in 2007 and 2008 with cumulative value of all these deals standing at USD 578 billion as per data reported by Merger Market. Oil & gas M&A activity in 2008 has seen a sharp decline by about 25% in both value terms and in the number of deals as a result of decreased M&A activity by about 45% in value terms in the Americas, the hotbed of oil & gas deals. As the financial crisis continues, analysts expect different players to join the M&A game.

Majors can boost reserves by acquiring struggling smaller companies with good sized portfolios and by gaining access to unconventional gas resources, at what may appear to be bargain prices. NOCs are showing a growing appetite to expand overseas to address increasing energy demand – either domestically or abroad National gas utilities are looking to strengthen their upstream asset portfolios to secure their gas supply.

And sovereign wealth funds with money in their pockets have already begun buying distressed assets. Due to constrained financing, only the large and cash rich global players are expected to drive M&A over the short to medium term. However, even the larger players are looking to preserve and judiciously use internal liquidity, mainly due to falling share prices. In this volatile scenario, smaller and relatively weak players will find themselves aligning with large players to survive and manage these uncertain times.

Large NOCs and IOCs, by the virtue of adequate product and technology diversification, together with strong balance sheets are better placed to manage prevailing risks such as volatile crude prices, E&P failures and geopolitical uncertainties.

The global financial and economic crisis has also led to falling stock markets and oil prices. The combination of falling stock markets and oil prices is likely to trigger strategic acquisitions and partnerships between large global oil and gas companies and smaller regional or non-core players.


Roll -02

PGDM –IB 2011- 13

Page 9

Current & Emerging Challenges in Global Oil & Gas Industry


Corrupt Practices

Oil and gas companies are no strangers to intense regulatory scrutiny in this area. Since the OECD nations began stepping up enforcement of their anti-corruption and anti- bribery legislation, most organizations have enhanced their anti-corruption programs in an effort to protect their reputations and avoid the significant penalties of non-compliance.

To safeguard these investments, they must ensure their acquisition targets have taken similar measures. If they don’t, they may find themselves acquiring bribery and corruption liabilities they never bargained for In addition to enhancing due diligence when engaging in global acquisitions, oil and gas companies can strengthen compliance by watching out for red flags that may signify questionable payments.

They can also help assure on-going compliance by setting up systems to monitor their employees, sub-contractors, local agents and joint venture partners both nationally and internationally. In 2010, six oil and gas service companies and a prominent freight-forwarding company agreed to pay about $236 million in criminal and civil ABHISHEK KUMAR Roll -02 PGDM –IB 2011- 13 Page 10

Current & Emerging Challenges in Global Oil & Gas Industry

penalties in one of the largest corporate bribery cases ever to focus on a single industry.7 according to a news published in New York Times in Nov 4, 2010. In February 2012, the Securities and Exchange Commission (SEC) charged three oil services executives with allegedly bribing customs officials in Nigeria to obtain illicit permits for oil rigs in order to retain business under lucrative drilling contracts.

More recently, several companies faced investigations involving alleged improper payments to customs officials in Kazakhstan. And these are not the first times the oil and gas industry has been under the scrutiny of regulators. Some of the largest enforcement actions under the United States Foreign Corrupt Practices Act (FCPA) have involved energy companies, including one against Italian oil and gas company Eni S.p.A. and its Dutch subsidiary Snamprogetti Netherlands B.V. that resulted in a $365 million penalty in 2010.3 Regulators have also pursued cases against oil service companies and industry providers. In short, now is the time for companies in the oil and gas industry to examine carefully the landscape of risks they face—and take the appropriate steps to mitigate them.


Market access limited by resource nationalism

Business and politics have always made for strange bedfellows. That’s particularly the case in the oil and gas industry. In the late 1990s, when oil prices were at record lows, governments around the world opened their borders to foreign companies in a bid to attract the infrastructure investment and technological advancement required to extract their resources, but as oil prices escalated, however, many countries began singing a different tune.

To lock up a share of the wealth generated by the oil and gas sector, many producer states set up nationally-owned oil companies. Today, NOCs control access to approximately 75% of the world’s proven conventional resources.8 At the same time, governments introduced fiscal measures targeted at energy companies.

In Canada, Alberta’s government increased royalty rates for oil and gas producers in late 2007. Similar royalty programs, as well as bans on domestic drilling, exist in the U.S At the other end of the spectrum, countries from Russia and Kazakhstan to Algeria and Bolivia tightened their grip on oil reserves by renegotiating ABHISHEK KUMAR Roll -02 PGDM –IB 2011- 13 Page 11

Current & Emerging Challenges in Global Oil & Gas Industry

contracts with the private sector. In addition to taking control of national assets, Venezuela threatened to nationalize private projects if oil majors failed to comply with its new rules. For its part, Ecuador took steps to award its refinery projects and the development of new fields exclusively to state-owned partners.

Also countries like South America is witnessing challenges to its oil and gas industry growth due to resource nationalization policies in major resource rich countries. Stringent, yet uncertain fiscal regulations and over protection of their hydrocarbon resources have made countries like Venezuela and Bolivia unattractive investment destinations.

Figure v: Source: World O & G Review 2012 eni spa – Reserve by Cluster of Companies


Reserves are getting harder to reach and extract

Oil and gas companies that fail to renew their resources on a continuous basis will suffer diminishing market values and eventual obsolescence as their reserves run dry. For their part, NOCs of producing nations must exploit their hydrocarbon reserves as efficiently as possible to meet national goals. For IOCs and NOCs of non-OPEC, importing nations, this means ABHISHEK KUMAR Roll -02 PGDM –IB 2011- 13 Page 12

Current & Emerging Challenges in Global Oil & Gas Industry

access to resources is quickly becoming a critical challenge. As the IEA states in its World Energy Outlook for 2008, oil and gas will remain the world’s main sources of energy for many years, even under the most optimistic assumptions about the development of alternative technology. Nevertheless, a significant proportion of the earth’s remaining fossil fuels exists in more difficult-to-extract form (e.g., the oil sands of Canada and the heavy oil of Venezuela’s Orinoco belt), with high levels of contaminants (e.g., sour reserves in the Middle East) or in difficult-to-reach places (such as the deep Gulf of Mexico, Far Eastern Siberia or below the Arctic).

Given the geological and technical implications of both extracting and refining this oil, many non-Middle Eastern companies are waiting out current market conditions rather than investing in projects that are economically unviable in today’s environment. Over the longer term, however, producers must create a business case for drilling in harsher climates and extracting non-conventional and “difficult” deposits.

Midstream and downstream operators will also have to make necessary investments to upgrade existing refineries, lay new pipeline and engage in other infrastructure renewal projects. Very likely, this activity will significantly push up oil costs. Many oil and gas executives agree. In a study sponsored by Deloitte LLP (United States), Oil & Gas industry group, 56% of senior executives at large petroleum companies said they believe the world would run out of reasonably priced oil in the next 50 years, which partly explains the urgency around the development of alternative fuel sources.9


Health and Safety Concern

Ever since companies first began drilling for, storing and transporting oil and gas, the risks of accidents have been a concern. Fire, explosion, release of gas and structural failure all have the potential to cause major loss of life. They can also result in severe environmental damage. Legislation is in place around the world to minimize the hazards related to the operation of onshore and offshore installations, wells and pipelines.

To protect their workforces and avert the negative publicity of serious accidents, oil and gas executives continue to place incidentfree days at the top of their agenda. Yet risks remain. Between 2006 and 2008, the UK’s Health and Safety Executive was involved in 1,042 incidents in the North Sea oil and gas ABHISHEK KUMAR Roll -02 PGDM –IB 2011- 13 Page 13

Current & Emerging Challenges in Global Oil & Gas Industry

sector alone. The Deepwater Horizon (Macondo) disaster of April 2010 continued to cast a long shadow over the industry throughout 2011 and is likely to do so in 2012 and beyond. Deepwater Horizon also gave rise to a number of investigations and reviews at national and international levels and those reviews reported and made recommendations during 2011.

As industry infrastructure continues to age, cost pressures grow and workforces operate in more isolated locations, companies will need to continue to grow their investment to maintain the highest standards of health and safety. They must do so not only to protect their people but also to attract much-needed talent to a challenging industry.


Carbon reduction targets rise in prominence

Since U.S. President Obama announced his intention to cut carbon emissions back to 1990 levels by 2020, all eyes have been turned to the oil and gas sector. While traditional extraction produces comparatively fewer emissions, non-conventional extraction, refining and the final consumption (i.e., combustion) of hydrocarbons are significant greenhouse gas (GHG) contributors. According to the IEA’s World Energy Outlook 2008, energy-related carbon dioxide emissions are set to increase by 45% between 2006 and 2030, reaching a total of 41 giga-tonnes.

Three-quarters of the increase is expected to arise in China, India and the Middle East, with a full 97% taking place in non-OECD countries. Given these statistics, some industry stakeholders argue that oil and gas companies can play only a small but important role in the reduction of GHGs. This can prove to be a dangerous stance. Already, the viability of some companies may be threatened as countries work to wean themselves off their hydrocarbon habits. In a bid to enforce stricter automobile emission standards, California is seeking a waiver to restrict the sale of energy whose extraction produces excessive GHGs, such as reserves from Canada’s oil sands.

Thirteen other states have indicated they will follow suit. Admittedly, this stance may simply serve to shift demand towards natural gas or alternative sources of oil, but only time will tell. Even companies whose products are not legislated out of existence face mounting challenges, including long waits for environmental clearances, more limited access to capital and on-going complexity in their attempts to comply with disparate, and increasingly onerous, global regulations. To ABHISHEK KUMAR Roll -02 PGDM –IB 2011- 13 Page 14

Current & Emerging Challenges in Global Oil & Gas Industry

tackle these issues, oil and gas companies must continue developing plans for addressing climate change – both within their organizations and in collaboration with various levels of government. Some of the key International Climate change milestones are listed below:

The UN Framework Convention on Climate Change (1992) • Committed all signatories – includes the US, China, and oil exporters, to ultimate objective of stabilizing atmospheric concentrations of greenhouse gases at levels that would prevent ‘dangerous’ human interference with the climate system. The Kyoto Protocol (1997) (not ratified by the US) • Most countries agreed targets adding up to 5% reduction from 1990 by 2012. • Clean Development Mechanism (CDM), countries could meet part of their reductions by buying credits created by investing in developing countries (China had most investment).

• Fund for adaptation, financed by revenues from the CDM. • Mechanism for transfer of technology. Bali Action Plan (2007) • Addressed political issues: common but differentiated responsibilities, special position of developing countries, funding, technology transfer and capacity-building, dealing with adverse consequences of responses. • Reduce deforestation etc. (REDD). • Developing countries to prepare Nationally Appropriate Mitigation Actions – for support from rich countries. • Efforts to include developing countries (with different obligations). Copenhagen agreement 2009 PGDM –IB 2011- 13 Page 15


Current & Emerging Challenges in Global Oil & Gas Industry

• Main emitters (including US, China) to ‘Pledge and Review Policies andMeasures’ for 2020–30. Cancun agreements (2011) • Target 2°C ceiling for warming. • Reduce deforestation and degradation (REDD and LULUCF). Durban Convention (2011) • Kyoto agreement to extend beyond 2012: but Russia, Japan and Canada will not participate. • By 2015 negotiate ‘outcome with legal force with commitments for developing countries’ from 2020. • Confirm $100 billion annual target for funding adaptation and mitigation (Green Climate Fund).

5. Conclusion

No one disputes that oil and gas companies are facing endemic challenges. Low oil prices, combined with the risk of resource nationalism and harder-to-access resources, are constraining growth across the sector. At the same time, companies face rising costs to sustain operations, comply with evolving regulations and meet swelling demand for alternative energies. In light of these circumstances, many companies will need to undertake some painful transitions and identify creative approaches if they hope to thrive into the future.

To forestall current challenges and position for long-term success, top-performing oil and gas companies are already adopting best practices, including a rigorous and relentless approach to capital cost management by focusing on cash preservation and negotiating supplier concessions, robust performance management processes, technological innovation, building alliances and strategic Collaborations.


Roll -02

PGDM –IB 2011- 13

Current & Emerging Challenges in Global Oil & Gas Industry

6. References1) Russian IPOs fall dramatically amid credit crisis, Wall Street Journal, Oct. 2, 2008 2) World Energy Outlook 2008, International Energy Agency, Paris. Pp. 77. 3) Claudia Cattaneo, “CERI Warns on Alberta Oil Sands Investment.” Financial Post February 5, 2009 4) US E& P Benchmark Study by Ernst & Young June 2012

5) Cost of Building and Operating Upstream Oil and Gas Facilities Reach Historical Highs Tuesday, December 4, 2012 in HIS-