Are vertically integrated oil companies doomed?

McKinsey study cites competitive shifts,
and how companies can revitalize

William Furlow
Technology Editor

• Rejuvenating integrated oil companies [85,396 bytes]

The heyday of the vertically integrated oil company may be over, concludes a recent study undertaken by McKinsey & Company and published in a recent house publication. Taking its place is a new generation, a group of companies it calls 'petropreneurs,' independent companies that are tightly focused and vertically specialized. These new companies are creating shareholder value by putting the emphasis not on size, but on their deal-making skills.

The growth numbers seem to support the argument that these smaller, specialized companies are able to adapt and grow faster than the majors. The McKinsey study points out that the majors have grown by only 2% on average per year for the last five years. Over this same period, the petropreneurs have experienced an average annual growth rate greater than 20%.

These petropreneurs operated in specialized niches where a smaller company is able to gain a competitive advantage over a major company. McKinsey sees this as an overall trend in the industry which it labels 'atomizing'. The report emphasized the advantage of having strategic insight and foresight, and noted that traditional advantages enjoyed by the majors such as structural position, size, vertical integration, and legacy assets are no longer an advantage.

Growth: real or not

This trend is beginning to manifest itself in the US, but McKinsey said it is beginning to be seen in other markets. While the majors are heard dismissing such upstart companies as enjoying unsustainable growth, McKinsey said the growth is real and points to a new paradigm in the market. Although these companies represent no more than 5% of the industry's market capitalization, they have enjoyed the majority of its growth.

As with much of the new growth, the US economy is experiencing, part of the petropreneurs success can be attributed to new technology. The commoditization of technologies such as 3D seismic, subsea completions, floating production, storage, and offloading, and horizontal drilling eat away at many of the advantages the majors have relied on to stay ahead of the game. If everyone bidding on a lease, for example, has access to a vendor with quality 3D seismic information on the land, then such technology is no longer an advantage to any one company.

Leveling the field

Consultants, service/engineering, and construction companies with knowledge of best practices and benchmarks have leveled the playing field and thus decreased the advantage of this type of functional excellence. Other areas where leveling is taking place are:

• Costs for majors and petropreneurs have become very similar.
• Risk management is another area where the traditional advantage of being big is starting to drop off.

Major integrated companies, simply by virtue of their size and pocket book, were able to hold large diversified portfolios that helped them hedge against risk. However current strategies such as establishing alliances, securitization, and derivatives are seen as a more effective risk management strategy than the traditional methods of internal diversification.

When the majors focused on vertical integration there was still an advantage to such a structure. But, with the collapse of official oil prices, the deregulation of natural gas markets, and a rapid expansion of the liquid spot market in the late 1980s, this new market destroyed much of the value majors were realizing from their integration, particularly in areas of upstream exploration and production and downstream manufacturing and retailing.

The advantages for the petropreneurs are many, once entities such as exploration and production, for example, are no longer considered as single businesses. If what was traditionally considered a single business is now thought of as an industry, it becomes obvious how a company focusing on a handful of each industry's most profitable areas could far exceed the profits of a major forced to address the petroleum industry as a whole. The petropreneurs can not only decide which sector of the E&P universe to participate in, but how they will compete in each phase they select.

These smaller companies seem to prefer acquisition to investment as a means of entering the industry. The companies buy up non-strategic assets from the majors. According to McKinsey, the majors sold $13 billion of such assets in the five years preceding 1995, of which the petropreneurs bought almost $7 billion.

Build and innovate

By buying up what the majors divest, petropreneurs can get a toehold in the market which they exploit through traditional means, for example, 'build and innovate.'

Once an independent is able to enter 'the deal flow,' the company looks for discontinuities in the market and exploits these to develop a new way of competing.

As examples, McKinsey cites Apache and Parker & Parsley, which took advantage of the majors' withdrawal from the US E&P market and the emergence of innovative financing and risk management products (such as long-dated gas swaps) to buy properties and create economies of scale in areas including the Anadarko Basin and Sprayberry Trend.

Ownership of these basins was fragmented prior to the companies taking their position in the markets. This broad presence in the basins gave the companies a cost advantage. This advantage, coupled with their skill at making deals, allowed them to step in as the natural owners of assets that the majors shed when the industry matured and oil prices fell.

Once these companies develop their niche, they roll it out, using the same successful strategy, coupled with new gained experience, to make profits in new geographic areas and markets. This can put a strain on smaller, more specialized organizations because such an expansion requires that they add to their skill base.

Skills, not assets

While these petropreneurs will have to develop a wider range of specialized skills, it is primarily their core skills and capabilities, not assets or a structural position, that gives them strength. These new skills have overtaken the traditional advantages that made the majors so powerful.

Now, it isn't how much a company has in assets, but how good its people are at deal-making skills such as building alliances, making acquisitions, managing risk, and other skills associated with growth. The majors don't develop these skills as readily as the independents because they have not traditionally needed them.

Some of the majors are beginning to catch on and are attempting to restructure themselves into autonomous units that are centered on key assets. Others are strategic alliances, but these efforts cannot compete with the focus and drive of these smaller upstarts.

The only strategy that will allow the majors to participate in this new marketplace, and possible regain their lost preeminence is through reasserting their structural advantages and fight the petropreneurs by closing the gap in commercial skills.

Atomizing structures

This will not be accomplished through reorganization alone. To succeed, the majors must atomize their current organizational structures, by allowing external market forces to dictate performance measures and rapidly acquire the necessary commercial skills. The new majors will be rebuilt from the outside in.

This atomization, to be effective, must be objective, which means external forces such as investment banks or turn-around firms, which must have a say in how the new companies are broken up. This will be a radical rethinking and will involve the purchase of the company, which will then be broken up, with some pieces being sold off. These external atomizers enforce market discipline by assuring that when a company's assets become more valuable than the whole it is bought, broken up, and sold.

To take advantage of this form of natural selection in the marketplace, without the exposure that comes from courting outside firms, the majors will need to establish internal atomizers.

These groups would function autonomously within the company to hold its divisions accountable to the same pressures the marketplace imposes. If managers of underperforming fields do not improve their profitability, through drafting and then sticking to a written plan, the internal atomizer would have the option of 'buying' the field, and having it managed by an outsourced operator.

For example, if the production department claims an oil and gas field is worth more than the outsource firm offers for it, then that department will be held accountable for ensuring the field lives up to this value.

How would internal atomization work?

(1) The first step would be to break the company down into value competitive business cells. A business cell is a unit of business that cannot easily be subdivided for sale or purchase. These units would then each be responsible for the profitability of their assets.

(2) With the threat of outside takeover, each of these cells woud function as if it were a separate business, accountable on an independent basis to the atomization department. The latter would be created to continually monitor the profitability of each cell and determine if the individual cells would be worth more sold off for their assets.

The internal atomizer performs the same function as an external company interested in launching a takeover. The threat of a sell off keeps each cell's focus on the bottom line, much as it would be if the cell were an individual business.

(3) Once the oil company has established its external market discipline it must shift to redesigning its core management processes, including performance management, run the company the way the stockholders would, gearing it toward long-term growth. In the area of capital investment, management often sets conservative investment assumptions in hopes of balancing the broad optimism that dominates the business units where performance metrics and retrospective analysis have little control.

Through the use of futures and forwards, companies can begin to set more realistic pricing forecasts. In human resources, skills must be emphasized over all else. High performing, ambitious workers are often lured away from the majors for careers with the petropreneurs, where their talents can flourish and be properly rewarded.

To combat this flight of talent, the majors must create attractive commercial career paths, provide greater autonomy for managers and match the economics of the petropreneurs with such things as overrides and stock options.

(4) The next step is for the majors to redesign their corporate center. This means the company needs to develop ways to add value to its newly atomized components. This can be done by the corporate center through superior knowledge management, talent management, and financial management.

(5) The final stage is for the major to develop and pursue an aggressive growth strategy. This strategy must be developed following the redesign of the core processes. After all, it is hard to acquire an asset in an increasingly efficient market using inflated discount rates and conservative price premises.

There also will need to be a shift in the company culture to encourage less risk aversion, more tolerance for experiments, and a shift toward faster decision making.

The idea is to make these cells a little nervous, in order to tap into the creativity of the managers. It is expected they will forge out in new directions, forming alliances with third parties and forming a different type of relationship in order to find a profitable market niche.

While several oil companies are in the process of less radical redefinition, these efforts are not showing much promise at the present, the McKinsey study points out.

The market conditions that created the majors has for the most part run its course. Changes in the markets and in technology-heavy areas, such as deepwater E&P, require nontraditional strategies such as those applied to emerging markets.

Using the provocative approach outlined here may not offer a magic solution, McKinsey points out, but at the very least it offers a means of shattering the traditional model which is the important first step to any improvement of substance.

Copyright 1997 Oil & Gas Journal. All Rights Reserved.