The non-governmental oil and gas business has witnessed a huge erosion of value in recent years. Between 1980 and 1993, a representative sample of 103 worldwide oil and gas companies destroyed a total of nearly US$300 billion in shareholder wealth, compared with the risk adjusted returns available in their respective countries (see Exhibit 1).¹ If extrapolated to all non-governmental oil and gas companies, the total loss worldwide would run to more than US$400 billion—more than the entire GDP of all but 11 countries—principally in the upstream (exploration and production) segment.

To be sure, leading firms have taken action to improve their returns and have even met with some success in the last couple of years. But these actions have not been sufficient to lay the basis for vibrant future growth. These companies continue to face a substantial cost/price squeeze, exacerbated both by increasing competition for access to the attractive areas that remain and by a stagnant or declining resource base. Conventional solutions, therefore, simply will not work. Meaningful growth is impossible without new game strategies founded on a no-nonsense exploitation of market, political, and technological discontinuities.

This haemorrhage of value has been pervasive, affecting companies of all sizes and all degrees of vertical integration. Upstream-focused independents have been the hardest hit, but almost all the majors and large integrated players have been hurt as well. The value loss has also been worldwide in scope, touching operations across the globe (Exhibit 2). And it has been persistent.

Despite a 10-year effort to turn things around, including asset restructurings and aggressive cost reduction programs, the destruction of value has continued into the nineties—as current oil prices, as well as expectations about future oil prices, have fallen (Exhibit 3). True, in the last few years, cost reduction and exploration refocusing programs have taken effect in many companies, and the returns in some are now above the cost of capital. But conventional strategies and skills are not providing for much better than survival in most.

The numbers on value destruction are not merely the artifice of shareholder return calculations; other measures of performance tell much the same story. Between 1980 and 1992, for example, the return on assets of US-based oil and gas companies fell by some 8 to 12 percentage points. Similarly, for the years from 1980 to 1991, measurements of value per barrel discovered among a sample of 29 large US firms show an erosion of value of about US$246 billion across both US and foreign programs. The numbers are real and the problems they reflect, neither local nor transient. A fundamental, long-term shift in industry structure is under way.

An industry in transition

Under such intense and wrenching pressures, conventional strategies have lost their ability to capture growth or adequate value

These problems in earning an adequate return for shareholders are caused by an obvious but difficult-to-elude shift in industry structure. Despite aggressive cost reduction programs, increasing producing field maturity and declining new discovery size are pushing total costs up until they are close to flat or declining oil prices in most core regions. At the same time, access to more attractive areas has either been restricted or been made available only on quite difficult terms. Under such intense and wrenching pressures, conventional strategies have lost their ability to capture growth or adequate value.

The cost/price squeeze

From the 1960s on, with the exception of the OPEC-driven crises of the 1970s and Gulf conflicts, real oil prices have either remained flat or fallen. Indeed, they are much lower in 1994 than they were in the mid-1970s. Although no one can accurately predict oil prices, it is unlikely they will rise dramatically in the foreseeable future (see the insert, "Understanding oil prices"). Fields in North America, the North Sea, and areas such as Australia have proved the mainstay supply sources for most industry players since the 1960s and 1970s, when access to Middle Eastern and many developing country fields became problematic. But as these core areas have matured, the industry has faced enormous cost pressure (Exhibit 4).

There are a number of reasons for this relentless pressure on costs:

Increasing maturity of producing fields. As existing fields decline and new—and smaller—fields are brought on stream, average costs per barrel go up. All costs, a large portion of which are fixed, must be spread over fewer barrels of oil or gas. In fact, many new fields are economic to develop only if they are located close to an existing platform, gas plant, or pipeline infrastructure.

Declining find sizes. Despite the extension of search activities into deeper water and more difficult areas, the average size of new finds in the North Sea, United States, Canada, and Australia is declining sharply. In some of these areas, many new finds are too small to be worth developing (Exhibit 5).

Environmental protection regulations, which have grown by 250 percent in the US since 1984, now represent 3 percent of total exploration and production costs.

Government "take" has remained high in percentage terms despite poor industry returns and increasing dependence on foreign energy sources. In the US, for example, the total government take, including taxes, amounts to roughly $21.1 billion a year. Around the globe, governments have become quite sophisticated at extracting high economic rent from oil companies seeking access to exploration acreage.

As a result, between 1974 and 1991, the aggregate real costs of US-based producers grew by approximately 20 percent—in spite of all the efforts to reduce them. During this period, despite the fact that exploration costs fell, US development costs per barrel rose by 60 percent; production costs by 106 percent; and overhead costs by 131 percent.

In the North Sea and some other regions, the cost to develop a field has fallen since the excesses of the early 1980s in response to aggressive cost reduction programs. As a result, some leading players can now engage in profitable new developments at oil prices as low as $15. Nonetheless, with declining new discovery sizes, even these firms will struggle to find growth—and, on a worldwide basis, they are the lucky ones.

The access/competition dilemma

As the cost/price squeeze has intensified in core regions, many players have shifted their focus to apparently attractive opportunities in Asia, South America, Africa, and the CIS. Unfortunately, this has granted them little respite, for in these new locations they have run head on into increasingly stiff competition.

US-based companies, for example, have cut their North American exploration and development spending from $53.5 billion (in 1992 dollars) in 1980 down to just $13.1 billion in 1992 in an effort to improve returns. At the same time, they redirected their spending to less mature areas, particularly in Asia. (Overall, foreign exploration and development, which accounted for only 24 percent of total spending in 1981, now accounts for more than 70 percent.) But that is exactly the point: they all did so at the same time. These companies ended up chasing the same new opportunities in the same places, thus limiting their future profit streams, driving up their operating costs, and encouraging national energy authorities to set ever more demanding terms.

To make matters worse, they also encountered in these Asian and other locations new bursts of activity from national oil companies operating outside their home countries; private Japanese, Taiwanese, and Korean oil companies enjoying state support (such as partially forgiven loans if exploration is not successful); long-time incumbent players with unique knowledge, strong asset positions, and deep government relationships, such as Shell or Exxon in Malaysia; and unconventional players like the traditionally non-oil Asian conglomerates. Since 1976, Japanese exploration spending in Asia has gone from 20 percent to more than 60 percent of its total spending.

During the 1980s, 90 percent of the world’s oil and gas reserves were in areas that were entirely or mostly off-limits

Equally troubling, the attempt to shift away from maturing core assets has taken place during a period when Western non-governmental oil companies have had great difficulty in securing access to new, resource-rich areas. In fact, during the 1980s, 90 percent of the world’s oil and gas reserves were in areas that were entirely or mostly off-limits to these companies (Exhibit 6). True, since 1990, countries like Vietnam, Russia, Azerbaijan, China, and India have partly opened to foreign firms, but these nations usually keep the best acreage for their own state oil companies. They also set tough terms—forced participation, for instance, as well as a government "take" of between 80 and 100 percent of the value created—in exchange for allowing entry. And the more foreign interest grows, the tougher the terms become.

In the more familiar oil provinces of Asia, such as Indonesia and Malaysia, the terms have been adjusted downward in recent years. These changes have been marginal, however, keeping the government take from new oil projects above 90 percent. With more than thirty firms vying for access in recent acreage bidding rounds, these policies do not look set to change soon.

Conventional responses

As noted above, the vise in which these oil companies now find themselves has rendered most of their conventional forms of strategic response either unworkable or insufficient to drive growth. They have become, for the most part, high-cost players in a low-cost game (Exhibit 7)—a game, moreover, where access to areas of low-cost supply is controlled by others. Those others can, in turn, largely determine the industry’s economics by setting prices at a point low enough not to damage the growth of consuming economies, encourage additional capacity investments by high-cost players, or spur conservation and substitution.

In the face of such realities, the conventional responses pursued by oil companies have, of course, been essential, extensive, and impressive. But, for the most part, they came too late to stop substantial value erosion and have fallen short of what is required to build solid future growth.

These responses include:

Cutting employment. At its peak in the early 1980s, the US oil and gas industry em-ployed some 700,000 people in the extraction of crude petroleum and natural gas (Exhibit 8). Seven years later, more than half of them had lost their jobs. These reductions have continued, albeit at a slower rate, during the 1990s, bringing with them a 4 percent annual increase in productivity since 1988. Similar or larger reductions have occurred in the North Sea, as every producer has scrambled to be "lowest quartile" in costs.

Restructuring assets. During the 1980s, the oil companies restructured their asset portfolios in mature areas, sold off unrelated and underperforming businesses, and consolidated their production and exploration property interests. Between 1984 and 1990, the number of large property and M&A transactions in the US oil industry more than doubled, for example, and the cumulative turnover in the US reserve base accelerated sharply. Indeed, almost half of it changed hands between 1974 and 1989. All told, fewer than half of the large companies that were operating in 1980 remained independent entities by 1992, as Exhibit 9 indicates.

Reducing exploration costs. A sample of 200 large oil and gas companies cut their worldwide expenditure on exploration from US$76.5 billion (in 1992 dollars) in 1980 to just $43.5 billion in 1992. Determined efforts to "high grade" exploration prospects and improve procedures allowed US producers to cut related costs by 60 percent—down from a high of $8.63 per BOE (barrel of oil equivalent) in 1981 to $3.10 a decade later.

New areas of exploration. The oil companies shifted their focus from mature areas to new sites in Asia, Latin America, the CIS, and Africa (Exhibit 10). In 1970, more than 70 percent of US company exploration was domestic. By 1992, the same percentage took place outside the US, especially in Asia.

Innovation. A whole host of technical innovations—including 3-D seismic imaging, horizontal drilling, deepwater platforms, multi-phase pumps, and tertiary recovery techniques, for example—have enabled oil companies to increase exploration success, reduce development costs, boost recoveries, cut downtime, and improve access to new exploration areas.

Necessary but not sufficient

These initiatives were essential, and they worked. They generated demonstrable benefits and created value. As Exhibit 11 shows, the companies that raised productivity, restructured assets, and conserved capital fared better in generating returns for shareholders. But these benefits were too limited in scope and too short-term in focus to create growth or long-term value. Being low cost is essential. It is just not enough.

Headcount reductions did prune costs substantially, for example, but the average number of employees needed to produce a million barrels of oil was only half as good in 1991 as it was in 1970. Similarly, asset restructurings helped, but most acquisition-led strategies did not prove successful. The "high grading" of exploration portfolios clearly boosted efficiency, but in most regions it has neither replaced the volume (or value) of maturing production nor clearly identified the sources of future growth. And even technical innovations, for all their obvious success, have not been able to alter the fundamental economics of the business in ways that dramatically improve financial returns in a low price and increasingly mature core operating environment. Hoping for higher prices is one approach, but is probably not a good bet.

Perhaps most disappointing, the move to focus new activities on Asia and other "new" regions has proved more difficult than expected. Asia’s underlying attractiveness is not in question: the potential resources are extensive (finds in excess of 100 million barrels of oil and 1 trillion cubic feet of gas are made virtually every year); local economies are expanding rapidly and will consume a growing share of world hydrocarbon production; the region is vastly under-explored in comparison with other core areas; and territories that were long off-limits—Kazakhstan, Uzbekistan, Vietnam, Laos, China, Bangladesh, and India, among them—have recently opened to foreign investment. Even so, most conventional exploration-led strategies have been stymied from a value creation perspective by restrictive host governments (with their aggressive demands for taxes, royalties, and profit splits), entrenched and/or state-supported competitors, high operating costs, and poor infrastructure.

On balance, then, despite all the pain they have caused and all the managerial attention they have absorbed, these conventional responses have been insufficient for most players. Companies without the resources and reach of the best majors continue to struggle. Local improvements notwithstanding, the US upstream industry has continued to leak value, both domestically and internationally (Exhibit 12). A similar story is true for oil and gas companies from most other regions.

There is grim confirmation of this judgment in the actions some companies have taken to return cash directly to their shareholders: they have chosen partial self-liquidation in preference to devoting additional resources to value-destroying investments. Between 1971 and 1990, the value of dividends paid out by a sample of the 20 largest US oil companies increased from 5.5 percent of equity to more than 8 percent. During the same period, the cumulative net stock issued by these companies went from 5 percent annually to minus 20 percent (through buy-backs).

Moving to a new game

Conventional strategies and skills, then, are unlikely to provide a platform for growth even for the better players. For average firms, they will not even stem the loss in value. Something else is needed. Those companies that have done well during the past decade have not followed any single, "one size fits all" approach. Instead, they have demonstrated their willingness to move to a new game. That is, they have reinvented themselves by combining a deep understanding of industry dynamics with their own special capabilities to create distinctive, difficult-to-imitate strategic responses to the key questions facing the industry. Exhibit 13 cites several examples of such responses.

Varied as these new approaches are, they have some elements in common. In most cases, there is heightened attention to building new kinds of working relationships with host governments, to restructuring assets so that a company can focus on the best value-added opportunities available to it, and to exploring a wider range of alliance relationships.

Beyond these general, "needed to play" elements of strategy, there exist numerous company-specific choices to be made about the elements "needed to win"—the particular technologies to adopt or geographies in which to operate or products on which to focus or segments in which to integrate vertically, or, for that matter, the particular balance to strike between exploiting geographic presence and leveraging technology advantage. (See the inserts, "Renaissance Energy in Canada" and "Shell in deepwater" for examples of how two successful firms have made these choices.)

Exploration, for example, is a part of many players’ growth strategies—but it is exploration grounded in real strategic advantage. The relevant point here is not that there is any one answer to the problem of growth. It is, rather, that effective strategies link emerging opportunity with company capability in value-producing ways that are difficult to imitate.

Crafting "new game" strategies

Industry economics, the limitations of an organization’s skill base, tougher competition, more demanding host governments—all these factors make it extremely difficult for an oil or gas company to reinvent itself, develop a new strategy, or "step out" successfully into a new business area, concept, geography, or base technology. The 1980s were littered with the wreckage of ill-considered attempts to diversify into plastics, coal, solar power, chemicals, and so on. But given the demonstrated limitations of staying with—or even incrementally improving—traditional strategies, new strategies and "step outs," including horizontal and vertical expansions, are essential for most players to find growth.

In our experience, successful "new game" or "step out" strategies depend on the right foundation being in place.² This foundation has four main elements:

1. Discontinuities

In the oil and gas business, dozens of large and small discontinuities create transient, but capturable, "bubbles of value." These "bubbles" can arise from many different sources—among them:

• market (de)regulation (for example, US natural gas)
• price changes and local imbalances of supply and demand (the US gas "bubble")
• breakthrough technologies (3-D seismic imaging; horizontal drilling)
• emergence of new growth markets (gas-fired power generation; energy-related financial derivatives)
• restructuring and divestment by other players
• stock market over- or under-valuation
• environmental pressures (such as the demand for clean fuel).

Successful companies pay inordinate attention to identifying such trends and developments early on, as well as to predicting their implications for money-making opportunities that may be short lived.

2. Capability platforms

Companies seldom spend enough time trying to understand which of their skills, privileged assets, and special relationships really matter

In seeking to exploit these opportunities, companies seldom spend enough time trying to understand which of their own skills, privileged assets, and special relationships really matter. Nor do they fully appreciate the size and nature of the commitment that is needed to build and manage these core elements of their capability platforms. It is rarely enough, for instance, just to hire in some senior experts. To be truly distinctive, platforms must bundle together people, management processes, and assets in ways that other companies cannot easily imitate—much as Shell did in building its expertise in deepwater exploration and production (see the insert).

In the international independent power production business, the critical capability is that of conceiving and structuring a complex deal that involves long-term fuel supply and electricity sales contracts, construction contracts, operations contracts, and sophisticated financing and risk management. Operations skills, by contrast, are something of a commodity, and can be contracted for in the open market. It is not surprising, therefore, that the business is dominated by companies like Enron (United States) and Hopewell Holdings (Hong Kong), which possess world-class deal-making skills, rather than by historically strong electricity operating companies, which might have fancied themselves the "natural owners" of this sector.

3. "Staircases"

At each level on the "staircase," a company widens its skill, asset, and relationship base

Though discontinuities may bring new strategic opportunities, developing the capabilities to tap them most effectively usually entails building on the current platform in a continuous series of incremental steps. At each level on this "staircase," a company widens its skill, asset, and relationship base, thus preparing for the next step. Lacking the patience to follow this kind of painstaking "bootstrapping" approach, many oil companies have preferred to attempt large jumps such as major acquisitions—more often than not, with dismal results. By contrast, setting out from its base as a US interstate gas distributor, Enron has, within eight years or so, deliberately built a stair-case to become a major player in the global electricity generation business (Exhibit 14).

4. Passion and commitment

As in so many other areas of management, new game strategies cannot succeed—no matter how attractive the opportunity or how sound the plan for building capability—without genuine passion, commitment, and long-term vision from senior managers. This is especially true in the oil and gas business, where people down the line are prone to believe that the allegiance of their seniors to any new game is only skin deep.

In the face of changing industry structure, oil and gas companies must continue to lower their costs, manage their assets, and focus their exploration programs. To create growing, exciting futures, however, they must do more. They must craft new approaches and develop new skills. Attending to discontinuities, creating suitable capability platforms, building the staircase step-by-step, and demonstrating real top management passion—together, these comprise the necessary foundation for the "new game" strategies required to reverse the oil and gas industry’s decade-long dilemma.