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Post-traumatic efficiencies in order

In 2017, the E&P sector needs to sharpen its focus. A price recovery, when it comes, will only reward low-cost explorers

The exploration and production industry has faced a toxic combination of plunging oil and gas prices, a legacy of cost inflation, and high levels of debt, weak exploration performance, and low public trust. This should be plain to everyone. A trend of diminishing returns was already apparent in the $100+ era when the industry grew fat and happy. The excesses of the $100-plus oil era have left the upstream industry badly exposed in a $40-a-barrel world, with severe strain to company balance sheets and producer-country budgets. The UK is but one example. There, despite higher production, tax returns turned negative in 2015-16 as the government share of abandonment costs exceeded tax revenues from production.

The price crash of 2014 has proved more than a short-term blip, but a rebalancing of the oil market and higher prices will happen - it's just a question of when.

For now, corporate and investor behavior is amplifying the price cycle. Asset prices have crashed and it is currently cheaper to buy distressed assets than explore for new ones. So history would suggest that now is a good time to invest. In practice, though, counter-cyclic investment is difficult for incumbent companies. They either all have lots of cash at the price peaks, or not enough cash in the troughs. In the good times, growth becomes the goal for management (cheered on by shareholders and lenders), competition intensifies and capital discipline is lost. In the bad times, conserving cash, preserving dividends and servicing debt becomes all consuming.

Yet the longer the present downturn, the sharper the eventual upswing. This cycle is no different to previous cycles, with overall capital spending down 43% and exploration spending down 75% from its peak in 2014. Even allowing for climate-change mitigation policies, most projections foresee an increase in oil demand through 2035. Combined with natural production decline, an undersupplied market before the end of the decade is highly likely.

Beware, though, the zombie companies: they're coming. Investors created too many new E&P companies in the upcycle leading to too much competition for diminishing opportunities and spreading the industry talent pool too thinly. In the downturn investors stick with the integrated majors for dividends and flee smaller E&P companies. The result today is a generation of zombies, surviving from day to day but without the means to invest and grow.

Meanwhile, tight oil's potential should not be overplayed. Investors love it because it is more predictable and flexible compared to conventional exploration. North America's tight oil plays have been the key new supply source brought by high oil prices. Innovation and efficiencies have driven costs and breakevens down. But the geological sweet spots are finite and technology can't advance forever. So this will eventually cap production potential at a given oil price.

Ironically, in a world awash with oil, it is getting harder to find conventional deposits. The last major new multi-billion-barrel oil province to emerge was Brazil's pre-salt in 2006. The plays since have been 1bn barrels or less in scale. In fact, $20bn of spending on drilling frontier wells in the past eight years has found enough oil to meet only 70 days of global demand. Often the industry has found gas where it wanted oil.

At $40/b, commercially viable geology is limited. We've identified only 12 conventional offshore oil plays that had delivered a discovery larger than the minimum economic field size at that price in the past five years. Discovery costs for new conventional oil in 2016 are at record highs. Exploration performance has been undermined by a systematic underestimation of commercial risk.

But much of this changes if the price does too. At $60/b - a price I believe will be reached by end-2018 - the inventory of commercially viable geology increases and exploration becomes much more attractive.

Still, explorers need to focus on finding cheap reserves. Low-cost oil will always find a market, never mind the current stranded-assets mantra. Also, finding costs need to be kept below $1-2/b. This will demand an efficient exploration process with larger prospect portfolios and fewer wells targeting bigger prospects at higher commercial success rates. It also means making discoveries that won't be stranded commercially or politically.

In 2017, the industry will emerge from the trauma with a lower cost base and new strategies. Some companies will continue only by the grace of their lenders and some will go bust. The industry will emerge fitter - but will it be able to keep its discipline during the bull market that will come?

This article is part of Outlook 2017, our annual book looking at energy market trends for the year ahead. To purchase a copy, click here

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