Analysis: Independents’ frontier successes ramp wider offshore activity

Julie Wilson

July 10, 2013

Analysis: Perspectives

Independent oil companies have led the way opening new frontiers in recent years, but this may change as companies of all sizes have locked-up huge swathes of frontier acreage, creating opportunities for exploration-driven deals. Many new frontiers are offshore in deep waters, and a surge in frontier deepwater exploration will be facilitated by dramatic changes in rig supply. The risks of frontier exploration are high, but are even greater when opening a new country. Since 2006, nine countries have seen their first material discovery – Ghana, Sierra Leone, Liberia, Uganda, Kenya, Cyprus, Sri Lanka, French Guiana, and the Falkland Islands. All nine of the country-opening wildcats were operated by independent oil companies: Tullow Oil, Anadarko, Noble Energy, Cairn, Rockhopper, African Petroleum, and Kosmos. This is not to say the Majors have been absent from frontier exploration. They have opened a number of frontier plays in countries with established production, but they have not opened new countries as an operator.

The major oil companies’ absence could be a reflection of cautious new ventures strategies that some have followed early in the past decade, when they were perhaps more focused on alternative growth avenues. It may also reflect onerous approval hurdles and materiality thresholds required for new country entry; exploration was centered on their large legacy positions in proven basins that offered lower-risk exploration opportunities. Meanwhile, the Independents could not gain access to those prolific basins and had to take more risks to grow. Many Majors reacted quickly to the new era of frontier exploration. Shell and Total farmed-in to French Guiana ahead of the discovery well. Others have moved to establish positions, once the potential of frontier countries had been confirmed.

Total and Eni were fast-followers into Uganda and Ghana, respectively. In Liberia, Chevron farmed-in to operate three deepwater licences during 2010. In 2012, Shell announced a frontier exploration partnership with Tullow, covering the Atlantic basin. Further moves by the Majors to enter these emerging plays are likely to accelerate the discovery of new volumes. The results have been very rewarding for the companies involved. Over seven billion barrels of oil equivalent (Bboe) of reserves have been added to the participants’ portfolios, creating over US$18 billion of value. However, in a global context the numbers are quite small. The volumes represent only 3% of total global volumes discovered since 2006, which are close to 250Bboe. Over US$350 billion of value has been created in the same timeframe, and new countries are 5% of the total.

The economics of frontier exploration have advantages and drawbacks when compared with the economics of exploring in more mature provinces. Resource discovery costs in frontier basins have been just US$1.20/boe since 2008 versus US$1.92/boe elsewhere. The competitive environment may also be easier. For Majors, the opportunity to get into basins early and achieve leadership in acreage, knowledge, and infrastructure, may be very attractive. Full-cycle returns are less enticing, averaging around 3% below emerging and mature basins since 2008. Four factors kept frontier returns down. Firstly, recent frontier discoveries have a high proportion of gas rather than oil, with lower revenues and longer field lives as a consequence. A related second factor is that frontier fields experience longer lead times, which can seriously erode returns when up-front exploration costs are material. Third, the lack of existing infrastructure often results in high development costs. Lastly, companies investing in frontier basins generally have no existing production revenues for early recovery of exploration costs. Offsetting some of these negatives, fiscal terms are usually more attractive in frontier provinces. Average government take is 58% in frontier basins, a full 5% lower than in mature basins. Governments offer more attractive terms to entice investors and reward them for the high level of risk they are assuming. Once a basin is de-risked, there is often a rebalancing of the risk-reward equation, with terms becoming more onerous.

Although the economics of frontier exploration are more challenging, they are nonetheless positive, and we have seen a shift in the spending patterns of the most successful explorers toward frontier and emerging basins. That shift has come at a time of increasing exploration expenditure; more is being spent on frontier exploration than ever before. The Independents are, relative to their size, spending more on exploration than the Majors. Most Majors are spending US$2–3/bbl of production, while Independents typically spend two to three times that amount. Shell and Statoil have hiked their exploration spending over the past few years to reach levels above US$5/boe of production. If ExxonMobil, BP, and Chevron were to increase their expenditure to the $5/boe mark, an additional US$12 billion would be spent on exploration each year.

Many companies can expand their exploration spending and activity further, and they now have the opportunity set. There has been a huge land-grab over the past couple of years as companies scramble to reload their acreage portfolios. Of today’s globally licensed acreage, around 30% has been acquired, since the beginning of 2010. Two groups have been particularly active in gaining acreage – the Majors, and a group of around 20 small cap companies, Figure 1. The Majors’ acreage, acquired since 2010, totals 1.1 million sq km (439,000sq mi) and represents 45% of their combined acreage portfolio, although as individual companies the proportion ranges from 80% for ExxonMobil to 14% for Chevron. The leading small caps have taken on similarly large positions.

This amount of new frontier acreage would normally command extensive drilling programs. A conservative estimate suggests that the Majors’ post-2010 acreage alone might merit some 200 high-impact wells with a total exploration investment of about US$40 billion. Clearly, neither the Majors nor the small caps have binding commitments to explore or invest at anything like these levels. We believe there will be a new wave of frontier exploration deals.

Some deals will be driven by the Majors. They have added more prospect acreage than can be realistically tested, and will farm-out selectively. Highimpact exploration drilling in unproven basins carries more risk than drilling in established areas, taking success rates much lower. This will test their risk appetite and tenacity. The average commercial success rate of frontier wildcats, at around one well in ten, is much lower than the portfolio average for the Majors, Figure 2. While success rates have their shortcomings as a performance measure, they are often used as a key decision-making metric. Each Major that opts to increase its frontier drilling will need to accept diluted success rates. However, their limited appetite for very low chance of success drilling, coupled with rigorous process prior to drilling decisions, will result in prospect high-grading and divestment of weaker opportunities.

Other deals will be driven by the exploration minnows. The biggest hurdle for this group is always access to capital. Even when the capital markets are at their most supportive, many small cap explorers rely on promoted deals to carry them through a large part of their drilling costs. Their recent frontier land-grab has redoubled this issue. First, there are now an unusually large number of such companies seeking funding. Second, much of their new acreage includes plays that will be expensive to drill.

The expanded requirement for funding coincides with a period of market nervousness. Investors have a diminished appetite for the broader oil and gas sector, which has underperformed over the past year. Exposure to pure exploration risk is particularly out of market favor. It is clear that the small caps collectively hold far more acreage than they can reasonably explore. Those that have insufficient production revenue to be self-funding will seek larger partners, especially when looming drill-or-drop decisions move them to partially divest, rather than fully relinquish acreage.

Companies that continue to focus on high-impact conventional exploration will welcome the enhanced flow of frontier opportunities. Likely buyers include well-funded and technicallystrong Independents. Many look wellpositioned to enhance their portfolios. We may even see some divestments of predevelopment assets, as strong explorers reposition on wildcatting.

New acreage includes huge swathes of offshore frontiers, dominated by Africa and the Arctic. Since 2009, over 11.5 million sq mi of frontier offshore acreage have been licensed – representing 30 times the licensed area of the deepwater Gulf of Mexico (and 43 times the size of Texas). Around half of the deepwater frontiers are in the hands of mid- and small-cap companies, raising questions around how much of the acreage can be drilled before it expires. Some resource holders, who might be expecting drilling to follow licensing, will be disappointed.

An expected surge in deepwater frontier exploration will be facilitated by changes in the rig and services sector. Our analysis suggests that the number of global deepwater exploration and appraisal (E&A) wells will climb to 240 in 2013, and above 350 by 2016, Figure 3. Growing levels of activity are supported by the ongoing renewal of the deepwater fleet with high-specification newbuild mobile offshore drilling units (MODUs). More than 100 new MODUs have been delivered to the market since 2008, with a further 90 expected by the end of the decade. This more than doubles the available capacity.

Lest we forget, the strategic focus on deepwater has been driven by exploration successes many of which are now entering the development phase. So while the demand for exploration drilling grows, this is in conjunction with rising levels of development activity. An already tight rig market has been further constrained as demands on the technical specification of rigs have grown in line with increasingly stringent operating and HSE regulations, as well as moves into ever more challenging operating environments. While the current deepwater-rig, new-build phase may be unprecedented in scale and duration, the combination of growing levels of exploration and development drilling indicate that from 2016, we expect demand for deepwater rigs to outstrip supply, resulting in constrained E&A activity.

Over half the newbuild rigs have been contracted by Majors and large-cap companies. Rigs have been used as leverage to access exploration prospects, and with remote frontiers resulting in high rig mobilization costs, the first-mover to drill in a basin may have an advantage.

Companies of all sizes are experiencing a resurgence in frontier exploration. Although the challenges of exploring and developing frontiers can suppress value and returns, the rewards can be sizeable. Rigs are available in the near term to facilitate an upturn in frontier exploration activity. The coming transition from acreage capture to frontier drilling will trigger a phase of portfolio adjustment with farm-in opportunities. Much of this activity represents the normal risk-spreading process before drilling, as early entrants look to share well costs. These acreage deals will be essential to sustain an upward trend of frontier drilling. OE

Julie Wilson, Senior Analyst, joined Wood Mackenzie’s Exploration Service team in January 2011, following 11 years in upstream consulting and research. Prior to Wood Mackenzie, she worked eight years for BP in the UK in political, commercial, and financial analysis, focusing on upstream assets. Wilson earned a BA Honours in Spanish and French from Heriot-Watt University, and an MSc in Marketing from University of Strathclyde.