Energy and Natural Resources: Powering Societies

How Energy and Natural Resources Companies Work

Energy is among the most capital intensive and complex global industries, with perhaps the most demanding requirements for long-term corporate planning and capital allocation outside of major government-led infrastructure investment. Focusing on energy specifically, a plethora of industry sub-sectors and different company types constitute the global supply chain from the identification, extraction, transport, processing, sale, and consumption of a resource.

Oil and gas (hydrocarbon-based) energy is the largest and most well-known energy sector, but there are many other sectors of varying size and growth potential.

Oil and Gas Company Structures

The oil and gas industry sector is somewhat representative of how the value chain of energy works across industry sectors and is a useful example for understanding the types of companies that operate in energy markets. Oil and gas is divided into three primary subsectors for operating companies: upstream, midstream, and downstream.  There is also a fourth sector comprised of the equity investors and lenders who support energy projects. Each of these sectors has, of course, a variety of smaller components, but in general the industry rolls up to these three groupings.

The upstream sector is also called exploration and production (E&P) and consists of the companies who search for oil and gas, drill wells, and bring the resource to the surface.

A variety of different types of companies operate within the upstream sector, each with different capabilities, competencies, and risk profiles. They range from “wildcatters” who drill exploratory wells with a high-risk / high-return profile, to companies who buy concessions once they have been proven and develop them in a lower-risk / lower-return profile. In addition to the operators, a variety of investors, services companies, and equipment manufacturers support the upstream sector.

The midstream sector includes the transportation and storage of oil and gas, as well as some elements of processing. Transportation of resources is a complex endeavor, especially when it involves long distances over multiple countries in volatile parts of the world. Transportation, storage, and logistics networks are integrated efforts generally involving several different companies and infrastructure requirements, as resources travel via tanker, rail, and truck through terminals, staging, and trans-loading areas.

The downstream sector consists of processing the resource into its consumable form, as well as marketing, distributing, and selling the products derived from crude oil and natural gas. Refining crude oil and processing natural gas are both complex industrial processes that separate impurities and create the variety of sellable products that can be extracted from these resources. Marketing and distribution includes all of the activities to move product to its final point of sale, which ranges from homes, to gas stations, to government and corporate customers.

Source: Forbes, company data

Other Sectors

To reiterate, oil and gas companies do not constitute the entirety of the energy sector, but the structure of the industry is useful to describe because it is generally aligned with how companies in the extractive sector function. Coal companies, for example, also have the requirement to explore for resources, bring them to the surface, transport them to a processing facility, process them into their useable form, then market and sell the resource. The mining industry operates in a similar fashion as well.

Renewable energy companies, however, operate somewhat differently. Wind and solar resources, for example, do not need to be explored for. Resource absorption facilities (i.e., turbines or photovoltaic panels) need to be built to extract the resource, but they are often co-located with “processing” equipment that turns the resource into useable power. Renewable energy companies still have the requirement to transport power to customers, but these facilities can often be constructed much closer to their end customers than traditional extractive companies.

It is also important to note the criticality of the investment community in the energy and natural resources business. To be certain, there are large, vertically integrated companies that finance their operations internally or via public markets, but many companies partner with capital providers to develop projects. Capital requirements for large projects can be enormous, as evidenced by the $36.8 billion investment to develop the Tengiz oilfield in Kazakhstan, which was announced by Chevron and its partners in July 2016. Not all projects are that large, and there are a variety of different capital structures and types of investors that support the energy industry at various levels. Private equity investors, for example, are very common investors in US domestic energy projects, with average investments ranging from millions to hundreds of millions per project.

Unconventional Drilling

To understand how oil and gas markets work, we must also briefly discuss the role horizontal drilling innovation to extract resources from shale is having on the energy industry. This technological innovation, commonly referred to as fracking or unconventional drilling, has disrupted global energy markets over the past 5 years by increasing extractable resources and almost doubling US crude production.

This increase, of roughly 5 million barrels per day, represented enough of a marginal increase to global aggregate production to structurally shift energy markets from supply-constrained to demand-constrained. This shift is  important, as we will discuss in more detail in a separate analysis. The bottom line is that a ~5% increase in global supply has resulted in a sustained 50%+ price decrease and transformed large parts of the energy industry.

Constraints

Some of the constraints that energy companies operate under are industry-wide, others apply only to specific sectors. Several of these constraints affect the energy and natural resource industries broadly, but we are focusing again on the oil and gas sector as a representative of the overall energy industry.

Resource Availability

Resource companies must operate where the resources are. This simple fact can result in extremely complex business challenges for companies, as the easily extracted resources in many cases have already been exploited. Upstream companies are driven farther and farther afield towards resources that are technologically difficult to extract, such as deep-water offshore, or countries that are politically difficult to operate in, e.g., the Tengiz project in Kazakhstan mentioned previously. Oil and gas companies in particular have developed into extremely sophisticated and risk-tolerant enterprises as the constraint of resource availability forces them to explore more and more challenging environments.

Investment Timelines

Energy projects take a long time to develop. The first phase of investment is exploration, where companies pay landowners or host governments for the right to explore for resources in a given area, then pay for the tools, equipment, and people to explore. This phase ranges from around a year to many years, and generally costs anywhere from hundreds of thousands to tens of millions of dollars. Once a resource is discovered, the next tranche of investment is to develop that resource into production. This also ranges in cost from millions to tens of billions of dollars and takes 3-10 years for larger operations, although smaller projects can be taken into production more quickly.

Project duration and investment size constrains agility. Energy companies routinely make significant long-term bets on projects that will not generate cash flows for a decade or longer. This makes it extremely important to place the correct bets, based on an accurate anticipation of the future price and risk environment.

Price

Energy companies are constrained by the market price for their resource. This is a business of commodities — crude oil, gasoline, natural gas, and electricity. The price for commodities is established by market supply and demand. While the largest energy companies can have a material impact on supply, most do not, and there is essentially nothing these companies can do to change the price at which their products can sell.  Downstream marketers and gas stations certainly make attempts to differentiate their products, but they tend to have very little impact on price.

The constraint of having to sell products at market prices introduces an interesting dynamic for energy companies, as they have to make fixed-cost investments now to sell products at an unknown, variable price at some point in the future. The long-term nature of many energy investments means there may be years or decades between capital investment and sale of the resource. This forces companies to accurately project price movements they can’t control far in the future, a challenging, potentially  impossible task.

Source: EIA

Politics

The energy industry is almost universally viewed as a national priority, which creates both regulatory and business challenges for companies. In many countries energy projects are an important source of government revenues, and in some countries they constitute the majority of government revenues and personal wealth for local elites, adding sensitivity and complexity. Politics manifests in a variety of different ways, from taxes, to protectionist policies, to the risk of asset expropriation. Energy companies are not free to purely purse the economics of a project. They must also consider and manage the political implications of projects, even in developed “free markets” such as the United States.

International politics and relationships also constrain the economics and decisions of some international energy projects. When a resource is extracted from one country but must transit through another country in order to reach market, it becomes an international project. This matters more in some areas than others, but generally adds complexity to energy projects, especially as energy is viewed as a strategic resource and element of national power, economic strength, and prestige.

Technology

Energy companies are both enabled and constrained by technology. These companies are at the forefront of the technological innovation that enables deeper-water and horizontal drilling,  more complex operations, higher outputs per well, and higher operating margins.

Technology also represents a constraint and massive risk for energy companies. We are constrained by the current power production and storage technology, which is such that hydrocarbons are the most effective and cost-efficient method to fuel large swaths of our lives and industries. This was not always the case. Let us not forget that the age of oil and the internal combustion engine are relatively recent, and the giants of the energy industry for the most part were created during the rise of this era. If, or when, a new technology is created that changes the dynamic and makes other sources of energy more cost efficient, energy companies will have to adapt.

Energy companies face a double challenge: to execute in competition with their peers on a daily basis, and to hedge disruption risk to ensure they remain relevant in an uncertain future environment. This is a monumental and complex challenge, as these companies are not structurally agile, burdened by massive investments in what will someday be “old technology”.

 

Strategic Imperatives

All companies are different, but there are common imperatives that compel companies who operate in the oil and gas industry. Similar pressures upon different types of companies can result in wildly different strategies and tactics, but understanding constraints and compulsions helps frame how the industry operates.

1)  Identify future supply-and-demand drivers of price. Corporate planners need to be at least directionally correct as to the future price environment, as there are fundamentally different strategies and project selection criteria for $75+ bbl markets than $40- bbl markets. If you are not confident in price projections, decrease fixed costs as much as possible to allow flexibility and scalability.

2)  Be selective with capital intensive projects. Correctly evaluate project risk, which requires an integrated assessment of technical, political, and market factors. Ultimately, companies get paid for risk, and the best companies excel at evaluating and managing risk.

3)  Maintain an accurate, rolling 10-year forecast of potential technological disruptors. In general, the energy and natural resources industry is among the most dependent upon the status quo, at least from a core technology and materials use perspective. Companies must be very careful to hedge against disruption, as capital-intensive businesses can be extremely hard to pivot. This specifically applies to the integrated supermajors that benefit from economies of scale across the system, but are also uniquely fragile to fundamental changes to the system.

4) Make enough bets in alternative energy to avoid being disrupted, or at least provide new sources of revenue to offset core business losses while you pivot infrastructure from old energy to new energy, if that happens.