During the recent boom, U.S. shale producers responded to investor demand by prioritizing volume growth over profitability. Now that the investors and markets demand positive free cash flow, operators will struggle to deliver even after prices recover. Refocusing on cash means operators must squeeze every dollar from their assets while simultaneously retooling for the new era. Such a dual challenge is familiar in other heavy industries, where companies have learned that when the ground shifts beneath your feet, you must transform your operations end-to-end.
This means attacking the flaws in operating models that took root during the growth era, where developments targeted initial rate instead of economic value, neglected base production, and lacked attention to corporate functions. Unlocking cash will take more than volume growth and G&A reduction. It will also involve rethinking capital allocation and creating long-term value from both technical functions such as drilling and organizational functions such as logistics.
An emphasis on development and production management
Transformations need to pay special attention to development plans including base production management. We’ve identified the following three keys to success:
- Optimize developments through experimentation with appropriate evaluation periods. Resetting developments to focus on value requires experimenting with new recipes for well design and spacing, following principles of experimental design, and basing decisions on economic indicators only.
- Challenge capital allocation rigorously. Capital spend should be optimized to deliver cash above all else, and operators should be prepared to change accordingly. For instance, updated type curves often lead to a reprioritization of inventory, and schedules should be updated within the constraints of lease agreements. Similarly, if the best use of capital lies in mitigating well declines or reducing operating expense, operators should be prepared to reallocate funding.
- Secure strong technical input. Many transformations focus on the most obvious cost levers such as overhead reduction, but the most successful transformations are technically driven. In this spirit, operators should get technical managers, engineers, geoscientists, and field personnel involved in identifying and tackling transformation opportunities.
Where companies stumble—and how they can prepare
Lean shale operators find some aspects of transformation challenging. Professionals who have to wear several hats and spend much of their day firefighting have little time to spend on strategic priorities. The following four actions, identified through our work with other heavy industries, can help:
- Define an inspiring top-down vision. Unpredictable commodity prices and high uncertainty lead to a sense of fatalism in E&P organizations, and change programs are often seen as management fads that come and go. To combat this mindset, smart leaders develop a change story that describes the urgency of the challenge they face and stresses that the transformation is a top priority for both themselves and the board. They take care to ensure that change is sustainable by improving organizational health alongside cash flow performance.
- Identify what drives underperformance. Ultralean organizations seldom spend much time on look-back analyses and other performance assessments. Companies may not know how far production shortfalls are driven by rock, execution, or overoptimistic forecasting; commercial teams may not be aware that overpayments are baked into their contracts. To shed light on such issues, companies should rapidly diagnose the causes of shortfalls at the start of the transformation, either by reassigning personnel temporarily or deploying SWAT teams.
- Set targets that are aspirational and achievable. Companies that struggle to understand underperformance also have trouble knowing what they could realistically achieve. Understanding the real potential starts with a thorough bottom-up diagnostic of what’s possible, combined with competitor benchmarking and best practice assessments from other sectors.
- Institute performance management. Many E&P companies are suspicious of structured processes, seeing them as contrary to their lean ethos. Leaders should provide staff with adequate resources and tools to minimize time spent on necessary performance tracking that provides crucial visibility.
Capturing the value
Any successful transformation delivers not only long-term value but also quick wins to generate momentum and build confidence in the change effort—a critical factor for shale producers used to moving fast.
One shale producer had basin-leading performance in drilling and completion, plus highly effective development recipes in core acreage, yet cash flow stayed stubbornly negative. At the start of its transformation, it found that oversize completions, aggressive drawdown, and accelerating declines in midlife were harming economics, and widespread frac interference was making matters worse.
Alongside these issues, the company identified significant opportunities to create value, including reducing spud-to-sales time through a sustained engineering push, tapping into procurement economies, and improving the reuse and disposal of water. As it worked to tackle these issues and opportunities, the company also pursued quick wins: renegotiating service contracts at a lower rate, securing long-term sand contracts to reduce dependence on spot markets, restoring production from a backlog of offline wells, and deferring low-tier obligation wells in the development plan.
After six months, the transformation had delivered impressive results. Base production was 5% higher than forecasted declines thanks to proactive artificial lift installation, the maximizing of well and compressor uptime, and better defense of parent wells from frac hits. Multiple initiatives delivered benefits on a similar scale, with rig days per well down by 22% and spending in key categories cut by 30%.
By building some of the world’s leanest and best technical teams, shale producers have survived downturns in ways few analysts could have predicted. But they face a tough new challenge as the industry refocuses on cash flow. Transformation may be an unfamiliar concept for them, but other industries provide success stories to light their path.
This article was written before the outbreak of the COVID-19 pandemic and the collapse in oil prices, but during booms and busts alike, the message to operators remains the same: achieving profitability will require end-to-end transformation. For more, see An operator’s guide to transforming E&P.
Jeremy Brown is a specialist in McKinsey & Co.’s Houston office, where Florian Christ is an alumnus and Tom Grace is a partner.
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