Why cost discipline and consolidation inspire confidence in oil and gas

A number of indicators point to the health of the sector, even in 2023’s more modest prices vis-à-vis 2022. Output continues to grow, and 2023 crude oil production was 17% higher than 2019, while natural gas output was 19% up. While most companies used at least a part of 2022 retained profits to fund 2023 capex, the plowback ratio (capex as a percentage of revenues after production costs) remained under 100% for the sector as a whole, with only the smaller independents spending more than they took in. But Andrew Morrison, one of the leaders of the study, explained that this result somewhat obscures the solid operational performance of the independents’ peer group as well. “The higher ratio for the independents was largely driven by significant acquisitions, and this group as a whole actually had the highest M&A net spend of $21.6 billion last year,” says Morrison. In contrast, the majors spent collectively $13.3 billion, while large independents spent $14.3 billion.

Significantly, reserves of both oil and gas did fall year over year for the first time since 2020. But for both crude oil and natural gas, the results of drilling operations did manage to replace more than those volumes produced (in 2020, only natural gas replaced 100% of annual production through extensions, discoveries and improved recovery) — the negative impact on reserves reflected the significant decline in the reference price used by the SEC to calculate proved reserves in 2023. But even with these negative revisions, and despite expanded output, the reserves-to-production ratio for oil stood at 9.82 years and natural gas at 11.43 years, both just slightly under the five-year average figure. The companies in the study group are not achieving their improved performance simply by “sweating the assets.”

Perhaps the strongest indicator of this is comparing 2023’s performance not with the high prices of 2022, but with the roughly similar conditions seen in the 2021 market. The companies in the study saw revenues in 2023 of $40.07 per barrel of oil equivalent (BOE), just slightly ahead of the 2021 figure of $39.72 per BOE. These figures mask more differentiated changes in oil and gas prices, as well as shifts in the relative output of each commodity, but they do allow for a comparison of aggregated operations across the studied companies.

These companies did see a significant rise in production costs over these two years: from $56.7 billion in 2021 to $71.6 billion in 2023, an increase of over 25%. But looking at per barrel costs, the increase was much more modest: It cost $10.69 to produce a BOE in 2021 compared to $11.73 in 2023. The per barrel cost rose only 10% across the two years, but the headline inflation figure rose 17.6% over that same period.

The breakdown of this figure is more instructive: The independents saw their average price of production rise from $11.21 per BOE in 2021 to $12.76 per BOE in 2023 — a 14% increase that is in line with broader inflation measures. The large independents’ costs rose from $9.94 per BOE to $11.09 per BOE, for a 12% increase over the two years. While the $11.09 per BOE figure still represents the lowest cost of production among the three peer groups, the integrateds’ average costs rose from $12.25 per BOE to $12.66 per BOE, for an average of only 3% over these two years.

Herb Listen, an EY Oil and Gas Assurance Partner and lead author of the study, has been watching these trends for several years. “The key to the integrateds’ superior performance in controlling cost inflation and the large independents’ continued cost performance leadership is going beyond trying for year-on-year improvements,” says Listen. “These companies have identified core areas to focus on, have seen the benefits of consolidation around those cores and are leveraging their ability to allocate capital spending over a greater scale of operations.”

Consolidation is likely to continue to deliver improvements in the sector for some time. Some major deals announced in 2023 did not close in time to be reflected in the current study, notably ExxonMobil’s acquisition of Pioneer Natural Resources that closed this year, and Chevron’s announced bid for Hess that is still underway. And earlier this year, ConocoPhillips announced an all-stock acquisition of Marathon Oil Corporation, and Diamondback Energy agreed to merger terms with Endeavor Energy Resources. Although these are complex deals, in many cases involving a global portfolio of assets, each also has a core value driver around consolidation of positions in the US unconventional space.

Bruce On, a leader in the EY Oil and Gas Strategy and Transactions Services group, sees the same drive toward improved efficiency at the heart of dealmaking over the past several years. “Companies remain focused on capital discipline while driving profitable growth,” according to On. “And the companies driving dealmaking are doing so through a continuous evaluation and alignment of their core assets and portfolios with long-term strategies,” adds On. This focus helps drive the optimization of operations and technology implementation, as well as improvement of the design, engineering and processes through adoption of the best approaches of both entities.

Somewhat paradoxically, consolidation may actually see a ramp-up in capital spending in the coming years. As positions grow in critical areas, so does the rationale for new infrastructure. This is especially true for takeaway capacity in areas such as many of the plays in the Permian Basin, where associated gas production is driving the need for more gas processing and pipelines. Having a reduced number of players with larger positions makes these capital investment decisions easier. This will not only help keep US gas production at healthy levels even as Henry Hub prices continue to soften (with gas prices in the first half of 2024 more than 10% off compared with the same period in 2023), but it will also help mitigate key methane gas venting and flaring issues.

This impetus is likely to continue for some time, as the 2024 announced M&A deals attest. Economic uncertainties may be growing in the short term (and long-term questions remain on future levels of hydrocarbon demand), but the commercial fundamentals of the US patch are strong. As the EY study indicates, leading players in the patch have sub-$10 per BOE production costs, indicating long-term viability of operations even in the event of downside economic imperatives. These companies can leverage that ability to design and develop longer laterals and employ differentiated approaches to drive more value from assets held by lagging companies in their core operating areas. And in the aftermath of enterprise deals, evaluation of the new portfolio will reveal assets that are no longer core, providing the impetus for further M&A activity.

“In the second half of 2024, deal flow will likely slow, as players — following historic norms — pause a bit to evaluate the potential outcome of the US presidential election in November,” notes On. “But we expect this to be a relatively brief pause as participants quickly factor in any election impacts and move forward based on the business fundamentals.”

Change in the rigor around sustainability disclosure and performance continues to accelerate for US oil and gas operations, highlighted by the finalization of the SEC’s climate disclosure rules. First proposed in 2022, the SEC published its final rules in March 2024, but voluntarily stayed implementation pending judicial review of consolidated legal challenges. Whatever the decision by the U.S. Court of Appeals, there are growing requirements from many jurisdictions — including the EU’s Corporate Sustainability Reporting Directive (CSRD) and the United Nations Environment Program’s Oil and Gas Methane Partnership (OMGP) — driving action on a host of GHG emissions reporting requirements.

Although the study does not examine compliance with any particular set of reporting requirements, 80% of all study companies voluntarily reported Scope 1 and Scope 2 GHG emissions. Forty-two percent of the companies included external assurance over this reporting, and a similar percent reported at least one category of Scope 3 emissions. And 64% of companies reported a climate-related target or goal as part of their voluntary submissions.

There have been steady, although modest, improvements in these reporting factors over the past several years and the integrateds group as a whole saw 100% reporting across these categories, offering a proxy of the industry’s readiness for both currently proposed and future reporting requirements.

“The leading companies in the energy space are already shifting from the measure, report, verify (MRV) mindset to one where GHG footprints and impacts are elevated along with traditional financial and operational metrics in strategic decision-making,” says Ryan Bogner, EY Americas Digital Sustainability Leader for Energy. In this shift, sustainability is viewed less from a compliance lens and more as a key element of value, and as a key part of determining a future growth strategy.

Even as companies allocate billions of dollars to new low-carbon business units, neither a sustainability focus nor an accelerated energy transition means the end of traditional oil and gas operations. There is a growing acceptance among even the most ardent climate hawks that oil and gas will continue to play a major role in the energy mix for several more decades. With a goal to significantly lower the carbon intensity of the energy system as quickly and as affordably as possible, US hydrocarbons will likely hold their competitive advantage over the long term. The cost discipline demonstrated in the study has translated into improved operational efficiencies and a lower carbon intensity of US production. Combined with some of the natural geologic features of certain US plays, US oil and gas compares favorably with many other key producers worldwide. Furthermore, the low production costs also point toward a profitable path to the production of low-carbon fuels for the global market when coupled with carbon capture or other emerging technologies.

“We are starting to see companies recognize that investing in core digital systems infrastructure to facilitate carbon reporting requirements today is helping set their companies up for success by identifying, quantifying and facilitating business opportunities for the future,” notes Bogner. “Cost savings, efficiency and reliability in performing compliance obligations are important to shareholders today, but smart investments in carbon reporting infrastructure will also translate into opportunities in reduced-carbon areas and improved resiliency for these companies in the future.”