View From the Top: A Leading Energy Economist’s Perspective on Digital Energy
This column is part of a continuing series by Alec Walker, cofounder and CEO of DelfinSia.
The oil and gas industry is saturated with conferences, publications, and sales pitches pertaining to digital strategies for efficiency and performance. Industry incumbent participation in the hype reflects something of a mix between FOMO (fear of missing out), FOAB (fear of appearing behind), and fatigue (“When can I leave this session and go back to work?”). Will digital transformation continue to drive business impact beyond the duration of the hype? Is it important enough to receive devoted resources today? To answer these questions, I thought to seek a perspective positioned a few steps back from the operations business and focused on the greater forces shaping the digital transformation trend to begin with. For such a perspective, I turned to Ken Medlock, (https://www.bakerinstitute.org/experts/kenneth-b-medlock-iii/) the James A. Baker III and Susan G. Baker Fellow in Energy and Resource Economics at the Baker Institute for Public Policy and the senior director of the Center for Energy Studies at Rice University.
I met with Dr. Medlock toward the end of 2019, grateful for his having given me an hour of his time. Medlock is the kind of person whom the heads of countries solicit as an economic consultant. He is a highly decorated economist and thought leader, and his making time for me and this article was very generous. The rest of this article is a transcript of our conversation, starting with me laying down the context for the meeting.
AW: The oil and gas industry is undergoing an unprecedented collection of widely discussed simultaneous changes: A generation of experts is in the process of retiring; a new and much younger generation is stepping in; onshore development has grown enormously; domestic prices have dropped and would seem poised to remain low; operational efficiency has become a primary goal; digital transformation has become a hot topic toward that end; collaborative data optimization efforts between industry players are under way; and third-party venders are lining up for a piece of the action. The scope of discussions on these topics within industry incumbents is deep and focused, but these are tied to larger global economic trends and are more thoroughly understood when also viewed from high-level economic perspectives. Along those lines, Ken, what is happening right now in energy at a macroeconomic scale?
KM: The global energy economy is very dynamic, and many of the changes currently are regional. Talking at too high a level runs the risk of whitewashing the important regional dynamics. Let’s start with energy-producing regions in the US. They have become increasingly outward facing, meaning export orientation has become more the norm. If you go back to the middle of the last decade, nobody in the US was talking about exporting. Now, it can sometimes seem to be all anyone is talking about. That said, the domestic market remains massive. The US consumes enormous amounts of energy across the power generation, industrial, residential, commercial, and transportation sectors. The opportunities to deliver to domestic consumers still matter.
That said, in terms of growth opportunity, aside from natural gas, it is really a discussion about the developing world, with Asia in the limelight. When we look at demand collectively in OECD [Organization for Economic Cooperation and Development], that demand is flat. The interesting dynamics there are about how certain fuels are outcompeting other fuels. So, some energy sources are increasing but at the expense of others. All the growth in global energy demand is occurring outside of that umbrella of countries. That is very important because you are talking about growth at a scale that is unprecedented for the next 20 to 30 years. A lot of energy companies are getting their heads around that right now. It’s unprecedented because there are 1.3 billion people in the developed world, the OECD, and 7.7 billion in total. So, we have propensity for demand growth from roughly 6.4 billion people today, plus another 2 billion between now and 2050—all outside the OECD—that is unlike anything we have ever seen. Just to be blunt and make it simple, this means that everything is needed.
A lot of energy companies are trying to find their way in that new reality and figure out how will they fit in. Does a decline in market share mean a decline in market? Generally, no. For example, if I own 50% of a pie that doubles in size and my market presence needs to be of the same scale, what share do I need? 25%. This concept is something that folks in the energy space are still getting their heads around. Many companies and their investors are worried about declining market shares, and some of that worry is misplaced. In the policy arena, this misplaced worry also exists. A lot of that is engendered by the fact that we all view the world from where we sit. Here in the developed world, demand is not really growing, so there is an intense competition for market share. Gas is knocking coal off the stack. Renewables are capturing various margins of growth in electrification. Electrification continues to increase, which is natural in the course of development. How that all ties together is something that everyone grapples with on their own scale and within their own part of the energy economy.
AM: How do you reconcile the growth in demand you mention internationally with the touted longevity of domestic break-even pricing that I keep hearing about?
KM: Particularly in the US, onshore upstream development has been a challenging situation because of the pricing that you mention. Unconventional resource development is still a new frontier. A lot of people believe that shale is what it is and the processes for developing it have reached an asymptote. Those people say that development is going to cost what it’s going to cost, and so the price needs to be above a certain threshold for it to make sense. That is just not true. People had those same thoughts in 2008 and in 2014. Here we are in 2019, and, despite excellent reductions in development costs, many still cling to the same false assumption that no more innovation can be achieved. What’s remarkable about that is that the price environment needed to make everything work has been different in each of those cases. The space is still evolving.
Another consideration is that the thin margin environment is not bad for all players. It serves to increase the comparative advantages that larger companies enjoy. The firms that can bring scale efficiencies to the field benefit as their smaller competitors suffer. They can acquire contiguous acreage and connect up wellsites, allowing for management of processes like water distribution, crew allocation, how rigs are rotating, and in-field produced-fluid treatment. This lowers their costs. The pricing environment, being where it is today domestically, rewards scale efficiency. That means these companies expand their presence, driving production increases that keep prices low. In a Darwinian sense, we are in a heard-thinning time.
The smaller competitors need to lean into their comparative advantage, which is their relative agility, and adopt new technologies quickly to create more efficiency and hence more margin. Some of them are doing that, and those will be the ones that survive. When margins are thin, companies do not necessarily just bunker down and lay people off; they actually try all kinds of new things. There is evidence that innovation accelerates when margins are thin, because intense competition serves a higher potential reward from any successful innovation. Coasting at high margins is what discourages innovation. If you have $100+ oil, you may be just interested in drilling the next well and not really be thinking about efficiency in operation and capital the way you do when margins are thin.
AW: What’s keeping domestic prices low if exporting is such a good idea right now?
KM: In the short term, you bring enough supply on that demand cannot absorb it all and the price has to drop to encourage demand to be higher. At the end of the day, the market has to balance, and price is the signal around which they balance. There are a lot of concerns recently about global economic health and trade wars. That puts a negative bearing on price, because there doesn’t appear to be a consensus that the economy will continue to grow sustainably. When companies are looking at a greenfield investment opportunity, like the full set of value chain investments aimed at exporting their products to developing countries in Asia, they do not just look at the next 5 years; they look at the next 30 to 40 years. If you have a big enough balance sheet, you can absorb short-term challenges and will continue to push forward with a view to the long-term future.
Upstream onshore is the major casualty of the weak price environment, because it is a lot about short-cycle development. The capital costs are spread out over many smaller leases and individual wells, so it is easier to scale back in reaction to short-term political and pricing signals. This leads to a slowdown in drilling and a decline in rig count, which means a decline in production, which we saw in a major way just a few years ago. If people are not sensing that growth is going to be robust in the next 9 to 24 months, they slow down a little bit. When you get into bigger infrastructure projects like offshore rigs or facilities designed to trade hydrocarbon products internationally, those are not impacted in a similar way when it comes to near-term concerns about the economy. Overall, long-term global demand is there and it is not going anywhere, so projects with long lead times and operating lives tend to be focused differently.
AW: How are new popular perceptions of trade wars and environmental regulations adjusting oil company political affiliations?
KM: Energy and other capital-intensive industries just want clarity on regulation. They tend to have much more long-lived assets, and they seek confidence that they can generate a predictable return over the course of a few decades from those assets. If the regulatory environment shifts dramatically, the forecasts they counted on are disrupted, and they are less likely to invest in the next project until they sense stability again. Any connection to conservative or liberal politics are more an indication of how things are moving recently. If a US president announced that there is going to be a carbon price of X and that it is going to be legislatively determined and hence written into law, there would be some hand-wringing, particularly by firms that have already sunk investments in assets that will do poorly under the new law. But, even a drastic regulatory shift could help overall if it firmly and clearly establishes a new norm under which all firms can adjust and operate. The polarization of politics injects more uncertainty into what legislation is likely to be passed and what regulations are likely to last. Political uncertainty like we are seeing today is generally bad for all capital-intensive industries, including energy.
AW: Is the current importance of efficiency the cause for all the consolidation in the energy industry currently, and what can companies without large-scale operations do to become more efficient?
KM: It has a lot to do with it, certainly. We are in a thin-margin environment in onshore upstream. That favors efficiency. If you are a firm that can’t bring scale efficiency to the table, you’ll have to look for other efficiency or else get out of the industry. Some of the small independents and mid-caps are looking at divestiture, and others are throwing all their weight into new efficiency technologies. The big IOCs [international oil companies] constantly look for ways to improve operational efficiency regardless of the pricing environment, but they are the slow-moving behemoths in the energy space. They are not generally the entrepreneurs but, instead, tend to move in once a concept is proven and often find ways to improve upon it or better integrate it. In that sense, when an oil major starts using a technology, it sends a signal to the industry that the technology is proven and valuable. In some cases, it is innovation by acquisition, but you have to understand that the innovation space is diverse. It’s not just about trying new physical technologies in drilling or completions; it’s also about how you approach your operations. As you see something develop in technology generally that could have a place within your organization to create operational efficiencies, you can move projects from low to reasonable margins and you can even transform negative returns into positive returns. This part of the oil major’s approach to innovation is particularly encouraged by the current pricing environment and is also typically where you see the majors looking at making acquisitions.
AW: Are there cultural barriers to achieving the focus on operational efficiency?
KM: That is a firm-by-firm type of question. The oil and gas industry actually has a pretty broad range of culture from company to company. While I can make generalizations by firm size as I did answering your last question, historically there have been firms that lag the operational efficiency frontier, and there are firms that are pushing the cutting edge through internal research, partnerships, and contracting. Overall, though, I think it is fair to say that the US oil and gas industry is currently looking for ways to improve efficiency across the board.
AW: What are some ways you’ve seen that firms are trying to boost efficiency?
KM: A lot of what firms are doing to try and boost efficiency involves data. There is a tremendous amount of data gathered about how crews are moving, how water is transported, how waste management is occurring, and many other of these sorts of things. Bringing this all together and making sense of it is a classic big-data problem. There are new and innovative ways to analyze it and streamline it that do not necessarily come from within the oil industry. The oil companies are being pushed into digitalization, artificial intelligence, and data science. This is a big category with a lot of low-hanging fruit. There is also a tendency toward remote operation and toward robotization, which creates more data from increased communication between humans and from more sensor output. This feeds into the data science area, and they are capable of driving big efficiencies. If someone in Houston can manage a well in West Texas without driving out there, and they can operate it using remote control and automation, that is already cutting costs. Add on to that how they can make faster and better-informed decisions from their data, and you can begin to see how efficiencies can really increase.
Something else to recognize is that benefits from all these new technologies do not only fall in the realm of efficiency. Companies can discover entirely new opportunities using data science or through robotization. We hear about companies using cutting-edge techniques to review their knowledge and data and discovering new ways to stage their wells or a previously overlooked pay zone. Technology can also help them to dodge important pitfalls that they might not have otherwise. Efficiency may be a primary driver, but oil companies are deriving other categories of value from embracing new technologies.
AW: How practical is it for oil companies to try to tackle software development?
KM: Wow. Now that is an interesting question. There is an element of that occurring with internal tools that are relatively simple to develop and closely tied to the physical expertise of the industry. The oil and gas majors are very technically savvy and are doing some Space Age stuff in the field and offshore. That said, there are many different disciplines in engineering, and it should come as no surprise that software is not the oil industry’s comparative advantage. We are starting to see companies in the industry explore more third-party contracts and partnerships. They are look at how to work with Google and other large software firms, but they are also looking at how to work with smaller and industry-focused solution providers. In software, there is a place for all three: internal development, outsourcing to major software companies, and outsourcing to smaller industry-focused players. They make these decisions depending on where they see the most direct path toward achieving operational efficiencies. Despite fantastic engineering capabilities internally, the fact is that they still often get more value more quickly and cheaply from working with companies that have a specific focus and proven track record rather than reinventing the wheel internally. I often get some looks of surprise from my students when they begin to realize that the oil industry is one of the world’s top high-tech consumers.
AW: Where do you recommend leaders in oil and gas turn for information on how to evaluate these decisions?
KW: The statement “paralysis by analysis” is commonly applied to this situation in the energy industry. There is a widely noted risk right now that leaders can wind up doing nothing because they are overly focused on learning what they should do. In reality, the first thing that leaders in the energy industry need to do is to recognize and accept that the world is changing. From there, it becomes a matter of considering how various changes in the global energy-economy affect your firm. Then, while heavily utilizing their internal expertise, they can lean on consultancies and other institutions for aid in that domain. This is largely what they are doing already. If there are ways of better utilizing internal knowledge to make decisions more accurately and more efficiently, that should be done, and it generally is. From that perspective, investing resources into finding the best way to capitalize on internal knowledge and creating an environment where its dissemination is encouraged can be a valuable exercise.
Kenneth B. Medlock III is the James A. Baker III and Susan G. Baker Fellow in Energy and Resource Economics at the Baker Institute and the senior director of the Center for Energy Studies at Rice University. He is also the director of the Masters of Energy Economics program, holds adjunct professor appointments in the Department of Economics and the Department of Civil and Environmental Engineering, and is the chair of the faculty advisory board at the Energy and Environment Initiative at Rice University. Medlock holds a PhD degree in economics from Rice University.
Alec Walker is the cofounder and chief executive officer of the natural-language-processing and data-analytics firm DelfinSia in Houston. Delfin helps the oil and gas industry extract value from unstructured data. Walker has led digital-transformation and internal entrepreneurship projects for a variety of leading organizations including Intel, Inditex, AECOM, and General Motors. He has worked for Shell as a technical service engineer in refining, a tech tools software product manager, and as a reservoir engineer in unconventional oil and gas. Walker holds a BS degree in chemical engineering from Rice University and an MBA degree from the Stanford Graduate School of Business.
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19 May 2020
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