North American shale plays driving growth at the expense of returns among Tier II independents
Tier II independents are focusing on North America unconventionals production which will rise to 50% of their total output by about 2020-compared with less than 35% of total current production. This focus has led to declining returns on capital employed from 21% to 10% in the last 4 years.
In contrast with the more diversified upstream strategies pursued by the Global Players and larger Tier I Independents (E&P companies with the potential to generate >1 mmboe/d in production), the North America-focused companies within the smaller Tier II Independents peer group-BHP Billiton, Hess Corporation, Marathon Oil, Murphy Oil, Noble Energy, and Talisman Energy - share the common theme of increased portfolio concentration within North America. Production from the US and Canada accounted for more than 50% of combined global volumes for the peer group in 2013, versus ~35% as recently as 2010.
This portfolio concentration is the result of an increased focus on US and Canadian onshore unconventional resource plays, a strategy which has driven output growth in recent years. This trend is expected to continue, with IHS Energy's Upstream Competition Service forecasting a ~6% production CAGR for the combined peer group over the next five years (compared with ~4.5% during the prior five-year period.)
The other side of this coin is the increasing peer group exposure to the challenging oil and gas market fundamentals in North America-reflected in continued low gas prices and substantial, cyclical discounts in regional crude oil prices relative to Brent. The result has been shrinking returns, with upstream ROCE (on a 3-year rolling basis) among the peer group declining from 21% in 2009 to less than 10% in 2013. This returns challenge is compounded by increased pressure from shareholders to improve returns and increase distributions to equity investors.
As a result, several of these companies have identified the need to develop core areas in addition to North America, while also pursuing divestitures or farm-downs of interests in non-core areas in order to focus on higher-return and strategically important assets. The primary challenge for the Tier II peer group lies in determining the appropriate portfolio balance between the growth prospects provided by US and Canadian unconventionals, and the potentially stronger returns attainable outside the North America energy market.
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