All independent oil and gas companies will have to drop the idea of growth at all costs and focus on free cash flow if unconventional production is to be profitable, McKinsey & Co. said in a report released Aug. 15.
While most of the largest independents have shifted gears and are now preaching capital discipline and an emphasis on shareholder returns, McKinsey said not all producers have followed their lead. Some continue to push the idea of growth at all costs, leaving them heavily in debt and investors treating their stocks as if they were radioactive.
"Independents will need to address the weaknesses and bad habits that have taken root during an era of growth and take steps to improve their capital productivity and attain profitability," the firm said. "Our experience with operators indicates that this will require a transformation focused on achieving operational excellence, cost leadership, disciplined growth, and balance sheet fitness."
McKinsey said the independent producers have "mastered" the concept of satisfying investors by injecting large amounts of capital back into their business to push production growth. While oil and gas production has rapidly expanded, most independents have shown low capital efficiency and have hurt themselves by weakening their balance sheets. Now, with lenders shutting off access to producers and investors now demanding returns above growth, the firm suggests many independents need to shift gears quickly.
"[The lack of shareholder returns] was evident during the first three quarters of 2018, when both EBITDA and free cash flow were negative despite an average [West Texas Intermediate crude] price of $65 per barrel. This suggests that the US unconventional sector can sustain itself only with a price of at least $70 per barrel," the firm said.
McKinsey's data showed that independents are close to even when it comes to free cash flow per boe produced and have pushed back from a low of more than minus $4 per boe earlier this decade, but they remain in the negative. An independent's return on capital employed, the firm said, is less than 1.0, with an average between 2014 and 2018 of less than 0.5. Major producers, on the other hand, have a four-year average of nearly 1.5 and approached 2.5 in 2018.
"To win in the era of cash, independents across the unconventionals sector will need to overhaul their strategies and operations across the board," the firm said. Chief among the changes suggested were rejecting the mantra of constant growth, concentrating instead on sustaining current production levels while becoming more efficient. Leaner producers who focus on their top-producing regions while repairing their balance sheets, McKinsey indicated, will come out ahead.
"Independents must maintain a relentless focus on operational performance that seeks to maximize economic value rather than production volume. One way to do this is to pursue value-focused development: designing wells and development plans to optimize economic value rather than initial well rates or total production," the firm said. "To succeed across cycles, operators need a balance sheet that enables them to weather storms. If their growth comes at the expense of balance sheet health, they will struggle to survive downturns."