A Step Change to Value Creation

By John J. O'Connor, Senior Vice President Worldwide Exploration and Production
Texaco Inc.

UBS Warburg LLC Energy Conference

Good afternoon. I'd like to thank UBS Warburg for inviting me to their Energy Conference because it gives me an opportunity to tell you about Texaco's value-driven change process. Texaco's E&P business has gone through this change not only to position ourselves as a strong competitor in the industry, but also to position ourselves as an attractive "buy" for the capital markets.

In the energy business, it's a truism, even a cliché, to say that change is the only thing that's constant. The oil industry is also renowned for strong, central management, which is the antithesis of empowerment. And while most change to our industry has resulted from external shocks such as nationalization, price collapse, and so forth, I'd like to take the time this afternoon to tell you about Texaco's internally initiated change to its E&P business, which was part of our drive to become fully competitive in the industry.

I do this in the recognition that the fruits of this work may well be bound up in the ultimate change an enterprise can experience -- the merger of the business with a competitor.

Nonetheless, the signs are encouraging that the changes we've made have already created a stronger, more valuable enterprise, with knowledgeable employees, and increasing credibility in the equity markets. I also believe that the process we followed is applicable to most E&P businesses, regardless of size.

The need for change was driven by a wakeup call from the financial markets. Some, like our Vice President of Investor Relations, Liz Smith, [who is here today,] were sounding an alarm -- warning of what could happen to an under-performing, asset-based company with depleting assets. No doubt this message was also conveyed by many of you, when you were advising your clients.

Texaco's senior executives reacted by demanding a solution to the problems. They sent a strong signal, and challenged the prevailing company culture, by recruiting outsiders with new perspectives. As a result, in the Upstream, the leadership team responded by creating a plan to achieve two overriding goals for the business: first, to restore short-term value, and second, to build an attractive foundation for growth. We also acknowledged that to do this successfully would require a drastic change from our traditional ways of doing business!

In short order:

  • We took stock of the facts of our business,
  • We determined which key changes were needed, after we evaluated our strengths and weaknesses,
  • We constructed a new strategic direction, and
  • We set out to implement it at breakneck speed.

By the mid-1990s Texaco's upstream business had become heavily dependent on mature, well-exploited, domestic U.S. legacy assets. Our exploration program was less successful than we would have liked. New development opportunities were minimal, and we had not acquired any new assets in years.

You know the results. Texaco's reserves for 10 years through the mid-1990s were flat, at just below 4 billion BOEs. Our reserve life was less than nine years. The key financial measures of ROCE and earnings per barrel were fourth quartile. This was a resource business running out of resources, which held little appeal for investors!

Texaco, of course, was not unique in this respect, but was simply a prominent example of the consequences of an "operational" fixation that had evolved in the E&P industry over more than 100 years.

There were many, many reasons for Texaco's dilemma, but in any event it was apparent that renewal would necessitate a truly significant change to the "status quo."

The Upstream Leadership Team debated the options and agreed that:

  • A new, realistic, value-creation model for the business must be constructed,
  • Investment CAPEX must be increased, and new development projects with both scale and appropriate timing needed to be captured,
  • The insular internal culture must be changed, and
  • The traditional E&P organizational structure, with integrated business units covering discrete geographies, must be re-evaluated.

Once we thoroughly understood the capacity of our own assets and cash resources and our competitors' performance capabilities, we put together a comprehensive plan designed to deliver a ROCE of 12 percent and to grow production at 3 percent p.a., in an $18 WTI world, by 2002. This combination we saw would deliver better than 10 percent p.a. earnings growth and represented for us a realistic vision, not to mention being a significant improvement on our track record.

To ensure that this outcome was sustainable and predictable, we also agreed to take a portfolio management approach to all of our assets and investments. We planned to balance our cash position and ROCE with a strategic mix of assets from the past, present and future. Assets of the present -- those that are plateaued -- generate current cash. Assets of the future -- those that are being developed now -- represent the growth segment of our portfolio.

And what about assets of the past, those with declining yields? We agreed to selectively sell off these declining fields to regional players who know how to maximize their value. Balancing the assets and activities in each element of the Value Chain would keep us cushioned against the vicissitudes of the industry and allow us to deliver our plans with confidence. It would also enable us to balance future cash plowback and burn rates with a disciplined eye toward delivering the desired ROCE.

Because our organizational structure had contributed to a lack of strategic vision, to poor capital allocation and to sentimental attachment to assets, (regardless of their ability to generate new value), we looked for some new structure that would better serve our growth and value-creation ambitions. We decided to organize around the E&P value chain.

Finally, and consistent with our desire for step-change, we put in place investment criteria to force us toward projects of scale and profitability that could really impact our business, and that would be the nemesis of "investment incrementalism," which had served us so poorly in the past.

While working up these longer-term changes, we quickly restored short-term value through a number of initiatives. We shut down those exploration plays where prospect sizes were marginal. We redirected capital away from those "bread and butter" domestic businesses that had been our mainstay for many years. And regrettably, of course, we had to right-size the employee base for the new business realities.

I am often asked why an E&P business should move toward becoming a value-chain organization. For Texaco's Upstream, we simply had to use changes in organizational structure to drive behavior. For us, it was the right thing to do.

The old integrated regional structure and its accountability systems had limited our ability to think and act globally, severely restricting our ability to share resources across geographic lines. Of course, there is a role in our industry for regional competitiveness and concentration. However, one must have a near seamless global sharing of skills and resources to achieve global competitiveness.

Texaco's organizational shift created an environment that allows for an almost transparent understanding of the fundamentals of our business, so that we can quickly identify areas of strategic strengths and weaknesses. It has also created the conditions for us to project our competitive strength anywhere in the world.

We began to refer to the base producing business as the "bank," a source of cash and earnings to fund our growth ambitions. This is, perhaps, the most fundamental shift. We moved from being an operating company to being a global entrepreneur. In a matter of months, our focus switched from the tactical to the strategic.

The outward evidence of this transition is best expressed in our capital budgets. As late as 1996, our spending was evenly split between domestic and international opportunities. Now in 2001, however, our international budget accounts for 75 percent, and this divergence is growing.

We began to measure better: All of these structural changes were underpinned by a rigorous system of metrics and accountability. Each functional segment of the business was given specific metrics that tied to three or four key success measures for the entire Worldwide Upstream. For example, with ROCE as a driving measure at the overall Upstream level, we used segment metrics such as Exploration expense for exploration, Development cost for commercial development and earnings per barrel for our base business. Through this we were able to demonstrate how success in each functional sector would accrue to the good of the business as a whole.

The new metrics allowed us to change our culture: Texaco is also jettisoning the old command and control mentality that has been such a hallmark of our industry. Like other successful companies before us, from GE to Southwest Airlines, we are empowering our people to do their best.

Metrics are critical to this cultural shift. First, they clearly define performance expectations, and provide a common language.

This common language creates a second deliverable --empowerment. Once our people understand what is expected, and how their actions support the total business, they have a framework to create value. Our leadership sets the "what" with strategy, and the "why" with metrics. We now leave the "how" to individuals. The result has been internal debates that are robust, with self-imposed standards rising to dizzying levels.

We invested in new resources: Between 1997 and 1999, Texaco built a completely new foundation for growth by:

  • Purchasing Monterey Resources in California,
  • Entering into the Karachaganak and North Buzachi projects in Kazakhstan,
  • Acquiring 30 percent of the Hamaca project in Venezuela, and;
  • Buying a 45 percent interest in the Malampaya gas development in the Philippines.

While we have enjoyed various levels of success with these projects, all told, these initiatives added 3 billion BOE of resources for an A&D cost of under $3/bbl, fully developed. And, of course, in 1999 and 2000 we discovered, and confirmed, the discovery of the giant Agbami oilfield offshore Nigeria.

We sold high: To high grade our producing assets, we took advantage last year of the high commodity price environment by selling 75 TBD of production, generating $600 million in cash. This successful resizing of our production base increased our ROCE. Just as important, it solidified our internal commitment to move to a portfolio management approach to the business. It also signaled to the market that we would make similar portfolio shifts over time to deliver the results we promised.

All in all, our reserves have grown by 7 percent a year since 1996. And to highlight this trend, two weeks ago we announced a reserve replacement figure of 172 percent for last year, raising our reserve volumes to nearly 5 Bn Bbls. and our reserve life to 11.5 years. Quite a change since 1996!

Here's another thing we did.

Exploration became more focused. The ability to buy into discovered-reserve projects has freed us to be more strategic in our exploration and to reduce our spending considerably from historical levels. Texaco now drills wildcats only for prospects of scale, where individual success can create significant value, concentrating for the most part on the most promising areas of Nigeria, Brazil and the Gulf of Mexico.

In such deepwater environments, there are long lead times between discovery and first production. So we plan for this portfolio to add new, high-margin volumes in the 2005-2010 time frame. Agbami, our giant oil strike offshore Nigeria, and its more "gassy" counterparts, Nnwa and Bilah, should be seen as the first contributors to this staged strategy.

Beginning in 2002, we project that the mega-projects will come on stream at roughly one-year intervals. They all meet our stringent financial criteria. Just as important, they will account for over 2 BN bbls of added reserves over time.

And because our business has such long lead times, we are already planning, by the end of this decade, to bring to market large volumes of Texaco's unbooked gas resources from our world-scale projects offshore Nigeria, Angola and Australia.

We truly have an inventory of high-impact, high-value development opportunities stretching as far into the future as even this far-sighted industry can see!

There are other aspects of the new Texaco I want to discuss.

We became Flexible: The classic value trap in this industry is the trade-off between volumetric growth and good financial returns. We learned to value flexibility, which translated into deliberately calibrating production growth, by buying and selling assets -- without regard to sentiment or legacy, in order to meet market expectations.

Of course, it is not good enough to bring about change if you cannot measure what you are changing. So, as I said earlier, we imposed a complete set of metrics for all aspects of our business to drive value growth and make us attractive to the energy investor. And if Texaco's E&P performance looks like it is deviating from our overriding objectives, we can now fine-tune outcomes in any functional sector -- Exploration, Development or Production -- to ensure that the enterprise as a whole performs.

In short, because we refocused our entire business, refocused our people, and refocused our cashflows, we can now credibly forecast the delivery of consistent, competitive results, which is what the market demands.

Such a transformation has not been easy. Incrementalism is encoded in the DNA of our business. In changing the way we work and think, we learned a few lessons that any E&P outfit can bank on.

  • First: Thoroughly understand the competitive measures that best explain results to investors.
  • Second: Evaluate the likely through-cycle cash available, then size your portfolio to suit your resources, without regard to historical considerations.
  • Third: Adopt a resource-management, cost-control and capital-discipline approach to each functional element of the value chain so that development of new projects occurs at appropriate strategic intervals, with attractive economics, to deliver the targeted growth trajectory.
  • Fourth: Make sure your metrics are clear to the employees.
  • Fifth: Structure the organization so that regional units can draw on global economies of scale to deliver strategic outcomes and empower employees to deliver. Compensate appropriately.
  • Sixth: Communicate as effectively as possible to the organization and to the market. Then listen to the feedback.

In the years ahead, the super majors will deliver results that, by their very nature, will readjust and intensify performance levels. It is clear that the industry leaders will continue to drive competitive metrics to levels we would not even have comprehended as recently as a decade ago. This should come as no surprise, for what is true of a bulge-bracket investment bank is no less true of the oil industry. Beyond the advantages in portfolio management and cost, larger companies have the opportunity to leverage vast intellectual resources across a world of challenges.

I describe the renewal of Texaco's E&P business with some measure of humility. I know all too well that capital markets are justifiably cynical. I know too that it would have required more time and consistent delivery of results for Texaco's credibility to have been fully restored.

Nonetheless, I do believe that we have a good story to tell. And I believe that it is being heard and understood. Certainly, it is a story being acted upon by one audience in San Francisco. And I hope that the transformation of Texaco's E&P business is both welcomed and valued by many of you here today.

Thank you very much.

Updated: February 2001