For the Oil & Gas Industry, Defining Questions Loom Large
Although the worst of the latest oil and gas industry downturn seems to be behind us, global oil prices have remained under $50 per barrel as of late-May 2016. Even when prices do rise again, neither the industry nor the market context is going to change any time soon. What lies before the industry is an opportunity to redefine itself to promote industrywide stability and healthy bottom lines for companies. As history has proven time and time again, however, the industry tends to reach for the low hanging fruit and address only its near-term needs. The current response just echoes the past.
Let’s consider where things stand today, starting with the industry context. Many upstream operators have already announced capital spending reductions for 2016. These reductions to capital expenditures build on reductions made in 2015, which, combined with reduced production spending, have resulted in widespread industry layoffs. Many projects to develop and construct production facilities have been recycled or cancelled. The effects of these decisions are amplified as they reverberate down the supply chain. Operators have divested themselves of assets that no longer align with their strategic outlook. As for the market context, although scant signs of increased demand for oil have been observed, ample oil supply and sustained production levels are likely to prevent prices from rising sharply.
So what are we to make of how the industry has responded to the market downturn? Company decisions to reduce capital and operating expenditures are both predictable and rational, given the need to maintain cash flow and financial flexibility, and to pay dividends to shareholders. Ironically, asset investment decision making at some companies has improved because of the capital spending cuts. Indeed, the limited capital not allocated to maintaining asset safety, production rates, and compliance upgrades is being spent on the most promising opportunities in the project portfolio, often asset investments with short cycle times. In addition, companies say they have been successful in driving down stubbornly high project costs by slowing projects’ progress through development. A little more on this later.
What’s concerning, however, is that a substantial—and arguably still ongoing—industry crisis was necessary to force companies to think seriously about and act on capital discipline, and to start thinking about the systemic changes needed to generate efficiencies. Unfortunately, to maintain financial flexibility, sustain desired production rates, and keep debt in check, companies’ hands were forced to “pull the trigger” and ask questions later. But the consequences associated with more than a year of industrywide staff layoffs cannot be ignored. Although owner companies are now in a better position to leverage lower project costs, it is time to find lasting ways to keep project costs low and build more sustainable industry partnerships.
As we begin to see indications that oil prices have bottomed out, let us consider some key topics that will define the upstream industry’s future. IPA will release a series of articles over the next few months, each providing a more in-depth look at the following topics:
Project organizations: With so many experienced project organization professionals having been forced out the door (or about to walk out the door), how do we retain and begin to rebuild competent business and project teams capable of delivering production assets cost effectively? It won’t be easy. Some young professionals will not be willing to join or return to the workforce because of employment instability. On the other end of the career spectrum, a lot of the industry’s most experienced professional have retired. Meanwhile, no one is left to train mid-career professionals. The industry has seen this happen before. How are we going to get the skills we need and where are we going to find them? Owner companies have already drawn much talent from engineering, procurement, and construction (EPC) firms. How can we prevent our project organizations from hollowing out again?
In working with our clients, IPA has discovered a few creative ways companies are approaching the talent problem. Some are taking a systematic look at other parts of the company to see where people can be transferred to acquire new skills. One example is to transfer people out to business units or sites where capital is being (or rather should be) spent—and boy is such cross-training needed! There is no upside to having fewer people produce the same number of work deliverables. Some companies are systematically looking at work process to ensure that not just headcount but also unnecessary work steps are eliminated so that the remaining staff isn’t overburdened. In fact, a recent IPA study identified a staffing “sweet spot” to generate superior outcomes. You do not want to be overstaffed, but you certainly do not want to be understaffed. A subsequent article will discuss this topic in more depth.
A new framework for “big oil”: The industry is clearly in an oversupply situation. Many are predicting that big oil’s raison d’etre—big projects to develop big volumes to feed an increasingly hungry world—may be under threat. We believe it is premature to talk about the demise of big oil. But one thing is certain: if big oil companies cannot fundamentally alter their approach to projects, they may not be able to make them go at sub $50 per barrel—and that could spell big trouble. One element big oil should reexamine is the penchant for volume over value and using net present value (NPV) as a key performance indicator (KPI) of merit. During a high commodity price environment, heavily NPV-focused companies almost always end up with project scopes that are overdesigned and expensive. Given our industry’s production history, these facilities are often underutilized. The industry should seriously consider ways in which to achieve more competitive and lean scopes. For instance, do we need to scope projects to deplete the entire recoverable volumes or should we consider phasing? A recent IPA study revealed that the relationship between recoverable volume and profitability index (NPV/Capital) is not linear; there is an inflexion point beyond a certain size when bigger reservoirs actually end up being less profitable per barrel. To survive this context, companies need to act on other KPIs, ones that drive competitive, lean scopes. “Design to Cost,” profitability index, or cost of the marginal barrel are elements that can drive lean scoping decisions. However, none of this will work unless we recalibrate our systems, processes, and KPIs, which are currently designed to optimize and maximize each project’s NPV.
The supply chain: As mentioned earlier, owner companies have been able to get EPC firms and vendors to reduce costs by drawing out development durations, delaying tendering, or outright asking for concessions. EPC firms recognize that projects are less likely to be sanctioned without these cost reductions. Lower oil prices should bring project costs for equipment, procurement, drilling, and services back down from highs that were making projects uneconomical even with oil near $100 per barrel, but EPC firms are struggling in light of the reduced owner company capital spending. Going forward, the industry needs to rethink its relationships with vendors and figure out ways to improve the supply chain. It also time to once again tackle the need for industry standards. Finally, we need to start shifting from a “zero sum game” to building “supplier ecosystems.” Building ecosystems is nothing new; it has been done in the information technology sector for a long time. In fact, many oil companies have adopted it in their own IT shops. The same can be done in the E&P industry. It takes time to mature and leadership perseverance to succeed, but supplier ecosystems can be the right solution to foster cost reductions industry-wide.
The upstream industry is cyclical. The industry as a whole is not doomed to repeat history every time oil prices plunge. Although several companies boast healthy balance sheets, kneejerk reactions to market downturns, only to be followed by wasteful capital spending when prices rise, characterize the industry. As Royal Dutch Shell plc Projects and Technology Director Harry Brekelmans said at a recent industry conference in Florence, Italy, the birthplace of the Italian Renaissance, “The oil and gas industry is in need of its own Renaissance. This will be how we collectively respond to the tough business environment we find ourselves in.”
We, as an industry, should embrace this call for change.