We are all aware of the significant change that has occurred in the oil and gas market since late 2014, but how many have recognised it as a paradigm shift and responded with an equivalent level of sustainable fundamental change in how they operate and contract?
Some companies have, but they are in the minority. Most however have cut rates and cut back on spending, but their operating models remain unchanged; they are arguably still hoping for the best, waiting for the good times to return when they can repair their balance sheets and carry on as before. With an inevitable low and slow oil price recovery under way and the UKCS not getting any younger, now is the time to really innovate. The influx of new independent field operators can help enable this innovation.
A Quick Recap
Though the UKCS won’t be an easy market going forward, there is still a lot to benefit from.
First the good news:
• There is potentially a third of the UKCS production still to be extracted, but much of that requires innovative cost-effective solutions to access.
• Last year the oil and gas industry employed 185,000 people (or 330,000 if you add in indirect employment) generating around £28billion annually and has been (prior to the oil price collapse) the largest industrial tax contributor to the UK government.
• The UKCS has a significant installed base of pipelines, offshore platforms, and subsea field developments, creating strong maintenance, modification, operational and decommissioning markets for service companies to benefit from.
• Focus on increased reservoir management has resulted in greater productivity than originally forecast, contributing to the extension of economic life.
• Asset swaps and new operators often bring development capital, increased focus on the basin and an opportunity to contract differently.
Now the not so good news:
• From a global production perspective, we are becoming less significant. The UKCS has 0.14% of proven global reserves (shown in the chart below) and 1.1% of current global production, or 3.8% of global offshore production, with our remaining potential reserves the most difficult to produce from.
• About a quarter of our platforms are more than 30 years old. Most were built with a 25-year design life, using bespoke engineered solutions, making cost of upkeep complex and expensive.
• The industry has not controlled escalating unit operating costs during periods of high activity.
• Industry wide, we have a poor track record in delivering complex projects on time and on budget.
With dwindling reserves, limited UKCS exploration activity, and a high lifting cost relative to others, it would be easy to conclude that the UK oil and gas industry has a limited life. Many industry commentators have over the years suggested that the UKCS’s days are numbered, yet time and time again our operators and service companies have demonstrated resilience, ingenuity, and embraced the challenges presented to them.
Since late 2014, the UKCS competitive position is even more precarious. How do we remain competitively attractive to international oil and gas company investment when there are other more commercially attractive field development opportunities elsewhere?
Learning lessons from the past
Arguably the supply chain dynamics create challenges – all the operators and contractors have focused procurement on cost reduction. Understandably, in a low-margin environment minimising costs from your suppliers is a priority, and most would agree that there was scope for efficiencies within the supply chain. However, is it truly in your interest to simply demand a price reduction when there are potentially more valuable ways of doing so? It is an easy but effective short term option for a client with huge bargaining power to slap a blanket price reduction on all suppliers of 15%. This strains working relationships, and the contractor will then look to reclaim this and more from the client when the market tightens. If additional effort was put into developing alternative methods of contracting such as incentivisation in reducing running costs, industry would be in a more progressive, innovative and robust position.
As we plan for future investment in the UKCS, it is worth looking back at our track record in Capex and Opex spend.
From a Capex perspective, many projects are not delivered on time and on budget. Several industry studies over recent years have indicated that around 70% of large oil and gas Capex projects complete six to 12 months late and on average 25% over their original budget.
Key operational failings in these projects often include weak project team structures, siloed working practices, poor delegation of authority and strained co-operation with the supply chain. This is accentuated by our herd mentality resulting in a race to get available resources when market conditions are favourable. Projects being sanctioned based on unrealistic prices and a lack of available resources (drilling rigs, support vessels) which are poorly factored into the supply chain, have been a common cause of cost overrun/project delays, as well as beginning detailed designs before initial FEED work has been completed.
Well run projects with high levels of front end loading (identifying risk, gathering information, and developing strategy) before sanction have much more predictable costs, demonstrating a greater likelihood of on time delivery, and are more likely to meet target objectives. It seems obvious, but our industry performance speaks volumes.
One relatively straightforward solution is to include independent third-party verification to highlight project risks and issues well in advance. This would increase investor confidence and improve future project approval processes.
From an Opex perspective, too often we permit a high oil price to paper over the cracks and we eventually become unattractive economically. An example of this was our ability to manage operating costs in the early 2010s; the UK and Norwegian divergence in unit operating costs over the past few years demonstrates this. Why can other basins operate with a higher degree of price stability, yet we cannot?
One could argue that it is cyclical, or based on supply and demand. What the graph below really shows us is that the commercial relationship between companies in the supply chain is broken; we can go from boom to bust – we inflate rates in a tight market and grudgingly cut rates when it is over-supplied. Playing out this commercial situation in the UKCS means that if rates don’t recover in the short to medium term, then companies will either fold or diversify into other markets. Because of the lack of trust and collaboration in the supply chain, any reduction in supply will result in higher prices being sought, yet the market may not have recovered by then, making the UKCS less commercially attractive overall.
Now more than ever, it is vital that operators and service companies collaborate more, drive standardisation, and encourage innovation in an effort to bring costs down in a long-term, sustainable manner.
Collaboration, standardisation, and innovation. Cynically, these are just buzz words we’ve heard before and failed to truly embrace as a sector, however, the scale of change in the market, coupled with the maturity of the UKCS, means it is more urgent than in previous industry cycles, and will have more immediate implications in terms of project sanctions due to the increased marginality of domestic projects. Thankfully during this cycle, we are beginning to see some success in these areas, but there is still more we can do.
What about commercial innovation?
The industry focus on innovation tends to support engineering, design and manufacturing technology. Efforts to innovate commercially are limited. We can and should be more ambitious.
Stop Cost Plus, Start Gainshare
If we continue with the parent/ child contracting arrangement, buyers are often rewarded through their key performance indicators for being able to demonstrate rate reductions. Tendering companies who win the contracts based on offering the lowest rates look to recover their margins through contract variations.
Not many firms incentivise buyers or suppliers to identify cost avoidance rather than cost reduction or refurb/recycle versus replace. We all see cost saving solutions that exist throughout the supply chain, but unless there is mutual benefit, then the contracting status quo remains. When was the last time you tendered a contract with sensible gainshare rather than cost plus? Gainshare contracts need to be win-win on a long term sustainable basis. These are difficult conversations and require trust and openness from all parties. We all know that, at best, cost plus encourages the supply chain to be commercially lazy, and at worst it can lead to a supplier loading the contract with unnecessary costs, yet we continue to accept this as the norm within contracts.
Next time you send out a tender, why not ban the use of cost plus? Ask bidders to promote gainshare and encourage other suggestions that encourage efficiency? Both parties benefit, but more importantly, the market remains focused on delivering value. With shared commercial incentives, the relationship improves and the market will certainly take notice.
Budgeting from a whole life cost perspective
There has historically been a limited relationship between project team budgets (Capex) and operational team budgets (Opex). Linking the project budget to the whole life cost seems obvious, but we rarely see this approach in the market. Most people wouldn’t buy the cheapest budget flight they see without first checking whether they needed to add in baggage costs, hotel costs and ongoing travel costs. Yet we structure project budgets with little consideration to the total cost over the asset’s operational life. Failure to appreciate the total cost at the beginning of the project all too often results in operational cost overruns and acrimony within teams.
As we move into the late life asset management phase, we have an opportunity to learn from past mistakes and develop a global centre of excellence, maximising profitability from our old, yet significant and still incredibly valuable asset base.
Regardless of whether you are an operator, a service company or a manufacturer, challenge yourself to be commercially innovative, build more value into your offering and next time you are reviewing a tender, perhaps the New North Sea will look more prosperous.
Ewen MacLean is director of Calash, an Energy and Natural Resources Commercial and Strategic specialist consultancy, headquartered in Aberdeen with additional offices in Houston, New York, London, and Sydney