David Delvin, vice president at Hitachi Consulting, takes an in-depth look at the pressures facing the E&P supply chain.
The recent UK upstream oil and gas supply chain surveys conducted by EY (April 2014) and the Wood Review (February 2014) have highlighted a number of worrying trends. Despite turnover growth, driven largely by healthy capital expenditure, the forecast does not look so positive. This means the supply chain will need to focus even more on eliminating inefficiencies in its processes to reduce activities that do not add value and optimise costs.
A major factor in the improvement of supply chain turnover has been the increase in capital investment in the UK Continental Shelf (UKCS), which has grown 140 per cent between 2008 and 2012. The main reasons for this rise in investment can be linked to:
- Five multibillion-pound projects being sanctioned from start of 2010, which are now nearing completion
- Fiscal policy, as new field allowances have increased attractiveness. Half of the £14.4 billion in CAPEX in 2013 was incentivised by an allowance
- A renewed focus on asset integrity and prolonging asset life
- A stable and relatively high oil price
E&P supply chain service providers have been a major beneficiary of the increased capital investment and have had significant revenue growth over the last five years as a result with turnover increasing by £11.4 billion, or 47.5 per cent, between 2008 and 2012. However, this increased turnover has failed to translate into increased EBITDA margin. This suggests that despite substantial top line growth in the UK supply chain, significant inefficiencies are still present. Splitting the supply chain into the main categories, one can see that supply chain companies associated with reservoirs, which include services such as seismic, have actually seen EBITDA profit drop by 10 per cent while turnover has increased by 70 per cent (between 2008 and 2012) [1].
Future Outlook
Current market trends observed in the UKCS suggest that top-line revenue for the supply chain will come under pressure. The current forecast for capital investment is for a dramatic downturn of around 50 per cent reduction in the next five years. Exploration drilling rates are also at an all-time low, which is a leading indicator for lower future investment through development.
There is a trend of increasing operating costs. Adjusting for inflation, nominal costs are the highest ever in the UKCS. Coupled with lower production, this means that unit operating costs, or lifting costs, has increased from around £4/boe to over £17/boe in the last decade. Operators have historically absorbed this cost, but the lower margins will eventually be taken on by the supply chain as operators are forced to cut costs themselves. Although the oil price has remained steady, any significant drop will expose a number of operators and make it uneconomical to produce.
What is causing the inefficiency in the Oil and Gas Supply Chain?
Cost competitiveness
The UKCS is regarded as one of the most expensive basins in the world to operate. International competition and a shift in demographics have led to a shortfall in the required skills and experience required to fill existing needs. This has inevitably pushed up demand and, subsequently, wages to well above the national average. Within well services, for example, average salaries have increased by 16 per cent in recent years, while employment sectors across the rest of the UK have only seen flat or minimal increases.
Other significant cost levers for supply chain service providers are their overhead costs or the scale and complexity of their operating footprint. This includes the size and location of offices, warehouses, back office support and distribution. Many supply chain service providers need to update their current processes to meet what a lean and agile supply chain would look like in today’s economy.
Fragmented market with larger number of smaller operators
An influx of smaller independent operators buying assets from the larger integrated majors with a view to extending their life has brought opportunities for the supply chain providers, but has also fragmented the marketplace. Projects have reduced in size, which has made it increasingly difficult for the service providers to benefit from economies of scale. Supply chains have also become stretched as they seek to deliver services on multiple fronts. With more operators offering smaller pieces of work, the tendering and contracting process has become wasteful and time consuming. Oil and Gas UK’s LOGIC suite of cross-industry standard contracts to promote collaboration has been effective for a number of scopes of work; however, there is still a lot to be done in terms of buy-in and expansion.
Limited collaboration
Collaboration is certainly not uncommon in the oil and gas sector. Large and complex projects have required multiple service providers to work together and joint ventures exist between operators to manage risk and exposure to the significantly high investment costs required when developing field opportunities. However, further collaborative opportunities such as sharing exploration rigs, field cluster developments, exploration and drilling projects, sharing of critical spares and technology innovations need to be considered as a way of reducing costs within the industry.
Operator expectations of supply chain service providers
Over the years, operators have placed a significant emphasis on being able to measure the performance of their internal processes. However, when it comes to being able to measure the performance of their supply chains, the clarity starts to become diluted. A number of operators still struggle to measure the performance of their service providers accurately and transparently. This means delivery and lead time infringements have limited consequence. Operators have a tendency to blame service providers for not delivering while the service providers blame the operators for not providing enough detail, providing requests with too little notice or changing the scope of work at the last minute.
Inefficient commercial structures
As the industry has developed, so too has the complexity of the tendering and contracts process. As operators and service providers try limit their exposure to commercial risk, a significant amount of inefficiency has been introduced to the process. A vast amount of back office support is now required to manage and navigate through these processes, which is exacerbated by the fact that service companies now deal with more operators in a fragmented market.
This is often acceptable for the larger operators but for the smaller niche service providers, this can be a considerable cost. Contracts have traditionally included an understanding that successful “over-delivery” will result in a share of the rewards. In reality however, it is often the case that an over-zealous contracting process has fostered at best an untrusting, and at worst an adversarial relationship between operator and service provider. There has not, therefore, been a noticeable movement towards a genuine and mutual risk and reward contracting structure.
Conclusion
The UK supply chain has been able to generate significant revenue from exporting services, which accounted for 42 per cent of turnover in 2012. For this to be sustainable, there will have to be a significant reduction in its cost base to remain competitive in a global service market where lower cost options are available overseas. A decrease in the cost base for the UK supply chain is therefore imperative both for revenue growth overseas and profitability from a squeezed UKCS market. This may be achieved through:
Better Planning and Visibility
To ensure the correct goods and services are received On Time and In Full (OTIF), greater visibility has to be provided to the supply chain via better planning and an increased collaborative work environment between purchaser and supplier. An effective Integrated Activity Plan (IAP) should include a prioritisation process which provides focus to the business to deliver on the key activities, an integrated materials management process which reduces the costs and inefficiencies associated with the movement of materials and increased collaboration between activity sponsor and contractor. The use of Service Level Agreements (SLAs) can enable operators to have greater control over budgets, provide greater transparency to the supplier and allow shared responsibility for performance.
Reducing the inefficiencies through contracting and tendering:
The demanding qualification process is one of the reasons why the tendering process is inefficient. The PILOT Supply Chain Code of Practice (SCCoP), along with FPAL, has introduced supply chain KPIs that benchmark performance for both purchasers and suppliers, thus reducing the necessity for excessive qualification reviews. However, with just over 150 signatories from over 1,500 companies, there is still substantial progress to be made, particularly with the smaller niche contractors. Bundling similar services is an attractive solution, and The Wood Review suggests sharing exploration rigs to reduce cost. This could even be further expanded through the supply chain to include service contracts such as wireline operations and cementing.
Make the working environment more efficient:
The industry as a whole can reduce inefficiencies. Current Hitachi Consulting benchmarking measures UKCS offshore wrench time at 52 percent. Increasing the workforce efficiency would allow more work to be done without extra labour costs, especially with offshore bed space at such a premium. The industry needs to be honest about current productivity and work together to address the underlying issues, as the current levels observed in the UKCS are not sustainable. Changes to the commercial structure of the big contracts would provide an incentive to the service companies to increase their productivity and performance.
A realignment of the infrastructure and footprint would increase margins by reducing the costs associated with managing the complex and fragmented supply chain infrastructure centralised around Aberdeenshire. Suppliers could share warehouse facilities and, in turn, collaborate to bundle tier-2 and tier-3 supplier contracts, affecting the whole supply chain. Operators could improve working capital by adopting consistent sparing philosophies. This will also increase delivery performance (OTIF) and have a positive effect on safety and production by reducing the lead time of critical equipment.
The success of the UK oil and gas supply chain should not be undermined but, looking to the future, significant changes must be made to both process and behaviour for this industry to remain world-class in a competitive global economy.
