Operational Excellence Becomes Oil Industry Watchword (again)

Cost-cutting is set to remain the main focus for the oil industry for at least the next two years as petroleum producers adjust to an environment of much lower prices.

If the boom was characterised by an emphasis on ambitious and complex engineering and technology projects, the downturn has brought a renewed focus on simplification and efficiency.

It marks a return to what was called "operational excellence" during the long years of low oil prices in the 1990s.

Operational excellence is about more than just short-term expenditure reduction.

But not even the free fruit for employees at BP's  giant campus at Sunbury near London has been spared from the search for economies.

The fruit is a good symbol of the industry's approach to cost control: it was also axed during a previous cost-cutting drive in 2008 only to be restored when prices and revenues boomed again.

But the current round of cost cuts and efficiency measures seems set to go deeper and last longer than in 2008/09.

Unlike the previous downturn, which was associated with a drop in demand many considered temporary, the current drop in prices is the result of the supply side shale revolution that most expect to lower prices for at least several years.
 

Cycle of Cost Control
The cost of finding and developing new oil fields (covering everything from leases and seismic surveys to hire rates for rigs and pressure pumping equipment) has always been strongly correlated with oil prices.

In boom years, the race to develop new resources causes the industry to lose control over the cost of everything from roustabout wages and drill pipe to consumables like fracking sand and drilling mud.

When the bust arrives, surplus rigs are idled, field workers dismissed and field developers renegotiate the costs of everything with their contractors.

The industry has experienced busts before in the 1960s and 1980s when the number of rigs drilling for oil and gas in the United States fell by more than 50 percent.

The current downturn is no different with developers and operators looking to cut costs which had become inflated during the 2004-2014 boom.

"We all get a little lazy, a little flabby," the chief financial officer of drilling contractor Transocean (RIG)  admitted at a conference recently about the impact of years when oil prices were above $110 per barrel.

"It's been painful, but (the downturn) allowed a lot of folks to extract efficiencies" said an executive from another service company ("Energy companies grew lazy and flabby while oil prices were high" June 4).

Drilling and completion costs have fallen by as much as 20-30 percent since the start of 2015, the Dallas district wrote in its contribution to the Federal Reserve's Beige Book for June.

The Fed's survey of regional economic conditions is mostly based on anecdotal contacts so caution is advised before placing too much emphasis upon it.

But it is consistent with other reports that show developers and contractors cutting wages and prices to improve returns.

The industry is pursuing four major strategies for cutting costs.

First, reducing wage rates and contractor fees. Britain's North Sea operators have imposed a 10 percent reduction in contractor rates across the board and are pressing offshore workers to move from a shift pattern of two weeks on/three weeks off to three weeks on/three weeks off.

Second, cutting fees and hire rates to service companies. Saudi Aramco has demanded steep reductions of as much as 30 percent in hire rates for drilling rigs and other oilfield equipment.

Third, standardising operations as much as possible. Shell is centralising its procurement and logistics operations in Canada's oil sands region to boost efficiency and squeeze economies of scale.

Finally, cancelling or postponing capital projects which are irreducibly complex, speculative and offer the highest risks and most marginal returns to improve performance for the portfolio as a whole.

Operational Excellence
 "The recent collapse of oil prices from a peak of $147 has once again made operational excellence a central imperative for upstream oil and gas companies" management consultants for McKinsey wrote in 2010.

"The fall of oil prices has exposed an inflated cost base in many oil and gas companies, forcing them to reduce operating costs, rationalize investment budgets, and boost operational efficiency."

The lesson is even more important now that prices are expected to remain lower for some years.

"Previous industry cycles have shown that companies should use a price drop as an opportunity to drive through fundamental improvements in the way their operations function," McKinsey concluded ("This is the time to deliver on upstream operational excellence" Feb 2010).

The shale revolution is transforming the entire industry because of where it sits on the cost curve.

The mature shale plays of the United States are more expensive to develop and produce than the low-cost giant reservoirs of the Middle East.

But they compare favourably with higher cost resources such as Canada's oil sands and Britain's North Sea fields.

And they are certainly cheaper and less risky than some of the mega-projects that have been proposed for areas like the Arctic and ultra deepwater.

Compared with ultra deepwater projects and high pressure high temperature wells, the technology employed in the shale fields is relatively straightforward.

Shale is more like a mining or manufacturing process than a traditional oil exploration and development one and it rewards the same mindset and approach.

The focus is on process efficiency, standardisation and cost minimisation, rather than complicated, bespoke, cutting edge and expensive engineering.

As shale output has effectively become the marginal barrel in the oil market it is forcing other oil producers to rethink their approach.

Complex engineering, megaprojects and big oil still have a place in the next few years, but only if they can become cost competitive with simpler shale plays.
 

(By John Kemp)