Cost Management in Upstream Oil and Gas

By Andy Tidey

Wood Mackenzie recently completed its Global Upstream Cost Survey and published a perspective entitled “Cost management in upstream oil and gas: Has upstream kicked its cost problem?” The survey demonstrates that many in the industry have made progress on costs over the last two years. Considerable cost reductions have been achieved, but there are significant concerns about whether the actions are truly sustainable.

Cost Management in Upstream Oil and Gas

Verisk Review sat down with Andy Tidey, senior vice president and global head of performance improvement at Wood Mackenzie, to discuss this urgent matter.

Verisk Review: What major changes do you think are necessary in the oil and gas industry, given the current market situation?

Andy Tidey

Andy Tidey: There are various aspects to this question, but the main issue is this: Given the expectation of 60- to 80-dollar oil for the medium to long term, what cost level do companies need to get to? Despite the significant pain over the last 18 months and the good work many people have done, there’s still a lot more that likely needs to be accomplished just to get to optimal cost levels and do so in a sustainable manner.

Our work at Wood Mackenzie shows that, in the upstream oil and gas market, there’s still a significant focus on short-term cost control and approaches that can be quite adversarial between operators and the supply chain. The operators have been very much focused on rates, on renegotiating and retendering contracts, and on cutting back discretionary spending. Of course, this is all legitimate and shows good discipline, but what we haven’t seen many in the industry thinking through is how—among all the participants in the supply chain—you actually address the costs in the system for the benefit of all in the supply chain. I believe that’s a fundamental change required.

Verisk Review: What possibilities do you see to make that happen?

Tidey: Well, when you look at parts and materials, for instance, there’s a lot more variability in our industry than in other industries. Recently, someone who’s working in the North Sea told me something interesting: The operator he was working with had more than 100 shades of yellow paint for their platforms. So, let’s take a step back and look at U.S. unconventionals. You see that they are much more focused on standardization and on manufacturing type disciplines. A major cost reduction in other industries, such as the automotive industry, was realized by standardization of parts, consolidation of the supply chain, deep long-term relationships between the OEM and tier-one suppliers, and value engineering.

Verisk Review: If efficiency and working across company borders are the necessary conditions for change and progress in the sector, how can you become more integrated?

Tidey: If those in the industry really want to make a change, there’s a strong need for a change in mindset and a change in commercial arrangements. From a historical perspective, there are some long-standing adversarial relationships in the market. In England, we have the expression “when the boot is on the other foot.” There just aren’t really enough incentives to make major changes for the long run, which in fact is quite different from having long-term relationships, stable pricing, and the kind of contracting mechanisms often used in other industries.

We do see good examples of suppliers and operators working together to optimize a development and implementation schedule. The key question is whether these examples are sustainable when oil prices and activity levels recover.

Verisk Review: What is your opinion on the day-rate model?

Tidey: The day-rate model can be counterproductive to what operators want to achieve. Of course, the model is tempting for a procurement person because it makes it easy to compare rates between the various suppliers. But after that initial phase, when working in the field, the incentives can be completely misaligned. As an alternative, why not consider working for a fixed-fee structure? There are a lot of industries, like my own consultancy industry, that have moved away from the day-rate model over recent years to one which is more focused on the outcome based on a fixed fee or value-based pricing. This is a very interesting contrast.

Certainly, safety and operational risk are paramount and cannot be compromised by cost considerations. But there are other industries that face similar safety challenges, for example, commercial aircraft. There is a significant difference in the way that the supply chains work. Airlines order aircraft from manufacturers such as Boeing and Airbus and their engines from Rolls Royce or GE, for example. They’re buying a relatively standard system, rather than designing it. The commercial models have also evolved, for example, paying the aero engine manufacturer for availability and for flying hours.

Verisk Review: What can you recommend to the players in the market?

Tidey: First of all, many in the industry need to get their heads around what it means to operate in a low-margin environment. Part of that is getting a better balance between technical and physical outcomes and financial benefits. Some players already have a great opportunity to build on the experience from their downstream operations.

Secondly, many in the market need to focus on how to reduce costs sustainably across the whole supply chain. Sustainable cost management, rather than a short-term focus on rates, will be key.

And last but not least, new commercial models like “risk and reward” sharing might be interesting to experiment with. Performance-related and outcome-based incentives can stimulate collaboration on a mutual benefit supply chain basis. Models that can reduce the up-front capex investment for the operator and get more projects past FID are a significant win for all parties. By doing so, we will likely see a new and “healthy” market place.

Verisk Review: How do data and analytics support these assessments?

Tidey: The respondents to our cost survey and the evidence from published financial statements make it very clear that the industry has made significant strides to reduce cost. The interesting question now for the industry is whether the action to date and current plans fundamentally reset the cost structure at a sustainable level. The view from our survey is that less than half of respondents consider the cost reductions truly sustainable.

Verisk Review: Where do things go from here?

Tidey: The industry faces a challenge to go further and to drive fundamental change—within organizations and across the supply chain. We work with clients to build a detailed view of their true operational and financial performance and to bring the deep knowledge, data, and experience of Wood Mackenzie to bear to demonstrate how performance can be transformed. Bringing this real transparency can be a significant challenge in the upstream space because of the inherent complexity introduced by joint venture ownership structures and fiscal regimes, for example. We have well-developed tools and approaches to bring this transparency, but we’re very excited about how we can collaborate with our Verisk colleagues to bring to bear big data capabilities. Oil and gas operations produce huge volumes of data, which—with the right combination of analytics, industry knowledge, and advisory capability—could yield huge value.