National oil companies (NOCs) and international oil companies (IOCs) are under greater pressure than in previous down-cycles due to the last year’s sharp falls in petroleum prices and demand. This time, the accelerating decline in output from mature fields requires oil majors to invest in new, more complex assets and territories. Companies not only have to maintain capital expenditure against the backdrop of lower commodity prices, they also face intense competition from companies in emerging markets that either control vast reserves or have aggressive plans to secure them.
The squeeze on capital and operating costs is therefore inevitable. But oil companies should not repeat past cycles by aggressively cutting costs to the detriment of the industry’s value chain, especially technology investment. They must move beyond today’s somewhat adversarial supplier relationships if they are to reduce costs without endangering their long-term performance.
Meanwhile, NOCs and IOCs should also support their own local suppliers by finding innovative ways to encourage foreign investment that maximize local content and enable sustainable industrial development, creating direct and indirect employment in a framework that nurtures new competitive capacity.
Whatever the medium-term outlook for oil demand and prices, both NOCs and IOCs are entering uncharted waters. Some NOCs face demands on revenues by local treasuries protecting government budgets. And IOCs, needing to satisfy shareholders with healthy reserves-replacement ratios, have to fund robust capital expenditure commitments. They are therefore driven to minimize the gearing, or financial leverage, required to support such expenditure and to mitigate the rise in upstream exploration and production costs. These have risen 230% since 2000, according to Bernstein Research.
No surprises, then, that oil majors have turned to their main suppliers, the oil field service (OFS) companies. Hiring rates for drilling rigs are being renegotiated at 10-30% lower than previous levels. Total SA expects reductions in supplier costs of up to 20%, BP PLC of up to 40%. Royal Dutch Shell PLC’s outgoing Chief Executive Jeroen Van der Veer recently said: “If the business environment stays very lousy, then we expect very large procurement savings from all our suppliers.”
The commodity-price surge under the last cycle played a major part in the industry’s consequent capacity crunch and high prices. Due to the fragmentation of the value chain over the last decade, operators have sought to improve efficiencies in areas of excellence and specialty, but sectors such as the seismic industry have suffered long-term damage as large cost cuts prevented necessary long-term investments.
Identifying efficiencies
So how does the industry find an equitable relationship with its suppliers?
There’s no doubt that the $300 billion OFS sector will have to identify efficiencies itself. Cost reductions will be found through more advanced supply-chain management systems and shared-service infrastructures, for instance. These are particularly important for OFS firms operating in multiple markets where new-found standard processes can help diminish costs. Industry restructuring will also inevitably play its part as low company valuations result in a possible wave of consolidation.
But as industry interdependence rises, oil companies themselves must adopt an entirely new approach to supplier relationships and procurement. Today, for example, NOCs and IOCs will often procure services at the lowest headline cost in an attempt to minimize short-term outlay. This can often result in rewarding suboptimal suppliers and raising longer term expenditure. In what effectively boils down to a commoditized transaction, contracts are less likely to be awarded to the most innovative business model or to the most technically advanced solutions. Instead, the transaction can add costly management resources and processes.
IOCs must therefore ensure that procurement is led by a search for value creation to distinguish more effectively between lowest headline costs and lowest true total cost of ownership. Procurement should also be pursued with a relentless drive for higher levels of performance across all areas of the integrated value chain, including advancement in the health, safety, and environmental impact.
During the coming cycle, this principle should also be adopted by more NOCs. This not only reflects the growing power of NOCs and the reserves they control, but it also follows from the increasing levels of cooperation between IOCs and NOCs. The sustainable exploitation of new fields demands a healthy support for suppliers—local and international—as these regions seek to create skills-rich labor forces that they currently lack.
On line markets
A major advance for local suppliers in recent years has been the establishment of transparent online markets aligned to NOCs’ needs. Petrobras’s Petronect, a pioneering joint venture, is one such example. In addition, Brazil’s Ministry of Petroleum established a model for local capability and capacity enhancement that is now being followed elsewhere.
The Nigerian Petroleum Exchange (Nipex), the electronic marketplace for the Nigerian oil and gas industry, which has been operating since the end of 2005, has improved the efficiency of procurement itself, with savings of up to 15% through faster, more transparent setting of technical specifications, and the reverse auction system. But it has also helped to increase local content from about 14% to over 30%. Angola’s Sonangol has established an online marketplace, which helps vendors win new business by participating in a growing supplier network.
But local marketplaces are not a panacea in themselves. It still remains for the presiding NOC to choose whether to use an efficient online marketplace to hold auctions and pursue procurement by headline cost or to adopt a comprehensive approach that rewards optimal suppliers who can deliver lower total costs over the long term. Combining the two elements of value creation is critical for a sustainable future.
Cuts necessary
The outlook for the economy and the oil industry may be uncertain today. But it is clear that significant cuts in supplier costs are necessary and that strong demand will at least resume in emerging markets.
It is also clear that technology innovation will continue to be the essential backbone that supports the industry.
It is against this backdrop that a more equitable approach to supplier relationships is required to ensure the sustainability of the industry’s value chain in both mature and emerging markets.
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