Performance-based contracting improves project execution

Aug. 3, 2015
Greater information-sharing and a new operational framework will help the oil industry mitigate project delays and overall risk. This article looks at how such a framework has worked in other industries and is being adopted by some oilfield service providers, and how it could accelerate a new approach to contracting for material supply and services at the wellsite.

Mohit Dubey
E2open
Dallas

Greater information-sharing and a new operational framework will help the oil industry mitigate project delays and overall risk. This article looks at how such a framework has worked in other industries and is being adopted by some oilfield service providers, and how it could accelerate a new approach to contracting for material supply and services at the wellsite.

Inefficiencies working with external partners often lead to project delays. Incentives or penalties for contracted work cannot mitigate delays or the entire project risk because they are proportional to-and limited by-the scope of the outsourced work.

Oil and gas producers use contractual frameworks to manage intercompany relationships, improve efficiencies, and mitigate project delays. Companies procure material supply and oilfield services other than drilling on a primarily transactional basis, with a service performed or material procured at a predetermined price, rather than a performance basis under which the service provider takes a greater share of both risk and reward.

But the number of performance-based service and supply contracts in the oil and gas industry has increased.1-3

Service, supply PBC

Performance-based contracts (PBC) shift risk and corresponding reward to the party best placed to improve performance in a particular activity over time. The supplier or contractor has the leeway to benefit through integration, optimization, and performance improvements, while defining the outcome in a way that directly aligns with the overall project.

The size of the contract and inherent risks of the project define the payouts and penalties for hitting or missing performance targets. Overall compensation to the service provider, consisting of the base price and the incentive, may be higher under a performance-based contract, because the risk premium is explicit rather than absorbed in the owner's operating expenditures.

This approach has been used effectively in other industries. The US Department of Defense (DOD) let contracts for major weapon systems that would be equivalent to maintenance and repair contracts for oil and gas field equipment.

According to DOD, performance-based life-cycle product support offers the best strategic approach for delivering required readiness, reliability, and ownership costs. The DOD's contractor improved aircraft availability by minimizing asset downtime caused by unavailable spare parts or technicians and reaped the corresponding rewards.4

Other studies have shown that product reliability is 25-40% higher under PBC than under time-and-material-contracts for service and support, such as those used predominantly in the oil and gas industry.5

A study of PBC in support services for capital-intensive industries found that when a company is less risk-averse than its suppliers, performance incentive increases while the cost-sharing incentive decreases over time. Conversely, when a company is more risk-averse than its suppliers, the performance incentive decreases while the cost-sharing incentive increases over time.6

Service providers also benefit under PBC because the contracts no longer specify how the service levels may be achieved. The service provider has the flexibility to pool assets across multiple projects in the same geographic region while providing the required service levels to each.

Closely monitoring contract definitions and risk assumption, as well as material supply and service performance, is essential in high-risk environments, as service companies will not want to take on an unlimited share of potential problems.

PBC execution

Performance-based service and supply contracts are part of the overall incentive-based project management offerings of leading integrated-service providers that not only have well-recognized project management expertise but also the ability to provide most of the products and services using in-house resources.7

Schlumberger Ltd. defines integrated operations as streamlined and coordinated performance of products, services, and personnel as if they were a cohesive system with a single objective. Such operations are achieved by first integrating services in field operations, technologies, and engineering workflows in the office.7 Halliburton Co. also offers various levels of integrated services to suit the operating models of its customers.8

PBC contracts give service providers the flexibility to manage execution details. This is contrary to the prevailing practice in the oil industry in which control is retained by specifying service-execution requirements and material-supply metrics in fine detail. Integrating the expertise of multiple service providers, each operating under a separate PBC, is difficult for the contractor, as well.

Developing an operational framework that addresses these challenges and enables relatively smaller contractors and suppliers to bid for PBCs requires an understanding of project organization and its implications for coordination and control.

Project participants, interfaces

Fig. 1 shows typical project structure, regardless of the nature of contracting relationships.9 In practice, multiple organizations with relevant expertise, as well as available capacity, come together to execute projects.

Fig. 2 is more generic and establishes a project layout in which each node represents a product or service acquired and integrated into the project. In this example, the integrated project management company (IPM), is responsible for successful project delivery. Baker Hughes played this role in redeveloping Iraq's Zubair oilfield for a consortium of operators.10

In an arrangement in which all products and services are delivered through internal resources, there would be no interfaces and the operator or IPM would be able to monitor all tasks and control all activities.

The IPM manages any change to the scope of work, engineering, design, or delivery schedules. It has less control when external partners are brought into the mix.

Fig. 3 illustrates this limited access to the schedule and project status. A subcontractor's impact on overall project performance is difficult to infer in this configuration. It is also difficult to ensure that the two major contractors engaged by the operator are working toward a common goal.

Limited visibility implications

If a project is experiencing delays in some of its tasks and the work is internal, task statuses would be continuously evaluated against project schedule. If the task was critical resources would immediately be brought to bear to alleviate the problem.

If a contractor is doing the work, however, it would try to resolve the problem and manage the schedule itself, informing the operator only after the full impact of the situation was known and a mitigation plan developed.

This is a rational response under the prevailing contracting paradigm. A contractor, aiming to deliver on time, is not incentivized to reveal potential delays early or expected to share news of internal delays before gaining a full understanding of the situation.

The operator expects the contractor to deliver to the agreed-upon schedule or face penalties based on the incentive structure. Project-level incentives may influence behavior on quarterly (or longer) timeframes, but are not effective in managing daily (or even more frequent) interactions of an extended project team.

Losing early warning of potential delays in contracted activities results in project-wide inefficiencies, including last-minute schedule changes, idle service personnel, or an inability to redeploy resources quickly. As projects have grown in size, delays have grown longer, reaching an average of 2.5 years for projects greater than $1 billion as of 2012.11

Given that incentives or penalties for the contractor have to be proportional to the value of the outsourced work, only a limited amount of project risk can be transferred to the contractor. The contractor cannot suitably compensate the operator for delays in a megaproject coming online, or compensate the IPM for the cascading impact of delays on the IPM's own incentive payment.

Contract litigation is time and resource-intensive and adversarial. It will also not change project interactions in shorter timeframes. An improved standard operating procedure for operator-contractor interaction is needed.

New operational framework

Bidirectional information sharing on activities up to one or two levels beyond the main project interfaces is critical to coordinated project execution. Operators and lead integrators regain early warning to potential delays and participate in reviewing mitigation plans when a delay exceeds agreed-upon thresholds (Fig. 4).

There are several PBC-based rationales for such information sharing.

Coordinated execution of tasks and activities among all parties working toward a common project milestone aligns outcomes. This coordination is performed by a lead contractor, the integrated service provider, or even the operator. Overall timeline achievement, sharing data across the PBC interface, and timely performance of individual tasks that influence the performance of other parties form the basis of incentive profiles.

New operating procedures based on these ideas seek both to address existing problems and support new contractual arrangements. New procedures must:

• Support management of both material supply and service execution.

• Support current transactional contractual relationships in addition to new performance-based arrangements.

• Support management of service-supply by contractors/suppliers through increased visibility of all tasks on the project.

• Allow the operator-integrator sufficient access to status of service and supply to coordinate dependent project activities.

Track task-supply status continuously against the latest schedule to enable exception-based intervention by all parties for developing a risk-mitigation plan.

This could mean a turnkey supplier of control systems shares status updates with the operator or IPM for the delivery of equipment to the wellsite, and informs them of progress of the installation in greater detail than has so far been the case. When there is a delay in the delivery of a small but critical subassembly to the wellsite, the operator or IPM is able to immediately evaluate its impact on related activities and the project milestone. The early warning and a systematic plan for intervention replace the reactive, ad-hoc, and urgent back-and-forth that characterizes the common response to late-breaking news of high-impact delays.

An operator, currently, is deploying a global, cloud-based platform that provides a comprehensive view of material movements over multiple hand-offs to the wellsite, not just the last leg, as is common today.12

Information is linked along the path the material follows and is visible regardless of the party handling the materials or the system in which the data resides, even as ownership changes. With these capabilities, collaborative planning and execution can occur in real-time between all stakeholders: procurement, logistics, worksite and central materials management, as well as suppliers and contractors.

The linkage to and dependency of each party on the next becomes visible to all, and each hand-off in a project schedule is measured separately, not just in the aggregate. This framework is expected to make project execution more effective for traditional contracting relationships as well as PBC.

References

1. "Jacobs Receives 2-Year Contract from Canaport LNG," Jacobs Engineering Group Inc. press release, Mar. 9, 2010.

2. "Nexen Contracts Jacobs for Maitenance at Long Lake Bitumen Complex in Canada," Jacobs Engineering Group Inc. press release, Oct. 19, 2010.

3. "Schlumberger Announces First-Quarter 2014 Results," Schlumberger Ltd. press release, April 17 2014.

4. "Operation of the Defense Acquisition System. Instruction No. 5000.02,"US Department of Defense, 2008.

5. Guajardo, J. A., Cohen, M. A., Kim, S. H., Netessine, S., "Impact of performance-based contracting on product reliability: an empirical analysis," Management Science, Vol. 58, No. 5, pp. 961-979, March 2012

6. Kim, S. H., Cohen, M. A., Netessine, S., "Performance contracting in after-sales service supply chains," Management Science, Vol. 53, No. 12, pp. 1843-1858, December 2007.

7. Schorn, P., "Industry Challenges Drive the Need for New Business Models," Journal of Petroleum Technology, Vol. 66, Iss. 10, pp. 132-135, October 2014.

8. "Project Management Commercial Models," Halliburton.com, 2015.

9. Chafcouloff, S., Michel, G., Trice, M., Clark, G., Cosad, C., Forbes, K., "Integrated services," Oilfield Review, Vol. 7, No. 2, pp.11-25, February 1995.

10. "Turnkey Workover and Completion Project Restored Production in Southern Iraq Field," Baker Hughes Inc. case study, 2013.

11. "From Discovery to Production - The Challenges of Execution," presented by Schlumberger Business Consulting to the Oil & Money Conference, London, UK, 2013.

12. E2open customer engagement, 2015.

The author
Mohit Dubey ([email protected]) is senior director, strategy, at E2open, a provider of cloud-based collaborative planning and execution software. He is based in Dallas and has more than 18-years experience working with oil and gas, aerospace and defense, and hi-tech industries. He holds a BS in electrical engineering from the Indian Institute of Technology, Kanpur, and an MBA from the Indian Institute of Management, Ahmedabad.