MANAGEMENT PERSPECTIVE A COST CUTTER: NONCORE OUTSOURCING

Carl Schwenker
Vice President
Enron Administrative Services Corp.
Steve Senia
Accounts Director
Enron Administrative Services Corp.
Houston

Since 1988, employment in the U.S. natural gas and petroleum extraction sector has declined 53%-to 350,000 from 750,000 jobs.

As government regulations and competition continue to restructure the industry, this response of downsizing shows little sign of subsiding.

Successful exploration and production managers, however, believe effective cost reductions in this decade will take more than the across the board staff reductions of the late 1980s and early 1990s. They will require constant improvements in operational and administrative efficiencies.

A new approach is needed. Like other modernizing industries, producers should focus resources on their core business activities and consider outsourcing or divesting noncore activities.

ORGANIZATIONAL STRUCTURE

Consultant Charles Handy, in his book The Age of Unreason, describes business organizations of the future as a shamrock, made up of three very different types of work forces.

The first leaf, the "professional core," is an increasingly smaller staff of experienced planners, managers and decision makers that focus on the company's core business.

Noncore activities are outsourced to the second leaf, the "contractual fringe," made up of service companies that specialize in such activities. "All noncore work, work which could be done by someone else, is therefore sensibly contracted out to people who make a specialty of it and who should, in theory, be able to do it better for less cost," Handy wrote.

The third and fastest growing leaf, the "flexible work force," consists of part time and temporary workers hired to enable the core business to more flexibly serve its market.

New service companies, whose core business is oil and gas administrative services, are expanding the range of options available under the second and third leaves by offering more comprehensive and flexible packages of customized administrative services.

AN OIL IDEA

Outsourcing to specialty service companies is nothing new to the oil and gas industry. Geological, geophysical, seismic processing, and drilling activities have been contracted out for years, and outsourcing has proven to be an effective method for reducing finding and development costs and improving the level of those services (OGJ, Sept. 30, 1991, p. 42).

In contrast, general and administrative (G&A) costs have increased significantly since 1987 (OGJ, Jul. 13, 1992, p. 22).

Outsourcing of administrative services is a largely unexploited technique for reducing those costs. It also is a means for smaller E&P companies to substantially increase their production without adding a significant number of employees.

To understand the emerging administrative needs of the restructured oil and gas industry, we recently analyzed the administrative structure of several E&P companies.

One successful company in our study uses the shamrock concept to develop discoveries as quickly as possible with as small a staff as possible. It produces 1,265 bbl of oil equivalent (BOE)/day/employee by leveraging its core of experienced professionals through outsourcing. As a result, it can compete at roughly the same production level as another company with 12 times the staff.

Except for accounting, most operational areas of the company are run by one highly skilled "educated buyer." This in-house service buyer makes decisions regarding the outsourced service and gives strategic direction to the service companies but is not encumbered by the day to day operational and interpersonal problems associated with an internal department.

Another successful producer in our study, which produces 654 BOE/day/employee, performs exploration activities in house but has eliminated its marketing efforts and related administrative costs. It has been able to reduce its G&A costs below those of other producers by selling virtually all of its production at the wellhead on a long term basis to just one customer rather than 12 times a year on the spot market to a number of customers.

This approach reduces the complexity-and therefore the labor costs-of the marketing function.

The second producer's chief financial officer acknowledges that his company may forego 0.5-1cts/Mcf on the sale price. He finds, however, that the labor cost savings realized from eliminating the marketing function and reducing administrative overhead makes the arrangement more profitable on balance.

Those examples illustrate efficiencies achieved from eliminating internally as many noncore activities as possible. They also demonstrate that producers can effectively outsource noncore activities and maintain effective control of the business.

THE NEW TWIST

The Federal Energy Regulatory Commission's Order 636 and other industry changes continue to increase the competitiveness and complexity of the industry. As a result, E&P companies are looking for new ways to address this problem. Service companies have responded by offering a wide array of industry-specific administrative services.

These new customized service packages allow an E&P company to outsource the entire transactional process, including marketing, volume determinations, royalty and other owner interests payments, tax filings, contract administration, transportation management, and invoicing.

Some producers believe that, under Order 636, access to premium gas markets requires expanding downstream. However, many producers lack the appropriately skilled people, financial resources, or corporate culture to effectively compete in these downstream markets.

An alternative to additional human and financial investment in downstream expansion is to form a strategic alliance with one customer.

By selling gas at the wellhead to a single buyer or buyer's representative and outsourcing marketing and related commercial activities, the administrative structure is simplified and streamlined. Routine but increasingly complex functions are bypassed, G&A costs are reduced, and management can increase its focus to a greater extent on strategic aspects of the core business.

In a good outsourcing situation, the producer should be concerned only with receiving valued, high-quality services on time. The efficiency or the methods used to provide these services is the concern of the service company. The burden of investment in resources and new technology for administrative services is transferred from the E&P company to the service company.

Decision makers in the professional core are responsible for evaluating, selecting, and monitoring the service companies.

In addition, the best of a noncore department's employees typically are offered positions in the service company. Those transferred employees, in turn, become part of the service provider's core business rather than a backroom cost center for the E&P company. This may give them greater opportunity for job enrichment and promotion.

OUTSOURCING CONSIDERATIONS

To make the most of new outsourcing opportunities available in the oil and gas industry, producers should consider the following:

What is the company's core business? Generally, the core activities are funding, exploration, production, and development.
Which of the remaining noncore activities can be performed by an outside party? Noncore activities may include production and revenue accounting, marketing and related services, and other administrative tasks.
What are the benefits of outsourcing? Many times direct labor savings are only the tip of the cost iceberg. Secondary savings can be significant. Other considerations include cost effective access to specialized expertise and current technology and the ability to respond to dynamic personnel requirements and rapid changes in the business.
What service companies are available to perform these noncore activities? Find companies whose core business is performing one or more of your noncore activities. You can maximize the benefits of outsourcing by contracting out an entire process, rather than selected functions, 'to one service provider.
Which of these service companies best fits your company's outsourcing needs? Consider each service company's knowledge of the entirety of the business, ability to provide multiple services, willingness to customize service, cultural compatibility, long run costs, and financial strength.

The successful low cost producers of the 1990s will be companies that concentrate their resources in areas that add the greatest value to their bottom line. They will outsource noncore activities to parties offering more comprehensive packages of related administrative services. They will be smaller, more flexible, and quicker to react to changes in the competitive environment.

Now that opportunities for outsourcing traditionally in-house activities are available, producers should consider outsourcing as the cost effective business strategy to deal with challenges of the 1990s and beyond.