Drilling costs and professional development affect bottom line

A GLOBAL DRILLING ORGANIZATION-Conclusion

George F. Boykin
Amoco E&P Technology
Houston

The effects of drilling costs on the bottom line can be measured, proving that the retention of the drilling function within a major oil company can tangibly add value to corporate endeavors.

An effective global organization needs to communicate how the role of the drilling professional directly adds value to the company and customer. To justify this investment in human resources, it must be demonstrated that drilling activities are fundamental to a corporation's long-term success, especially since no successful company will make such an investment in the absence of demonstrated value.

This conclusion of a two-part series provides examples of how Amoco E&P Technology's (EPTG) centrally run drilling organization promotes professional career development and manages the level of staffing during fluctuating periods of activity. In addition, it shows how a centrally structured organization benefits a global organization, allowing EPTG to effectively compete well into the 21st century.

Linking drilling to profit

The link between drilling and performance requires an understanding of where value is actually added. Despite conventional thinking, this value can be evaluated through an analysis of full-cycle costs and revenues.

By evaluating the return on capitalized cost (ROCC), the impact of drilling performance on corporate profitability can be measured. ROCC is reported to shareholders in annual reports each year and is defined as revenues minus expenses divided by the average capitalized costs for the year. Drilling activities affect all three of these accounting parameters.

Drilling affects revenue because virtually all of Amoco's exploration and production revenues are generated through well production from an inventory of well bores currently on line. This revenue source is supplemented with additional production through present and future drilling programs.

Some drilling projects will not affect the company's total revenue figures for the year in which they are drilled. But they are all linked to long-term revenue streams because depleting production must be replaced by new wells. Without economically viable drilling opportunities, production replacement is not possible.

Even though some companies can purchase additional production, over time the realities of supply and demand necessitates the drilling of additional wells.

There are numerous examples where innovations have reduced total well costs to the point that previously unprofitable plays became viable. EPTG has numerous examples, including the Greater Green River basin in Wyoming, and the Davy-Bessemer project in the North Sea where drilling-project management has reduced costs and made a formerly uneconomical play, profitable.

Amoco is not the only organization where this has happened. British Petroleum plc at Wytch Farm and Union Pacific Resources Co. in the Austin chalk provide notable examples where reduced drilling costs resulted in economic plays that at one time were too costly.

But unlike some organizations, Amoco has an advantage because executive management recognizes the contribution that drilling professionals make to these success stories. This occurs because the organization motivates people to share successes around the world. Success breeds success and communicating success is much simpler in a centralized organization.

Drilling organizations also affect corporate expenses when an unsuccessful exploration play is drilled. According to the Financial Accounting Standards Board's Successful Efforts rules, well costs associated with an unsuccessful play are fully expensed that year. This number can be relatively large. For instance, Amoco spent $220 million on unsuccessful exploration wells in 1996.

Total net income from operations was $1.55 billion. Reducing drilling costs by 20% for these unsuccessful plays would have saved the company about $44 million, and would have represented a 7% increase in the ROCC, from 15% to 16%. In addition, this money could have been reinvested elsewhere, enhancing the ROCC.

Because the costs of developing successful exploration projects are capitalized, drilling enters the equation for the third time as a capitalized cost. For example, in 1996, Amoco's capitalized drilling costs were about $1.05 billion.

These costs represented about 65% of the total costs capitalized in Amoco's operations in 1996. Reducing these costs through better management of drilling activities directly affects the bottom line.

Because these charges are capitalized, however, changes in these figures do not have an immediate impact on ROCC. This means noteworthy reductions in the cost of these successful efforts will not greatly alter the 1996 figures.

However, the effects will compound. Over time, reductions in capitalized cost can reduce the ROCC denominator by an amount roughly equal to the percentage change in well cost. Thus, long-term reduction in successful exploration and development drilling costs will increase ROCC proportionally.

Capitalized costs

Drilling performance directly affects the ROCC. In the following example, Amoco's foreign operations were modeled using annual report data from 1982 to 1996. The model assumed that EPTG drilled the same suite of wells with the same effect on reserves and production, with and without the drilling performance improvements experienced over the last decade. The different effects of performance on the bottom line were then compared.

During this period there were marked improvements in drilling performance (Fig. 1 [98,314 bytes]). However, to objectively test the impact of the performance improvement on Amoco's return on capital, EPTG removed the effects of increased drilling efficiencies and reanalyzed the ROCC.

Fig. 2 [81,565 bytes] compares the ROCC with and without this improvement. As shown, the only difference between the two curves is the drilling cost with and without the improvement actually experienced over the last decade.

If the same number of wells had been drilled with the same production rates and oil price, without the drilling performance improvement, then Amoco's ROCC would have been about 30% less in 1996. This shows that drilling performance's long-term effects can fundamentally affect the bottom line.

Total drilling costs often represent a large fraction of an operator's total expense. However, costs directly associated with the drilling team that manages these expenses represent only a few percent-normally 2 to 5%-of total drilling cost. This means that the drilling management function provides a cost-to-benefit leverage of over 20 to 1, where $1 of management expense controls $20 to $50 of drilling expense.

As a result of this leverage, small expenditures on drilling management can produce large increases in project return. Drilling competence allows an operator to more-effectively understand and control this sensitivity. Being able to demonstrate how drilling performance links with the bottom line is critical for a company's success.

Proper business decisions can only be made if the value drivers are understood. It is also important because it provides the foundation for market-based pay tied to competencies and the advancement of drilling as a profession.

A reward system

In the past, an oil industry professional's pay was determined primarily by tenure, a practice left over from the days when a person stayed with one company for life, and seniority and loyalty counted for more than just the results they had on the business.

It was a method that worked when U.S. companies dominated the market place. However, in a global market place it has become necessary to develop and maintain a high-performance organization.

Linking pay to business-related competencies and success, in part controlled by the global economy, is a key ingredient in attracting and keeping high performing professionals.

Attracting and retaining competent professionals will allow an organization to succeed in the future. While compensation commensurate with the value a person creates is not the only ingredient used to attract and retain the best people, it is certainly a key factor.

To link compensation with competency, competence must be defined. As follows, EPTG has defined eight capabilities that are critical for success in the drilling profession:

Communication-The ability to express ideas verbally and in writing.
Technical expertise-The ability to effectively use drilling equipment and materials.
Influence and negotiation-The ability to get others to want to achieve the organization's goals.
Project management-The ability to allocate resources to meet project goals.
Organizational learning-The ability to capture and share experience with others.
Business focus-The ability to make the choices that add the greatest total value.
Innovation-The ability to produce, recognize, and implement good new ideas.
Team work-The ability to work effectively with others.

EPTG Drilling ties base compensation to competence as measured in these dimensions. To implement such a program, it takes both the drilling professionals, who know the competencies, and human resource professionals, who know compensation mechanisms, to work together and develop a process that fits the needs of the central drilling organization.

Keeping pay in line with competing organizations is another important compensation factor. Top organizations will determine compensation based on market influences. Recognizing and rewarding superior performance, instead of tenure, is becoming a major differentiating factor.

Organizations that succeed in the future must recognize and reward key skills and competence. At EPTG, a program has been implemented to ensure that pay scales are at the industry average, while using stock options, bonuses, and pay raises above the industry average to recognize exceptional performance.

Strategic staffing

One of the most important roles of management in any organization is to ensure availability of the resources (people, tools, and time) needed to perform a given job. EPTG Drilling employs strategic staffing to consistently utilize the right number of people, with the right skills, in the right place, at the right time.

If optimum numbers of skilled people are not placed on the right project at the right time, then performance suffers. If the situation goes on long enough, it will demoralize even the most dedicated professional.

Because drilling activity in an area changes quickly, worldwide drilling resource allocation is more important, and often more difficult, than for most businesses. Fig. 3 [68,697 bytes] shows Amoco's recent situation, which is typical of the industry as a whole.

In any single year, the rig count can fluctuate by 30%. Staff requirements also fluctuate by about this much. To make the situation even more challenging, over half of the rigs operate outside the U.S., while EPTG's staff is largely U.S. based.

Over the past year and a half, U.S. rig activity has risen from a low of 807 active rigs in January 1997, to a high of 1,032 in September 1997, back down to 823 rigs in June 1998.¹ This fluctuating demand provides challenges for managing EPTG's human resources. Unfortunately, the situation is expected to worsen over the next 5 years now that the excess people capacity has disappeared and many of the industry's veterans will soon be retiring (See Part 1, OGJ, July 27, p. 72).

To bring the maximum value to the corporation, EPTG must manage its staff in a cost-effective manner. The company cannot afford to have 30% of its staff sitting idle during lulls in order to provide sufficient staffing during peak periods.

Peaks and troughs

EPTG must also have the right skills available to accomplish the work at hand. To help determine the proper staffing level, EPTG Drilling has developed a drilling manpower planning process (DMPP).² This process is periodically used to predict the number and type of personnel that will be needed to staff the company's drilling operations 1-5 years in the future.

As input for formulating the DMPP, EPTG uses major cash estimates, predictions on where Amoco will drill, and internal assumptions about well cost, risk, and technical difficulty. When provided with good estimates and descriptions of the company's drilling activity (input), detailed estimates of needed manpower (output) can be derived.

Unfortunately, because the inputs are estimated, outputs used in decision making become uncertain. Nevertheless, the approach remains a very useful planning tool (Fig. 4 [57,450 bytes]).

EPTG Drilling must decide whether to staff to handle peak activity, trough activity, or somewhere in between. The challenge, of course, is to find the most cost-effective work force, and determine how to handle people throughout situations of over and under supply.

There is an obvious trade-off between peak and trough staffing levels. Trough staffing requires minimum operating expenses such as personnel-driven costs. But if value-added work is not fully completed during times of high activity, operational efficiency is reduced, unscheduled events increase, and capital drilling costs increase.

Conversely, with peak staffing, there are enough people on hand to do all the work needed to properly manage operations during the busiest times. The increased consistency in personnel brings benefits from increased teamwork and sharing.

However, staffing for peak times requires the highest operating expenses, and much of the staff may find themselves idle for part of the year (Fig. 4). Besides the obvious excess cost, this is detrimental to motivation of professionals.

The consulting wedge

To achieve a balance between the two extremes, EPTG Drilling has chosen to use a wedge of temporary consultants to handle the peak activity. The goal is to maintain a consultant staffing level that ranges from 5 to 20%, with 15% being ideal. If the consultant staffing level remains at 20% for more than a quarter, EPTG Drilling will increase its hiring effort.

This strategy brings its own challenges; however, EPTG believes they are manageable when the consulting wedge is maintained at or below 20%. It can be hard to find qualified consultants when activity is high and technical assessment is difficult. In addition, the time required to bring new people up-to-speed may be extensive because they must be integrated into EPTG's empowered team environment.

By predicting the expected total-staff requirements, and by determining the consultant wedge, EPTG is able to determine the base level of staff needed for the company's drilling operations. While not perfect, this method works better than any other approach EPTG Drilling has tried.

Building a global organization

A global drilling organization does not consist of U.S. employees working on overseas projects. It is also not an organization where a large percentage of national staff members are involved in meaningful positions in their home countries.

A truly global organization is one whose multinational staff provides contributions anywhere in the world, directed by the needs of the business.

There are three reasons why a truly global organization is a key factor to success:

An abundant supply of qualified new entrants into the market from traditional sources simply does not exist anymore.
Many of the industry's best drilling professionals are not from the U.S.
There is strength in diversity. People with different perspectives can bring new ideas and new ways of doing things.

EPTG's organization realizes the benefits of a team-based organization. An organization that can constructively discuss new methods and different ideas will truly benefit from a diversity of perspectives.

In choosing the best qualified people, EPTG has recently assigned:

A Pakistani drilling engineer to Azerbaijan
Trinidadian drilling foremen to the Gulf of Mexico
A Russian drilling engineer to Houston
A British drilling superintendent to Egypt
A Canadian drilling manager to the North Sea.

Two out of six of EPTG's drilling leadership team members-a round table of drilling managers-are not U.S. citizens. Even with these successes, measured against our vision of globalization, EPTG still falls short of its goals.

Barriers

In the truly global organization of the future, these examples will be the norm rather than the exception. To achieve this vision of a global organization, there are a number of barriers that must be addressed.

The industry as a whole would benefit by addressing the following issues:

Language barriers-Not every world-class drilling professional has English as his or her first or even second language. In a truly global organization, multilingual professionals would be the norm.
Cultural issues-A truly global organization would build its own unique culture and develop common language for communicating issues critical to its business.
Compensation issues-Pay scales and the cost of living in different parts of the world vary. A truly global organization would compensate its people within the global market place equitably, instead of tying them to a home country payroll.

The biggest barrier to achieving true globalization involves the legitimate concerns of host governments around the world, namely, a way needs to be found that satisfies government worries that globalization may cause a brain drain or reduce employment opportunities for its own citizens.

As an industry, companies must first begin by understanding and respecting these concerns. Then they must demonstrate that the development of "free trade" among drilling professionals is in the best interest of the global market place.

This will help keep petroleum costs competitive in relation to other energy sources while developing the skills of each country's drilling professionals by exposing them to a wider range of operational environments.

Redesigning a profession

The industry must recognize that drilling competence is critical to the health of the energy industry. A profession is "An occupation requiring significant training and specialized study, such as the professions of law, medicine, and engineering."

There is no question that drilling requires significant training and study. The development of fully capable drilling professional takes at least as long as it does to train a medical doctor-6 to 8 years.

Compared to the medical profession, however, our body of knowledge is not nearly as refined or codified. The petroleum industry does not assess competency nearly as rigorously, nor has it historically managed drilling as a profession.

To illustrate this last point, consider the major professions for a moment: doctors, lawyers, and architects. They do not climb some never-ending hierarchical ladder. Instead, they perform the same kind of work that they did when they graduated from medical school.

They may specialize, work on harder cases, or use better technology, but they still deliver a professional service to their customers. When Johnnie Cochran (a famous American Attorney) was young, he may have only defended traffic tickets, but today he works on major trial cases. If the industry managed drilling as a profession, it would give its best people the most challenging drilling projects, instead of promoting them out of the profession, away from operations.

A changing mentality

EPTG believes successful organizations of the future will manage drilling as a profession. This means employing the best professionals on projects where they can do the most good. In other words, assigning them to the most difficult problems in which they are capable of solving.

Drilling professionals manage such complex technologies that it is even more foolish to squander the experience of these skilled individuals.

The industry needs to do a better job of defining its body-of-knowledge and assuring competence. Competency-based pay is a start. Next, a professional career development program, including formal training, mentoring, and hands-on experience designed to develop these core competencies, will help complete this goal.

Too much of the industry's drilling know-how is experienced-based. Like the medical profession, the petroleum industry needs to put its body-of-knowledge on a more scientific footing.

To complete the professionalization of drilling, the mentality that the corporation owns each individual must be forgotten. For a true profession, pride in job performance is more important that moving up the organizational ladder.

This is an important topic because drilling professionals take pride in job performance, an issue that is more important than moving up the organizational ladder.

Finally, not only is drilling challenging, it is also lucrative. Fig. 5 [78,949 bytes] shows a comparison between drilling and the other major professions. The figure shows that counting the full-cycle cost and lost income from the years spent formally training for the medical and legal professions, a career in the drilling industry compares quite favorably.

The downside to viewing drilling as a profession is that it will inevitably lead to a further loss of corporate loyalty, which has been shattered over the last 10 years.

Lifetime employment is no longer realistic. The truth is, no organization can guarantee lifetime employment. The best that a professional can hope to do is engender lifelong employability. Organizations that treat drillers as professionals can offer lifetime employability.

Reducing loyalty to the organization will probably mean continuous turnover. This is not necessarily bad. Jack Welch, CEO of General Electric Corp., once said that healthy organizations have a turnover of 10% each year.

New blood keeps an organization sharp and brings in new ideas. Turnover does not necessarily mean that the bottom 10% will be the ones to leave either.

References

Baker Hughes North American Rig Count.
Brett, J.F., McCuish, J.D., and Oates, K.W., "Drilling Manpower Planning: Using a Systems Dynamics Approach," SPE paper 24562, presented at the SPE annual meeting, Washington D.C., Oct. 4-7, 1992.