COST RESTRUCTURING: CHALLENGE OF THE 1990S

Jeffrey A. Schmidt
Towers Perrin
Chicago

The mid- to late-1980s constituted a period of growth in total shareholder return for the major integrated oil and gas companies. The 5 year rolling average return for the median company among the 17 largest oil and gas concerns rose from roughly 2.5% in 1985 to more than 20% by 1989.

This growth reflected the robust economic conditions of the refining and marketing and petrochemicals sectors as well as the cost and balance sheet restructurings that followed the crude price collapse in 1986.

However, by the end of this past decade, total shareholder returns had begun to fall, and all of the major business sectors that make up the large integrated companies had become distressed.

This current decade is likely to be one of the most challenging for the petroleum industry. Though petroleum remains among the world's biggest businesses, news of consolidations, restructurings, and layoffs permeates the oil patch from the Gulf of Mexico to the Arctic Isles. The recessionary economy has accelerated these changes, particularly in the upstream sector.

Today, even the best-managed companies are transforming their cost structures, and companies that fail to do likewise probably won't survive as independent companies. Indeed, significant consolidation took place during the 1980s. More consolidations can be expected in this decade for companies that do not adapt to the economic realities of a mature business.

THE MATURE BUSINESS

Basins for conventional exploration are well drilled in the U.S. and Canada. With declining prospectivity, companies are reducing and retargeting exploration budgets, consolidating their exploration operations, shifting their exploration efforts overseas, and taking an increasingly stern view of exploration performance.

As Fig. 1 illustrates, aside from periods when crude oil prices spike, such as was true in late 1990, many of the largest oil and gas concerns have not been able to create value for their shareholders through new exploration in recent years.

Declining production and weak prices are also exerting pressure on oil and gas producers. While price escalation and rising demand created conditions in which cost didn't matter very much in years past, cost containment is the primary management concern in today's austere economic environment.

The majors have found that their management, administrative, and technical costs are too high, particularly for the large numbers of small-interest properties still on their books. On a normalized basis, as Fig. 2 demonstrates, these costs may be two or more times greater than for a well-run independent.

For example, we found staffing efficiency (or the relative number of employees per unit of work) and average employment cost (pay, benefits, etc.) make up 73% and 27%, respectively, of this difference in a direct comparison between a major and a well-run independent.

The pattern for cost restructuring in the 1980s tended to progress through the stages of transformation depicted in Fig. 3 and encompassed a wide range of management philosophies and actions.

During the early part of the 1980s, average employment in the petroleum industry fell more sharply than for all industries represented in the Fortune 500 (37% compared with 20%). However, from 1988 through 1990, average employment in oil and gas companies remained relatively unchanged while the Fortune 500 average declined by almost 5%.

'RIGHTSIZING' COST STRUCTURES

Overoptimism about future performance, management complacency, and organizational inertia can lead to unaffordable cost structures. Management must redress this situation by "rightsizing" its cost structure.

How do you transform an unaffordable cost structure in the right way? There is no simple answer, unfortunately.

The "right" approach is company-specific and depends on a careful balance between ends and means. Nonetheless, successful cost restructuring programs share several characteristics:

Performance improvement targets are established for guiding the analysis that identifies the steps needed to close the gap between actual and acceptable levels of performance.
Each business entity and function is challenged to produce efficiency gains, regardless of internal perceptions about relative industry or functional performance.
Changes in total employment stem from an understanding of the relative value and cost of the work, and value is judged by customers, external or internal.

Management must also have a sense of urgency and single-minded commitment to the corporate mission; namely, to create value for shareholders and to be among the best performing companies in the peer group.

Such a commitment should be framed in terms of nonnegotiable performance goals that management will attain by specific dates. These goals will usually encompass revenue enhancements, business portfolio changes, and improved asset utilization, together with fundamental cost restructuring.

If achieving an affordable cost level leads to layoffs, management must also address how to make these cuts in an informed and compassionate way. Rational decisions about such things as where to cut, why to cut, and how to cut costs require knowledge about cost drivers and the value of physical work.

APPROACHES TO 'RIGHTSIZING'

Three major types of approaches are used for cost restructuring in the petroleum industry.

Many companies have used all three at one time or another. Some have combined two or more approaches in their cost restructuring plans.

THE MANDATED CUT

Although mandated cuts are commonplace and might have a rational basis, they are frequently characterized by the "ready-fire-aim" school of decision-making. Not surprisingly, the results often reflect a wide range of expedient actions, which may have been predicated on false economies.

For example, eliminating vacancies that would probably not be filled anyway is a common technique. Another is substituting contract labor for full-time employees in specialized areas where the only qualified contractor is an employee who has just been laid off.

The worst examples of mandated cuts are motivated by the bureaucratic concept of fairness. This concept holds that cost restructuring, regardless of the business rationale, is a kind of punishment that should be shared equally by all departments.

The net effect is communal pain-sharing that rewards big spenders (who experience relatively light pain) and penalizes managers who have been running lean and effective organizations. In addition, this kind of cost cutting merely scales down the cost structure, ignoring differences in business requirements or competitive cost positions in various business segments.

In the final analysis, the greatest problem with mandated cuts is that they never seem to go far enough. Management's tendency is to achieve the mandated targets and go back to business as usual.

Thus, many companies have settled into a pattern of following one mandated cut with another. Management may eventually get at the core problems of the cost structure, but in the meantime employees are victimized-overworked while they wait for the next series of layoffs.

RATIONAL APPROACHES

If a mandated cut fails, management may decide to pursue a more rational approach to cost restructuring. Such approaches are most widely known by their acronyms-CVA (customer value analysis), AVA (activity value analysis), OVA (overhead value analysis) and the like.

They are derived from fundamental industrial engineering techniques that have been around since the early days of scientific management. And they normally require outside help.

Rational approaches are intended to correlate activities with some level of value added, such as customer satisfaction. They have two major premises:

Lasting cost reduction must be accompanied by work elimination.
Managers will eliminate unessential and low-value work once identified through the analytical process used.

Rational cost restructuring is a balancing act. To eliminate work, a company must simplify work processes while maintaining appropriate service standards. Accordingly, rational approaches address a series of questions about work requirements and their associated service standards and work processes. The most fundamental question to ask is why the work is done in the first place.

This question, in turn, gives rise to a series of other related questions, such as: What generates the demand for the work? Are work drivers internal or external to the organization? Does the value created exceed the costs involved?

Rational approaches have many advantages over mandated cuts, but they are neither quick nor foolproof. For instance, building an activity database takes time and creates considerable employee anxiety. In fact, productive work may essentially shut down while employees wait for the outcome.

Ultimately, management judgment determines the changes needed to cut unnecessary costs in an intelligent and permanent way. Rational approaches can help shape management's thinking but cannot be substitutes for it.

CONTINUOUS IMPROVEMENT

The third of the major approaches to cost restructuring is continuous improvement, which focuses on improving productivity through process reengineering and better teamwork.

Mandated cuts and rational approaches usually result in layoffs, but continuous improvement tries to realize savings through attrition and redeployment of surplus employees. Continuous improvement also relies on employee involvement initiatives rather than on management edict or the analytical mechanism of one of the rational approaches.

Continuous improvement has several other advantages over the other cost restructuring approaches. Without question, it fosters the highest degree of employee commitment to change, develops cost sensitivity at all organizational levels, and is usually able to get at the more complex sources of inefficiency not visible to upper (and often middle) management.

However, producing measurable economic gains can take significantly longer-3-5 years longer-than with the other approaches. In a mature business like oil and gas, the time needed by continuous improvement may be unacceptable as the sole means of cost restructuring.

Moreover, the evidence of competitive performance breakthroughs via continuous improvement concepts is still emerging. A comprehensive survey of cost and quality management approaches we conducted in conjunction with the American Productivity and Quality Center found that more than half of the companies were dissatisfied with results.

We concluded that unfocused or unrealistic expectations and a lack of economic training and analytical discipline are frustrating even the best-intended cost and quality improvement plans. And, in the final analysis, the ultimate test of these plans will be whether they yield substantive improvement in operating margins and returns.

COMBINED APPROACHES

Increasingly, companies are using multiple cost-cutting approaches as elements in comprehensive, multiyear cost restructuring initiatives.

For example, a rational approach might be used to bring about an improvement in cost structure that falls short, by design, of the ultimate goal. The difference would then furnish an agenda for a continuous improvement process implemented at the same time.

As Fig. 4 suggests, the potential impact of stepwise cost reduction and continuous improvement should reflect the size of the performance gap, the complexity of the underlying competitive cost problems, and the time available to close the gap.

If balanced properly, either a mandated cut or a rational approach can help ensure that a company cuts deeply enough in the initial phase of cost restructuring.

The continuous improvement process, together with strategic actions like divestment of noncore businesses and assets, can help ensure that the logic and philosophy of doing business in new and better ways take hold and a sense of urgency is developed for even more improvement.

RESTRUCTURING PROSPECTS

Industry employment generally tracked hydrocarbon prices in the 1980s. For the 17 largest oil and gas companies listed in the Fortune 500, 1990 employment was about 60% of the 1981 level. In constant 1982 dollars, 1990 natural gas wellhead prices were at roughly the same 60% level relative to 1981, and crude oil refiner acquisition costs were even lower.

Petroleum industry employment is likely to continue falling if prices remain depressed in real terms throughout this decade.

Of immediate concern on the domestic side, finding costs have been above value added for exploration and development for most of the past 8 years (Fig. 5). Obviously, selling at less than replacement cost is not tenable over the long run. And we believe significant price improvement will be needed to produce acceptable returns unless costs can be reduced and exploration success raised.

Thus, the reasons for cost restructuring in the 1980s will persist into the 1990s; namely, to reduce expenses to competitive levels, to increase profits, to improve cash flow, and to maintain shareholder return on investment.

While every management hopes to have seen the last of severance programs, a recent survey we conducted suggests more cost cutting, not less.

As Fig. 6 indicates, the petroleum industry is somewhat below the all-industry average in terms of the number of companies making staff cuts in 1990-91 and those planning to do so in 1992. Also, the industry lags in terms of the average depth of the cuts made in the past few years.

Additionally, in the 1990s, white-collar employees are likely to continue bearing a large share of layoffs as companies struggle to keep their overhead cost structures in line with their competitive economics. Over the past 3 years, 40% of the positions eliminated in the Fortune 500 through cost restructuring programs have been whitecollar positions. Similarly, most of the job eliminations in the petroleum industry have also focused on white-collar employees.

For many oil and gas companies, the most recent wave of cost-cutting has been particularly traumatic. Prior layoffs, early retirements, and attrition have cut to the point where management is finding relatively few easy cost-cutting opportunities.

Accordingly, more fundamental cost restructuring will be needed in the future. The ideas for how to improve costs must also come from the employees whose job security may be jeopardized as a result. Under these circumstances, creating the internal climate and rationale for ongoing cost improvement is a formidable management and communications challenge.

This challenge won't be easy to meet. Stamina and morale are low today as many employees find themselves being overworked and their capabilities underutilized.

In a study of more than 400 companies that had restructured since 1984, the Society for Human Resource Management found that employee morale and loyalty had deteriorated together with the credibility of executive management.

In addition, the impact of restructuring on organizational effectiveness and efficiency indicated mixed results. For example, only half of the companies reported improved productivity, and only a quarter said their decisionmaking cycles had been reduced.

Similar surveys done elsewhere have corroborated these results. They should be sobering to any management now planning to restructure.

PRODUCTIVITY, TOTAL COSTS

Productivity growth must also keep pace with declining production if a company is to remain economically viable in the long run. Even though the data are not conclusive, recent productivity growth (in terms of net income per employee) seems to correlate with the combined effects of reduced work forces and new investment in productivity-enhancing technology (Fig. 7).

Nevertheless, real productivity in 1990 was only slightly above the 1981 level, and significantly reduced real capital and research and development expenditures have undoubtedly helped support net income during the past decade.

Furthermore, recent productivity gains notwithstanding, current returns on invested capital remain below costs of capital (12%, on average) and reinvestment hurdle rates for most of the major integrated companies (usually 15-20%).

Cost cutting will be necessary for these companies, but significant productivity improvement is also imperative. In fact, industry-leading performance in productivity and cost improvement are the best, and perhaps only, sources of competitive advantage in the oil and gas business over the long run.

As with productivity, containing growth in total employment costs will become an especially important priority of petroleum management in the coming years. These costs are made up of salaries and benefits as well as associated people costs for such items as facilities, personal computers, travel, management development programs, and training.

Total employment costs, defined in this broad way, are the major portion of controllable overhead, accounting for 80% or more of total overhead expense excluding depreciation, depletion, and amortization, interest expense, and the like. About two thirds of this controllable overhead is made up of salary and benefits expenses.

Notably, salaries and benefits have traditionally been high in the petroleum business compared with most other industries. And our survey of planned movements in salary structures and merit pay budgets showed that the petroleum industry is still well above the all-industry average (Fig. 8).

Thus, reducing total employment costs will be among the most vexing challenges for oil and gas company management in the 1990s. Given the composition of these costs and the rate of their escalation (e.g., due to retiree medical expenses), management will need to contain pay and benefits at affordable levels while exhorting employees to work harder and smarter. This will be no mean feat.

It also requires that hiring be treated as a long-term financial investment. Like other such investments, hiring should be analyzed rigorously.

For example, the total cost of a new college recruit over a 35 year career is nearly $5 million, and the net present value of this hiring decision is nearly $630,000. When viewed in this context, the recruiting decision takes on an entirely different character. It provides meaning to the notion that "people are assets."

Entry-level recruiting notwithstanding, decisions to fill vacancies and to add new positions also have significant economic implications. In Fig. 9, we show two replacement scenarios-one for a junior-level clerk and the other for an experienced engineer. The present costs of these decisions are $400,000 and $1.5 million, respectively.

The economic significance of recruitment and replacement decisions requires that certain questions be answered both for selecting the right people and for assessing the need to fill a vacant position or create a new one. These questions, as with any investment, focus on the impact on capital returns and cost/benefit:

Does the work performed generate returns higher than the cost of capital?
Can our organization be made productive and efficient enough to reduce our investment in human capital?
Are employee costs in line with peer companies and industry economics?
Is each component of the employee cost structure appropriate and affordable?

By challenging recruitment and replacement decisions, management can look for ways to redesign jobs and work to ensure that they continue to add value in light of the long-term costs involved.

CONCLUSIONS

Cost restructuring will be essential to the economic survival of oil and gas companies in this decade. The list of companies announcing major restructuring moves grows weekly and now includes even the well regarded competitors.

In the near term, this will cause considerable disruption and anxiety within the industry. However, in the long run, as the effects of today's cost restructuring and strategic shifts to foreign exploration and development take hold, the companies that survive will be stronger and more prosperous than ever before.

ACKNOWLEDGMENT

The author is grateful to his Towers Perrin colleagues and to David Ross III and Angela Minas of Sterling Consulting Group for their help in preparing parts of this article.