Managing the best, and worst, of times
Companies need new operating models to address today's challenges
Dennis J. Cassidy Jr. and Michael O'Connor, Alix Partners LLP, Dallas
These are the best of times and the worst of times for oil and gas companies. With the price of crude oil about double what it was five years ago, we anticipate big profits and record capital investment - nearly $1 trillion - by global public companies this year. However, many oil and gas companies - especially the larger ones - are failing to receive an adequate return on their investments.
In addition, with the rise today of unconventional oil and gas, many companies are confronted with the additional challenge of how to best operate in two vastly different businesses: technically-complex mega-projects on the one hand in the traditional oil-and-gas space, and lean, rapid-cycle ones in new, fast-moving markets such as shale. The result: Companies need new operating models to address the unprecedented challenges, and complexity, they face today.
Many people, even inside the industry, think the oil and gas business is homogeneous. In reality, the industry is a combination of literally dozens of different businesses, each with very different needs. Most oil companies and equipment/service companies span dozens of segments and have adopted "blended" or "average" business models that attempt to serve a broad array of customer/market needs.
As a result we often observe situations where oil and gas companies scale back for certain operations, provide extra engineering for others and so forth, resulting in either over- or under-serving the business. In most cases this results in constrained growth at higher costs. Often, managers feel overwhelmed.
Worse yet, very few companies can develop clarity and deep insights about their business from their ever-increasing clutter of data, systems and information overload. Far too often they are left to rely upon opinions or "this-is-the-way-we-have-always-done-it" approaches. As a result, companies often move too slowly to take advantage of opportunities to respond to risks, overspend when efficiency is required, or cut broadly without understanding the risks for their specific businesses.
Take procurement for example. Typically 70% to 80% of an oil company's operating cost is related to third-party spend. Thus, many companies have invested heavily in building centralized procurement and sourcing functions designed to exploit leverage and reduce the cost of purchased goods and services, to drive savings and increase margins. Despite these investments, which often take the form of added people and technology, it is not uncommon for half or more of reported savings to never make it to the bottom line. Why?
Many procurement and sourcing groups lack the ability to mobilize an entire company to stop the leakages that end up cannibalizing savings. Such leakages occur for many reasons:
- Lack of established savings methodologies. Procurement groups tend to be overly optimistic with savings projections. They assume that switching to new suppliers can be accomplished quickly, when in reality such changes often require weeks or even months to implement.
- Increased supply-chain complexity. Global sourcing takes advantage of less-costly goods from places like India, China, the Middle East and Eastern Europe. However, these cost reductions can be offset quickly if an extended supply chain is difficult to manage or requires added inventory, thereby contributing to increased carrying costs.
- Maverick purchases. Field operations and branch locations are often far enough away from headquarters to escape recourse for failure to use only approved suppliers. In such cases, convenience often trumps savings, leading to the unchecked use of local suppliers regardless of cost implications.
- Legacy sales practices. Sales departments within equipment and service companies that have grown accustomed to cost-plus selling often show little deference to reduced input costs. Instead, they maintain old habits and continue to price jobs at the "allowable" margin rather than at a margin that could be achieved by leveraging the reduced costs that procurement has won from suppliers.
- Customer demands. Customers themselves may present a barrier by being unwilling to convert to new, but equivalent products and suppliers, citing issues such as cost of testing new products and qualifying new suppliers. Often, customers have to be incented with a lower price to switch, thus eroding a portion of the savings.
To avoid these leakages, successful companies realize that effective procurement and sourcing programs need to do more than just negotiate better prices from suppliers. These companies have developed the know-how to translate reported savings into realized EBIT. How? They focus on raising the level of procurement capability while also changing behaviors in other parts of their own company that are known areas of leakage. This means:
- Building capabilities for continuous improvement, rather than one-time benefits, by:
- Involving the people from the beginning and assembling a team that includes influential decision-makers.
- Upgrading the talent level within sourcing and improving processes to assess total cost versus just price. Instead of increasing the number of people and systems, successful companies change the focus from managing transactions to managing spend categories and suppliers, which leads to improved sourcing decisions and more realistic savings forecasts.
- Capturing negotiated savings in contracts, rigorously enforcing contractual obligations and effectively managing suppliers to lock in the savings.
- Creating KPIs and dashboards to track savings and facilitate regular communication among finance, procurement and the core business so all may quickly identify and address areas of leakage.
- Reducing supply-chain complexity, by:
- Optimizing end-to-end supply chains by creating natural supply chains and tailoring offerings based on the requirements of target customer segments.
- Investigating "local-for-local" sourcing as an alternative to global sourcing.
- Avoiding complex and hard-to-manage supply chains that appear to deliver savings, but actually wash-out most, if not all, savings by increasing inventory or introducing unfavorable payment terms.
- Streamlining the procurement process and aligning metrics between sales, operations and procurement by:
- Increasing compliance by eliminating the "everyone's-a-buyer" behavior. Only procurement is empowered to commit the company to a supplier relationship. Progressive penalties for noncompliance should be implemented to reel in repeated offenders.
- Aligning sales compensation to reward margin growth, with less emphasis on incremental increases in tiered compensation structures, can be an effective way to reward increased margin and increased volume.
- Integrating operations input into procurement strategies help ensures the value is real and understood by the front-line management who will implement the new contracts and sustain compliance.
- Proposing a win-win situation for customers by:
- Passing on a portion of savings to entice them to buy into sourcing efficiencies.
- Offering other incentives in terms of improved service levels and supply reliability.
Few companies have successfully realized the savings potential from their sourcing programs without institutionalizing processes like these for driving results that deliver value to the bottom line. Instead, many companies conduct sourcing programs that identify value and then declare "success" without making much impact to EBIT.
On the other hand, winners typically maintain high degrees of capital discipline. Even during a "gold rush" (such as the shale revolution), they deploy segmented and tailored business models that fit the market dynamics in which the assets are positioned to compete; and they maintain a relentless focus on successful project execution. Underperforming companies tend to accelerate through many of those crucial elements, exposing themselves to unanticipated risks.
Even though the timing of investments versus the timing of returns (because of lags in bringing production online) may play a role in the current picture of investment productivity, we don't think it explains the majority of the issue. Some companies today are losing their capital discipline due to:
- A perceived abundance of profitable opportunities and the fear of falling behind;
- A lack of a clear investment strategy linked to differentiated capabilities;
- Efforts to maximize options by placing many small bets rather than a few focused investments;
- Overcapacity of certain types of equipment-intensive services that are driving prices below attractive reinvestment levels; and
- Shortages in the human resources and management capacity needed to closely plan and execute projects.
Add to those concerns the real possibility of lower oil prices - which could depress return on investments across many sectors of the industry - and many companies may need to pay closer attention not only to the level of their capital expenditures but also to whether they are doing everything within their power to ensure their capital is earning an attractive return.
Securing attractive returns on investment depends increasingly on the company's ability to design and execute projects. However, according to Independent Project Analysis only 22% of major upstream (exceeding $1 billion in total costs) can truly be seen as successful. That's as measured by ability to meet stated final-investment-decision objectives in terms of budgeted cost, schedule, production volumes and/or operational efficiencies. Clearly, poor functional integration during the design phase often sows the seeds of poor performance during the asset's lifecycle.
Even for relatively small capital investments, failure to integrate operations and functional input into the design impacts achievable returns on that investment by driving up the operations and maintenance cost and reducing asset availability.
By way of example, a drilling contractor's engineering team continued to specify a particular manufacturer's equipment into new rig packages destined for long term operations in a certain African country. This decision resulted in significantly higher non-productive time and increased maintenance costs because the manufacturer had no service network in the country and did not allow its technicians to travel to the country. As a result, operations had to sustain significantly higher costs to repair and certify critical equipment because it had to be exported out of the country and transported for service. This design decision also resulted in lower overall asset utilization and subsequently even more capital employed for additional operational spares required to improve rig availability.
Our experience in helping clients in oil-field services improve field operations performance also underlines the importance of cross-functional integration. Building good general-management capabilities is vital to realizing and sustaining the benefits of the cross-functional integration, and building a performance culture among operations leaders is also key.
The journey starts by making immediate, if sometimes subtle, changes in daily operations.
Increasing awareness among operations managers of the root causes of lost revenue and increased operating costs enables specific actions. Here, examples of the typical levers we work with companies to employ:
- Labor management, including proactive daily and weekly labor planning to deliver the maximum number of jobs at the optimum labor cost by improving available crew time, reducing overtime and optimizing the crew composition to reduce total labor cost and deliver safe, reliable operations.
- Supply-chain planning and execution through deliberate cross-functional planning with material planners and logistics coordinators integrated into the daily operations meetings. This leads to better synchronization of the supply chain even in dynamic environments where the customer's schedules are changing.
- Preventive maintenance planning and execution integrated into the daily/ weekly operations planning to ensure robust preventive maintenance plans are in place for operations critical equipment and execution targets are supported and shared by operations. This integration of preventive maintenance into operations reduces equipment downtime and total repair and maintenance costs.
- Weekly, fact-based, cross-functional performance reviews facilitated by senior operations leaders provides short interval feedback. This allows the team to make changes to take advantage of new opportunities and to address the root causes of higher operating costs in real time.
Incorporating these suggestions can transform oil and gas businesses of all kinds into ones that can make better, faster decisions while increasing operational productivity and right-sizing overheads.
A comprehensive approach to maintaining and enhancing capital discipline can help these unprecedented times in the oil and gas industry become nothing but the best of times for a long time to come.
