A dangerous narrative about a rising market

Over the past few months, that dread has risen to a fever pitch as the noise around service price increases has gotten louder and louder. As a result, the same questions are surfacing in every boardroom:

• What will happen in supply markets?

• Are rapid and universal price increases underway?

• How can we identify those markets that are constrained and those where slack remains?

• What strategies can we use to hold onto our gains and find new opportunities in each market segment?

Before we can answer these questions, we must first take a closer look at a problem within the market for oilfield services and materials today: framing. Major players are framing the market in such a way that it is very hard to see places to hold down costs or to find new cost reduction opportunities.

To understand what we mean by framing, let's first take a detour into the world of psychology to illustrate how a powerful and potentially dangerous narrative about the market is shaping the way we think about pricing within E&P.

A powerful narrative emerging within Oil & Gas

In a now-classic study, renowned psychologists Daniel Kahneman and Amos Tversky posed an extreme scenario to their participants, asking them to imagine that they exist in a region afflicted with a deadly pandemic. Participants of the study were then tasked with determining the appropriate course of action to respond.

In one group of participants, the psychologists offered the two options outlined below, both framed in terms of the number of lives saved. But in a second group, the psychologists threw in a twist. This time, they framed the options in terms of losing lives. Critically, each of the matching choices in the saving lives scenario and the losing lives scenario resulted in the same outcomes, even though they were framed in different ways.

So what happened? Since the scenarios were logically equivalent, we would expect participants to choose the same outcome each time. But instead, Kahneman and Tversky found that 72% of participants preferred the sure thing when framed in terms of saving lives, but only 22% preferred that option when framed in terms of losing lives. In other words, the framing of the scenarios was powerful enough to result in vastly different decisions (see Figure 1).

We begin with this anecdote because E&Ps are witnessing similarly powerful framing effects at play in today's market. Who hasn't heard from a supplier recently that the market's rising, it's rising fast, and it's time for necessary price increases?

For instance, in a recent feature in the Wall Street Journal, the CEO of Halliburton was quoted as saying that E&Ps "know in their heart of hearts that service prices have to go up." His call for higher prices has been echoed by the earnings calls of Schlumberger, Weatherford, Helmerich & Payne, and dozens of others, all reiterating the need to recoup lost margins through service price increases.

This framing of a rising market would be mere noise if it weren't also being endorsed by influential commentators: Tudor Pickering recently told the market that frac prices "have to go up," Raymond James declared constraints in pressure pumping, and Simmons & Company has told the market that "the system is already getting tighter and strained."

With all these commentators reiterating the same message, a consensus perspective has started to emerge. Perhaps more concerningly, many E&Ps are starting to accept that framing for reality: in a recent Barclays survey, 79% of E&Ps expect service costs to significantly increase in 2017. Meanwhile, dozens of operators' investor presentations have incorporated double-digit price increase assumptions into their budgets.

Countering a dangerous framing of the market

As Warren Buffet famously wrote, "be fearful when others are greedy and greedy when others are fearful." In other words, whenever a consensus perspective starts to emerge, it's time to consider looking in the opposite direction.

So let's take a look at some of the common tactics that OFS providers are using to propagate the narrative of a rising market. From there, we can identify why they break down under scrutiny and show how E&Ps can respond with effective counter-arguments.

One of the most common arguments that suppliers use to support price increases is that "demand is rising so fast that we can't keep up." For example, suppliers often use supporting data points like rig count to argue that demand has risen by 70-80%. But what happens if we frame that same data in a broader historical context, as shown below? We instead find incontrovertible evidence that demand is down by a full 58% from its peak in 2014 - in other words, capacity is nowhere near as constrained as suppliers are framing it to be (see Figure 2).

How about another common argument? Suppliers often tell us that their cost structures are rising, citing increasing labor or commodity costs like those in Figure 3. But again, what happens if we look at those same commodities in a different frame? By zooming out to the peak of the market, we now see that suppliers' cost structures should still be significantly south of where they were just a few years ago.

Beyond selectively chosen data on demand and input costs, OFS providers have developed a whole toolkit of techniques to support their frame of the market: citing third-party forecasts of constrained capacity, hiring teams of analysts to build favorable escalation mechanisms into contracts, and returning for price increases on a quarterly basis are just a few.

The truth, however, is that there is no one market that's rising or falling. In fact, there are many different markets, which are each moving at different rates that can be negotiated in different ways. In other words, the market for sand isn't the same as the market for OCTG or for workover rigs. Some of these are constrained and others present further opportunities to lower prices as capacity outweighs demand. Painting every market with the same brush runs the risk of erasing significant pockets of remaining cost reduction.

How to approach distinct market segments

If we acknowledge that "the market" is really composed of multiple market segments, not one large market of rapidly rising prices, we then need tools for evaluating those segments and developing corresponding strategies for each.

We can discern what is really happening in each segment by asking questions such as:

• Is this market highly differentiated?

• Is this market highly constrained?

• Is this market impacted by rising input costs?

The answers to those questions will, in turn, determine the corresponding strategy of attack. For instance, in highly differentiated and constrained markets, operators rightfully focus on reducing the slope of price escalation. But in markets that are less at risk, operators can take a more aggressive stance and negotiate against price increases in the first place.

It has become clear that some operators are approaching these markets more effectively than others: based on our E&P data, we see 20%-50% pricing spreads across everything from commodity items like biocides to major service contracts like rig day rates. So let's look at a few of those types of markets and identify where outperforming E&Ps are gaining leverage.

Negotiating against rate increases

In many cases, suppliers are asking for price increases that aren't justified by supply/demand fundamentals. Typically, those increases are supported with arguments like "labor costs are up, demand is high, and I just gave your competitor a much higher rate."

Operators know that these arguments often don't reflect market realities, but there's an open question around how to effectively respond. The secret lies in cost modeling, a capability that was recently unlocked by advances in machine learning and big data. Operators can use cost modeling data to quantify how contract prices for categories like workover rigs should have actually moved with the market and then identify whether suppliers' price increases are in line.

For instance, the cost model in Figure 4 breaks down the cost of a workover rig contract into its individual cost components such as operating charges, triplex pumps, crew travel, and equipment rentals.

Each of those cost components, like operating charges, can then be linked to the market using indices that move over time, allowing operators to quantify how their prices should have moved with the market and generating significant leverage in negotiations. Data like this enables operators to respond directly to arguments like "our labor costs are rising by 7%" with information like "the decline in steel plate costs outweighs the increase in labor by 3x." See Figure 5.

So in cases where operators believe the market isn't as tight as suppliers might suggest, market data provides a wedge for contesting price increases effectively, to the tune of 5% - 30% savings.

Holding down escalation over time

Let's take another case: what if suppliers ask for a price increase in a market that you do believe is constrained? In that case, the best bet is to ensure fair and tempered escalation and to put in place a longer-term contract to ensure supply.

Indexing a contract to the market is a common practice for establishing fair price movements over time. But in a world where it's common for suppliers to employ teams of analysts solely dedicated to developing favorable pricing mechanisms, choosing the wrong index model can cause more harm than good.

As operators think about minimizing upward volatility in those price adjustment mechanisms, there are a series of dimensions to consider, spanning from the type of index to the frequency of pricing updates. In Table 1, we summarize a number of the most common dimensions for reducing the volatility of escalation in a contract:

The result is that seemingly similar price adjustment mechanisms can end up with very different outcomes. In Figure 6, for instance, a WTI-based model would have resulted in a 57% escalation rate vs. a cost-based model, which would have escalated much more slowly over the same time period.

So in cases where the best you can do is hold down the level of escalation, a conscientiously chosen mechanism for adjusting prices can help assure supply while holding down costs. Avoiding dangerous tricks that drive up price volatility is a critical skillset in today's market. In fact, we've seen these kinds of index-based contracts result in 20+% savings in key categories like well stim, OCTG, and wireline.

Moving beyond price to cost

The strategies we've addressed so far have had one thing in common: they're all about responding to suppliers' narrative around rising prices. But are there other ways to more sustainably hold down costs outside of reacting to suppliers' framing of the market?

When we shift our focus to total cost reduction, we often find that even where prices have decreased in the last two years, there are still many areas with significant inefficiencies and waste.

A particularly effective tool for quantifying total cost is to create well cost benchmarks on a normalized (e.g., $/foot) basis across each key cost category (e.g., OCTG, rig services, mud logging, fluid services, etc.) With that data in hand, operators can identify average wells, underperformers, and pacesetters.

The question that naturally surfaces is: What's common among our pacesetter wells in each cost category? See Figure 7.

One explanation could be a meaningful difference in spec: perhaps one kind of casing or specialty chemical is driving a meaningfully lower $/foot vs. another. If operators normalize wells across downhole conditions, temperature, pressure, and other meaningful geological differences, they can identify whether those specs are, in fact, required to satisfy operational requirements or whether it's possible to shift to lower-cost specs.

Another explanation is that different suppliers are providing truly different levels of efficiency - in one recent case, for instance, we saw that the majority of an operator's highest cost wells for well stim were served by OFS #1 while their lowest cost wells were primarily served by OFS #2. When we ran the numbers, it turned out that while both providers had the same rate, they were achieving 17% differences in total cost due to stand-by time, inefficiency, and other forms of waste.

These deeper investigations into pacesetter wells are a meaningful way to preserve a lowest total cost structure independent of price variations that come with rising or falling markets. Engaging lower total cost suppliers or using lower-cost specs are just a few ways of preserving those cost efficiencies and hedging against suppliers' framing of the market.

In a world where we're told that the market is at an inflection point, it has become all the more important to distinguish between markets that are truly constrained and markets that still have slack. Much of the hype around a rising market is due to a powerful consensus perspective emerging out of suppliers' framing techniques. In response, savvy operators are responding to that narrative with the data to combat price increases, hold down escalation, and increasingly turn to strategies that address total cost rather than price.

ABOUT THE AUTHOR

Paul Smith is a senior vice president in PowerAdvocate's Oil & Gas Group and serves as a member of PowerAdvocate's executive team. Smith works closely with executives from dozens of Oil & Gas firms to help drive cost reduction using data and analytics. He has previous experience as a business unit leader at C&M Wire and Cable and a consultant at Monitor Deloitte, has been published extensively on the topic of cost reduction in Oil & Gas, and holds an MBA from Northwestern's Kellogg School of Business and a BA from Union College.