Making better strategic cost decisions

Adding to the challenge is the difficulty of setting cost targets. On the basis of public data, can we really know-as analysts frequently assert-which companies are low-cost or high-cost operators when compared to their peers?

E&P companies and the analysts who cover them spend a great deal of time poring over public data purporting to measure relative financial and operational performance. Particularly now, with commodity prices continuing their sluggish path, accurate and reliable measurement is crucial for determining strategic cost moves, setting the course for performance improvement, and perhaps even surviving. But can available measures allow for meaningful comparisons across companies, which differ significantly in accounting treatments and definitions of inputs? And more importantly, how do you translate this data into actionable insight for making department level cost decisions?

Relying on data from the PwC General and Administrative (G&A) Diagnostic, this article suggests that the answer to those questions, at least for a couple of important cost measures, is "no."

Evidence from 30 E&P companies (representing more than 55% of US onshore production) participating in the PwC G&A Diagnostic-a benchmark that begins with income statement G&A and then makes uniform adjustments to that figure to achieve greater peer alignment and comparability-supports the view that internal perceptions of whether an individual company is truly high or low cost relative to peers are generally wrong. And those perceptions are based largely on public data.

Furthermore, this may also call into question a company's Lease Operating Expense (LOE) performance and ranking, as definitions of G&A versus LOE personnel vary from one E&P to the next.

We explore the implications of misestimating those measures, and conclude by outlining our views on strategic cost reduction in the current environment.

PERCEPTIONS OF G&A COSTS RELATIVE TO PEERS

The finance executives participating in the PwC Diagnostic were asked the following question: Prior to completing the PwC G&A Diagnostic, what was your opinion of your company's true G&A cost relative to that of peers?

Results indicate that the vast majority of participants responding to that question held perceptions that were at odds with their actual gross adjusted G&A results versus their peer set (see Table 1).

On the basis of net barrel of oil equivalents (BOE), 82% of respondents held perceptions of their G&A relative to peers that were inconsistent with their actual standing relative to peers. On the basis of revenue, 77% likewise had misperceptions when compared to actual gross adjusted G&A results relative to peers.

These findings suggest that inconsistencies in the way income statement G&A is calculated have led the E&P segment to collectively misunderstand relative cost performance. They also suggest the need for industry to standardize on a better measure for understanding G&A costs.

STRATEGIC COST MANAGEMENT

Companies across the industry, regardless of relative cost performance, have been challenged lately to cut costs. Determining the appropriate level of G&A and the necessary cuts is not always straightforward. For example, cutting capital spending 20% does not typically imply that a 20% G&A reduction is warranted.

There are many drivers of G&A costs; capital spending and drilling activity, while often the most visible, are not the only drivers. In our diagnostic we saw significant G&A performance differences based upon a company's asset mix (gas-weighted operators tend to have lower G&A cost-particularly on a BOE basis-than do their oilier peers) and business model (exploration and development capital-intensive companies tend to have higher G&A cost than do more acquisition-focused operators (see Table 2 for details). Therefore, setting the "right" G&A level and the actions to achieve it requires a deliberate and thoughtful approach that is fit for purpose given the company's strategy.

The correct approach to right-sizing G&A costs and the necessary actions to do so are largely dependent upon how far a company needs to go on its cost reduction journey (see Table 3). The journey consists of five levels that range from basic discretionary spending cuts to business model changes. The actions, their impacts, and the challenges vary at each level on the journey.

Today, most companies have taken action across many of these levels, but most have been focused on levels one and two (basic cost management and workforce reductions), while holding short of fully embracing levels three, four, and five.

Levels three and beyond, while providing greater impact, are much harder to do right. These levels require taking a holistic view of cost reduction. To make sustainable changes at these levels requires re-thinking how, where, and by whom work gets done - that is, re-thinking your company's operating model. There are four areas to evaluate for unlocking cost reduction potential:

• COST - Break down costs to identify reduction/elimination opportunities (see Figure 1)
• PROCESS - Take out process complexity - streamline, standardize, and automate
• TECHNOLOGY - Focus investment on tools that enable differentiating capability or drive costs lower
• DELIVERY MODEL - Evaluate outsourcing opportunities, reduce management layers, and reorganize around a more sustainable headcount

Keith Considine is PwC US Advisory Upstream Leader and leads PwC's Energy Finance practice. He has over 20 years' experience in the energy space and focuses on integrated strategy, planning, and business transformations driving performance improvement in leading global oil and gas companies.

Richard Rose is a Houston-based manager in PwC's Energy Advisory practice. He has more than 10 years of experience and focuses on assisting upstream oil and gas companies with performance improvement.

Steve Wright is the Oil and Gas Benchmarking Lead at PwC. He has over 25 years' experience in benchmarking and applied research. He has developed and led oil and gas industry studies on cost management, operations, upstream land management, supply chain, finance, and human resources.

CHALLENGES

While each situation is unique, executives typically face the following cost management challenges:

1. Lack of certainty whether prior cuts have been enough, too much, or in the right areas.
2. Transitioning from cutting costs within departmental silos to building capabilities across end to end processes that are scalable and efficient.
3. Eliminating cultural bias from the process -"…this is the way we've always done it."
4. Thinking beyond the current reductions and knowing "what's next" if further measures are required.

• Discretionary spend reductions (travel, incidentals, training, etc.)
• Modify spending authority and approval levels
• Contractor management (3rd party spend reductions)
• Budget accountability

• Perform overdue personnel actions
• Eliminate unnecessary redundancies
• Exercise early retirement
• Don't fill vacancies/curtail recruitment
• Compensation and benefits cuts
• Employee furloughs

• Eliminate "nice to have" activities
• Streamline processes
• Reduce levels of management
• Reduce service levels (time, detail, etc.)

• Eliminate all non-core activities (down to "must haves" and "lights on" activities
• Implement new org and operating models (e.g. centralized services)
• Adopt new delivery models (e.g. outsourcing)

• Adopt new business model (e.g. shifting from "owner-operator" to "owner only"
• Shift corporate DNA/identify - who we are and what we do

ABOUT THE PWC G&A DIAGNOSTIC

To facilitate comparisons across companies, the PwC G&A Diagnostic defines and uses "adjusted gross G&A," as outlined in Figure 1. The simple measure begins with a company's income statement G&A, adds any capitalized amounts and amounts billed to third parties that have been netted against income statement G&A, and then deducts a host of non-comparable or one-time costs (such as deferred compensation, insurance premiums, legal settlement fees, severance or restructuring fees, management or sponsor fees, pension costs for retired or severed employees, and hardware/software systems implementation costs). In company 10-Ks, these are the items often highlighted to explain year-to-year variation in G&A costs.

• To ensure further comparability, the tool outlines specific guidelines for determining what is included or excluded in the G&A cost number (and the submitted data are then vetted accordingly):
• For integrated and diversified companies, this means reporting G&A as if the entity were a stand-alone E&P-that is, not including costs and headcount from non-E&P-related businesses (e.g., midstream or services).
• Following Council of Petroleum Accountants Societies (COPAS) guidelines to delineate the G&A/LOE boundary. (If personnel can be charged out to partners under COPAS guidelines, they constitute LOE. If not, they are considered G&A.) G&A in this approach includes corporate G&A as well as "field admin" and any other personnel above first-level field supervision.
• Itemizing only those non-comparable items that were in fact included as part of income statement G&A. And ensuring that these were legitimately non-comparable-typically, one-time occurrences or items that would otherwise distort comparisons across companies.
• Including both core technical areas (Commercial Operations, Supply Chain, Land, HSE, Technical Support, and Marketing) as well as traditional support or overhead areas (IT, HR, Legal, Headquarters, and Finance & Accounting) in the definition of G&A.
• Ensuring all data are specific to Lower 48 US domestic only.

Once defined in this way, the G&A cost data were normalized in the usual fashion (by production, revenue, well count, etc.).