The oil and gas (O&G) industry is going through a rough patch, yet again. First, the supply versus demand game of cat and mouse in the open market pushed the industry through several up and down cycles. Then, as if it were not complicated enough, the coronavirus pandemic broke the industry’s back, bringing it to its knees in 2020. Who could have ever imagined a negative price of oil!
When the aftermath of the 2014 oil price crash exposed glaring holes in the industry’s spending habits, every oil company raced to reduce their cost base by restructuring, reorganizing, prioritizing investments and squeezing contractors. At operators and oilfield services (OFS) companies, the conversations shifted from investing in new fields and the latest and greatest technologies to frugal cost discussions. But just as the industry was starting to get back on track, with plans to invest in future reserves, 2020 struck with full force. One thing that has become clear over the past few years is that the oil industry needs to reconsider its cost structure. More importantly, any reduction in cost structure needs to be sustainable.
Figure 1: Chart compares common stocks from the top four OFS companies, top six O&G companies, and Brent Crude price, all indexed to 100 on January 1, 2014.
Trying to squeeze discounts out of oilfield contractors and service providers to achieve reduction goals in capital expenditures (capex) is anything but sustainable. Figure 1 shows the impact that the slump in the oil industry has had on the stock prices of oilfield services companies and the major players in O&G. Compared to their value on January 1, 2014, while the O&G company stocks are down by about 40% in January 2021, the value of OFS company stocks has decreased by 80%. The OFS companies have lost twice as much shareholder value as the O&G majors.
This begs the question: how can the oilfield ecosystem survive and deliver value to its shareholders on both sides of the spectrum? Consolidation is one obvious way, and we’ve started to see a wave of consolidations already happening across the world. Consolidation brings organizational efficiency, reducing unit cost. Another sustainable solution is value generation through smart contracting models that encourage efficiency and performance, thereby reducing the unit cost to produce each barrel of oil.
The old way
The procurement philosophy of the oilfield has long been fragmented. Each individual service used to be tendered separately, leading to each individual contract being executed as a standalone, often resulting in the same service company providing several standalone services for the same project. Giddy with the oil wealth generated before the 2014 oil price crash, O&G company operations teams went on a purchasing spree, buying the latest technologies available in the market. The OFS industry also saw revenues ballooning, and investments in technology development became a necessity to continuously reinvent the narrative and avoid commoditization. When the crash of 2014 hit the industry, the procurement teams of the O&G companies were put in charge of delivering deep cuts in contractor spending. Nearly the entire industry went through a repricing exercise in which hefty direct discounts were sought from contractors in return for keeping their contracts active, but as the industry emerged from the aftermath of the 2014-2016 crash, further squeezes on contractors were no longer feasible. Many O&G companies tried divesting oil fields, restructuring, or reducing project capex to survive, and others explored different strategies.
As a result, some O&G companies looked at consolidating their service contracts through an integrated approach, in which several services were tendered together, and more risks were passed on to contractors in return for a larger scope of work. While this helps reduce costs, this strategy is not sufficient to deliver sustained cost efficiency and improvement.
The way out
The best way to approach this issue is by changing the contractual models from paying for services to paying for value. When evaluating commercial proposals, the total cost of operations must be considered by accounting for the overall value a service can bring to the whole system instead of seeking the cheapest cost for an individual service or group of services. In other words, the oilfield needs to pay for value rather than widgets.
Consider the following example: Imagine you run a delivery kitchen staffed by four chefs. Your kitchen delivers 100 dishes at $10 each in a day, and you pay each of your four chefs $100 daily. You could do more deliveries because your kitchen is popular, but the chefs protest that they can each make only 25 dishes a day. There is no incentive for the chefs to make more dishes a day because they get paid the same $100 per day, whether they make 20 dishes a day or 30. You want to grow your business, but your finances don’t allow you to add more chefs. But what happens if instead of paying the chefs $100 a day, you pay them $4 for each dish they make? Provided your food quality and Google ratings don’t suffer, the chefs are free to make changes so that the kitchen becomes more efficient. You would be surprised to see that just by changing the chefs’ compensation model, your business starts to grow. Given the opportunity to earn more, the chefs would improve kitchen processes by reducing or streamlining tasks that don’t add value, allowing them to increase their production from 25 to 35 dishes a day. They are now incentivized to make the whole system work better, so their daily earnings grow from $100 to $140 per day, while your cost remains constant at $4 per dish.
Figure 2: Performance-based kitchen business model
Of course, drilling a well is a lot more complex than running a kitchen, but this very simple example illustrates the concept of buying value. A vast majority of the cost to drill a well today is still time-based, whether it be for compensation of the people involved or the day rate of contracts for services. As with the kitchen example, there is no incentive for the service contractors to be more efficient and improve performance, which would reduce the hours of their contract and thus their earning potential. In fact, depending on the contract scope and structure, they might be de-incentivized for being more efficient. For example, in a five-well drilling contract in which the rig contractor is paid on a per-diem basis, improving efficiency might enable the contractor to complete all five wells in less time, thus earning less money. If the same drilling rig contractor was compensated on a per well basis instead of per day, the contractor now has incentive to be more efficient. The sooner the five wells are drilled, the contractor can generate the same amount of revenue in a shorter duration. The cost of the rig for the O&G company is the same as it was in the case of the day rate contract, but since the wells finish sooner, the company saves money on other time-based costs, is able to get to oil production sooner, and can drill more wells in a year.
Depending on the service, several forms of such performance-based contracts are possible, such as compensation based on footage drilled, wells drilled, length of well delivered within reservoir, uptime of pumps, or eventual rate of production. These performance-based contracts have one thing in common: instead of adherence to service-level agreements (how will the objective be delivered), they focus on performance and outcome (what has to be delivered), with the potential upside being proportional to the amount of value created. In these performance-based pricing models, the operator passes on additional risks to the service provider. For these contracts to be successful, the potential upside for the service provider should significantly outweigh the risk.
If these contracts are implemented correctly, the interests of the service providers are aligned with the interests of the operator all along the value chain. When the entire value chain is aligned to the same objective, operators and service providers have better control over the eventual outcome.
The need for sustainable reduction in the cost of producing each barrel of oil is more important now than ever before. Redirecting commercial and operating models so that all service providers are contractually working towards a common goal can help the industry get there. Many O&G companies have started moving towards such performance-based models, but aligning contractors and changing contracts takes time and effort, so the ones that get there sooner will be well-positioned to face the next oil-industry down cycle and be able to better ride the wave of the subsequent up cycle.
About the author: Ankur Prakash manages global sales and commercial function for well construction at one of the world’s largest oilfield services companies. With nearly two decades of expertise, he specializes in operations management, maintaining synergy between service lines, developing and implementing new business ventures and performance models, and managing commercial responses for the global oil and gas industry.