06 Mar Oil and gas: From Kobe Beef to Ground Chuck
The last several meetings that I’ve had with oil and gas industry executives have ended with a variation of the same question: now that we have reduced our costs to match commodity prices, how do we keep them from rising again?
The question raises the suspicion that the cost reductions captured to date might not be sustainable – costs could come roaring back if commodity prices rise. Why have many industry executives reached this conclusion?
They are right to speculate, of course. The prize at stake is substantial – assume oil prices rise to US$75/bbl from US$50 today, and on an industry volume of 4 million barrels per day of production. That’s an incremental US$35b in annual revenue. My estimates are completely wrong as Canadian oil quality is lower than global pricing benchmark grades, and our oil doesn’t even trade globally but even so, there’s a prize to be had.
Here’s my view on why costs are likely to come back, and what can be done about that.
This situation reminds of an analogy from the business process reengineering wave that swept through many industries about 20 years ago.
Imagine for a moment that an oil and gas company is like a finely marbled cut of wagyu Kobe beef (the tenderest, fattiest, most tasty and expensive beef on the planet), and chef’s job is to remove the fat.
You reach for your trimming knife and you cut away all the exterior visible fat. The oil and gas industry has executed this move to perfection over the past 3 years, by extracting price concessions from suppliers, reducing capital spend, laying off staff and lowering the dividend. Companies look like leaner animals as a result. But are they?
We can see the results. Oil production in Canada is holding steady, some 43,000 oil industry jobs are gone, and 25% of the office tower space in Calgary is vacant. Suppliers tell me that they’re operating on negative margins.
But you don’t want to cut into the muscle of the company if you can avoid it (by canceling key growth projects), and you don’t want to hit the bones either (by laying off hard to find skills). If you do, you might not have the organizational strength to respond quickly should prices rise. Put the knife down, however, and executives can still see the fat in the company, in the form of inefficient processes, poor quality data that causes lots of rework, lots of systems investments that appear redundant, and a curiously resistant G&A cost that doesn’t respond to oil price or volume reductions.
Is there a way to get the fat out of finely marbled wagyu beef? Yes, but unfortunately, you have to grind it up and fry it, and the fat will then pour off.
I know what you’re thinking. That sounds really really painful. Grinding? Frying? But the oil and gas industry needs to confront that which it fears the most – change – and transform itself into a much leaner and more effective beast.
Not that there’s a choice in the matter. Canada’s oil and gas basins used to compete with each other, for talent and the attention of suppliers, but with the downturn, there’s plenty of talent and suppliers about. The basis of competition has fundamentally shifted – Canadian oil now competes for capital with light tight oil deposits (shales), and soon with modern fuels like renewables. Early signs are that Canada is not winning the capital game (here, here, here and here).
The Fat Trimming Approach
The one dimensional strategy for survival that most producers have followed (cut costs to the bone) is simply too limited in our complex world. Here’s how the business model of oil and gas has responded.
Oil and gas strategy is usually pretty straightforward. Producers choose among basin types (oil sands, shale, conventional), and generally aim to be the low cost producer, the most efficient at capital execution, the lightest possible environmental footprint, the most attractive to talent, and first quartile financial returns to shareholders. Perhaps there’s a statement about innovation or collaboration, but once the resources are on the books, strategy typically reverts to getting them out of the ground fast and cheap.
This is the actual work of the industry. Buying stuff. Building drilling pads. Drilling wells and laying in pipelines. Building plants. Operating assets. Maintaining the infrastructure. Selling products. Complying with rules. Suppliers will tell you that Contracting and Procurement has gained strength and power these past 3 years, costs are definitely down, but this is largely due to price – the work of the industry hasn’t structurally changed.
I think of culture as the way work gets done, and the culture of the industry also hasn’t changed much. In part this is because many of the technologies haven’t really changed, but producers also cling to a do-it-ourselves model with little outsourcing, and simply lean on suppliers for cost reduction. Little has structurally changed in the nature of the work, who does it, the relationship with suppliers, and the emphasis on continuous improvement and process innovation.
Technologies haven’t materially moved in the past 3 years (capital constraints took care of that), and are for the most part not well suited to a process view or a digital future. Many predate the latest innovations like cloud computing, artificial intelligence, smart devices, and automation, and are partially or wholly incompatible with newer solutions. Technologies and how they interoperate dictate the nature and quantity of skills needed, cement processes in place and drive culture. There’s some terrific innovation happening with drilling technology that helps reduce headcount needs, but that benefit tends to accrue to the drilling contractor. Automation has been slowly making its way into the oil sands.
Organisation structures haven’t really changed that much. Producers still organize themselves around functions and assets, unlike manufacturers who are structured around processes. People are grouped according to technical specialization (land or drilling, for example).
Here’s where most of the change has happened in the producers and the suppliers. Force reductions are relatively easy to do, if very painful for managers to actually carry out. Thus, staffing levels are way down, a “more for less” strategy. Producers want to keep it this way.
My conclusion is that the minute there’s any pricing relief (as we’re seeing now), line managers will approach senior management and ask for some investment funds to get back to business as usual. Their argument will be that there’s been lots of sacrifices made, work is not getting done, risks are emerging, talent is hungry for a raise, suppliers want a price increase, new kit is available, things need upgrading and repairs, and so on. In other words, add more cost.
So the executives are indeed onto something. Costs are poised to return.
The Hamburger Approach
To keep the costs out structurally, Canada’s oil and gas industry needs to rethink its game plan:
Company strategies need to recognize the shift in Canada’s basins from growth to operations, the need to be globally cost competitive, the important role that innovation and collaboration play, an unrelenting emphasis on zero harm to humans and the environment, the drive to low carbon and water impacts.
Actual work will be defined by process, and designed to a level of granularity that it can be automated or delivered as much as possible by automation or robots. Assets will need to be harmonised and simplified to reduce their cost of ownership and enable automated maintenance. Processes will go through a wave of simplification followed by streamlining to reset their costs permanently, and will be designed without humans in them. Compliance will be built into processes, not executed as an after event cost.
Ways of working will be different. The relationship between producer and service company will look more like the collaborative supplier relationships typical of technology or auto manufacturing. The industry will embrace much more outsourcing, more reliance on an ecosystem, and much more international supply options.
Fortunately, oil and gas companies are vested in ERP systems which are generally process centric, but all will have to go through reimplementations to remove their current focus. ERP systems will extend their reach, and will be required to enable the kinds of automation (crewless drill rigs, driverless vehicles, aerial supervisory drones, robotic process automation) that keeps headcount at bay. Blockchain applications will flourish in compliance realms, capital project execution, supply chain and trading. Field kit and infrastructure will be designed on principles of lifetime cost (not just capital cost), self management, and festooned with sensors that give remote visibility to operating state, removing the need for full time field crews.
To capture and lock in labour savings, next generation organisational models will need to be more like those in manufacturing, based on an end-to-end view of work processes. There will still be functional overhead teams like Finance, but even they will be structured on process lines. The manufacturing industry has had a lot of success implementing process-centric organisations with single process owners who drive changes that lead to sustainably lower cost structures.
Finally, I can actually see headcount rising in oil and gas, but the skills will be different. More process oriented, more digital, more collaborative, more orchestration and less doing.
Grind and Fry
Conditions are right for oil and gas to start the grinding and frying. There’s little resistance to change by employees and suppliers, the necessary technologies exist, and prices are rising, giving a bit of financial help.
Executives must resist the urge to simply give money back to managers, or we will start the cost cycle all over again.