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Cost and effect
How national oilcompanies cantransform their coststructures amid amarket rout
Strategy& is part of the PwC network
Strategy&
Dubai
George [email protected]
David BransonExecutive [email protected]
Anil [email protected]
Contacts
Previously published in “Trends,” March 2016.
George Sarraf is a partner withStrategy&, part of the PwC network,based in Dubai. He is the leader of theenergy, chemicals, and utilities practicein the Middle East. He specializes in theoil, gas, and utilities sectors across thevalue chain. His functional experienceincludes sector and business strategy,regulatory frameworks, business cases,due diligence, operating models,operations, and systems.
David Branson is an executive advisorwith Strategy& in Dubai and a memberof the energy, chemicals, and utilitiespractice in the Middle East. He has over25 years of experience in oil and gasoperations, and specializes in strategy,organization and processes, exploration,and mergers and acquisitions for oil andgas companies.
Anil Pandey is a principal withStrategy& in Dubai and a member ofthe energy, chemicals, and utilitiespractice. He has over 17 years ofexperience in the oil and gas industry,with a focus on the upstream sector.He advises international and nationaloil companies on strategy formulation,business performance improvement,and operating model design andimplementation in the Middle East,North America, and Europe.
About the authors
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he current weakness in global oil prices requires that national oil companies (NOCs) increase their focus on controling costs. This is
an unfamiliar situation for many firms that have previously focused manage-ment attention on meeting production targets and supporting national devel-opment objectives. Many NOCs have started responding with cost cuts, for example, renegotiating contracts with key suppliers. However, with few signs of a rebound in oil prices, NOCs need to adopt a more holistic approach to cost transformation with a goal of improving operational efficiency. Cost transfor-mation will be far more difficult than short-term cost-cutting and will involve far-reaching changes across the spec-trum of activities and will require diffi-cult choices and trade-offs.
Cost transformation mandateIn response to lower oil prices, most inter-national oil companies have implemented cost-reduction programs, based around staff reductions and project deferrals. Short-term profitability and cash flow im-provement are the overriding priorities for these companies. For NOCs, however, cost optimization and profitability imperatives need to be balanced with other longer-term national strategic objectives, which typi-cally include commitments to production targets and creating employment opportu-nities. As a consequence, typical cost-re-duction levers, such as manpower reduc-tion, are normally less applicable to NOCs, while a commitment to production targets limits the ability to defer expenditure on producing assets and new developments.
A crucial first step in NOC cost trans-formations is to develop an understanding
with their stakeholders so that they are aligned on the trade-offs between poten-tially conflicting objectives. Developing this understanding requires making vis-ible to stakeholders the costs that relate to national strategic objectives outside of core oil and gas operations. The impact of potential cost reductions on future pro-duction targets should be quantified and discussed. In this way, NOCs can develop a cost-reduction mandate that explicitly recognizes the costs they incur to support longer-term strategic objectives.
Approach to cost transformationA major element of cost transformation is having a clear view of which activities are critical for the delivery of the company strategy. Rather than applying blunt, across-the-board cuts in all areas, NOCs should develop approaches tailored to
Cost and EffectHow national oil companies can transform their cost structures amid a market rout.
By George Sarraf, David Branson & Anil Pandey, Dubai
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different activities, which can typically be segmented into three categories:• Value-adding oil and gas activities,
where costs include spending on the reliability and integrity of assets and infrastructure to sustain production, enabling exports and ensuring refiner-ies and petrochemical plants are able to meet domestic and international de-mand. For costs associated with these activities, which include both capital and operating expenditures, companies should strive for continuous improve-ments in efficiency to maximize the effect of every dollar spent.
• Mandated non-oil-and-gas activities, which are activities that the NOC conducts specifically in support of longer-term national strategic objec-tives. In some cases, value-adding and mandated activities may be difficult to differentiate. For example, national
strategic objectives may call for main-taining spare production capacity, imposing investment requirements on the NOC beyond maintaining existing production volumes. Other cases are clear, for example, where the NOC is mandated to develop and manage health and education services for lo-cal communities. At the very least, the impact of such requirements on NOC costs should be made transparent. As with other costs, NOCs should ensure that costs associated with mandated activities are managed as efficiently as possible. In some cases, it may be ap-propriate to consider privatizing non-core activities.
• Discretionary activities can be reduced or eliminated. A holistic review across operational and support areas may high-light activities initiated during times of higher oil prices that should now be
reworked. Costs associated with such activities may include expenditures on infrastructure upgrades that can be deferred without affecting production targets, or the deferment of high-cost exploration activities with uncertain outcomes and long payback times. A comprehensive categorization of ini-
tiatives across the spectrum of NOC ac-tivities forms the basis for a clear view on which costs are addressable by cost-re-duction initiatives and the establishment of clear targets that reflect the role each cost item plays in supporting company and national strategies.
Transforming oil and gas costsAddressing costs related to mandat-ed non-oil-and-gas activities typically requires more extensive stakeholder discussions. Therefore, many compa-nies are focusing on identifying and eliminating discretionary activities to generate short-term cost reductions and quick wins. However, achieving mate-rial and sustainable cost reductions and
A holistic review across operational and support areas may highlight activities initiated during times of higher oil prices that should now be reworked.
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transforming the cost structure requires NOCs to also address their core, val-ue-adding oil and gas activities.
In the short term, NOCs are taking advantage of market conditions by re-negotiating contracts with key suppli-ers. Many companies are also conduct-ing a wide range of activities to reduce operating costs through, for example, aligning plant shutdown schedules and streamlining supply-chain and logistical operations. Tighter controls on major contracts are an important step to ensur-ing that NOCs get value for money from ongoing capital projects.
Transforming cost structures will re-quire NOCs to complement short-term actions with longer-term considerations of their key internal processes. Cost transfor-mation entails conducting a holistic diag-nosis, supported by internal and external benchmarks to identify the root causes of sub-optimal cost performance. For exam-ple, a recently-conducted diagnosis of an
NOC’s drilling operation isolated a num-ber of factors driving higher costs, includ-ing delays in rig mobilization. In this case, the root cause was traced back to instabil-ity in the drilling sequence and the man-ner in which drilling priorities were set in the portfolio. Addressing the process in which the drilling sequence was estab-lished led to improved plans and reduced costs associated with mobilization delays.
Similarly, improving cost performance for capital investments might require a company to address all stages of its cap-ital projects process. At an early stage, ensuring that key uncertainties have been addressed might require modifications to processes describing how technical func-tions work together, while consideration of modular and standardized designs might be expected to improve costs. Ad-ditional cost savings may be achievable by reviewing and amending contract-tender-ing procedures and through rigorous sup-plier and category management.
An important element in transforming core, value-adding costs are the criteria based on which targets will be set and progress measured. Cost-reduction targets are often expressed in terms of a percent-age of overall costs, or in dollar terms. For NOCs seeking to balance cost reduction and volume growth, more appropriate tar-gets may be expressed in dollars per bar-rel, which incentivizes cost reduction and production increases. Such targets, when based on relevant benchmarks and linked to individual performance measures, form a powerful basis for truly transforming cost structures.
In some cases, simply reviewing the portfolio through a cost and profitability lens can provide dramatic results. For ex-ample, an NOC of a major oil-producing country recently conducted a cost diag-nostic exercise on a subset of its produc-ing fields. The diagnosis showed a distinct mismatch between expenditure levels and the production and profitability of indi-vidual fields, with too much expenditure on poorly performing fields.
Based on this diagnosis, expenditures and manpower resources were redirected
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Improving cost performance for capital investments might require a company to address all stages of its capital projects process.
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to better-performing fields. Action plans were developed to address the poorly performing fields, including ending pro-duction in some cases. The company has identified initiatives related to business planning, project management, technical standards and supply-chain procedures, which together can reduce overall costs for the pilot fields by ten percent to 20 percent, while maintaining production levels. Approaches developed in the pi-lot field are being introduced across the NOC portfolio.
Developing a cost cultureNOCs can transform their cost structure over time by systematically conducting diagnoses of key activities, benchmarking cost performance, isolating root causes of cost performance issues and amending key processes, with a focus on improving efficiency metrics. Ensuring the sustain-ability of such a transformation and driv-ing further improvements, requires NOCs to develop a cost culture.
Given their broad mandates, NOCs have typically not had to scrutinize costs and profitability in the same manner as
international oil companies. Creating a cost culture will require NOCs to increase emphasis on the management of costs. A first step is to ensure transparency on cost performance through providing access to cost information at all levels in the organi-zation and amending performance targets to include cost-efficiency targets.
Enlisting the whole organization in cost transformation and providing the right environment for discussions of cost per-formance are essential. One particular challenge for NOCs, which typically have strong functional departments, is to en-sure that cost transformation is accepted as a cross-functional exercise. Transfor-mation can only be effective when dis-ciplines work together in a coordinated fashion across organizational boundaries and with a common objective.
In our experience, developing a compa-ny culture where the management of costs is valued equally alongside production and safety should recognize and lever-age the strengths in the current culture, rather than seeking to reinvent the culture from scratch. Typically, this would start with the identification of a few critical
behaviors that, if adopted across the or-ganization, would enhance the focus on costs. Such behaviors might include the sharing of cost information, forums to bring forward cost-saving suggestions and celebrations of achievements in cost performance.
Adversity leads to opportunityIt is hard to change long-established ways of working, yet the current oil-price envi-ronment presents a unique opportunity and an imperative for NOCs to address struc-tural inefficiencies. For the first time in many years, these companies must make difficult choices and trade-offs between national strategic priorities and cost man-agement. In this environment, superficial cost reductions will not suffice. Instead, NOCs that launch a more comprehensive cost transformation will be rewarded with lower costs and be better prepared to meet longer-term national strategic targets.
George Sarraf, Partner, David Branson, Executive Advisor and Anil Pandey, Principal at Strategy& (formerly Booz & Co), part of the PwC network.
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