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The Next Barrel Must Cost Less - Grinding Vendors Not The Answer


Writer’s prologue: I live on an acreage west of Calgary that sits above the Lochend Cardium light tight oil play which has seen considerable exploitation in the past few years. A second well was recently drilled close to my house, an offset to one drilled three years ago. The leases are visible from my front step and I can hear the diesels. I pass the roadside locations at least twice daily and always look to see what’s going on. Rigging up (including assembling and filling a giant frac pool) for the latest completion took days. But it became obvious when the frac pumper engines were silent for extended periods the completion wasn’t going as planned. Lots of time with equipment and personnel on standby and the meter running. The earlier well quit producing after only two years because it was apparently drilled wrong and the operator couldn’t case the full length of the horizontal section leaving only a portion of the reservoir exploited. Not once in two years of the pumping unit reciprocating did I see a tank truck hauling away oil. I doubt this well ever recovered total cost. Any vendor price reductions extracted by the oil companies were likely vaporized by operational errors: standby charges for the recent frac and poor wellbore construction on the first well. This is not uncommon.

One major challenge the oil industry must resolve to survive and prosper in a lower commodity price environment is accepting the total cost of any new barrels (or barrel of oil equivalent) should not be determined exclusively by the total sum of the invoices submitted by oilfield service (OFS) vendors.

Since oil prices started falling late last year, exploration and production (E&P) companies have demanded and received significant price discounts from all their suppliers. But it’s more complicated than that. Consultancy Wood Mackenzie studied this subject and concluded extracting lower prices from vendors does not always result in commensurate reductions in total costs. The firm noted while oil companies are targeting 20 to 30% reductions in direct vendor costs, on average the total cost saving will only be half that, 10 to 15%.

A September 21 Daily Oil Bulletin article read, “…operators will also need to focus on project optimization and adopt smarter ways of working with the service sector….Illustrating the needs to reduce costs in the industry, Wood Mackenzie’s analysis estimates that $1.5 trillion of uncommitted spending on new conventional projects and North American unconventional oil is uneconomic at $50 a barrel”.

This makes it imperative OFS and its customers figure out how to make this work or everybody will be going out of business.

James Webb, research manager for Wood Mackenzie, said, “Additional measures are needed to manage costs – reworking field development plans, optimizing project design and more innovative approaches to projects will all play important parts. A prolonged period of low prices over a number of years is likely needed to bring about profound, structural changes to industry costs”.

What does this mean? Clients should consult with and cooperate more with their vendors to create win/win scenarios. Or at least survive/survive scenarios. One egregious example of cost-saving measures gone wrong is Esso/Exxon-Mobil’s Kearl oilsands project north of Fort McMurray. The operator figured an effective way to control total costs was to build processing modules in South Korea then ship them by truck to Kearl from a port in Lewiston, Idaho. However, faced with stiff local opposition to having loads of this size shipped on narrow highways, Imperial was forced to disassemble them into smaller pieces, ship them to Fort McMurray, and then reassemble them on site.

While Imperial has never disclosed exactly what this logistical planning error cost, it was surely expensive. According to the Financial Post on February 1, 2013, Kearl was original planned to cost $7.9 billion in 2009, a figure that was raised to $10.9 billion after design and scope changes. In the end the final figure was $12.9 billion with the module transportation boondoggle a major contributor.

This cost overrun was in no way related to vendor input expenses from manufacturers, transportation contractors or whoever and whatever (cranes, camps, etc.) was waiting at Kearl for the plant components to arrive for assembly. The one thing Esso/Exxon-Mobil is famous for is engineering and logistics for major capital projects. These are the folks who invented horizontal drilling in Canada and built islands in the middle of the Mackenzie River to fully exploit the Norman Wells oilfield.

The Kearl story and the prologue are three examples of how lower OFS prices alone do not always reward E&Ps with lower finding and development (F&D) costs. Teamwork is essential to put future production on stream at the lowest possible cost. E&Ps can likely produce existing barrels for less than the market price and keep the lights on but if they don’t replace reserves they are effectively going out of business. Just a matter of time. If OFS loses too many clients or investment because E&Ps cannot afford to replace reserves the service sector will also fail. So E&P and OFS are in the same sinking boat. Either collaborate to develop effective cost-saving solutions or disappear.

Historically, E&Ps and OFS have had a master/slave relationship in which the clients say “jump” and the vendors say “how high?” It is common knowledge oil companies (just ask them) are staffed by engineering and logistical experts that know exactly what they need and when they need it. OFS merely quotes a price and delivers the goods. But independent studies and practical experience have repeatedly demonstrated vendors often have much more expertise in their specific product and service lines than their clients and, as importantly, know more about best operating practices than many of their customers because they work for everybody.

But OFS has learned over the years not to offer too much advice unless asked. Telling the client how to do his job is seldom good for business.

There are many examples of how paying more can yield more. Drilling is a perfect example. The day rates for modern, high performance “walking rigs” is much higher. But the total drilling time is greatly reduced, saving the client a bundle. A big frac in which logistics are expertly coordinated with no operational downtime costs significantly less. The savings of doing the job on time and on budget are often much greater than the collective reduced daily or hourly rental rates for the massive amounts of equipment and manpower on location if the job doesn’t go well.

Service companies have shaken their heads for years watching clients drill wellbores at the lowest possible cost which are difficult to complete and even more difficult to service over the years. That’s because in too many oil companies the drilling, completion and production departments are compartmentalized with no executive oversight ensuring every wellbore delivers the most barrels at the lowest cost per barrel over the anticipated life of the asset. The assumption is the lowest possible component cost will yield the highest full cycle return on capital. This is not always correct.

Fortunately, the hunt for lower total costs for the next new barrel is underway and E&Ps are, out of necessity, examining their own operations. Clients have realized OFS has been ground down to the breaking point and now it is up to project managers to examine their own processes to extract greater efficiencies.

The Daily Oil Bulletin reported September 16 Suncor Energy Inc.’s CEO told a Peters & Co. Limited investment conference in Toronto part of its strategy was to use the most localized workforce possible and reduce the number of fly-in/fly-out workers. This is really expensive. Besides wages, oilsands developers have paid to fly workers to and from home every two weeks from as far away as Atlantic Canada, the most expensive plane ticket in the country from Fort McMurray. Hiring workers who live closer cuts costs, as does watching overtime and lowering non-salary incentives (hiring bonuses, retention payments).

For its vendors, besides seeking lower prices Suncor is also looking at single-source procurement. This has been proven to be more cost-effective for producers than using multiple vendors by cutting paperwork and administration. It is also more profitable for vendors because they can secure revenue certainly and spend less time and money looking for more work. (The drawback for OFS is clients want to hire fewer, larger vendors which puts pressure on smaller operators).

Cenovus Energy. Inc. told the same conference it was looking at redesigning its SAGD well pad modules to use 30 to 40% less steel and accessories. This is all above-ground facility design and investment changes intended to achieve the same production at a lower capital cost. Husky Energy Inc. reported switching to “walking rigs” to drill its well pads resulted in wellheads being closer together which reduced the costs for the plumbing and equipment to tie them all together.

The design of SAGD surface components is one area receiving extensive attention. Right now each company and project has its own specification for equipment like steam generators. Vendors are pointing out how offshore production platforms were made more economic by standardizing designs for certain components creating economies of scale by manufacturers. Isn’t there one design for these systems that would work for everybody? Can the oil industry not start mass producing something and in doing so duplicate the enormous savings the automobile industry has generated out of economic necessity? Does every piece of equipment from a drilling rig to a frac pumper to a steam generator to an emulsion separator have to be custom designed and custom built, regardless of the extra cost?

With OFS working almost at cost, E&Ps are looking at their own fixed costs to become more competitive. Canadian Natural Resources Limited recently announced it was cutting all head office salaries by 10% across the board to reduce expenses but preserve it management and administrative team. Cenovus Energy Inc. announced it would be eliminating another 540 jobs taking its total staff count to 3,900 at the end of 2015 from about 5,200 at the end of 2014. Other E&Ps announcing more staff reductions are ConocoPhillips Canada and PennWest Petroleum.

Retooling the Canadian oil industry to be competitive at lower prices is much more complicated than sifting through stacks of quotes to save $20 a day on a rental light tower, pre-mix tank or wellsite trailer.

OFS must educate itself as to what its clients are trying to accomplish and start bringing forward solutions to save their customers money. Managers must understand it is imperative they help their customers stay in business by figuring out how to help replace reserves economically at market commodity prices. It’s not war but survival.

E&P management must reclaim the future of the company from the purchasing department and start sitting down with major vendors to find common ground. A large number of struggling or insolvent suppliers is not the answer to creating operational efficiency which will unlock lower reserve replacement costs.

The adversarial love/hate relationship between oil companies and their suppliers is broken. Success will follow if we fix it.