Major changes, fuelled by the COVID-19 crisis, are occurring in the oil and gas sector with the value chain being stress-tested like never before. In an industry that has operated under a successful model for many years, downstream facility owners and the contractors that serve these facilities are being pushed outside their comfort zones, with even the most stable facing threats to their survival. What will be the drivers of future value? Does the current service delivery model support this? Having spent a number of years experiencing the challenges within the downstream industry, this article aims to discuss these key questions and position some readily accessible opportunities that could evolve the model.
The changes over the course of 2020 have been bewildering in terms of speed, nature and depth of impact. While coverage has focused on upstream exploration, the supply-side, OPEC+ nations and oil prices - and rightfully so - the refining and processing side downstream of the well-head has received much less attention. Yet this area is by far more significant in terms of direct employment numbers. It also creates opportunities for many related sectors and as such warrants more discussion as changes in this area have broader impacts.
The current state
Who would have thought 18 months ago that by September 2020 ExxonMobil would exit the Dow Jones Industrial Average and that its market capitalisation would be lower than NextEra (a clean energy group). Yet, it happened! Similarly, in less than one year, oil and gas producers have written-down asset values by US$80 billion and shed tens of thousands of jobs1. These changes cannot be undone (easily). Traditional hydrocarbon companies such as BP, Total and Shell have also drawn a very clear line in the sand on their directions and are pivoting towards a zero-carbon (or reduced carbon) future. These are unheard of changes in this industry and have coincided with rapid advancements (and record installation) in the renewable energy sector, electric vehicles sales and closures of coal-fired generation plants, particularly in North America and Europe.
This highlights the breadth and scale of change that has converged in a highly compressed timeframe. These changes are increasingly structural in nature and their impacts are flowing into downstream oil and gas and petrochemical owner organisations2.
Suppliers, general contractors and service providers (collectively ‘Service Providers’) are fighting to survive. It is a daunting thought as market consensus points to a sustained period of weakened global demand for refined products coupled with a global over-supply of crude oil and refined products. Consider the following:
- Significant inventories of crude and product with a circa 20% reduction in global demand.
- 7.1 million bpd of new refining capacity additions from 2020 - 2027, predominantly in Asia3.
- Refinery utilisation levels of 70 - 75% (historically 85 - 95%)4.
- Structural shifts in demand from telecommuting, ‘work from home’ and travel curtailment.
Refiner margins have reduced, project deferrals (or cancellations) have occurred, outputs have reduced, and aggressive cost cutting has been implemented. To date, at least 12 US-based refineries have indicated permanent closure, idling, or conversion to alternative fuel facilities or terminals. The most recent global lockdowns are likely to delay fuel demand recovery even further, which will exacerbate the stresses already faced by the downstream sector further.
There will likely be a degree of reversion to historical levels as the industry still remains essential to the global economy. However, in an over-supplied refining market with a revised future product-mix profile, coupled with existential industry competition, it is not hard to envisage further ‘squeezes’. With the projected new refining capacity coming on-line, many sites will become unprofitable on a cash basis unless they are able to unlock value across their operations and value chains. The focus centres on what participants need to do in order to remain competitive.
The subjectivity of differentiation and undervaluing of excellence
Contracted services for routine maintenance, Turnarounds and outages to the US downstream refinery and petrochemical industries is highly competitive, diverse, geographically dispersed and mature. Like any mature industry, aggressive competition has driven prices down. Differentiation has typically followed HSE, execution capability, productivity, experience of key personnel and access to skilled personnel. Nearly all Service Provider’s make bold statements in these areas.
Outside of safety performance, which is measured, tracked and reported consistently, the other ‘differentiators’ are largely subjective. That is not to say they do not exist as many Service Providers5 have truly demonstrated excellence for a long period of time. Rather, there is no consistent basis for rating across Service Providers. There is no industry equivalent of the refinery Solomon Industry Benchmark for Services Providers. Each owner forms their own conclusion(s) and views are rarely aligned.
In the absence of being able to consistently validate key differentiators, without bias, they risk getting: viewed as marketing speak; tied to pre-existing views; undervalued; and/or diminished. This is a problem as HSE, capability, experience and productivity absolutely drive value to owners. This does two things:
- It makes comparisons between Service Providers challenging to qualify.
- Good performance and exceptional performance get valued equally as the reward for both is work retention. What is the incentive to strive for excellence?
The owner's primary objectives are safety, production, reliability and utilisation. Owners will be challenged to drive never-before-seen levels of efficiency in each of these areas. Innovation is required, and the right Service Provider has a critical role to play. It makes sense that the services model be aligned and incentivise excellence.
Barriers to innovation
It is challenging for Service Providers to proactively deliver new technology, methodologies and processes. This is especially the case for services to the owner's maintenance organisation. Owners, rightfully, need convincing and every owner (and site) has different requirements and approvals. It is costly to deploy innovation and the terms are generally restrictive. This hinders the willingness of Service Providers to invest heavily into innovation as the return on investment (ROI) can be limited. Therefore, innovation is not maximised or transformational, rather improvements are largely incremental6.
Safety, throughput, reliability and utilisation are paramount to owners. It would make sense that effort be focused on initiatives that increase performance in these areas. A 1% performance improvement in these areas could yield orders of magnitude more upside than an equivalent percentage improvement in Service Provider rates. However, significant effort is directed to seeking rate reductions under the notion of cost discipline. This does not advocate owners accept uncompetitive pricing or that some services are largely commoditised and warrant price-based decisions. Rather, aggressively pursuing price reductions from key Service Providers should not be confused with cost discipline. The former does not drive long-term value and points to more systemic underlying issues. We have lost our focus here.
Transformation requires innovation, and innovation requires investment. Innovation, once deployed, unlocks value and margin expansion, which allows further investment and continuation of the cycle.
Developments fuelled by new technology are beginning to hit the market. These come at a cost and cannot be done in isolation of the owners. Deploying innovation into facilities may necessitate a completely different approach from owners in terms of how they procure, contract, manage, track progress and reward Service Providers. The test is how far owners will be willing to shift the current model to support step-change innovation, and whether it can be deployed timely into downstream facilities.
The relationship framework creates opportunities for value capture
The ability to address the coming changes requires true partnership and more integrated working relationships. This can only occur through deeper levels of trust. Many past initiatives have tried to achieve this with varying degrees of success.
How much influence, control or autonomy should a Service Provider be given? It is a sensitive area for owners and rightfully so given the value and criticality of assets involved. There have also been past mistakes from some Service Providers that have eroded trust and led to some of the restrictions we see today. However, holding on to past mindsets will not deliver change. The platform for step-change has to be built on the relationship and this can only occur through trust, and behavioural and cultural alignment.
Some areas of value capture that could deliver and unlock further upside are outlined below. This list is by no means exhaustive and without doubt other opportunities can be identified.
Value capture 1: integrated owner-supplier relationships
This is not another preferred supplier procurement initiative! In the author’s experience, preferred supplier agreements are generally viewed favourably, but their ability to be properly implemented has left people weary. Despite all the right up-front messaging, things revert over time to the prior state. With so much on the line, particularly for major turnarounds, the risk of change is a huge barrier for owners. Hence ‘preferred’ status is rarely shared collectively across owners.
There are many Service Providers with excellent delivery capability, and under the right model, many would align their business around a few key clients. In the absence of a trusted relationship framework it is hard to progress past the status quo. Getting there requires a shift in approach. There is considerable value being left on the table.
- Address the internal barriers completely before commencing the procurement process - there has to be 100% alignment between corporate and site(s) to avoid future issues.
- Ensure there are checks and controls that address regression or issues - true partners will be all-in to overcome any challenge.
- “Have we planned for collective success?” is a question rarely asked. Support and reward collective success and not just your own organisation.
Value capture 2: reduce costs through alignment, not the rate sheet
Work volumes in this industry can be very volatile. Volumes are indicative at best and subject to change with little notice. As a Service Provider, it is never easy receiving news that planned work has been deferred or cancelled, especially if you have declined other opportunities. It goes with the turf and there has been a level of total industry volume and cyclicality that has enabled Service Providers to survive. This may not be the case in a more uncertain, volatile and cost constrained future market.
The lack of visibility to work impacts many areas of operation. Uncertainty leads to pricing conservatism, unrealised potential and indirect costs, all of which are pricing inefficiencies impacting owners and Service Providers. It becomes a volume and margin preservation game and leads to degradation of service levels. Further, the incentive for Service Providers to (re)invest diminishes. Any innovation under this climate has to be marginal, if at all.
Competition and market factors have largely driven out the ‘fat’ and the rate sheet is not the incubator of value. The key to unlocking value, total cost reductions and margin expansion for owners is through capability, planning and reducing the critical path. Considerably increasing the dialogue with Service Providers in this area will drive performance improvement. There is considerable value being left on the table.
- Spend excessive time discussing operational solutions, capabilities and leading indicators, instead of haggling on rates.
- Enabling the right Service Provider to share in the upside incentivises (re)investment in capability and technology for the owner.
- One-way rate reductions lead to commoditisation or dragging everyone to average – is that where you want your best technical Service Providers to be?
Value capture 3: simplification of schedule of rates
The majority of contracted maintenance labour and equipment services to the downstream industry follow a reimbursable schedule of rates (i.e hourly rates) and hours worked. Rate sheets focus huge detail into the individual cost component mark-ups that determine the sell rate. However, is the focus and effort in the right areas? The sell rate determines the sticker price. If the intent is value-for-money and transparency, there are more efficient ways than driving detail into the mark-ups whose calculation is not an exact science and based on owner-provided assumptions in many cases (e.g indicative annual work volumes).
There is a level of mistrust and desire to play rate ‘police’ on account of some Service Providers that have abused the model in the past. Transparency and compliance are absolutely necessary, but excessive granularity in rate sheets is counter-productive and over time results in hidden costs to owners. It is a legacy approach that could be revised.
Selecting the right partner, aligning the performance metrics and creating equitable long-term agreements (i.e value capture items 1 and 2), solves the transparency and trust equation. There is considerable value being left on the table.
- Simplification of the rate sheet approach could yield annual cost reductions to owners far in excess of any available rate sheet reduction.
- Simplification could be achieved easily and would reduce administrative burdens, errors and ongoing maintenance needs.
- Cost reductions and internal efficiencies would flow across Owner and Service Provider organisations.
Value capture 4: strengthen planning and FEL
The correlation between poor planning and poor execution results is very strong. The greatest ability to influence the performance of turnarounds and capital projects occurs in the planning stage. Yet, the industry is littered with examples of turnarounds and capital projects that have ‘failed’ and more often than not it is as a result of inadequate planning and scoping. Some recent projects have failed so badly that individual careers have been impacted and some companies have exited certain markets until things change.
Poor FEL impacts everything thereafter and compromises the outcomes of any project. This is not a new topic. The tell-tale signs almost always show up in incomplete bid documentation that is vague or contradictory. This is followed by contract documents with lop-sided risk transfer terms, highly compressed bid response timelines and an inability to sufficiently clarify bid documentation. No contractor can bail out a poorly planned and scoped event, nor can they submit accurate estimates against incomplete documentation. Failure in the front-end introduces conservatism into the base estimate (i.e the owner overpays). It also provides limited incentive for a Service Provider to deliver better than the base estimate (i.e the owner overpays again).
Under a forward environment where owner margins are tested even further, the ability to execute efficiently and with the lowest total cost (not bid price) has never been more important. There is probably no greater area for ROI than upfront investment in turnaround and project planning. It is also an area where the right Services Provider has the greatest ability to influence successful outcomes. There is considerable value being left on the table.
- The owner controls the timeline and agenda - best practice is commencing planning and scoping 8 - 12 months prior to the event.
- Poor scoping, scope creep or a lack of scope ‘freeze’ are probably the biggest influencers of schedule and cost overruns - do not use the turnaround to complete your wish list projects.
- he risks/penalties must be balanced with equivalent rewards/upsides for there to be an equitable delivery model – it is in everyone’s interest to incentivise beating the schedule.
There is no doubt the global economy will rebound - by how far, and how fast is unknown. Regardless of where the macro environment lands, the industry could benefit from a ‘reset’ to refresh its approach in order to remain competitive. Investment dollars have already exited the oil and gas industry and there is little value in arguing all the reasons. The avenues to manoeuver will not exist like they once did.
Future profitability and viability require a different approach and way of thinking. The changes needed require investment by owners to fuel the capability improvements, better planning and critical path reductions that will deliver margin expansion and maximise throughput efficiency. But being efficient demands efficiency in every aspect of the business, and the ‘quick wins’ have largely been tapped already. Broader structural changes may be necessary to capture greater value.
Service Providers play a critical role and will be pushed to align and deliver against the owners future objectives. Owners pursuing excellence and top-quartile performance should ensure there is an aligned incentive for all parties to strive for excellence otherwise the ‘minimum’ becomes the benchmark. Other industries have shown what is possible through innovation and evolving the incumbent model. There will be opportunities and rewards for those that are able and willing to adapt.
Written by Hari Gopu, Alto Project Services. Hari specialises in the energy and infrastructure sectors with a focus on growth, operational performance and commercial improvement. He has over 20 years' international experience across Australia, Asia, North and South America and has served both developers and services companies. Most recently he was a divisional President for a leading US based industrial services company serving the oil and gas and petrochemical industries.
- BIC magazine: oil majors wipe 80billion off books
- 'Owner Organisation' refers to owners of downstream refining, production and/or processing facilities.
- Wood Mackenzie Product Markets Services.
- Hydrocarbon Processing News - 26 November 2020.
- Service Providers primarily relate to those performing routine (daily) maintenance, planned maintenance, major turnarounds, outages and emergency repairs.
- Excluding EPC’s performing major greenfield and brownfield construction projects.
Read the article online at: https://www.hydrocarbonengineering.com/special-reports/20012021/adapting-to-thrive-in-a-changing-downstream-energy-market/