Procurement-driven contracting model is an obstacle:

Bureau28-04-2016, 12:29 AM

“The combined capabilities of the E&P operators and the leading service companies have the potential to realize the required performance upside for the industry. Still, this requires a willingness to modify the existing commercial model because the procurement-driven contracting model of the late 1990s is today the main obstacle to create the needed performance progress,” stated Schlumberger Chairman and CEO Paal Kibsgaard while addressing the Scotia Howard Weil 2016 Energy Conference held in New Orleans in March this year. Excerpts from the presentation in his own words:

I would like to cover three main subjects. First, I will discuss the current industry challenges, which are only partly driven by the massive drop in oil prices but also as a result of our industry’s failure to sufficiently improve performance over the past 15 years to tackle increasingly more complex hydrocarbon developments. Second, I will stress the urgency for the industry to accept that the current commercial and collaborative model between operators and service companies is suboptimal. I will outline how changes to this model can benefit our customers and what we at Schlumberger are doing to lead this process of change. Furthermore, I will show that the breadth of our technology portfolio, combined with our unique size advantage, makes us a significant partner and enabler as the industry enters a new era of collaboration and commercial alignment.

Third, I will share with you our latest market outlook and the short-term and medium-term implications this has for our activity levels. And I will also comment on how we are continuing to navigate the challenging commercial landscape and how we are creating one of the strongest technical and financial platforms in the industry, which makes us a very exciting investment proposition.

Today the E&P industry finds itself in the deepest financial crisis on record, with profitability and cash flow at unsustainable levels for most oil and gas operators which in turn has created an equally dramatic situation for the service industry. In spite of the unique structural nature of this downturn, oil and gas operators have once again activated the traditional playbook they have used to navigate every industry downturn since the 1970s. This dictates halting investments in exploration, aggressively curtailing development activity, and relentlessly squeezing service industry prices.

This ‘hold-your-breath and-hope-for better-times-soon’ playbook has in the past allowed the industry to live through shorter-term demand downturns while waiting for business to return to normal.  The major difference in the current industry situation is that we are unlikely to see oil prices returning to the $100 level because this downturn is not driven by lower demand or by external factors. It is instead an immediate result of OPEC’s decision to protect market share rather than oil price which clearly demonstrates that they still have a firm grip on the global E&P industry.

This shift is likely to have deep and long-term consequences for the industry similar to how limited access to reserves in the 1990s drove international and independent oil companies to pursue unconventional and deepwater resources. It is also similar to how high oil prices over the past decade created a surge in investment and production from these higher-cost resources even though the underlying progress in project performance was insufficient.

Going forward, the industry is likely facing a ’medium-for-longer’ oil price scenario, subject to periods of volatility, as the national oil companies within OPEC can still generate significant returns for their owners in such an environment due to the low cost base of their conventional resources.

The combination of a moderate price and higher market share could largely restore the oil revenues for many of the challenged oil-producing economies and is also likely to prevent uncontrolled production growth from higher-cost resources.

So what are the implications of a medium-for-longer oil price scenario?

Assuming a 1 per cent demand growth scenario, it first means that the ‘hold-your-breath’ approach of the oil and gas operators will be unable to deliver the required production growth. The apparent cost reductions seen by the operators over the past 18 months are not linked to a general improvement in efficiency in the service industry. They are simply a result of service-pricing concessions as activity levels have dropped by 40-50 per cent and most service companies are now fighting for survival with both negative earnings and cash flow. The unsustainable financial situation of the service industry together with the massive capacity reductions mean that the cost savings from lower service pricing should largely be reversed when activity levels start picking up.

The fact remains that the industry’s technical and financial performance was already challenged with oil prices at $100 per barrel as seen by the fading cash flow and profitability of both the IOCs and independents in recent years. Over the past decade, our industry has simply not progressed sufficiently in terms of total system performance to enable cost-effective development of increasingly complex hydrocarbon resources. This can be seen by the escalating industry cost per barrel. So what needs to change to overcome these challenges to the benefit of all the operators in the industry?

We firmly believe that the combined capabilities of the E&P operators and the leading service companies have the potential to realize the required performance upside for the industry. Still, this requires a willingness to modify the existing commercial model because the procurement-driven contracting model of the late 1990s is today the main obstacle to create the needed performance progress.

In the procurement-driven approach, all aspects of project scope selection and technical design for new hydrocarbon developments are done by the technical teams of the operators. The work scope is then fragmented into a myriad of small parts and subsequently put out for bid by the procurement organization, seeking the lowest price for each element and expecting that this will bring both the lowest project cost and the highest project value. The rationale behind this approach is driven by two factors.

First, service companies are generally perceived to have little to offer towards creating fit-for-purpose designs or optimize planning and execution and are therefore engaged too late to have a meaningful impact on the technical and financial performance of the projects. This limited engagement is in spite of the service industry producing the lion’s share of the hardware and software technologies used to develop the world’s hydrocarbon resources.

Second, the procurement-based contracting model can only compare pricing levels for the least common denominators, which are the basic products and services that all qualified suppliers offer because the impact of any differentiation is too complex to model and evaluate. Therefore, the procurement organizations simply assume that all suppliers are equal as long as they meet the minimum qualification criteria, which creates a constant drive towards commoditization and fragmentation. The consequences of this procurement-driven approach are three-fold:

First, a failure to drive forward a sufficient rate of intrinsic performance improvement in quality and efficiency because there is no real incentive for the service providers to create any performance differentiation. Second, a highly fragmented approach to technology system innovation and system performance as project solutions are a mosaic of individual services and products with no common data model or optimization platform. And third a complete lack of concept and design phase collaboration between the operators and the suppliers, which has large implications on project cost and performance.

Altogether, this contracting model leads to suboptimal technical solutions and corresponding project performance from both a design and executional standpoint as well as financial returns. Based on this, we believe that project performance can only be improved by finding ways of breaking with the past and replacing the existing model with a new approach based on collaboration and commercial alignment between the operators and the largest service companies. From the Schlumberger side, we are ready to engage on a completely different level and we are well advanced in evolving our company to excel in such a new industry environment. So let’s take a closer look at what this entails.

Two years ago in this forum I made the case for change in the way the E&P industry works. My position was based on the fact that a quadrupling of global E&P investments over the preceding 10 years had only yielded a 15 per cent increase in global oil production. I expressed the view that a transformation was required to change the way the industry works in order to restore technical performance and financial results to match that of other technology-based industries. The past two years have only strengthened my view.

And at Schlumberger we have not only laid out a plan for transformation  based on the pillars of technology, integration, reliability, and efficiency, but we have also executed a number of phases of that plan that have delivered significant performance improvements. These in turn have permitted us to deliver strong financial performance in the past few years as seen by our industry-leading operating income margins and free cash flow.

The company-wide transformation and change-management framework we have developed over the past four years has also led us to expand the scope of our transformation, which initially was focused on the efficiency and quality of all our processes and workflows. This scope has now been broadened to first include our efforts to develop total drilling and production systems that are fully digitally enabled and also our drive towards expanding and strengthening the commercial and collaborative models we use in working with our customers.

So let’s look closer at these three complementary dimensions of transformation. The foundation for our transformation is the large opportunity we see to improve the intrinsic performance of our processes and workflows, including our internal support functions as well as our external product and service delivery. We identify and capitalize on these improvement opportunities by being willing to challenge our existing ways of working and by actively seeking impulses and learnings from the best companies in other technology-based industries.

As mentioned, we have already seen noticeable impact on our technical and financial results in recent years demonstrated by solid improvements in the areas of HSE, quality, capex intensity, and free cash flow in spite of the ongoing industry challenges. And there is still significant upside potential to be realized in all aspects of our intrinsic performance which we will capitalize on in the coming years.

In the second of the three transformation dimensions, we are looking to accelerate the rate of technology system innovation by shifting our development focus from discrete technologies to the creation of complete digitally enabled technology systems. These integrated technology systems will significantly reduce the cost per barrel of future hydrocarbon developments by introducing software control and optimization on top of the best hardware products in the industry, while fully leveraging the latest advances in big data analytics and machine learning. The rationale for the pending acquisition of Cameron is fully predicated on this total technology system transformation where we will combine Cameron’s surface technology with our leading downhole and subsurface offering.

This second dimension of the transformation will give us a technology capability that is unrivalled and that can offer the step change in financial performance that the industry really needs going forward. So let’s take a closer look at the strength of our technology portfolio and the investments we are making in total technology systems. The foundation of our technology portfolio lies in our Reservoir  Characterization Group, which houses our market-leading product lines in wireline, seismic, well testing, core and fluid analysis, data consulting, and E&P software.

The Group is present throughout our operations from identifying sweet spots in unconventional reservoirs, ensuring optimal placement of horizontal wells in thin reservoirs, and collecting high-quality reservoir data in the deepest and most complex operating environments. The Reservoir Characterization Group has also established leadership positions in sensor and instrumentation design, numerical modelling, and the development of software and control systems.

Further, enabled by more than 30 petaflops of computing power and several thousand petro-technical experts that are actively supporting the full range of reservoir, drilling, and production workflows, the Characterization Group represents the technology backbone of Schlumberger.

Building on the unique capabilities of our Reservoir Characterization Group we have, over the past decade, also created an industry-leading Drilling Group.

We started by transferring wireline technologies into the measurement  and logging-while-drilling services of our Drilling and Measurements  product line, and then by using our downhole tool design capabilities  to build the industry’s leading rotary-steerable systems. Five years ago we extended our drilling offering through the Smith, MI-SWACO, and Geoservices transactions to give us a complete range of drillbit, drilling tool, drilling fluid, and mud logging capabilities. With this we brought all the individual hardware components of the bottomhole assembly into a fully integrated system leveraging our deep knowledge of instrumentation, software optimization, and automation. In parallel with expanding our Drilling offering, we have also continuously evolved our Production Group portfolio, once again building on our core scientific platforms together with targeted M&A activity.

In hydraulic fracturing, for example, we have combined reservoir expertise with fluid chemistry to improve well and reservoir production with innovative stimulation services such as the HiWAY and BroadBand techniques. Our geo-engineered shale completions, which consistently deliver higher production compared to standard techniques, are built on unique formation evaluation measurements combined with reservoir and completion modelling software.

In coiled tubing, we have used wireline sensors and innovative telemetry technology to help establish our ACTive platform and building on the Camco acquisition of the late 1990s we have evolved the basic hardware products into an industry-leading intelligent completions system.

Finally, we have also established a leading position in the ESP and gas lift markets augmented by a series of acquisitions in rod lift and progressive cavity pumps to build a complete life-of-well artificial lift solution. The overarching technology strategy continues to be to evolve individual hardware components into integrated systems that set new standards of performance facilitated by instrumentation, software modelling, control, and automation.

As we continue to seek new ways to drive total system performance it has become very clear that there is huge potential in a much closer integration between surface and subsurface technologies in both the drilling and production domains. With the imminent close of the Cameron transaction we are now ready for the next stage of this technology integration.

So let’s look closer at a few examples of the new technology systems we will introduce in the near future.

Our land drilling system of the future represents the ultimate integrated drilling platform bringing together digitally enabled surface and downhole hardware on top of a common optimization software to create a step-change in operational efficiency. In this technology-system project, we bring together five years of research efforts from our drilling center in Cambridge, UK, with the leading expertise and downhole technology from our Drilling Group product lines.

From the drilling equipment portfolio of Cameron, we get top-drives, pipe handling, and blow-out preventers, while T&T Engineering, which we acquired in 2015, brings world-class expertise in rig design. We also have access to unmatched German manufacturing capabilities from the joint-venture we signed last year with Bauer. The software backbone of this project, which includes all aspects of well design, operational planning, and drilling optimization is being jointly developed by our software centers in Houston, Texas, and Beijing, China, and is further supported by our Big Data and Cloud Computing technology center Palo Alto, California. Five engineering prototypes of the new system will be ready for field testing in 2016 in Ecuador and the US, with full commercial introduction on track for 2017.

Turning to integrated production systems, we will also introduce a completely new hydraulic fracturing system in 2017 where, in a manner similar to the land drilling system, we will bring together new digitally enabled hardware technologies and significant process reengineering as well as  common operating and optimization software. The system will span the complete range of surface components such as CAMSHALE pressure control and wellhead systems together with our perforating, fracturing clean-up and flow-back services as well as our latest downhole completions technology and fracturing fluids. The total system is designed for continuous operations leveraging automation and real-time data capture to reduce human intervention.

The common operating software provides process-control monitoring of inventory and equipment performance and enables standardized job execution and multiskilling of people, which again improves operational quality, efficiency, and safety. When combined with our advanced fracturing fluids, downhole completion technologies, and geo-engineering workflow, this total system will significantly reduce the cost-per-barrel for our customers and at the same time lower the operating costs and capital intensity of our hydraulic fracturing operations.

The third transformation dimension focuses on the deployment of more aligned business models where risk and reward are shared in commensurate parts between operators and service companies throughout the life of the field. This approach fully leverages the complementary capabilities of the operators and the integrated service companies. Today as much as 80 per cent of our work is still performed under a single-product-line contract that, in most cases, fits the standard procurement-driven contract model. Within this standard contracting model we price our differentiated technologies separately, and generally include these in the final contract.

For customers that are regular users of the high-end technologies, we provide technical and optimization support during the execution phase of the work although this is not stipulated in the contract. While for customers that are generally only deploying the basic commodity-type technologies, this additional support is not offered.

Looking beyond the single-product-line contracting model, the first level of integration we offer is Integrated Services Management, where our specially trained project managers provide scheduling, planning, and activity coordination for the various Schlumberger product lines involved in the project. Within this offering, the improved planning and preparation driven by our project managers is consistently converted into better Quality and HSE performance compared to our single-product-line contracts. The next level of the offering involves our Integrated Drilling Services (IDS) and Integrated Production Services (IPS) offerings where we house a large part of our project management, engineering design, and technical optimization capabilities as these contracts are fully performance-based.

In IDS, these contracts are generally focused on how fast we can drill each well and how we can optimally place it in the reservoir, and in IPS the contracts are focused on turnkey intervention work as well as extracting incremental production for individual wells. The highest form of integration we offer is through our Schlumberger Production Management (SPM) model where we take full-field management responsibility using the complete range of Schlumberger products, services, and technical expertise. SPM contracts, where we risk the entire value of our products and services and in certain cases additional cash investments, can reach up to 20 years in duration and we are entirely compensated for our work through the value of the production we generate from the field. Over the past 15 years, we have gradually expanded the size, complexity, and number of SPM projects we undertake to the point that we today manage around 250,000 barrels per day of oil production.

Through our thorough screening and evaluation process and clear financial return requirements, we have built a portfolio of projects that represent a win-win situation for both our partners and ourselves, and hence we see SPM as a significant growth opportunity going forward.

I would now like to move on to discuss the market outlook and the short- and medium-term implications on our activity. The current downturn has now persisted for 17 months since the US land rig count peaked in October of 2014. Using this rig count as a proxy, we have seen three distinct phases as the downturn has deepened. The third and most severe phase is taking place within this current quarter with the global activity impact and rate of disruption reaching unprecedented levels, showing an industry in a full-scale cash crisis.

So far, we have successfully managed the challenging commercial landscape of this downturn by balancing margins and market share and by aggressively reducing our global capacity. In parallel, we have steadily improved our intrinsic performance through our ongoing transformation programme and this has enabled us to protect our financial strength. However, the third phase of E&P spending reductions that we are currently experiencing will have a significant impact on our earnings per share in the current and coming quarters given the magnitude and erratic nature of the activity disruptions. As an indication of the impact, we now expect our revenue to come in around $6.5 billion in the first quarter, which is a drop of more than 15 per cent sequentially, and with the outlook suggesting a further weakening in the second quarter.

Going forward, we will continue to tailor cost and resource levels to activity in order to protect our financial strength. Looking at the macro picture, the physical balances in the oil market continue to tighten with OPEC production outside Iran now appearing to stabilize and with decline accelerating in non-OPEC production. On the other hand the IEA global oil demand forecast was recently revised upwards and 2016 growth now stands at 1.2 million barrels per day.

The latest data points have, in recent weeks, sent the oil price up towards $40 per barrel and we would expect the upward trend to continue as the physical balances tighten further in the coming quarters. In spite of this, we maintain our view that there will be a noticeable lag between higher oil prices and higher E&P investments given the fragile financial state of our customer base, which means that there will be no meaningful improvement in our activity until 2017.

Still, in the midst of this unprecedented industry downturn, there are several positive elements of the scenario that make me optimistic and confident about the medium-term outlook for Schlumberger. First, the magnitude of the ongoing E&P investment cuts is now so severe that it can only accelerate production decline and upward movement in the price of oil with a growing chance that we will be facing an upside spike in prices.

Second, our underlying cash flow is still solid, and with more than $10 billion of cash and short-term investments on the balance sheet after the close of the Cameron deal we can operate in this environment longer than most.

Third, while we have reduced capacity significantly we have still safeguarded the core expertise and capabilities of the company above the current market needs. This, combined with the strategic moves we have made during the downturn, leaves us very well positioned as the industry starts to transform.

And fourth, with the massive capacity reductions undertaken by the entire service industry we are optimistic that we can restore a good part of the temporary international pricing concessions we have made as oil prices and activity levels start to normalize.

In closing we firmly believe in a medium-for-longer oil price environment where there is an urgent need for the industry to move to a contracting model with significantly more collaboration and commercial alignment between operators and leading service companies. In the scenario, Schlumberger is perfectly placed to lead the way.

Our ability to change the game and transform ourselves through intrinsic performance improvement, through the development of integrated technology systems, and through more collaborative business models makes us an ideal partner to also help transform our customers’ project performance. Underpinning this is the industry’s broadest technology portfolio that will be further expanded once the acquisition of Cameron has closed, which is still on track for the end of the first quarter.

Through our people, size, capabilities, and business offering we are an essential part of an industry that for the foreseeable future will produce one of the largest sources of energy to the world. The activity challenges we will face in the coming quarters will only serve to compress the robust and very powerful Schlumberger coiled-spring a little bit further. But rest assured, our energy and growth potential are very well preserved. 

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