Hard Oil – The Drive to Cut Industry Costs

John Westwood

The quest to meet the world’s growing demand for oil grows more difficult by the year as conventional sources are depleted and oil companies are forced to access technically more challenging and higher cost resources from shales, oil sands, ultra-deep waters and the arctic. Looking back through the rose-tinted spectacles of time, it seems that yesterday’s challenges were lesser; it was a time of so called ‘easy oil’. But the 21st century most definitely is not; global oil discoveries peaked in the 1960s and as their own production peaks, oil majors struggle to find new sources when 80% of remaining reserves are controlled by state oil companies. Looming over all of this are soaring costs.

According to the US Energy Information Agency, between 2000 and 2008 average US well costs climbed from some $800,000 to near $3.8 million. Much of this increase was due to the costs of drilling and completing more complex shale wells. From 1987 to 2000, oil & gas exploration and production expenditure grew by 48%; between 2000 and 2013 the growth was 374%. However, oil production increase was a mere 24% (and natural gas 43%). Welcome to the world of hard oil!

Around the year 2000, a major change occurred in global oil demand as the emerging economy of China switched into overdrive and started the process of becoming the workshop of the world. While North American oil demand grew at 1% in the years that followed, the Asia-Pacific region’s oil demand grew at 92%. As meeting this became more difficult, markets reacted accordingly and annual average Brent oil prices climbed from some $24 in 2001 to more than $110 in 2010 – all well and good, rising costs were being matched by rising oil prices. But by 2011, Chinese economic growth began to slow and in 2012 oil prices hit a plateau. However, industry expenditure rose by 9%. Then in 2013, the Brent oil price fell by 3% while industry spending rose by 13%. This is indicative of an unsustainable situation.

The engineering of projects must adjust towards fitness for purpose. We need an end to the approach of “gold plating,” and, where possible, standardize.

The reason for the rise in prices throughout the oil & gas industry supply chain is quite simply that as oil & gas companies scrambled to place orders, demand for products and services exceeded capacity to supply. Take for example the key area of subsea production equipment. The order backlog for this sector nearly doubled in the period from Q1 2010 to Q3 2013 and as one investment bank industry analyst noted, “the industry is currently too busy to be very efficient.”

In 2013, as part of an investigation of industry cost problems, Douglas-Westwood examined nine floating production storage & offloading system projects, or FPSOs (these are the huge super tanker sized floating platforms used in deep waters). The original budget for the nine was $6.8 billion – the cost delivered $9.4 billion, up 38%; and the total delay to deliveries, 146 months! The major reasons for the delays (and cost increases) were difficulties in finalizing the engineering scope and integration of the various modules with each other and the hulls. Douglas-Westwood forecasts demand for a further 100 new FPSOs between now and the end of 2017, but in order to achieve this on time and on budget, something in the system has to change!

In early 2014 big oil responded with a series of announcements reining-in capital expenditure (Capex), a process we have described as Capital Compression. Chevron stated that its Capex peaked in 2013 but it expected that “future spending should stay flattish through 2016.” Exxon Mobil announced that its capital spending in 2014 will decrease from $42.5 billion in to $39.8 billion – a drop of 6.3%. Shell announced that Q4 earnings had plunged to $2.2 billion and that the 2014 Capex would be reduced. More companies followed suit.

Meeting future global oil & gas demand will require massive numbers of new development wells to be drilled. In 2014 we estimate some 83,000, of which 80,000 will be onshore and 3,000 offshore. However, a forecast of 17% increase in oil & gas demand by 2020 means that annual well completions will need to climb 35%; to meet this demand, an additional 670,000 wells must be drilled by the end of the decade. And as the International Oil Companies (IOCs) rein-in their spending, the National Oil Companies (NOCs) drilling will surge.

New annual onshore well numbers are set to grow 35% by 2020, as more completions are required to offset ongoing production decline. Worldwide, more drilling for less oil & gas is a recurring theme. The Middle East will need to achieve more than 30% growth in drilling as the NOCs of KSA, Kuwait, Qatar and UAE start large redevelopments in the near term – nevertheless, production will rise just 10% due to the impact of existing fields maturing.

So what options are available to control costs? The reality is that there is no single solution, but as I implied earlier, drilling forms one of the largest outgoings. As Bente Nyland, Director-General of the Norwegian Petroleum Direct noted recently, “first and foremost the well costs must be reduced.” But there are other areas that also require attention.

The days of easy (cheap) oil are gone.

The oil & gas companies must understand their supply chain capacity. They must endeavor to determine likely future supply & demand pinch points – when and how severe – and understand how this will impact individual projects and plan accordingly.

The engineering of projects must adjust towards fitness for purpose. We need an end to the approach of “gold plating,” and, where possible, standardize. Will an existing solution suffice, or if not, can an industry-wide standardized solution be developed?

New technologies need to be developed and deployed. Operators’ risk aversion and reluctance to pilot technologies – particularly offshore – needs addressing. Government incentives are perhaps needed based on sharing results industry-wide.

Skills shortage is a major issue that significantly contributes to increasing costs. We need to act as an industry to increase recruitment by changing external perceptions, and then work to retain key skills through the down-cycles. It is also important to effectively capture exiting knowledge as older employees retire. Further, there is a growing need to use technology to try to reduce our dependence on human labor.

Finally it is necessary to recognize that governments are a key player in the oil & gas game. They must adopt realistic local content ambitions, for present ones can reduce efficiency, add dramatically to costs, increase bureaucracy, foster corrupt practices, and affect taxation. Oil & gas is a long-term industry that needs long-term policies – those are are not subject to change after and in between elections.

The oil & gas industry has woken up to its problem of high costs and is addressing them. Following the global financial collapse, over the period 2010 to 2013 capital expenditure increased at an average of 13%, but from 2014 to 2018 we forecast that spending will not collapse, while growth will reduce to an average of 6%. The Financial Times noted on April 16 that Shell’s stock price had hit a two-year high as its approach changed to applying capital discipline and focusing on shareholder returns. In the same week, Total announced that it had cut the cost of its Kaombo project off Angola by about a fifth to $16 billion and decided to proceed with its development.

There will be more spending cutbacks as higher costs force more economically marginal projects to be postponed, but some sectors of the supply chain will suffer less than others. For example, big oil needs big projects, and accordingly, deep water is one area that is expected to suffer less than others.

Exploration and production is a cyclical business and without doubt the market will eventually correct itself. Any major cutback in spending will eventually result in reduced oil production in a world where demand is rising, so oil prices will eventually rise, oil company profits will increase, and capital expenditure will continue to grow. But one thing remains certain – the days of easy (cheap) oil are gone.

John Westwood is chairman of Douglas-Westwood, an international energy business research & consulting firm he founded in 1990. The firm recently completed its 1,000th project. In addition to oil companies and financial organizations, John has acted as an advisor to government agencies and presidential offices in six countries.

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