Beating Betteridge’s Law

The Oil and Gas Project Supply Chain Can Deliver at $40/bbl

Betteridge’s Law states that if a news headline is posed as a question, then the answer to it is – No. That’s because such headlines are often implausible or clearly false – Does this App Solve Weight Gain? – designed only to attract attention. So the proposition can the oil supply chain deliver at today’s prices is not posed as a question here – mainly because we have recent plausible evidence that oil industry projects can indeed be produced successfully at $40/bbl and below, the “Lower for Longer” scenarios.

For two decades, from the mid 1980s to around 2004 the oil price moved in quite a shallow range, between $25-35/bbl (real and nominal). To be sure, many companies came and went in this time, and some will say we lost a generation of engineers to the industry. But the oil business came through it, and then seemed to thrive from 2005 onwards during higher income.

Nonetheless, the industry needs to quickly readjust to this back-to-earth reality – and here’s why: its underlying performance in that period of high oil prices makes far grimmer reading than even today’s glum headlines.

It’s been a performance slide on two fronts: rapidly increasing costs across all project supply chains, and increasing dependence on mega-scale projects (those greater, often far greater, than $1bn), most of which have not met their targets.

To get a tighter grip on the problem, and its possible solution, let’s first allow the numbers to do the talking.

Start with costs: as a benchmark, over the last ten years global manufacturing productivity has improved by about 5-8% per year – which means today its about twice as productive as it was a decade before. Over the same time, according to the McKinsey Global Institute, energy project construction productivity has not improved at all – totally flat, nil.

And project delivery performance? It’s often noted that 70% of major industrial projects over-run, which is supposed to be sobering, but tends to allow many project managers and teams to assume they will be in the golden 30%. In fact, McKinsey’s data tells a more chilling story – every major project in their large database has over-run – so all large-scale projects fail the cost or schedule test at some point.

And the aggregate result? – since 2004, as IHS Energy consultants show in their regular reports, oil industry input costs have doubled, and overall costs have bloated up to four times in key areas such as LNG. Oil prices also doubled, and briefly tripled in the period, but the response of a multiple-times increase in cost is now a systemic problem for the industry. Its true that project scopes and scale have increased, but on a relative basis the mega-project trends have been sharply upwards – as an instance, Wood Mackenzie data indicates some current LNG plant costs of over $2000/mt versus previous decade costs of ca $500/mt. A combination of input cost inflation due to materials and labour, plus the impact of mega-project over-run.

So the past can be defined by three troubling, and inter-related, performance numbers: project construction productivity was zero, 100% of major projects were over budget, and overall costs quadrupled in some key sectors.

That’s the legacy of a $100/bbl oil price for project performance, and energy share price performance has consequently slumped as oil revenues have collapsed.

And the future? That cost issue may be about to get bigger. McKinsey reckon over $60 trillion (trillion), dollars of infrastructure projects will be sanctioned from today out to 2030 – and even with the latest oil price forecasts factored in over half of these projects will be energy-related. In addition, almost 80% of these projects will be “mega-projects”, and if the past is our guide, then all of these will over-run, many hugely so.

So, how can we state that the industry can adapt and even prosper at $40/bbl or less given its pathology of poor cost and project management?

Put another way, what needs – rapidly – to happen to the current supply chain management of the energy industry to make it effective at revenue prices that prevailed only 10 years go?

A key point to make before we get into solution mode is that this needs to happen irrespective of future oil price dynamics. The next wave of projects are unlikely to be much smaller or more simple – the winners are those who can grow profitably in such a world, with far less fat in the system. And the focus should be on self-help: forex changes or fiscal policies for example may improve economics, but they are largely, or fully, outside any one project’s direct influence.

The proposed solution comes in two parts – the obvious one, better portfolio selection and project management. The strategic one is using large-scale projects to your advantage, being more confident in doing them well, and not adding back the risks.

So, to begin to resolve the project delivery issues there is in fact a ready-made prescription that the industry needs to follow more diligently and in a far more disciplined way than before – Ed Merrow from Independent Project Analysis (IPA) and multiple others have been stating variations on an effective project life-cycle framework for many years – a typical summary is:

• More thorough portfolio selection at the outset
• Better investment in design and planning stages
• Appropriate organisation of project teams, partners and processes
• Standardisation of engineering design and equipment where possible
• Strong interface management between engineering and construction
• Equitable contractual risk allocation between Owner, Prime Contractors and vendors
• Effective information technology selection for performance management and project control
• Careful and effective change management and claims avoidance

In sum, far better discipline between the three pillars of project delivery – engineering, contracting and procurement and construction.

Already in the industry there are pockets of lean-style modular manufacturing in unconventional gas and oil projects, making production viable at lower oil prices than before: indications that various supply chains can exist in this new financial environment.

Overall, best guesses suggest doing all the above well, which is clearly far from easy, will net you between 25-40% reduction in costs. That takes us roughly half-way back to the supply chain numbers of 2004, and $40/bbl oil: Wood-Mackenzie consultancy estimates that the full-cycle break-even price for major oil firms has recently decreased to around $65/bbl from over $100/bbl. The Goldman-Sachs Top 420 Projects 2015 analysis also shows cost curves improving into the $60/bbl range, dependent on project type.

But what gets us the other half of cost reductions necessary? It’s likely we need to turn to the nature of megaprojects themselves.

These entities currently dominate the industry commercial landscape and are likely to continue to do so in some form in 2016 and beyond – and they are a new phenomenon compared to the pre 2004 world, where multi-billion dollar projects were comparatively rare.

The dominance of megaprojects exists due largely to the loss of easy-access oil, and they are inherently exposed to a high likelihood of cost and schedule over-run – as the data attests. They are typically technologically difficult and geographically disperse, have multiple strong-minded stakeholders (for example, state plus regional governments), require large organisations from scratch to deliver, and can take so long to complete that the expertise of any given individual or team is likely to be limited, with learning curves steep and experience gained highly contingent.

Such scale and complexity has therefore lead to very large project owner management teams relative to project size – typically now 12-15% of overall cost, far higher in percentage terms than for smaller projects. There appears to be a negative return to scale of megaprojects in terms of owner costs – a legacy of the complexity, longevity and increasing density of the contract management involved. Indeed, in the case of some mid-size oil firms, the scale of the projects starts to reach the overall size of the parent corporation – with deep consequences for the systems and controls used to manage them.

To compensate and mitigate cost spirals, oil firms have developed corporate project standards and benchmarks to promote learnings, and have re-cycled project teams to maintain skills. This has begun to improve performance, but it will likely still leave us well short of any $40/bbl cost survival goal.

Stepping back in time a little for perspective, Oliver Williamson’s classic work in the 70s noted the fundamental distinction between markets and hierarchies, and how companies make the decision to either buy goods externally, or make them internally.

Megaprojects cannot be delivered fully by a single firm, but neither can they be bought effectively by purely market means: the standard approach of increasingly dense and more precise contracts to establish a set price for these vast ventures is unlikely to solve the cost over-run issue. Some form of strategic development in organization and contracting method needs to be devised.

The industry now needs to recognize that such megaprojects represent a fundamental unit of the current energy business, and are effectively mid-size companies in their own right. As a result, they need the same sort of business management investment that internal organisations are given. For example, whilst large energy firms expend major effort designing interior corporate management and information tools, megaproject EPCI contracts still tend to be managed via a blend of extensive and tailored contract negotiations, mixed with improvised business systems. As a result, most effort often goes into debating contract interpretation and adherence (a traditional market model), rather than running efficient transactions with experienced contractors – a more relational-based approach, part-way toward the hierarchy model.

Such relational-based approaches do exist when project scale is clearly vast and the limits of traditional approaches plainly undermine project value – eg the tri-field Azeri project by BP in Azerbaijan, or the Shell Integrated Gas portfolio for Floating LNG. These examples are far from the loosely-defined alliance structures of the 90s. They are formally contract based – the latter centered on pre-agreed and modularised contract forms with chosen suppliers. Strategically, they attempt to address mega-project complexity by working continuously with proven contractors to agreed terms and pricing formulae, and using working practices and replicated business systems set up to cater for very large, but temporary organisations. For sure issues remain with such structures, such as lock-in, but the benefits in terms of reduced engineering and specifications, organization design and deployment, and systems set up are considerable and will create substantial cost and schedule reduction.

Future major projects can and must be delivered at significantly lower oil prices: the infrastructural and economic value of trillions of dollars of energy industry investment depend on it.

Better project choice and design, and more disciplined execution with reduced supply chain costs may get us half-way back to the efficiency of the previous sub $40/bbl era. The other half will need to come from understanding what we have become: very dependent on massive yet transitory projects, which have failed to deliver on cost or schedule, and which now also require updated organisational and contractual systems.

The headline asserts the industry can survive and deliver at or below $40/bbl: it’s not questioning that – yet.

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References

McKinsey & Co – The Construction Productivity Imperative – McKinsey Productivity Sciences Centre, June 2015

McKinsey & Co – Megaprojects – The Good, The Bad and the Better – Infrastructure Analysis, July 2015

Goldman Sachs Equity Research – 420 Projects to Change the World, May 2015

Flyvbjerg, B – What You Should Know About Megaprojects And Why: An Overview – Project Management Journal, Apr/May 2014

Lise Arena, Eamonn Molloy – The Governance Paradox in Megaprojects. Entretiens Jacques Cartier, 2010, Lyon, France. pp.NC, 2010. , www.archives-ouvertes.fr
Williamson O E – (1975), Markets and Hierarchies: Analysis and Antitrust Implications, New York: Free Press