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22 May 2019

Achieving Sustainable Cost Management in Upstream Oil and Gas

Johan Nell

Johan Nell
Partner | Resources lead | London

Adrian Chapman

Adrian Chapman
Partner | Oil and gas | London

The Cost Management Challenge: Why more of the same is not sustainable

Over the past few years, the upstream oil and gas sector has faced some of its toughest times and witnessed the most significant period of low prices for 30 years, putting pressure on margins and investment.

The industry has broadly reacted quite effectively to the challenge. For example, UK North Sea unit production operating costs have roughly halved from $29.6 / boe in 2014 to around $15-16 / boe in 2018 [1]. However, this has largely been achieved through a reduction or postponement of operational activity, as well as a squeeze on the supply chain. This has raised concern over the sustainability and the capacity of the supply chain to meet any future service demand growth. 

With the volatility and uncertainty of oil price, capital discipline and cost control will remain a priority for the industry going forward. Companies are indicating that any new investments need to break even at $40-50/boe [2]. Ultimately, the industry needs to move away from traditional boom and bust cycles - with operating costs rising and falling in tune with oil prices (see figure below showing Brent oil price and North Sea operating cost movement) - and focus on more sustainable cost management.

North-Sea-Unit-Operating-Costs-(3).jpg

North Sea Unit Operating Costs and Brent Crude Price Movement [3]

Many organisations will admit that their reactive methods of cost management have not served them well in achieving sustainable cost reduction or delivering a culture of cost management. When oil prices are high, cost is not foremost in mind; when oil prices fall, cost reduction focus is on prioritising or ceasing work or squeezing the supply chain and contracts. Neither deliver long-term cost efficiency and sustainability.

All this suggests that more needs to be done to manage and reduce capital and operational costs, challenge waste, and drive efficiency in processes and operations - whilst ensuring continued safe and reliable operations.

Cost Out and Stay out: Six levers for Sustainable Cost Management

To deliver sustainable cost efficiency and control, a comprehensive approach to cost management is required.  Based on our experience of working with oil and gas clients, companies that outperform peers in cost management adopt a set of six leading practices:

1. Formalised cost management policies and guidelines

How costs are budgeted, accounted for and controlled across different functions can vary in line with the scale of costs and the type of work activity. In addition, how Finance regards cost management versus how the business regards it can be different. Formalising cost management policies, guidelines and definitions within and across all business functions provides clarity to the organisation and ensures consistency of reporting, thereby reducing any reassessments of the numbers. This said, even with consistent policies, there remains the challenge of ensuring the business is committed to adopting and adhering to them

2. Aligned and adopted work breakdown structures and codes of resources

Most organisations will have a set of work/activity and cost breakdown structures (e.g. asset, asset type / expenditure, asset system / structure, service / activity) that are defined centrally to a level that enables consistent financial consolidation, accounting and reporting. Whilst this serves the purpose of central accounting, effective cost management within the operating businesses / functions generally requires a further breakdown of activities into codes of resources (equipment, functions and activity types) that are aligned to work packages and / or contracts. Typically, however, costs are contracted, captured and managed differently across the operating functions (drilling, capital projects, operations). To truly enable full lifecycle cost management (e.g. full lifecycle well costs), a level of consistency in the code of resource breakdown is needed throughout.

3. Integrated activity-based plans and costing

The starting point for effective cost management has to be an understanding of the expected project, field or asset activities and the associated expected costs. Businesses that do this well adopt methods such as activity-based costing or zero-based budgeting to estimate costs, with work and costs aligned to agreed work and cost breakdown structures. They are also rigorous in the identify-plan-estimate-approve process during budget preparation. Adopting these methods enables a clear understanding of the relative value, type and justification of proposed operational activities and creates transparency in the budget detail by activity, work order, cost centre, and budget owner.

4. Empowered and commercially-minded budget owners, with clear accountability and delegations for cost control and improvement

With clear budget and cost centre accountability aligned to work plans, budget owners and people with authorisation to make purchases need to be well versed and active in the cost management processes: budgeting, purchase commitment, activity tracking and execution, actuals and value of work done, forecasting through to invoice tracking and reconciliation. In many cases, once budgets are approved and commitments made, the focus is on reporting, as opposed to controlling and managing the commitments.  When it comes to purchasing, it is imperative that decisions are made by those accountable and not delegated, with every purchase commitment raised against a work order. In turn, commitments should be tracked, strengthening the sense of budget ownership and ensuring that any potential overruns are agreed before execution. Central to this should be structured performance conversations about opportunities for cost improvement between operations, finance, supply chain and budget holders.

5. Collaboration and integration of suppliers into the cost management process

With a large proportion of operational activity in upstream oil and gas outsourced to third party service providers and with an expectation of tighter operational and capital investment into the future, it is important that suppliers are aligned and integrated with the business in the management of costs. Indeed, in some functional areas, third party service providers are already used to estimating costs, albeit with operator oversight. Once in the delivery of work, at the most basic level, suppliers need to understand the purchase commitment and invoicing processes, as well as the rules of activity approval. This could include formal approval of purchase commitments against discrete activities; invoices based on work orders and associated activities; formalised purchase order amendments. In some organisations, suppliers are fully integrated into the cost management and control objectives – with incentives to optimise and reduce delivery costs through gain shares. 

6. Leverage of effective digital technology and tools to manage and control costs linked to processes

Corporate ERP systems, while effective for accounting, consolidation and reporting, do not always have the functionality and / or configuration to enable cost management at a more detailed level in operations. As a result, cost engineers / managers resort to extracting data from various sources, creating spreadsheets to consolidate, manipulate and analyse data and then inputting data back into systems.  All of which provides opportunity for calculation error, creates single point of failure in processes, gives way to multiple versions of the truth and lacks an audit trail for when costs are queried. What is needed is a combination of data capture, analytics and reporting tools to enable cost management in both finance and operations - yet more integrated, failure proof and efficient. Some of the more advanced organisations are looking towards leveraging robotic process automation, apps and APIS, excel spreadsheet management and control tooling, as well as analytics and Artificial Intelligence, to do just that.

Many of these recommendations may seem to be common sense, and often in oil and gas organisations elements of these practices will already be in place. However, few (if any) businesses are mastering them all. What’s more, only when they are all in place can organisations truly build a culture of cost management and control that drives sustainable productivity improvements. Those who don’t take action now, run the risk of operating costs rising again in line with oil prices and the industry retuning to the boom and bust cycles of old.

Making It Happen

Implementing the practices outlined above does not necessarily mean major disruption to the day-to-day business. To get going, an approach for driving improvements could be along the lines of:

  1. Engage with senior leaders to agree the targets for cost improvement and control
  2. Understand how costs are managed and accounted for across the business and functions (reservoir development, wells, projects, operations, supply chain, finance), from a process and work / cost breakdown perspective
  3. Develop standard and integrated work and cost breakdown structures at the corporate and functional levels, in line with or through adaptions to the corporate and operational systems
  4. Design and implement a process for activity-based / zero-based budgeting, in line with the integrated business and activity plans to develop a true understanding and baseline for activity costs
  5. Review cost management processes to identify opportunities for process improvement e.g. spreadsheet consolidation, removal or control; robotic process automation; analytics and Artificial Intelligence.
  6. Develop cost management policies and guidelines outlining how costs should be captured, managed and reported in line with clear definitions
  7. Develop training for cost management professionals and budget holders to enhance commercial mindset of everyone in the organisation
  8. Engage with suppliers to outline goals for cost management and efficiency, align on expectations and understand how suppliers can contribute, on a win-win basis, to reducing and / or sustaining costs

How Baringa Can Help

Baringa is an award-winning management consultancy in the Energy and Resources sectors. Our work with Oil and Gas clients spans the Commercial and Trading; Supply Chain Management; Core Operations Performance Improvement; and Digital, Data Management and Analytics. We have worked with a number of Oil & Gas and Energy clients to establish cost management methods and processes which change the cost culture, drive increased cost consciousness, increase business ownership and achieve sustainable cost reduction.

[1] Oil and Gas UK – Economic Report 2018

[2] Oil and Gas UK – Economic Report 2018

[3] OGA - UKCS Operating Costs in 2017.  Operating costs as a % of oil price remained steady at around 16% until 2011, then escalated to 40% in 2015 whilst oil price also rose