Cost reduction strategy in the oil industry is now being adopted by oil firms as a core strategy. With global economies facing recession and wide fluctuations in energy demands, it seems low costs is becoming the safety valve for oil firms.
The oil and gas industry is under tremendous revenue and costs pressures. The indication is that globally, the oil and gas industry has experienced a huge drop in revenue in 2020. Some exploration and production oil firms have either halted or slowed down their production operations.
Adopting the right cost reduction strategy now is key to survival and growth. Most companies are recently cutting their planned projects and budgets. This is called cost avoidance and this is a wrong cost reduction strategy.
Our understanding is that what the federal government, NNPC, DPR and IDSL are recommending is cost savings. This is the right cost reduction strategy. Cost savings as a cost reduction strategy enables oil and gas companies to achieve their planned production volumes at reduced costs.
Extracts from this article were earlier published as an interview in Business day newspaper of September 6, 2020, with the title Marginal oil fields: How to meet FG’s low-cost order through ‘third party cost savings’.
Drive for low unit operating cost
The Federal Government in June 2020 pegged the crude oil unit operating cost (UOC) per barrel at US$10 whereas it had been about US$28 as at end 2019. This was in the face of oil price crash to below production cost levels due to a freeze in industrial activities all over the world. The economic freeze was induced by the Covid-19 pandemic.
As oil companies grapple with the order for a drastic reduction of costs, industry experts and management consultants have started digging into their bags of tricks to find the formula for reduced, competitive, and sustainable production cost scheme in Nigeria.
This situation seemed to open the eyes of Nigerians that high production costs can no longer be sustained. Thus as a Nigerian oil industry expert, Dr Leesi Gborogbosi floats a template to help bring down oil production cost through what is known as ‘third party costs savings’ system.
This is a cost-savings tool for low-cost production. This new focused delivery will help bring down operational costs in the oil industry so Nigeria’s oil sector could cope with increasing global competition.
Third-party costs are costs that companies incur in their business relationships with third parties (e.g. contractors). Whereas an oil company would have a range of costs it incurs in-company with its own staff, there are costs passed to an oil company by its contractors and partners that have a huge bearing on the overall cost of production per barrel.
Now, companies are expected to take actions that would lower these ‘third party costs’ to arrive at the FG cost objective to arrive at same overall business goal (under-US$10 production cost per barrel). When this is done, we can then say the company has achieved at ‘third party cost savings’.
Understanding cost implications
In the oil and gas industry, companies that manage their costs effectively will gain a competitive advantage. The oil market has less maneuverability. Oil cartels determine the international price of oil.
Cost profile is one of the key areas that oil and gas companies can have flexibility. In some companies, you may find that about 70 per cent of their costs come from third parties through contracts and procurements.
A technical definition of ‘third party costs savings’ concept as: “the difference between the latest estimates for the third party spends and the annual planned budget. Third-party costs savings for projects is determined over the full lifecycle and on an annual basis.”
It is challenging to manage the process of third party cost savings, but by engaging highly rated and experienced consultants, these challenges could be overcome. Dr Gborogbosi is one of those who have had hands-on industry experience in delivering cost-saving programs in the Nigeria operating environment.
Cost reduction strategy – Cost savings
I discuss this cost savings strategy by using an example of how I successfully executed the strategy to achieve third party cost savings at a leading multinational E&P oil and gas company in Nigeria. The organization I worked for, expressed the desire to have a uniform and clear definition of the third party cost savings (TPCS).
Responding to request by the leadership of a business function for support to enable the delivery of cost reduction program, the finance team took on the responsibility of designing and developing a robust structure for reporting cost savings.
To achieve third party cost savings, we adopted six strategic levers. These include technology-driven cost reduction initiatives, contract optimization reviews, category management, cost behaviours and among others.
Our detailed process flow-maps provided the needed transparency to the cost savings process and aided a better understanding of cost savings. We developed a cost savings structure for defining cost savings, capturing, verifying, and reporting of actual cost savings achieved.
We provided advisory to the contracting and procurement leadership and finance function that the innovative and sustainable solution is to have greater cross-functional collaboration between the contracting and procurement function and finance function in driving the cost ambition programme.
The project managers, finance manager, contracting and procurement manager as the responsible parties should review the cost savings that will be reported. These managers should review and sign off. There is the need to have the “third party cost savings” signed off timely to have a transparent process for the organisation-wide cost reduction programme.
The organisation adopted the cost savings template and reporting structure as best in class. This removed barriers and resistance to the organisation’s cost reduction programme.
Our work enabled the organization to have the assurance that the cost savings programme will be delivered.
Also read: Nigeria’s oil reform bill foresees privatisation of National Petroleum Company, royalties changes
Cost reduction strategy – Leadership roles
Managing ‘Third Party Cost Savings (TPCS)’ is a key component of executing a company’s cost reduction programme. We had the challenge of setting stretched targets. Our team had to secure the buy-in of project cost managers to ensure planned cost savings targets were delivered.
A key challenge is to get the managers in your company to agree on the distinction between cost savings and cost avoidance. We can define cost avoidance as the reduction in budget scope. As managers are the ones expected to deliver on cost savings, they are often tempted to adopt cost avoidance approaches.
Receiving commendation from management is a sign that the work can be cascaded across the organisation. Senior leadership need to fully support the third party cost reduction programme. This makes the entire organisation focus on the cost reduction programme and achieve a competitive advantage in the best costs and project delivery on schedule.
With transparency and understanding of the cost savings process, managers will be willing to undertake more cost savings projects. They will identify new cost savings projects to replace other projects that are not delivering on the plan. Any changes to the “cost savings guidelines” should be cascaded across the organisation.
Managers should build a shared vision. It is imperative to organise third party cost savings workshops for the business managers, business finance managers, contracting and procurement leadership team. This will aid a shared vision on how to implement the cost reduction strategy.
Investing and operating in the oil and gas industry is usually complex, challenging and rewarding. However, there are a lot of blind spots. It is advisable that the services of ex-managers with decades of actual working experience in the oil and gas industry should be sought. This is to avoid mistakes made by earlier investors and operators.
Cost implications of new investments
Oil operators and investors do spend a significant portion of their capital expenditure on-field development. Managers in the oil industry will find insightful Dr. Leesi Gborogbosi doctoral dissertation focused on how managers can collaborate with host communities to create mutual benefits and execute strategy at low costs.
Department of Petroleum Resources (DPR) stated that they will be seven key implications for the field developers which include ownership of the asset, low investment cost, lower risk of development, early time to production, shared infrastructure, regulatory support, and scalability. All these implications have underlying cost impacts for new investments.
Investors in marginal oil fields will face comparatively low investment cost projected at between $50m and $100m as opposed to capital investments by the major oil companies. However, the delivery time between investment and production is between 18 and 24 months. It is therefore important to have the right cost reduction strategy at the onset.
Investment in the marginal oil field is scalable; thus investors can start small and grow big. On shared infrastructure as an example, operators are encouraged to collaborate on common usage of facilities to ensure optimum utilisations for crude transportation and export. For regulatory Support, the government will enforce regulatory practices of general application.
It is important to understand the cost implications of marginal field investment especially in the pre-investment costs of assured marginal economics, exploratory well drilled, portfolio rationalization, and president’s discretion factors.
Written by Dr. Leesi Gborogbosi, Member of the African Energy Chamber
Original article on Africa Oil & Power