By John Kemp
LONDON, Jan 30 (Reuters) - Cutting the cost of everythingfrom salaries and steel pipes to seismic surveys and drillingequipment is the central challenge for the oil and gas industryover the next five years.
The tremendous increase in exploration and productionactivity around the world over the last ten years has strainedthe global supply chain and been accompanied by a predictableincrease in operating and capital costs.
When oil and gas prices were rising strongly, petroleumproducers and their contractors could afford to absorb costincreases.
But as oil and gas production have moved back into line withdemand, and prices have stabilised, the focus is switching onceagain to cost control.
"Operational excellence," a euphemism for doing more withless, is back in fashion and set to dominate industry thinkingfor the rest of the decade.
SPENDING DISCIPLINE
Paal Kibsgaard, chief executive of Schlumberger, oneof the largest service companies, has been emphasising "smartfracking" and other ways to raise output and cut costs for twoyears.
Speaking as long ago as March 2012, Kibsgaard warned: "Inthe past ten years, exploration and production spend has grownfourfold in nominal terms, while oil production is up only 11percent."
"In this environment, we believe our customers will favourworking with companies that can help them increase productionand recovery, reduce costs, and manage risks," he added.
Schlumberger's website and those of its main competitorsHalliburton and Baker Hughes all prominentlyfeature technologies and processes intended to cut costs, suchas dual-fuel diesel-natural gas drilling and pumping engines.
It is just a small example of profound industry shift froman emphasis on increasing production to controlling spending.
Issuing a shocking profit warning on January 17, Royal DutchShell 's new chief executive pledged to focus on"achieving better capital efficiency and on continuing tostrengthen our operational performance and project delivery."
On Thursday, the company cut its capital budget for 2014,and announced it was suspending its controversial and expensiveArctic drilling programme.
Shell is catching up with peers like BP and Chevron, as well as perennially tight-fisted Exxon, inpromising to stick to a tighter spending regime and return morevalue to shareholders .
The problem is not unique to oil and gas producers. Minerslike BHP Billiton, Rio Tinto and Anglo American have all axed projects and pledged to tighten capitaldiscipline after costs spiralled out of control.
MEGAPROJECT MADNESS
The worst over-runs have been on so-called megaprojects -investments costing over $1 billion, sometimes much more. Infact, the bigger project, the worse the cost overruns and delayshave tended to be.
Pearl, Shell's enormous gas to liquids project in Qatar, isnow regarded as a success, but was seriously delayed and wentwildly over-budget.
Other megaprojects like Chevron's Gorgon LNG in Australiaand the Caspian oil field Kashagan - which is being developed byan industry consortium including ENI, Shell, Total, Exxon andConoco - have been similarly late and bust their original costestimates.
It is convenient, but wrong, to blame poor projectmanagement for all the days and cost overruns. Some decisionshave been flawed, but on projects of this size and complexity,at least some errors are to be expected.
Megaproject managers in 2013 were not, on the whole, worsethan in 2003. Unfortunately, the economic and financialenvironment has become much less forgiving. When projects startto go wrong it has proved much harder to limit the delays anddamage to the budget.
By their nature, megaprojects are so big they strain theglobal construction and engineering supply chain and pool ofskilled labour. Megaprojects create their own adverse "weather,"pushing up the cost of specialist labour and materialsworldwide.
Attempting to complete even one or two megaprojects withsimilar characteristics at the same time can strain the globalsupply chain to the limit. Attempting to complete severalsimultaneously is a recipe for severe cost escalation anddelays. The multi-commodity boom over the last decade created a"perfect storm" for the megaproject industry.
While there is not an exact overlap, massive offshore oilfields like Kashagan, LNG facilities like Gorgon, floating LNGplatforms like Prelude (destined for Australia), gas to liquidsplants and even simple onshore shale plays like North Dakota'sBakken, are all competing for the same limited pool of skilledengineers, construction workers and speciality steels.
The result has been a staggering increase in costs andwages. And once a project falls behind, there is no slack in thesystem to hire extra workers or procure additional orreplacement components to get it back on track.
SUPPLY CHAIN RESPONDS
Rampant inflation and delays have been worst on megaprojectsbecause they require a much higher proportion of very specialistcomponents and the supply chain is least-elastic.
But even simpler projects like shale oil and gas have beenplagued by a rapid rise in costs as they stretch theavailability of drillers, rigs and pressure pumping equipment,as well as fracking sand, fresh water and guar gum.
Between the end of 2003 and the end of 2013, the number ofemployees engaged in oil and gas extraction in the United Statesincreased by 70 percent, from 117,000 to 201,000, according tothe U.S. Bureau of Labor Statistics.
Soaring demand for specialised workers has produced anentirely predictable surge in wages.
Employees in North Dakota's oil, gas and pipeline sectorswere taking home an average monthly salary of $9,000 in thefourth quarter of 2012, and staff at support firms were makingan average of more than $8,000, according to the latest datafrom the U.S. Census Bureau.
Their colleagues in Texas were doing even better: averagesalaries in the oil and gas extraction industry were over$15,000 per month, and $11,000 in pipeline transportation.
That made them some of the best-paid employees in the UnitedStates. Only financial services employees in New York ($28,000),Connecticut ($25,000), California ($17,000) and a few otherstates were routinely making more.
Rising wages and other prices were the only means to rationscarce workers and raw materials. But they were also the onlyway to attract more workers and supplies into the industry.
EXTREME CYCLES
It takes a long time to train new drillers, petroleumengineers and construction specialists, and give them theexperience needed before they can assume positions as expertsand team leaders.
Similarly, the expansion of specialist constructionfacilities and manufacturing firms for items like oil countrytubular goods takes years; and companies will only expand orenter the industry if they are convinced the upturn in demandwill be durable rather than fleeting.
While the boom in oil and gas prices dates from around 2003or 2004, the big expansion of exploration and productionspending started much later, around 2006 or even 2007, and ithas only filtered down to the labour pool and the rest of thesupply chain much more slowly.
It is the long delay between an increase in demand for oiland gas, an increase in production and exploration activity, andan expansion of the whole supply chain, which explain the deepcyclicality of the petroleum industry and mining.
Extreme cyclicality is hard-wired into oil, gas and miningmarkets. Companies like Shell which have tried to ride throughthe cycle by ignoring short-term price and cost changes to focuson the long term have eventually been compelled by theirinvestors to fall into line.
In the next stage of the cycle, oil and gas prices are setto remain relatively high but are unlikely to rise much further.For exploration and production companies, increasing shareholdervalue therefore means increasing efficiency and bearing down oncosts, including compensation and payments to suppliers andcontractors.
For the supply chain and oil-industry workers, capacity andthe availability of skilled labour will continue to expand,while demand is set to stabilise or taper off. Major oilcompanies and miners have already cancelled some projects.Costs, wages and employment will fall, or at least start risingmuch more slowly.
