Significant progress in cost reduction in the oil and gas sector is likely to bottom out this year. The latest Supermajors Cost Index – Has cost efficiency peaked?, available from Apex Consulting, determines the oil and gas industry’s efficiency in developing its reserves by analysing the performance of the seven supermajors: BP, Chevron, ConocoPhillips, Eni, ExxonMobil, Total and Shell, setting an important cost benchmark for the industry as a whole.
This third of a three-part series describes the challenges that the supermajors face to continue to mitigate the risk of rising costs.
A reduction of more than 40% in our Cost Index since its 2014 peak clearly demonstrates the impressive progress the industry has made in bringing costs down over the last few years. However, challenges remain, not only in sustaining this cost deflation but also in preventing a recurrence of the cost escalation we have seen in the past.
The global economic outlook, while strong in the short run, has become less even. Heightened geopolitical tensions, mounting trade protectionism, and the growing possibility of disorderly movements in the financial markets have clouded global growth prospects, both in the short and medium term .
While geo-political crises and concerns about the lack of global spare capacity may support prices in the short term, the ability of the US shale industry to respond quickly to market movements will cap any upside movement. And oil’s long-term demand potential remains subdued, not least because of increasing energy efficiency, a rise in renewables and the growing electrification of transport.
Uncertainties in global growth, a strong recent price recovery, and the effectiveness of U.S. shale as a marginal producer all point to muted price growth in the near term, barring unexpected supply disruptions. What’s more, the weak long-term demand outlook suggests there is limited prospect of a strong long-term growth in prices.
On the investment side, sustained price recovery led to a resurgence in upstream capital spending in 2017, with 33 major projects reaching FID, compared with 9 in 2016 . With the level of capital spending in 2018 expected to increase by 5% compared with 2017 , it looks like the industry is gradually moving into a growth phase. This poses a number of challenges to the sustainability of cost reduction achieved since the downturn.
Maintain capital discipline
During the previous growth phase, capital productivity declined significantly, as poor project execution caused cost overruns and delays, and a prolonged ramp-up in investment activities caused industry-wide cost escalation. We might see a repeat of this trend if capital discipline is not maintained. Early signs of this have already emerged in the US shale plays, where a pick-up in drilling activity has tightened service sector capacity, prompting the cost of materials, rig rates and labour to rise significantly in 2017. This upward trend in service sector costs is expected to continue.
Although recent upstream investments have so far focused mainly on smaller brownfield developments, the industry is expected to move into large-scale project developments, with a number of major LNG projects expected to reach FID in 2019. As investment in greenfield and relatively larger projects increases in 2019 and beyond, overcapacity in the offshore service sector is likely to ease. It is possible, therefore, that the rates charged by offshore service companies will go up as demand for their services increases.
Challenges to growth
The widespread job losses that occurred during the downturn also pose a challenge for the industry in this growth phase. With a significant number of skilled workers having left the industry altogether, oil and gas companies may find it difficult to attract and retain suitable talent to support their growth plans.
What’s more, protectionist measures such as tariffs on coal, steel and other components threaten to raise the cost of manufacturing equipment and building facilities significantly.
This potential upward pressure on costs will be moderated somewhat by cost-saving measures that are not dependent on third-party rates, such as optimising logistics and production operations, simplifying processes, adopting lower cost drilling techniques, and so on. However, approximately 50-60% of the cost savings achieved by the industry in the last few years could be lost as a result of increased activity, higher rates, tighter labour markets and input tariffs, given that a third of this cost deflation resulted from lower activity and two-thirds from lower costs .
As a result, developing resources that cost more than conventional assets, whilst price growth potential remains muted, requires superior project execution to manage the technical risks and prevent cost overruns and delays. A new approach is therefore needed to achieve this objective and make cost savings more sustainable.
To mitigate the risk of rising costs, operators and suppliers need to work more closely towards the common goal of improving project profitability and reliability. Not only do we need greater collaboration between operators and service providers, we also need a more transparent and shared approach to risk allocation so that oil services companies are incentivised appropriately to find innovative ways to cut costs.
Integrated development model
The integrated development model is an example of an approach that promotes greater collaboration between oil companies and their suppliers. Led by an “integrated project management” (IPM) team, operators and their various service providers work together in this model on all aspects of the project to develop cost effective solutions and deliver profitable projects. Remuneration schemes are designed to ensure that the goals of relevant stakeholders are aligned and match the project’s objectives.
Several oil and gas players have already taken steps towards greater collaboration with their suppliers. For example, Equinor cited close co-operation with its suppliers as the main reason for the reduction in investment costs of its Johan Sverdrup project . Project owners also identified collaboration as one of the key drivers behind the 60% reduction in BP’s Mad Dog phase 2 cost estimates .
Some oil executives believe that two-thirds of the cost savings achieved in the last few years can be sustained, even if upstream investment accelerates . Due to the risks mentioned above, we believe the potential for costs to escalate rapidly is high, especially if the industry tries to manage costs in the same way it has for the last twenty years. However, the threat of rising costs can be managed through greater collaboration and risk-sharing between operators and their suppliers. This new model of collaboration with appropriate incentive structures must be guided by the overarching mantra of “value accretive volume growth” to prevent the recurrence of the runaway cost escalations of the past and make the industry’s activities more resilient to adverse price movements.
Read part one: Supermajors Cost Index – Dramatic changes
Read part two: Supermajors Cost Index – Leaders and laggards
 International Monetary Fund (IMF); “World Economic Outlook Update”; July 2018.
 Wood Mackenzie; “Q4 pre-FID upstream project tracker: A big December lifts 2017 sanction total”; 09 January 2018.
 International Energy Agency (IEA); “World Energy Investment 2018”; 17 July 2018; page79.
 International Energy Agency (IEA); “World Energy Investment 2016”; 12 September 2016; page 70.
 Equinor’s (previously Statoil) press release; “Increasing the value of Johan Sverdrup”; 29 August 2016.
 Jessica Tippee; “Re-engineered Mad Dog Phase 2 gets the greenlight”; Offshore Magazine; 01 February 2018.
 Andrew Ward; “Oil majors on road to recovery after years of pain”; The Financial Times; 02 November 2017.
A highly experienced consultant with considerable expertise in project economics, modelling of upstream projects and portfolios, capital raising activities, commercial/contract negotiation strategy, and regulatory compliance, Muktadir Ur Rahman has worked extensively with major oil and gas companies worldwide on a variety of projects, from undertaking independent reviews of economic models and modelling various fiscal regimes to leading investment appraisal, risk and sensitivity exercises to identify commercial value drivers for clients’ commercial teams.