4th Wave Value – Upstream Oil and Gas

I’ve been engaged in several discussions recently on the benefits (or otherwise) of the 4th Industrial revolution [link] applied to oil and gas. I’ve decided to write a couple of pieces on this topic so I can refer to them with clients.

Technologies driving the revolution

I accept the WEF identification of the following general technologies that underpin the revolution:

  1. Wide-spread sensing of information
  2. Increased computing power, predictive models leading to increased understanding
  3. Artificial Intelligence leading to:
    1. Automation of actions
    2. Optimisation of whole systems
  4. Distributed, additive manufacturing

Benefits from the revolution

What will be the outcome of the 4th Industrial Revolution for upstream if we are successful?  Well there can only be three fundamental differences that can be made – I think we’ll get a combination of these:

  1. Per unit cost reduction in produced barrels
  2. Increased safety for the people involved in operations
  3. Decreased impact on the environment from activities

Items 2 & 3 tend to be driven on a compliance basis and form the requirements for permission to operate granted to companies by society using various methods of regulation, consumer pressure and protest. For my purposes I’ll assume that these are utilities [link] and that we always want more when there is no increase in cost, and that we’re unlikely to cut spending or trade down. Therefore, any cost-neutral improvement will be adopted and spending will only increase when it is mandated.

Driving down production costs

I am going to concentrate on the cost per unit production. This comes from the cost of capital used to find and develop a field, the cost to operate facilities, and provisions for decommissioning at end of life. As the owner-operator of an oil field there are distinct supply chains for each of four phases of life:

  1. Exploring, Finding and Appraising deposits of oil;
  2. Planning, Designing, Building and commissioning facilities to extract and transport it to market;
  3. Operating the facilities; and
  4. End of life decommissioning, facility disposal and restoration of the environment

Benefits for exploration

In the initial phase of oil field life I would say that we’ve already captured many of the benefits. Wide spread sensing and large computing power would be a great description of what happens with Seismic data, Geoscience earth-modelling and directional drilling.  I am sure that if I looked at the number of people employed and unit-cost of discovery of a deposit I would see a much more efficient scenario than we did in 1980. The figures are somewhat distorted on a cost-per-barrel basis as we have been finding smaller deposits (a feature of geology rather than our abilities).

Benefits for Development and Projects

In the field development phase, we have seen some ingress of new technologies – ROV, Subsea completions, dynamic positioning of FPSO’s and such has led to economically possible concepts for some small or hard-to-reach fields that we’ve found. Field and facility performance is more accurately understood through simulations and we’ve seen some benefits to designers from the use of CAD systems. There is still scope for development to reduce the cost and errors associated with Engineering, Procurement, Construction and Commissioning. There are few real-time feed-back loops here, or analysis of project simulations. The management of large capital projects is still a mine-field of risk, change orders, document control, cost-overruns and schedule blow-out. These are caused by fluctuations in the real-world vs. plan with late in-flight adjustments. More accurate planning, contingency, dependency management, construction order, logistics, pre-commissioning maintenance, start-up etc. would provide benefits.

Benefits for Operations

The revolution should be able to affect operational optimisation the most, this is an area almost untouched by the revolution so far. An OIM on a field from 1980 would recognise a lot of the technology (if not the work-practices) used today. The exception to this is the wide-scale adoption of communication meaning that the split between on-shore and off-shore is far less.

It is possible to argue that the 4th wave has enabled the shale revolution and that the operating practices from this type of development are fundamentally different to conventional offshore and on-shore fields. The operating margins are smaller, decline curves more dramatic and the constant drill-complete-operate cycle has forced change.

I may be controversial but I’d say a lot of the operational work-practice changes seen in the North Sea have majored on reducing manning offshore and increasing the safety of operations. I believe that, despite the vast increases in potential data, the fundamental way that information is gathered and acted upon has not changed much.

When I walk into a remote operations centre I see a lot of people collaborating with each other, lots of excel spreadsheets, cameras and discussion. Integrated planning and turn around planning are still being done off-line and I don’t see visibility of supply, logistics or automatic optimisation of these functions.

There is a conundrum here of course. The facilities that are in operation (and those still being commissioned) are not designed to harness 4th wave opportunities so we have (at least) two problems. Firstly we must retro-fit new concepts into facilities that will be with us for the next 30 years, and secondly we need to influence design and development so that this retro-fitting is no longer needed in the future.

Benefits for de-commissioning

It’s early days on the decommissioning front. I suspect that for operators the benefits will show up through normal procurement cycles. The smart profits are likely to accrue to those that can operate quickly and safely. Examples of clever automated technology are emerging – such as the self-levelling rams that lift whole top-sides fitted to the Pioneering Spirit [Link]

Next steps

With the current climate in Oil and Gas we’re seeing an increased interest in how to transform the operational environment and supply chain to drive out OPEX cost (development and exploration are of course now sunk [link)

Now I’ve set the context I’ll start to explore how an operator, or service company, can start to participate in these changes – what an operations business case will look like, what skills and approaches will be needed, what approaches are stopping innovation and what the risks are.

(Image source : http://ohioline.osu.edu/factsheet/cdfs-sed-2 )

You heard it here first folks…

I’m not normally known for left-leaning political judgement but – just in case you missed it the Scottish Government is being asked to consider a motion to fund public investment in the infrastructure of the North Sea.

“UK OIL would work with the Oil and Gas Authority to identify strategic assets that are potentially profitable. That would help to prevent platforms and pipelines being lost earlier than planned, and potentially help fund new ones for the future.

“We urgently need imaginative thinking like this now – otherwise the oil and gas sector could continue to decline due to lack of investment.”

Here’s the [link]

13 month’s ago this blog published an article which, amongst other points said:

To address this will require restructuring the way that the industry operates. If not outright nationalisation of parts of the network, this – at least – requires more control and probably limited subsidies. For goodness sake – we subsidise the tracks that our trains run on, I can’t see any argument for the creation of economic value there that does not apply to our North Sea processing and export network.

Here’s that [link]

 

 

Subsidy on the agenda?

Last year I suggested that there were strategic reasons to maintain North Sea production. The system of interconnected assets and their cross-reliance on each other means that it will be in the common good for “UK PLC” to maintain key infrastructure despite it being a poor proposition for individual operators.

For goodness sake – we subsidise the tracks that our trains run on, I can’t see any argument for the creation of economic value there that does not apply to our North Sea processing and export network. [Link]

So I was heartened to see that David Cameron is in Aberdeen with what the FT called an emergency investment package. I was less pleased to see what the promised £250m investment was to be spent on:

The prime minister will promise a new “oil and gas technology centre” in Aberdeen to fund future research, including into innovative ways to extract oil and gas.

The package will also help expand the harbour and support the city’s pharmaceutical and agri-food industries to try to help Aberdeen diversify from its reliance on oil and gas. [Link]

Well that’s not exactly the response I was thinking about – seems to be a rather poor investment case for UK PLC. Luckily we’ve formed another task force.

His visit coincides with the first meeting of a new task force of senior ministers set up to deal with the issue, chaired by Amber Rudd, energy secretary. The group will include Anna Soubry, business minister, and David Mundell, the Scotland secretary.

Together with the OGA there seems to be plenty of civil servants looking at the issue.

True to form – the FT actually got to the nub of the issue with its parting shot:

Many in the industry are also urging George Osborne, the chancellor, to relax the rules around who pays to decommission oil platforms when they reach the end of their lifespan. Many argue that the strict laws making anybody who has ever owned a particular platform potentially liable for its eventual dismantling are discouraging companies from buying up ageing assets and investing in them.

One energy banker said: “One of the things that could really help is if we see more takeover activity, with companies buying either struggling rivals or older rigs.”But the main thing stopping that right now is that nobody wants to take on potentially massive decommissioning liabilities.”

The BBC covers his visit here [Link]

Despite the decline in oil prices there is risk capital available but to take this opportunity irequires a few critical pivots. They are:

  1. Decommissioning liabilities stopping the trade in assets to lower-cost operators
  2. Un-certainty surrounding enabling infrastructure operated by others
  3. Mis-alignment of interests between partners meaning operating committees stopping development plans

Perhaps rather than expanding Aberdeen Harbour we could change the rules and use this £250m to help sort these out? At least it would be a start.

What do you think, is the proposed disbursement the best use of the money?

Collaboration reduces costs?

There has been a lot of hand-wringing around collaboration recently. For instance Paul Goodfellow Manager of UK Upstream at Shell said companies working in the North Sea need to learn from other industries on how to work together [Link]. Quite which industries he is talking about I’m not sure, also I am not sure what type of collaboration he’s looking for.

Worryingly for me there seems to be a focus on input costs. For instance one quote in the article stands out: “work with the supply chain on how to collaborate and get common purpose whilst driving waste from the system and driving unit costs down”.

When I analyse situations like this with clients I encourage them to take a view on both industry and supply chain, and be clear about the distinction. In Shell’s case their industry consists of other oil and gas operators. MMO companies, Scaffolding providers, helicopter operators and a myriad of other companies are part of the supply chain. They belong their own set of industries. Of course many companies supply services in more than one industry – so I need to consider them both in relation to their “competitors” and their own internal structure.

Here are three ways that cost can be removed:

  1. Industry collaboration between operators – to increase standardisation or share resources
  2. Adoption of new technology and methods
  3. Drive new processes to reduce unnecessary steps

These actions can increase efficiency which I define as the ratio of units of output to units of input. Assuming that output remains constant then efficiency comes from reducing system costs by removing labour or materials. This will increase the profit available for distribution among companies within the supply chain.

Reducing costs within the supply chain does not necessarily mean that Shell will see their input prices reduce – the location in the value-chain where profits are captured is subject to other factors. One model to explain how profit is captured was described by Michael Porter [Link]. Supply chain collaboration is, of course, important to organisations such as Achilles backed by my friends at Hg Capital [Link]. They set out some of their views on the issue here [Link].

In a commodity industry – like crude Oil and Gas production – there is little that producers such as Shell can do to change the selling price of their product (of course OPEC might have a different opinion [Link]). To protect profits producers need to reduce cost. At the moment operators seem to be forming committees to squeeze the supply chain. They are also laying off employees to cut overhead. I don’t see any action from Operators to collaborate with each other to reduce their own structural costs. Claims that they are seem to be a joint-ganging-up to encourage the supply chain to collaborate and reduce prices. That’s different.

Oil and Gas UK have stated that the North Sea needs to reduce costs by 40% within 5 Years or face very tough times indeed. Stephen Marcos Jones, Oil & Gas UK’s business development director, said: “Companies are having to make tough decisions on their capacity during the downturn and are individually taking measures to improve efficiency. However, co-operative working across the industry … can also help deliver the cost and efficiency improvements required to secure a long-term future for the UKCS.” [Link]

This quote from the Shell article highlights the inefficiency in buying within a single operator:

One very enterprising supplier came forward and said we’ve got a great piece of quick erecting scaffolding, but we don’t understand why you haven’t been picking it up. The reason was because they were trying to work at various front-line levels of the organisation and it wasn’t important to one individual, because they didn’t know the totality of what we were spending on that service. When they came in through the strategic contracting team and demonstrated to the facility managers and made the decision there and then and we’re in the process of deploying it across every facility and rig we have in the UK sector.”

I feel this is an example of an operator missing new technologies due to their internal bureaucracy and inefficiency. My clients can tell me about literally hundreds of examples of this type of behaviour. The reality of course is more complex. When I ran the technology investment process at a major operator I found that the cost (and risk) of scaled change was such that it can easily outweigh the demonstrable benefits delivered from a new technology. Therefore this type of change can be slow and the results can be counter intuitive.

So in summary to drive out costs we must answer the following:

  1. What time scale and magnitude do we need to work to (some are long-term structural and will take many years to deliver, other are tactical and can reduce Op-Costs quickly)
  2. What can we do to reduce the cost within the supply chain, and how will we ensure that those costs flow to the prices we are charged?
  3. What can we do to reduce costs within our industry by collaboration and standardisation
  4. What can we do to reduce our individual costs by simplifying what we do, eliminate unneeded activity and increase work-rates?

Of course, as you would expect, the professional services firms have opinions on this. Their approach and advice is nuanced and reflects many of the same themes. Some of what they are thinking can be found here: PWC [Link], Deloitte [Link] and [Link], EY [Link], Bain [Link] and KPMG [Link].

Incidentally the word-cloud image at the top of this post contains many of the words I’d expect to elicit from a group of oil executives. It comes from VOTE – an organisation based in New Orleans – the Voice of the Ex-Offender. It is a grassroots, membership based organization founded and run by Formerly Incarcerated Persons (FIPs) in partnership with allies dedicated to ending the disenfranchisement and discrimination against of FIPs. [Link]. Goes to show that many of the issues that surround collaboration are human ones and not things specific to our industry.

Private Equity Buying O&G Assets

With the INEOS deal completing I cast my mind back to 2014. It was rumoured then that over 75% of North Sea assets were for sale, but questions around ability to shoulder decommissioning liabilities and inability to agree on an oil price stifled deal making. Prices are depressed but major operators wish to raise cash and stifle outflows the interest for private equity investment is increasing. Managers such as Bluewater Energy [Link], Riverstone[Link] and many others are said to be considering deals.

The Financial times reports that this month’s redetermination of reserves in relation to asset-based lending is unlikely to cause havoc [Link] but it may accelerate deal making.

I recently asked a senior partner at a well-known advisory firm what he thought would be different with private equity arriving. He pointed out that the PE players backed management teams – such as Siccar Point, Fairfield and others. He thought that these management teams might be surprised about the amount of data and “proof-points” that the PE backers would require, he also reflected that some management teams would be used to working within large corporates with in-house teams they can mobilise. They will now have to find providers they can trust and who are credible in-front of investors.

The known model of exploration and farm-down during development is now giving way to a new world where valuations are determined using a DCF model and a decommissioning cost. There are no proven rules-of-thumb here now. This means that investors are more cautious doing deals in this context than before. It does appear odd that in a business known for taking investment risk on exploration there is almost no appetite for assuming risk or unknown in this investment stage.

Another advisor at a large accountancy firm noted that very few companies operating in the North Sea were likely to make a profit any time soon (not only because of tough trading conditions, but also because they have various offsets and other tax-shields). This means that decommissioning offsets and other tax-carry forwards are of little interest to them – this might suggest that either a change in the rules is required or that sale to a profitable entity could provide differential value and hence facilitate win-win deals.

Shell recently announced its opinion that oil prices may spike upwards soon [Link], that may be music to the ears of financial buyers. If this is the start of deal-making season it will be interesting to see who the players looking at acquiring assets are. Will it be PE backed new Co’s, will it be established late-life operators like Enquest, or will assets be acquired into existing profitable entities to enable tax optimisation.

INEOS, Small Fields, Politics and Tie-backs

Political intervention can swing both ways.  Political intervention in the L1 acquisition of DEA assets has enabled the INEOS deal announced today [Link]. This sees Jim Ratcliffe enter into the Upstream business with an opportunistic deal to buy assets reluctantly removed from the DEA portfolio [Link]. INEOS previously looked to be moving into shale developments in Scotland [Link] – the logic of vertical integration to supply his other assets is compelling. The shale move was stalled by the Scottish Government [Link]. Plus Ca Change, Plus C’est la meme chose as they say in the French Speaking regions around Lake Geneva where Jim’s HQ is located.

Perhaps Jim may consider lending his political influence to influence the debate over offshore developments – an area which is controlled by the UK goverment not the whims of the Scottish Parliament.

Perhaps he will point out the difficulty faced by new developments of  a small offshore oil-field which must find a way to process and transport the fluids to where they can be used. One way is to hook up to old platforms – many of which are now operating below their design capacity. As fields age production rates decline and this means platforms and pipelines built to support them become underutilised.

However, oil price declines means pressure has mounted to decommission the infrastructure that supports some of this production in the North Sea. For example Alex Mitchel [Link] says that he believes that the current fundamentals will lead to significant growth in decommissioning activity on the UKCS. He adds that operators are under increasing pressure to reduce exposure to high-cost regions, and remove decommissioning liabilities from balance sheets. Without traditional sale routes, operators will increasingly make strategic decisions to push forward with asset decommissioning. Advantages for first movers are evident, with the opportunity to avoid constraints in the supply chain, and take advantage of suppressed rig rates for P&A.

I asked a member of the Bestem Network who negotiated the commercial terms of some of the recent marginal developments what he thought. He told me that an FPSO option is often chosen not because it’s best, but because it increases control and reduces uncertainty. Tie-backs would be better but the modest initial tariffs can quickly change to become uncontrollable cost-sharing agreements.

FPSO’s require a certain volume to work effectively so they will inevitably not drain fields as fully as other options. Other fields will never produce enough to make an FPSO a viable option.

Once key infrastructure is gone, it is gone for ever. It will never be replaced. We have to act now if we are going to save this national asset.

Tax relief is not the answer – subsidy might be

As I was driving to Aberdeen last week I wondered what would happen if I considered the export and processing infrastructure in the North Sea was a road network on land.

Why would anyone build a factory in a remote area if they did not have access to roads? The same could be said of remote field developments that hook back into export and distribution systems.

Taking the analogy further, what if there was a road outside your proposed factory but it only led to the M6 Toll Motorway. What if that toll booth could raise its prices whenever it liked and there’s nothing you could do? What if sometimes when you turned up at the toll-booth it was broken, and no-one knew how long it would take to fix. What if, one day, you received a letter to say that they were digging up the motorway and restoring the land back to farming?

As a business man, I would find that unacceptable. I’d be a fool to build my factory at that location. And that, friends, is the situation we have currently have in the UK North Sea.

Not only is that the situation but – because oil prices are down – the probability of bad things happening has increased. Despite this Oil voice reports that MPs do not favour support of the oil and gas industry [Link] their report says that:

‘Tax reliefs and allowances can never fully offset the operational challenges posed by the falling oil price […] Whilst the majority of Government MPs appear to have made up their mind about their position, the latest developments could prompt a rethink. There is a potential opportunity for the industry to engage with undecided Labour MPs to make the case for additional support at this challenging time.’

I agree with the position that this is not about Tax relief. To address this will require restructuring the way that the industry operates. If not outright nationalisation of parts of the network, this – at least – requires more control and probably limited subsidies. For goodness sake – we subsidise the tracks that our trains run on, I can’t see any argument for the creation of economic value there that does not apply to our North Sea processing and export network.

When I talked about this at a networking event, an experienced member of the Bestem Network informed me that decommissioning must be sanctioned by the government. So, in a sense, because you need to apply for permission the assets are indirectly controlled by the government. But, as he then said, there are really no sanctions if you fail to operate assets productively or if they’re closed for maintenance. And, apparently, declaring a safety critical event before shutting in is something no-one has the balls to question. Apparently there is a voluntary “infrastructure code of conduct” [Link] that defines principles for access to other companies infrastructure but how effective this is in practice is something some members of the Bestem Network question.

The oil industry is in a down cycle – now is the time to be investing as a nation to maintain the capability to produce.

I am sure there are macro-economic arguments regarding the value of extracting assets under our control for any price (including opportunity costs for displaced workers and spending within the economy) vs. the export of national treasure in exchange for the import of similar from overseas. I am not qualified to make those arguments – if you are, please comment.