By John Kemp
LONDON, Jan 30 (Reuters) - Cutting the cost of everything from salaries and steel pipes to seismic surveys and drilling equipment is the central challenge for the oil and gas industry over the next five years.
The tremendous increase in exploration and production activity around the world over the last ten years has strained the global supply chain and been accompanied by a predictable increase in operating and capital costs.
When oil and gas prices were rising strongly, petroleum producers and their contractors could afford to absorb cost increases.
But as oil and gas production have moved back into line with demand, and prices have stabilised, the focus is switching once again to cost control.
“Operational excellence,” a euphemism for doing more with less, is back in fashion and set to dominate industry thinking for the rest of the decade.
Paal Kibsgaard, chief executive of Schlumberger, one of the largest service companies, has been emphasising “smart fracking” and other ways to raise output and cut costs for two years.
Speaking as long ago as March 2012, Kibsgaard warned: “In the past ten years, exploration and production spend has grown fourfold in nominal terms, while oil production is up only 11 percent.”
“In this environment, we believe our customers will favour working with companies that can help them increase production and recovery, reduce costs, and manage risks,” he added.
Schlumberger’s website and those of its main competitors Halliburton and Baker Hughes all prominently feature technologies and processes intended to cut costs, such as dual-fuel diesel-natural gas drilling and pumping engines.
It is just a small example of profound industry shift from an emphasis on increasing production to controlling spending.
Issuing a shocking profit warning on January 17, Royal Dutch Shell ’s new chief executive pledged to focus on “achieving better capital efficiency and on continuing to strengthen our operational performance and project delivery.”
On Thursday, the company cut its capital budget for 2014, and announced it was suspending its controversial and expensive Arctic drilling programme.
Shell is catching up with peers like BP and Chevron , as well as perennially tight-fisted Exxon, in promising to stick to a tighter spending regime and return more value to shareholders .
The problem is not unique to oil and gas producers. Miners like BHP Billiton, Rio Tinto and Anglo American have all axed projects and pledged to tighten capital discipline after costs spiralled out of control.
The worst over-runs have been on so-called megaprojects - investments costing over $1 billion, sometimes much more. In fact, the bigger project, the worse the cost overruns and delays have tended to be.
Pearl, Shell’s enormous gas to liquids project in Qatar, is now regarded as a success, but was seriously delayed and went wildly over-budget.
Other megaprojects like Chevron’s Gorgon LNG in Australia and the Caspian oil field Kashagan - which is being developed by an industry consortium including ENI, Shell, Total, Exxon and Conoco - have been similarly late and bust their original cost estimates.
It is convenient, but wrong, to blame poor project management for all the days and cost overruns. Some decisions have 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, worse than in 2003. Unfortunately, the economic and financial environment has become much less forgiving. When projects start to go wrong it has proved much harder to limit the delays and damage to the budget.
By their nature, megaprojects are so big they strain the global construction and engineering supply chain and pool of skilled labour. Megaprojects create their own adverse “weather,” pushing up the cost of specialist labour and materials worldwide.
Attempting to complete even one or two megaprojects with similar characteristics at the same time can strain the global supply chain to the limit. Attempting to complete several simultaneously is a recipe for severe cost escalation and delays. 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 oil fields like Kashagan, LNG facilities like Gorgon, floating LNG platforms like Prelude (destined for Australia), gas to liquids plants and even simple onshore shale plays like North Dakota’s Bakken, are all competing for the same limited pool of skilled engineers, construction workers and speciality steels.
The result has been a staggering increase in costs and wages. And once a project falls behind, there is no slack in the system to hire extra workers or procure additional or replacement components to get it back on track.
Rampant inflation and delays have been worst on megaprojects because they require a much higher proportion of very specialist components and the supply chain is least-elastic.
But even simpler projects like shale oil and gas have been plagued by a rapid rise in costs as they stretch the availability 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 of employees engaged in oil and gas extraction in the United States increased by 70 percent, from 117,000 to 201,000, according to the U.S. Bureau of Labor Statistics.
Soaring demand for specialised workers has produced an entirely predictable surge in wages.
Employees in North Dakota’s oil, gas and pipeline sectors were taking home an average monthly salary of $9,000 in the fourth quarter of 2012, and staff at support firms were making an average of more than $8,000, according to the latest data from the U.S. Census Bureau.
Their colleagues in Texas were doing even better: average salaries 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 United States. Only financial services employees in New York ($28,000), Connecticut ($25,000), California ($17,000) and a few other states were routinely making more.
Rising wages and other prices were the only means to ration scarce workers and raw materials. But they were also the only way to attract more workers and supplies into the industry.
It takes a long time to train new drillers, petroleum engineers and construction specialists, and give them the experience needed before they can assume positions as experts and team leaders.
Similarly, the expansion of specialist construction facilities and manufacturing firms for items like oil country tubular goods takes years; and companies will only expand or enter the industry if they are convinced the upturn in demand will be durable rather than fleeting.
While the boom in oil and gas prices dates from around 2003 or 2004, the big expansion of exploration and production spending started much later, around 2006 or even 2007, and it has only filtered down to the labour pool and the rest of the supply chain much more slowly.
It is the long delay between an increase in demand for oil and gas, an increase in production and exploration activity, and an expansion of the whole supply chain, which explain the deep cyclicality of the petroleum industry and mining.
Extreme cyclicality is hard-wired into oil, gas and mining markets. Companies like Shell which have tried to ride through the cycle by ignoring short-term price and cost changes to focus on the long term have eventually been compelled by their investors to fall into line.
In the next stage of the cycle, oil and gas prices are set to remain relatively high but are unlikely to rise much further. For exploration and production companies, increasing shareholder value therefore means increasing efficiency and bearing down on costs, including compensation and payments to suppliers and contractors.
For the supply chain and oil-industry workers, capacity and the availability of skilled labour will continue to expand, while demand is set to stabilise or taper off. Major oil companies and miners have already cancelled some projects. Costs, wages and employment will fall, or at least start rising much more slowly.