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IBP2109_12 COST TRENDS AND ITS STRATAGIC ROLE TO THE SUCESS IN DEEPWATER PETROLEUM EXPLORATION AND PRODUCTION Thales

Viegas1, Edmar de Almeida 2, Francisco R. Real3

Copyright 2012, Brazilian Petroleum, Gas and Biofuels Institute - IBP


This Technical Paper was prepared for presentation at the Rio Oi & Gas Expo and Conference 2012, held between September, 1720, 2012, in Rio de Janeiro. This Technical Paper was selected for presentation by the Technical Committee of the event according to the information contained in the final paper submitted by the author(s). The organizers are not supposed to translate or correct the submitted papers. The material as it is presented, does not necessarily represent Brazilian Petroleum, Gas and Biofuels Institute opinion, or that of its Members or Representatives. Authors consent to the publication of this Technical Paper in the Rio Oil & Gas Expo and Conference 2012 Proceedings.

Abstract
The aim of this article is to discuss the main cost drivers in deepwater projects and to analyze how the companies face that costs trends. This article is a part of a Ph.D. thesis which is being developed. First we presented the market factors to figure out the relationships between commodities prices, costs trends and capital investments in upstream. We also discuss the demand and investment correlation and the supply and demand sides of the equipments and services in the contractors industry. In addition, we did a short discussion about capabilities and strategies helpful in order to mitigate the effects of the cost escalation. Based on offshore project database we analyzed the cost structures using our cash flow model developed previously. Analyzing the results we could observe the regularities in those projects. Results show the huge importance of scale economies as well the capabilities development. Experience, long term partnership, technology skills and flexibility in project management are determinant on costs and financial results.

1. Introduction
The cost evolution trend of deepwater petroleum exploration and production are driven essentially by the limits and possibilities offered by the state of the art of the technology and by market conditions. The market analysis is undertaken through the comparison between supply and demand of services and equipments. During the last decade there was a scarcity of supply of goods and services for the upstream to deepwater projects. The evolution of the installed capacity of suppliers and contractors was slower than the increase rate of the demand for them. So, there was a continuous pressure on the prices of the factors of production. They trended to keep growing in the next years. Therefore, the market structure of the contractors industry is relatively concentrated. It gives them an important capacity to fix prices. Thus, the costs of upstream have some stiffness down when oil prices fall and the rate of investment (demand) slows down. However, when prices are rising rapidly, the costs follow that trend. In recent years, the volume of physical activity increased much less than the nominal upstream spending due to escalating costs. This issue was in a great concern worldwide due to rapid changes and the impacts it has on corporate strategies, on their risk and project management processes. And also, the regulatory framework is the main guideline to the cost management, so there are boundaries to the innovation initiatives that can improve the cost efficiency of deepwater projects. In addition, the exploratory frontiers have particular characteristics witch make the cost structures higher. Reservoirs placed in complex geological formations, in higher depth and remote locations became feasible because of the recent knowledge and technology advances but they are more expensive. On one hand, investments in technology research and development can help reducing cost of equipments and process if the innovation is successful. On the other hand, if does not work it jus add more cost. Innovation is risky, especially if the regulatory police are very descriptive. This article is divided into seven parts. This introduction presents the debate. The second section discusses general aspects of the evolution of the upstream costs, identifying key-drivers and market factors that determine the cost level. In the third segment we mention some regulatory issue. Then, we discuss the role of the development strategies and skills for successful performance on complex projects (deepwater), which have high capital requirements. The fifth

______________________________ 1 Ph.D. Student, Industry and Technology Economics - Grupo de Economia da Energia IE/UFRJ 2 Ph.D., Economics Grupo de Economia da Energia IE/UFRJ 3 Ph.D., Economics Universidad de La Laguna /Spain

Rio Oil & Gas Expo and Conference 2012 segment presents the methodology, which explains the set of modeling techniques used and the analytical tools developed for the study design. The sixth section discusses the results and the seventh part is the conclusions.

2. Cost Drivers in Petroleum Upstream


The history of international oil prices is quite marked by volatility. Due to its importance in determining the volume of exploration programs and production (E&P) oil and gas (O&G), investments in these activities are also cyclical. There are several factors that influence the trajectory of prices. It should only mention the most relevant, as following: i) the relative scarcity of petroleum and its products embodied in the relations of market supply and demand for these products, ii) changes in the cost structures of reserves development in different exploratory regions, reflecting geological factors, regulatory framework, and market conditions (supply and demand for inputs and services), iii) the dynamics of financial markets, where assets tied to the price of oil are traded; iv) the geopolitics facts related to the difficult access to reserves. However, the relationship between oil prices and investment in E&P is very strong in both phases of the price cycle, during the ascent and descent phases. Generally, there is a gap between the changes in each of these variables also due to long-term nature of the oil industry investments. However, there is an autocorrelation between the variables of investment, cost and prices of petroleum. There is not only one causal direction, although the influence of prices on the other is predominant. Figure 1 shows the annual variation of investments in the upstream side. It shows that other reasons may influence the level of investment. Technological aspects, economic and market conditions can accelerate or reduce investments in E&P. Highlights for the technology advance in the second half of the 1990s that opened new frontiers and potentiated exploratory activities in deep water, reducing cost of meters drilled over the time. Similarly, the costs of upstream equipment and services keep important relations with the price and investments levels in E&P. Although the correlation between oil prices and costs are high, it is more relevant in the ascending phases of cycles. This correspondence is reduced during periods of falling oil prices and investment. There is stiffness to decrease costs trends. There are four main reasons for this feature. First, the investment projects in offshore fields are complex and long term, as well as the supply contracts associated with them. These generally do not allow immediate adjustments in prices. Second, the concentration of industry contractors gives them great ability to fix prices, competing for oil revenues with oil companies. Third, the price of some inputs such as wages of the workforce, for example, is hardly reduced as a function of falling oil prices. Fourth, the majority of hydrocarbons found in the exploratory frontiers are placed in regions where the geological and environmental conditions are less favorable. It means that the cost structures of development and production of these reserves are increasingly higher. One relevant approach to understand the costs trends and industry cycles is looking to the finding and development cost. When the prices fall, capital expenditures (CAPEX) and drilling also drop off. At some point the supplier's products and services trend to reduce prices too; even there is any gap between those changes. So, it will be an incentive to the growth of new CAPEX. As the price rise, the higher marginal cost projects attract new investment. During oil and gas business cycles, the price falls below marginal cost of incremental supply sources begin to drop out of the market and the next cycle is generated. The full breakeven finding and development (F&D) costs is essential driver for the oil and gas prices. Full breakeven F&D costs include "drill-bit" exploration and production costs and the operational costs (OPEX) of hydrocarbons production. The figure 2 shows the breakeven oil price and full finding and development (F&D) cost are highly correlated. On average, depending upon other conditions, price was around 3-4 times greater than F&D cost to cover all expenses and provide a sufficient return on investment to spur drilling. Another indicator of coincident cost trend is the steel prices. There is roughly 74 percent of correlation between oil price and the common steel products price index (CEE, 2011). There are inputs in their supply chains. When steel prices are high, the oil costs and oil prices trend to increases and vice-versa. Steel production is an energy intensive process and oil projects, especially offshore, are steel intensive. That is the main reason to this closed relationship. Analyzing the US CAPEX composition between 2006 and 2010 it is clear the price elasticity of both Exploration and Development CAPEX per barrel was much lower than the changes in Proved and Unproved Properties Acquired cost per barrel in response of price variation. The larger amount of these acquisitions was made by the oil majors. Exxon have had the larger expenditure in reserves acquisition in 2010, accounting for 51% of the total proved reserve acquisition cost in that year. It makes sense because the 5-year (2006-2010) average of proved reserve acquisition cost per boe (US$ 11.89), significantly lower than the F&D cost per boe (US$ 20.83) as well the reserve replacement cost per boe (US$ 17.89). Exxon F&D cost in average was US$ 79,79 between 2008-2010. The 5-years average operational cost per barrel of the industry was US$ 12.09 (Enerst Young, 2011). This is general data including all sources of reserves from a cost benchmark study. In addition, there is an important inverse correlation between OPEC spare capacity and oil prices. The low level of supply capacity additions, at least during the last five years, made the spare capacity tighter adding worries about crude oil shortages in the market. Price level is directly impacted by incremental cost of supply. When the demand increases, oil supplies are delivered from even more expensive sources. It could make the demand and prices falls, so 2

Rio Oil & Gas Expo and Conference 2012 the most expensive projects are abandoned or delayed first, when the variable cost are higher than the marginal income. Deepwater activities usually involve complex and long term projects. They are not much flexible and frequently the larger part of the costs expended is like upfront CAPEX. Delays are very expensive and project abandon in many cases is not an alternative considered. The frontier reserves evolving more complex reservoirs, the advanced drilling and production equipments have attendant safety and environment considerations. In addition the increasing remoteness of frontier resources creates additional logistics management constraints and higher CAPEX requirement. Over the year 2000 the volume of oil reserves discovered in deepwater was upper than the volume found in shallow waters even if the amount of capital has been employed in the last one was higher. Furthermore, the increase of the nominal investment was greater than the magnitude of the increase in physical production, which expresses the rising costs. This inflationary trajectory will be further explored below. The deepwater discoveries in the world grew in number and size of reserves. In 2009 the average size of new discoveries onshore was approximately 25 million barrels of oil equivalent; while in deep water was more than 150 million barrels (Rigzone, 2010).

Figura 1: ndices de Custo de Capital, de Preo do Ao e de Preo do Petrleo WTI, Nmero ndice, de 2000 a 2012 Fonte: CRUspi, EIA, IHS (Elaborao Prpria)

Figura 2: U.S Full Breakeven F&D Costs and Crude Prices, Annual Basis, 1977 a 2009 Fonte: Bureal of Economic Geology Center of Energy Economics

Actually, the size of the reservoirs tends to have a significant impact on unit costs of production and development and therefore economic value of projects. Economies of scale are very significant in these activities. That's why some supermajors tend to be selective, preferring large projects comparing to smaller players. This is basically because it is the exploitation of large reserves that have significant financial and production impacts for these companies, besides being more profitable. Although the deepwater offshore production has begun in the 1970's, it became significant just in the 1990's. The increase in deepwater production occurs in the same period in which new technologies are the drivers of best practice performance of the E&P activities. In 1995 deepwater production was less than 200.000 boe per day in 1995. In 2001 she would have reached 2 million boe per day and in 2010 it reached 8 million boe per day (DOUGLAS WESTWOOD, 2010). Since the 1990s the main investors in R&D of technologies are contractors and suppliers. In some segments of suppliers the market the technology innovation is the best way of competitive differentiation of firms. 2.1. Investments and Market Structure of Suppliers and Contractors Industry: Demand and Supply Sides The investments worldwide in deepwater projects, from 2001-2005 were around $ 58 billion. Only the drilling expenditure between 2003 and 2006 were 10 billion dollars annually, the equivalent of 23% to total spending on offshore drilling. It is estimated that the annual value has doubled between 2008 and 2012. The forecasting for the five year period 2010-2014 is that the total investments will reach $ 167 billion. They practically multiply for threefold in a decade. About 85% of these investments have been growing for directing the three most promising regions, namely North America, Brazil and West Africa (Douglas-Westwood, 2007, 2010). The Figure 3 shows the positive correlation between CAPEX investment and oil demand. It called the attention to the periods (1981-1985 and 2007-2012 excluding 2009) when the oil prices and upstream costs where higher than the historical trends. 3

Rio Oil & Gas Expo and Conference 2012 Analyzing the trend line coming from 1995 its derivative is higher. Variations in oil demand cause stronger changes in E&P expenditures comparing to the trend coming from 1980. Since that decade the oil consumption keep increasing during almost the whole period. The oil supply side, usually follow the oil demand trend with some lag. The industry spare capacity swings gives signals, which has impacts in the oil price and the CAPEX investment levels. At the supply side is the equipment and service industry of upstream of O&G. It includes businesses that provide equipments and services of different types on a contractual basis. They get inputs from various sectors of the economy making the complete chain of the oil sector relatively complex. Nevertheless, the offshore rig supply could be used like a good proxy of the other offshore services supply because they are much correlated. So, the Figure 4 shows that the elasticity of the offshore rig supply became really low after the investment boom at the begging of 1980s, followed by the oil counter shock. And until 2007 when the high level of oil prices became consistent, the offshore rig supply did not change significantly as a function of the oil prices variations and to the equipment and services demand changes. However, in 1999 the first semi-subs and drillships were built. Since then, an increasing part of the capacity additions were composed by those rigs. From 2007 the high oil prices and deepwater opportunities had been given the enough incentives to capacity additions of the offshore drilling industry, which should be maintained looking forward.

Figura 1: Correlation between E&P Capex Expenditure and Oil Demand, Fonte CLSA (2012a)

Figura 1: Supply, Demand and Utilization of Rigs, Rig Rate and Utilization Rate; from 1981 to 2011 Fonte CLSA (2012a)

The whole industry is fragmented in several segments and most of them have a concentrated market structure. However, taking in account the whole industry the three leaders have together around 20% of market share. It is not too much, but in each market segment the leaders have a great portion of market share. In addition, they are evolved in most of these sub-sectors, the exception is the infrastructure segment and drilling contracts, which are the two extremes in terms of profitability. Firms more focused dominate these segments. Both involve high capital requirements and are less technology-intensive. The integrated firms (leaders) invest systematically in Research & Development (R&D) of new technologies to get competitive advantage. Since 1990, Merger & Acquisition (M&A) movements increases motivated by seeking of specific technologies and capabilities, especially among suppliers and contractors (Porter, 1998). Between 2003 and 2007 the profit margins in this sector have varied, on average, around 20% to 30% of gross revenues. The infrastructure segment has the smallest margin (around 10%) and the segment of drilling contracts can even hit an average of 40% of profitability, as happened in 2007, when the industry contractors earned around US$ 250 billion (Bain & Company, 2009). The set of segments connected to the drilling activity could be considered the most important of the whole chain, because it accounts for about one third of global turnover in the sector. This industry has been growing during the last decade. The 12-year CAGR (2000-2011) of the global oilfield market was 12.4%. In 2011 the global income was around US$ 300 billion and it should around US$ 343 billion in 2012. The top three major segments are, as following: i) pressure pumping services responding by 14%, the offshore contract drilling by 11% and the offshore construction services by 10%. The first are related to the shale gas boom which requires hydraulic fracturing. Its income was more than US$ 16 billion in 2006 and almost US$ 38 billion in 2011. The offshore drilling varied between US$ 26 billion to US$ 42 billion in the same period (CLSA, 2012). Although the growth rate of the industry was high, some segments coexisted with insufficient supply capacity to meet the demand in the last decade. There are some bottlenecks in supply. The shortage of skilled and experienced workforce is an important part of the problem. Economic cycles also do not give enough incentives to a systematic trend of investment in new capacity, at least because of three reasons. First, idleness is expensive in this sector and supplier's 4

Rio Oil & Gas Expo and Conference 2012 investments increase their idleness risk. Second, the relative scarcity of inputs may allow higher profit margins to contractors. Third, there are significant barriers to entry in this activity that has low external competitive pressures. For example, the big oil companies only contract services of companies which have more technological capabilities and experience. Other entry barrier is the capital requirements. The drilling activity is very capital intensive, for example. These features only reinforce the trend towards concentration in the contractors sector.

3. Regulatory Framework
The strong price volatility in recent years and incident at Macondo oileld in the Gulf of Mexico added uncertainties to the deepwater oil industry. Players are yet recalculating the risks of the deepwater offshore activity. U.S. government changes the regulatory system and the industry agents expect it may lead to higher costs, around additional 10%. From the smaller oil companies point of view, the raise of the insurance premiums and liabilities cap in GOM could be cost-prohibitive to invest in new projects. Together they produce by around 60% of the GOM production. In addition, the incident gave incentives to changes in oil companies operational strategy, particularly as their safety record are becoming one of the most important factors in gaining access to reserves around the world. Some oil firms, especially BP and Shell, has demonstrated reviewed its drilling performance and also their managerial reward structure, as well as their relationships with contractors and suppliers, to manage risks better (The Economist, 2011a). Increased proportion of expenditure should be directed towards investments into safety and accident prevention. The US regime becomes more prescriptive which is similar in many ways to what already exists in some countries in Europe. It involves fairly detailed technical aspects of drilling, some of them related to equipment requirement like blow-out preventers (BOP) and well cap. Recognizing the increased risk, Shell, Exxon Mobil, Chevron and ConocoPhillips established the Marine Well Containment Company, a non-profit venture aimed at reducing the industrys exposure to big incidents. The costs of a disaster usually are much higher than the prevention initiatives. US government should require a well cap service contract of the potential operators companies in GOM (). In fact, the safety regulatory policy is very important to the technologic path too. The regulatory authority faces a trade-off between a discretionary and a market-oriented environment. If the regulatory agency allows any innovation the risks could be higher, but if it intend to leader the technological development the innovation incentives are reduced. The petroleum fiscal system can influence the results of a project as we discussed in Almeida et al (2011) and Viegas (2012). First, the difference of time when the incomes and expenditures happens changes the cash flow outputs. Second, the parameters like government take and risks are not the same and they are relevant to the financial results. Third, there are more incentives to operators innovate on a concession regime then a production sharing contract (PSC). The operator and the other investors enjoy all benefits achieved by technological or organizational improvements on concession system. In addition, the cost management on the PSC regime is more complex and expensive too. Local content requirements in countries such as Brazil may also raise costs even more. If the local industry can develop and compete with international players, operators have much to gain from increased competition, but if the local market is unable to provide the critical resources (materials and labor) in the quantity and quality desired by the industry, the costs tend to rise. This is because the security market allows local industry to operate with higher margins than their international competitors or even sustain its market share despite being far less efficient than them. Frederice (2008) and Promimp (2005) discuss this issue. We should call attention to the Brazilian fiscal system, which has an important weight on the local products prices. It helps to make Brazilian products and services less competitive. Cost escalation existed before 2008, with rising materials and labor costs, could come back in the next years. Inflationary process should come from contractors manpower too. It happened because of the global skills shortage. The lack of suitably qualified labor is even worse in regions where the investments are increasing fast like Australia and Brazil, for example. There are challenges in training the new labor force. Some skills, knowledge and experience lost through retirement are more difficult to replace in fields like subsea with other workforce areas. The generation gap in the industry and the insufficient training investments in some periods are the main causes of this lack of labor force. So, training programs policy is a strategy to improve capabilities and should have incentive from the public policy too.

4. Capabilities and Strategies


Companies are shaped by its history. Similarly, the different experiences of the workers can make them reach different results in some degree; even they receive the same training and use similar instruments. The differentiation of economic agents is a major form of market competition. In the business model of the upstream petroleum sector, however, there is an apparent paradox. It is common cooperation between the different actors involved in this activity (Acha & Cusmano, 2001). Even among oil companies in developing solutions for improved security conditions, health and environment (HSE), for example. Most investments are made by consortium; however the main reason is sharing risks in several fields. 5

Rio Oil & Gas Expo and Conference 2012 The model of risk management of a company can generate market differentiation. Some companies may prefer to get the majority share of the fields and act as operator in most of their investments because they believe to be more capable and efficient to operate deepwater fields, for example. The majority of the partnership trend to be the most important way to define the operator, but it is not the only one. There are others incentives to be an operator. First, having more flexibility of portfolio managing. Second, controlling the whole development and operational processes. Third, use its capabilities and its relationships and take advantage properly of the opportunities for scale economics. Another company may prefer to position itself in an exploratory frontier just as an investor. The aim to invest could be accumulating knowledge about the operating process or also to take advantage of the capabilities of its possible partner, even if it means not to accumulate experience as operator. Even each company has their own strategy; all of them have a competitive nature and seek to extract the greatest return of the resources and opportunities available. Although the 1990s was marked by a migration of most R&D for the oil companies contractors, some majors still invest significantly in technology. The ability to position themselves into new frontiers of technological knowledge requires the efforts of R&D even toward learning and technology absorption from outside. The ability to specify and design the project, equipment and appropriate services could be a source of cost efficiency and market competitiveness. Different conceptual models and project development strategies important elements of costs differentiation. However, Osmundsen (2010a) call attention that oil companies must be challenged to give weight to technical and organizational quality when awarding contracts, including technical performance in excess of specifications, in order to provide incentives for the development of new technology and solutions. According to Osmundsen (2010b), taking in account shallow water fields, the experience of the drilling facility and the experience in a particular area (measured by the cumulative number of wells drilled) has no positive effect on productivity of well drilling, suggesting that congestion externalities and depletion effects dominate learning effects. However, the experience is important when drilling large water depth as well as in areas where there are challenges in terms of pressure variation. Oil price recovery at the second half of 2000s and the recent technological advantages helped oil companies to achieve even tough deepwater areas. These technologies dominated by some oil and gas firms give them capabilities to develop resources in deepwater, which is one of the most challenging environments and where enormous challenges for the industry remain ahead. It means, higher capital expenditure and more complex techniques are required. Most of deepwater drilling evolves horizontal wells, which are more expensive to drill, by definition. Rising operating costs are also a big concern for oil companies. The deepwater activities are increasingly more technically challenging and evolving higher financial requirements Herold & Lovegrove (2009). In fact, the cost structures can vary significantly. Differences in geological formations, settings and location of reservoirs, as well as the differences of technological and organizational capabilities of companies may have important impacts. The skills of contract negotiation, in many cases, could be another good source of efficiency. It allows companies taking advantage of the scale economics, of the long term relationship building and of their proper market analysis. It usually is more relevant to the super majors and less important for the oil majors and the small firms. The ability of the big oil companies to design scenarios and strategies for contracting and bargain better prices depends on their market share at the demand side. In deepwater the access to the drilling equipments could be an advantage taking in account the supply shortage. In this case, from the point of view of the oil company the long term contracts could be a cost-efficient strategy if it has enough drillings opportunities to avoid gaps in the drilling activity. Costs growth and delays may reduce the relative economic attractiveness, with marginal projects being cancelled or delayed. This kind of risk is more significant to big projects. So, increasingly, companies are relying on smaller sized construction projects to balance cash flow and risk in their portfolios. The smaller operations can be delivered faster and more efficiently than mega capital investments. Having a portfolio with them helps to secure steady the organic production growth. It offsets the long period requirements to development larger projects. In order to be more cost-efficient, companies streamline project development by standardizing processes, procedures, supply chain relationships and management methods. Standardization technique enables project teams to speed construction, cut costs and secure incremental advantages on subsequent projects. It allows get better returns of the investments. The benefits of this technique are achieved only when owners, contractors and project teams implement strategies to reduce risks and capitalize on lessons learned. It requires keeping in mind the duplication approach since the first project, as well a rigorous project management structure and strong leadership of the sort more frequently associated with larger investments. Through the standardization of components and project management methodologies, oil and gas companies can cut cost by 15-30% and time to completion by 15-40% of their projects (The Economist, 2011b). Standardization is a long-term process that require an integrated approach and an optimized process. The time and cost savings comes from scale economics gained by supply chains for volume discounts, streamlining decisionmaking, building long-term relationships with contractors and formally implementing a companys lessons learned through an iterative process (Langdon, et al 2010). This requires several years of acquired expertise to deliver projects with speed and precision. The company should identify cross-functional optimization strategies between relevant work teams. It reduces wasted time and increases productivity. 6

Rio Oil & Gas Expo and Conference 2012 However, the main challenge of applying this technique is reallocating the top talent teams and leaders from the large projects. They are essential in both in order to reduce risks and costs of them. As well big projects, the replication process requires support of experience and leadership of a project manager and a rigorous project management structure. The standardization allows developing a portfolio of project templates which evolves common drilling scenarios. This gives flexibility to companies to manage their portfolio, mixing and matching project components to face physical or environmental challenges, and the scalability of modular processes for expansion.

5. Methodology
The model developed has assumptions according to the Brazilian taxation under the oil concession system. The model is founded on a cash flow that considers a production curve of 30 years and based on the cost structure associated to its production rate. The model calculates the return on invested capital. We created two scenarios for comparison. They differ according to the following variables: (i) relevant geological conditions of the reservoir, (ii) the discount rate and (iii) investment cost (Capex), (iv) the average price of a barrel of oil equivalent. It is also performed a sensitivity analysis with these four elements. We used just one scenario for oil price of US$ 80, which is approximately the average price between 2009 and 2011. It represents the possibility of price falling, from average level of 2012, because of the current world economic cycle. The second is about the current price level. The discount rates were considered 10% and 12%. These levels are compatible with the cost of capital and risk involved in these kinds of projects. Capital cost of investment (CAPEX) is the most difficult variable to estimate in order to do an economic analysis of projects, so we use our cost database. We choose to consider three values of CAPEX based on historical projects cost (updated with the proper cost index) and expectations of players inside the market: $ 8, $ 12 and $ 15/barril. The CAPEX does not include the exploration phase (finding costs). The project cost information used in this modeling is part of a database composed by the first author for use in his doctoral dissertation. It allows the economic modeling required. They refer primarily to the costs of exploration and appraisal (E&A) Capital costs (CAPEX), operating costs (OPEX) and Cost of Dismissal. The geological risk rate is 50%. Both interest rates of equipments lease and the discount are 10%. Decline rates vary from 10% to 15% according to size and location of the field. The modeling of the taxation process, cost structures and production curves are made separately from cash flow. The first is the framework of different categories related to the regime of REPETRO, chartering, rental and other services. The calculations of Income Tax, Special Participation and Depreciation (per unit of output) are also carried out separately and follow the current law. In order to build the model we used the bottom-up approach to capture the relevant geological conditions of formation and the cost structure of the project. Top-down approach sets the oil prices, the end the capital discount rate. In this case, these two variables work as independent variables in the model. Established the reservoir and cost profile used (including production curve), the model allows sensitivity analysis using four dependent variables. Their levels are defined according to the top-down logic, by changing their magnitudes, coefficients and other structural parameters of the model. This means that the model is flexible, adjusting to the analysis of different projects at the regarding of the Brazilian regulatory framework under the concession regime. Although the database used contains projects based worldwide, we decided to restrict the analysis only to fields developed in Brazil, GOM, North Sea and West Africa, totaling 140 projects. Multiplier coefficients were adopted to make the costs comparable. The coefficients were calculated based on the cost structure of projects in different regions, namely, based on the costs of the four following items: i) production/host unit, ii) subsea systems; and iii) pipeline infrastructure. The costs were submitted to a cost index for the upstream to allow the comparison between projects performed at various points in time and in different regions. The basic cost index used was the UCCI, available for download from IHS website. The index UCCI is robust for the analysis of the upstream petroleum industry. To adjust to deepwater market we use a correction factor to fit better to characteristics of the specific projects on analysis. Costs calculations and analysis were done based on three field sizes. The first has 250mmboe, the second has 500mmboe and the last one has 750mmboe of hydrocarbons reserves. Among them there are 74 oil fields with recoverable reserves level between the lower and the higher levels mentioned. The cost data was weighted by many differences between projects as: region, location, technology and regulatory. This study used information which can be found mostly from the following sources: (i) SubseaIq (ii) Rigzone (iii) Baker Hughes (iv) ODS-Petrodata, (v) Agncia Nacional do Petrleo (vi) IHS, (vii ) Transocean (viii) BP Statistics, (ix) Energy Information Administration (EIA), (x) Base Edgar (SEC), (xi) Statements of Operations and Financial Companies, (xii) American Petroleum Institute, (xiii) U.S. Department of Interior (DOI) and (xiv). Highlight the following sources of cost information: EIA (2009), Eastern Research (2011), Enerst Yung (2011) and Howard Weil (2012). A supported data source above analyzes conducted cost studies that will be presented. The main variables used in this model are: (i) name of the field, (ii) water depth, (iii) drilled depth, (iv) the field of development capex (vii) reserves (viii) date of discovery, and (ix) date of first oil produced, (x) the province of the field, (xi) the name of the operator (which are blamed). The objective is to analyze the cost efficiencies of different 7

Rio Oil & Gas Expo and Conference 2012 projects of exploration and production at large depths. Furthermore, also using the cost index developed by IHS for upstream to analyze the correlation with oil prices and the utilization rate of drilling rigs in deepwater. It will also be made a separate analysis of correlation between the industry cost inflation, the costs of finding and developing reserves of the companies and the provinces where their projects and the main characteristics of the same. The aim of this is to know if the cost escalation was more relevant than the entry into new frontiers to explain the rising costs in recent years.

6. Results
Actually, some factors of production such as labor force do not have flexible compensation, preventing movement of adjustments in the same period. When oil prices increase again the market tends to get over demanded. Many oil companies have had to postpone their projects in the downward phase of the price cycle has occurred recently. In this sector the delays are costly. We analyzed the effects on costs and investment return rate of three kinds of oil companys capabilities. Later we represented the aggregated effects of them. At the end we calculate the SMS Regulation Effects. All of them where shown by the three amounts of reserves level represented by IRR1, IRR2 and IRR3 on the graphs. Results are presented on the vertical axis in percentage of capital investment. The four capability development stages are shown on the horizontal axis. The number one (first group) are represented by companies which has, generally, the minimum required expertise and a small size. The second group is more experienced then the first. The third is made by larger companies and the forth by the big leaders in offshore reserves development and production. The first and very important aspect is the technological capabilities which are shown on the figure 5. In average the IRR change in 3,5% between the lower level of capability and the highest are. It represents changes a relative difference which varies around 18% and 20%. At the very beginning, using the gross company level data it is not possible to see a very clear and direct relationship between higher technological capability and better results on costefficiency. As expected, the bigger reserve gives better results because of the many ways of scale economics. The figure 6 was calculated based on the life period of contracts between the operators and the suppliers of services, rigs and platforms. The smaller companies usually do short term contracts while the leaders trend to prefer long term contracts, especially because they have more projects the operate across the time and the can bargain better conditions in their contract negotiations. The IRR changes 5% in average between the two extreme types of companies. In other words, the results can change in until 34% from the higher efficiency level to the lower.

Figura 5: Technological Capabilities Effect on Investment Return Rate, four cases, (%)

Figura 6: Relationships Capabilities Effect on Investment Return Rate, four cases, (%)

Figure 7 shows the organizational capabilities can contribute to get better financial results of at least 20%, achieving 30%. Figure 8 presents the all capabilities effect on the investment return rate. It can change almost 100% from the worst to the best case. It means that a company which takes advantage of its high capabilities can have results to fold better then a firm which have no experience and capabilities internally developed.

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Figura 7: Organizational Capabilities Effect on Investment Return Rate, four cases, (%)

Figura 8: Agregated Capabilities Effect on Investment Return Rate, four cases, (%)

The Health Safety and Environmental (HSE) regulation analysis are shown on Figure 9. The last case are the more strict and expensive regulatory environmental. The larger field represented by the IRR3 do not have much impact until the third case, but in the last one its very significant. The additional costs with well cap and equipments redundancies probably will penalize larger fields.

Figura 9: Ambiental Regulation Effect on Investment Return Rate, four cases, (%)

The local content effect on costs is very significant. However, it is hard to measure or estimates its real effect, because it changes case by case, so it is even hard to generalize.

7. Conclusions
Oil industry is facing many challenges in the last years. The main one should be finding oil, but the amount of oil discovered was significant during the last years. Actually, many of these resources discoveries come from unconventional sources or from traditional reservoirs placed in hard environments like deepwater or pre-salt exploration and reserves development, for example. It requires specific capabilities to find that oil, but especially to develop reserves efficiently, maintaining the economic attractiveness and also the safety and reliability of the whole project. There are differences between characteristics like location, geological feature and regulatory framework between different oil fields. They influence the concepts of reserves development adopted by companies, but do not explain the regularities presented between different projects operated by the same company. This study tried to control these peculiarities reasonably in order to make projects more comparable. The data confirm the importance of economies of scale related to the reservoir side as well associated with standardization and replication strategies. On the other hand, those strategies require using the best and most experienced work force when at the beginning. The cost reduction can be higher than 30%, especially by reducing the time of drilling and completion. The technology influence on the project results can happen by many ways, either through equipment or knowledge related to their specification and use. Obviously, the type of platform used and its capacity has an impact on costs, as well as the infrastructure related to it. First, the technologies used in the equipment are similar in accordance with the best practices. Second, the ability to use and specify equipments properly, adapting to different situations, provide opportunities for differentiation in terms of cost efficiencies. Actually, there is no only one best practice, but it 9

Rio Oil & Gas Expo and Conference 2012 can change somewhat field by field. Maybe we can say there is a best practice to a specific location and reservoir. However, the essential skills are related to the experience and therefore the number of projects executed by an operator. Companies that operate more projects have more power in the relationships with suppliers. The bargaining power in negotiating and the ability to identify non-compliance items have an important impact on costs. Furthermore, establishing relationships based on longer-term contracts can promote relational learning which is capable of reducing time and cost, maintaining the reliability. So, the main forms of learning that cost impacts are the following, namely: geological, regulatory, technological and relational. There are other sources of cost efficiencies as: i) exploitation of economies of scale, ii) the standardization and replication strategy, iii) better access to reserves more accessible, iv) minimizing rework and project changes. This last one requires the ability to anticipate potential problems and a welldefined implementation roadmap, as well as the suitability of each project inside the long-term global strategy. In addition, managing projects jointly increases the portfolio flexibility and the cost management can be even more efficient. There is also a typical dilemma between make (internally) or buy (in the market) some specialized services for which there is some shortage of workforce. The technical activities carried out by consultants can be of better quality in many cases, but can be more expensive in many cases. Anyway, many companies do not run a lot of projects of similar features and they prefer to buy that services because they do not need some professional full time, it gives them more flexibility. So, they can work with specialized labor force and some of them try to over compensate the cost in downturns companies lay off workers and reduce their spending on staff training. On the other hand, during the ascending phase of the cycle businesses they face some difficulty to hire workers with the required level of knowledge and experience. In fact, some factors of production, such as labor force, do not have flexible compensation, which do no allow adjustments in a short term. When oil prices increase again the market tends to get over demanded. Many oil companies have had to postpone their projects in the downward phase of the price cycle has occurred recently. In this sector the delays are costly and there are some variables that can be controlled to avoid time wasting. Planning expertise is essential to be successful, but the oil companies cannot avoid delays from suppliers and they must be prepared to that. Some companies do not want their portfolio performance to be based only on major projects. Even smaller projects do not necessarily have smaller risk the balance between them comes with its own set of challenges. Replication of projects done in the same region with similar regulatory conditions can allow reducing the compliance time and cost. The regulatory learning curve matters to delivering consistent projects after changes in the regulatory environment postMacondo incident. Oil and gas exploration and production is a risky activity, by definition. In order to offset these risks even big oil companies can diversify their investments to balance high-risk mega-projects with smaller initiatives. Currently, that is a trend because large fields are increasingly hard to discovery. On one hand, the smaller fields are usually less profitable than the larger fields, but on the other hand the smaller can be streamlined and replicated to reduce uncertainties, speed delivery and produce a steady stream of profits at increasingly lower costs.

8. References
ACHA, V.; CUSMANO, S. Sharing capabilities, Patterns of R&D Co-operation in Upstream Petroleum Industry. In Conference The future of Innovation Studies Eidhoven, 2001. ALMEIDA E.; VIEGAS, T.; DIAS, F.; EBELING, F. Production Sharing versus Concession Contracts in Brazil Upstream: An Economic Comparison. 34rd IAEE International Seminar Stockholm, June 2011. AGNCIA NACIONAL DO PETRLEO (ANP). Desenvolvimento e Produo. Disponvel em http://www.anp.org.br (Acessed em outubro de 2011). BAIN & COMPANY. ESTUDOS de Alternativas Regulatrias, Institucionais e Financeiras para a Explorao e Produo de Petrleo e Gs Natural... BAIN & COMPANY. Disponvel em: <http://www.bndes.gov.br/SiteBNDES/export/sites/default/bndes_pt/Galerias/Arquivos/empresa/pesquisa/RelConsol -4de6.pdf>. Acesso em: 05 dezembro. 2009. BEGCEE. BUREAU OF ECONOMIC GEOLOGY CENTER OF ENERGY ECONOMICS. Economic & Policy Consideration: Reserves Symposium, July 19, 2011. CLSA. Subsea Acceleration: fathoming new technologies. Blue Books: Experts views for expert investors. 2012 DOE. U.S. Department of Energy. Energy Information Administration. 2008. Financial Reporting System Survey - Form EIA-28. Schedule 5112 - Analysis of Income Taxes. http://www.eia.doe.gov/emeu/finance/page1a.htmlDownloaded April 22, 2008 Douglas Westwood. World Deepwtaer Market Report 2010-2014. 2010. ERNEST & YOUNG. Revenue from contracts with customers impact on the oilfield services sector. IFRS financial reporting issues in the oil and gas sector. 2011 HEROLD, J; LOVEGROVE, H. (2009) Global Upstream Performance Review 2008. 10

Rio Oil & Gas Expo and Conference 2012 HOWARD WEIL (2012). F&D Cost Study 2011. LANGDON, S. ET AL. Deepwater Drilling Challenges Demonstrate Learning Curve with New Connection Technology. IADC/SPE Drilling Conference and Exhibition. 2010. OSMUNDSEN, P., T. Sorenes, and A. Toft. 2010a. Offshore Oil Service Contracts - New Incentive Schemes to Promote Drilling Efficiency, Journal of Petroleum Science and Engineering 72, 220-228 OSMUNDSEN, Petter & Roll, Kristin Helen & Tveters, Ragnar, 2010b. "Faster Drilling with Expercience?," UiS Working Papers in Economics and Finance 2010/7, University of Stavanger. PORTER, M. E. Competitive Advantage: Creating and Sustaining Superior Performance. New York: Simon and Schuster. 1998. RIGZONE. Analysis: Deepwater Discoveries, Production Still Critical to Reserve Base. 2010 THE ECONOMIST (2011). Deep water ahead? The outlook for the oil and gas industry in 2011. THE ECONOMIST (2011). Economies of scale: How the oil and gas industry cuts costs through replication. VIEGAS, T. Explorao e produo de petrleo e gs em guas profundas: evoluo e tendncias IV. Blog Infopetro. Rio de Janeiro, 26 de maro de 2012.

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