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Perspective Eric Spiegel

Matthew McKenna
Andrew Steinhubl
Looking to the Future
Managing Procurement
And Supply Chain in a
New Environment for
Oil and Gas
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CONTACT INFORMATION
McLean
Eric Spiegel
Senior Partner
703-902-3813
eric.spiegel@booz.com
Matthew McKenna
Senior Executive Advisor
713-650-4156
matthew.mckenna@booz.com
Houston
Andrew Steinhubl
Partner
713-650-4183
andrew.steinhubl@booz.com
Originally published as:
Looking to the Future, Managing Procurement and Supply Chain in a New Environment for Oil and Gas
by Mark Funk, Matt McKenna, Eric Spiegel, and Andrew Steinhubl, Booz Allen Hamilton, 2006.
1
Looking to the Future
Managing Procurement and Supply Chain in a New Environment for Oil and Gas
Procurement and supply chain strategies and
practices are set to move to the front of oil
companies critical issues in 2006. A combination
of external pressures is rapidly reshaping the
landscape to one that will have many perils, some
surprises, and a few opportunities.
External Pressures
Energy prices remain high. Current expectations are
that strong price levels are sustainable midterm. The
Organization of the Petroleum Exporting Countries
(OPEC) anticipates that oil prices will remain at roughly
$50 per barrel (bbl).
Industry capital spending on renewal and expansion
rose significantly in 2005; forecasts indicate that this
spending will increase more than 30 percent in 2006.
Last year, energy oil service and supply sector
customers experienced more than 20 percent inflation,
which was driven by demand growth and raw material
price increases. For example, some rig categories saw
nearly tripling of day rates within a one-year period.
Consequently, many major new projects have had to
absorb rising costs and the pressure of a tightening
labor market.
Heightened operational risks and uncertainties are
also considerations. Natural disasters (Hurricane
Katrina), business security (attacks on pipelines and
energy installations), and other, similar factors are
increasing project slippage risks and lengthening
1
Sheikh Ahmad al-Fahd al-Sabah (Opec President) said that he wanted the price of Opecs basket of crude oils to average between $45 and $55 in 2006 (December 2005).
operational integrity backlogs, in turn driving up the
cost and complexity of conducting business.
Each of these external pressures would in themselves
create challenges for oil companiestogether the
impact could be dramatic (see Exhibit 1).
The implications are that international and national oil
companies alike will need to reexamine procurement
and supply chain effectiveness. They will require new
robust strategies that can deal with the complexity
of this midterm business environment. Many players
have procurement models better aligned with the prior
supply environment, which featured commodity and
service excess capacity. Practices that maximized
value in this environment, such as spot bidding, will
not meet the demand of todays situation of broad
capacity shortages. Something has to give. For some
Exhibit 1
Procurement and Supply Chains under Pressure
Source: Booz Allen Hamilton
Sustained High
Prices
Renewal and
Expansion Spend
Heightened Risk
and Uncertainty
Tight Supply
Markets
Procurement
and Supply
Chain
2
2
Quarterly EBITDA of the 30 largest oilfield service companies has more than doubled in the year to q3 2005
3
Earnings before interest, tax, depreciation and amortisation
Exhibit 2
Announced 2006 Capital Spending Forecasts
Source: Booz Allen Hamilton
ConocoPhillips
Petrobras
Shell
Suncor Energy
35% increase 2006 capital budget to $14.8 billion
45% increase in 2006 cash capital to $10 billion
63% increase to invest $56.4 billion in 20062010
27% increase in 2006 capital spend forecast to
$19 billion
30% increase 2006 capital budget to C$3.5 billion
(U.S. $3 billion)
Chevron
Exhibit 3
2004-2005 Quarterly Service Sector Capitalization and EBITDA
Note: Suppliers here includes 30 suppliers from Bloomberg OFS Index (including Halliburton
Schlumberger, Baker Hughes etc.)Source: Booz Allen Hamilton
Source: Bloomberg
M
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Supplier Market Capitalization and
Quarterly EBITDA
Q1 04 Q2 04 Q3 04 Q4 04 Q1 05 Q2 05 Q3 05 Q4 05
200
180
160
140
120
100
80
60
40
20
0
10
9
8
7
6
5
4
3
2
1
0
the situation will catalyze changes and allow an
opportunity to build a new advantage over competition.
Current Reality Equals Aggressive Plans
Spend levels and expansion plans for international oil
companies continue to indicate strong growth. Exhibit 2
illustrates some recent announcements suggesting a
30 percent capital increase to meet inflation, under-
take renewal, and advance new megaprojects in 2006.
Details of these plans show that there is a desire to
increase spending in the upstream and downstream.
Expansion and renewal plans are increasingly common
among the national oil companies (NOCs). The Oil and
Natural Gas Commission (ONGC), Indias national oil
company, announced plans last October for roughly
$1 billion to renew its offshore vessels and jack-
up fleet. Saudi Aramco is investing $14 billion to
increase production from 11 billion to 12.5 million
barrels per day by 2009. Kuwait continues to entertain
discussions on bringing foreign investment into its
developments, e.g., the 20-year Northern Fields
project, with initial investments estimated between $8
billion and $11 billion.
The price optimization procurement and supply chain
strategies that oil companies developed to exploit oil
company buying power (advantages of large category
or commodity buckets of spending) at the end of the
1990s are not well aligned to current and midterm
market conditions.
Although the assumption that scale provides
purchasing power was effective in a soft service
market, this is not the case in the current environment.
Evidence suggests that several suppliers have
terminated or renegotiated long-term contracts with
oil-majors, realizing that short-term penalties could
be more than compensated by new and higher priced
rates. In a similar way to the structural change in oil
prices, the old rules no longer apply for procurement.
The service and supply sectors are enjoying greatly
improved shareholder returns and profitability (see
Exhibit 3), but are suffering equipment and skilled-staff
shortages. While it will take time to determine how
quickly the sector can expand, the relative benefits
of high rates versus volume growth will likely work
slowly through the system.
Will PSCM Create New Strategic Trends?
If these high-pressure procurement and supply chain
management (PSCM) conditions remain for the
next couple of years, will they have wider strategic
implications? Oil companies will sort out their supply
chain quickly if they see significant competitive
opportunities, and certainly if they start to experience
real business disruption. Already, accessing certain
construction and service skills has affected the timing
of major projects. When players do take action, what
might we see?
n
Will in sourcing make a comeback? Counter to a
core competency focus we may see select skills (e.g.,
capital project management) and some equipment
3
capacity coming back in house (e.g., liquefied
natural gas tankers, cofunding of rig fleet expansions)
n
Regarding prioritization, can industry deliver on it
plans, or will we see a move to managed growth, or
in some cases retrenchment. Avoiding the most acute
supply chain pinch points and delivering only the
highest-return essential projects may be the reality.
n
Further expansion into unconventional and alternative
energy projects may also occurareas that are less
reliant on the most stressed elements of the supply
chain. The creation of BP Alternative Energy may be a
move in this direction
n
Barriers to entry in the supply chain, especially at
scale, have in the past been substantial. However,
we may see new supply chains develop and
nontraditional suppliers gaining a stronger foothold.
Chinese, Indian, East European, and longer-term
Russian suppliers could become more important.
Access to cheaper labor and raw materials might
be an advantage, albeit with old equipment and
practices. The rise of NOCs (e.g., China National
Offshore Oil Corporation [CNOOC] and ONGC)
investing in international assets may act as a
bridgehead for the expansion of their national
service sectors.
Can We Simply Adopt a Wait-and-See Stance?
Oil companies that take a wait-and-see stance or
believe that existing approaches will keep a lid
on prices could have considerable problems with
2006 business delivery. New project delays and
cost increases were key features in 2005; in 2006,
these delays and price increases could affect smaller
projects and impact normal operations.
It does not appear that companies are outwardly
preparing for further inflationary shock to their costs.
Comments have been made in analyst and market
presentations describing inflation impacts but generally
after the fact
4
. Companies are likely to experience
staff-cost inflation as gaps appear and rates increase
in the service sector. Of most concern are shortages
of critical goods and equipment to be delivered in
accordance with existing business plans (e.g., the
impact of steel shortage in early 2005).
Service sector relationships have always been a
vital part of the business. For many years, service
companies have looked to build and enhance their
customer relations capabilities. Now, the pressure
may shift to the customer needing to keep good
relations with suppliers, or the capacity may simply
select to serve others.
Overheating has occurred previously, but not on the
current scale. The number of places in which supply
markets are tight continues to grow. Oil sands projects
in Canada
5
, Qatar, and Angola; new investments in
Libya; and growing interest in India are all on top of
activity levels in traditional areas.
Things to Consider
Companies can take many actions to be more effective
in this environment. They can begin by defining
PSCM as a strategic threat, then taking actions that
provide a balanced commitment to both cooperative
relationships and cooperative pricing, what we call
balanced sourcing (see Exhibit 4, page 4).
Taking action is not without problems. For example, the
desire to tie in capacity must be tempered with the risk
of overcommitting at the top of a rate cycle. Therefore,
examining the entire spend portfolio is required to
balance the short-term (spot) purchases, midterm
project commitments, and long-term supplier alliances.
Practical steps could comprise:
n
Understand the total system value of major
spending categories. This requires thoroughly
identifying costs and options across the supply
chain for each category and determining appropriate
interventions (e.g., seeking new supplier, changing
specifications, altering contract terms)
n
Build fit-for-purpose procurement processes that
provide clarity, engage suppliers early, and dont stop
at the transaction point; follow through to execution
and into operations
4
2005 Oil company quarterly trading statements
5
Greg Melchin, Energy Minister indicated in December 2005 that $80bn worth of new projects have been announced in Alberta
4
The likelihood is that something has to give. The
service and supply sector simply does not have the
current capability or capacity to absorb the spending
ambitions of all the players. The unknown factors are:
Who is well-prepared for this environment, and who will
be caught out?
Through these actions is it possible the industry could
break out of the cycle that for many years has seen
power shift from owners/operators to contractors/
suppliers and back again? We are well into one of
the most dramatic swings in that cycle. Could a
combination of smart actions by customers, longer-
term thinking by suppliers, and the emergence of new
scale players create a breakthrough?
Exhibit 4
Co-operative Procurement
Source: Booz Allen Hamilton
High

Unclear incentive to drive


improvement

Assumes supplier goal


congruence

Supplier may capture all of


the value creation

Appropriately leverages supplier


capabilities

Nature of relationship drives


improvement at both owner and
supplier

Requires signifcant owner


capability to structure
appropriate relationship
High
Low
Low
Trust-based "Partnership" Balanced Purchasing
Unleveraged Purchasing Darwinian Rivalry

Requires signifcant purchasing


clout

Eliminates supplier lethargy but


may instill resentment

Does not drive synergistic


improvement

Clerical purchasing mentality


of traditional Purchasing

"Price taker" results

Leaves lots of money on the


table
Target
Commitment to
a Cooperative
Relationship
Commitment to a Cooperative Pricing
n
Manage risks across the entire spending portfolio
not just within individual projects or commodities, or
splitting capital from operations spend
n
Proactively manage the supply base, select relevant
suppliers (not just the lowest-day-rate ones), focus
on alignment and sustainability (i.e., dynamic
relationships), and ensure company ownership and
accountability is clear to suppliers.
n
Institutionalize the capabilities required for supporting
procurement and supply chain activities. Today these
scarce skills are at a premium. In the next few years,
it will be just as important to cultivate the right
talent here as it will in the most critical technical and
operational areas.
10/08 Printed in USA
2006 Booz & Company Inc.
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