Supply Chain Management & Outsourcing Strategies

Supply Chain Strategy in the Oil and Gas Sector

a report by

Eric Anderson
Supply Chain Management Strategist

Background

Buying Power

Eric Anderson is a supply chain management strategist working for a major engineering company. He has worked for engineering contractor majors since 1997, until recently heading e-procurement at Kvaerner. He has 20 years of experience in engineering, marketing and supply chain management, spanning the Americas, Asia and Europe. Mr Anderson holds a BSME from the University of Connecticut and a Masters in Economics from the University of the Philippines.

The supply chain in oil and gas consists of operators (oil companies), main contractors, subcontractors and suppliers. Procurement is performed during the development and abandonment of oil and gas fields and during operation of fields (production). During development, the majority of procurement is structured as project execution tasks. Projects are unique and typically range in size from the tens of millions of dollars to billions of dollars for large offshore new builds. Big projects perform like fiscal expansion in an economic sense. Forces that govern the supply chain in oil and gas are internal (business-related) and external (political/economic). Of the factors that influence supply chain strategies and differentiate this sector from other business sectors, there are four that will particularly be considered here: the cost of field development must go down if marginal (profit) fields are going to be developed and alternative energy is going to be kept at bay; oil companies are big and getting even bigger mostly through mergers; oil prices fluctuate greatly; and oil companies are subject to various political pressures. Large operators interface with governmental entities worldwide and some are closely linked to governments themselves. Main contractors are often traditional engineering/construction/service companies, some of which have been nurtured under years of protective development policies. Subcontractors and suppliers are manufacturers and service companies or regional agents with added value in the form of engineering. Expertise is the common factor that binds this supply chain network together with the assumption that requirements for safety and uninterrupted operation are never compromised.

Important to consider is that the cost of bringing oil out of the ground is going to increase as more challenging fields are being tapped, while cost of alternative energy is decreasing as technology improves. In addition, oil companies compete with each other when bidding for licences to operate. Among operators, it is commonly thought that only the biggest will survive because they can absorb risk better and have lower relative operating costs. The mergers of the 1990s confirm this. Academia agrees. As expressed in textbook equations, after optimum size is reached, companies become difficult to manage, logistics clog up and supplies run out. However, with improvements in information technology (IT), optimum size keeps increasing, therefore oil companies still merge, unite their buying power and make it more difficult for new entrants to compete in what could be coined oligopoly infanticide. The result is being felt at the top end of the supply chain bigger means stronger buying power. With increased buying power, long-term supply chain strategy such as win-win, which was still an issue in the 1990s, tends to lose out to short-term strategy such as reverse auction. In theory, the rate of main contractors and suppliers being taken over or going under should increase as a function of increasing operator buying power. This, in itself, could be a supply chain strategy, since survival of the fittest is a legitimate concept in todays economy. Buying power induces efficiency since, when a supplier collapses, a new, better one soon appears. Whether this is really the case is a question that may warrant a hard look in the future. Does the increased buying power really result in more efficient suppliers or just push the links below towards oligopoly? This may depend on whether operators use buying power in a strategic manner or a tactical (short-term) manner.

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BUSINESS BRIEFING: EXPLORATION & PRODUCTION 2003

Supply Chain Strategy in the Oil and Gas Sector

Taking Charge of the Supply Chain Shorter Project Execution

Size also induces firms to take charge of procurement in links further down the supply chain, increasing the effective procurement volume and potential savings from use of buying power. This is accomplished in various ways intentional or unintentional. Having the main contractor buy on behalf of the operator on a reimbursable basis instead of on a lump sum basis essentially transfers all savings due to lower price to the operator. However, since the reimbursable basis gives no incentive for the main contractor to save, the operator must require competitive bidding or use of operator frame agreements. This leaves less room for main contractor frame agreements with suppliers. Abandoning the engineer, procure, install and commission (EPIC) or EPC(I) contract concept and going back to smaller module and assembly contracts instead transfers responsibility for some of the larger elements in the supply chain back to the operator. Shortening the project execution time means that more front-end company-provided orders of large equipment packages are required.

Main contractors also want to use buying power; however, sitting one notch lower in the supply chain, the main contractor is at a distinct disadvantage strategically. It could seem that, through its own efforts at horizontal integration, the main contractor may hope to gain high ground within its area of expertise, but this is generally not the case. It is in the planning and front-end engineering and development (FEED) phases where most tactical decisions relevant to supply chain management are made. By the time requests for quotation (RFQs) for main contracts are issued, little room is left for manoeuvring. Factors such as reimbursement basis, standardisation, bidders list and company-issued equipment are already defined. The situation worsens for main contractors in the operational phase (modifications, maintenance and operations (MMO)) where due to standardisation requirements procurement mainly consists of call-off against operator frame agreements. For the operator, taking over control of the supply chain comes at a price: increased risk. On the other hand, for the main contractor, the price of reduced risk is less ability to differentiate competitively. With

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Supply Chain Management & Outsourcing Strategies

Figure 1

Ability to influence supply chain management

FEED

Bid

Project Execution

MMO

Time

profit margins already down to a minimum, the way around this is to compete on shorter execution time. This is exactly what main contractors are attempting to do. Meeting close milestones is the name of the game. The focus on logistics and cross-functional knowledge is growing in supply chain management.
Factors in the Supply Chain

contracts are often big enough to make or break a company, and internationally confident and competent high-level specialists are lacking. Although there is an inherent resistance to internationalisation, it is inevitable that it will gain momentum, and it has already begun within sourcing of human resources. This is where fluctuating oil prices come into the picture. Main contractor turnover fluctuates likewise, and since it is too costly to operate with idle staff during slow turnover, external consultant services are sourced during peak times instead. This is a problem for operators who, in effect, are paying the premium for external manpower services (due to the reimbursable contract format). One solution to this in the past has been to bring in low-cost temporary staff from abroad, but now, with Internet communications gaining ground, it is becoming apparent that it is more efficient to develop and use specialised engineering and service expertise locally in low-cost countries with highquality education and untapped brainpower. Brain drain could become a waning trend one day. Another phenomenon, of minor importance but interesting conceptually nonetheless, is also related to the business cycle. When the economy is strong, oil and gas prices increase due to high demand; however, the inflated energy prices in turn reduce growth. For countries that have an economy that is highly dependent on oil and gas exports, such as Saudi Arabia, Norway and Venezuela, the business cycle is often opposite to that of the rest of the world. A natural result of this phenomenon would be a crossover of mobile elements of the supply chain for such countries when the cycles are at their turning points.
Protectionism

A popular strategy to shorten project execution time is to implement e-business solutions. While e-procurement has been the focus in many industries, it will be e-collaboration that is important in oil and gas, and it should be the main contractors that take the lead in this. Internet-based RFQ solutions are a form of e-collaboration in procurement but this will probably be absorbed into general e-collaboration applications in the future. Several existing document control applications are being developed to handle e-collaboration and this is a logical approach since built-in integration between document control and project execution, including procurement administration and management, will simplify project execution. Reverse auction applications, on the other hand, can stand alone because they are not time-saving devices as much as price-reducing devices.
Internationalisation

While the main contractor hones its project execution model, suppliers look for ways to sell higher volumes to fewer clients. The best way to accomplish this is to market itself directly to the operator instead of the main contractor and be awarded a frame agreement, or at least become pre-qualified. The other way is to set up in a low-cost country. For some, this means countries like Singapore and Mexico, but for others it means countries like Russia, India and the Peoples Republic of China. There should, in theory, be a trend for the supply chain to relocate to ever-lower-cost countries. Within IT, this phenomenon is apparent, and IT/IS can be considered as a pilot, or test case, for the rest of the technology sector. However, only very progressive companies seem to get this right. Single

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A floating production platform can essentially be constructed in any country with access to competence and the sea. Upon completion, the platform is simply towed to its oilfield. The supply chain associated with such an infrastructure is a huge economic asset that

BUSINESS BRIEFING: EXPLORATION & PRODUCTION 2003

Supply Chain Strategy in the Oil and Gas Sector

governments try to control in various ways. In the EU, Norway, Brazil and Canada, for example, the oil and gas sectors would not have become what they are today without government intervention; however, with privatisation of more and more government oil and gas enterprises, intervention is becoming a more difficult task. Since the end of the cold war, the possibility for international competition has also increased. In the service sector, the Internet is a growing factor that is sometimes able to circumvent trade barriers. Governments in Organisation for Economic Co-operation and Development (OECD) countries (the US, Canada and the 16 most economically developed European countries) have traditionally been using subsidies, duties, influence and establishment of isolationist trade blocks to lock out competition mainly from less-developed countries. From the standpoint of supply chain management, subsidies are embraced, while duties are frowned upon. In reality, both are detrimental, since protectionism in any form throws a wrench in the survival-of-the-fittest concept and reduces efficiency by protecting the inefficient, causing the efficient to go out of business. However, subsidies are more likely to be increased than decreased by OECD governments if unemployment in the oil and gas sector was to increase. The alternative of an artificially protected high-price market is not sustainable in the long run because it will make the cost of oil and gas production too high.
Conclusion

Competitive forces and regulatory forces influence the direction of supply chain strategies in the oil and gas sector. The most important trend currently is the merging of oil companies to form ever-bigger entities with enormous buying power that spans further down the supply chain. This, in turn, forces main contractors to shift their supply chain strategy from focusing on price and risk to focusing on administration, increasing the need for use of e-collaboration and crossfunctional competence. Development of low-cost supply markets will proceed but will be stagnated by a lack of ability to overcome risk and (perhaps) mounting protectionist use of subsidies. s
Additional Information

This article is based on the authors independent assessment of the oil and gas sector and does in no way reflect the confidential supply chain strategies of his past or present employers.

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