Energy OIL S WILD RIDE DRIVING VALUE FROM THE SUPPLY CHAIN AUTHORS. Keric Morris, Partner Curt Underwood, Partner Bob Peterson, Partner

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1 Energy OIL S WILD RIDE DRIVING VALUE FROM THE SUPPLY CHAIN AUTHORS Keric Morris, Partner Curt Underwood, Partner Bob Peterson, Partner

2 TAMING THE SUPPLY CHAIN The recent decline in oil prices has begun to tame the spiraling cost increases of the oil and gas supply chain. High oil prices, the proliferation of projects, and the scarcity of skilled resources and equipment have greatly increased the cost of oil field supplies and services. While the market pressure will naturally flow through to the supplier base, we believe that the most savvy oil companies have an opportunity to gain longer-term strategic advantage through their supplier relationships. Realization of cost reductions in the oil field supply chain has been slow, since much of the work in this field is delivered through long-term contracts. A correction in the market is underway, however, with many upstream players reducing their exploration and production investment in 2015 and beyond. With demand dropping, the overheated services and supply market will be prone to consolidation and business failure. For customers, this presents a window of opportunity to change the shape of their relationship with suppliers through renegotiation and new approaches to contracts. Certainly, this includes the opportunity to renegotiate cost, but oil companies who do so without an eye to their future will miss out on a great opportunity. Oil companies should take advantage of this opportunity to improve their supply chain risk exposure and ensure supply stability long into the future. Of specific note are contracted services, which have been an increasingly important part of oil company operations. Contractors accounted for three fourths of all resources used in 2014 by one of our super major clients. The importance of contracted services for future financial performance must not be underestimated. Cost reductions can be had during this downturn, but future operations are equally important. It is possible to maintain a relationship with a desired incumbent through a competitive process, which achieves market pricing. Achieving a balance between relationship and risk management, while also building in ample commercial and operational flexibility, is critical to achieving short-term cost competitiveness, ensuring long-term business delivery, and thriving during inevitable future changes. 2

3 Exhibit 1: Supply chain cost escalation Both capital and operating costs have been increasing faster than inflation during the last decade in most categories except steel and rigs. EVOLUTION OF UPSTREAM COSTS IHS-CERA COST INDICES 240 INCREASE IN COSTS FROM 2008 PEAK TO 2012 CHANGE IN COSTS 20% CAGR 7.1% CAGR 5.4% Operating costs Capital costs 10% 0% -10% -20% Construction labor Engineering & PM Subsea Equipment Bulk materials Yards and fabrication Offshore installation Land rigs Offshore rigs Steel As a result, international oil companies have faced declining upstream margins and significant challenges with talent and labor acquisition. Cost inflation has contributed to significant cost overruns at large projects, increasing the importance of project management experience. Source: IHS, CERA, Deutsche Bank 3

4 THE OLIVER WYMAN APPROACH Many businesses have spent years developing more integrated procurement organizations. These organizations not only drive effective category management, but also act as informed buyers helping to shape strategic decisions about operational and investment issues. With the recent shift in the market, these organizations must step up to the plate again, working with their local partners in the business to help drive significant risk management and cost improvement. While the specific approach for each business will vary, there are a number of core levers that will need to be applied in order to drive value. Many smaller independents as well as most of the shale players in the US grew organically, one rig at a time. These companies have been more focused on driving operational delivery than on creating robust supply organizations. A site engineer s natural default is to manage much of the supply locally in order to manage the rapid changes on the front line, leading to limited cross-business, and long term demand forecasting. Many of these businesses have struggled to work with bigger oil field services players, which focus on long-term supply contracts to manage their delivery organizations. Instead, they have been using smaller, local, organizations in more nimble ways because they are willing to take on the additional costs and risks to keep that flexibility. Price pressures will make it essential for independents and shale players to move to a more centralized approach to realize cost savings. This, in turn, could require them to redesign their operating approach to create consolidated demand forecasts that support procurement teams in negotiating longer term and lower cost deals. However, it is also important to obtain the highest quality, most reliable resources left in an over supply market and get them at the new, emerging market price (likely lower than contemplated a few years ago). All of this must occur against the backdrop of a balance between centralization and flexibility. Many smaller suppliers survived in recent years through a more fragmented, local approach, with higher prices and constrained supply. Now, they must either change their models or consolidate to avoid being forced out of business. Failure to address these issues will leave independents and shale players at a disadvantage in terms of both costs and supply. Reaching this goal will require going back to the basics. They must clearly define the scale and categorization of the expected future investment and operations portfolio. This is the first step in defining the future demand forecast by category. The approach will also need to incorporate broader changes that are taking place in the business in response to the downturn: process simplification and standardization, maintenance approach redesign, etc. This effort should also include a review of key feeders into the supply chain, such as labor, raw materials, finished products, energy, etc. Defining demand helps to develop a platform to analyze and improve the supply base. 4

5 SUPPLIER EXPOSURE REVIEW Define levels of current exposure to both direct suppliers and their supply chains in order to understand the potential impact of business failures and other supply disruptions. Determine the criticality of relationships and a focus attention on mitigating the most risks. DELIVERY RISK REVIEW Refine project delivery stage gates, processes, and controls to streamline activity and focus on rebalancing commercial risk vs. cost. Retreat from over-engineered processes that have limited impact on reducing project risk and focus on proven methods and standard low cost designs. SOURCING The goal of the sourcing effort must be (at least) two fold. First, maintain the best of the best. Suppliers aren t all providing commodity materials or services. Leverage data and field knowledge to understand which are the most valuable to the business. Second, ensure that retained suppliers are charging market competitive prices. A well-run multi-round sourcing process that is transparent and honest can give a valued incumbent supplier the opportunity to retain business and long term opportunities while bringing pricing to market competitive levels. Beyond these basics, aggressive competitors are considering more radical approaches often borrowed from other industries, to take advantage of the downturn by strengthening their supply capability and building strategic advantage. These competitors will be best positioned to succeed in the near-term and when the market (eventually) rebounds. Draw the best suppliers closer: Form joint ventures for key assets and skills of the best suppliers. Develop separate business vehicles or insource talent to service core elements of baseload operations. These approaches help to insulate the company from unexpected supply disruptions while consolidating the best talent in-house during a down market. (Buy low!) Partner with competitors in key markets (geographic, technical, etc.) in order to aggregate buying power and ensure access to scarce resources when markets bounce back (such as on the west coast of Australia). See the paper on improving joint ventures for examples of models used. Index an appropriate portion of material or labor pricing to oil or other commodity indices and ask suppliers to do the same. Introduction of significant variable pay to endorse longevity has helped some unconventional service providers to reduce turnover while attracting top-qualified applicants and attain premium pricing in the marketplace. Indexing, when done well, has the advantage of enabling longer term buyer-supplier relationships without acrimonious price negotiations interfering every time the market moves. Consolidate raw material spending for smaller supplier. Smaller suppliers often lack buying power and sourcing capability. Innovative companies have found ways to leverage their total commodity spend for their suppliers. For instance, we have helped consumer products companies negotiate blanket packaging materials for their third-party manufacturer supply base. 5

6 SUMMARY The supply and demand dynamics in oil and gas have changed dramatically with the significant drop in oil prices. Operating models need to adapt to this change. The supply base price inflation during the last few years must be reversed. The best companies will use this opportunity to build strategic advantages and prepare for the next up-turn, rather than simply slashing and burning their suppliers. Winners will emerge with increased capabilities, reduced risk, and a strengthened position to compete in this new market. These companies will take a forward-thinking approach to improve their current business positions and prepare to ride the next upswing. 6

7 This article is part of a series that explores the impact of the recent market disruption on the global oil and gas industry. MARSH & MCLENNAN COMPANIES S APPROACHTO MANAGING THROUGH THE DOWNTURN PMI in the downturn Using M&A in the downturn to reposition the business Optimizing JVs Creating more flexible joint-venture approaches Innovative Supply Chains Redesigning and cutting risk in supply chains OIL S WILD RIDE REDESIGNING THE OPERATING MODEL Managing Risk, Driving Efficiency Blending operational excellence and risk management to drive value The Talent Continuum Using a data approach to drive strategic human resources delivery Process Standardization Driving for repeatable, low-cost processes Regulatory Change Influencing regulators to reflect market changes Right-Sizing IT Driving performance from existing investments 7

8 ABOUT OLIVER WYMAN Oliver Wyman is a global leader in management consulting. With offices in 50+ cities across 26 countries, Oliver Wyman combines deep industry knowledge with specialized expertise in strategy, operations, risk management, and organization transformation. The firm s 3,000 professionals help clients optimize their business, improve their operations and risk profile, and accelerate their organizational performance to seize the most attractive opportunities. Oliver Wyman is a wholly owned subsidiary of Marsh & McLennan Companies [NYSE: MMC], a global team of professional services companies offering clients advice and solutions in the areas of risk, strategy and human capital. With over 53,000 employees worldwide and annual revenue exceeding $11 BN, Marsh & McLennan Companies is also the parent company of Marsh, a global leader in insurance broking and risk management; Guy Carpenter, a global leader in providing risk and reinsurance intermediary services; and Mercer, a global leader in talent, health, retirement and investment consulting. For more information, visit Follow Oliver Wyman on ABOUT THE ENERGY PRACTICE Oliver Wyman s Energy Practice helps companies address strategic and operational challenges through proven, results-oriented approaches across all sectors of the market. The practice s work is based on deep industry expertise across the energy sector and is informed by decades of work with industry leaders. The energy team has worked with leading international and domestic oil and gas companies operating in the Americas, Europe, Asia, Africa, and the Middle East. FOR MORE INFORMATION ON THIS REPORT, CONTACT KERIC MORRIS Partner BOB PETERSON Partner CURT UNDERWOOD Partner

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