Adapt for success in a changing Downstream Energy sector

Major changes, fueled by the COVID-19 crisis, are occurring in the Oil & Gas sector with the value chain being stress-tested like never before. In an industry that has operated under a successful model for many years, Downstream facility owners and the contractors that serve these facilities are being pushed outside their comfort zones, with even the most stable facing threats to their survival. What will be the drivers of future value? Does the current service delivery model support this? Having spent a number of years experiencing the challenges within the downstream industry, this article aims to discuss these key questions and position some readily accessible opportunities that could evolve the model.

The changes over the course of 2020 have been bewildering in terms of speed, nature and depth of impact(s). While coverage has focused on upstream exploration, the supply-side, OPEC-plus nations and oil prices - and rightfully so - the refining and processing side downstream of the well-head has received much less attention. Yet this area is, by far, more significant in terms of direct employment numbers. It also creates opportunities for many related sectors and as such, warrants more discussion as changes in this area have broader impacts.

The current state.

Who would have thought 18 months ago that by September 2020 ExxonMobil would exit the Dow Jones Industrial Average and that its market capitalization would be lower than NextEra (a clean energy group). Yet, it happened! Similarly, in less than one year, Oil & Gas producers have written-down asset values by US$80 billion and shed tens of thousands of jobs. These changes cannot be undone (easily). Traditional hydrocarbon companies such as BP, Total and Shell have also drawn a very clear line in the sand on their directions and are pivoting towards a zero-carbon (or reduced carbon) future. These are unheard of changes in this industry and have coincided with rapid advancements (and record installation) in the renewable energy sector, Electric Vehicles sales and closures of coal-fired generation plants, particularly in North America and Europe.

My point is not to debate energy transition, or draw a political line on climate change. Rather, it is to highlight the breadth and scale of change that has converged in a highly compressed timeframe. These changes are increasingly structural in nature and their impacts are flowing into downstream Oil & Gas and petrochemical Owner organizations.

Suppliers, general contractors and service providers (collectively “Service Providers”) are fighting to survive. It’s a daunting thought as market consensus points to a sustained period of weakened global demand for refined products coupled with a global over-supply of crude oil and refined products. Consider the following:

• Significant inventories of crude and product with circa 20% reduction in global demand.
• Wood Mackenzie estimates 7.1 million bpd of refining capacity additions from 2020-27, predominantly in Asia.
• Refinery utilization levels of 70-75% (historically 85-95%).
• Structural demand shifts from telecommuting, ‘work from home’ and travel curtailment.

Refiner margins have reduced, project deferrals (or cancellations) have occurred, outputs have reduced and aggressive cost cutting has been implemented. To date, at least 12 U.S-based refineries have indicated permanent closure, idling, or conversion to alternative fuel facilities or terminals.

I don't doubt there will be a degree of reversion to historical levels as the industry still remains essential to the global economy. However, in an over-supplied refining market with a revised future product-mix profile, coupled with existential industry competition, it’s not hard to envisage further “squeezes”. The focus centers on what participants need to do in order to remain competitive.

The subjectivity of differentiation and the undervaluing of excellence.

Contracted services for routine maintenance, Turnarounds and outages to the U.S downstream refining and petrochemical industries is highly competitive, diverse, geographically dispersed and mature. Like any mature industry, aggressive competition has driven prices down. Differentiation has typically followed HSE, execution capability, productivity, experience of key personnel and access to skilled personnel. Nearly all Service Provider’s make bold statements in these areas.

Outside of Safety performance, which is measured, tracked and reported consistently, the other ‘differentiators’ are largely subjective. That’s not to say they don’t exist as many Service Providers have truly demonstrated excellence for a long period of time. Rather, there’s no consistent basis for rating across Service Providers. There is no industry equivalent of the refinery Solomon Industry Benchmark for Service Providers. Each Owner forms their own conclusion(s) and views are rarely aligned.

In the absence of being able to consistently validate key differentiators, without bias, they risk getting: viewed as marketing speak; tied to pre-existing views; undervalued; and/or diminished. This is a problem as HSE, capability, experience and productivity absolutely drive value to Owners. This does two things:

1. It makes comparisons between Service Providers challenging to qualify.
2. Good performance and exceptional performance get valued equally as the reward for both is work retention. What is the incentive to strive for excellence?

The Owner's primary objectives are safety, production, reliability and utilization. Owners will be challenged to drive never-before-seen levels of efficiency in each of these areas. Innovation is required, and the right Service Provider has a critical role to play. It makes sense that the services model be aligned and incentivize excellence.

Barriers to innovation.

Having sat on the Service Provider's side for many years, I can attest it is challenging to proactively deliver new technology, methodologies and processes. This is especially the case for services to the Owner's maintenance organization. Owners, rightfully, need convincing and every Owner (and site) has different requirements and approvals. It’s costly to deploy innovation and the terms are generally restrictive. This hinders the willingness of Service Providers to invest heavily into innovation as the ROI can be limited. Therefore, innovation is not maximized or transformational, rather improvements are largely incremental.

Safety, throughput, reliability and utilization are paramount to Owners. It would make sense that effort be focused on initiatives that increase performance in these areas. A 1% performance improvement in these areas could yield orders of magnitude more upside than an equivalent percentage improvement in Service Provider rates. However, significant effort is directed to seeking rate reductions under the notion of cost discipline. This does not advocate Owners accept uncompetitive pricing or that some services are largely commoditized and warrant price-based decisions. Rather, aggressively pursuing price reductions from key Service Providers should not be confused with cost discipline. The former doesn’t drive long-term value and points to more systemic underlying issues. We have lost our focus here.

Transformation requires innovation, and innovation requires investment. Innovation, once deployed, unlocks value and margin expansion, which allows further investment and continuation of the cycle.

Developments fueled by new technology are beginning to hit the market. These come at a cost and cannot be done in isolation of the Owners. The test remains whether the commercial model can support step-change innovation, and whether it can be deployed timely into downstream facilities.

The relationship framework creates opportunities for value capture.

The ability to address the coming changes requires true partnership and more integrated working relationships. This can only occur through deeper levels of trust. Many past initiatives have tried to achieve this with varying degrees of success. 

How much influence, control or autonomy should a Service Provider be given? It is a sensitive area for Owners and rightfully so given the value and criticality of assets involved. There have also been past mistakes from some Service Providers that have eroded trust and led to some of the restrictions we see today. However, holding on to past mindsets won’t deliver change. The platform for step-change has to be built on the relationship and this can only occur through trust, and behavioral and cultural alignment.

Some areas of value capture that could deliver and unlock further upside are outlined below. This list is by no means exhaustive and without doubt other opportunities can be identified.

 Value capture 1: Integrated Owner-Supplier relationships.

This is not another preferred supplier procurement initiative! In my experience, preferred supplier agreements are viewed favorably, but their ability to be properly implemented has left people weary. Despite all the right up-front messaging, things revert over time to the prior state. With so much on the line, particularly for major turnarounds, the risk of change is a huge barrier for Owners. Hence ‘preferred’ status is rarely shared collectively across Owners.

There are many Service Providers with excellent delivery capability, and under the right model, many would align their business around a few key client’s. In the absence of a trusted relationship framework it’s hard to progress past the status quo. Getting there requires a shift in approach. There is considerable value being left on the table.

• Address the internal barriers completely before commencing the procurement process - there has to be 100% alignment between Corporate and site(s) to avoid future issues.
• Ensure there are checks and controls that address regression or issues - true partners will be all-in to overcome any challenge.
• “Have we planned for collective success?”…a question rarely asked. Support and reward collective success and not just your own organization.

Value capture 2: Reduce costs through alignment, not the rate sheet.

Work volumes in this industry can be very volatile. Volumes are indicative at best and subject to change with little notice. As a Service Provider, it’s never easy receiving news that planned work has been deferred or cancelled, especially if you have declined other opportunities. It goes with the turf and there’s been a level of total industry volume and cyclicality that has enabled Service Providers to survive. This may not be the case in a more uncertain, volatile and cost constrained future market.

The lack of visibility to work impacts many areas of operation. Uncertainty leads to pricing conservatism, unrealized potential and indirect costs, all of which are pricing inefficiencies impacting Owners and Service Providers. It becomes a volume and margin preservation game and leads to degradation of service levels. Further, the incentive for Service Providers to (re)invest diminishes. Any innovation under this climate has to be marginal, if at all.

Competition and market factors have largely driven out the ‘fat’ and the rate sheet is rarely the incubator of future value. The key to unlocking value, total cost reductions and margin expansion for Owners is through capability, planning and reducing the critical path. Considerably increasing the dialogue with Service Providers in this area will drive performance improvement. There is considerable value being left on the table.

• Enabling the right Service Provider to share in the upside incentivizes (re)investment in capability and technology for the Owner.
• Spend excessive time discussing operational solutions, capabilities and leading indicators, instead of haggling on rates.
• One-way rate reductions lead to commoditization or dragging everyone to average – is that where you want your best technical Service Providers to be?

Value capture 3: Simplification of schedule of rates.

The majority of contracted maintenance labor and equipment services to the downstream industry follow a reimbursable schedule of rates (i.e hourly rates) and hours worked. Rate sheets focus huge detail into the individual cost component mark-ups that determine the sell rate. However, is the focus and effort in the right areas? The sell rate determines the sticker price. If the intent is value-for-money and transparency, there are more efficient ways than driving detail into the mark-ups whose calculation is not an exact science and based on Owner-provided assumptions in many cases (e.g indicative annual work volumes).

There’s a level of mistrust and desire to play rate ‘police’ on account of some Service Providers that have abused the model in the past. Transparency and compliance are absolutely necessary, but excessive granularity in rate sheets is counter-productive and over time results in hidden costs to Owners. It is a legacy approach that could be revised.

Selecting the right partner, aligning the performance metrics and creating equitable long-term agreements (i.e Value capture items 1 and 2), solves the transparency and trust equation. There is considerable value being left on the table.

• Simplification of the rate sheet approach could yield annual cost reductions to Owners far in excess of any available rate sheet reduction. 
• Simplification could be achieved easily and would reduce administrative burdens, errors and ongoing maintenance needs.
• Cost reductions and efficiencies would flow to both Owner and Service Provider organizations.

Conclusions

There’s no doubt the global economy will rebound - by how far, and how fast is unknown. Regardless of where the macro environment lands, the industry has an opportunity to ‘reset’ and refresh its approach in order to remain competitive. Investment dollars have already exited the Oil & Gas industry and there is little value in arguing all the reasons. The avenues to maneuver will not exist like they once did.

Future profitability and viability require a different approach and way of thinking. The changes needed require investment by Owners to fuel the capability improvements, better planning and critical path reductions that will deliver margin expansion and maximize throughput efficiency. But being efficient demands efficiency in every aspect of the business, and the ‘quick wins’ have largely been tapped already. Broader structural changes may be necessary to capture greater value.

Service Providers play a critical role and will be pushed to align and deliver against the Owners future objectives. Owners pursuing excellence and top-quartile performance should ensure there is an aligned incentive for all Parties to strive for excellence otherwise the ‘minimum’ becomes the benchmark. Other industries have shown what is possible through innovation and evolving the incumbent model. There will be opportunities and rewards for those that are able and willing to adapt.

Got feedback or want to reach out? Please comment below or connect with me.

__________________________________________________________________________

Hari Gopu specializes in the energy and infrastructure sectors with a focus on growth, operational performance and commercial improvement. He has over 20 years' international experience across Australia, Asia, North and South America and has served both developers and services companies. Most recently he was a divisional President for a leading U.S based industrial services company serving the Oil & Gas and petrochemical industries.

Connect with Hari on LinkedIn