Building a world class organization in a volatile oil price environment

Part 3 – Value contracting of equipment and services, and true measurement of results are key ingredients necessary for oil companies to compete effectively in today’s business environment

John de Wardt, de Wardt and Co. Inc., Steamboat Springs, Colorado

he old adage, "You get what you pay for," applies to contract services in the oil and gas business. From the 1970s, finance and procurement departments have driven the process to select and contract services. Through their lack of understanding of value, they have focused organizations on contract prices. Basically – regardless of the hype surrounding the information-gathering process on safety, quality, technology and the like – contracts usually are awarded on a price basis. Low bid wins the work.

What Oil Companies Really Want

Oil companies really want to find and develop hydrocarbons at the lowest cost, in the shortest possible time, so they can sell their products for the highest profit. In exploration, this means collecting data and modeling the subsurface terrain. The ultimate objective for most exploration ventures is to have sufficient information available, to be able to make good decisions on further development or relinquishment. This data is acquired primarily through seismic and drilling.

As a consequence, exploration drilling must focus on cost-effectively collecting sufficient information of high quality. The cost-effectiveness of drilling has two benefits: the direct benefit of the expense of exploration and the future cost model of any development, based on the cost achieved in the exploration phase.

In production, the objective means drilling a well that can achieve maximum output and recovery. These objectives require that several steps be satisfied. For example, the well has to be placed in the most desirable location, and data must be available from the well to update the subsurface model. In addition, a conduit must be able to deliver hydrocarbons to the surface for as long as needed, with the least intervention possible. Finally, a low-friction connection from the reservoir to the completion conduit must be installed.

For the more complicated wells that are drilled in today’s highly demanding business environment, liaison with every service as a hub in a spoke system does not work.

What Companies Measure

Many oil companies have built systems that measure leading indicators and not the end-results that they really need. These measures are often subjective, because they have not found ways to establish absolute measurements. Subjective measurements are a ruse that can, and do, lead companies to a false sense of performance. A subjective calculation is often driven by the relationship between the person making the measurement and the one being measured. Improvement of this relationship may yield a higher score without actually bringing the benefits that the oil company really desires.

An excellent means of measuring the performance of activities that lead to results is via non-subjective leading indicators. They do not, however, measure the desired result. In order to translate these leading indicators to the end result, an entity must take responsibility to manage the integration of activities, causing the leading indicators to create the result.

Oil companies often took this role without actually organizing to do this in an optimal manner. As services have moved from simple equipment and personnel rental to an integrated solution – for example, rotary steering systems – the service companies have assumed this role to some extent. The oil companies’ current mistake, with regard to achieving their objectives with the highest possible performance, is that they have not changed their practices in this transition process.

Operators Ask One Thing, Want Another

Oil companies’ contracting practices are out of step with other modern industrial practices. They are geared to delivering leading indicator results without managing the integration and alignment to the solution that will cause their businesses to succeed. In straightforward terms, oil companies are still contracting as if the supply of materials, equipment and personnel is the measure of success and not the result that they are able to achieve using these resources.

In a recent example, an oil company gave a service firm a maximum score for the preparation of services and the lack of downtime / failure of equipment. This service company was, however, unable to either assume the responsibility of delivering a successful result from the service or manage the overall performance of the service. The service company’s focus was personnel and equipment rental, as called for in the contract.

When another service company replaced the first one, significant time-savings and quality delivered results were achieved immediately. The first service company had achieved great success via a rapidly-rising market share based on low-price bidding, while the latter had more expensive technology and support expertise. In a world of high, daily operating costs, the latter firm achieved huge savings for the oil company. These were missed totally by the conventional contracting and measurement methods.

Oil companies could manage all these individual services that deliver people and equipment, if they were in the business of site management and not delivery of overall well objectives. This is a huge gap that the industry thought it managed in the past and is certainly not managing today.

In the past, the ever-industrious drilling engineer and drilling supervisor were trained to liaise with every service as a "hub" in a "spoke" system. For straightforward wells with only a reasonable expectation of performance, this system worked. For the more complicated wells being drilled today, in a business environment that demands high performance, this simply does not work. It is not possible for even the most well-trained, hard-working engineer to achieve world-class performance with this arrangement.

This failure to align measurement to the ultimate value also pervades the oil company structure, itself. These organizations were built up as functional silos with bureaucratic control systems. Within these silos, the measurements of success imposed on staff – usually through annual reviews – relate to cost-effective delivery of the function’s own goals. In many instances, these goals are not aligned to the business objectives of the projects they are supporting, be they exploration ventures or production operations.

A typical example is the logistics function that manages bases, boats and helicopters. These organizations often measure performance on absolute cost under their control. This often leads to a clash with the project objectives. It is quite common for a project to see value in planning the sailing of an extra boat, while the logistics department would see failure in its own measures of limiting the number of additional sailings over scheduled sailings.

While the internal measures of the logistics department appear to lead to a well-run business, it is extremely doubtful whether the customers of these organizations would choose to use them in a free market. The constraints imposed by a large company on using its own internal services mask these inefficiencies. In all fairness to people in logistical groups, this is a systemic problem, from which they cannot escape without the company re-creating the system. It is a recipe for mental seizure.

Furthermore, the internal customers can be unrealistic in their demands, when they do not plan ahead and, instead, live in traditional reactionary mode. An example would be requiring a cost-effective service that caters to every whim. This is like telling an airline that you want both a low fare and the plane to leave on the individual customer’s schedule that differs from the one that all customers adhere to. This may be ridiculous, yet it has been accepted as a practice in large oil companies.

How To Improve Performance

Oil companies must recognize what the values of their businesses are for them, relate these to their operations, procurement and financial staff, and then design contracting practices and measurement methods to meet these goals. This will require that they review the manner in which value is generated, and examine the contributions of their suppliers and staff. It will require that they bring their financial and contracting departments into line with this value generation.

Operators also must change the old practices that they may still have that drive the selection of suppliers to the lowest bid price. Once the value drivers are understood, they can be measured and rewarded – suppliers will deliver what is measured and rewarded. This process of change will be neither easy nor quick. Paradigms in internal departments will have to change, contracts will have to be re-written, and companies will need to pay for added value when it is delivered – in both the planning and execution phases.

Currently, oil companies may be buying the wrong thing. Worldwide supply agreements and regional awards for large volume do not equate to delivering performance. The new contractor welcomes the significant increase in work. However, the oil company can immediately lose, if it fails to award the level of purchase agreed; treats services as a commodity; or ignores the reality of rigging up new equipment and gearing up service personnel in a mad rush to force the supplier to meet the contract requirement.

How Companies Can Get What They Need

It is time for rational thinking to take over and for the right expertise to be exercised, to develop the contract strategy. First of all, oil company managers need to decide what it is they want to deliver and then deduce what equipment and services a supplier can provide that will contribute the greatest value. In this way, oil companies can become clear in their requirements and allow suppliers the room to propose methods that can deliver additional value.

An example is the introduction of drilling performance services in place of bit sales. The former sells many commodities that the oil company engineer has to figure out how to use. The latter delivers the rate at which usable hole is delivered. Would engineers rather have the low-cost bit or blow away past results by doubling the best performance previously achieved?

The significant improvement in performance achieved at many different projects, through the application of drilling effectiveness, demonstrates that a move away from treating services as commodities will bring large benefits. In Lean Drilling* projects, similar gains have been made by treating drilling mud as a service and not as a commodity, casing running as total tubular management and other similar changes.

Defining scope boundaries is the first step in developing a contracting strategy that can support the delivery of world class performance. This is a process of restructuring products or services requested from suppliers into systems (sets of components or groupings) that deliver the greatest value aligned to the oil company’s desired outcome. This process yields a clear identification of services that will add value and products that can be treated as commodities.

This process is very different from traditional approaches and is often more complicated. However, the results are well worth it. This method spawns local teams that focus on the results desired by the client – a huge contrast to the traditional central purchasing method that applies large contracts with price leverage across a wide area. Competition between teams delivering on different projects, and assignment of additional work based on project results, can improve performance far more than regular re-tendering of very large contracts.

If the process of selecting scope boundaries is not conducted properly, pitfalls will be encountered. These include the use of historical boundaries rather than creating new ones and using supplier portfolios rather than integrating different suppliers into teams. Other examples are defining broader responsibilities but continuing to manage in a narrow, detailed manner; failing to create boundaries that offer suppliers opportunities to provide total systems over which they can influence results; and failing to recognize the impact of local issues.

Selection of suppliers, and design of the scope boundaries, is an interactive process that takes into account suppliers’ abilities to take on necessary responsibility, the competencies they have and the competitive advantages they offer.

Subsequently, payment schemes in contracts need to be revised to reward additional value brought by the supplier; such strategies have been referred to as value-based pricing. Traditional pricing methods are usually not aligned to delivering added value, and they can be a significant source of conflict between improved performance and revenue streams. Ultimately, support for these changes can come only from management, whose commitment is a necessity for success. Unfortunately, the oil industry often appears to be driven too much by short-term wins that look good to managers, rather than the real hard work of change.

Where The Industry Should Go From Here

Forecasting the oil industry is very difficult and has proven many people wrong. However, it is interesting to consider the range of possibilities. The ideas brought forward by the author in these articles describe a world in which payment schemes drive and reward added value. This added value is aligned to the value that the oil companies want to create.

Two major builders of highly effective, offshore drilling units have emerged, and they are able to support a high level of performance from these units. Regional drilling contractors, who do not own or maintain the units they use, have emerged to deliver high drilling performance in the local environment.

Service companies are providing equipment and services that add value and are rewarded properly for doing so; commodity purchasing of specialized items has disappeared. Management personnel, who are committed to a high-performance future, have enabled this change to occur in a relatively short time.

Unfortunately, the oil industry rarely seizes an opportunity to increase value and performance without trying to destroy the process that is bringing the change. So many people believe that they can create yet another version of the new mousetrap, that the trap, itself, becomes ineffective and gets a bad name. Ultimately, changes are sporadic and often subdued by industry apathy. Traditional methods remain largely in place.

In the near future, the oil industry will lay between these two extremes but not in a uniform manner. Companies or regions will vary between these extremes which, unfortunately, will continue to confuse suppliers and employees. Ultimately, the highly competitive environment that is likely to result from a need to drive up stock prices in a volatile oil price environment will force changes upon the industry, thus bringing a higher performance level.

Some leaders of these changes will emerge and influence the rates of accomplishment and success. The big surprises will come from new entrants, who see the business in a completely different perspective than traditional players, particularly in the e-commerce area, as recently demonstrated by BP Amoco’s outsourcing of its personnel function to a start-up company in California.

The author

John de Wardt is president and founder of de Wardt and Co. Inc., an international management consulting firm providing services to the worldwide E&P industry. He is a mechanical engineering graduate of University of Newcastle in England, where he focused on business studies. Mr. de Wardt has more than 23 years of experience in engineering, contracts, senior management and management consulting. Previously, he worked for an international oil company, international drilling contractor and major service company. He has developed proprietary programs for transforming E&P organizations to lean enterprises capable of achieving world class performance and developing strategies using scenario planning.

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