Are Oilfield Suppliers, Contractors Expected to Make Profit?
The answer to this rather simple question depends on whom you ask. Take the stakeholders of supplier or contractor companies, for example. A company has three sets of stakeholders: investors, employees and customers. I think it is obvious that two of the stakeholders, investors and employees, expect the company to make a profit.
Oilfield suppliers and contractors may have several important measurement criteria, such as safety performance, environmental sustainability and increasing the size of their capital asset base, but being a profitable company is the number one expectation of these stakeholders.
Profit certainly influences the company's stock price and is the basis of employee compensation.
How would the third stakeholder, the customer, answer the question about profitability? Unfortunately, I think their answer would be "not necessarily."
While most customers want their suppliers to stay in business, many customers are not motivated to contribute to their supplier's profit. In fact, they may feel that the supplier's profitability negatively impacts their own profitability requirements. Here lies the dilemma.
I do not feel there is a conspiracy by oil companies to drive oilfield suppliers and contractors out of business. In fact, the opposite is true. We can see the oil companies (operators) taking positive steps to try and ensure the future viability of some suppliers and contractors.
However, it is also true there is a concerted effort by the operators to reduce their costs.
Operator cost reduction efforts take many forms, including competitive bidding, passing risks on to suppliers, implementing contractual terms and conditions that are more favorable to the oil company, and developing "alliances" where the oil company receives better service at a lower price.
In fact, buyer practices such as these are common in most industries. Unfortunately, in the oil patch, we may be approaching the point where some suppliers and contractors can no longer be profitable and the point at which many companies engaged in this business will cease to exist.
While this is Economics 101, it may not be fully appreciated by many oil and gas companies. As enough of the suppliers and contractors merge or disappear, supply-and-demand economics will swing to the supplier side and operator costs will increase.
Market shifts such as this are normal and generally healthy in most industries, but the speed of the shifts within our industry have not been healthy, and future cost increases will be dramatic.
Operators are focused on reducing cost. There are a number of drivers for this, but many of them result in lower supplier/contractor profit.
These include the following:
Operator Cost-Cutting. All companies strive to reduce their costs and the oil companies are no exception. No matter how profitable any company is, there is always a consistent focus on doing better. One common way to do this is to reduce the prices paid to suppliers.
Operator Mergers. There is less competition on the operator side of the business today because of recent mergers by the major oil companies. The sheer size of the resulting companies also makes it difficult for start-up operator entities to survive, much less prosper.
The number of offshore projects is still about the same, but the number of operators working in an area has been greatly reduced. The Gulf of Mexico gives us an excellent example of this market contraction. If a supplier was not among the fortunate few that landed one of the recent GOM supplier or contractor frame agreements, the supplier's ability to maintain a business base in the GOM will be more difficult.
Downsizing/Re-engineering. As operator employees are put under pressure by downsizing and re-engineering, these employees then put similar pressures on their suppliers. This not only drives cost-cutting, but promotes risk aversion by oil company personnel. They, therefore, try to push these risks on contractors.
Operators, over the last few years, have developed a culture where the suppliers and contractors are expendable. This culture is detrimental to the long-term health of our industry.
Turnkey Contracting. This has become much more common recently and has allowed oil companies to place increasing responsibility for large projects on contractors.
Unfortunately, there has been more supply than demand, so contractors have been willing to take on more risk and have accepted lower profits in order to obtain work.
Several major contractors have suffered financially to the point that they have publicly announced that they have stopped or significantly restricted turnkey contracting for large projects.
Companies that have expressed these concerns include McDermott, Halliburton and Stolt.
Partner Pressures. While many operators are willing to pay for better service, improved safety performance, in-country support facilities, etc., they still must have the approval of their partners in order to award the work.
It has been my experience that any time multiple companies are involved, particularly national oil companies, the low bidder is generally awarded the job. This is generally after a technical review where all suppliers are vetted to make sure they can supply the appropriate equipment.
Unfortunately, being technically qualified does not mean that all suppliers are equal in other areas, such as service support, in-country facilities and safety record.
I have seen several large projects where in-country manufacture was stated to be critical to the bid, but at the end of the day the low bidder won without regard for this capability. In several cases, another bidder could have been more competitive, except they had included the cost to build equipment in-country, which was more expensive than building it in established locations and importing it as finished goods.
Alliances. There are some positive examples where oil companies have formed alliances or frame agreements with suppliers and have worked with them on a long-term basis. This often has resulted in regular work for the suppliers and contractors and has given the oil companies an extended staff to support their needs.
The disadvantage is that the oil company may miss out on the benefit of new technologies being provided by other suppliers. Additionally, the oil company may try to encourage their alliance supplier to acquire or copy proprietary technology.
Also, if competitive suppliers don't win enough other work, they may not be around to meet the operator requirements if and when the operator wants to consider changing due to poor performance by current suppliers or concern about high costs.
Alliances are one example where supplier/contractor profitability has been improved. The supplier can focus key resources on its alliance customers and provide a more standardized long-term product without the high costs associated with bidding each project.
Bid Cycle Time. It is not uncommon to see bids for large offshore developments last over two years from start to award. This is very expensive for suppliers who bid these drawn-out projects, as well as for the operators who have to keep project teams in place during the bid phase.
It is also not uncommon to see operators "turn on" the contracting industry several times during project pre-engineering phases. The expenses borne by the suppliers for this effort is disproportionate to the reward.
Can It Be Fixed?
It is easy to point fingers and find challenges with the current operator/supplier relationships. However, there are a number of possible solutions that have been used in the past and could be used by operators in the future.
It is important that operators understand why their suppliers and contractors need to make a profit as seen from the operator's viewpoint.
Technology Development. Historically, the oil companies, particularly the majors, have been the hosts for technology development and they have been willing to work with and pay for suppliers to implement this technology.
In the past, it was not uncommon to find operator personnel highly involved in supplier technology development. The recent trend is for the operator to put his money into different areas with more emphasis on drilling, reservoir and flow-assurance issues.
Operators are increasingly unwilling to pay for technology development in traditional equipment supply industries. While the industry has been successful in many ways in meeting the technology needs, more and more of the development costs are being borne by the suppliers.
Unfortunately, most technical achievements can be copied in some way and the inventors are not often able to fully recover their technology development costs and remain competitive. Suppliers that make consistent profits can reinvest in new technologies, which benefit the operators.
Key Personnel. There has been an exodus of good personnel from our industry due to the speed of its business cycles. This has led to periods of limited supply for experienced personnel, and both oil companies and suppliers have been trying to hire this talent.
In general, oil companies are able to hire the best talent because they will pay significantly more than suppliers, even if they hire key personnel as consultants. It is not unusual for oil companies to state there is not enough key personnel in the industry.
One solution is to have operators "contract" key personnel from the suppliers for a specific project, as opposed to hiring them directly or getting them through consultants. This would allow these key personnel to stay with one employer (the supplier) while working on an operator's project until no longer needed.
The employee would then go back to work for the supplier with a career path as opposed to working project by project. The supplier benefits from the experience gained by its personnel and by having long-term employees.
Facility/Equipment Investment. As the industry moves into deeper water and more remote locations, it is important that suppliers/contractors be able to meet the operator's needs. As an example, longer offsets for subsea tiebacks require longer flowlines and umbilicals as well as bigger vessels to install them.
Suppliers must make consistent profits in order to reinvest in new facilities and equipment.
Long-term Relationships. While the terms alliance and frame agreement may have been misused in the past, there is a value to operators forming long-term relationships with key suppliers.
It is not necessary that they have only one supplier in each category, but there is a value to minimizing the competition to two or three suppliers who can meet their needs on an ongoing basis. Petrobras has been very successful at developing general specifications and then requiring that all suppliers meet these specifications. Also, Petrobras has been willing to buy from those companies that build in-country facilities, thereby creating jobs in Brazil.
Life-Cycle Evaluation. "Low Bidder" may not be the lowest cost; operators sometimes focus on initial as-bid costs as opposed to looking at what happens if the supplier's equipment does not operate reliably or if a contractor cannot perform in the field.
This is sometimes a matter of looking only at capital costs (Capex) at the time of purchase vs. operating costs (Opex) over the life of the equipment. Life-cycle evaluations are becoming more common, but this concept is still ignored in many purchases.
This can be particularly important if a key piece of equipment can shut in production or if it can impact a much larger operational cost. A "low bidder" selection does not always end up being the lowest cost solution.
Risk Sharing. Operators have pushed more risk on contractors over the last few years. Unfortunately, contractors do not normally have the opportunity to recover their costs if a project goes over budget or is late.
The operator has a reasonable chance of covering any cost overruns over the life of a field. Therefore, contractors should only take on risks that they can control. They should not be asked to be responsible for risks outside their control such as weather delays, supply of equipment/services by other suppliers that were contracted by the operator, or delays associated with operator changes or indecisions.
Third World Facilities/Employment. Most national oil companies are requiring that more work be performed in their own countries to stimulate in-country investment and create jobs. This is certainly a worthwhile goal.
However, suppliers are often expected to pay for the costs to do this. Therefore, prices must be higher to allow this in-country investment. Operators need to make it clear how much in-country supply is required, and then allow suppliers to price that in their bids.
It is often difficult to fully estimate these costs and evaluate them, but in general, suppliers will need to be paid more to build new facilities in country. While this is not actually profit, it translates to higher prices to operators.
Bid Cycle Time and Cost Management. Two years to issue a bid invitation, evaluate bid responses and award a contract is too long and too much of an industry burden for the suppliers to bear. Operators need to look for ways to shorten this cycle and try to have only one bid cycle.
There will be a few projects where parameters change significantly, requiring major re-bids, but most projects can be bid one time after appropriate front-end design.
Also, operators should use more restraint in soliciting supplier bid resources or be willing to pay for this support if it is just to provide data for field development cost trade-offs.
Competition. Last, but certainly not least, is the fact that suppliers that do not make consistent profits will no longer remain in business. Operators need multiple suppliers in all areas and should want to make sure that qualified suppliers are in business to meet the operator's future needs.
However, all of the suppliers, in whatever form they take, must show consistent profitability to survive.
In summary, it is clear that all three of a supplier's or contractor's stakeholders benefit from the effort to generate profits. These include customers, who benefit by having financially healthy suppliers that invest in technology, capital assets and personnel, and take appropriate risks.
Operators who understand the need to make sure their suppliers generate consistent profits will benefit over the long term by ensuring that their suppliers can provide operators the technology, equipment and services to improve production and maximize recovery of reserves.
Bruce Crager, President of ABB Offshore Systems Inc., has over 27 years of experience in the oil and gas industry. ABB OSI manufactures surface and subsea control systems for the drilling and production industry. The company also provides offshore project management, engineering, procurement, construction and installation of subsea field developments. Mr. Crager was previously senior vice president of Oceaneering International Inc., with responsibility for mobile offshore production systems. During his time at Oceaneering, he held several other senior positions related to worldwide marketing and the manufacture of subsea products. Prior to joining OII, Mr. Crager served in various management roles within Vetco-Gray Inc. and Hughes Offshore and as an engineer with Seaflo Systems and The Offshore Company (now Transocean Sedco Forex).
He is a graduate of Texas A&M University with a B.S. in ocean engineering and an M.B.A. from the University of Houston. Mr. Crager is the author of numerous articles and technical papers, and he is a co-author of four patents related to subsea equipment. He is a licensed professional engineer. Mr. Crager is a member of the Advisory Council of the Dwight Look College of Engineering at Texas A&M University and of the Advisory Board of the Offshore West Africa Conference and of the Subsea Tieback Forum. He is also secretary of API Subcommittee 17, related to subsea production systems.