Never has the old adage that ‘the only certainty is uncertainty’ been truer for the energy sector.
In just the past 12 months, we’ve seen a strong emphasis on green energy evaporate as country after country withdrew support for renewables. While the green imperative slipped, natural gas took centre stage—particularly in the United States, where a raft of new shale gas production has put the country on course to be a net exporter rather than an importer of natural gas. If that transition takes place quickly, European and Asian gas distributors and users that had locked in long-term, oil-price-related contracts could be vulnerable.
Japan’s Fukushima earthquake has tainted the prospects for nuclear energy, once considered by many to be the answer for abundant clean power. Germany has already banned nuclear utilities, and we can expect a slowdown in nuclear plant development in virtually every country.
Oil will remain extremely sensitive to political turmoil in the Middle East, risks of potential environmental accidents, the dollar’s value, and the notion that it is a dwindling resource—all contributing to ongoing price volatility and supply uncertainty. In North America, the debate over the Keystone XL pipeline project further highlights the uncertainties facing this industry, as political decision makers balance concerns over energy security, the environment, jobs growth, and consumer prices. Another great unknown affecting oil price and availability is the extent of future production from producers outside the U.S., such as Brazil, Canada, Iraq, Russia, and West Africa. Biofuel, improved gas mileage, and the increased use of hybrid and electric vehicles will further nibble away demand.
All these factors will contribute to the uncertainty with which companies in the energy sector will have to cope. Most energy companies will find that their current operating models, strategy and planning processes, and optimisation practices are inadequate for this new environment. They will need new capabilities to enable them to meet whatever the future holds, rather than taking the risk of betting on one particular outcome.
Four types of capabilities are particularly important:
- Strategy and long-term planning
- Managing the inherent risks in joint ventures
- Capturing information and insight
- Supply chain optimisation
Let’s look at each in turn:
Strategy and long-term planning
Leading an energy company in the next few years will be like sailing. At any given moment, companies will need to look at the way the wind is blowing and execute an integrated plan to align the sails in the right direction—while remaining alert to any changes in the wind’s direction and rapidly adjusting the strategy as required.
In other words, we believe that energy companies will need to develop dynamic strategy development capabilities. These involve betting on a set of integrated options, any one of which can be switched on or off depending on results and how the business environment evolves. This involves integrated option planning.
Integrated option planning is often overlooked because companies don’t usually think of it as a capability they must develop. They believe (wrongly, most of the time) that it is simply a part of the normal course of business, something that they already do routinely, perhaps on an annual basis. They think that coordinating disparate elements of the business to operate in sync is a natural by-product of organisation. But, in fact, it requires a concerted investment of time and resources to create the structure that can coordinate a complex set of elements, behaviours, and analysis at a very high strategic level. This is particularly true if a company may suddenly need to change course to a different direction at short notice. For example, there could be a shift in financial, supply chain, and human capital resources toward more liquids-rich gas basins and away from dry gas fields or a shift in capital deployment based on geopolitical changes.
A company with a strong integrated option planning capability is accustomed to laying out multiple options and linking strategic choices—such as which projects to pursue, which markets to focus on, and which regions to target—to the appropriate operating models, including supply chain, logistics, workforce planning, and capital management. With a holistic integrated planning capability in place, a company can react quickly to uncertainties, responding dynamically to changing upstream and downstream conditions (including price and other market signals) and redirecting resources, technology, talent, and capital toward areas of opportunity and away from risk.
For many energy companies, this is an elusive capability. With so many different layers and business operations to manage, few organisations have systems that fuse the right processes, people, and data to drive profitable outcomes on a consistent basis. But the lack of integrated option planning can often lead to missed opportunities. For example, one oil company hoped to broaden its Middle East operations with a series of investments. Focusing solely on the financial angle, the company spent months developing a ‘can’t miss’ capital structure for this expansion, including an inexpensive approach to building the new plants. However, management completely neglected the substantial costs of hiring and training the skilled workers that would be needed, nor did it put in place contingency plans for the potential spread of political disruptions in the Middle East. Already, it’s clear that this company will not get the return on investment projected by its initial one-dimensional plan. A more risk-mitigated plan would have built in a variety of options, including the ability to withdraw at various checkpoints if certain criteria were met, without fear of writing off sunk costs.
Managing the inherent risks in joint ventures
In periods of high uncertainty, delivering on multiyear capital projects requires unique risk management capabilities. Energy projects tend to be big, complicated, expensive, and risky—and for those reasons, they are often best pursued through joint ventures and other multi-owner entities. Indeed, for some energy companies, minority stakes or joint ventures to spread project risk are the only practical way to access resources and build portfolio diversification.
But the success rate of joint ventures is stunningly low. Often the varied owners have different conceptions of, or outright misunderstandings about, their respective roles in the project. Sometimes the partners’ agendas (what they each hope to gain from the project) work at cross-purposes, ultimately affecting the smooth running of the operation. Insufficient attention may be given to governance or assigning accountability. The decision-making processes are typically not designed to deal efficiently with complex, multi-stakeholder issues, let alone to flexibly redeploy or redirect investment in response to changing market conditions.
Moreover, the Macondo incident of 2010 brought attention back to operational risks for all offshore assets, and the fracking debate continues to intensify for shale gas and oil. The public battles over environmental impact highlight the need for well-honed operational capabilities and incident preparedness—particularly for operators that have until now lacked the scale and focus to build those capabilities, and that typically conduct their work through joint ventures on capital-intensive projects. Many of these companies, pursuing opportunities without a coherent view of their strengths and strategy, have built up project portfolios that have become overly broad and incoherent over time.
Dramatic improvements in joint venture management capabilities can be gained by any energy company. Those that have this capability have learned to invest the time to understand the strategic intent and objectives of partners and make sure that these objectives are aligned. They identify in advance the capabilities that the projects will require and the roles played by each operating and nonoperating partner. They then allocate assignments for each entity based on the capabilities it has or can develop. They also develop the influencing and communication skills needed to guide operating partners toward best practices. Finally, they have a governance and decision-making model in place that lets each owner protect its strategic agenda and that maximizes the efficiency of joint decision making; this model also establishes processes for information sharing, performance review, and flexible capital allocation.
Capturing information and insight
This capability can make the difference between earnings and losses, especially where oil products and gas inventories are involved (as in the downstream) or where there is high dependency on third-party suppliers (as in the upstream).
Companies that have been diligently pursuing the more traditional paths to prosperity—for example, by executing multiple rounds of cost cutting and restructuring—may well find that any gains in their earnings are dwarfed by the impact of price volatility. These companies need to invest in the capability of capturing information and insight and putting them to use.
At the heart of this capability is an integrated information base that covers every aspect of the marketplace and operations, and that is available to every business and function, spanning the traditional silo structure that exists in many companies. Skilled people on the front line can now make split-second decisions about opportunity and risk. They have updated information, for example, about where the tanker ships are located, how much stock is available, what will be left after each shipment, whether demand is rising or falling, where customers are located, which are fixed- versus variable-contract customers, how much profit they can make under different options, and much more.
For example, a ‘strategic pilot’ working within this capability might say, “I won’t meet a customer’s suddenly increased demand today, because I can’t get enough product in time and still make a profit. However, tomorrow, if the price goes up, I’ll have shipments and a new contract ready.’’
The capability to leverage information and insight can create value and reduce risk across the oil and gas value chain and across functions. A “control tower operator” role for supply chain and logistics can improve coordination and avoid unnecessary expediting costs. Rig movements within and across fields can be better optimised to increase asset utilisation and worker productivity.
This capability is not just an IT tool. It also involves the shift in decision making that ensues, with all the appropriate risk-managed processes, authorities, and commercial and technical abilities required to make it work in the front office. These abilities are equally required for managing third-party procurements.
Supply chain optimisation
As much as 80% of the operational budgets at most oil and gas companies is earmarked for supply chains—primarily for materials and services provided by third-party suppliers. Because of the size of this percentage, many companies have over the years targeted supply chains for cost cutting and efficiency improvements. And though these campaigns have led to incremental, short-term successes, most oil and gas companies are poorly equipped to take the big-picture steps that would drive supply chain management improvement.
A powerful way to address this shortcoming, particularly in companies with diverse business models, is a concept that we call natural supply chains. Under this approach, business operations are segmented into a few relatively similar groups, such as deepwater domestic offshore production, onshore unconventional development, onshore production, midstream, and refining. The goal is to take advantage of economies of scale for those supply chain activities that can deliver cost and value advantages to all of the groups, while customising supply chain capabilities for the specific requirements of disparate segments of the portfolio.
Human resources, information technology, and contract support can probably be shared across the organisation. But other supply chain activities must be managed individually, in a way that empowers the front line to be agile.
For example, one part of an energy company’s portfolio might demand services such as maintenance logistics to support an overarching objective around production uptime. A pressure pump truck may be needed every 30 days in each of several different locations. To manage this schedule, the company would establish an exclusive arrangement with its trucking suppliers, with incentives and penalties based on meeting deadlines and on the quality of work. For this part of the business, performance and safety imperatives outweigh all other considerations, including price.
Another business in the same company may centre on major capital projects, for example: pipeline construction. As it buys 400 miles of pipe for half a dozen projects scattered across a continent, the company will negotiate low-priced bid contracts with a primary focus on delivered cost. There would not need to be as much emphasis on narrow delivery windows, because of access to warehouses and staging locations. The difference in priorities is explicit, and if people move from one part of the business to the other, they easily manage that shift because it is clear to everyone in the front line.
Putting it all together
The subject of building capabilities to deal with uncertainty is particularly important in the oil and gas sector. Many independents are already running up against the limits of their scale, struggling with the clash between their small-company cultures and the process and bureaucracy inherent in large projects. They are scrambling to manage an increasing portfolio breadth that stretches the limits of their existing capabilities. For the large companies, continuous rounds of cost cutting and restructuring have failed to yield sufficient profits, in part because gains in earnings are often offset by price volatility, and also because they have not invested in building the essential capabilities and agility they need in order to grow in these uncertain times.