Redesigning Strategy for Survival through Project Economics and Risks Management in

Upstream Oil and Gas Industry

Modesty Ekeh, Halliburton, Houston Texas USA

Abstract

The upstream economic structure of the petroleum Industry differs strongly with unprecedented
waves of added cost due to great risks and uncertainty associated with oil and gas projects,
coupled with dangerously volatile price domain and new regulatory challenges. The upstream
sector faces the necessity in the increasing proclivity for survival, to reduce projects cost and
cutting other measures as it tries to navigate the shoals of risk management towards preserving
its bottom line. Hence, understanding the distinctive strategy to lower project costs that leverage
economic impulse, balance risk and deliver impactful cash flow is very useful in this era of
spectacular volatility. This paper postulates distinctive low cost operation model and integrated
strategy for project optimization through cost and economic drivers and risk management in oil
and gas upstream Industry.

Keywords: Low cost operating model, projects economics, Risk management, cost & economic
drivers, upstream oil and gas.

1.1 Introduction
In today reality, large projects in the oil and gas industry face similarly daunting challenges as
they become increasingly complex and technologically demanding. Schedules and budgets are
tight, safety is crucial and every project faces a network of stakeholders concerned about its
impact on the environment and communities. Even so, today’s project managers still rely on
concepts that the builders of the Colosseum, as well as other large projects of antiquity, such as
the Pyramids of Giza and the Great Wall of China, would recognize: work breakdown plans,
design-to-cost and make-or-buy decisions, but experience working with projects in oil and gas,
particularly in upstream, suggests that while best practices and experienced talent are essential,
they are not enough to address the new reality and its project economic – dynamics. The
challenges to maximize projects cost and reduce risk to the least significant decimal is harsh and
the consequences of uninformed strategy can be unforgiving on company’s balance sheet. I may
argue that although companies have been focused on cost and productivity since before the
collapse in oil prices, beyond incremental accommodations to change, minimal attention has
been allotted to their internal enterprise operating models which should have been a critical
concern. So, as activities ramp up and deals are closed on a trend that points more oil and gas
production moving to frontier and unconventional resource areas, project economics are
becoming larger and more complex. Some of these projects include an offshore facility in the
Arctic, budgeted at more than $3 billion, and an $8.4 billion petrochemical complex spread
across 45 kilometers in South America. Such projects involve many stakeholders, including
shareholders, local authorities and regulators, and environmental and community advocates.
Schedules are compressing, too: For one oil company, more than 90% of its field discoveries
from 2009 to 2011 are due online in less than eight years (Roberto Nava & Tiziano Rivolta,
2013). Of course, no company manages only one project at a time. Firms’ portfolios may include
hundreds of complex projects, which they prioritize not only on financial goals and risks
(including execution, commercial, health-safety- environmental [HSE] and reservoir risks), but
also increasingly based on the availability of scarce resources like engineering talent. Some are
building up their internal engineering staffs by as much as 80% to effectively manage the many
contractors and suppliers on each project. Scoping projects accurately is an important skill. For
small companies, delivery of a smaller, technically complex project may be as demanding as
larger projects are for large companies. However, projects that look very big (for example,
upstream shale production projects) may in fact be a collection of smaller projects. Companies
that approach their unconventional strategy in the same way they would approach a large,
complex project run the risk of over-engineering their upstream production if they treat many
small projects like a large one. Owner-operators, contractors, and suppliers working in the
upstream petroleum industry all must find innovative solutions to minimize complexity and risk
in these massive undertakings, as it becomes a top priority to have all players on a project team
work more closely together. All of these factors and more are adding costs or reducing revenues
and creating new risk management challenges for oil and gas companies.

1.2 Framework of Petroleum Economics

A successful petroleum project typically passes through six phases in its life cycle, as shown in
figure 1. In petroleum economics a project constitutes: “the link between the petroleum
accumulation and the decision-making process, including budget allocation” (World Petroleum
Council, Petroleum Resources Management, 2007). Such projects may represent either 1) a
single reservoir or field; 2) an incremental development in an already producing field or
reservoir; or 3) the integrated development of a group of fields or reservoirs. This referenced
group can be held in common ownership. In addition, an individual project would seek to reach a
level where a decision to proceed with spending money on it, or not, is made. Of course, the
associated range of estimated recoverable resources would be established for the project. The life
cycle of a typical oil and gas project have been portrayed as six distinct stages. These are
identified below in Figure 1. It has been observed practically though, that, over these six stages,
the risk-reward profile of the project changes. And, further, such risks typically comprise three
core elements; namely, geological, financial and political. As a rule, geological risks tend to
diminish as petroleum finds and discoveries are made, but in the cases of the latter two risks
(financial and political) these can in practice multiply. This changing risk-reward profile often
produces changes in the balance of negotiating power between the Owner, and the Contractor.
Figure 1: The life cycle of a petroleum projects
(modified after Johnston 2003)

1.3 Cost Drivers and Economic Analysis in the Upstream

As companies became more adventurous with the aim of increasing reserves and boosting their
corporate image, huge capital costs have grown even larger, given the industry’s increasing trend
and proclivity for mega-projects that leverage economies of scale. Mega-projects have become
commonplace in the upstream oil and gas industry, as activity fans out in more challenging
physical and technological demanding environments. With the expanding project scope comes
bigger challenges to manage project risk. Offshore oil and gas development increasingly tilts
toward the mega-project scale because of the burgeoning exploratory success the industry is
enjoying in ultra-deep waters, where development project costs routinely run into the billions and
schedules can span half a decade or more. The relative scarcity and greater cost of capital also
looms large for the upstream industry, with capex constraints becoming increasingly important
as mega-projects proliferate. The largest upstream cost is the "spread rate" or daily cost to
operate oil rigs. That includes the rig lease itself and the cost of personnel, fuel, food, and so
forth. Rig rates can change whenever the lease is renewed, so there is a strong supply and
demand component to rig cost. Capital expenses such as well tubulars and production facilities
are usually a large slice of the pie. Exploration/development costs like seismic data acquisition
(to find new prospects) can be expensive. But not as expensive as failed wells, dry exploratory
wells impose an enormous cost because of a high level of uncertainty at this stage, and success
rates of exploratory wells(~60%) are much lower than that of development wells(~90%),
expectedly. The cost of recovery depends on the formation, age of the field, location (onshore/
offshore) and reserves in place, so risk-management absolutely must be considered in upstream
economic models. Employee compensation is a relatively small part of the total cost breakdown;
I've heard 20% is considered high. Upstream revenue is the sales price of whatever comes out of
the ground: oil, gas, and condensate. That is sometimes spot prices (the quoted price of oil that
day) but more often is based on a fixed-rate production contract to reduce volatility. Higher
oil/gas prices mean more revenue. In comparison with midstream costs, which are driven by
installation /repair /maintenance of pipelines and pumps, as well as personnel. Revenue is linear
with volume of oil/gas moved through the pipeline. Generally, higher oil consumption across the
board increases profits.

2.1 Key Business Risks Indicators Exposed to the Upstream Projects

All companies need to take risks at strategic, tactical and operational levels to deliver their
objectives. Anything that makes achieving these objectives uncertain is a risk and needs to be
managed. For the upstream side of the oil and gas industry, risk identification and analysis plays
pivotal role in the optimization of project economics. It further provides clear frameworks,
processes, context and a structure for managing and communicating risk and reward to internal
and external stakeholders. The five key risks identified are related and the occurrence of one may
affect another. The risk management process of XYZ Company showed a high degree of
correlation of the company’s loss exposure to five key risks and the corresponding impact on its
financial statements. The case study identified risks are:

a) Commodity Price Movement

b) Natural Disaster
c) Industrial Accident
d) Political Instability
e) Resource Availability

Apart from above risks, there are many other risks such as foreign exchange, insurance risk, joint
ventures, competition, credit risk, transportation infrastructure, general protection safety, legal
and regulatory requirement etc. which can be analysed in similar way or in a more customized
occurrence. The Risk Flow diagram below provides an overview of the possible relationships
between the individual risks

Figure 2: Risk Flow diagram showing individual relationship

(Risks management case studies – oil & gas Industry, Feb. 2016)

The figure above is based on the understanding of the individual risks. It’s designed to
underscore an indicative view of how the individual risks may relate to one and another.

2.2 Project Economics Optimization and Risk Management

Within the Oil & Gas Upstream Industry, Process Optimization is a key focus area that generally
looks at optimizing fluid production via Technical tools and deep Petroleum Engineering
expertise. It is important to remember that behind the deep science there are some basic things
we can do to improve any process. Oil and gas exploration and production (E&P) activities are
costly, risky and technology-intensive. With the rise in global demand for oil and fast depletion
of easy reserves, the search for oil is directed to more difficult areas – Deepwater, arctic region,
hostile terrains; and future production is expected to come from increasingly difficult reserves –
deeper horizon, low quality crude. All these are making E&P activities even more challenging in
terms of operations, technology, cost and risk. Therefore, it is necessary to use scarce resources
judiciously and optimize strategies, cost and capital, and improve business performance in all
spheres of E&P business. Optimization and Business Improvement Studies in Upstream Oil and
Gas Industry contains eleven real-life optimization and business improvement studies that delve
into the core E&P activities and functional areas covering a wide range of operations and
processes. (Sanjib Chowdhury, 2016) It uses various quantitative and qualitative techniques, such
as Linear Programing, Queuing theory, Critical Path Analysis, Economic analysis, Best Practices
Benchmark, Business Process Simplification etc. to optimize;
 Productivity of drilling operations
 Controllable rig time loss
 Deepwater exploration strategy
 Rig move time and activity schedule
 Offshore supply vessel fleet size
 Supply chain management system
 Strategic workforce and human resource productivity
 Prevent incidents & Losses
 Standardize consumption of materials
 Develop uniform safety standards for offshore installations
 Improve organizational efficiency through business process simplification

Process Optimization is the discipline of adjusting a process so as to optimize specified

parameters without violating business constraints, and should be always link back to a business
strategy and measurable KPI. The outcome should have clear and unambiguous business benefits
(Terry Price, 2017).
It is also common to get dragged down in the specifics of data quality, it’s important to focus on
a standard repeatable process which users will adopt; data can be refined once the process is
recognized. It is also important to start at the outcome (KPI’s), if the data element does not have
an impact on the outcome ignore it. Very often process optimization projects fail to meet any
goals due to over attention on resolving inherent data issues. Remember, process optimization is
an on-going activity, applying this mind set to goal setting is key to success. If the final goal is a
25% improvement in downtime then a short term goal of 10% may yield immediate benefit to
the company.

3.1 E&P’s Low- Cost Operating Model

This Low- cost operating model have shown the ability to shape and directs these capabilities –
including human expertise, technological capacity, and financial resources – to execute core
functions, such as frontier exploration, subsurface interpretation, resource de-risking and
development, upstream supply chain procurement and management, production operations and
maintenance, EH&S, midstream logistics, commercial, etc. The precise list of an enterprise’s
most critical capabilities, and their relative importance, is determined by its resource portfolio
and other positional assets, strategy, and implementation of the strategy (i.e. as manifested by its
operating model). This reconciliation of portfolio, strategy, and operating model, is the first step
in the now essential transformation toward a sustainable, low-cost operation – a process to
identify and strengthen key capabilities while cutting, revising or outsourcing others. There is a
growing body of organizational research that suggests operating model design has been more
evolutional than any conscious, rational effort toward optimization. Companies evolve their
operating models subconsciously, on the basis of industry convention and the emulation of
competitors. They use a limited number of different forms and operating models (e.g. functional,
holding company, multi-product-division, country-division, split-business chain, etc.) These
models are implicitly on assumptions about the economic characteristics of resources,
technology, institutional environment, human capital, scarcities in the economy, etc. However,
since these elements are changing, so too are the economic models, and so too must the operating
models. But industry adaptation of operating models to new economic realities is often
halfhearted. The upstream oil and gas industry has undergone dramatic evolution and disruptive
change; many aspects of its resources, technology, institutional environment, human capital, etc.
are changing. Moreover, very few, or virtually no, operators have proven to be “world class” at
unconventional, and deep-water, and late-life assets, and oil sands, and arctic drilling, and
international new frontier exploration, etc. Each of these resource types has its own requirements
in terms of critical capabilities, and therefore requires unique accommodations in terms of
operating models. Not only has the prevailing industry operating model proven to be not
successful across all plays, maturities, and resource types, but it is no longer consistent with the
demands of prevailing prices, industry economics, technologies, talent, etc. In many cases,
circumstances have demanded for lower-cost operating model, with fewer layers, more agility
and local control /adaptation by asset teams, and better collaboration with local vendors and
operators. In a few cases, operators have implemented change to accommodate a tailored
operating model, but history have shown that, oil and gas companies only changed their
operating models on an enterprise-wide basis in a post-merger integration, or in concert with a
financial restructuring.

Figure……??:
However, the upstream oil and gas Industry should proactively engage with operating model
innovation and rethinking strategy in response to evolving Industry economics and technologies.
In the face of increasing unfavorable challenges and risk in the oil and gas autonomy, it remains
possible to redesign operating models to address the new realities, and workflows can be
streamlined more effectively through expanded operating model redesign than just changes to the
organizational design.
Figure….???: Revenue Throughout Lifecycle