The recent and dramatic drop in the price of oil is spurring significant cost cutting in the oil and gas industry, making for some difficult choices for energy companies facing a “new normal” of $50-$70 per barrel. The large layoffs in the oil patch that USA Today reported this week represent some of these choices.
Indeed, in an interview today with Bloomberg TV, oil historian Daniel Yergin says that major oil companies will be facing budget cuts of 10-25 percent, while independent producers in North America could be looking at cuts of 30 percent or more.
The good news is that the oil and gas industry can take advantage of cost reduction tools and techniques, such as outsourcing and related cost optimization strategies, that other less-profitable industries have successfully used to create sustainable savings.
We all know that when the market price of a product plummets and production levels don’t change, it’s not difficult to predict a double-digit decline in revenues. In addition, market values for most major oil and gas companies are already well below “fair value” and return on equity is sure to lag. Though it was common to see return on equity percentages in the high teens among the industry’s major players just three years ago, these figures could easily drop by nearly two-thirds, considering that industry return on equity figures were around seven percent when oil prices plunged like this in 1998 and in 2008.
Oil prices have certainly exhibited significant volatility in the past, so why do industry executives and analysts believe we now have a new normal? In short: Saudi Arabia. The Saudis (with other OPEC members) have had only limited success over the past 40 years in keeping production low in order to keep prices high. But the inverse – keeping production high in order to keep prices low – has so far been an extremely effective technique for the Saudis to dampen competition and protect market share. That policy is not likely to change as King Abdullah’s successor takes over the world’s largest crude exporting nation. Saudi Arabia can tolerate the pain of low oil prices pretty well; its production costs are the lowest in the world. But its rivals, non-OPEC producers such as Russia, Nigeria and Venezuela, cannot. Russia, for example, reportedly needs a crude price above the mid-$80s just to be stable and to avoid further draining its cash reserves at its current level of military spending. A barrel of oil at $50-$70 certainly helps to defang both Russia and ISIS. These are clearly stated Saudi policy goals, but the most compelling indication of a new normal is that Saudi Arabia’s first order of business is to exert cost pressure on U.S. shale-fracking production efforts, which represent a long-term threat to OPEC.
The industry’s challenge in a $50-$70 per barrel world is that it can’t simply scale down operations to cut costs. Most of the industry is made up of highly capital-intensive businesses; once the capital has been invested, incremental costs are low. This is the reason that two specific oil and gas sectors – oil and gas extraction and pipeline transportation – have traditionally been so profitable. Unfortunately, the inverse is also true; cutting back production saves only those low incremental costs. In addition, the industry has less room to maneuver. It has suffered a gradual decline in operating margin over the past ten years. According to ISG research, average operating margins of the 10 largest oil and gas firms in the world were around 17 percent from 2005 to 2007. As the chart below indicates, margins had not recovered through 2013, prior to this current slide in oil prices.
To stem the decline in energy company stock prices, the industry has several obvious options, each with varying impact on market capitalization: 1) it can cut back on making capital investments, and the majors are already talking publicly about such plans, but this is hardly the path to growth, 2) it can cut dividends, although this doesn’t help stock prices, and 3) it can conduct targeted layoffs, which several of the majors are currently doing in middle management and other non-operational functions.
Most critically, however, the industry must make structural changes to run leaner and more efficiently than they have in the past on a permanent basis. This requires a fundamental shift in priorities for the industry. A focus on efficient operations has not previously been nearly as important to financial success as better exploration and production techniques.
The opportunity for the oil and gas industry is to take advantage of cost reduction tools and techniques that other less-profitable industries have used successfully for years. First-generation outsourcing of IT and other back office functions, for example, is a time-tested and sustainable strategy. While 45 percent of the Forbes Global 2000 currently use outsourcing to a significant degree, only 36 percent of oil and gas companies in the Forbes Global 2000 have taken advantage of this basic business strategy. Considering net business case savings for first-generation outsourcing is typically at least five percent, the opportunities are obvious. Mature cost optimization strategies, such as application portfolio rationalization and leveraging cloud infrastructure, are often used alongside outsourcing to drive even greater cost performance.
While working with 75 percent of the Forbes Global 2000 over the past few years, we have learned that clients gain the greatest value from outsourcing after a strategic analysis of costs and performance of various IT and back office functions. This technique yields an indicative business case that reveals whether first-generation outsourcing is part of the answer, is unlikely to be helpful, or not worth the risks. An upfront analysis can seem counter-intuitive to a CFO looking for the fastest path to significant savings, but the several weeks it takes is well worth the identification of the right functions to be outsourced and the certainty it brings that an outsourcing project will, in fact, deliver the planned benefits. And it is far more likely to deliver real value than the ready, fire, aim approach that can happen when a sourcing advisor is not at hand.
ISG can help. Contact us to discuss further.
