Successful operators are responding to the market by adopting a more strategic view of the role of their supply management organizations and implementing advanced contracting strategies to manage costs and secure supply.
Chris Newton, Preston Cody and Rick Carr, Deloitte Consulting LLP
Low natural gas prices favoring economically advantaged shale gas resources, combined with a need for operators to drill to maintain leases, have spurred a rapid recovery in drilling and completion activity in unconventional basins. The resulting boom has led to a rapid tightening of critical services and equipment capable of developing these onshore resources. Given the continued volatility in commodity prices and fluctuating cost drivers, operators must focus on achieving lean, low-cost operations, which require stable and reliable sources of critical services and materials. Securing supply in the face of a tightening supply market of intermittent availability, interruptions to operations, and increasing costs has become the No. 1 challenge for today’s unconventional resource-focused oil and gas supply chain organizations.
MARCELLUS SHALE
Nowhere has the growth in unconventional exploration and production been illustrated faster than the Marcellus Shale, where drilling activity has tripled since January 2008. This has put an enormous strain on the regional supply base for drilling and oilfield services, which until recently has been relatively small. For example, Pennsylvania has a drilling and oilfield services workforce about one-seventh the size of Oklahoma’s. The rig count has leapt from about 20 to more than 100, mostly through newbuilds and rigs moving in from Canada, Texas, Arkansas and Oklahoma. The subsequent increasing drilling activity and the high number of fracturing stages per well have greatly affected demand for services. Pricing has rebounded handsomely for services in the Marcellus, with the dwindling availability of suitable rigs and fully utilized stimulation crews in the area. As a result, rig day rates are up 25–40% from recent lows and stimulation costs have jumped nearly 100% since the lows of 2009.
Given the strong interest in recent Marcellus acreage sales and high levels of shale-oriented mergers and acquisitions and joint venture activity, operators’ demand for services will likely continue to outstrip service providers’ ability to expand supply and infrastructure for this play. With estimated breakeven gas prices of $2.5–$3.5/Mcf, Marcellus Shale operators can still profit handsomely in this play as long as they keep finding and development costs down.
SECURING SUPPLY WHILE MANAGING COSTS
The economics of unconventional resource plays demand that E&P companies run efficient, “production line”-style operations at low cost. The tightening supply market presents two major challenges: securing stable supply and simultaneously managing costs.
Securing supply. In today’s shale gas operating environment, operators would ideally lock in a rig or dedicated stimulation crew under contract to ensure that operations flow smoothly from pad to pad, but this is a seller’s market. Some service providers are avoiding longer-term agreements with operators, reasoning that guaranteeing future utilization is not worth the risk of missing out on anticipated price increases. As such, they either want to play the spot market and avoid dedicating their resources to one operator, or require a premium for term contracts. For example, drillers have sought 10–20% premiums on their day rates to enter contracts greater than 12 months. In the case of stimulation, a market dominated by three main players, service providers have carefully segmented their customer base and have allocated portions of their fleet to dedicated crews for their top-tier customers while allocating an ever-growing percentage of their crews to spot-market work for other customers who are willing to pay more for services.
Operators that look for a rig or stimulation crew only a few weeks prior to their need may find that there are few options on the spot market. In addition to the high premiums associated with spot work, operators may also have to settle for less technically efficient or capable equipment. Given these challenges, operators should go to market for critical services months in advance of the commencement of work. This widens availability and provides the operator with greater leverage during negotiation—not just on pricing but also on contractual terms.
Managing costs. In addition to the supply constraints, there has been continued upward pressure on pricing from service providers. Recent pricing for spot-purchased stimulation work in the Marcellus Shale is averaging $150,000 per stage, up from $50,000–$75,000 in mid-2009, and crew availability is becoming more limited with each day that passes. Some of the pricing increases can be attributed to service providers taking advantage of the tight market. Other increases are tied to higher costs-to-serve incurred by the service providers, which must be passed on to customers in order to maintain margins. In the case of stimulation, demand for frac sand in many basins has increased dramatically, and the market has already shown signs of 5–10% increases in sand prices since the beginning of the year.
Active rig and drilling permit counts have been generally trending higher week to week, indicating that the current tightening supply and escalating price environment will continue in the near term. These dynamics risk undermining long-term investment plans and operational improvement programs, yet there are new supplier relationship models that can help operators mitigate these risks.
NEW SUPPLIER RELATIONSHIP MODELS
Operators that rely on traditional, transactional business models with service providers will experience schedule delays and significant rate increases. There are two alternative models that leading operators are pursuing: strategic partnerships and developing sources of supply.
Strategic relationships. Some operators looking to gain a competitive edge have initiated strategic relationships with their key service providers. These go beyond the traditional provider-managed alliance and include provisions that align operator and service provider interests over a long-term period. One key mechanism is the use of long-term (over 12 months) contracts with rates linked to public indices designed to manage price fluctuations in cost components tied to commodity prices and labor rates. This provides the operator with a stable source of supply, enables the service provider to secure long-term utilization for its crew and equipment, and gives both parties a mechanism to share market pricing risks. Another mechanism is collaborative improvement agreements in contracts, where both parties agree to work together to manage costs. In one recent example, a long-term agreement for stimulation services included a provision for collaborative efforts to improve materials and transport costs. In accordance with this provision, the service provider is working to develop a rail spur that will enable the transport of frac proppant closer to the operator’s acreage. It is estimated that this move will reduce the per-stage cost to the operator by 10–15% in stimulation costs over the life of the contract.
A third mechanism that has been seen in these alliances is the concept of including gain share provisions in contracts. This aligns both parties’ interests in achieving highly efficient operations, and can be achieved through pricing models structured to promote productivity. For instance, payments for a dedicated stimulation crew should cover fixed costs, and then provide additional revenue for the number of fracs performed in a month. Structured correctly, the operator can realize a volume discount for high usage of the crew in a month, while the service provider earns additional revenue and margin. Such a partnership incentivizes each party to maximize the number of fracs performed per month. Implementing this involves adopting shared targets for key performance indicators, tracking performance against these over time, and meeting regularly to review performance and launch improvement initiatives. It is critical that these performance metrics cover both operational and health, safety and environment (HSE) measures.
Developing alternative supply sources. Moving rigs across a continent and making required equipment upgrades (such as installing a top drive) can run from $500,000 to over $2 million. A new frac spread could cost upward of $30 million. With recent market volatility for both commodities and oilfield services, many suppliers are reluctant to make speculative investments in capacity. When the market lacks the required capacity for an operator to develop a strategic partnership, one alternative is to induce the investment in supply. This strategy works best when an operator can identify a smaller service provider that still offers sufficient technical and HSE capabilities, and can offer that provider a large and long enough contract to induce it to invest in capacity for the work.
This model turns the table on the normal balance of power in the relationship between small, independent operators and their much larger service providers. The operator will likely become the service provider’s largest and most important customer, ensuring its best efforts. Such arrangements also enable operators to contract under favorable terms and conditions and require the service provider to implement desired operational and HSE programs.
Implementing these models at North American E&P companies will require a larger and more sophisticated role for supply chain organizations than in the past.
ENHANCED ROLES FOR SUPPLIER MANAGEMENT
The legacy operations view of supply chain is that of an “order-taking” department with little or no contribution to supply strategies. This outdated philosophy can leave a tremendous amount of value on the table if followed. Those operators that have been most successful have learned to use their supply management organizations to drive the creation of supply strategies based on operational demands. Through clear channels of communication with operations personnel, supply chain organizations are able to better manage the balance between securing supply in a tight market and managing costs. Operations personnel should provide timely updates informing the supply chain organization of their development and production plans as they are compiled. This will allow the supply chain professionals to poll the market and determine availability, lead time and costs of materials and services, and then craft an appropriate go-to-market strategy. This allows for cross-functional coordination of sourcing supply and management inventory of wells to be drilled and completed. As this information passes between the two groups, schedules can be adjusted, budgets can be maintained and targets can be met or exceeded.
One successful operator has established weekly meetings between its supply chain and operations personnel where operations shares updated stimulation schedules and supply chain reports on the stimulation market and supplier availability. Through this collaboration, both parties can take a longer-term view and work together to achieve the goals of the company in a more impactful way.
As supply chain organizations mature and become responsible for increasing amounts of spend, many operators are opting to use a “category management” approach to handling key areas of spend. Category managers hold responsibility for monitoring the market, understanding supply availability and maintaining contact with key service providers. They are closely tied with operations and understand short- and long-term supply needs. As category managers become commercial subject matter experts for their area, the value that operators can extract from supply chain organizations increases.
Category managers also act in “reverse business development” roles, seeking out new suppliers in tight markets to increase competition and improve the likelihood of securing supply. Opening up sourcing events to as broad a pool of suppliers as possible will both identify the widest range of available capacity and ensure a competitive process that limits supplier pricing power. For example, a Marcellus operator was recently able to add three rigs to its fleet when most operators were struggling to find any available rigs capable of horizontal shale drilling. This fleet expansion was the ultimate outcome of a category management and sourcing process initiated months earlier. As such, the operator was able to add these rigs at about 15% below market rates with the most favorable contractual terms and conditions on any of its drilling contracts to date.
Additionally, the different perspectives and market intelligence that can be gained from maintaining contact with numerous suppliers can provide category managers with a broader view of the market. Many operators are increasingly turning to category managers to provide strategic advice and analysis to drive decision making company wide. One operator recently initiated the creation of a should-cost model to better understand its suppliers’ costs-to-serve for stimulation. As a secondary goal, the company also wanted to understand whether there was sufficient justification for a wide price variance that had existed in what was being paid for services between the company’s operating areas in different geographic regions. Through the resulting analysis, the company’s executives were able to substantiate the price differential, and also extract valuable information to utilize in negotiations with service providers.
CONCLUSION
Given the economics of many unconventional plays and increased scrutiny on meeting production targets, the current tight supply markets pose a significant risk to operators. Any operator intending to maintain or expand operations in unconventional developments should review its approach to securing supply of critical drilling and completion services and equipment in this light. Tomorrow’s successful operators will be those who adopt a more strategic view of the role of their supply management organizations, and implement advanced contracting strategies to manage costs and secure supply. 
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THE AUTHORS
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Chris Newton is a Manager with Deloitte Consulting LLP’s oil and gas practice with a focus on strategy and operations. He has over nine years of energy industry experience, and has performed work in the areas of strategic sourcing, business process optimization, contracts management, inventory management, corporate strategy, supply chain management, ISO compliance and change management. Mr. Newton is also a frequent instructor for Deloitte’s internal oil and gas training programs.
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Preston Cody is a Manager with Deloitte Consulting LLP’s oil and gas practice with a focus on strategy and operations. He has eight years of industry and consulting experience in the areas of operational performance improvement, strategic sourcing, capital projects accounting and oversight, and process reengineering. Mr. Cody has served both global and independent producers working on supply chain projects for upstream operations, with an emphasis on drilling and completion activities.
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Rick Carr is a Principal for Deloitte Consulting LLP and serves as the oil and gas Operations and Supply Chain Lead within the Energy and Resources group. He leads Deloitte’s practice area for drilling, operations, maintenance, capital projects, contracting, procurement and logistics, and also serves as the E&P champion. Mr. Carr has over 20 years of experience in various supply chain and operational roles for oil and gas and industrial companies and in consulting.
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