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This crash could add the finishing touches to the grand
reshuffling of the upstream service sector that started in
2014
The last month has been a nightmare for the upstream service
sector. Brent plunged to around $20 in March. And the signs of an
impending upstream service sector recovery in 2020 was quickly
vaporized. Demand destruction as a result of COVID-19, and the oil
market price war are the key factors derailing the recovery. Both
are unforeseen and their future development are highly uncertain.
The upstream supply chain must brace itself for an uncertain and
volatile future.
Out of fear, buyers have deferred a significant portion
of pre-FID projects in 2020, despite the much lower costs today
compared to 2014
At first sight, this crash seems a repeat of 2014, but much have
changed since 2014. Costs levels are different. Costs levels in
2020 is still way below that in 2014. This means that although
Brent price has slumped to the $20/bbl range, project economics
have not deteriorated as much as back in 2014, when oil price had
also slumped to $20/bbl.
In addition, after 5 years of pressure to reduce costs,
operators are much more open-minded with their procurement and
development strategies than in 2014, which further reduce cost. One
such area is the wider use of supplier's specifications and
repeated designs rather than insisting on operators' unique
in-house standards and designing everything from scratch. For
complex facilities like FPS, this could reduce EPC cost by a
third.
Furthermore, standardisation, which began at the component level
before 2014, has intensified after 2014. Standardisation not only
reduces item unit costs, but also inventory and logistic costs.
Since then, standardisation has spread to entire facilities at a
rate not seen before 2014. Concepts such as SBM fast4wards and
Modec 350 FPSO are gaining popularity.
Lastly, supported by rising competencies, new contracting models
have reduced the risk to buyers for using lower costs, but new
contractors. This has opened many opportunities promising buyers
lower cost in the previously expected inflationary environment of
2020-25.
Project fundamentals aside, fear of a prolonged low oil price
has overwhelmed the market. Demand destruction is real as most
operators are bracing themselves up for a prolonged period of very
low oil price. We have already seen major oil and gas companies
cutting capex budget for 2020 by 20-30%. Almost all yet to FID
projects of the IOCs for 2020 have been shelved for now. We are
bracing ourselves for two more years of winter.
Figure 1: Global upstream
E&P capex by case
All the bad news and pragmatism aside, many are hoping for a $55
oil. We must stress that $55 is not in any of our scenarios for the
next 2-3 years. But if oil price were to rebound to $55, we will
see a sharp recovery in tendering activities. This is because many
of the projects that have been delayed in 2020 like Barossa,
Scarborough, Cambo and Tano are all in very advanced stages of
tendering. Their progress is only derailed by the sudden drop in
oil price.
Only the strongest contractors will survive this time;
the contractor market might achieve the sustainable balance 2014
did not managed to bring about
The fate of the contractors is bleaker than before. The
survivability of contractors has generally deteriorated in the last
five years.
Figure 2: General survivability of contractors
(2020-21)
Firstly, flushed with cheap money and historically high backlog,
capacity destruction is insufficient to balance the oversupplied
contractors' market five years after 2014. Today, the market is
generally still oversupplied. E.g. the vessel market, there are
about 10% more vessels today than five years ago. The
much-hoped-for recovery in 2020 was supposed to breathe a second
life into many of these contractors. This recovery is not coming,
and many contractors will not survive this crash.
Secondly, excessive competition, which manifested itself in
under bidding, went undeterred even when it was the cause of
reduced margins before 2014 and losses after 2014. We saw EBITDA
and shareholders' equity falling as suppliers burn more money as
they work through projects. After five years of weak financials,
contractors as less financially positioned to survive today.
Lastly, moreover, the wish of draining down a huge backlog is
futile for many today as a weak recovery that started in late-2018
has not sufficiently beefed up many contractors to survive another
two years of deep winter. Worse when arguably much of the existing
backlog is toxic and priced on loss-ensuring bids.
Too big to fail might apply to some financially strong
contractors like the major FPSO leasing companies and those deemed
strategic to the state such as the major shipyards. Most upstream
contractors are neither. This crash will bring about the balance
that 2014 failed to bring about to enable the competitive
contractors to build a more sustainable supply chain.
And what about the cheap money that kept them afloat after 2014?
Upstream contractor is just one sector among the industries wreaked
by COVID-19. Governments have injected multiple trillions of
dollars worldwide, but there is likely not enough to go around.
Only a rebound in oil prices could save many of the upstream
contractors. Not many are going to survive these 2 years.
After this crash, unit cost inflation is needed, but
whether it is a "sustainable future" or one haunted by "ghosts of
the past" remains to be seen
Our future after this crash will depend on how the recovery
looks and what procurement and development philosophy and strategy
the operators will adopt. We see one certainty with two
futures.
The one certainty is inflation. Do not let the inflationary
decade between 2002-12 dash our hope for the future. History does
not necessarily need to repeat itself, if we learn from it. And the
two futures are one of higher unit costs but lower project costs
and the other being one of even lower unit costs, but higher
project costs accompanied by runaway cost overruns.
Today, there is only one way for the upstream supply chain to
survive sustainably - that is to increase unit cost, but to
decrease project cost. We are, may be to the disdain of many,
advocating letting unit cost increase. But we stress the importance
of keeping project costs down. And bear in mind from experience,
cost overruns can easily eliminate any savings in unit cost.
The prices that many contractors are charging today are
unsustainable given the risks they are taking for many projects.
Many contractors have little room to cut costs further today. For
many, even surviving on today's unit rate is akin of eventual
bankruptcy and the loss of accumulated capabilities. This is not
good for the operators too. We may have no more good contractors
like a DSME or Keppel to build our FPSO. We may not have a
McDermott to lay our pipes or a Transocean to drill our wells.
As such, the approach to cost reduction must change more.
Structural cost is the key. We saw green shoots of tackling
structural costs sprouting since 2014. Some of them were mentioned
earlier. This got to continue. It is a start and we are confident
this crash will and must hasten it.
Ding Li Ang is the Head of Research (APAC),Head of Engineering & Fabrication for the Upstream
Costs and Technology team at IHS Markit.
Figure 1: Global upstream
E&P capex by case
