Creating Supply Advantage For Oil And Gas Companies With Strategic Procurement

11/01/1999

In 1998, the rich, historic epic of the oil and gas industry entered a new era-one defined by mergers of
breathtaking scope and scale and high-stakes positioning for the world-class projects of the future.
"Shareholder value" is the clear and consistent rallying cry, requiring competitors to intensify their
efforts at cost leadership, while also seeking to boost revenues through the deployment of innovative
technologies and processes. Many look to market innovations, while others seek to unlock "supply
chain" value through innovative relationships with suppliers as a powerful tool to enhance shareholder
value.
A recent A.T. Kearney survey into the latter trend-the industry's efforts at creating supply advantage-
shows how leading oil and gas companies are taking strategic procurement beyond cost savings and
actually contributing to revenue growth. The effect is quite striking, as many of these companies are
discovering the full leverage that procurement can provide in driving the total return to their
shareholders (see related story, p. 56).
In our study, we found a consistent viewpoint from procurement executives on how procurement
strategies can create supply advantage. However, we also found that the execution of these strategies-
as reflected in the alignment of implementation efforts with the agreed priorities-continues to lag,
remaining largely focused on the traditional tools of cost leadership.
Creating supply advantage

Over the past decade, procurement has evolved from a tactical activity focused primarily on placing
purchase orders to a more-strategic process in support of the business (Fig. 1). The procurement
function now works effectively with users to understand requirements, select suppliers, and manage the
supply base to fulfill needs. Most Fortune 500 companies have implemented, to varying degrees,
strategic sourcing programs that have targeted tangible cost savings, most frequently measured in
purchase price (despite an acknowledgment that this is a poor substitute for total cost). The oil and gas
industry is no exception, as most of the major North American players have completed or are in the
process of implementing strategic sourcing programs matched to their own business models.
As we examine leading trends in procurement-as shown by early innovators in the automotive and high-
technology sectors, for example-it appears that procurement is ready for the next level of sophistication
beyond strategic sourcing:
The company aligns its procurement strategy with its overall business strategy, while taking into
account the characteristics of the industry in which it operates.
Such a company then enhances its competitive position by changing the nature of relationships with
suppliers-seeking to accelerate innovation and provide access to new markets.
The company further moves to apply best practices in all areas that complement and strengthen the
procurement strategy.
It was clear that the game was changing for procurement across a wide range of industries. Less clear,
however, was where the oil and gas industry stood by comparison with other industries in this
evolution. The A.T. Kearney survey was aimed at understanding the current state of the industry's
procurement practices. We hypothesized that the focus would go beyond traditional cost leadership,
seeking to align business and procurement strategies to create supply advantage (Fig. 2).


The survey posed four key questions under an overarching theme (Fig. 3): How can strategic
procurement add to oil and gas industry participants' drive to create shareholder value-especially
important for an industry whose returns in recent years have lagged those of the S&P 500 (Fig. 4)? The
principal questions were:
What procurement strategies are cited to contribute significantly to business success in today's
challenging industry environment?
What is the level of implementation across various procurement strategies among industry participants
What barriers and issues does the procurement function face in the drive to add value?
What are the most important issues for oil and gas procurement between now and 2002?


We purposefully did not look to quantitatively "benchmark" the companies on traditional productivity
measures-instead choosing to focus on strategic issues that would materially influence the future of the
function.
Top procurement strategies
The participants responded that the majority of "hypothetical" procurement strategies we suggested in
the survey are applicable to their business. Those that were least applicable related to shifting
ownership of assets to suppliers as a tool to increase capital productivity. The top strategies clearly fell
into two major areas of focus, consistent with the mission statements and stated strategies shared by
the participants. Four of the strategies focus on supplier selection and supplier management, while an
additional four focus on total supply chain management. The top eight strategies, as ranked by the
participant responses based on applicability, are detailed in the following sections.


Non-equity supplier incentives
Topping the list as the most applicable strategy for increasing shareholder value are nonequity supplier
incentives.
Some participants reported, for example, providing suppliers with "balanced scorecards" and sharing
the gains when benchmark performance (of, say, development wells in predictable formations in West
Texas) was surpassed. Others were attempting to tie the revenue of all suppliers on a project to overall
project performance, as has been done on at least one large offshore development. Other incentives
include automatic contract extensions for MRO suppliers, effectively eliminating the retendering process
when performance has been good. Safety incentives could also prove valuable. "Safety incentives
promptly stopped accident(s)..." explained one executive.
But the executives noted that implementation of such incentive programs continues to lag, highlighting
common barriers to achieving full success with this strategy. Predictably, many of the companies appear
to struggle with defining the right metrics, benchmarking current performance, and measuring
performance going forward.
"We are way behind... in the usage of performance measures," said one participant. "Having vendors
capture data and measure performance is not satisfactory."

Another noted that when suppliers propose ideas to increase revenue or ways to reduce costs other
than purchase price "...coming up with the right formula can be tough." And still others acknowledge
the inadequacies of current performance measurement systems, as reflected in the comment that there
are "no great successes because the metrics are not comprehensive" (Fig. 5).

Strategic sourcing
All the participants acknowledge the importance of strategic sourcing, procurement's major source of
contribution to cost leadership. Most are currently engaged in sourcing activities that are generating
positive business results. To ensure clarity, let's start with a consistent definition. We define strategic
sourcing as: A rigorous and disciplined process by which a company segments its purchases into
categories defined from the suppliers' perspective and then takes each category through a process to:
define requirements; understand the supply market; and negotiate with selected suppliers to achieve
advantageous commercial terms-leading to a portfolio of selected suppliers.

For example, several participants have used sourcing techniques for oil country tubular goods (OCTG)
and line pipe. One participant achieved very significant cost reductions on OCTG by applying a
probabilistic model that recognizes mills are able to produce pipe at much greater tolerances than those
used for specifications by the American Petroleum Institute and that therefore lower-weight casing can
be safely used. The same company also reached an agreement with a single Japanese mill for line pipe
for the majority of projects worldwide, advantageous because it was able to bundle previously discrete
buys for major projects around the world. "Sourcing has helped develop strategic relationships with key
suppliers for key commodities and services," claimed one executive.
However, participants see opportunities to go beyond their initial sourcing efforts to achieve even
greater returns. Sourcing, some report, "...only covers 20-30% of total spend" or "Sourcing only covers
materials, not services and capital." In general, participants have picked the "low-hanging fruit" of less-
complex categories-such as MRO, chemicals, and nonoperating services, e.g., travel. They are now at the
threshold of attacking the major spend areas such as rigs, engineering-procurement-construction (EPC)
contractors, and drilling services provided by the big three: Schlumberger, Halliburton, and Baker
Hughes. Many of the participants are already expanding their sourcing activities, stressing that "Sourcing
of services is a big area of opportunity," or sourcing is "...primarily completed for Tier 1 suppliers, (now)
being expanded to Tier 2."
Standardization programs, spec reviews
Most of the survey respondents see a fertile ground of opportunity through this strategy yet predict an
uphill battle that will require significant commitment from alliance suppliers. Others are reporting early
evidence of success: "The prize was standardization...created by cross-functional teams working with
the fabricating engineer and the procurement group." At least one company surveyed considers the
process "well-embedded," although somewhat inconsistently, because strategic sourcing encourages
standardization. One case example of success involved reaching standard specifications for large-
horsepower turbines for use in gas reinjection. By agreeing with the supplier that the various operating
companies would utilize a set of base specifications, with some fine-tuning to local requirements, the
supplier committed to significantly reducing equipment lead times-on items that are frequently on a
critical path for major projects.
But similar to strategic sourcing, there are barriers. In fact, the most significant barrier to many of these
procurement strategies is the "we're different" mindset, especially as it relates to buying services. In
particular, one respondent laments that it is "difficult to standardize foreign operations"-an experience
echoed by others polled.
Capital procurement processes
As a capital-intensive industry, oil companies have developed extensive project management processes,
such as CPDEP at Chevron Corp. and Advantage at ARCO. As 90-95% of project costs are paid to
suppliers, and acquired materials and services drive a project's technical performance, it's critical that
procurement processes integrate with the capital project process from start to finish. Several executives
believe that they've made good progress in this area. One stated, "A major alliance is in place for capital
project execution and procurement in both the upstream and downstream businesses." A second
respondent noted having a "formalized process in place since 1996," while acknowledging that the
expansion of the practice beyond refining and marketing into other business areas remains a future
opportunity.
The nature of integration varies, too. In general, participants are flexible in how they integrate with the
project team, recognizing that it's most important that they work together:
"For large EPC projects, we use the EPC contractors' procurement system or give EPC contractors access
to the operator's ERP (enterprise resource planning software) system"-depending on the business unit
and supplier involved. Flexibility and choice surface as consistent themes-"Procurement works with
suppliers to determine whose supplier agreements to use...and EPC contractors sometimes provide
innovation," but "relationship management is tough in this area"
Inventory management
Oil and gas executives see inventory management as a work in progress, saying that their organizations
have a long way to go in this area.
Technology is providing some tools to more effectively manage inventory, such as including site-facility
excess inventory as a virtual supplier in web site procurement catalogs. And there is an increasing trend
toward sharing spares with other local operators, for example on the North Slope of Alaska, or moving
inventory onto the suppliers' books and responsibility.
Some participants continue to pursue legacy-systems solutions, but recognize that "We are probably 2-3
years away from MRP (materials requirement planning) systems generating direct material orders when
inventories reach reorder levels," explained one study participant.
Challenges are seen as significant and long-term.
"There is a 'cultural challenge' in getting plant operators to give up site inventory," said one executive,
especially when it may have already been expensed or capitalized as part of a large project. Some view
inventory management as "a never-ending process."
Another agrees, claiming that, while no successes have been reported to date, "...refining and chemicals
inventories are now under central stewardship and are targeted...for reduction." Fortunately, the old
accounting barrier ("I can only sell it for market value") is being proactively removed by some
participants in order to get to the right answer for the business.
Access to suppliers' technical capabilities
With continued downsizing and consolidation, oil and gas companies find themselves in an initially
uncomfortable situation where suppliers have greater expertise, deeper resource pools, and larger R&D
budgets in their selective areas.
One participant says his company has developed relationships with three key suppliers solely to address
technical capabilities, explaining it as a straightforward attempt to "...focus efforts on the critical few."
Oil and gas companies have long been comfortable outsourcing activities in areas where they have
traditionally not held expertise and resource depth; now they are increasingly willing to look to suppliers
to provide capabilities in a much broader, more pervasive range of services.
Indeed, this practice is becoming a standard procedure, particularly in areas outside a firm's core
competence or not in its base business. Procurement executives report confidence in this practice,
indicating that "A number of alliances are designed to exploit supplier technical capabilities;" that "Joint
technology licensing agreements are in place;" and in one company's case, its OCTG "ellipsesupplier is a
part of an integrated team. They manage the supply chain on our behalfellipse" and are responsible for
ensuring pipe is delivered inspected and ready to go.
Leverage supplier capabilities, infrastructure
This strategy is distinct from the preceding one in that it's focused on more local or operating company
execution, rather than as a corporate-wide relationship.
The participants are well aware of the value of leveraging their suppliers' resources and infrastructures
and do so extensively but not consistently. For example, participants commented that, in some
disciplines and locations, "supplier employees are on our site."
The logging representative may be on-site for one business unit and included in engineering discussions
aimed at developing a suitable technical solution to a particular problem. Yet, in another unit, these
representatives maintain the more traditional "master-slave" relationship with their supplier.
In many cases, the motivation is sharply focused on joint cost reduction, such as "They use our facilities,
we use theirs." In others, we find more sophisticated arrangements where the participant "ellipseoften
utilizes a large supplier's buying power in commodities in which we have a small presence." And in yet
another case, a respondent reported having "access to suppliers' knowledge of industry best practices"-
for example, in scheduling turnaround maintenance work in multiple large plants.
Asset commercialization cycle time
Asset commercialization cycle time (that is, the time it takes, on average, to move from concept to
revenue flow in major capital investments) is acknowledged as an area of opportunity that procurement
can affect.
Nevertheless, it has received little direct attention from the survey participants-in fact, six of the nine
respondents did not pinpoint any specific efforts, successes, or issues in this area in either their written
comments or in interviews.
However, participants that did respond indicated that they are making some progress in this area,
specifically where they have been involved in the "front-end loading" of capital projects. Front-end
loading is the practice of making smaller investments at the start of asset development, before
committing the major capital, to prove out the technical and economic viability as input to a decision to
kill or complete the project. One participant has leveraged strategic sourcing of project requirements,
linked to a bundling of similar requirements worldwide, to ensure that the project economics
adequately reflect the potential true cost and to move a field into development.
This continues to be challenging for many of the participants, however, as they struggle to win the
support of the project managers (who are, of course, accustomed to being in total control of their
project's destiny) in order to provide procurement expertise.
The survey findings reveal a definite difference between the strategies that procurement executives
rank as important to creating supply advantage (Fig. 7) and the strategies that they are currently
implementing (Fig. 8).
The four strategies with the largest gaps between importance and implementation (Fig. 9) relate
principally to enhancing capital productivity-not to achieving cost leadership (Fig. 10). While supplier
incentives can drive towards all three applicable value levers-capital productivity, reserve additions, and
cost reduction (Fig. 11)-if the correct metrics are in place, the remaining three strategies are all focused
on capital productivity.
By the same token, standardization, inventory management, and improved cycle times for asset
commercialization also enhance capital productivity. Standardized specifications reduce capitalized
engineering costs. Lower inventory levels reduce the level of working capital. And accelerating the time
to commercialization generates increased revenues. All three improve a company's ratio of sales to
capital.
On the other hand, two strategies that are not expected to deliver significant value, outsourcing and
total cost of ownership models, are getting more attention than the participants feel is merited. Could
this be in response to corporate pressure to pursue outsourcing as part of the current wave of cost
reductions, although executives are not convinced of its validity?
Noticeably, the national oil companies show a markedly different strategic focus, highlighting strategic
sourcing as a highly applicable strategy not being fully pursued.
When asked, "Which barriers to strategic procurement are most significant?" the answers were the
boom-and-bust business cycle along with mergers and acquisitions (Fig. 11).
The boom-and-bust cycles have made it exceptionally difficult to develop sustainable high-value supplier
relationships, because behavior (on both sides) tends to revert to the more antagonistic them-and-us
mindset in the face of economic adversity. Other barriers are internal constraints and insufficient
capabilities in developing countries. Inadequate information technology (IT) systems, legal constraints
on alliances, and supplier distrust of alliances were also significant barriers. The least problematic were
production-sharing contract agreements, suppliers as future competitors, and supplier oligopolies.
IT and electronic commerce led the list of the top five procurement issues from now until 2002,
consistent with procurement in other industries, too (Fig. 12). Cost leadership came in second, followed
by personnel skills and retention, cultural and organizational factors, and oil prices. Less critical but still
significant are issues of trade barriers, industry consolidation, integrating procurement and business
strategies, and supplier alliances.
Conclusion
The survey has demonstrated that oil and gas procurement strategies do have the potential to
meaningfully affect shareholder value creation but that implementation is firmly focused on cost
reduction, presumably because this is what is demanded by company leadership.
The procurement executives who participated in the survey "get it" but do not have permission to
expand their horizons to significantly affect value creation. The major challenge for the industry's
procurement executives-and, more importantly, for the corporate and line-business executives they
serve-is to reframe their thinking to accept that excellence in the procurement and management of
externally purchased goods and services is truly one of the most powerful and leverageable drivers of
shareholder value for the enterprise.
Until that time, this function in the oil and gas industry will remain behind the leaders (in such
businesses as high technology and automotive) in adding value for shareholders.