Is a New Approach to Procurement and Consolidation Required?
Mohammad Faiz Azmi
Welcome to the International Investor: Oil & Gas Strategic Review 2017. The objectives of this roundtable meeting are to discuss the Malaysian oil and gas sector in the context of the low oil-price environment and to reach a consensus on how to secure a sustainable future. The core of the debate will focus on the areas of service procurement and industry consolidation.
Turning first to procurement, Zamri, could you get the ball rolling by outlining the state of the Malaysian oil and gas industry in 2017?
Muhammad Zamri Jusoh
Regarding production, PETRONAS closed 2016 three per cent up from the previous year, with approximately 2.36 million barrels of oil equivalent. In terms of operational efficiency, performance has been sound and I expect this to be reflected in the final figures.
From the global perspective, the Organization of the Petroleum Exporting Countries (OPEC), in conjunction with certain leading non-OPEC producers including Russia, Mexico and Kazakhstan, announced in January 2017 that they would be cutting production by the equivalent of 1.8 million barrels per day. As a result, crude oil prices reached a more stable price of approximately US$50 per barrel during the first quarter of this year, compared to about US$29 per barrel over the same timeframe in 2016.
In relation to expenditure, no significant cuts were made in 2016 and PETRONAS spending during that 12-month period did not differ extensively from the initially devised plans. Our operating expenses (opex) were approximately MYR13 billion in 2016, while capital expenditure (capex) was slightly below the original budget at the end of the fiscal year. Regarding project numbers, PETRONAS made no cuts or deferrals from our original sanctioned plans in 2015 and the project pipeline proceeded as normal throughout 2016. The budgetary outlook for 2017 in terms of upstream expenditure is between MYR60 and MYR65 billion, with an equal spread between capex and opex, while spending on exploration is expected to total between MYR2.5 and MYR3 billion.
Overall, I do not anticipate the low oil-price environment to change significantly in the short-term because further steps are required to address the oversupply situation. However, I am cautiously optimistic about the future of the industry beyond 2017.
PETRONAS conceptualises procurement as four separate components: downstream production, downstream projects, upstream production, and explorations and projects. Generally, the low oil-price environment has not significantly affected downstream production and projects since the former continues as normal and expenditure on the latter, as Zamri explained, remains unchanged from 2015 levels. This is largely due to our ongoing commitment to investment in the Refinery and Petrochemical Integrated Development (RAPID) project in Pengerang, Johor.
Regarding the upstream segment, it is business as usual in terms of production, but exploration and projects have been affected, including drilling and projects on wellhead platforms and central processing platforms, among others. However, it should be noted that Malaysia is not unique in this regard since upstream capex has been reduced by approximately 20 to 30 per cent worldwide in recent years.
When oil prices were close to US$100 per barrel, service providers invested heavily in new assets to be able to provide PETRONAS and parties to production sharing contracts (PSCs) the necessary support for ongoing drilling campaigns and production. Following the 2014 fall in oil prices, large numbers of the newly purchased assets, such as specialised vehicles and fabrication yards, have been heavily underutilised due to cost-cutting measures across the market. As a consequence, there is now a significant excess capacity of these assets and many service providers are struggling to meet their financial obligations. This situation represents a sizeable challenge to the services sector.
Mohammad Faiz Azmi
While many companies around the world are making cost reductions, I have been told anecdotally that certain countries, including in the Middle East, are not reducing their exploration budgets. This raises a question regarding where the industry sees itself in the medium to long term, particularly given that oil and gas reserves are declining. Is cutting exploration budgets an adequate response to the low oil-price environment?
Muhammad Zamri Jusoh
First, exploration constitutes only a small fraction of PETRONAS’ total spend. Second, the exploration baseload will remain consistent: 19 exploration wells were drilled in 2016 and this number will be the same in 2017. We are fully aware that PETRONAS needs to explore new wells to secure our resource base for future growth, hence this consistency. As Samsudin explained, the area most affected by the price downturn is not exploration but rather development projects on the capex side. For example, we had 27 rigs operating at the peak of our activity, but following the price collapse, and our subsequent deferral of certain projects, this number has fallen to eight or nine.
Moreover, PETRONAS is keen to heed the warnings from other major players in the global oil and gas industry, such as BP, who have experienced the negative consequences of large-scale exploration cuts. Although focus may shift depending on our interest in oil or gas, we will keep both the number of exploration wells and the exploration budget constant over the coming years. Our objective is to avoid a scenario in which, given the deferral of projects that I mentioned, we are suddenly faced with a large-scale drop in production in 2021 or 2022. The most prudent strategy is therefore to take pre-emptive steps to guard against this situation from arising in the first place.
Mohammad Faiz Azmi
Beyond PETRONAS, what can be done in the services sector in terms of procurement to help overcome the most difficult issues facing the industry?
Boustead Penang Shipyard (Boustead)
One important way forward relates to consolidation. There is a perception in some quarters that fabricators are unwilling to work together to overcome ongoing difficulties. This is a misconception and I can confirm that players in the fabrication sector are ready and willing to collaborate by means of working performance consolidation. This could include dividing workflow and conducting, for example, modular fabrication in which equipment is built off-site at one fabrication facility prior to its worksite delivery, installation and integration at another yard or directly into field operations. This is one way to increase the utilisation of the excess capacity in this particular segment.
Using a working performance consolidation approach as opposed to equity consolidation is preferable in this context. Although equity consolidation has proved successful in other industries, such as banking, it would not translate well to the Malaysian oil and gas industry scenario in 2017. This is primarily because the business of fabricators comes directly through PETRONAS, rather than the general public, as is the case with the banks.
From the perspective of an international oil company (IOC), I would contend that players have no choice but to adapt to the low oil-price environment. The downturn in prices put many oil companies into a period of negative cash flow, with more money going out than coming in. A necessary first response was to cut costs in discretionary areas, which, for many companies, included exploration. The need to cut costs became more acute as it became apparent that the downturn may be prolonged. Since revenue from existing production keeps the companies running, expenditure to maintain production from existing producing assets tends to be prioritised over new investments and more discretionary spend.
In general, it is easy to view exploration and production as two independent areas. However, all cost reductions achieved in production and all efficiencies gained along the way help to improve a company’s cash flow. In turn, these improvements enhance the funding possibilities for exploration and development projects. It is important that companies and national authorities understand how the two areas are closely linked.
The first point to note is that the Malaysian oil and gas industry is composed of multiple segments, each with its own priorities and concerns, and these must all be treated differently. Since Sapura Energy exists on both the operator and contractor side, we have first-hand experience of how distinct segments work.
Regarding the different segments on the services side and the issue of excess capacity in the market, some segments, such as fabrication yards, reached overcapacity during the peak in oil prices although additional yards continued to be developed. There is also excess capacity in drilling, globally as well as in Malaysia, yet increasing numbers of jackup rigs are still coming online.
The pursuit of consolidation in relation to commodity-based segments will not resolve the problems facing most companies. If two companies that each operate with 50 barges consolidate to form a new company with 100 barges in a market where there is only demand for 50, the remaining 50 will still need financing. This type of consolidation is expensive and unfeasible and so the most effective way to resolve the problem is to remove the excess capacity from the market.
Genuine consolidation requires the consideration of several crucial aspects such as competence, capabilities and employment in the oil and gas industry. In order to safeguard these aspects, I suggest the adoption of a managed approach to the levels of capacity required by each player based on volume of oil projections. This may sound counterintuitive to a free market model, but consolidation is a multi-faceted undertaking and its long-term success depends on securing a sustainable future for all parties involved.
Mohammad Faiz Azmi
Related to that point, sentiment in certain parts of the industry is that over-reliance on market forces has led to increasing numbers of companies entering the market, thereby creating excess capacity. To what extent could this kind of managed approach help to determine which players survive and how the market responds?
All companies have a social responsibility to develop capabilities and create job opportunities. Therefore, allowing the Malaysian oil and gas industry to become fully subject to market forces is imprudent, as consequences from industry cyclicality may lead to large-scale job cuts and loss of competencies and talents, which is key to maintaining the country’s competitive advantage.
PETRONAS has been very successful in building local competencies in the industry. Indeed, Sapura Energy is a case in point: initial PETRONAS commitment to develop basic capabilities has helped transform us into a leading global company today. Furthermore, alliances that we have entered into with international companies on a local level have, in turn, generated additional competencies, creating a healthy virtuous circle of capability building. It is this type of stimulus provided by national oil companies (NOCs) that constitutes the primary reason for international companies to invest and localise capabilities in that particular market and enter into such alliances with local companies.
As such, a managed approach must include policy dialogue with all stakeholders based on prioritising a genuine understanding of industry needs and the development of capabilities and competencies. This step is essential to spur the creation of job opportunities in Malaysia and the flow of talent from abroad.
Shell Malaysia & Shell Upstream, Malaysia and Philippines (Shell)
It is also important that industry leaders view the current situation from a global, rather than parochial perspective. On the services side, many Malaysian players are able to compete for international jobs. On the operator side, players seek to allocate capital based on where they will receive the best returns. Accordingly, one potential danger of an overly managed business environment is that it risks pricing itself out of the international market. Therefore, a delicate balance has to be struck.
Mohammad Faiz Azmi
Turning to the excess capacity of underutilised assets, and with the previous question regarding a managed approach in mind, how can excess capacity be resolved?
Baker Hughes South East Asia (Baker Hughes)
I have two perspectives. First, market forces have been one of the contributing factors to this excess capacity. Therefore, an initial step is for all service providers, including Baker Hughes, to engage in a certain amount of self-reflection on whether they are contributing to this excess capacity and what steps can be taken in response. For example, companies may wish to analyse what returns are being generated from their continued presence in a particular segment and to define possible alternative pathways moving forward.
Second, and linked to consolidation, is the need for all parties to understand existing market capabilities. One possibility is to identify areas where local and international players are able to collaborate to naturally reduce the amount of capacity in the market, as Azman has said. This would involve an international player withdrawing from a full service model and a local counterpart occupying part of that space. This contrasts with the usual situation in which two players directly compete for the same piece of the metaphorical pie.
These two approaches are not solely based on altruism or a nationalist sense of Malaysian companies prospering at the expense of non-Malaysian entities. Rather, they constitute alternate ways in which companies can adapt to an evolving market. It is important not to become the dinosaur by refusing to do things differently, because we all know what happened to the dinosaurs!
ExxonMobil Exploration and Production Malaysia (ExxonMobil EP Malaysia)
A salient issue is the structure of the upstream procurement process in which the service provider, the operator and PETRONAS work together in order to secure a service agreement between the two former parties. This is a time-consuming exercise in which discussions have to be held in a particular order throughout this three-party process. Therefore, liberalising this procedure by enabling the service provider and operator to finalise the service contract directly, with only guidance being provided by PETRONAS, would increase efficiency. Within the new framework, the operator would still need to adhere to guiding principles and local industry development, including assurances to safeguard operator involvement in international alliances.
A useful governance example is the downstream oil and gas sector, which applies a less structured model. Liberalisation along these lines would facilitate greater flexibility in the system and help the upstream segment to begin to address the excess capacity we have been discussing.
Furthermore, it is important that a secondary part of this modification to the procurement process is geared toward bolstering service provider capabilities. It is common for service providers, especially smaller ones, to operate reactively by simply doing what is required, rather than adopting a proactive approach of working according to their own in-house standards of safety and/or capability. Therefore, any new framework could also ensure that guidance is provided to local companies in a collective manner, rather than stewarding them on an individual basis, as is the case at present.
These kinds of steps would not only foster greater efficiency in upstream procurement, but also improve safety standards and sector-wide capabilities.
Governance is key, and I understand why the word ‘managed’ has been used a number of times because there is always a temptation to try to actively manage a process to resolve a particular problem. However, I believe that a small dose of management in conjunction with a large dose of free market will, in the long term, provide the best solution to excess capacity in the market.
Pursuing forced consolidation is not the right solution since naturally occurring consolidation will be far more sustainable. For example, with regard to the 100 barges mentioned by Shahril, the 50 barges removed from service as a result of consolidation efforts should be the oldest ones that are the most expensive to run and the poorest in terms of emissions and safety. Inevitably, this kind of step will involve a transition period and, unfortunately, there will be difficult decisions to be made and tough consequences as a result. In the medium to long term, however, I would suggest that exposure to competition will deliver the healthiest and most competent supplier industry.
First, any small dose of management will depend on the objective we have as an industry. Second, efforts to increase procurement efficiency will not necessarily help to tackle excess capacity. I understand the need to create jobs and build a capability-led industry in Malaysia, and that this process entails certain rules regarding how procurement is effected. However, the way things have been done in the industry for a number of years have, to some extent, generated this lack of cost competitiveness and excess capacity in the market, which suggests that certain other changes are required. It is therefore important to address each challenge individually, whether efficiency or excess capacity or another aspect, in order to iron out the creases.