Procurement, E&P Asset Management and TCO
The Procurement and Supply Chain Management (PSCM) organization plays an important role in optimizing operational and financial efficiency. This technical article dives into the involvement of PSCM in the E&P process and total cost of ownership (TCO).
Simply put, the E&P asset management cycle consists of a sequence of ten processes:
1. Recognize and assess exploration opportunities. This is the process by which we determine the economic viability of a potential field. How much oil and/or gas is present? What quality? What are the risks versus the potential rewards
2. Acquire exploration rights. This is the business process whereby drilling rights are obtained from the host country/NOC.
3. Generate exploration prospect. The process of developing an understanding of the stratigraphy of the potential prospect. What is the porosity of the rock? What type of trap?
4. Drill and evaluate exploration well.
5. Appraise discovery and create a field development plan.
Process 4 and 5 consist of four stages:
- Exploration. The reservoir and its contents are just beginning to be defined and understood. This is accomplished through drilling a series of test wells.
- Delineation. The size and extent of the reservoir is determined through drilling a series of step-out wells.
- Development. The understanding of the reservoir continues to improve and field activity is high.
- Maturity. The reservoir is well understood and its contents are modified as oil is depleted.
6. Design facilities and sanction development project. If economically justified.
7. Commission and construct facilities.
8. Produce asset.
9. Exploit asset.
10. Dispose of/decommission asset.
All of the above processes require coordinated effort across disciplines within the organization, and all require the delivery of the appropriate products and services at the right place and right time while meeting organizational objectives. However, given these process sequences, where does the procurement function add the most value?
The greatest value is most likely in Process 7, commissioning and construction of facilities. Procurement’s role in this process can be extremely complex due to timeframes and expense involved, as well as the fact that both materials and services need to be procured. Time to first oil, HSE and cost must be understood and a balance established. This leads to the concept of Total Cost of Ownership (TCO). This is also referred to as Life Cycle Costing (LCC). For the purposes of this article, these two terms are synonymous.
TCO is generically defined as a structured approach to calculating the costs associated with buying and using a product or service. TCO takes the purchase cost of an item into account but also considers related costs such as ordering, delivery, subsequent usage and maintenance, supplier costs, and after-delivery costs as well as disposal. Originally designed as a process for measuring IT expenses after implementation, TCO typically considers only financial expenses. The purpose is to quantify financial values for a project from inception throughout its entire life. This process provides hard information in order to make choices between options, and also to perform “what if” analysis.
Key terms related to TCO analysis:
► First Cost – often referred to as “acquisition cost” or “capital cost”. The literature points to a tendency to confuse first cost with TCO. This can occur if responsibility for the project is compartmentalized. Remember that an effort to minimize first cost can negatively impact project TCO by pushing higher costs elsewhere.
► Operational/Maintenance Cost – often referred to as OPEX, these are costs incurred during the operational life of the asset or service. These costs can be positively or negatively impacted by decisions made during the acquisition phase.
► End of Life Cost – costs associated with the disposal, termination or replacement of the asset or service. In the case of assets, disposal costs can be negative because the asset may have some residual value.
► Cost Savings – often referred to as “hard” cost reduction. Savings are tangible, easily defined cost reductions that can be traced directly back to the P&L. Savings can be a direct reduction in expenses or a reduction in prices paid over historical averages.
► Cost Avoidance – often referred to as “soft” cost reduction. These are much more difficult to define. A cost avoidance may not reduce the historical price paid for a good or service, but it avoids the negative impact a price increase would have caused. Examples include productivity increases (more output with same resources), and process improvements which increase efficiency. Clear definitions and metrics across the company for calculation of cost avoidance are important.
► Substitution – If a buyer manages to find another product that performs the same function, or is able to collaborate with a supplier to produce a functionally equivalent specification that is more economical to produce, then the buyer has achieved a cost reduction for the organization. Substitution cost avoidances are easier to calculate.
► Inventory Management – Inventory is considered an asset on the balance sheet, but too much inventory, the wrong inventory, or storing obsolete inventory incurs carrying cost and can become a liability. Inventory can be reduced by finding suppliers who can accommodate shorter lead times or when inventory is turned over to a vendor who specializes in inventory management (vendor managed inventory, or VMI), thus reducing TCO.
TCO = first cost + operating maintenance and repair (OPEX) + energy + water + replacement – salvage value
All projects are different, however, TCO analysis consists of a series of fundamental steps that are common between projects.
1. Clearly identify the decision problem, identify all alternatives.
2. Prepare the cost breakdown structure (CBS), choose the analytical model (e.g. net present value (NPV) or payback period (PBP)) for comparing the alternatives and formulate the assumptions. Literature provides many CBS formats where costs compared range from a few to several hundred. A point here is to be as comprehensive as possible but keep it manageable and able to be consistently utilized across alternatives. Some significant cost elements to consider:
- Mean Time Between Failure (MTBF)
- Mean Time Between Overhaul (MTBO)
- Mean Time to Repair (MTTR)
- Time Between Scheduled Maintenance
- Energy use rate
3. Acquire cost and performance data. This is often the most difficult step because of the unavailability of accurate data. Estimations and approximations will be needed but keep them consistent.
4. Compute the TCO for all alternatives and rank them.
5. Perform a scenario or sensitivity analysis to gain insight into the impact of the hypotheses made and the uncertainty of the data. What we are referring to here, and one of the benefits of this analysis, is to determine the impact of certain changes to variables, and modeling their cost impact. For instance, if costs of raw materials swing over time, or labor shortages or surpluses are forecast, what will the TCO impact be? It is entirely possible that various scenarios being examined may be more sensitive to volatile cost components than others, and thereby affect rankings.
6. Decide which alternative is best based on cost and performance.
One thing to keep in mind regarding the TCO process is that it is not done in a vacuum. Absence of a robust company-wide TCO process inhibits valuable stakeholders' inputs into the definition requirement phase and often leads to project fragmentation. Project fragmentation occurs when different phases of a project are viewed as separate entities. When projects are fragmented, stakeholders tend to focus only on their visible costs and underestimate direct, indirect, and cumulative impacts of their actions. As a result, there is little or no incentive to holistically apply the principles of TCO, because it is more rewarding for each group to minimize the cost that they are responsible for without considering the impact of their actions on total project cost. Thus, in the absence of a holistic framework for managing projects, TCO will seldom be used effectively. An example of this situation would be that the E&P function is responsible for design of an offshore facility with an eye to managing CAPEX, then “throws it over the wall” to Operations for them to deal with any OPEX issues. It is also important to note that the ability to influence total project cost is highest in the acquisition phase of a project and lowest in the facility management phase, although it is estimated that over the life of the project facility maintenance and operating costs can be up to three times higher than acquisition costs.
TCO analysis is also a critical aspect of the supplier selection process, whether for materials or services. The total cost of ownership takes into account all costs of acquisition, personnel training, operation, maintenance, modification and disposal, and is used for the purpose of making decision on procurement/contracting of materials and/or services and selection of Vendors/Contractors. Major contributors to TCO which may affect the selection of Vendors/ Contractors to consider are:
► Purchase order / Contract price for materials/services
► Associated charges like transportation, duties etc.
► Order handling and expediting charges
► Third-Party Inspection charges
► Internal materials discrepancy resolving expenses
► Installation and commissioning expenses
► Commissioning and startup spares’ expenses
► Operation / Maintenance training expenses
► Spares Inventory stocking expenses
► Weighted charges on spares consumption & maintenance expenses during the life cycle of the equipment
► Disposal and or remediation expenses
Can the PSCM organization impact TCO?
Absolutely. One of the key benefits of implementing TCO is the increased visibility across the organization to total costs. This results in a change of mindset from concern with costs of an isolated piece of the project to the costs of the whole project. Some things to consider in procurement:
► Standardization of capital equipment can contribute to reduced TCO through reduction of spare part inventories. Standardization paired with a reduction in the supply base may also result in volume discounts along with the cost reductions associated with managing fewer part numbers.
► Partnering with key suppliers to obtain beneficial pricing and superior service thereby reducing the TCO for goods and services.
► Review policies for procuring and stocking spare parts inventory for cost reduction opportunities.
► Actively looks for product substitution opportunities. Ask questions of engineering and maintenance or your suppliers. Is the design over specified?
In procurement, one fundamental change must be a movement away from overemphasis on price metrics which may undermine efforts to focus on cost structures and TCO. Procurement management must support this effort with appropriate metrics.
One thing to remember about performing TCO analysis is that it is not quick or cheap. Considerable resources within the organization may be required in order to gain a thorough understanding of the project cost structure. Failure to account for all project outlays often leads to the selection of suboptimal alternatives. Therefore, procurement must perform due diligence on what materials or services are candidates for this analysis.
Characteristics of Items for TCO Project:
► The firm spends a relatively large amount of money on that item.
► The firm purchases that item with some degree of regularity in order to provide some historical data, but more importantly, to allow opportunities to gather current cost data.
► Category Management believes the item has significant transaction costs associated with it that are not currently recognized.
► Category Management believes that one or more of the currently unrecognized transaction costs is individually significant.
► Category Management has the opportunity to have an impact on transaction costs, via negotiation, changing suppliers, or improving internal operations.
► Those purchasing and/or using the item will cooperate in data gathering to learn more about the item’s cost structure.
Benefits of TCO
► Allows procurement to evaluate competing options. This statement is true provided assumptions used are the same across the different options and that all outlays are accounted for. These techniques allow evaluation of competing proposals on the basis of cumulative total costs for acquisition and total life operational and maintenance costs. TCO can apply to most equipment and service purchasing decisions provided they meet the criteria.
► Improved awareness of total costs versus strictly acquisition cost.
► More accurate forecasting of cost structure. TCO requires a thorough understanding of all lifecycle costs in order to be useful. It leads to improved decision making at all levels, for example major capital investment decisions, or the establishment of cost effective maintenance and support policies.
► Visibility to the performance vs. cost tradeoff. Lowest first cost does not necessarily result in the lowest TCO.
Limitations of TCO
►The process is extremely resource intensive. Even if a cost breakdown structure is available, collecting all the required data still requires a lot of resources. Also, the data can be unreliable and lacking.
►Assumptions typically become less valid the longer the timeframe of the project.
►Does not do a good job of capturing non-financial costs/benefits. For example, two competing alternatives may have slightly different TCO calculations, but what if the more expensive alternative increases customer service levels by a significant amount?
This last bullet is extremely important….as with any financial modeling tool, forecasting technique or any other business management tool requiring the use of quantitative data, SOUND BUSINESS JUDGEMENT MUST STILL BE APPLIED TO THE OUTPUT.
To learn more about TCO, procurement and the E&P process we suggest enrolling in the upcoming session of Inside Procurement in Oil and Gas or browse the full list of Procurement/Supply Chain Management courses here.
1. PetroSkills. “Inside Procurement in Oil and Gas”. Retrieved from http://ref1.petrocore.com/jmc/SC-61/2/Pages/Total-Cost-of-Ownership-TCO.aspx
2. Stonebridge Consulting. “Oil and Gas Procurement Optimization 101”. Retrieved from https://www.sbconsulting.com/blog-category/procurement-process-optimization-101-primer-oil-gas-companies