Contractors face lean times as producers make cuts

With Australia’s large-scale energy projects all but shelved and its gas demand growth looking poor for the foreseeable future, financially constrained oil and gas operators are pressuring contractors and suppliers to significantly cut costs. But with contractor margins already under 5%, some warn that further pressure on the service side of the business risks eroding skilled labour and could jeopardise the industry’s long-term future.

With the gas market glut expected to continue well into the next decade, energy chiefs are becoming increasingly vocal about the need for suppliers to slash rates for project construction and labour, as well as for maintenance and operations. Wood Mackenzie data shows upstream capex costs have come down by at least 15% globally in the past year and that suppliers are being squeezed.

Geoffrey Cann at Deloitte told Interfax Natural Gas Daily that service providers have been under pressure for some time. "Contractors have told me informally that their margins have been eroded from 15% or better in 2014, to less than 5% today," he said.

On Australia’s east coast, the operators of the three LNG projects on Curtis Island have been putting pressure on their suppliers for price reductions for the past year. "I have seen letters from one operator to their suppliers demanding an immediate 10% rollback for calendar 2015 and expectations of a 30% further roll back in 2016," Cann said.

"The CFO of one of the projects has told me that his project successfully lowered their supply chain cost by $600 million in this past year largely through better management of their supply chain (price reductions, consolidation of suppliers, halting rogue spend, buying used etc.). One international firm has told me that they have seen day rates for offshore rigs fall by 70% this year. However, almost all other costs have been stable (wage rates, etc.)," Cann added.

Australia is part way through a predicted 70% slump in construction and engineering work that will last for the foreseeable future, with resource-rich Queensland and Western Australia the worst hit. The decline follows A$200 billion (US$149 billion) of investment in new LNG projects that is due to come to an end in 2017, the Australian Financial Review reported this week.

Collaboration is key

Speaking at this week’s APPEA conference in Brisbane, Clough Chief Executive Peter Bennett said asking contractors to cut margins is not the way forward, noting instead that what is needed is improved cooperation between industry and contractors, in addition to more accurately defined project scopes and targets.

"Better collaboration between operators and contractors is going to be fundamental to driving down project development costs and ensuring that our industry here in Australia has a bright future. Innovation and collaboration in the way we define and deliver projects is key to making real cost reductions," Bennett said.

"Our margins are already marginal, so putting a squeeze on margins is not going to be enough to make the next phase of projects feasible, and frankly it drives bad behaviour in our industry […] Reducing these margins to zero isn’t going to be enough to reduce the capex on these new developments to get them across the line – not even close," Bennett said.

Outgoing Chevron Australia Managing Director Roy Krzywosinski – who oversaw huge cost blowouts at Gorgon LNG – has been vocal in highlighting the need for collaboration across the industry as it shifts from boom times to lean times and faces tough demands from buyers for cheaper LNG.

But collaborating in a competitive industry, particularly during a downturn when every dollar counts, is challenging. Instead, it can be quicker and easier for oil and gas companies to squeeze supply rates. While this can certainly drive short-term efficiencies, the depth of cuts now being demanded could end up damaging the industry’s longevity, Cann said.

"Margin erosion is not sustainable unless the operator or contractor or both make other, more fundamental business changes – outsourcing, restructuring, business transformation, systems rationalisation," Cann said.

"There are real risks that suppliers will simply exit the market, which will create eventual shortages in capability, and prices will eventually rise to reflect that shortfall. This is already happening in East Coast Australia. Bankruptcies are starting to take a real toll in the United States," he added.

This week, Woodside Chief Executive Peter Coleman criticised the cost and timeframe for bringing Australian LNG facilities to market, which has compounded the problems faced by operators in an era of low spot prices and excess supply. "We were taking years to build our projects and we have become too expensive, we allowed the opposition, the competition to come in and take our place," Coleman said.