Why Producers And Service Companies Need To Come Together To Thrive
Producers and service companies have long had an adversarial relationship. Why changing that could benefit everyone
If you’ve ever taken an introductory economics course, you’re probably familiar with the concept of a prisoner’s dilemma. For those who didn’t, well, let’s just say it doesn’t have anything to do with whether eating the lunch special is a good idea or not. Instead, it’s a hypothetical situation that tries to explain why in situations where co-operation between two related parties would yield mutual benefit for both, they tend to do the opposite. And while the prisoner’s dilemma properly belongs in the field of game theory, it’s often seen in – and relevant to – the business world as well. That’s particularly true in the energy sector, where co-operation between producers and service companies has both clear benefits and almost insurmountable obstacles. And like those hypothetical subjects of the prisoner’s dilemma, their inability to find a way around those obstacles is costing both sides dearly.
The give and take between service companies and producers is nearly as old as the business itself. In good times, producers give service companies whatever they want in order to keep them in the field – their fields, specifically – and turning the drill bit as fast and as often as possible. And in bad times like the ones we’re in now, those same service companies are expected to take it on the teeth in the form of mandatory – and often major – rate reductions. “It’s part of the nature of the beast of the business, historically,” says George Coon, the regional director for Northern Alberta at First West Capital. “It’s an adversarial business model, and it’s been around for 100-plus years. It’s hard to change that culture.” That culture, he says, is defined by individual entrepreneurs competing against each other – not one, in other words, that naturally lends itself to co-operation. “It’s a bit like two guys driving on the road playing chicken – who gives in first? Because once the bar is set, everybody has to re-set to that bar.”
The problem with that, according to STEP Energy Services CEO Regan Davis, is that it makes the entire sector less productive – and profitable – than it could otherwise be. In weak commodity price environments it tends to encourage a race to the bottom on pricing, which hurts the service companies, drives workers out of the business and impairs their ability to respond effectively when the cycle turns. That leads inevitably to cost inflation, which in turn erodes the profit margins of producers and limits their upside exposure to rising commodity prices. “There’s just a whole bunch of inefficiency that gets built into the system and that sucks up money that doesn’t necessarily allow those higher prices to result in more profitability,” he says.
Davis doesn’t blame producers for doing business the way they do, and he doesn’t think they’re blind to the damage it does. “I don’t think that’s lost on the producers, I really don’t. I think they understand what’s happening to the business, and I think that all of them realize that the pricing they’re receiving today is not sustainable. It’s not a level that will keep the service sector alive. I think the service sector is finding ways to reduce costs and become more efficient, but I believe the CEOs of the E&P companies understand the reality they face. And yet, what are they to do?” In the near term, there’s not much they can do.
Capital-constrained public companies can’t exactly go out and decide to pay their contractors and suppliers more, given the competitive disadvantage this would immediately put them at relative to their peers. “Ideally, if they could solve it, I think it would be better for all players on both sides,” Coon says. “But someone has to take the initiative, and the challenge is that it’s still price-sensitive.” And while service companies might like to be able to offer the kind of “frack now, pay later” incentive programs that Schlumberger and Halliburton both rolled out earlier this year, they simply don’t have the balance sheet to support them. And even if they did, Coon says, it’s not clear that they’d do it anyways. “The challenge is whether the capital markets like that. The work they do has a cost to it, and if you defer the payment until it produces, you’re beholden to when they decide to put that production on, so there could be a time lag that’s a challenge.”
He also says that such profit-sharing arrangements – or even the prospect of them – might actually make the relationship between producers and service companies more adversarial. “In most things, if you can shift risk down your supply chain, that’s great. But there is a cost to that supply chain for taking on that risk, and you see that with fixed contracts on the construction side where they’re carrying the burden of the risk,” he says. “In the oil and gas sector, I don’t think you could pass that risk down the supply chain – and I don’t know if the supply chain would accept it, either. So it could become more adversarial rather than less.”
Producers and service companies might struggle to find a way to effectively co-operate when it comes to drilling a well and harvesting its bounty, but there are other parts of the sector where the two sides have found some common ground. Dieter Körner, the managing partner for North America with T.A. Cook, says that the refinery turnaround space offers some lessons on how co-operation can be done. Oftentimes the operator will effectively “sell” the turnaround of a given refinery or asset to the service company, who will take on both the upside and the downside. “The contractor will do everything to come up with a safe, reliable and highly efficient turnaround in the shortest period of time, because it’s to their benefit,” Körner says. The operator, meanwhile, gets both cost certainty and the ability to reallocate internal resources to other projects. But while it sounds like an easy win for both sides, Körner says it’s easier said than done. “It requires a completely different way of thinking. It’s not about me against you or them against us. It’s really about figuring out how you can achieve a
STEP’s Davis knows how difficult it is to actually put new ways of thinking about how to do business – never mind actually doing business that way – into practice. “I think we can all dream up solutions to this, where we partner more and lay out activity programs so that we level load them and can ride the highs and the lows. Everyone can intellectualize that. But the business environment has not yet been able to create that opportunity.” One way to do that, Coon says, is by trying to bring the two sides to the same metaphorical table – something that, COSIA notwithstanding, hasn’t happened on an industry-wide basis yet. “The service companies get together, and the E&Ps get together, and they talk about their individual businesses and the capital markets with the different stakeholders. But they never jointly deal with that. It’s not an industry conversation. They’re all separate conversations.” If nothing else, breaking down those silos might help to overcome the misperceptions that each side has about the other’s motives. “The producers believing they’re being gouged in good times and then the service sector believing they’re being taken advantage of in the low times, but it’s really just the market working,” Davis says. “There’s an opportunity to become more sophisticated about how we do business together.
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