How to Unlock Value in Oil and Gas CapEx Contracts Amid the Downturn

Oil and gas, which is going through its third slump in 12 years, is a capital-intensive industry. The need to constantly replace depleted hydrocarbon reserves requires large capital outlays.

During years of high demand, oil and gas producers usually set aside more than 75% of their spend budget for capital expenses (capex), while the rest goes towards operating expenses (opex). And even in a down year, capex can exceed 60% of the overall spend, according to GEP research and analysis of company annual reports.

Average Upstream Spend: Capex vs. Opex

Source: GEP analysis

But so much spending during a downturn, like this current one on the back of a pandemic, poses major business risks.

In this scenario, a conventional spend reduction program would urge producers to reduce capex activity since oil and gas prices have crashed. 

But it is not so easy to simply switch off spend, since capex in oil and gas comes with complex and long-term supplier contracts.

A typical contract in this industry is loaded with many cancellation clauses, payment guarantees and nuanced remuneration and indemnification structures that need scrutiny before a producer can end the pact.

Failure to pay heed to the fine print can lead to massive penalties and litigation that can drag on for years — even in cases where the producer canceled the contract citing poor or non-performance. Given the sheer size of these contracts, even a portion of the contractual value, if awarded to a supplier due to a lawsuit, can mean a loss of hundreds of millions of dollars.

Reducing the Contract Burden

Since oil and gas producers cannot walk away from these complex contracts without deep financial consequences, many of them have chosen other forms of capital cuts, like reducing headcount in back-office functions such as procurement and supply chain management. 

But this ends up putting the producers in a bind. On the one side, they need to quickly find opportunities to cut capex spend. But on the other side, they do not anymore employ those contract managers who have the expertise for conducting long, hard negotiations.

To avoid such situations, oil and gas producers need to review contracts and segment them to reduce contract spend and limit penalty and legal exposure.

They should start off by scanning the contracts for:

1.   Cancellation penalties and delayed payments

2.   Ancillary clauses impacted by or triggered during delays

3.   Punitive or exorbitant charges tied to non-value generating activities

This approach will allow producers to make a key decision and a key sub-decision.

A.   Should they cancel the contract right away or delay it?

While many contracts require suppliers to perform their work according to a strict timeline, the documents often also leave the door open for producers to push for medium term to indefinite delays or slower work. This clause will allow them to reduce capex and ride out the depressed market while avoiding the steep penalties of outright cancellation.

B. If they want to keep the contract, should they renegotiate?

Supplier contracts often have ancillary payment mechanisms that are triggered even without any work activity. In the event of a producer delaying a capex contract delivery, an analysis of the ancillary clauses that could impact the overall cost position will allow the producer to reconfirm its strategy of delaying rather than canceling the contract. It will also help determine if any renegotiation is needed to eliminate exposure to value-destroying clauses that would pay a supplier for essentially doing no work.

With this segmentation, producers are free to set up their own evaluation parameters of value, time and ease of implementation, as shown in this table. 

Segmentation Model for Contracts

Source: GEP

Necessity of Digitizing Capex Contracts

As producers do this segmentation, there is an important “step zero” they must not skip: the collection and digitization of contract metadata.

While this sounds basic, most oil and gas producers have failed to fully digitize their supplier contracts, mainly due to contractual complexities and the geographical spread of their activities.

Fortunately, advances in artificial intelligence (AI), notably computer vision, in the last few years have simplified this digitization process. There are now tools that can digitize contracts and categorize metadata in a much smaller amount of time than consultants and auditors.

This speed of digitization is far more important than just reducing the total fee paid to the suppliers. It also means oil and gas producers, who use these AI technologies, will have a competitive advantage, given the rapidity at which they are able to redefine their contract positions.

This approach can help producers prevent potentially hundreds of millions of dollars in lawsuits and penalties, retain preferred suppliers and identify key negotiation levers that may have gone unexamined.

To know more such strategies, read GEP’s white paper – What’s Next for Oil & Gas? Recovery Scenarios and Navigation Strategies to Power Through the Crisis

References:

• https://www.reuters.com/article/us-diamondoffshore-bankruptcy-lawsuit/diamond-offshore-sues-australias-beach-energy-for-terminating-drilling-contract-idUSKCN2292NW
• https://www.offshore-energy.biz/transocean-beats-eni-in-lawsuit-over-drillship-contract/
• https://oilprice.com/Latest-Energy-News/World-News/Chevron-Slashes-Capex-Again-To-Protect-Dividend-In-Oil-PriceRout.html
• https://www.rigzone.com/news/wire/chevron_to_cut_global_workforce_by_up_to_15_percent-27-may-2020-162215-article/