The recent oil price downturn continues to force companies to rethink their business models. As a strategy to stay a float, players in the upstream oil industry – oilfield service companies in particular – continue to engage in activity cutbacks, service price renegotiations, cancellations, and postponements of future service commitments. Left unchecked, heuristics may continue to undermine strategic decision-making.
Many of the factors that explain how oil prices fluctuate are interconnected. The fall from a peak of $115 per barrel in mid-2014 by more than 70 percent at some point – compared with the June 2014 levels – remains one of the most important international macroeconomic developments of the last two and a half years. Energy economists explain this in terms of the shocks to demand and supply arising from the complex interplay of geopolitics, economics, and technology. Considering the excess supply and inventories that have built up in the market, lower prices continue to force producers to adjust supply, stockholding, and investment flows. As we head into 2017, uncertainty around what oil prices might look like in the future weighs heavily on operators, contractors, investors, and regulators.
The current low-oil-price environment presents a number of supply chain and procurement challenges for energy companies. Declining revenues and evaporating earnings are forcing companies to decommission their rigs, in addition to massive cuts in exploration and production investments. Keeping other factors constant, lower investment today will translate into lower output and higher prices tomorrow. For instance, deferred high-cost projects may create a shortfall in future production, resulting in a tight demand-supply balance that may push prices even higher over the medium term. As such, procurement and supply chain strategies remain on the front burner as the downward spiral of oil prices plagues the industry. Despite having succeeded in cutting costs in the last two years, many wells remain unprofitable. This continues to trigger the price-cost debate.
On the true relationship between the price of oil and the cost of production per barrel, classical economic thinking posits that in a competitive industry, the cost of producing an additional unit of output – i.e. marginal cost – determines price. In the same vein, traditional management and economic theories suggest prices should reflect value. The tough challenge, however, is figuring out the precise value prices represent. Perhaps even tougher is the question of whose judgement should be relied on in arriving at the perceived or estimated value of the particular good or service in question. To the extent that oil prices drive costs, it is often expected – on the supply side – when oil prices fall, a corresponding cost deflation will be required to ensure profitability. The corporate decision-making process often hinges on value maximization. In the realm of supply chain management, this implies finding the lowest-cost suppliers that meet certain minimum quality standards.
In the face of competitive pressures, procurement teams across the energy industry continually rely less on innovation and efficiency improvements as a strategy to increase operating efficiencies. Instead, they focus more on negotiating price reductions from suppliers, in addition to exploring other avenues to improve capacity and reduce short-term, discretionary spending. Recent statistics from the United States Bureau of Labour Statistics show the Producer Price Index (PPI) – an indicator used to track oilfield service companies’ rates – continues to fall for drilling and extraction companies. This PPI trajectory confirms weakened demand for services and the ongoing battle to maintain market share as companies seek operating efficiencies. Such short-termism can result in long-term damage. There is always a trade-off. This has huge implications for long-term profitability.
A fundamental assumption in mainstream economics is consumers and firms act logically and rationally in the decision-making process. While it is true firms actively seek value maximization by consistently pursuing loss minimization strategies, the field of behavioural economics shows asymmetric information and individuals’ affective states – which include emotional and motivational states – have a huge influence on their judgements, which often result in suboptimal decision-making. For instance, emotional theory suggests agents place a lot of emphasis on certain information that may skew the heuristics they follow. Since consumers are not automatons, perhaps rather than focus exclusively on price, procurement, and supply chain, specialists need to craft strategies that incorporate customers’ overall buying experience.
While sound economics and business analytics remain vital, it is equally very important industry executives focus on behavioural and cultural change as a tool for engineering key players to deliver leaner, fitter, and efficient operations under a continued low-oil-price regime. Industry operators need to rethink their contract management and supplier relationship management strategies. While it remains a fact that it will take time to achieve significant efficiency improvements, companies need to carefully weigh the costs of short-term cost-reduction strategies against the benefits of deploying long-term supply chain best practices in the most optimized way. This is in addition to managing expectations and reaching a consensus with suppliers with regard to the important – and often complex – issues of safety, training, and equipment specifications.
In closing, beyond budgets and costs, firms should be lean, competitive, and continually attract investments. Because price shocks affect firms in an industry differently, companies need to critically examine their changing cost economics, in addition to long-run shifts in the cost position of competitors. These combined will provide the necessary ingredients to craft an effective strategy to help avoid the competitive pricing trap. And, of course in addition to economics, strategy, analytics, marketing, and sales, greater attention should be paid to the behavioural science of forecasting and decision making.