Like many industries, the upstream sector of the oil and gas industry is facing challenges on several fronts: volatile commodity markets driving higher cost inflation, geopolitical instability causing supply chain disruptions, competition for construction talent and labor in certain geographies such as North America, and increasing pressure to accelerate bringing new production online.
Capital expenditure (capex) is rising as a result, calling for cost optimization and innovation in capital deployment processes along the value chain. Traditional procurement models are often not agile or resilient enough to respond to the growing pressures on upstream capital costs and development speed, potentially affecting on-time and on-budget project delivery.
To cope with this increasing complexity, some oil and gas players are introducing innovative procurement strategies, such as expanding the traditional supply base, testing new tendering models, and adopting should-cost methodology from other industries, such as the automotive sector.
The last approach, especially, offers a promising solution for managing upstream costs: it is structured, fact-based, and models a fair price for a given project or service, considering both the underlying cost drivers and expected margins of suppliers along the value chain.
In this article, we assess the factors causing inefficiency in traditional procurement models in the current environment and how upstream organizations could use process innovation and the should-cost methodology to overcome them.
New challenges are changing oil and gas procurement
The industry’s capital deployment approach requires a rethink to address a range of challenges, including rising costs and competition for resources and contractor capacity, the growing number of alternative supply chain solutions, and the increasing complexity of commercial approaches.
Higher costs are causing a shift away from traditional lump sum approaches
Fluctuations in the price of raw materials have made it difficult for upstream oil and gas companies to rely on benchmarks to support the cost estimation of new capital project developments. For example, the cost of shipbuilding grade steel in 2023 increased more than 55 percent compared to 2022 prices.
A key challenge facing new project development is the recent shift toward supplier risk-sharing agreements in procurement models. Following unprecedented disruptions, such as the COVID-19 pandemic and an evolving geopolitical environment, suppliers now tend to prefer risk-sharing agreements (for example, moving from lump sum contracts to bonus-malus provisions). These require upstream players to negotiate new commercial clauses, with limited or no experience on the potential cost implications, and shift from debt financing toward equity risk capital, which comes with higher return premiums.
We recently analyzed a sample of projects in the sector presented at the 20th international conference and exhibition on liquefied natural gas, LNG2023. Industry experts estimated that the average percentage of total bid costs allocated to provisional sum versus lump sum has doubled compared to the past few years (Exhibit 1).
These challenges are driving the need for single-sourcing procurement approaches
The rapidly evolving landscape with its new challenges—including faster time-to-market demands and the scarcity of suppliers in certain geographies—requires the industry to find innovative solutions for streamlining procurement. For example, recent market uncertainties have financially challenged most contractors, while local content rules limit the spectrum of suppliers that can be engaged.
To address these challenges, players could start using single-sourcing procurement models. The “technical and commercial partnership” approach is emerging as a new method for single sourcing and is becoming the most relevant for the oil and gas industry—it is better positioned to deal with the increasing complexities impacting capital equipment costing compared to traditional approaches like design competition and fixed design tender (see sidebar, “Procurement model types”).
Evolving procurement approaches require new capabilities
To leverage new procurement approaches, many upstream companies require a step up in capabilities. This includes developing an independent perspective on the fair cost of a project to run negotiations with suppliers successfully. Here, should-cost methodology can be used to support such negotiations, as it can strengthen the shift from a lump sum approach to the technical and commercial partnership approach. This can be achieved by supporting information symmetry between engineering, procurement, and construction (EPC) companies and oil and gas operators during the technical and economic optimization phases.
As well as enabling the identification of multiple optimization levers (such as alternative technical solutions, direct-buy on specific procurement categories, and broader supply chain footprints), we have observed that should-cost methodology, coupled with a technical and commercial partnership approach, can shorten overall timelines for final investment decision (FID). For projects with long bidding times, time to FID could be reduced by six to nine months, corresponding to a two-to-three-month reduction in each design phase (concept design, preliminary design, and FEED) (Exhibit 2).
In the course of our work with clients in the industry, we have observed how should-cost can help reduce time and optimize overall project spending across the oil and gas industry:
A floating liquefied natural gas (LNG) owner carved out some hull sections and topside modules from the lump sum agreement to bid them out independently, achieving cost optimizations through best-cost suppliers in new geographies.
In the midstream sector, more than one company is moving to convertible contracts with separate FEED to maintain direct-buy flexibility on key categories.
Some players in the offshore industry, especially in regions experiencing geopolitical instability, are taking in suppliers as equity partners to reduce risk margins that are priced into supply.
Some oil and gas players are developing strategic partnerships with contractors by negotiating multiple projects in the pipeline up front to ensure technical standardization and unlock cross-project procurement synergies.
Should-cost methodology creates information symmetry with EPCs through granular cost transparency
Should-cost methodology is emerging as one of the most reliable solutions to help upstream players address their current challenges, providing the granular cost transparency needed to deal with the changing landscape. So how does it work?
After breaking down the total cost of a project, product, or service into granular components and assessing the cost drivers for each, companies can determine the reasonable should-cost of a service or product based on its constituent elements. Compared to traditional solutions (which limit the benchmark to a finite number of past projects), should-cost can estimate the costs associated with any combination of design, geographic footprint, and commercial agreement.
Initially developed, fine-tuned, and deployed at scale in the automotive sector, the should-cost methodology uses bottom-up modeling of all supply chain costs through a four-step approach:
Step 1: Analyzing the design choices and 2D or 3D drawings of the project to derive a bill of quantities for raw and bulk materials.
Step 2: Mapping the end-to-end value chain to identify all the manufacturing steps required to produce each component.
Step 3: Costing the required quantities and value chains to calculate direct costs, leveraging proprietary databases and productivity models tailored to each country, technology, and sector.
Step 4: Completing the bottom-up should-cost calculations to define should-cost components, including all elements of suppliers’ cost structures.
Through its flexible, unbiased, and fact-based methodology, a should-cost analysis can, therefore, provide up-to-date, end-to-end transparency on the entire supply chain cost structure for an upstream project’s tenancy in common (TIC) investment.
To illustrate, we performed a deep dive should-cost analysis for LNG tanks, providing full transparency on key cost drivers for further negotiation with the supplier (Exhibit 3). This analysis enabled a fact-based negotiation with the supplier and led to an 8 percent cost reduction on the final negotiated price compared to the initial bid.
Should-cost applications in the oil and gas industry’s upstream market
A significant advantage of the should-cost methodology is its flexibility in the upstream market, making it deployable along multiple phases of a project’s timeline—from concept design to FID and commissioning. This allows companies to make informed investment decisions and allocate capital more efficiently.
The should-cost methodology has benefits across multiple applications. They can lead to more effective negotiations between suppliers and oil and gas operators due to improved information sharing, allowing operators to pinpoint their efforts on high-potential cost categories. The methodology can enable faster and more factual decision making along the procurement process, from assessing design alternatives to selecting optimal supply chain structures and investment decisions.
The should-cost methodology can increase overall profitability, too, typically for both operators and suppliers, given the opportunities for identifying and tackling inefficiencies. This analysis also has specific applications where end-to-end transparency on the supply chain is key to securing and creating value in project delivery. Specific instances where these benefits can be realized include:
First-of-a-kind projects: In-house benchmarking can be challenging for innovative, new technologies due to the lack of project precedence. Should-cost can provide a sound solution to this problem by independently modeling the expected costs of these new technologies.
Stakeholder alignment on investment costs: Should-cost can support fact-based discussions, approvals, and negotiations with complex stakeholders—such as governments or investment partners—by providing detailed transparency on cost drivers for specific projects.
Assessment of a supplier’s learning curve when realizing past project replicas: Should-cost models can help assess past project learnings, determining which activities should be replicated and which can be accelerated or avoided. For example, in our experience, one oil and gas organization that applied this approach was able to quantify this replica effect in more than 10 percent of total project costs.
Quantification of price evolutions in highly volatile markets: Should-cost can provide full transparency on project cost breakdowns and enable the overall project price to be linked to the evolution of underlying market indexes (such as for raw materials or labor cost). An oil and gas company harnessed this approach to dynamically model the price evolution of a megaproject based on more than 35 inflation indexes.
Assessment of local constraint implications: Several countries have tight constraints on the incidence that local activities can have on the overall project price. Based on local country risks, should-cost can quantify the economic value of required risk mitigation actions—or expected suppliers’ contingencies.
Trade-off analysis for supply chain optimization: Should-cost can simulate expected costs for different supply chain structures. For example, an oil and gas operator wanted to determine if it should move the construction of topside modules for a vessel to another country. In less than two weeks, should-cost modeled the variations in logistics and labor costs between the two countries, leading the operator to conclude that it, in fact, should not switch countries.
Contract strategy definition: Should-cost analysis can support the definition of a contract’s terms and conditions (T&Cs), optimizing economic and contractual value. This can be done by modeling the expected extra cost and risk buffers that the supplier would need to incur to comply with the contractual T&Cs.
Claim management: Should-cost can be employed to assess the fair value of a potential supplier’s claims after the launch of the construction phase. Suppliers’ quotations can be compared and then negotiated by modeling the expected delta price of a given variation.
Price renegotiations: If needed, should-cost can support the economic evaluation of bonus-malus provisions. By calculating costs bottom-up with quantities and unitary prices, should-cost allows operators to quantitively determine if costs incurred during production are the same as those determined in the bid. Through comparison, they can then work out if there is a corresponding bonus or malus provision.
Consistently capturing should-cost benefits requires new capabilities within the organization
While should-cost application comes with undisputed benefits in terms of capital deployment optimization and time-to-market reduction, to consistently capture them, oil and gas players are required to build dedicated capabilities within the organization. Through our work with organizations within and beyond the oil and gas industry, we have identified three typical models—buy, hybrid, and make—that companies use to step up their should-cost capabilities.
Buy solution: A buy solution results in the complete externalization of should-cost modeling for all purchase categories, with an external partner used for every need. The type of companies that could adopt this model could be purchasers of sophisticated systems with low volumes, high innovation, and limited knowledge of the production process.
Hybrid solution: In a hybrid solution, only the modeling for high-complexity or first-acquisition purchase categories is externalized, while modeling for the remaining categories stays in-house. A small internal team with should-cost competencies is needed, working with an external partner.
Make solution: A company internalizes should-cost modeling for all purchase categories. As a result, a structured internal team is needed that constantly updates systems and databases through external data providers or benchmarking. Developing a fully autonomous internal should-cost team requires a combination of expertise, tools, processes, and organizational support, such as skilled talent in cost engineering, supply chain management, and data analysis.
We believe that the hybrid solution could be the best-fitting model for the oil and gas context—an operator using it could develop internal should-cost capabilities for standard items or categories (such as subsea structures and mooring components) while outsourcing higher complexity items and categories (for example, new technologies for high-pressure oil separation).
Global volatility, a competitive market environment, fluctuating prices, and shifting business models have created new challenges within the oil and gas industry’s upstream supply chain—challenges that traditional procurement models are increasingly unable to address. By adopting should-cost methodologies to provide granular data and transparency, organizations could enhance operational efficiency, optimize cost structures, improve supplier negotiations, and, ultimately, drive sustainable value creation.