Unlock Efficiency in Upstream Oil and Gas Procurement with Should-Cost

Challenges Facing the Upstream Oil and Gas Sector

The industry's capital deployment approach is under scrutiny as it faces a range of challenges. Rising costs are causing a shift away from traditional lump sum approaches. Fluctuations in raw material prices make it difficult to rely on benchmarks for cost estimation. Additionally, the recent shift towards supplier risk-sharing agreements in procurement models presents a key challenge. For example, the cost of shipbuilding grade steel in 2023 increased by more than 55 percent compared to 2022. These challenges are driving the need for more innovative procurement solutions.

The rapidly evolving landscape with new challenges, such as faster time-to-market demands and supplier scarcity in certain geographies, requires the industry to find ways to streamline procurement. Single-sourcing procurement approaches are emerging as a potential solution. The "technical and commercial partnership" approach is gaining popularity as it is better equipped to handle the increasing complexities in capital equipment costing.

Evolving Procurement Approaches and New Capabilities

To leverage new procurement approaches, many upstream companies need to enhance their capabilities. This includes developing an independent perspective on the fair cost of a project to negotiate successfully with suppliers. Should-cost methodology can play a crucial role here by strengthening the shift from a lump sum approach to the technical and commercial partnership approach. It can also help identify multiple optimization levers and shorten overall timelines for final investment decisions.

For instance, a floating LNG owner carved out some hull sections and topside modules from the lump sum agreement and bid them out independently, achieving cost optimizations. In the midstream sector, companies are moving to convertible contracts with separate FEED to maintain direct-buy flexibility. In the offshore industry, some players are taking in suppliers as equity partners to reduce risk margins. And some oil and gas players are developing strategic partnerships with contractors to ensure technical standardization and unlock cross-project procurement synergies.

How Should-Cost Methodology Works

Should-cost methodology is emerging as a reliable solution to help upstream players address their current challenges. It provides granular cost transparency by breaking down the total cost of a project into components and assessing the cost drivers. Compared to traditional solutions, it can estimate costs for any combination of design, geographic footprint, and commercial agreement.

Initially developed in the automotive sector, the should-cost methodology uses a four-step approach. First, it analyzes the design choices and drawings to derive a bill of quantities. Then, it maps the value chain to identify manufacturing steps. Next, it costs the required quantities and value chains to calculate direct costs. Finally, it completes the bottom-up should-cost calculations to define components. Through this flexible and fact-based methodology, it provides end-to-end transparency on the supply chain cost structure.

For example, in a deep dive should-cost analysis for LNG tanks, full transparency on key cost drivers was provided, leading to an 8 percent cost reduction in the final negotiated price.

Should-Cost Applications in the Upstream Market

The should-cost methodology is flexible and can be deployed at multiple phases of a project, from concept design to FID and commissioning. It has benefits across multiple applications, such as enabling more effective negotiations between suppliers and operators, facilitating faster and more factual decision-making, and increasing overall profitability.

Specific instances where these benefits can be realized include first-of-a-kind projects, where it provides a solution for in-house benchmarking. It also supports fact-based discussions with stakeholders and helps assess a supplier's learning curve. It can quantify price evolutions in volatile markets and assess local constraint implications. It can also be used for trade-off analysis and contract strategy definition. And it can support claim management and price renegotiations.

Building Dedicated Capabilities for Should-Cost

While should-cost application offers significant benefits, oil and gas players need to build dedicated capabilities within the organization. There are three typical models - buy, hybrid, and make. The buy solution involves externalizing should-cost modeling for all purchase categories. The hybrid solution externalizes only high-complexity or first-acquisition categories, while keeping the rest in-house. The make solution involves internalizing should-cost modeling for all categories.

We believe the hybrid solution is the best fit for the oil and gas context, where an operator can develop internal capabilities for standard items while outsourcing higher complexity ones.

In conclusion, global volatility and changing business models have created new challenges in the upstream supply chain. By adopting should-cost methodologies, organizations can enhance operational efficiency, optimize cost structures, and drive sustainable value creation.