The story goes that, in 1821, Dingman #1 well in Turner Valley, the citizens of Fredonia, New York, also known as “the best-lit city in the world”, could enjoy the benefits of natural gas, because it was piped to town through hollow logs. Almost 100 years later, circa 1915, petroleum products were transported from the Dingman #1 well in Turner Valley, Alberta using large tanks fastened to a wagon pulled by horses. Fast forward another 100 years, and imagine the number of cardiac arrests and protests that would result from such primitive methods of transporting oil and gas products in Canada today.
Gasoline Tanks on wagon
pulled by Frank Coutts' percheron team
Turner. Valley, Alberta
Nowadays, even the perception of a lack of due diligence by an oil and gas producer, mid-streamer, or pipeline company (“owners”) can lead to significant project delays and embarrassing news coverage. Over time, ever-evolving regulatory requirements have certainly decreased the risks to the air, land, water, and populations surrounding owner’s assets, but at a significant cost. Compliance to regulations that govern quality, OH&S, and the environment all add to the price of designing, engineering, building, sustaining, and decommissioning oil and gas assets. To a large extent, this driver of ever more control over petroleum products is one cause of the procurement predicament.
A second driver of the procurement predicament is, of course, the downward price pressure exerted by the market on the oil and gas industry. We’ve all observed that, when the price of oil is high, more capital projects are announced, budgets are approved faster, and contracts are signed relatively quickly. That is not so today. Today, budgets take longer to approve, annual capital commitments have been communicated as ranges that ‘are subject to change’, and greater scrutiny is observed before awarding contracts.
Only the top portion of the wave that illustrates the boom-bust cycle may be considered free of downward price pressure. In such times, lowering supplier prices is only temporarily put to the side when the lost revenues of not completing a project substantially outweigh collective bid prices. But, back to reality, the years 2014 to 2016 are the lowest trough of the boom-bust cycle in 15 years, and significant downward price pressure for oil and gas players has been the norm for several years now.
In essence, the procurement predicament is that owners and their procurement teams are required to manage conflicting market conditions, including:
1. Ever-evolving regulatory requirements that exert upward price pressure
2. Near constant downward price pressure
3. The need for price certainty
4. Limited alternatives to existing methods, technologies, and suppliers
It’s important to note too, that savvy owners value price certainty almost as much as they do lowest price. The delegation of authority structures within owner companies dictate that some manager or VP is beholden to some SVP or CEO to justify why money for scope “X” is being awarded to supplier “Y”. The senior executive with the authority to approve the spend naturally asks pointed questions, reviews the math, and challenges assumptions to ensure the recommended bidder provides the lowest Total Cost of Ownership (TCO). Because executive reviews are a given, procurement teams, managers, and project oriented VPs must be sure all the prices are transparent (backed-up in writing) and are not subject to change. Thus, the TCO for the various bidders can be reliably calculated and the recommended award presented with confidence. The drive for price certainty is universal in top performing, procurement oriented organizations.
Finally, the speed and magnitude of innovation applicable to the oil and gas industry constrains the price lowering/value optimizing solutions available to owners. In a lot of markets, the power to innovate over time allows prices to drop at a foreseeable rate (think of the price of a 60” TV ten years ago compared to today’s benchmark price). What is different in very regulated markets (think oil and gas, aerospace, and medicine), is the industries’ methods of production tend to be much more capitally intense and must account for changing regulatory requirements. It takes longer and costs more to do R&D, testing, get regulatory approval, retool, train employees, update systems, etc., and by the time you’ve done all that, regulations might have changed the required solution. Oil and gas innovation does happen and provides great value (think of drilling 100 conventional wells in the past versus 20 wells plus horizontal drilling today). But, oil and gas managers and procurement teams can’t count on such advancements. Thus, procurement teams are constrained to the same methods, technologies, and suppliers in any given year a project is to be executed.
So, given such a predicament, how do procurement teams meet their mandate to deliver the required goods or services on schedule at the lowest possible price? The simplified answer is by using ‘best practices’.
Best practices are procurement methods that transparently demonstrate technical compliance at the lowest TCO with the greatest degree of price certainty possible. Procurement best practices are not new, but the use of procurement best practices in the Canadian oil and gas market has lagged behind other mature industries. Perhaps, when Alberta gas was transported behind horses in 1915, the deal was made with a handshake. Today’s equivalent of a handshake is a 30-page contract and a purchase order. Business today is more sophisticated and will continue to become more sophisticated over time.
It isn’t possible to describe the various methods of today’s best procurement practices in one article, but the overarching themes of procurement best practices can be categorized into three areas of concern: credibility, technical superiority, and commercial superiority.
The “Fredonia Hollow Log Company” is on nobody’s bidders list today. The first checkbox on any owner’s credibility criteria is technical. Only businesses that can clearly demonstrate they have the people, processes, and systems to comply with the appropriate standards (think CSA and ABSA) are even considered for possible inclusion on a preferred supplier or bidders list. The second criteria investigated is safety. Low TRIF or TRIR histories (depending on which owner you ask) are an absolute must. Next on the list is capacity. Do the potential suppliers have the shop space to build the equipment? Do they have the right managers available, and what about the manpower? This is followed by the suppliers’ list of similar projects. Have they done the same type of job in similar circumstances? Of course, the financial health of the businesses is also examined. In the current market circumstances, this will often include examining debt and liquidity ratios.
Receiving well documented evidence of each of these pre-qualification criteria is critical for owners’ procurement teams. Suppliers that answer specific owner questions and can demonstrate with solid evidence that they can do the job will be invited to share further information (i.e. proposals). Suppliers that send standard business development documents instead of detailed technical manuals and audited financial statements won’t be invited to the party.
No owner, no manager, and no procurement team can ever relent on demonstrating that proper technical control has been exercised when sourcing or constructing company owned assets. To relax technical requirements is illegal. It may lead to costly rework and will open the company and its leaders to liability. If discovered, it will destroy the trust of investors and the public.
For these reasons, the level of technical due diligence has gone nowhere but up over time. Leaders within owner companies, as well as leaders within tier one supplier companies, have either been formerly mandated by their boards or self-directed as a matter of survival to demonstrate the highest technical compliance.
After successfully pre-qualifying for work, the next technical hurdle to demonstrate a supplier’s execution plan is a) compliant and b) at least as effective as, but preferably more effective than, other bidders. An effective execution plan meets the codes required for the equipment, the schedule of the project, etc.
You may think meeting technical requirements should be easy for a pre-qualified bidder. However, best procurement practices don’t dictate the award should go to just any supplier that can meet the project requirements. Best practices dictate the award should go to a supplier that can demonstrate in writing they can meet the project requirements. This doesn’t mean the bidder with the best-written proposal wins. It means that just because a company can do the work doesn’t mean they’ll be taken seriously by the owner.
An owner cannot technically disqualify a bidder that meets the specs, schedule, and other express project deliverables. Indeed, relatively few pre-qualified bidders are technically disqualified after submitting a proposal. Rather, compliant, competitively priced but poorly documented bids are simply out-competed by competitors who have invested in people, processes, and systems to insightfully answer owners’ specific questions. An example of how bidders may be differentiated technically is their project schedule. One bidder may provide a level two schedule with a) area specific equipment delivery and install dates, b) mechanical completion dates, and c) a compliant project completion date, while another bidder might include just a table with a) area specific completion dates that amount to a compliant completion date. Both bidders may be compliant, but the need to demonstrate certainty to executives means the bidder that has demonstrated a logical and stepwise schedule will receive a higher technical score.
Best practices dictate the award should go to a supplier that can demonstrate in writing they can meet the project requirements.
As mentioned, transparent low priced bids that are guaranteed for the duration of the project (i.e. not predicated on a list of conditions at the bottom of the price table) will be prioritized for further negotiation by the owners. Best procurement practices require all prices and their various components be written down to logically demonstrate the buildup of the total proposed price. Procurement teams that use best practices need to be savvy and work with skilled technical teammates to ensure the prices included within the bids are mutually exclusive (to avoid double-dipping) and collectively exhaustive (to avoid change requests during project execution).
When using best practices, the commercially superior bidder is usually identified only after some negotiations. Commercial negotiations must be equally applied to all short-listed bidders as close to the exact same time as possible. Negotiations need to be documented and time-stamped to ensure a level playing field throughout the procurement process. Best practices allow for bid prices to be justified, challenged, and negotiated, provided no bid shopping takes place and the technical criteria remain the same for all bidders. In most cases, commercial negotiations are a form of fine tuning the prices offered by the bidder.
Price negotiations are an equal opportunity exercise. They can lead to price increases for some line items and price decreases for others. Suppliers know the actual cost of goods and services from the get go, and owners have a pretty good idea of the same. So, when owners negotiate prices, the real issue at stake is the supplier’s margin and overhead. Owners often leverage future business in exchange for lower bid prices, extended payment terms, or long term discounts like volume rebates.
If both players involved in price negotiations comply with contract law and are open to change, there is room for win-win solutions that often lead to better outcomes for both parties. Owners and suppliers that use best practices will find optimal solutions faster and at more sustainable prices than those organizations that operate ad hoc.
In the end, exhibiting transparency and establishing certainty to demonstrate the TCO of a proposal is not out of reach for any owner or supplier. Canada is a beautiful land, and the regulations that protect it and its people will not be going away. Procurement best practices are the only effective way to manage the complexities operating on the oil and gas market today. The decision to invest or not invest in people, processes, and systems needed to manage the procurement predicament will continue to be the difference between profitability versus under-performance in the good times and survival or failure in the bad times.