Gulf countries and their respective National Oil Companies (NOCs) have a major influence on the world economy. Collectively they hold 30 percent of the world’s proven oil reserves and produce one in every four barrels. Yet the successful development of the GCC’s energy sector has often happened to the detriment of other industries.
Consequently, economies are very dependent on oil related revenues and require the price of the barrel of crude to be between $75 and $110 to balance off their national budgets. When the oil price dropped dramatically in 2014, it led to a logical slowdown of GCC economies which had in turn impacted the national budgets. Most analysts now expect the oil price to stay low for the foreseeable future.
Two years on the time is right to assess how NOC’s have responded to their national economic challenges, as traditional value levers proved to be less effective than in the past. Indeed, production increases have been limited by the tight supply-demand balance in the market.
In addition to this, NOCs have a mandate to maintain national employment and to promote local development, which limited their ability to reduce their staffing levels. This left operating cost as the only available lever to deliver additional value. Although GCC NOCs have all taken various actions to reduce their cost base over the past two years, these have often been short term solutions and superficial in their impact. Moreover, adopted solutions were also implemented following the 2009 oil price drop. Experience shows that companies were not able to sustain them for the long term, a situation likely to be repeated.
Beyond superficial cost cutting, we propose that NOCs should seek to build an enduring low cost competitive advantage. Companies should focus on sustainable cost reduction as well as on realizing structural efficiencies to improve their ways of working and become more agile regardless of the future oil price.
The benefits from a program combining recommended initiatives can help NOCs to achieve significant savings across OPEX, SG&A and CAPEX and improve the ability to respond to future market shifts. Given the significant role NOCs play in their local economies and for their government, implementing structural changes to the way NOCs operate is a key step in helping GCC economies weather the current economic instability.
Low oil price impact in GCC
GCC countries have been associated more than any other with oil production and remain today, through their respective NOCs), significant influencers in the world economy. Collectively the GCC holds 30 percent of the world’s proven oil reserves and produces one in every four barrels, while four of the five GCC NOCs are within the Top 20 Oil companies globally.
Given the amount of easily accessible hydrocarbon reserves, with some of the lowest production costs anywhere in the world, GCC countries have historically focused predominantly on developing their energy sector. Thus, the NOCs and the energy sector at large have become pivotal to their economies, and the main source of income for their state’s budget. NOCs also play a critical role in the development of their country economies and in creating employment opportunities for nationals.
However, the greater focus on the development of the energy sector versus other sectors has limited the level of industry diversification. Today 55 percent of GCC GDP and 74 percent of the state budgets on average are dependent on energy sector revenues. Although all countries have a significant level of dependency some are more dependent than others. While the UAE has more diversified sources of revenue (only 28 percent of GDP derived from oil and gas), KSA and Kuwait are the most dependent economies (76 percent and 93 percent of GDP derived from oil and gas).
A combination of high oil prices in recent years and very low marginal production costs have, until recently, been generating around $600 billion in annual revenue across GCC countries. This wealth has fueled large national infrastructure projects as well as generous welfare states. Unlike international oil companies, the key metric is not production cost per barrel, but the break-even oil price to balance state budgets. Although GCC production costs are between two and ten times lower than the world average, GCC countries state budgets require a barrel price between $75 and $110 to balance national expenditure.
The context has now dramatically changed since Q3 2014. With a high oil price, a much greater proportion of world oil reserves could be developed profitably. This resulted in major developments in high cost areas (deepwater, oil sands, remote locations such as the Arctic, etc.) as well as the Shale oil revolution in the US (and increasingly in other countries).
This caused oil production to begin to run ahead of demand. GCC countries, used to play the role of swing producers, realized that their low-cost production was being squeezed out of the market by high-cost production in other geographies (of which the most notable was US Shale production).
GCC states, through OPEC, decided to maintain production levels rather than reduce them, and let market forces decide on production and oil prices. Since then, WTI crude oil prices have plummeted from over $100 in 2013 to below $30 in 2016 before staging a gradual recovery to $50. The result has been billions of dollars of planned investment in large conventional oil and gas projects being put on hold.
This will impact oil supply in years to come as currently-producing fields follow the normal production decline curves. In addition, the previous rapid growth in US Shale oil production has stopped as producers struggled to get their costs down to below the oil price. At current prices, they are now just profitable but returning to rapid production growth will be a challenge. However, the short-term impact of the oil price volatility on GCC economic growth has been significant. Between 2012 and 2016, GCC countries have lost an average of 4.6 percentage points in GDP growth.
Unsurprisingly, the most oil dependent economies have suffered the most, with Kuwait being showing the greatest GDP contraction. While most GCC economies’ growth slowed down, Kuwait has been in recession since 2014. Moreover, oil related revenues of GCC state budgets have fallen much more rapidly than national expenditure, leading to fiscal imbalance. Between 2012 and 2015, GCC countries state budgets have lost an average of 18.5 percentage points in fiscal balance. Although governments have initiated cost-cutting programs, they have mainly addressed the oil crisis to date by digging deep into their cash reserves to maintain state expenditure levels (for example, public welfare state and subsidies). Some actions undertaken by NOCs to maintain balance between finance and sustainability.
Reduce headcount and benefits:
Driving reductions in headcount and associated costs focusing mainly on the expat workforce. For example, KPC attempted to reduce employee benefits which resulted in a companywide strike; following this, job cuts essentially targeted the expat workforce. While ADNOC announced an objective to cut 5,000 jobs by the end of the 2016.
Review expense policies
Revise their travel policies and their application to eliminate all non- essential travel. For example, PDO has targeted savings of $900 million over the next five years through a waste elimination program.
Enforce stricter tendering policies
Focus their tender awards on the lowest price bids as opposed to technical quality or overall value. For example, Saudi and Western engineering firms are facing pressure to lower their bids on projects due to a high number of awards to lower cost providers in Asia.
Renegotiate ongoing contracts
Renegotiate the terms of their ongoing contracts at the end of key project phases to reduce the cost of future work. For example, in January 2016, Saudi Aramco was reported to be renegotiating oil field services contracts with major supplier’s mid-way through Capex programs.
Reevaluate planned projects
Review their project portfolios to reduce scope, defer or cancel projects requiring significant upfront CAPEX investment. For example, QP announced it was delaying additional offshore production developments. However, project delays or cancellations have also impacted local firms, resulting in reduced local employment and talent development opportunities.
Reassess local content initiatives
Revisit their local content programs to increase the focus on driving up the proportion of local content. For example, Saudi Aramco announced an ambitious plan to localize 70 percent of spend and create 500,000 jobs by 2021 through its IKTVA program.
Although these cost reduction initiatives have gained some traction, their impact has been limited as they do not form part of a strategic or long term efficiency program initiated by NOCs.
The lessons from the 2009-drop in oil prices show that these types of short-term cost reduction actions do not deliver sustainable results. At that time NOCs resorted to the same short term cost take out measures but over time the impact eroded as companies were not able to sustain these cost reductions.
Over and above the current cost reduction actions which NOCs are currently undertaking, companies should also take steps to sustain their cost management efforts over time, by taking a strategic view rather than a reactive one. NOCs should build on the cost optimization momentum with a structured program to sustain over time the achieved savings. In addition to reducing the cost base the focus should also be on making structural changes to their operations to improve their ways of working and become more agile in the future regardless of future oil prices.