A New Normal - Persistent Trend of Rising E&P Costs

CIRU - Your Partner in Strategic Research & Insight
February 2010
CIRU Research No 9
CIRU Industry Research
February 2010
Research Team:
Khairuddin Sani
General Manager
khairsn@petronas.com.my
Ext : 4613
Abd Rahim Mahmood
Senior Manager, Corporate Research
rahimma@petronas.com.my
Ext : 6750
M Faizal Othman
Manager, E&P
faizaot@petronas.com.my
Ext : 1391
A New Normal Persistent Trend of Rising E&P Costs
Azleen Suraya Zainen

Manager, Oil
azleen_ suraya@petronas.com.my
Ext : 2482
Lenny Marlina Omar
Manager, Gas
lennyomar@petronas.com.my
Ext : 1711
Siti Haslinza Abd Rahman
Manager, Petchem
haslinr@petronas.com.my
Ext : 4113
Nadia Zaabar
Analyst
nadiazaabar@petronas.com.my
Ext: 1232
Corp. Information & Research Unit (CIRU),
CPDD,
Level 75, Tower 1,
PETRONAS Twin Towers,
Kuala Lumpur City Centre,
50088 Kuala Lumpur
1|Page
CONFIDENTIAL
2010, Corporate Information & Research Unit, CPDD, PETRONAS
No portion of this presentation may be reproduced in any form without prior written consent.
February 2010
Abstract :
This research on A New Normal - Persistent Trend of Rising E&P Costs will attempt to
provide insights on the rationale behind the escalating E&P cost, and why it would continue to remain
elevated in the foreseeable future. This research will also analyze the fundamental drivers of E&P
costs and illustrate how this new cost environment would impact and change the dynamics of the
E&P industry. In meeting these challenges, this report will also highlight key enablers and success
factors that can be implemented by E&P companies in order to maintain their long-term
competitiveness, growth and survival.
We foresee that the focus on cost optimization would once again return high on E&P companies
agenda as rebound in oil prices continues to exert upward pressure on the cost of equipment and
services. We believe that this elevated cost environment would continue to linger in the foreseeable
future as supported by several fundamental drivers that indicate a sustained period of high cost
environment. We are of the view that surviving in this new environment requires solutions from
outside the box especially in the way that companies manage the overall supply chain and
procurement system.
This report would also touch on strategic implications to PETRONAS and avenues that PETRONAS
could capitalize to navigate this challenging cost environment in its quest to pursue growth and
sustainability.
2|Page
February 2010
Contents
Page
The Big Picture
Looking Back To Look Ahead: 2009 - The most subdued

year for E&P
Scanning Tomorrows Horizon: 2010 - What to expect
A New Normal: Why the high cost environment is here to

stay
Mitigating strategy to tackle cost escalation
18
Implications and opportunities to PETRONAS
23
Epilogue: Surviving the New Normal
28
3|Page
14
February 2010
The Big Picture
The period of sustained cost escalation in the E&P sector reached a breakpoint
in June 2009 when the upstream capital cost index (UCCI), which tracks the
cost associated with the construction of new oil and gas facilities, fell by 8.5%,
consequently punctuating the rally in E&P cost which began since 2000.
This development had prompted some industry observers to proclaim the end
of runaway cost escalation in the industry.
CIRU is of the view that the decline in cost is just a temporary phenomenon We believe that as activities in the oil patch return to normalcy - in tandem with
the global economic recovery, a new cost paradigm, which we termed as a
New Normal, will emerge. The defining feature of the New Normal would be
persistent trend of rising E&P costs.
The drivers of this new E&P cost paradigm include amongst others, greater
influence of the financial forces on the commodity market creating greater
volatility to the E&P cost base. The industry is one the largest consumers of
industrial metals either in raw form or as finished products.
This situation is compounded by the shake-out in the industrys service sector,
creating mega-service providers who command a larger share of the market
and through their monopolistic power feeds greater pressure on the E&P cost
base.
Against this backdrop, the E&P terrain continues to be challenging, as the cost
of production continues to be elevated due to the shift of supply from shallow
waters to frontier regions and the monetization of unconventional resources.
Surviving in this new cost reality would require companies to deploy innovative
solutions - such as executing defensive mechanisms in managing its supply
base.
4|Page
February 2010
Looking Back to look Ahead
2009 The most subdued year for E&P

Waning E&P activities
The E&P industry went

throughaperfectstormlast
year as global financial
crisisresultedin:
demand
destruction
oilpricecollapsed
slowdown in E&P
activities
massive
retrenchment
2009 was indeed a challenging year for the E&P sector as the
sharp fall in oil prices due to the economic crisis had severely
dampened global E&P activities. Global rig count a key
barometer of the state of the E&P sector, fell from a high of 3,000
units in October 2008 to a low of 1,983 in May 2009 one of the
sharpest declines compared to the previous three downturns.
(Chart 1).
Chart 1 : The scale of this downturn surpasses others in the

past 20 years but it is not unprecedented
the worse financial

performance in a
decade
Weakest financial performance in a decade

The global economic crisis has also caused cataclysmic impact on
E&P companies performance. Q1- Q3 2009 net profits were lower
by 61% compared to similar period the year before (Chart 2).
5|Page
February 20
010
CIRU
C
- Your Parrtner in Strategic Research & Insight
Chart 2 : Net profits of major E&

&P companies
s
% dec
cline in net pro
ofits vs. simila
ar period in 20
008
0%
al performancee
2009 financia
has been disappointing
g
o the previouss
compared to
year
Q1 2009
9
Q2 2009
Q3 2009
-10%
-20%
-30%
-40%
-50%
-60%
-70%
Source: Bloo
omberg.
6|Page
Massiv
ve reductio
on in headco
ount
Compa
anies embarrked on dow
wnsizing exe
ercise in order to optimizze
cost. In
n our estima
ate, more tha
an 50,000 jo
obs were elim
minated.
Cha
art 3 : Numbe
er of staff rettrenched
25,000
20,000
15,000
10,000
5,000
Source: CIR
RU analysis
Total S.A
Conoco
Baker Hughes
Halliburton
OMV
PDVSA
BP
Schlumberger
0
Shell
m
The industryy went from
talent crunch
h situation in
n
2008 to taleent surplus in
n
2009
as
companiess
embarked on massivee
retrenchmenttexercise
February 20
010
CIRU
C
ncostis driven
n
The decline in
bylowerrawmaterialpricess
Moderration in cost escalatio

on trend
Perhapss, the only silver
s
lining in 2009 wass the moderration in cosst
escalatio
on as dema
and for E&
&P activities subsided. The cost of
o
construc
cting upstre
eam oil & gas facilitie
es measured by th
he
Upstream
m Capital Co
ost Index (U
UCCI) fell by 8.5% (Charrt 4).
Chart 4
4: Cost esca
alation has moderated
d
Inde
ex
Upstream
m Capital Cost Index
240
220
200
180
160
140
120
Q3 2009
2008
Q1 2009
2007
2006
2005
2004
2003
2002
2001
2000
100
Source: IHS CERA (Decemb

ber 2009)
Scanning the Horizon
What to
o expect in 2010
Elevatted trend off oil prices beyond
b
201
10
nce of green
n
The emergen
shoot of glo
obal economicc
recovery spellls better dayss
aheadfortheE&Pindustry
7|Page
CIRU is of the view

w that the trrough in the oil cycle ha
as passed an
nd
a new upturn is un
nder way driiven by the global
g
econo
omic recove
ery
momentum. In th
his instance,, prices of crude oil and
a
other ke
ey
commo
odities whicch are vital to
t support th
he economicc rebound will
w
remain
n elevated. We still be
elieve that ccrude oil su
upply remain
ns
fundam
mentally cha
allenging due
e to slow grrowth in new
w investmentts,
and that demand rationing
r
pricces will returrn in the yea
ars ahead.
We ex
xpect the glo
obal oil dema
and growth tto remain po
ositive beyon
nd
Q1 2010, which, along
a
with continued
c
slu
uggish non--OPEC supp
ply
growth
h, would resu
ult in oil price
es hovering above $80ss/bbl in 2010
0.
February 20
010
CIRU
C
Oilpricesareexpectedto
strengthenin2010
E&Pactivitieswillrebound
in2010suppo
ortedbyhigherr
utilizationofd
drillingrigs
Beyond 2010, oil prices are expected

e
to experience more upwa
ard
pressu
ure in line w
with the stre
engthening g
global econo
omic recove
ery
(Chart 5).
Charrt 5: Oil price

es forecast (US$/bbl)
1
2
3
4
Morrgan Stanley
EIA
Gold
dman Sachs
Barcclays Capital
2010E
2
85
84
90
85
2011E
95
94
110
97
2012E
105
107
105
93
Source: Bloo
omberg
A susttained rebo
ound in E&P
P activities
E&P activities
a
are
e expected to
t regain itss lost mome
entum in 201
10
driven by stronge
er oil pricess on the b
back of global econom
mic
recove
ery. The rebound is evid
denced by th
he rise in drrilling activitie
es
which have been m
mounting sin
nce May 200
09 (Chart 6)..
Chart 6 : International rig coun

nt have imprroved in rece
ent months
sugges
sting a turnaround in the
e E&P sector
No of rigs
s
1,600
1,500
noperation
Drillingrigsin
haverisensinceMay2009
1,400
1,300
1,200
1,100
1,000
900
Source: Bakker Hughes. Excludes United Stattes
E&Pcompanieesare
reactivatingd
deferred
projects
8|Page
Asizableshareofthenew
investmentswillbefocused
onthedevelopmentof
unconventionaloilandgas
resources
9|Page
February 2010
Increasing CAPEX to sustain

unconventional resources
growth,
particularly
for
In tandem with the sectors positive outlook, E&P companies are

expected to increase their capital spending in 2010, especially for
deepwater play in Gulf of Mexico, Latin America and West Africa.
A sizable share of the investment will also be focused to accelerate
the development of unconventional oil and gas resources,
particularly shale and oil sands in North America, heavy oil in
Venezuela, and coal seam gas in Asia-Pacific. The successful
development and commercialization of shale gas in the US
provides the impetus for E&P companies to replicate this success
elsewhere in the world (please refer to CIRUs research entitled
Unconventional Gas : Future Game Changer and Driver for New
Ventures).
We believe Europe would be the next beneficiary of new
investments in unconventional gas resources, as evidenced by the
moves made by various international oil companies in acquiring
vast land banks in the continent (further insights are available in
our forthcoming research paper E&P Megatrends which will be
published in February 2010)
A survey of more than 100 companies revealed that 52% of the
companies surveyed will increase their capital expenditure in 2010
(Chart 7).
Chart 7: Estimated direction of CAPEX in 2010
25%
52%
23%
Increase CAPEX
Source: Barclays Capital
Maintain CAPEX
Reduce CAPEX
February 20
010
CIRU
C
APEXis
GlobalE&PCA
expectedtoin
ncreaseto
US$400billion
nthisyear
ductioncould
Oilsandsprod
propelCanada
atobecome
theworlds3rddlargestoil
exporterby20
015
Thediscoveryofgiantoil
fieldsinGhanahasopened
upanewplayystretching
1,000kmacro
oss4countries
inWestAfrica
a
10
1 |Page
In line with the possitive outlook, we expecct the global E&P CAPEX
X
to rebo
ound to $400
0 billion in 20
010 (Chart 8
8).
Chart 8 : E&P CAPE
EX will incrrease in 201
10
CAPEX (in US$ billiion)
450
400
350
300
250
200
150
100
50
0
200
05
2006
2
2007
2008
2009
2010
Source: CIRU analysiss
Develo
opment of oil
o sands to
o intensify
Driven
n by stronger oil price
es, we expect the acttivities in th
he
Canad
dian oil sand
ds to intensiffy and return
n to growth in 2010 on th
he
resumption of defferred proje
ects by Exxo
on, Conoco
o, Suncor an
nd
Devon
n. Assuming all planned
d projects p
progressed as
a schedule
ed,
we be
elieve Cana
ada will be
ecome the worlds thirrd largest oil
exporter by 2015 (further elaboration in our forthcom
ming researcch
entitled
d Canadass Oil Sands
s: Dead Ca
at Bounce which will be
b
publish
hed in March
h 2010)
Emerg
gence of ne
ew oil produ
ucing provin
nce in Westt Africa
Driven by a few g
giant discove
eries in We
est Africa, we
w foresee th
he
emerge
ence of new
w group of oiil exporting ccountries fro
om this regio
on.
These countries arre Ghana, Sierra
S
Leone, Cote dIvoire and Liberria
(further insights arre available in our forth
hcoming ressearch entitle
ed
E&P Megatrends
M
which will be
b published
d in Februaryy 2010).
Higher prices of iindustrial metals
m
Prices of industria
al metals su
uch as stee
el, aluminum
m, copper an
nd
nickel to perform strongly in 2010 drive
in
en by the resurgence
r
manufa
acturing actiivities arising
g from the g
global econo
omic recoverry.
February 20
010
CIRU
C
Speculation and hedging ac

ctivities are expected to
t further put
p
upward
d pressure o
on price mov
vements.
Our be
elief is prem
mised on th
he Commod
dity Super Cycle Theo
ory
(Chart 9) which envisages a period o
of sustained
d increase in
commo
odity pricess between 2000 to 2020 driven by rap
pid
industrrialization an
nd urbanizattion in emerrging econo
omies such as
a
China and India. This
T
develop
pment may n
negatively im
mpact the E&
&P
sector,, as the sector is one the largestt consumerss of industrial
metalss.
Chart 9: Fo
our commod
dity super cycle
c
since 1990
Asupercycleisaprolonged
d
(decades)riseeofreal
commodityprrices,drivenbyy
urbanizationa
and
industrializatiionofmajor
economy
Source: CIR
RU analysis
Cost optimization
o
n will be the
e central the
eme for E&P in 2010
We als
so believe that the foc
cus in cost optimizatio
on will be th
he
centrall theme in the
t
E&P sec
ctor this yea
ar. This is because
b
mo
ore
than 60%
6
of a tyypical oil companys CA
APEX are spent
s
on E&
&P
activitie
es and highe
er costs erod
de profit margins (Chart 10).
E&Pcostwillrrisein2010
11
1 |Page
Chart
C
10: Hig
gher cost trranslates in
nto lower ma
argins
Net Profit Margin (%)
Index
50
45
40
35
30
25
20
15
10
5
0
250
200
150
100
50
2009
2008
2007
2006
2005
2004
2003
Source: CIR
RU analysis, IHS CERA, Bloombe
erg
UCCI
Net Profit Margin
M
February 20
010
CIRU
C
Rising
g cost accep
pted as a n
new normal
Given the expectations of a po
ositive outloo
ok for the E&P sector th
his
year, we
w are of the
e view that cost
c
would n
not only stayy elevated but
b
has th
he potential to rise furrther. In our view, the cost declin
ne
witness
sed in 2009
9 (Chart 4) was only a temporary phenomeno
on
becausse of the syn
nchronized global
g
downtturn.
Thecostofdrrilling,
equipmentan
ndsupport
activitieshaveerisenin
recentmonthss
12
1 |Page
Our view is predicated on the strong ccorrelation between

b
E&
&P
activitie
es (represented by drilling rigs in
n operation) and cost as
a
depicte
ed in Chart 1
11).
Charrt 11: Highe

er E&P activ
vities are tra
acked by ris
sing cost
No. of rigs
Index
4,000
250
3,500
200
3,000
2,500
150
2,000
Drilling Rig
R
100
1,500
UCCI
1,000
50
500
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
Anelevatedcosstenvironment
isanewnorma
alforthe
industry
Source: CIR
RU analysis, IHS CERA, Bloombe
erg
The tre
end of rising cost has be
een quite con
nsistent if we
e were to loo
ok
at the following
f
bre
eakdown of costs
c
:
i. High
her drilling ccost
The co
ost of drillin
ng (Chart 12
2) has been rising since Novemb
ber
2009 as
a a result of resumpttion of defe
erred projectts as well as
a
continu
ued development of uncconventional gas projectss.
February 20
010
CIRU
C
Chart 12: Monthly percentage

p
c
change
in the
co
ost of drillin
ng oil & gas
s wells
Percentage
e
10.0%
8.0%
6.0%
4.0%
2.0%
Dec-09
Nov-09
Oct-09
Sep-09
Aug-09
Jul-09
Jun-09
Jun 09
May-09
Apr-09
Mar-09
-4.0%
Feb-09
-2.0%
Jan-09
0.0%
ndforE&P
Higherdeman
equipmentstrriggers
upwardspresssureonprices
-6.0%
-8.0%
-10.0%
Source: CIR
RU analysis
ii. High
her equipme
ent cost
The co
ost of oil & gas machin
nery (Chart 13) has bee
en on the risse
since August 20
009 arising from high
her demand
d from E&
&P
compa
anies.
p
c
change
in the
cost of oil & gas production
p
machinery
Percentage
e
3.0%
13
1 |Page
2.0%
1.0%
-3.0%
Source: CIR
RU analysis
Dec-09
Nov-09
Oct-09
S
Sep-09
09
Aug-09
Jul-09
Jun-09
Apr-09
May-09
-2.0%
Mar-09
-1.0%
Feb-09
0.0%
Jan-09
Thecostofsu
upport
activitiesisrissingdueto
higherdeman
ndofE&P
services
February 20
010
CIRU
C
iii. High
her cost of support
s
activvities
The co
osts of oil & gas supp
port activitie
es (Chart 14
4) have bee
en
increassing since August
A
2009
9 as higherr level of acctivities in th
he
oilfields
s resulted in
n greater dem
mand for oil and gas serrvices.

p
c
change
in the
costt of oil & ga
as support activities
a
Percentage
e
10.0%
8.0%
6.0%
4.0%
2.0%
Dec-09
Nov-09
Oct-09
Sep-09
Aug-09
Jul-09
Source: CIR
RU analysis
iv. Cos
sts of major E&P items to
t escalate by
b 2-5%
pect costs of m
major E&P ite
ems to escala
ate by betwee
en 2% to 5% for
f
We exp
this yea
ar (Chart 15).
Chart 15
5: Forecast cost escala
ation for selected E&P equipmentts
and services
Source: IHS CERA
J
Jun-09
09
Apr-09
-8.0%
-10.0%
Offshore rig
Equipme
ent
Yards and fabrication
Offshore installation vessels
v
Construc
ction labor
Subsea
14
1 |Page
May-09
-6.0%
Mar-09
-4.0%
Feb-09
0.0%
-2.0%
Jan-09
ajor
Thecostofma
equipmentiseexpectedto
escalatebetw
ween25%in
2010
Forecast
(% chang
ge from Q3 200
09)
3.1
3.0
5.0
3.4
2.0
4.0
February 20
010
CIRU
C
A New No
ormal
Why the
e high cost environment is here to
o stay
Several fundamental
f
l indicators support
s
the view of a prrevailing hig
gh
cost environment in tthe medium to long-term
m. These include:
Consolidationintheservice
sectorhavecrreatedmega
servicecompa
anies
Assuch,E&Psservicesare
beingdomina
atedbyasmall
numberofsup
pplierswhich
provideserviccesatpremium
m
rates
E&P co
ompanies depend on se
ervice provid
ders to provvide myriad of
o
essenttial service
es such as seismic data acquisition an
nd
interpre
etation, drillling, fabrica
ation, offsh
hore installa
ation, projecct
manag
gement etc. Over the
e years, th
he service sector ha
as
underg
gone rapid cconsolidation
n resulting in
n the formattion of mega
aservice
e companie
es which co
ontrols a g
greater share of globa
al
capacity (Chart 16, 17, 18 and
d 19).
The co
oncentration
n of skills an
nd expertise
e in the han
nds of a few
w
major players on the back of
o growing demand for specialize
ed
service
es creates a sellers environment
e
t. This stren
ngthens the
eir
bargain
ning leverag
ge that inccludes price arbitration and marke
et
syndica
ation.
C
Chart
16: Market share
e of seismic
c equipmentt (%)
17%
15
1 |Page
Conso
olidation of E&P servic
ce sector
Se
ercel
21%
62%
ION
Otthers
S
Source:
CIRU ana
alysis
Chart 17
7: Market sh
hare of offs
shore drilling rig servic
ce providers
s
(%)
20%
41%
18%
Transoc
cean
Ensco
Noble
21%
So
ource: CIRU ana
alysis
Others
February 20
010
CIRU
C
Chart 18
8: Market sh
hare of subsea tree (%
%)
15%
50%
Othe
ers
So
ource: CIRU ana
alysis
Ch
hart 19: Market share of
o gas turbine generato
or (%)
20%
41%
18%
GE
Alsto
om
Siem
mens
21%
Othe
ers
So
ource: CIRU ana
alysis
Higher cost of prroduction frrom margina

al fields
Asfieldsmatu
ure,costof
productionwo
ouldrise
Limitedaccesssibilityforces
companiestooperatein
frontierareasswherecostis
higher
16
1 |Page
Cameron
FMC
35%
The prractice of de
eveloping larrger and eassily accessib
ble fields firsst
has cre
eated a dem
mand vacuu
um for marg
ginal field de
evelopment at
a
a later stage. A su
ustained periiod of high oil
o prices the
en triggered a
deman
nd rush tow
wards technology, serrvices, equipments an
nd
talentss specializing
g in margina
al field devellopment. The smaller th
he
size off the remainiing resource
e (relative to its initial res
source base
e),
the mo
ore expensivve it is to be
e developed,, albeit in the absence o
of
improvvement in tecchnology.
Higher cost of prroduction frrom deepwa
ater areas
70% of the worldss reserves are
a located in the Middle
e East wherre
accesss is limited. As such, E&P compan
nies have be
een forced to
t
move into deepwa
ater regionss in the Gulff of Mexico,, West Africca
and Latin Americca. For this
s year alon
ne, it is esstimated tha
at
deepw
water blockss would co
ontribute up
p to 25% of
o global oil
o
produc
ction. Howevver, the costt of productio
on in deepw
water areas is
high to
o match the operational
o
complexity w
which requirres a differen
nt
set of expertise an
nd technolog
gy. As a com
mparison, th
he productio
on
cost of
o deepwate
er oil may range
r
betwe
een $60 - $80
$
a barre
el
relative
e to conventtional offshore oil producction at abou
ut $40-$60.
February 2010
Development of unconventional oil and gas resources is

capital and technology intensive
Monetizationof
unconventionalresources
requirescuttingedge
technology
Theshareofunconventional
oilinglobalsupplymixis
rising
Unconventional oil such as oil sands and extra heavy oil are
claiming a larger share of the worlds oil production (Chart 20).
However, the cost of producing unconventional oil is high
compared to conventional crude oil (Chart 21). This is because,
additional facilities are required to be built in order to upgrade this
heavy crude into lighter crude oil. For instance, oil sands produced
in Canada would be processed into synthetic crude oil before it is
sold to the refineries.
Chart 20: Breakdown of global oil supply
Source: IHS CERA
Conventionaloilisrelatively
cheapertoextractthan
unconventionaloil
17 | P a g e
Chart 21: The cost of oil by type
Source: Douglas Westwood
February 2010
Increasing trend of higher fiscal take
Statetaketendstoincrease
inhighoilprice
environment
Variouscountrieshave
imposedwindfalltaxtoseek
higherrevenue
More than 80% of conventional oil and gas reserves belong to

NOCs where access to upstream opportunities remains limited.
Fiscal terms are also subject to resource holders arbitration to
maintain control over their resources while optimizing returns at
the expense of their IOC/NOC partners. Nigeria and Venezuela
are the most prominent examples of resource rich countries
seeking to gain what they would consider a fairer share of
economic rent. Under the circumstances where costs are already
high, stricter fiscal regimes will add further financial woes that will
further erode margin.
Imposition of windfall tax

Host government tends to impose windfall taxes when oil prices
are high. Countries which have imposed windfall tax include the
US, UK, Canada and Ecuador. Alaska imposed windfall tax on oil
companies in 2008 resulting in US$6 billion revenue to the state
government. UK imposed similar tax measures to oil companies in
2005. Canada planned to impose such tax in 2009. Similarly, in
2007 Ecuador increased tax on oil companies to 99% in 2008.
Rising commodity prices may impact E&P projects
Commoditymarketwill
exertgreaterinfluenceto
theE&Pcoststructure
The price of industrial commodities has increased significantly

since 2000 (Chart 22). High demand from China and emerging
economies are driving this trend. Since the E&P sector is one of
the largest users of industrial commodities (for line pipes, drill bits,
well casing etc.), surging commodity prices contribute to a
significant part of rising production cost.
Chart 22: Rising trend of industrial commodity prices
Copper and Aluminum (US$/tonne)
Steel (US$/tonne)
1400
1200
Copper (RHS)
Aluminum (RHS)
30,000
25,000
1000
20,000
800
15,000
600
10,000
400
5,000
200
Source: Bloomberg
18 | P a g e
Steel (LHS)
CIRU
C
February 20
010
Mitigatin
ng strategy
y to tackle cost
c
escalattion
hisnew
Survivinginth
environmentw
wouldrequire
theexecutionofinnovative
strategyintheesupplychain
Alliancewithsservice
providerscoulldprovide
accesstocriticcalequipment
t
andservicesa
atlowerrates
Oneofthestrrategyto
enhanceallian
ncesisto
moveawayfr
fromthe
contractualreelationshipto
collaborativeandbusiness
nership
buildingpartn
19
1 |Page
We are of the view

w that cost escalation
e
co
ould be arre
ested throug
gh
the deplo
oyment of in
nnovative strrategy in the
e supply chain as followss:
Build alliance witth key serviice providerrs
The nature of re
elationship between
b
E&
&P companies and ke
ey
supplie
ers need to
o be enhanced in orde
er to mana
age cost an
nd
addres
ss service se
ector capacity constrain
nts. One of the
t means to
t
enhancce alliances is by movin
ng away from
m the curren
nt contractua
al
relation
nship to a more collaborative and business buildin
ng
partnership.
The ex
xisting conttractual rela
ationship ten
nds to be short
s
term in
i
nature, focusing on
o project to project b
basis. By elevating
e
this
relation
nship to a more strate
egic level b
by establish
hing strategic
alliance
e with key ssuppliers an
nd service providers
p
in critical area
as
(engine
eering, equipment, fabrrication and drilling) E&P companie
es
would be able to benefit
b
from the econom
mies of scale
e through th
he
consolidation and aggregation of critical ite
ems (turbine
e, generatorss,
pumpss or raw ma
aterials such
h as steel) o
on a portfoliio of projectts
rather than individu
ual project basis.
b
An exa
ample of a strategic allliance betwe
een an IOC
C and servicce
provide
ers is shown
n below (Cha
art 23).
Cha
art 23: BPs
s strategic alliance
a
with
h service prroviders
February 20
010
CIRU
C
onindesignoff
Standardizatio
upstreamfaciilitiesreduces
costandprojeectcycletime
ExxonsDesiignOne,Build
Manyhasyieelded
substantialco
ostsavings
Forwardplann
ningcould
resultinthea
aggregationof
equipmentan
ndservices
whichcouldtrranslateinto
lowerrates
20
2 |Page
Standardize design of upstream facilitie

es
Some companies have embarrked on a co
ommon upstream desig
gn
for E&
&P facilities.. By levera
aging on de
esign simila
arities acrosss
projectt, companies can reducce project cost
c
as it eliminates th
he
need fo
or bespoke d
design for ea
ach project.
This sttrategy could also reduce cycle tim

me as design
n is availablle
off the
e shelf. ExxxonMobil has
s successfully applied th
his concept in
i
the de
evelopment of Kizomba A projecct, in the deepwater
d
o
of
Angola
a. The com
mpany managed to sa
ave US$400 million by
b
applyin
ng this princiiple.
This concept
c
is not
n new. It has been used
u
widely used in th
he
automo
otive sector.. Automotive
e companiess used simila
ar principle by
b
produc
cing platform
m which cou
uld be used
d in differen
nt variants of
o
vehicle
es. For exam
mple, Toyota
a drives the design and production of
o
its entire fleet by using 13 common
c
pla
atforms and manages tto
produc
ce 40,000 diffferent finish
hed productss.
Chart 24
4: Exxons Kizomba A,
A deepwater Angola is an example
e
of a successful exe
ecution of Design One
e, Build Man
ny concep
pt
By u
using our dessign one, build
d
many concept with the Kizomba
aA
projecct offshore An
ngola, we havve
significa
antly reduced
d the capital cost
of the
e Kizomba B project,
p
saving
g
around
d $400 million
n and improvin
ng
implem
mentation time
e by 20 perce
ent
versus Kizom
mba A.
- Rex Tillerson,
T
CE
EO ExxonMob
bil
Effective forward
d planning
Effectivve forward planning
p
enssures better visibility of requirementts
of upsttream projeccts. By appllying this principle, com
mpanies coulld
ensure
e the continuity of supp
ply of equip
pment and services an
nd
able to
o leverage on
n demand where
w
scale is advantage
eous.
Throug
gh forward p
planning, co
ompanies ca
an leverage on the scalle
and sc
cope of their business by
y managing projects req
quirements on
o
a portffolio basis ra
ather than managing
m
on
n project to project
p
basiss.
In othe
er words, ccompanies forecast
f
their needs accross severa
al
projectts by aggrregating an
nd standard
dizing dema
and for raw
w
materia
als (such as steel), equipments and services.
More often than not, compa
anies lack e
effectiveness in forwarrd
plannin
ng resulting in increased costs (e.g
g., unanticipa
ated deman
nd
ChinaandRussiacould
becomeanalternative
providerforequipmentand
services
Talentsfromdeveloping
countriesarecheaperto
hire
21 | P a g e
February 2010
from project teams lead to rushed orders that incur additional cost
and expedited freight charges which feeds into the cost of
production). In some instances, lacking skill to forecast forward
demand burdens the companies with extra storage charges just to
keep the excess inventory.
Broaden supply base
Instead of restricting suppliers from developed countries, some
companies engage the services of companies from China and
Russia. Both of these countries have a long history of oil and gas
production, and are capable of providing goods at competitive
prices compared to established companies from developed
countries. A study revealed that service providers from developing
countries charges lower rates due to lower labor cost (Chart 25).
Chart 25: Better value from service providers from developing

countries
Source: Boston Consulting Group
Acquire talent from developing countries

More than 50% of the current workforce will retire in the next 5-10
years (Chart 26). Worsening the situation is the slow
replenishment of talents as evidenced by the fall in the number of
graduates in petroleum related courses, whereby the number of
degrees awarded were only 25% of the number awarded annually
in the eighties.
February 20
010
CIRU
C
oolisageing
E&Ptalentpo
Chart 26
6: Age profille of E&P professionalls
Percen
ntage
30
25
20
15
10
5
0
55-59
50 54
50-54
45-49
40-44
35-39
30-34
25-29
A
Age
<25
Developingco
ountries
produceahighernumberoff
petro-personnelcompared
nations
todevelopedn
Source: SP
PE
To arrestt this decline

e, companie
es may seek to employ
y E&P talentts
from de
eveloping co
ountries wh
hich produce greater number of
o
graduates (Chart 27)).
Chart 27:
2 Numberr of enginee
ering graduates produced yearly
No. of engineering
ates (in thousa
and)
gradua
25
50
20
00
15
50
10
00
50
5
0
22
2 |Page
USA
Source: Booz Allen and Ham
milton
Europe
India
China
February 20
010
CIRU
C
andthecosttislower
Additio
onally, com
mpanies ma
ay also consider emp
ploying E&P
professsionals from
m developing countries - which may
m
cost lesss
compa
ared to their counterpartss from US an
nd Europe (C
Chart 28).
Ch
hart 28: Average yearly
y salary of E
E&P profess
sionals
Annu
ual salary
(US$
$000)
90
80
70
60
50
40
30
20
10
0
USA
A
UK
K
India
a
China
a
Source: Booz Allen and Hamilton
Implic
cations and
d Opportun
nity to PET
TRONAS
Projectecono
omicswould
beunderpreessure
Soarin
ng cost en
nvironment poses a th
hreat to E&
&P projects
s
viability
A high cost environment
e
would re
ender some
e projects
uneco
onomic. Thiis could ressult in the cancellation
n of these
projeccts and ultim
mately impac
ct the growtth of future oil
o and gas
produ
uction. Add
ditionally, ongoing
o
p
projects wh
hich were
sanctioned based
d on lower cost estimates may ta
ake longer
time to generate
e sufficient returns or would turn out to be
unpro
ofitable at all.
Highe
er possibility of projectt delays
Projectdelaysswould
translateinto
oopportunity
lossintermso
ofproduction
23
2 |Page
We be
elieve that th
here is a hig
gher likelihoo
od of cost ov
verruns and
d
projects exceeding
g its comple
etion schedule. This is driven by the
e
difficullties faced by companies in estim
mating the cost
c
of raw
w
materials, equipm
ments and services due
e to the vola
atility in the
e
marke
et as well as bottleneck in the supplyy chain.
A stud
dy revealed
d that 40% of mega-p
projects had
d exceeded
d
budge
et and sche
edule (Chart 29). Cha
art 30 prov
vides some
e
examp
ples of high profile projects ope
erated by IOCs which
h
encountered simila
ar problems.
February 20
010
CIRU
C
24
2 |Page
Chart 29: Percen

ntage of pro
ojects which
h had excee
eded budge
et
Percentage
40
35
30
25
Exceed Budg
get
(%)
20
15
Exceed Schedule
(%)
10
5
0
Mega-p
project (>US$ 1 billion) Normal
N
project (<US$1 billion)
Source:: Booz Allen and

d Hamilton
C
Chart
30: Ma
ajor projects
s which had
d exceeded budget
Cost
(US$ billion)
25
20
Original Costts (US$ billion)
15
Revised Costts (US$ billion)
10
5
Gassi Touil
Skarv
Kashagan
Snohvit
Sakhalin-2
Megaprojecttsareprone
tocostandscchedule
overruns
ProjectsmanagedbyIOC
arealsoexpo
osedtocost
overruns
Higherdeman
ndforPetro
personneltra
anslatesinto
higherwagess
Source: Booz Allen and Hamilton
Soarin
ng manpow
wer cost
The co
ost of manp
power would continue to
o rise as grea
ater demand
d
for skkilled and experienced
e
personnel globally exxerts upward
d
pressu
ure on wag
ges. Generrally, the ssalary of skilled petro
operson
nnel moves in tandem with
w oil pricess (Chart 31).
February 20
010
CIRU
C
25
2 |Page
Chartt 31: Salary o

of geologists
s track oil price but is sticky upwards
s
B
Brent
(Index)
Salary (In
ndex)
170
4
450
160
4
400
150
3
350
140
3
300
6-9
9 years
130
2
250
15
5-19 years
120
2
200
110
150
100
100
nce
Experien
Ind
dex price of Brent
B
2009
2008
00
2007
2006
2005
2004
2003
2002
20
0-24 years
Source: AAPG, Bloombe

erg. Base year is
s 2002
Longe
er delivery llead time
We ex
xpect that the
t
delivery lead timess for E&P equipment
e
to
o
lengthen in 2010. For example, OCTG wo
ould take ab
bout 9 weekss
to be delivered co
ompared to only 4 wee
eks in Janua
ary last yearr.
Steel would take 4 weeks to
o be deliverred compare
ed to only 2
weekss in December 2008 (Chart 32).
Chart 32: D
Delivery lea
ad time for E
E&P equipm
ment
Weeks
Weeks
Source:
S
Bloombe
erg, Purchasing Manager
M
Dec 09
Dec-09
Nov-09
Oct-09
Sep 09
Sep-09
Aug-09
Jul-09
H Rolled Shee
Hot
et & Strip (RHS)
May-09
Apr-09
Mar-09
Mar
09
Feb-09
OCTG
G (LHS)
Jun-09
10
9
8
7
6
5
4
3
2
1
0
Jan-09
Longerdeliveerytimefor
criticalequipm
ments
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
February 20
010
CIRU
C
26
2 |Page
Lowerr exploratio
on spending
g
We arre of the viiew that an
n elevated cost
c
environ
nment would
d
result in lower exxploration sp
pend. As illu
ustrated by Chart
C
33, ass
cost riises (repressented by UCCI on the right axis), the amoun
nt
spent on exploratiion decrease
es (on left a
axis). These phenomena
a
could be attribute
ed to the fa
act that exploration is a high riskk
venturre whereby companies may or mayy not strike oil in drilling
g
explorration wells.
In view
w of this riskk coupled with
w the high
h cost involvved in drilling
g
explorration wells ((between US
S$20 million
n to US$60 million) E&P
P
compa
anies would rather alloca
ate a major portion of th
heir capital to
o
monettize oil resou
urces rather drilling explo
oration wellss.
Chart 33: Explora

ation spend
d declines a
as cost rises
Inde
ex
%
25
240
Exploratio
on as %
of total CA
APEX
UCCI
220
200
20
180
160
15
140
120
2009
2008
2007
2006
2005
2004
2003
2002
100
2001
10
2000
Companiesteendtospent
loweronexplloration
activitieswheenE&Pcostis
higher
Inexperienced
dE&P
personnelma
aycontribute
tohigherHSEEincidents
Source: CIRU analysis, B

Bloomberg, IHS CERA
Highe
er risks of safety relate
ed incidents
s
The tig
ght supply o
of skilled personnel mayy force serviice providerss
to hire
e inexperien
nced person
nnel in proje
ect executio
on. This mayy
pose higher safetty risk due to their unfa
amiliarity to oil and gass
operattions.
Creatingalliancewith
otherNOCscouldcreate
economiesofscalein
securingequipmentsand
services
Establishingstrategic
alliancewithservice
providersensureaccessof
criticalequipmentsduring
periodsoftightcapacities
Greatercollaboration
betweenstrategicplanning
andsupplychaincould
createclearerlineofsight
insecuringfuture
upstreamsupplies
Incentivesandpenalties
couldbeusedtospur
contractorsperformance
Lowerdutiesongoodsand
servicesprovidedbythe
FTAscouldtranslateinto
lowercost.
February 2010
Opportunity to pursue ventures with other NOCs to secure

bulk supply of equipment and services
NOCs from South East Asia are expected to spend about
US$15 billion1 for E&P activities in 2010. PETRONAS could
consider establishing an alliance with these NOCs to secure
critical E&P items. This could help to drive down cost due to
economies of scale.
Opportunity to establish strategic alliance with service

providers
PETRONAS could consider establishing strategic alliance with
key service providers in drilling, installation, fabrication, line pipes
and rotating equipment etc. to ensure secured access of critical
items in a tight market environment.
Strengthen linkages between strategic planning and supply

chain
Establishing closer linkages between strategic planning and
supply chain could provide the supply chain fraternity with vital
information regarding projects planned for the next 5-10 years.
This would allow the procurement of equipment and services at
todays prices (which may be lower) hence insulating the
Group from market volatility.
Provide incentives to good service providers and impose

penalties on bad ones
To arrest the issue of delays in project completion,
PETRONAS could perhaps provide incentives to service
providers who deliver their projects ahead of schedule. In
addition, PETRONAS could also impose penalties to service
providers who failed to deliver the commitments as scheduled.
Capitalize on the opportunities from the signing of Free

Trade Agreement (FTA) and AFTA
Malaysia is a party of several FTAs (either bilaterally or through
ASEAN) with Japan, China, South Korea, India, Pakistan,
Australia and New Zealand.
These FTAs came into force in January 2010. Also in the same
month, the ASEAN Free Trade Area (AFTA) came into effect.
FTA provides for the elimination of tariff on goods and services
originating from FTA member states. This move would
translate into lower prices. PETRONAS could capitalize on the
Wood Mackenzie
27 | P a g e
February 2010
commencement of FTA by securing oil and gas equipments

from FTA member countries.
Epilogue
Surviving the New Normal

The upstream sector is entering into a new cost paradigm. Unlike
in the past where E&P cost is not greatly influenced by
movements in the commodity market, the same principle would
not hold true today, as volatility in the commodity market impacts
the prices of O&G equipment.
Additionally, other above & below ground issues continue to exert
upward pressure on upstream cost. Oil - a precious resource
which is finite in quantity, became a political pawn, as resource
rich countries exercise their sovereign right to extract maximum
value from the escalating oil prices through drastic measures
made in the fiscal terms which granted more benefits to host
countries at the expense of oil companies. To avert the risks of
fiscal uncertainties and threats of resource nationalism,
companies are forced to seek their fortune in frontier regions
which are often technically challenging, requiring breakthrough
technology and as such pushing cost curve further upwards.
As oil companies grapple with the challenges in finding,
developing and producing oil in a challenging environment, the
landscape of the industry continues to evolve with the emergence
of superior service companies which came into being through the
acquisition of smaller rivals resulting in a monopolistic market
where key technologies and critical services are dominated by a
few niche companies. Aware of the fact that their support are
needed to find and extract greater quantities of oil, these niche
service companies exercised their monopolistic power on the
prices of upstream technologies and equipments further driving
cost upwards.
Under the backdrop of this challenging environment, what are
options left to the oil companies in order to mitigate the increase
in upstream cost?
One, is through creative management of the supply chain by
maximizing the economies of scale through standardization,
aggregation and consolidation of equipments and services.
The other is through forward planning firming in advance of
critical equipments and services locking price at todays relatively
low price environment.
Additionally, standardizing project design, centralizing critical
functions of project execution as well as taking advantage of
wages disparities between countries could also support the
battle in combating escalating cost.
Moving forward, the terrain of the E&P industry would continue to
28 | P a g e
February 2010
be challenging, volatile and uncertain. It appears that the only

certainty is the direction of cost. The key to survival is to continue
to be proactive in capitalizing the moment when the cost curve is
bottoming as well as deploying creative defensive mechanism to
minimize impact of extreme cost volatility.
DISCLAIMER
Analyst Certification
The research analyst(s) primarily responsible for the preparation of this research report hereby certify that all the views expressed in
this research report accurately reflect their personal views about any and all of the subjects. The research analyst(s) also certify that
no part of their compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in
this research report.
Other Disclaimers
This publication has been prepared by Corporate Information & Research Unit (CIRU), Corporate Planning and Development Division
as indicated in the cover page. CIRU takes responsibility for the content of the report.
This publication is being furnished to you for informational purposes only and on the condition that it will not form the sole basis for
any investment decision. This report may not be reproduced, distributed, or published without prior consent of CIRU, CPDD, and
PETRONAS.
29 | P a g e

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