Drilling Report Alliances: their advantages and pitfalls

Daniel C. Coolidge
Unocal Corp.
Lafayette, La.

Contract alliances between operators and service companies, contractors, and suppliers in the drilling and production industry have helped cut costs and improve operational efficiency, but there are pitfalls to be aware of. Operators and service companies tend to form alliances for long-term pricing or efficiency gains rather than for continuous quality improvement or as a technology sharing agreements.

A survey was sent to a total of 200 operators, contractors, and service companies to help identify the advantages and pitfalls with current alliance strategies in the U.S. petroleum industry. This article is the first of a two-part series on petroleum industry alliances. The second part, which will appear in an upcoming issue, covers the results of the alliance survey in detail. An alliance is defined as an agreement between two or more parties to align goals to achieve a common objective without regard to the legal or organizational aspects of the agreement.

The most common alliance in the petroleum industry is the joint venture partnership, or competitor alliance, between two or more companies with similar interests. In a joint venture, the partners typically share common costs, risks, and rewards. Also, the goals of each partner are usually very compatible, which helps develop a stable working relationship. This type of alliance has been extremely successful for both operators and service companies entering new markets or geographic areas, such as foreign countries or the Gulf of Mexico.

A typical customer/supplier alliance involves service companies working closely with a producer in a preferred or exclusive relationship. The customer/supplier alliance is usually the most challenging type of alliance to manage. Unlike a joint venture, the partners rarely share the same costs, risks, or rewards. Also, the partners can have conflicting goals which can interfere with developing a stable relationship.

In the past, the procurement practices of most oil producers ranged from highly relationship-oriented to a competitive bidding process. Many large producers commonly solicited bids from three qualified vendors and then accepted the lowest bid. This process is sometimes referred to as "three bids and a buy."

This type of buying behavior often encourages purchasing less than optimal quality products and services and can produce very adversarial relationships with suppliers, because of its attention to the purchase price rather than the value of the exchange. Many companies have used purchasing departments to avoid distracting their operational personnel with the problems of procuring products and services through a competitive bidding process.

Purchasing agents are usually not qualified to provide the actual job specifications. The functional groups (such as drilling, construction, or production departments) must then supply the specifications so the purchasing agents can solicit bids. This type of arrangement is highly efficient because the number of active buyers is limited, but it creates large barriers for collaboration between the supplier and customer before the bids are awarded, after which, changes in specifications may often occur.

Some companies rely on this important collaboration with the suppliers for their operational experience or technical support. These operators only allow their purchasing departments to buy products and services that require minimal specifications, like tubular goods and frequently used supplies. Operational personnel make most of the purchasing decisions based on experience or technical ability.

This type of procurement system is highly inefficient because of the large number of active buyers, but it facilitates an opportunity for close collaboration with the supplier, which is normally very beneficial. It is sometimes difficult to control abuses of the system, however.

Although technology plays an important role in the success of a petroleum industry alliance, most alliances are formed to reduce costs and improve operating efficiency. Too often the emphasis is placed on selecting the vendor with the lowest bid instead of the one most likely to meet the quality and service standards desired.

Many companies refer to an exclusive, long-term pricing agreement as an alliance, yet many of these agreements do not meet the criteria to warrant that definition. In reality, if there is no mutual commitment to develop a close working relationship and align goals, the agreement is just another long-term pricing contract.

Alliance types

There are basically four types of alliances practiced in the petroleum industry today. These alliances have been awarded on a local, regional, national, or worldwide basis.

• In the first type, a customer makes agreements with a set of approved or preferred vendors in hopes of reducing his purchasing or administrative costs, improving quality, or increasing communication and efficiency. This arrangement can be modified to include a first/second call status where the vendors will be used according to their preferred status. This method is popular for commonly used items such as rental tools and supplies.
• In the second type, a customer commits 100%, or a significant portion, of his business to a single vendor for a specific product or service. In return, this sole supplier usually offers better price discounts or commits to increased quality or special working obligations, such as sharing risks, technologies, etc.
• Integration of services is the goal of the third type, in which an alliance is formed between a customer and several suppliers in hopes of increasing communication, efficiency, and reducing costs. These suppliers agree to align goals, share risks or technologies, and work closely with each other to increase efficiency and communication.
• The fourth type, which is the most controversial, involves a customer forming an alliance with a single integrated supplier that has a wide range of services and products as well as the capabilities of assuming a significant portion of the engineering or planning involved to execute a project. These suppliers are also usually asked to share a substantial portion of the risk.

Single vendor

There are two main variations of these controversial alliances with major integrated service companies. In the single vendor alliance, the major service company serves as the coordinator of activities between the operator (customer) and the various service groups (wire line, cementing, etc.). The operator retains control of all decision making and management of daily activities. Discussion with specialists from each service group is usually required for detailed planning and execution, however. Fig. 1 (35673 bytes) illustrates this relationship.

Lead contractor

In the lead contractor alliance, the major service company is responsible for coordinating the completion and well servicing activities, and the drilling contractor is responsible for coordinating the drilling activities ( Fig. 2 (35794 bytes)). This form of an integrated service alliance gives both the drilling contractor and the major service company more control of their operations but usually requires them to assume more risk as well.

Some operators have provided the conceptual well design but allow their partners to handle some or all of the actual well design, planning, and execution. These operators hope that both the drilling contractor and service company will be more efficient in executing their operations when they are given more control of the operation.

Industry perceptions

There are many different perceptions among industry personnel concerning the formation of alliances between producers and suppliers. A significant percentage of the industry feels these type of agreements are unnecessary and will not translate into optimum procurement methods.

Equally significant, there is a growing number of individuals who are willing to experiment with such agreements because of recent success stories publicized in industry periodicals and technical papers or learned about through informal conversations.

There have been numerous trade journal articles and technical publications that have guided the industry toward these perceptions. For example, BP Exploration Inc. claims that by reducing its vendor base and developing closer relationships, they have controlled operating costs in the Prudhoe Bay field in Alaska.1 In another example, Vastar Resources Inc. and Halliburton Energy Services eliminated cement plug failures by using a quality management (sole supplier) alliance.2

Technological innovations that reduced costs or improved production rates were reported in two different integrated service alliances. In one case, Pennzoil Exploration & Production Co. was able to reduce its tight-sand fracture costs through proper planning and mutual commitment with Halliburton Energy Services.3 In the other case, Pogo Production Co. used an integrated approach with Baker Hughes Inteq to drill a multilateral horizontal well that resulted in an extremely high-rate gas well.4

Unocal Corp. reported success in using performance incentive contracts with Schlumberger Well Services and others to align goals which increased the performance of its wire line and directional drilling services.5

Some other common perceptions include the following: Alliances are more efficient than decentralized buying on a project basis; performance bonus incentives are required to guarantee successful programs; and alliances are better as informal hand-shake agreements than more formal, legally binding contracts. At the very least, the term alliance has become controversial.

Negative aspects

On the negative side, many customers believe that alliances are their management's way of intervening with their freedom to select the optimum mix of value in terms of performance, quality, service, and price. Some feel that sole supplier and integrated service alliances were constructed as a marketing ploy by the major service companies to eliminate competition, thereby reducing excess capacity in the service industry, which would in turn increase prices for customers and result in increased profits for these major integrated suppliers.

Others feel that shared risk schemes are not comprehensive enough to warrant their use and that alliances increase their purchasing expenses, which are not offset by the increases in efficiency or communication. Small to mid-size suppliers, which lack a wide range of services or products, often find difficulty competing against the major service companies for these integrated service alliances. They view integrated service alliances as a threat to their existence and have responded by trying to protect their niche markets.

Unfortunately, these suppliers tend to have trouble successfully integrating with other companies, especially when they have similar products, and there is large geographic overlap. They must balance pleasing the customer with the risk of losing their competitive advantages. They feel customers will suffer in the long run because of reduced competition and lower supplier profit margins which prevent many of them from investing in research and development or quality improvement programs.

Positive aspects

On the positive side, some customers feel that their alliance programs have been responsible for reducing purchasing and operational expenses. These customers seem pleased with not having to make a variety of purchasing decisions, saving them more time for engineering and operational planning.

These improvements are especially beneficial in international operations where service contracts must be approved by foreign governments or their regulatory agencies. Other operators feel that integrated service programs are a solution to better quality and efficiency. They also believe their integrated service alliances will result in increased communication which serves as a basis for continuous quality improvement and technical innovation.

Suppliers see alliances as excellent vehicles to permit better planning and forecasting to lower their costs of purchasing raw materials and managing their resources. Major service companies see alliances as an opportunity to show the customer the benefits of integrating all of their offerings to better fulfill the customer's needs.

Small to mid-size companies see alliances as an opportunity to provide products at lower cost. These smaller companies generally prefer an exclusive or sole supplier relationship.

Desk engineers

There are many other organizational boundary issues not well understood, such as the use of implants, otherwise known as desk engineers. In these cases, service company personnel are permanently assigned work space inside the customer's offices and may actively participate in the design, planning, and execution of projects. The biggest obstacle most of these desk engineers face is a total lack of acceptance or "buy-in" from their customer's operating personnel. Some of the operator's personnel may fear being replaced by the desk engineer or may feel threatened because the alliance was arranged by upper management.

Other destructive problems can occur if the desk engineer is inexperienced or has trouble communicating with the service company's field representatives. Also, some of these desk engineers feel isolated and fear they will lose contact with their peers on the operational side of the service industry.

Desk engineers may help eliminate wasteful or unproductive tasks for both producer and supplier because they can better understand the customer's needs and plans. They tend to develop close, personal relationships with their customers, fostering more information sharing and discussion. These close relationships also allow the desk engineer to learn about future projects during the conception stage, which helps secure more work for the supplier and a larger market share of the customer's business.

Overall, the greatest benefit of the arrangement is increased communication and a greater understanding of each partner's objectives.

Purchasing decisions

Although there have been numerous studies on operators' buying behavior of oil field services, this behavior is somewhat misunderstood and appears to be very dynamic and reactive to changes in product prices. It also varies greatly between companies and individuals.

One such study is conducted on an annual basis by Wertheim Schroder & Co. of New York.6 Results from this study identified that performance and quality were the most important factors in the decision to purchase oil field products and services. Service was slightly less important, and price was the least important factor of these four criteria (Fig. 3 (27551 bytes)). They also reported that customers viewed the oil field service industry in a positive manner and that there was too much excess capacity in the service sector.

The survey also compared the major service companies, for various categories of products and services, on how they were perceived by producers in terms of the value criteria listed above. The results showed very clearly that the oil field service industry was not dominated by one single supplier, but each one was considered to provide the best value at one or more specific activities.

For example, Schlumberger held an overwhelming lead in wire line measurement, perforating, and formation evaluation. Halliburton was deemed the best in cementing and coiled tubing services, and Baker Hughes Inteq held the lead in completion packers and service tools, including sand control services.

Unfortunately, the survey results were not segmented into different geographic areas, which would have likely identified some trends that are sensitive to location.

Because of each supplier's unique capabilities or competencies, some producers have been forming sole supplier alliances to maximize the value received from purchasing a particular product or service. Other producers participate in integrated service alliances in which a single supplier provides a wide variety of products and services, even though the producers may not consider that particular supplier as one most likely to supply the best value for each individual product or service.

Rather, they hope that improvements in communication, efficiency, and shared capabilities will offset any deficiencies in quality or performance. The value comes when the individual activities are considered as a complete system.

Results

Alliances between producers and suppliers in the U.S. petroleum industry are viable strategies to reduce costs, increase efficiencies, improve quality, and share risks, resources, or technologies.

There has not been much information published on which type of alliance strategy is superior for achieving a specific goal. Therefore, an alliance survey was developed to better identify the alliance experience of both producers and suppliers.

The alliance survey found an overall average success rate of 73%, indicating that customer/supplier alliances are usually beneficial. The sole supplier alliance was more successful than the integrated service alliance. In general, the more exclusive the relationship, the more chance of failure for a producer. Without an exclusive relationship, however, a supplier's chance of failure is greatly increased. Therefore, there is an optimum mix for mutual benefit. Alliances were slightly more successful for suppliers than for producers.

Alliances are customer driven and controlled. The alliances rarely last more than 5 years as producers are not likely to commit to longer terms.

Producers form alliances primarily to reduce cost and increase efficiency to improve their profitability. Quality improvement is somewhat less important and is used more for comparison of suppliers than as an absolute measurement. About half of the producers also want to share risks and resources, but very few measure their performance.

Suppliers form alliances primarily to satisfy their customers and increase (or defend) market share. Customer satisfaction is achieved by reducing the producer's purchasing or operational costs and increasing communication. Suppliers measure their performance similarly to producers, except they also measure increased sales or profits.

Alliances in the petroleum industry are often formed for long-term pricing contracts or efficiency-improvement programs, rather than continuous quality improvement or technology-sharing agreements.

Sole supplier alliances appear to be superior for reducing purchasing costs and improving quality, especially those that focus on the true competencies of the supplier. They have the highest chance of success for both parties. Sole supplier alliances might be difficult to successfully integrate where the various suppliers have competing products or services, especially where they share large geographic areas.

Integrated service alliances appear to be superior for increasing communication and efficiencies. They probably create a better environment for sharing technologies, risks, and resources. They allow suppliers to secure the market share necessary to build competency in their peripheral products and services, which tends to help improve their profitability. Producers must judge for themselves if the benefits of integration outweigh the disadvantages of reduced flexibility and control. A performance bonus incentive did not significantly affect the success rate of the alliances studied.

Recommendations

Based on these results, the following recommendations can be made for producers considering alliance options:

• Form reduced vendor alliances when flexibility and control are important, the exchange is mostly transactional, and prices are highly competitive such as with rental tools or oil field supplies. This allows more freedom to choose between vendors that can provide high quality and high costs, or low quality and low cost products or services, depending on the scope of the project.
• Form sole supplier alliances when quality is essential, such as with logging or formation evaluation, seismic processing, or pumping services. Be willing to invest in the vendor most likely to meet the quality standards desired, which will usually result in improved profitability in the long run. Sole supplier alliances are very useful when standardization is desired.
• Form integrated service alliances primarily to acquire technologies in areas where the company lacks knowledge or experience but also to increase communication and efficiency in activities where detailed collaborations can yield significant savings, such as with horizontal drilling programs or marginal field development programs. These alliances will be successful when the benefits of collaboration outweigh the costs for the supplier to build competence in its peripheral products or services.
• Form alliances based on unilateral commitment. Hold regular progress review meetings that include each partner's management to secure long-term support. Avoid suppliers with the "home run" mentality, or those that want to have all or nothing, as they are more concerned with their objectives than the operator's. Alliances should be formed to build competency, not dependency. Open and honest communication is the key to understanding and acceptance.
• Be careful to not eliminate the smaller, innovative companies (market niche) from the service sector as they are often responsible for developing many new products and services and keep pricing competitive. Even if an alliance is in place, try to reserve a limited portion of work where the niche companies can provide either higher-quality or lower-cost services so that marginal assets can be exploited profitability.
• Finally, simplify all performance bonus incentives and risk-sharing schemes as they can develop into great sources of controversy and can interfere with the team-building process. Long-term commitment and steady work are the greatest benefits for the suppliers. Even though a large portion of this study is biased toward the customer's perspective, the following are recommendations for suppliers considering alliance options:
  • Choose partners with high growth potential, well established business relationships, and a compatible organizational culture for better team building. The goal of the alliance is simple: grow the customer. A vendor's growth is truly derived from their customer's growth.

    In the long run, the supplier is likely to profit more as a partner than a vendor.

  • Avoid overselling the alliance to the customer's upper management. It is a good idea to educate them, but if an alliance is forced on their operational personnel, it can lead to disaster for both firms, especially the supplier. Management of both parties should participate, but they should challenge their business units to develop alliance strategies on their own to maximize the effectiveness of empowerment and ownership.
  • Avoid placing too much emphasis on desk engineers to increase market share, and allow them to focus on satisfying the customer. Desk engineers are very useful for design and operational planning and act as a conduit of understanding for both parties. If they are perceived as salesmen and not technical advisors, it will interfere with their ability to develop a stable relationship based on mutual trust.
  • Do not rely on performance incentives to supplement sales revenues or profits. These bonuses and incentives are designed to motivate continuous quality improvement. They should become more difficult to obtain as the alliance relationship matures, to stimulate improvement.
  • Actively involve the partner's research scientists, technical advisors, and operations personnel into the technical research or product development programs.

These people are likely to provide the supplier with valuable feedback to help it understand the changing needs in the industry. They will also be more open to experiment with new products when they feel partially responsible for the development of new services or tools.

Further work

Although the term alliance is fairly new to the industry, there are many producers that have worked in exclusive supplier relationships for decades, during which many of these suppliers acquired additional capabilities or services and would secure new market share from their customers.

Unfortunately, very few were able to deliver the performance and quality desired to satisfy their customers, who would often discontinue using these suppliers in favor of their newly acquired services. Will the recent changes in service company organizations be enough to guarantee that integration of services will be more successful now than it was before?

There is also much concern that the major service companies are monopolizing their market share and in a sense, reducing the number of small-to-medium size vendors. What will be the long-term effects on pricing with a reduced vendor base in the service sector, and will this be detrimental to the producers in the long run? Technological innovation and quality control are central to a company's success. Technological changes have helped U.S. producers remain competitive.

The cycle time from development to market is very slow by comparison to other industries, however. Most new technological breakthroughs can take years to develop and seem to be more of a continuous improvement on existing capabilities.

Likewise, quality programs can be very expensive but have reduced total exploration and production costs. How important are technological innovation and quality control to producers in the petroleum industry, and why were they not recognized as more important reasons to form alliances?

The alliances analyzed in this survey appear to be very short-term relationships. Most of the research concerning alliances stress that long-term commitment and alignment of goals are the most important success criteria.

Producers and suppliers are forming alliances for different reasons, however. Moreover, most producers will not commit to an alliance partner for more than 2 years. Is it the lack of commitment that has resulted in such short alliance life cycles, or is it a lack of performance by the suppliers? Possibly, it is simply because there has not been enough time to establish a higher frequency of long-term relationships because alliances are relatively new to the industry.

Many alliances in the 1990s are extensions of the quality programs from the 1980s. These alliances grew out of the need to acquire competitive technologies or to solve complex problems that extend across company boundaries.

Also, corporate management has been looking toward alliances to re-engineer their companies to improve long-term profitability and avoid repeating the mostly unproductive merger and reorganization activities experienced during the past 15 years.

References

1.Darley, J.R., "Alliancing process helps BP control Prudhoe Bay costs," OGJ, Aug. 3, 1992, pp. 42-44. 2.Heathman, J., Carpenter, R., Marcel, K., Rimer, C., and Badalamenti, A., "Quality Management Alliance Eliminates Plug Failures," Society of Petroleum Engineers paper 28321, 1994. 3.Hunter, J.L., and Stuchly, S.G., "Service company alliance reduces tight sands frac costs," OGJ, Aug. 15, 1994, pp. 89-91. 4.Schroeder, T., Mathis, D.E., Howard, R., and Williams, G.N., "An Integrated Technology Approach Yields 101 MMCFPD in the Eugene Island 295 'B' Horizontal Well Project," SPE paper 28464, 1994. 5.Pierce, C.A., and Perry, C.J., "Performance Contracts Reduce Drilling Costs," paper presented at the Petroleum Exploration and Production Conference, Cairo, November 1990. 6.Oilfield Service Industry: 1995 Wertheim Schroder Oilfield Value Survey, Wertheim Schroder & Co. Inc., New York, Jan. 24, 1995.

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