What can business do to protect themselves from the volatility of oil prices?

Falling oil prices are already affecting the global economy at a national level, and not only businesses within the oil and gas sector, but also the wider sectors that support them, including energy, mining and industrial and technology firms.

In the UK, falling oil prices are already significantly affecting the economy. At the time of writing, seven out of the top 10 biggest share price falls in the FTSE 100 were oil and gas related, together losing $42bn (€34bn) (12%) in market value in the past 30 days. With little prospect of the Organisation of the Petroleum Exporting Countries stepping in to prop up prices, companies in the sector need to react quickly and start using their supply chains to the full to survive.

One of the world’s leading engineering business groups, Weir Group, has been worst affected, having seen its share price fall 40% in the past three months because of oil price degradation.  However, what, if anything, can businesses do to protect themselves from this commodity price volatility?

Rethinking investment plans

News that the price of oil could fall to $40 per barrel in 2015 is forcing many of the major oil companies, and the oil and service businesses that supply them, to rethink their investment plans, and in some cases, increase their cost-cutting programmes. A recent analysis¹ of the lifting costs incurred when extracting and processing a single barrel of oil in different parts of the world has revealed that, in 2014, oil companies in Saudi Arabia spent less than $25 compared with almost $45 in Russia and $75 per barrel from US shale. These major differences make the understanding and reduction of operational and other costs critical to all parts of the supply chain as the industry enters what has been described a ‘survival of the fittest’ cycle.

In this new era of oil price volatility, the main challenges for the major oil companies is to right-size their operations and drive efficiency and agility into their operations, as well as carefully selecting where to invest their severely depleted investment budgets. BP has already announced its expectation of reducing its capital spend by  more than $2bn in 2015, with restructuring costs of $1bn expected to right-size its operations.

In the past, businesses in the sector may have been guilty of being complacent and allowing capital costs to spiral, safe in the knowledge that the price of the end product would justify the investment.  There is also a tendency to ‘salami slice’ the operation, with service providers focused on one element of the process, rather than working collaboratively. It is essential for the entire supply chain to work as a single system, with all parties working together to innovate and optimise production.

To allow businesses to succeed in a lower margin environment, it is vital that the major oil companies and those servicing them have an accurate understanding of the costs linked to every aspect of business operations. This is key in order to identify areas for improvement and take steps to reduce costs where possible. This knowledge is also vitally important when deciding how to spend the company’s slashed investment budget.

Winding-down strategies

Staying agile to market conditions is also essential. Businesses need to make sure they are in a position to wind up or down different assets quickly, depending on their total cost of ownership and the contribution they would be expected to make to the company’s operating profits. For example, an asset may have produced profitable yields in the past, but changes in subsidies, operating costs and the slip in oil price could have reduced its viability. In such circumstances, it may be sensible to wind down the operation, but this must be done in the knowledge that it can take three years to decommission this type of infrastructure. New collaborative supply chain solutions could also allow the outsourcing of operations to specialist providers, based on the need for increased flexibility and reduced operating costs.

For service companies, such as Weir Group, another sensible move would be to diversify their markets to protect the business from single sector market forces and increase their chances of survival. Most engineering businesses operate in a wide variety of industry sectors already, however, companies, such as Weir Group, may not have needed to consider spreading risk in this way before. Those days are gone.

Closer collaboration with suppliers is needed to help companies to drive innovation, but can also act as a key source of competitive advantage in preparation for if, and when, the global economy shifts and those that have survived can begin to grow again.

¹ Source: Energy Aspects.

Phil Bulman is managing consultant at Vendigital, a firm of procurement and supply chain specialists. Phil specialises in advising companies in the oil and gas and industry products sectors.