Oil-Sands Lessons

Since the start-up of Suncor’s first processing facility in 1967, oil sands have provided an increasingly important oil source—for Alberta, for Canada and the world. Production increased significantly over the ensuing 40 years, reaching approximately 1.3 million barrels per day in 2008. At the height of the oil-price boom in 2008, projections showed as much as 5 million barrels per day of incremental capacity coming online by 2021.

Motivated by oil prices in excess of $100 per barrel, oil-sands projects were completed under a “schedule at any cost” mindset—accelerating time to production with little concern for the impact on capital costs. As a result, breakeven economics rose to as much as $55 to $65 per barrel for steam-assisted gravity drainage (SAGD) technology and $70 to $85 per barrel for mining/upgrading.

Then, the bottom fell out. Oil prices plummeted, and capital spending was severely curtailed. Projects were stopped, delayed or cancelled altogether. The future of oil sands was brought into question: in a low-to-moderate oil-price environment, could oil sands remain a major and economically viable long-term portfolio option?

There is indeed a strong need for oil-sands production to be economically viable. Despite increasing policy focus on and investment in renewable sources, estimates suggest an additional oil-production capacity of nearly six times the current capacity of Saudi Arabia will be required by 2030 to meet global energy requirements. As publicly traded integrated oil companies face increasingly restricted access to conventional oil reserves, the role of Canada’s oil sands in a secure energy future for North America can only increase.

Oil-sands projects may never have breakeven economics approaching those of conventional oil, but significantly reducing breakeven costs is imperative and achievable. By improving the practices by which large oil-sands capital projects are designed and executed, project managers can reduce total life-cycle costs for new oil sands by as much as $10 per barrel.

Favorable oil prices over the past four to five years have triggered an investment wave and led to significant growth in oil-sands production capacity.

A role in recovery

Oil currently accounts for more of North American energy demand than any other energy type, closely followed by other conventional, carbon-based fuels such as coal and natural gas. Emerging energy policy in the U.S. is focusing on increasing the supply of renewable fuels and decreasing dependence on foreign energy sources.

Unless dramatic shifts occur in the transportation sector, however, fuels from renewable sources will most likely not result in a significant decline in petroleum-products demand over the next 20 years. Furthermore, the U.S. will continue to depend on foreign oil, as net imports will continue to account for more than 20% of the total U.S. primary energy demand by 2020, according to U.S. Department of Energy and Energy Information Administration estimates.

On the supply side, the top global conventional fields are facing a natural decline of more than 5% annually. This natural decline and the gradual recovery of the global economy will require new capacity additions of close to 23 million barrels of oil equivalent per day by 2015, and 64 million barrels equivalent per day by 2030, which equates to an addition of nearly six times the current production capacity of Saudi Arabia. It is estimated that sustained annual investment levels of nearly $275 billion will be needed to meet the new capacity-addition requirements.

Access to oil reserves further complicates the picture. National oil companies (NOCs) control 85% of the conventional oil reserves, whereas reserves more accessible to global investor-owned companies (IOCs) are relatively expensive to develop and produce.

Canada’s oil sands are an important source of supply, with established oil reserves at close to 100 years (at projected production levels). So, while future investment in oil sands faces economic and environmental hurdles, in all likelihood there will continue to be sufficient oil demand in the U.S. and globally to justify investment, provided economic and environmental criteria are met.

Capital-project excellence

Favorable oil prices over the past four to five years have triggered an investment wave and led to significant growth in oil-sands production capacity. However, current production capacity remains relatively low compared to the reserve levels. The annual production-to-reserve ratio (R/P) for Canadian oil sands is close to one-fifth that of Saudi Arabia and one-seventeenth that of Brazil, whose unconventional offshore reserves make up a significant portion of that country’s production portfolio. However, the total potential oil-sands capacity additions over the next decade dwarf current production capacity.

The economic viability of oil-sands projects presents the most important challenge for bringing additional capacity online. While the economics are highly sensitive to oil prices, royalty regimes, input factors and operating costs, as in any capital-intensive industry, the ability to execute large projects efficiently remains the most critical factor in determining the overall economic viability of future investment.

While dramatic increases in key input-factor costs such as energy, steel and labor certainly have played a significant role, the impact of capital-project and construction management has been even more dramatic. For example, the average delay for the top 100 upstream projects globally during 2005-2008 was 10 to 12 months, while 20% of the projects were delayed more than a year, according to Goldman Sachs. Capital costs per unit of production capacity have skyrocketed over the past decade.

Technological advancements and recent relief in input-factor costs should continue to reduce both capital and operating costs, but not enough. Consistent, leading practices in project execution must also be part of the equation. Delivering on time and on budget has a dramatic impact on the breakeven oil price for oil-sands investment.

Driving good performance

Our recent cross-industry study of capital-project excellence and leading practices offers insights into the root causes of poor capital-project execution and how leading companies are addressing these issues. We surveyed executives and project managers from more than 60 companies across a variety of capital-intensive industries. Participants shared practices along 11 key dimensions of performance.

Our study’s findings suggest that key drivers of capital-program performance fall broadly into four categories: program-governance and strategic-allocation process, scope definition, cost estimation, and project execution.

Program governance and strategic allocation are crucial to ensure alignment with strategies and maximize the return on capital as a scarce resource. Lack of a program-governance structure and disciplined capital-allocation process limits visibility into trade-offs (e.g., time-to-first oil vs. cost) and the ability to make dynamic choices in the face of changing market conditions. It also limits scale synergies such as cross-portfolio cost-containment strategies.

Scope-definition and project-strategy activities play a big role in ultimately determining the success of project execution. They are critical to a successful start-up upon project completion. As extraction and processing technologies and environmental considerations become more complex, up-front planning and strategic issues will grow in importance.

Estimating cost and schedules has historically been one of the most challenging tasks for large capital projects. Historical construction-cost data and reporting is often unreliable and increasingly irrelevant, given rapid changes in both technology and factor costs.

Problems in project execution can be mitigated to a large extent through proper planning, yet scope changes and unforeseen events are inevitable. In addition, ongoing shortages of experienced and skilled trade labor can present a significant risk.

The total potential oil-sands capacity additions over the next decade dwarfs current production capacity.
Capital costs per unit of production capacity have skyrocketed over the past decade.

Outperforming competitors

Our research indicates that leaders in capital-program management (across all capital-intensive industries) are able to outperform their competitors on a sustainable basis by systematically using seven key practices:

Adopting a portfolio view to capital-program management. This means planning capital strategy over a 15-year horizon with a rolling (continually updated) process. It allows project managers to better respond to changing market conditions, better align capital-project management processes with the organization’s strategy based on financial and nonfinancial criteria, and facilitate cost-containment strategies such as developing longer-term relationships with strategic suppliers and embedding complexity management in design practices.

Creating integrated teams instead of operating in functional silos. Migrating from traditional functional silos to the use of cross-functional teams can optimize installation, operation and maintenance. Effective coordination among design engineering, procurement, construction planning/execution and operations is key.

Attracting, developing, and retaining required skills and capabilities. Managers need to plan for resource continuity to manage scarce personnel on longer-term projects and programs. A particular challenge across all capital-intensive industries in North America has been developing suitable career “ladders” for the most capable and ambitious technical staff. Lessons can be learned from other countries (e.g., Germany, Japan) that place an extremely high value on “execution excellence” as the foundation of “business excellence.”

Optimizing around cost rather than schedule. Project managers must understand the trade-offs between cost and schedule and be flexible when possible to take advantage of market conditions. The recent peak in oil prices drove many companies to execute projects “at any cost” based on schedule considerations alone—only to be faced with a multitude of nonproductive and/or uneconomic capital projects when commodity prices fell at the onset of the current recession.

Managing complexity. Project managers should use standard/modular specifications and rigorous interoperability checks. Leading companies are resisting the urge to over-engineer what works well, and are aggressively leveraging functional, effective designs time after time. In addition, they can reduce construction complexity by adopting modular design concepts that limit the activity and workforce required at the construction site.

Realizing leverage through thoughtful procurement practices. Using risk-based contracting strategies and unbundling of spend creates leverage with narrow supply bases, manages cost and guards against escalation. Strategic, long-term relationships with key suppliers enable design troubleshooting and continuous improvement. Legacy “bid and buy” strategies, regardless of the spend level (i.e., regardless of whether for a single critical part or for technology-provider selection) have a high correlation with over-budget, late projects.

Predictive modeling to estimate contingencies. Using history, Monte Carlo, and Disaster LimitsTM simulations to estimate project budgets and establish contingencies is valuable. Poorer performing companies tend to use a single/consistent contingency value when preparing appropriation estimates. Leaders understand that uncertainties vary project-by-project and apply contingency factors accordingly. This is particularly important for oil sands, given that initial capital costs represent a high percentage of the total life-cycle costs.

Not surprisingly, many of the most effective practices and strategies for managing capital-project performance have a significant impact on the effectiveness of up-front planning (scoping) and strategy development.

Implications for oil sands

Like other asset-intensive industries, oil-sands developers and operators require well-executed large capital investments and operational excellence to realize their strategic objectives. Most of the lessons of capital-project excellence can be adopted in oil-sands development.

Constructing the next wave of oil-sands capacity will be a tall order. New technology, increasing project complexity, and the shortage of skilled resources all present challenges and increase the risks of completing these large capital projects on budget and on time. In this environment, the case for improved project execution is compelling: companies that excel in project construction can enjoy total breakeven crude cost advantages as high as 10% to 15% (an advantage of close to $10 per barrel in the current environment) relative to competitors.

As the industry prepares for the next wave of investment, it must recognize both the importance and risks of delivering these complex projects. Budget and schedule performance is critical to the business case for new SAGD and mining capacity. Fortunately, there are lessons to be learned from successes in equally large and complex projects across industries. If companies are able to successfully adopt these differentiating practices, the economic future of new oil-sands development has great prospects for helping North America satisfy its energy needs and reduce its dependency on imports from less stable regions.

Vance Scott is a partner with A.T. Kearney (atkearney.com) and head of the firm’s energy and process industries practice for the Americas. He is based in Chicago. Neal Walters is a partner and leader of the energy and process industries practice for Canada and is based in Toronto. Hakan Civi is a principal, based in San Francisco, with the firm.