Pre-read Materials for SC-61

Inside Procurement in Oil and Gas

Section 2
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THE INDUSTRY VALUE CHAIN
Value Chain Defined
The value chain, and its counterpart value chain analysis, is a concept from business
management which was first described and popularized by Michael Porter in his 1985 best-seller,
Competitive Advantage: Creating and Sustaining Superior Performance.
A value chain is a chain of activities. Products pass through all activities of the chain in order and
at each activity the product gains some value. The chain of activities gives the products more added value
than the sum of added values of all activities. The value chain categorizes the generic value-adding
activities of an organization. The "primary activities" include: inbound logistics, operations (production),
outbound logistics, marketing and sales (demand), and services (maintenance). Primary activities are
those that create value for the customer. The "support activities" include: administrative infrastructure
management, human resource management, information technology, and procurement. Support activities
support the primary activities and therefore only affect customer value indirectly, but are nonetheless
important. These support activities are involved in all facets of the value chain. The costs and value
drivers are identified for each value activity. Strategic positioning for competitive advantage involves
understanding and playing on the drivers of activity cost behavior and differentiation generated by
activities. The goal of these activities is to offer the customer a level of value that exceeds the cost of the
activities, thereby resulting in profit. Drivers, such as scale, capacity utilization and location, are key
determinants of firm performance. See Figure 2.1.
The value-chain concept has been extended beyond individual organizations. It can apply to
whole supply chains and distribution networks. The industry wide synchronized interactions of those
local value chains create an extended value chain, sometimes global in extent. Porter terms this larger
interconnected system of value chains the "value system". A value system includes the value chains of a
firm's supplier (and their suppliers all the way back), the firm itself, the firm distribution channels, and the
firm's buyers (and presumably extended to the buyers of their products, and so on).

Figure 2.1

The Value Chain

Value Chain Analysis

The value chain model is a useful analysis tool for defining a firms core competencies and the
activities in which it can pursue a competitive advantage. Once the value chain is identified, two areas for
analysis are as follows:

Cost Advantage: by better understanding costs and squeezing them out of the value-adding
activities.

Differentiation: by focusing on those activities associated with core competencies and

capabilities in order to perform them better than the competition.

A cost analysis can be performed by assigning costs to the value chain activities. Some business
judgment may need to be applied to the cost pool in order to allocate them properly to the value creating
activities. A firm may create cost advantage either by reducing the cost of individual value chain activities
or by reconfiguring the value chain. In the oil and gas industry, care must be taken in cost reduction. As
was noted in our discussion of TCO, reducing costs in one area can increase costs in another. Simply
focusing on reducing acquisition costs, or CAPEX, in a major EPC project for instance, can result in an
increase in operating cost, or OPEX, which may in fact more than offset any savings. The point of cost
analysis in the value chain is to reduce total costs, not merely to shift cost to other activities in the value
chain.

Porter identified 10 cost drivers related to value chain activities:

Economies of scale

Learning

Capacity utilization

Linkages among activities

Interrelationships among business units

Degree of vertical integration

Timing of market entry

Firms policy of cost or differentiation

Geographic location

Institutional factors (regulation, union activity, taxes, etc.)

One more critical point relating to cost in the value chain is worth discussion. In manufacturing,
the rule of thumb is that 85% of the cost of a product is incurred at the point of design. The procurement
function has minimal impact to product cost after this point in the development cycle. Consider an EPC
project for a platform. Typically, by the time procurement is brought into the project the specifications,
equipment and design have already been determined, the suppliers scoped, etc. Procurement is just asked
to source. The time for examination of opportunities for standardization and substitution, for example, has
passed. This is why it is extremely important from a value chain and TCO perspective that procurement
champion early involvement of the appropriate suppliers and procurement personnel in the development
phase of the project. One of the cost drivers noted above is learning. The more technically savvy
procurement personnel are in their respective areas, the more value they can add to the process. The
category manager for compressors, for example, should know as much about this equipment as any
engineer.
A differentiation advantage can arise from any part of the value chain. For example, procurement
of inputs that are unique and not widely available to competitors can create differentiation, as can a
distribution system which offers high service levels. Differentiation stems from uniqueness. A
differentiation advantage may be achieved either by changing individual value chain activities to increase
uniqueness in the final product or by reconfiguring the value chain. From a downstream oil and gas
perspective, consider the final refined product, a commodity like gasoline. How does one company
differentiate its product from the competition?
Porter identified several drivers of differentiation:

Policies and decisions

Linkages among activities

Timing of activities

Location

Interrelationships

Learning

Integration

Scale (for example, better service due to larger size)

Institutional factors

Note that many of these are also cost drivers. The reason for this is that product or service
differentiation can add cost. The tradeoff between cost and differentiation must be understood.
There are several ways in which the value chain can be reconfigured to achieve differentiation. It
can increase or decrease its level of integration (a phenomenon we are seeing in the industry currently as
ownership of retail outlets is being divested). It may implement new technologies or utilize new
distribution channels. Because technology is employed to some degree across all activities in the value
chain, changes in technology can impact competitive advantage by impacting the activities themselves or
making possible reconfiguration of the value chain. Ultimately, the firm may need to be creative in order
to develop a novel value chain configuration that increases differentiation.
When discussing cost, it was mentioned that merely shifting cost from on value chain activity to
another does not add value. Value chain activities are not isolated from each other. Rather, one value
chain activity often affects the cost or performance of other areas. Linkages may exist between primary
activities or primary and support activities. Bear in mind that when looking at costs in the value chain,
false economies exist where costs reduced in one activity can increase costs in another and result in
savings less than anticipated or actual cost increases. On the flip side, cost reductions in one activity in
the value chain can favorable impact other activities with no further effort. An example could be choosing
a more efficient compressor design which can simultaneously reduce energy costs and improve reliability
so maintenance costs also decrease.
Another consideration in value chain analysis is the interrelationships among business units.
Identifying interrelationships can offer direct opportunities to leverage synergy between groups. For
example, are different business units using similar MRO supplies? If so, can procurement of these
supplies be centralized to leverage volume price reductions? Remember, the goal is not to shift cost to
other value chain activities. When looking to potentially leverage synergies, there will be an associated
cost of coordination, loss of localized flexibility, and other organizational practicalities to consider.
One final benefit of value chain analysis is that it gives the organization an opportunity to
benchmark its activity costs. Upon examination it may be determined that certain activities are not the
organizations distinctive competence and other suppliers can do it better and cheaper. Thus, this activity
may be a candidate for outsourcing. The extent to which an organization performs its upstream and
downstream actives is known as its degree of vertical integration. To decide which activities to
outsource, management must understand the organizations strength and weakness in each activity in
question in terms of cost and ability to differentiate. Key considerations:

Whether an outside specialist can do it better and cheaper.

Whether the activity is a core competency which leads to cost reductions or differentiation.

The risk of performing the activity in-house. Fast paced technology and markets may point to
an outsourcing decision in order to maintain flexibility and avoid a risky investment in
specialized assets.

Whether the outsourcing of an activity can result in business process improvements such as
leadtime reduction, quality improvements, reduced inventory, etc.

The trend in the industry has been toward de-integration. Oil and gas companies have been
divesting themselves of less profitable (for them) value chain activities such as procurement and
warehousing of MRO, ownership of retail outlets for gasoline, and even refining activities to specialists
like Valero.

Petroleum Industry Value Chain

In order to apply Value Chain concepts to the analysis of the petroleum industry we need to
define the key activities and firms. Figure 2.2 shows the value system for the industry that serves endusers of petroleum products. The value system model only considers the firms directly involved in the
discovery, development, production and distribution of petroleum products. This is what is called the
primary petroleum value system.

PetroleumIndustryValueSystem
Exploration

OilRefining

Figure 2.2

Production

Transport/
Pipelines

Transport&
OilTerminals

Power
Generation

Retail

GasProcessing
Ops

Use

The Petroleum Industry Value System

Question: What components of the value system represent upstream, midstream and downstream?
In some ways, the petroleum supply chain is like supply chains in other industries in that it has
the same source, make, deliver paradigm. However, it is significantly more complex than any discrete
supply chain. The petroleum business involves many interdependent operations, beginning with the
search for oil and gas and extending to the delivery of finished products, with incredibly complex
manufacturing processes in the middle.
Each of these operations has developed into separate business units, each with its unique
objectives and demands. Often, the business units operate independently, unaware of the constraints and
opportunities of the other business units, often at odds with the overall corporate objectives. Although
certain business units may be operating at maximum margin, overall corporate profitability may be
suffering. This is the most significant opportunity for value chain analysis in the industry finding ways
to break down the walls between operating units and maximizing margins.

Until now, success has been measured by whether individual silos made a profit. Since the leastcost player dominates the commodity market, the way to more profit has been minimizing costs, which
has become the silos primary focus. Almost every conceivable measure to lower costs has been
implemented. Reductions have been made relentlessly in fixed costs, corporate overhead and working
capital. While corporate reporting mechanisms have been streamlined and corporate tracking systems
enhanced, silos have continued to operate haphazardly. ERP (Enterprise Resource Planning) systems have
been widely implemented within the last decade with the aim of reducing costs still further, but most have
yet to deliver the returns promised.
By their very nature, commodityy markets drain corporate profitability and resources. They are
extremely volatile, with prices moving dramatically and on short notice. Calculation of transfer prices
alone creates friction between silos. Commodity markets are low margin and margins are constrained by
the difference between wellhead cost and pump price. In an over-supplied market, competition is entirely
cost-based, with the least-cost supplier winning and determining the prices for the market overall. There
are no customers in the normal sense; there is only The Market.
Historically oil and gas that were vertically integrated over the whole petroleum value system
dominated the petroleum industry. With the creation of spot markets and the deregulation of the different
intermediate activities, most importantly the market for crude oil, the integrated petroleum industry has
been de-coupled along the different stages in the value system. De-coupling together with competitive
pressures has led even the majors to outsource activities. For example, majors used to transport oil using
their own tankers. This activity is now outsourced. However, a percentage of the crude is still transported
on tankers owned by the majors. This tapered vertical integration maintains a credible bargaining position
in addition to provide knowledge and information on the activity.