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David Yager

David Yager

Based in Calgary, David Yager is a former oilfield services executive and the principal of Yager Management Ltd., an oilfield services management consultancy. He has…

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The Broken Payment Model That Costs The Oil Industry Millions

The Broken Payment Model That Costs The Oil Industry Millions

The process has been around for so long that nobody questions its legitimacy. An exploration and production (E&P) company hires an oilfield service (OFS) contractor to perform services in the field ranging from a few thousand to several million dollars. Job done, a field ticket is prepared by the OFS representative and signed by the E&P counterpart. Next, the invoice. Once it has been exhaustively reviewed to ensure every “i” is dotted and “t” is crossed (it has to be perfect to ensure final payment), the invoice is sent to the client’s head office.

Finally, weeks or even months later, the bill is paid and cash for service received. There is nothing unusual about this process taking 90 days or longer. In fact, three-month payment has become an accepted norm.

In reality, the entire process is unusual. Try this in the real world to buy a car or house. “I’ll sign an IOU, you give me the keys, and I promise I’ll pay you in two or three months. Maybe longer if I’m busy. Great doing business with you.”

Think about it. In most purchase/sale transactions—consumer and business— you pay before you take delivery. Not doing so is called theft and the vendor calls the cops. Commercial services like tradesmen will deliver now and accept payment later, but they start getting mighty humorless after 30 days. Is there another business anywhere dealing in billions of dollars where the supplier delivers today and may not get paid in the same season? Related: How To Save $100 Million In A Commodities Downturn

This process is not popular. Suppliers grumble continuously. Although how it started is uncertain, in the early 1980s Dome Petroleum Ltd. was tight for cash and announced to its vendors it would like to not pay trade creditors for 90 days. This was more of a fishing expedition than a policy statement.

But it is clearly accepted. When most of Dome’s suppliers chose to accept extended payment terms, the practice became widespread. Now it is well known that certain oil companies won’t pay before 90 days and possibly 120. Not every vendor accepts these conditions, but no oil company has ever gone out of business because products and services were denied due to intentional slow payment.

The problem for suppliers is most of their costs are up front. Labor, a major component, is due every 14 days. Fuel is purchased daily. Vehicle leases and rents are due monthly. Worker subsistence is usually settled within 30 days. Expendables often come from pre-paid inventory. These cash expenses account for most direct costs for field services, 65 percent when business is good (35 percent gross margin on a field ticket) and 80 to 90 percent of direct costs when business is highly competitive, like now (10 to 20 percent gross job margin – hopefully!).

The supply business is the same except the vendor has already paid for the inventory. More cash up front. To be competitive, the goods have to be on the shelf or in the yard.

Slow payment for goods and services in not a flow-through expense. It is a financial subsidy to clients. Period.

Since OFS clearly accepts this bizarre commercial relationship as a cost of doing business, nobody talks about the cost on a macro level. It’s huge. In 2014, the combined capital expenditures for conventional oil and gas and oil sands in Canada were estimated at $69 billion. Related: Where In The World Is The Shale Gas Revolution?

Let’s assume everybody paid suppliers in 90 days, meaning all vendors had three months sales outstanding in accounts receivable. That’s 25 percent of the total, or $17.25 billion. Then let’s assume each vendor used a bank operating a line of credit to pre-pay up front expenses and run the business while awaiting payment. The prime lending rate in 2014 was about 3 percent. A typical operating line is priced at prime plus 2 percent. So the cost for vendors to finance accounts receivable would be 5 percent per annum. Most banks lend to 75 percent of accounts receivable. Based on the foregoing, the total interest cost born by OFS would be nearly $650 million per year. Big money.

This is admittedly overly simplistic. Many responsible oil companies pay much sooner than 90 days to vendors who submit correct invoices quickly. Financially strong service operators don’t all draw down their operating lines to the max. Others qualify for lower interest rates.

On the other hand, many vendors have receivables outstanding for more than 90 days, particularly private operations in smaller centers without large account teams dedicated to collections. Others don’t qualify for the best interest rates and therefore pay more. Some cash-poor OFS operators end up factoring receivables to secure working capital which is more expensive yet.

But the total cost is greater than bank interest charges. OFS must pay for administration, accounting, invoicing, software systems and collections personnel in a supply chain process that has gone from a handshake and quick payment to increasingly incomprehensible Master Service Agreements. Further payment delays occur when complex billing procedures and documentation are not followed exactly. Whatever OFS must spend to finally collect their cash in this cumbersome process is of little interest to customers. Getting paid quickly is not just the cost of capital; it’s a cost of doing business.

How does the service sector bear this added expense? Simple. Charge the client. Build it into the cost of doing business. This is essential to achieve internal financial objectives and service the capital required to start, expand and operate the business.

If OFS can accurately label this a subsidy to its clients, E&P companies should regard it a source of capital. And they do. But it shows up in the wrong place.

For example, on a major capital project like drilling a well or building a processing plant the operator could go to its vendors and ask what discount would be available if it paid cash. Vendors would most certainly sharpen their pencils. (Some E&Ps do this now by offering to exchange quick payment for a 1 or 2 percent invoice reduction). When the project is done, the asset will produce the same revenue but the oil company’s return on invested capital (ROIC) would be higher because it cost less. Related: Top 6 Most Powerful Women In Oil And Gas

With the way most operators do business now, it appears they don’t understand or acknowledge onerous payment terms are built into input prices and complete the capital project at a higher cost than it would be otherwise. This reduces ROIC, making the company look less effective and efficient. Cash on the balance sheet is higher with delayed payments, but so is accounts payable. Many in E&P treasury obviously figure this is a better way to do business. But investors who are increasingly picking winners through capital deployment efficiency (ROIC) might disagree if they really understood the process and potential opportunity.

Today’s market is brutal. Not only do customers want the lowest possible price but will not pay sooner. If paying in 90 days is good then paying in 180 must be great. One can only assume that never paying ever would be perfect. While this is a cynical and sarcastic overstatement of the argument, it has happened before. Because they know they aren’t expected to pay for three months, too many operators drill wells on credit and intend to pay from future production. Except when the well is dry or non-commercial. Oops. Fraud losses and non-payment are also built into OFS prices.

OFS has become a supplier of exploration and development capital, not just goods and services. And the sector can no longer afford it.

At some point in the near future, E&Ps must quit grinding their vendors and start worrying about who is going to survive to supply goods and services in the future. A great way to start a more productive and symbiotic relationship would be to acknowledge the delayed payment model— which was allowed to flourish because of an extended period of high hydrocarbon prices and exceptional prosperity— is damaging to both sides.

Ask what your suppliers would charge if you paid cash. You’ll be pleasantly surprised. Of course, it isn’t practical for E&P field reps to walk around with chequebooks, suitcases of cash or credit cards with unlimited spending limits. But acknowledging the current system is flawed and taking positive steps to rectify it would certainly help.

By David Yager for Oilprice.com

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Leave a comment
  • Juan on August 13 2015 said:
    If E&P is facing a new credit crunch, I don't see why getting onerous but competitive OFS lending would be bad. In fact, I see it as an opportunity for OFS that are sitting on cash.

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