THE ROLE OF WHOLE-LIFE COSTING IN THE ACQUISITION OF ASSETS - A CASE STUDY

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ARTICLES SCIENTIFIQUES Volume 02, N° 02, Juillet 2008

Messaoud ZAID (1)

(1) Algerian Petroleum Institute, IAP Spa, Avenue du 1^er Novembre Boumerdès 35000, Algérie (1) E-mail: zmessaoud78@gmail.com

Abstract: Whole life costing is well developed on theory while it still does not affect the decision on assets acquisition an d management. The reason for that is r elated to fact or s such as the la ck of under standing, motivation for its application and un cert ain ties on whole life costing (WLC) analysis.

In this con text the present work aims to identify the main components of an efficient WLC framework for it s implementation , and to carry out a detailed WLC analysis to identify the best option amongst alternatives.

A seven steps iterative process is identified to allow the feed back to the design phase.

Some important factors are identified and some particular emphasise has been made on the conflicts and barriers that can deviate the implementation from its stated objectives and goals. The uncertainty and risk framework has been revised to develop a tool to build a confidence level on the decision .

A road map ha s been developed to reach the excellence level towards the best practices of WLC implemen tation .

Finally; the present work has shown the significance of adopting WLC as a decision -making tool for a big company like SONTARACH.

Besides, it has given good implementation guidance.

Keywords: Whole life cycle; long term investments, cost benefit , confidence level, CAPEX an d OPEX

THE ROLE OF WHOLE-LIFE COSTING IN THE ACQUISITION OF

ASSETS - A CASE STUDY

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1. Introduction:

Capital costs are widely used as the main (if not the only) criteria for equipment or an investment options selection sometimes based on a simple payback period.

Whole Life Costing (WLC) is a vital technique that uses well stated principles of economic analyses to evaluate long-term performance of different competing projects or investment options.

The oil industry has assessed the financial viability of projects for many years on the basis of minimum capital cost (CAPAX), whereas operating costs (OPEX) have played little part in the decision making process. This has ignored a potentially large cost and has resulted in higher than expected operating costs [1].

This omission is now recognised by the industry, but it is not worldwide applied this due to the focus on production regularity to the most owners. A typical range of the ownership costs is 60 percent to 80 percent of the total WLC [2]. The oil Group SO- NATRACH and AGIP (GSA) practices on asset acquisition are limited only to initial capital costs rather than to the total cost of owner ship. Consequently; a greater understanding of these life costs is needed to plan more effectively the asset management. It has been emphasised that the greater importance is the need to make investment decisions based upon reliable cost models, wh ich include whole life costs [3].

A case study has been identified to carry out a detailed WLC to identify the best option and demonstrate its benefits

2. Introduction to whole life costing

There are many definition of whole life cycle costing; all agreed it is the total cost of asset acquisition and management throughout the life of the equipment or project. One useful definition is: “a tool to assist in assessing the cost performance of construction work, aimed at facilitating choices where there are alternative means of achieving the client’s objectives and where those alternatives difer, not only in their initial costs but also in their subsequent operational costs” [4]

The use of LCC, in any environment, exists on two levels. One level as a management tool; which indicate the lower level of life cycle costing; to help the decision- making process. The upper level of LCC is called the

‘Management System’ whose continuous operation dictates that responsibility for asset management should be retained (4).

WLC helps change business issues’ perspectives with emphasis on enhancing cost competitiveness. This can be reached by functioning for the least long term cost of ownership which is not an easy exercise.

2.1 Barriers for implementation of WLC

The barriers for implementation of WLC can be divided into managerial and technical:

a. Technical

These barriers are varied from lack of data to application of WLC approach and the feed back from the results realised.

Besides that; the absence of the data bases to collect and analyse the significant collected information and knowledge that gained over the life of the project or a facility [5]. In addition; Level of detail in the WLC calculations and extend of the model can render the WLC process as overcomplicated and laborious. This can defeat the ultimate purpose of it being the strategy incorporated into the frequent decision-making process throughout the life of the facility [6]

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b. Managerial

The manager’s barriers start from failure of designers to show and implement the WLC objectives and goals at the design phase. Furthermore; the short term responsibility of the owners and managers for an asset to consider effectively the long term impact of the decision on the asset management. There is a lack of motivation in cost optimisation because the design and cost estimating fees are usually a percentage of the total project cost [4]. As a general desire to minimise the initial costs to achieve a high rate of return on investments and/or meet budgetary restrictions.

2.2 The needed data for WLC

The WLC data falls into two categories. The first is the economical data which are the discount rate and the analysis period. And the second is expenditure stream or cost-related data which include the time when the activities occur and the related cots [7].

a. Economical data The discount rate

The discount rate is defined as “the rate of interest reflecting the investor’s time value of money” [8]. There is no clear criterion on how to choose the discount rate.

Life

For some systems the life may be indefinite such as building if there is a good strategy of its maintenance. The physical deterioration can affect the life of the asset [9].

Analysis period

The analysis period is defined as the time period over which the initial and future costs are evaluated for different design alternatives [8]. It should not be longer than the period for making reasonable forecasts. So; the time range should be the shorter of physical, functional and economic life [4].

b. Costs and time data

By definition the costs through the life of an equipment or project can be divided into two categories; CAPEX costs and follow on costs (OPEX) which may include operating, energy, maintenance and repair costs, salvage value or decommissioning costs, in addition to cash flows.

2.3 Risk assessment and uncertainty

In the WLC exercise there is dealing with future costs and parameters such as the period analysis, maintenance costs, repair, downtime, discount rate and inflation. These elements are uncertain and the uncertainty is the devil of WLC. The situation becomes more difficult since the required information and data cannot be easily obtained. So, dealing with uncertainty is crucial for successful application of WLC. In this part; two different risk assessment techniques has been looked for. The first is the sensitivity analysis and the second is the probabilistic-based modal.

Sensitivity analysis

Sensitivity analysis examines the impact of changes in input of single independent parameters on the results.

Application of sensitivity analysis can reveal where analysis results may be subjected to uncertainty. Through this process, analysts can: [6]

• Identify some subset of model variables that exert significant influence on model results and (or)

• Determine break-even points that alter the ranking of considered options.

The advantage of sensitivity analysis is that it explicitly shows the robustness of the ranking of alternatives [4].

Where this method suffers from disadvantages, such as the sensitivity analysis may be applicable only to a simple system with few parameters [2].

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The probability-based approach

The purpose of the probability-base approach is to address the shortcomings of sensitivity analysis through probabilistic comparison of considered options, as the portability is assumed to be random. In this work the Monte Carlo Simulation (MCS) is used as it is recommended by many researchers.

• Monte Carlo Simulation (MSC)

The MCS technique evaluates probabilistic properties of the performance indices against the possible statistical distributions of the parameters. It is used when there is no one solution can be obtained. Sample input values are randomly drawn from the defined frequency distributions and the selected values are used to compute NPV or EAC.

Even NPV or EAC can be defined as a random target.

Generally; the type and range of each input sampling distribution are user-defined. Although many types of frequency distributions exist, normal, log normal and triangular which are the most commonly used [8]. While some researchers recommended that in the last stage of evaluation, different alternatives are ranked in order of ascendant scale and the best alternative is selected such that it has the highest probability of being first [4].

One of the weaknesses of this approach is that the interdependencies of the economic variable are not honoured

In addition; this approach is criticised by its expense as it need experts and time.

2.4 Whole life risk management framework

An integrated process of risk identification, quantification, response and management strategies is suggested (Figure 1) It is believed that these interlinked processes are essential ingredients for any successful risk framework in the whole life costing of assets.

From the figure 1 whole life risk process for each project may be divided onto four iterative steps as shown. From this framework there is no emphasise on one step but a particular attention should be paid to the identification step. It can be easily noticed that management and engineers can move smoothly forward and backward from one component to another to identify and understand the course actions for each step.

Figure 1: A framework for integration WLC risk management [11]

3. Whole Life Costing Implementation and its Integration with Asset Management

3.1 WLC process

In the literatures many procedures of WLC analysis and implementation have been proposed [2], [4]. It is obvious that the procedures are not completely the same due to differences among the systems to be analysed. However, it has been found some common processes, which seem to be essential, in all of the proposed procedures. It may be summarised as seven basic processes as follows [4]:

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Figure 2: The steps of the WLC process [4]

3.2 Vicious circle of WLC

One of the major issues that face managers is how to implement WLC. WLC is a new concept for some of them;

which has great benefits if it is properly handled. The problem of WLC implementation can be modelled as a vicious circle (figure 3) [5].

From the picture 3 it can be seen that the interesting points to start with are either the evaluation of the current situations, or by collecting data.

Figure 3: Vicious circle of whole life cycle costing [5]

3.3 Important factors to consider in the implementation A. Policy

As a first step toward best practices on whole life costing, the policy is the most critical element for its success.

Managers’ commitment can be seen through this policy.

The policy and the strategy should not focus on short- term but concentrate on long term perspectives. For an effective WLC implementation a policy should be stated and communicated. In addition; to make it easy for the company staff to understand this policy; a guide clarifies the principles; WLC applications and its related terms, should be developed.

B.Roles and responsibilities

The company should pay an attention to this particular element. Responsibilities should be assigned to a person or a cell of group of persons responsible for carrying out the WLC implementation, evaluation and follow up. A continuous monitoring of the projects’ and the equipments’ operating costs that already had a first evaluation to make any adequate change for the future acquisition of similar projects; which means getting the feedback to the design process as well as the selection process.

C. Communications

Through all the process of asset acquisition, goals and objectives should be communicated to the different levels of acquisition process. The company should ensure that the objectives and goals are relevant to its strategy. In addition;

they should be well known by those who specify and prepare the offer documents. An external communication; to the contractors and manufacturers that to prepare the bidding document; should be established and maintained to ensure they are well aware and understand the selections criteria is no longer based on the east initial cost; but on the least cost of ownership.

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D. Information system

This system is crucial for data handling and storage, a well data format is important to WLC event for the current WLC exercise and/or for the future needs. The system should be able to handle the different data through the life of an asset.

Importantly; it should be able to provide a cost justification based on criticality for the operating cost and maintenance costs. Moreover, the system has to be able to identify where the high costs are going in order to target them and make any possible improvement to reduce them.

E. Data management

For an oil and gas company a massive data required to carry out WLC exercise either for current situation or for future perspectives. It is really important not only understand the process of data collection but also to consider what kind of data is needed and where is the source [1].

F. The cost breakdown structure (CBS)

For WLC implementation, a system for data collection should be put in place to identify the cost elements. If more details is needed a detailed break down structure should be used to identify the basic cost components. The reason for a CBS is to avoid the ignorance of any significant cost and to make a systematic cost collection framework [2].

3.4 Particular concern

The implementation of WLC needs some skilled persons, which can make time delay for implementing the approach.

To overcome this issue there is two ways either call consultancy or train the company people.

A.Consultancy

The consultancy will be a good start to gain the benefits from people has a great experience in different industries and particularly experts on this approach. But; a particular attention should be paid to the transfer of the experience as it can be stipulated on the contracts.

B.Training

SONATRACH does not have an experience with the application of WLC approach. The choice of alternatives is still based on the cheapest initial cost where the operating costs are of ignorance. As there are many joint ventures projects with SONATRACH in Algeria, an internal transfer of the experience with this approach can be made.

Otherwise, a consultancy for training people should be called if the company wants to make a progress toward the world class leaders. Indeed, the training should be tailored to the company specifications.

4. Whole life costing as a tool within asset management Asset management uses many different tools to get the most desirable value for money from the assets. These tools range from making the business objectives smart, alignment of strategies, capital investment decision and control, to a maintenance or/and restoring the functions of the assets.

From the figure 4 it can be noticed that the asset management tools range from asset health diagnostic through getting the condition of the asset health and using the embedded knowledge about the asset as an experience with this asset exploitation. The business value assessment is another important area that could be targeted to rank the alternatives based on their impact on the total business and their criticality to the business process. A capital planning, this where the most whole life costing benefits can be generated, through long term capital forecast, the asset renewable strategy when to upgrade it or change it and finally making a continuous process of asset performance analysis through the whole life of the asset.

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Figure 4: Asset management tools

5. Maturity approach of WLC within asset management This part presents how WLC can be implemented and embedded on a company. The first level of capability is that the managers have to be exposed to WLC approach, they become aware of the benefits and accept to implement it in the organisation. The second level starts when an active support is seen by initiating a policy, making goals and objectives, understand the principals and WLC processes. The principally element here is to understand the issues driving WLC. The third level is to apply the concept and it becomes a daily routine amongst asset management processes. In addition; an understanding on how to get the alignment between the WLC and the investment returns.

After that a competence level can be reached if the company is able to organise itself for sufficient WLC practice, making the roles and responsibilities clear and tracking the improvements and the results. The last step is the excellence step when the company can collaborate with external bodies and companies on WLC issues, either by calling for national or international conferences, providing an external consultancy services by demonstrating the benefits of WLC, or participating on standards’

development

Figure 5: The maturity modal for WLC implementation

6. Case Study Introduction

After the discussion with GSA managers, it was clear that they want to dig deep on the benefits of the artificial lift service management “It is worth to continue with hiring this service, or is there any benefit for owning this service?” in addition; they want to know the limits of the exploitation of the system.

After searching on the different possible scenarios, three are identified:

Option A: Hiring the service,

Option B: Owning the equipment by the company, and Option C: Continue hiring the service for two years than buy the equipment

Evaluation of the three options

As it is the same equipment and the selection based on technical criteria is already done; which is based on the matching between the well and reservoir performance, and the ESP’s capacities and characteristics. The second step is to perform an economical evaluation based on the net present value (NPV) as the three options supposed to have the same period analysis.

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b.1. the ideal scenario (there is no failures occur during the years)

For this scenario any failure will occur during the usage of the system either for the pump system or the well. After calculation: Table 1: NPV value for different options on the ideal scenario

Conclusion 1

On the ideal scenario the company can save 3 342 250 € over ten year if it buys the system for a new well that produces about 1200 BBL/D with a price about 15 €/bbl (20 $/bbl). In addition, at least the company will save more than three millions euros if it buys the system for the existing one well that equipped with this system in ten years time. It can be seen that the company will save at least on annual basis EAC A- EAC C 408 942,4 1 €.

b.2. The real scenario

For the option A, the assumptions made that the company will not pay any cost when the ESP breakdown except the work-over (which will occur for each two years) and other costs not related to the pump unit repair. When a break down occurs thirty days lost of production was assumed this include the mobilisation time and the work-over time. This time was supposed a little bit long due to the rig availability on the market as the price of oil is too high and the drilling activities are increasing.

In the best estimate the mean time between failures is assumed to be (2 years), so the repair cost will occur each two years for option B and option C.

Table 2: NPV value for different options of the real scenario

Conclusion2

The option B is the best amongst the three different options. The savings that the company can make if adopts one of the two options B or C in ten years time with the same assumption made before are presented on the following table:

Table 3: saving values for different options of the real scenarios

As the first decision comes out before uncertainties and risk assessment the best option is to adopt the option B for future decision if the conditions assumed are satisfied. The company can make at least savings about 2 460 896.70 euros over ten years time for each system with today’s money

C.Uncertainties and Risk assessment c.1. Sensitivity analysis

· The analysis period The net present value

of option Value

NPV (A) -1 644 583,83 ¼

NPV (B) -4 237 976,04¼

NPV (C) -4 105 480,53 ¼

The saving

between options Value

NPV (A) ± NPV (B) 2 593 392,22 €

NPV (A)- NPV (C) 2 460 896,70 €

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Figure 6: The sensitivity analysis of the analysis period

Figure 7: The Savings with time

It can be seen that the saving with time on the figure 7. Until the fourth year that the savings is less than on million dollars but it is worth to save it. In addition, it is clear that if the analysis period is less than three years the option A is the ideal option which reveals the company’s strategy is good in the current situation

The discount rate

Figure 8: The discount rate sensitivity analysis

From the figure above it can be concluded that the discount rate does not have an effect on the decision.

The mean between time failures (MTBF)

Figure 9: The sensitivity analysis of the MTBF The MTBF is a critical factor for using the ESP system, since any failure needs a work-over to pull out the equipment and reinstall it which exceeds the ESP price. So a sensitivity analysis is assigned to it. It revealed that it does not affect the decision. But only the savings decrease with the decrease of MTBF.

Figure 10: The saving with MTBF

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Well rate sensitivity analysis

Figure 11: The well rate sensitivity analysis The well rate is the source of cash flow of the system, so it has a great influence on the investment of such a system.

With the assumptions made before; the well rate limit for the option A is about 1200 bbl/D and for the option B is 900 bbl/

D and that is the same for option C. notice that the price of barrel is $20.

Oil price sensitivity analysis

Figure 12: The sensitivity analysis of the oil price The NPV of the different options are directly sensitive to the oil prices but it does not influence the decision of the choice between the available options. The option A is not economically possible if the price of oil is high than 19 $/bbl whereas the option B and C are not possible if the price of oil is higher than 17$/bbl. These decisions are valid under the assumption made earlier.

Sensitivity analysis of the repair cost

Figure 13: The sensitivity analysis of the repair cost The repair cost is estimated to be about 20% of the best estimate; it does not influence the decision that the option B is better.

c.2. Risk assessment using crystal ball (based on probabilities)

This part deal with the probabilities, it has been assigned a probability distribution for each risky parameter in order to try to get a confidence level on the decision that should be taken; the risky parameters and their assigned probability can be found on the appendices B. After running a simulation the following results have been found.

Figure 14: the certainty level of NPV (A) calculations

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The certainty level is 82,97% (from – infinite to -1 644 583,83 €), this mean that the NPV (A) has a probability of 82.97% to be less than the NPV (A) of the best estimate (-1 644 583,83 €). In addition, this means that the investment has a great probability (82.97 %) to make more benefits than the base case.

Figure 15: The certainty level of the NPV (B) calculation

The certainty level is 82,7% (from – infinite to -4 237 976,04), which indicates that the NPV (B) will generate more benefits than that of the base case.

Certainty level is 82,921% (from – infinite to -4 105 480,53

€). As a conclusion this option can make money more than that of the best estimates with a confidence level of 82.92%.

Figure 20: The comparison between the option A and C From this figure 20, it is clear that the option C is always better than the option A. the company can adopt the option C with 99.95% of confidence level.

Conclusion 3

NPV (B)= - 4 237 976,04€ < NPV (C)= - 4 105 480,53

€<NPV (A)= -1 644 583,83 €

The option B is the best option as it has the least NPV;

and the option C is better than the option A. so it is a good strategy to adopt owning the equipment if the usage of the system will last more than three years. The confidence level is too high which gives more self confidence for making the decision to own the system or hire the system for two years than buy it.

d. Conclusions and recommendations:

d.1 Conclusions

Based on the present research, the following major conclusions can be drawn

• The implementation of WLC can be started either from the evaluation of the current alternatives or from data collection.

• Much attention should be paid to the policy, roles and responsibilities; communications and the information systems for data handling as well as carrying WLC analysis.

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• The most benefits of WLC within asset management can be generated from the capital planning.

• The maturity modal for WLC capabilities can be climbed with emphasise on the continuous improvement within the company toward WLC applications and implementation.

• The strategy of the company for two years contracts on the ESP system is a good current strategy since it is the first experience, but, if they decide to use the system for more years, there is a great opportunity that should be saved. The typical results indicate that adopting the best option can save over 2.5 millions Euros with a high certainty level. A clear decision should be made on the analysis period as it is sensitive to the decision. In addition; The MTBF has a great effect on the savings of the ESP system. It can be doubled if MTBF changes from one year to five years. A careful study is needed to continue using the ESP system as the economic limits of the well rate are identified. Moreover; the price of oil and the well rate are the most sensitive elements to the decision.

• The lost opportunity that revealed by the application of WLC approach on a single artificial lift system is worth to save it. Besides; there are many opportunities that can be saved, if the company implements the approach on the decision process to reach longer term investments objectives.

d.2 Recommendations for further studies Implementation plan

A careful study should be held to make a detailed implementation plan to address the issues that may face the implementation process. This study should put in place a time frame for the actions necessary with designing a tool for measurement of the successful and performance of the implementation. In addition; this study has to make clear the characteristics of the information systems that will be used to fit the company’s specifications and how to implement that information system?

Development of a detailed modal

A detailed modal for whole life calculations should be developed to meet the characteristics of the oil and gas industry. For instance; for a typical project or an equipment acquisition it would be possible that many contractors will do different tasks and they may have different inflation rates, so the modal should address these issues. Furthermore;

the modal also should make a tool for dealing with non- financial criteria in the case where no decision is made. The modal should be flexible to suit the design of different information systems that currently exist on the market.

Moreover; the modal has to be based on a simple complete algorithm, which follows logic for handling all the costs through the whole life costing.

Standards and guidelines

Notional and international standards and guidelines should be developed to make the implementation and the application of WLC easy for companies. This will reduce the efforts and time of implantation within a company.

These standards should be reviewed periodically to meet any changes even on the WLC modals, information system characteristics or changes on the financial applications and principles. Far more would have been achieved if there has been a good data management and its transfer within the mother company SONATRACH. Furthermore; it has been clear that there was a lack of support and understanding of the approach. It is recommended to incorporate training on such approach in the training plan for the whole engineers and managers. For a typical project, WLC analysis needs a multidisciplinary team to reach its stated objectives. Thus, the interface of that project with many aspects such as design alternatives philosophy, marked conditions, strategy of the exploitation, taxations regimes, guarantee issues and additional overheads.

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