Underinvestment, a rush in activity, and upward market pressure keeps upstream and downstream industry costs high in 2022

A wide range of market forces have relentlessly exerted upward pressure on industry costs over the course of 2022. The disruption in global energy markets from the conflict in Ukraine led to elevated oil and natural gas prices and made energy security a priority for states looking to shield their economies from these disruptions. Other factors include general inflation, driven by tight labor markets and higher commodity, energy, and food prices. While these all play a part in the overall increase in costs, the main driver within the industry however has been the surge of demand experienced since the outbreak of war in Ukraine.

The sudden rush of upstream activity that followed came after an extended period of underinvestment in the upstream space. Many of the suppliers that cater to this demand have reduced their capacity considerably since 2015, leaving the overall market inadequately equipped to deal with the substantial work that lies ahead. Despite being unable to fully meet the needs of the many projects on the market today, suppliers have exhibited the same capital discipline that operators have demonstrated in recent years. Most remain in a precarious financial position, and few have the appetite to invest in expanding their own capabilities. These suppliers are facing higher internal costs themselves: while negotiating power has shifted to their favor for the first time in many years, the higher rates they are requesting from buyers are not aimed at growing their profit margins, but at reaching or maintaining profitability.

Upstream Capital Costs

The S&P Global Upstream Capital Costs Index (UCCI) increased by 0.5% in the fourth quarter, ending the year with an overall increase of almost 10%. Most markets monitored by the UCCS increased in fourth quarter 2022, with the largest increase from the land rig and offshore installation vessel markets, up by 8.1% and 1.8%, respectively. High oil prices, limited rig availability, and short-term contracts led to rising day rates. Land rig contractors are opting for contract churn to fulfill customer demand, which is allowing them to keep utilization and rig rates high. For offshore installation vessels, strong oil prices, sustained offshore demand from the industry, and the growing offshore wind sector sustained fleet activity, helping day rates recover from record lows.

Other markets with positive market movement in the US dollar index include offshore rigs, equipment, fabrication yards, subsea equipment, and construction labor. The offshore rig market is up owing to higher commodity prices and increased demand on crude oil. Equipment costs are up because of high demand supported by elevated oil prices, and the residual effect from high costs earlier in 2022 for inputs such as steel and bulk materials. Offshore fabrication costs increased as yards continue to price higher contingencies into lump-sum contracts. The increase in the subsea index was due to activity improving throughout 2022 and higher raw material and labor costs. Finally, the construction labor index increased due to tight labor markets in most regions and an enduring scarcity in skilled labor.

Upstream Operating Costs

The S&P Global Upstream Operating Costs Index (UOCI) grew by 0.6% in the fourth quarter, ending the year with an overall increase just under 9.5% for 2022. Most of the escalation came in the first half of 2022 and moderated into the fourth quarter. Activity, particularly in the US onshore and in offshore markets, is recovering. However, crude prices remain extremely volatile, and the "known unknowns" inject a significant amount of uncertainty into both the economy and the geopolitical system. With the threat of a looming global recession dissipating, there will be some oil demand growth in 2023. Limited spare oil production capacity, exacerbated by tight supply in key oilfield service sectors, is a concern for the rest of this year and potentially into 2024. The additional dimension of rising geopolitical tensions will mean downside risk in the near term.

The operations index increased by 0.5% in fourth quarter 2022 in the US dollar index, driven by a 5% rise in the diesel market. The index finished the year up by 10%. Diesel inventory levels remain low, and markets are tight, especially as the European ban on Russian crude and refined product takes effect. Unemployment remains low in all regions, which is keeping labor markets tight, and competition for labor should remain strong in 2023. The maintenance index grew by 1% in fourth quarter 2022 in US dollar terms. Overall maintenance demand is rebounding, but labor shortages combined with high demand are putting pressure on wages and subsequently on service rates. Suppliers have entered 2023 with high orders and backlogs and are working to improve supply chains to stabilize output and delivery times. Compared with the same period in 2021, the maintenance index is up 10%. The logistics index was flat, falling just 0.1% in the fourth quarter in US dollar terms and rising 1% in local currency terms. There was some relief in the second half of the year from escalating food and fuel costs; the index ended the year up by 6%. The index will likely escalate in 2023, rising 4%. The global wells index registered 3% during fourth quarter 2022 in US dollar terms while increasing by 17% for all of 2022. Higher oil prices in 2022 drove activity and therefore the wells index. Cost escalations were magnified by continued high inflation. Despite broader market volatility, demand for equipment and services will remain resilient. Strong demand and tight supply conditions are expected to be the hallmark of 2023.

Downstream Capital Costs

The S&P Global Downstream Capital Costs Index (DCCI) increased by 0.2% during fourth quarter 2022, ending the year up by almost 7.3%. Construction material markets remain tight. Suppliers have been slow to pass on cost savings and reluctant to increase production capacity. Supply availability is less scarce than it was at the onset of the pandemic, but delays persist. Essentially, economies have grown accustomed to the current purchasing environment.

Since 2020, there has been a transformation in downstream capital expenditure. Historically, labor accounted for most of the project cost. Since the pandemic, material costs have held the mantle. Material costs rose owing to higher raw material prices, lower factory utilization, and supply chain hiccups. As we enter 2023, two of those three issues are starting to level out. Raw material prices have cooled, and the supply chain is less volatile. Suppliers are still reluctant to increase utilization and are enjoying their increased margins. They do not want to entertain the hassle of hiring and certifying new employees. As we enter 2023, material prices are beginning to normalize but they will still hold at higher floor than pre-pandemic levels.

The DCCI refining index was flat during fourth quarter 2022. Project costs have normalized owing to lower steel prices. Steel accounts for 17% of refining project costs in the DCCI. While steel prices have cooled, the market will have a new pricing floor. The pricing floor is higher than pre-pandemic levels because of reduced capacity. Currency fluctuations in Europe and the Middle East resulted in higher labor and engineering charge-out rates. While there are limited refining projects in the forecast for Europe, engineering, procurement, and construction (EPC) firms are still capturing renewable projects. Sourcing engineers is still a challenge, especially when considering quality. Regardless of project activity in the region, engineers are still highly desired and will be compensated as such.

The DCCI petrochemical index increased 0.5% during fourth quarter 2022. Lower steel prices are impacting the following categories: electricals and instrumentation, as well as steel. Lower steel price has yet to be factored into equipment costs. Equipment manufacturers increased costs 1% during the quarter. Like the previous quarters, the main drivers for the cost rise in this quarter were the high input costs, such as labor and lagged steel and other materials cost. Equipment manufacturers are slowly losing pricing power. They are unable to use raw material price as a driver. They are still able to cite availability of materials and their own backlog. Wages for construction workers and engineers increased during the quarter. Sourcing qualified workers is an ongoing challenge. These key factors resulted in higher petrochemical project costs.

Downstream construction labor costs increased by 4% in US dollar terms and increased by 7.2% in local currency in all of 2022. Wage growth was witnessed in fourth quarter 2022 as tight labor markets continued and unemployment remained low in most regions. Global civils and construction material costs decreased by 0.1% in fourth quarter 2022 in the US dollar index. Weakness in oil prices in the second half of 2022 contributed to falling prices for asphalt. Construction material prices are expected to remain elevated in 2023.

This blog is an extract from the UCCI, UOCI and DCCI market reports that are available to subscribers on our Connect platform. The latest summary Cost and Supply Chain Indexes can be found on the Costs and Supply Chain capability pages on the S&P Global website. For more information contact James Blanchard.

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Posted 31 Martch 2023 by Zayd Wahab, Associate Director, Upstream Costs and Technology, S&P Global Commodity Insights

This article was published by S&P Global Commodity Insights and not by S&P Global Ratings, which is a separately managed division of S&P Global.