Post on 11-Feb-2021
3/23/2004 FORENERGY STUDIES
OXFORD INSTITUTE
Oil Company CrisisOil Company Crisis
Balancing Structure, Profitability Balancing Structure, Profitability and Growthand Growth
Dr Robert ArnottIAEE Conference Prague
7 June 2003
3/23/2004 2 FORENERGY STUDIES
OXFORD INSTITUTE
Why managers want to “grow value”Why managers want to “grow value”CEO base salary to capital
(O&G companies, 1996-98)
y = 0.30x + 4.04R2 = 0.59
5.00
5.50
6.00
6.50
7.00
7.50
4.00 5.00 6.00 7.00 8.00 9.00 10.00 11.00
Log of salary
Log of capital
3/23/2004 3 FORENERGY STUDIES
OXFORD INSTITUTE
The ChallengeThe Challenge
A decade of earnings growth has been achieved largely through cutting costsThe mega-mergers of the late 1990s represent the end of this processCompanies have not delivered growth expectationsVertical disintegration is widely proposed
3/23/2004 4 FORENERGY STUDIES
OXFORD INSTITUTE
Changing Market PressuresChanging Market Pressures
National Oil Companies and Governments
Independents
Super Majors
Utilities and RetailIntegrated Oil Companies
Restricted Supply Unrestricted Supply
Control
Res
ourc
es
100%
0%
Con
sum
er
0%
100%SQUEEZE
SQUEEZESQUEEZE
POWER AND CONTROL
Energy Supply Chain
3/23/2004 5 FORENERGY STUDIES
OXFORD INSTITUTE
What do we mean by integration?What do we mean by integration?
Operational integration– Integrated chain– Lower transaction costs
Financial integration– Ability to fund projects cheaply – Manage cash flows
The difference – Related to funding, rather than to operations
3/23/2004 6 FORENERGY STUDIES
OXFORD INSTITUTE
Operational Integration in 1991Operational Integration in 1991
Integration Index:
- 100 (100% Refining)
+100 (100% Upstream)
-100.0-80.0-60.0-40.0-20.0
0.020.040.060.080.0
100.0
Nip
pon
Mits
ubis
hi
Mar
atho
n
Pet
robr
as
Exx
on M
obil
Roy
al D
utch
/She
ll
Rep
sol-Y
PF
Che
vron
Tota
l Fin
a E
lf
Con
oco
BP
PD
V
Per
tam
ina
KP
C
Pem
ex
Liby
a N
OC
Son
atra
ch
NN
PC
Sau
di A
ram
co
NIO
C
INO
C
Adno
c
Qat
ar P
etro
leum
3/23/2004 7 FORENERGY STUDIES
OXFORD INSTITUTE
Capital Rotation 1990Capital Rotation 1990--20012001
0%10%20%30%40%50%60%70%80%90%
100%
90 91 92 93 94 95 96 97 98 99 00 01
CHRMGPEP
3/23/2004 8 FORENERGY STUDIES
OXFORD INSTITUTE
Current State of IntegrationCurrent State of Integration
-100-80-60-40-20
020406080
100
Nipp
on M
itsub
ishi
Sino
pec
Mar
atho
n
Exxo
n M
obil
Tota
l Fin
a El
f
Petro
bras
Cono
co
Reps
ol-Y
PF
Yuk
os BP
Chev
ron
Roya
l Dut
ch/S
hell
Petro
Chin
a
PDV
Perta
min
a
KPC
Pem
ex
Luko
il
NIO
C
NNPC
Liby
a NO
C
Saud
i Ara
mco
Sona
trach
INO
C
Adn
oc
Qat
ar P
etro
leum
Gaz
prom
3/23/2004 9 FORENERGY STUDIES
OXFORD INSTITUTE
So why disintegrate?So why disintegrate?
In a perfect world:– Focussed businesses are allegedly better managed– Industry maturity has reduced transaction costs to an
irrelevancy– Investors can construct balanced portfolios for
themselves
But, markets are not perfect!But, markets are not perfect!
3/23/2004 10 FORENERGY STUDIES
OXFORD INSTITUTE
Exploiting the inefficienciesExploiting the inefficiencies
Political– issues of access, differing terms, embargos
Institutional– OPEC, cartelisation
Economic– pricing issues, investment
3/23/2004 11 FORENERGY STUDIES
OXFORD INSTITUTE
Exploiting the inefficienciesExploiting the inefficiencies
Financial– tax, cost of capital, risk mitigation, default risk, markets
Operational– local monopolies, supply chains, project skills,
reputation
Technical– information transfer, cost of information
3/23/2004 12 FORENERGY STUDIES
OXFORD INSTITUTE
Upstream EfficiencyUpstream Efficiency
XOM
RD/SHEL
BPTOT
REP
CHV
ENI
STL
NHY
R2 = 0.79750.00
2.00
4.00
6.00
8.00
10.00
12.00
0 50 100 150 200 250Market Capitalisation ($bn)
FD C
osts
199
9-20
01 ($
/boe
)
Spreading the risk
Access to opportunities
3/23/2004 13 FORENERGY STUDIES
OXFORD INSTITUTE
TaxationTaxation
R2 = 0.02430%
40%
50%
60%
70%
80%
90%
100%
30.0% 35.0% 40.0% 45.0% 50.0% 55.0% 60.0% 65.0% 70.0% 75.0%
2001 Tax Rate
EP c
ontri
butio
n to
net
inco
me
(%)
Minimising tax
Cross-border offsets
3/23/2004 14 FORENERGY STUDIES
OXFORD INSTITUTE
Financial MarketsFinancial Markets
Access to equity markets
Higher risk focussed entities
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
18.0
2003
Pric
e Ea
rnin
gs
US EmergingPipelines Super-major Large EP EP EU RefinersIntegratedMid/Smal Integl rated Integrated
3/23/2004 15 FORENERGY STUDIES
OXFORD INSTITUTE
Cost of CapitalCost of Capital
R2 = 0.8047.0%
7.5%
8.0%
8.5%
9.0%
9.5%
10.0%
0 50000 100000 150000 200000 250000
Market Capitalisation ($mm)
Wei
ghte
d Av
erag
e C
ost o
f Cap
ital Lower cost for larger companies
Access to capital a barrier
3/23/2004 16 FORENERGY STUDIES
OXFORD INSTITUTE
Access to CapitalAccess to Capital
2.3
3.3
1.52.42.6
3.5
0.6
0.7
2.1
4.9
2.6
1.0
1.1
1.3
0.8
Cyclical industry financing
Invest through the cycle?
Financing($Bn)
Oil Price($/Bbl)
10 30
825
6
20
4
152
0 101997 1998(1) 1998(2)1993 1994 1995 1996 1999
Equity High Yield
3/23/2004 17 FORENERGY STUDIES
OXFORD INSTITUTE
Muddled Thinking in the Gas ChainMuddled Thinking in the Gas Chain
Despite losing faith in oil chains, oil companies are keen to integrate vertically into gas and power
They should instead concentrate on two motives: – focusing on their strengths– exploiting market inefficiencies
This may or may not require integrationThis may or may not require integration
3/23/2004 18 FORENERGY STUDIES
OXFORD INSTITUTE
Structure ConclusionsStructure Conclusions
Companies should identify and quantify market inefficiencies – operational and financialCompanies should identify the risks that would accrue from de-integrationCorporate capabilities are not merely energy-specific: they may comprise financial skills or customer franchise
3/23/2004 FORENERGY STUDIES
OXFORD INSTITUTE
Oil Company CrisisOil Company Crisis
Balancing Structure, Profitability Balancing Structure, Profitability and Growthand Growth
Dr Robert Arnott 7th June 2003
3/23/2004 20 FORENERGY STUDIES
OXFORD INSTITUTE
3/23/2004 21 FORENERGY STUDIES
OXFORD INSTITUTE
Profitability, Growth and ValueProfitability, Growth and Value
Companies have concentrated internal and external attention on one metric: ROACEEven if accurate, ROACE is too limited, as any growth at above WACC adds valueAccounting measures compound the problem: they overstate the profitability of old assets and understate the profitability of new ones
3/23/2004 22 FORENERGY STUDIES
OXFORD INSTITUTE
Case Study: Pipeline EconomicsCase Study: Pipeline EconomicsYear 0 1 2 3 4 5 6 7
Cash flow model:Investment (1,000)Cash flow from operations 200 210 221 232 243 255 268Free Cash Flow (1,000) 200 210 221 232 243 255 268Internal Rate of Return 13.1%
Accounting results:Opening Capital 0 1,000 857 714 571 429 286 143Depreciation 0 (143) (143) (143) (143) (143) (143) (143)Closing Capital 1,000 857 714 571 429 286 143 0Profit 0 57 67 78 89 100 112 125Return on Opening Capital 5.7% 7.8% 10.9% 15.5% 23.4% 39.3% 87.6%
Economic results:Opening NPV 0 1,000 931 844 734 599 435 237Impairment of value 0 (69) (88) (110) (135) (164) (198) (237)Closing NPV 1,000 931 844 734 599 435 237 0Profit 131 122 111 97 79 57 31Economic ROCE (opening) 13.1% 13.1% 13.1% 13.1% 13.1% 13.1% 13.1%
3/23/2004 23 FORENERGY STUDIES
OXFORD INSTITUTE
Integrating DCF Analysis with Integrating DCF Analysis with Management AccountsManagement Accounts
Investments are originally justified with DCFs, but subsequent performance is monitored and presented using conventional accountsTwo alternative approaches are improvements: CFROI and adjusted EVATMBoth permit investment and performance measurement to be related seamlessly
3/23/2004 24 FORENERGY STUDIES
OXFORD INSTITUTE
Method: Adjusted EVAMethod: Adjusted EVATMTMAccounting Method Adjusted EVATM Method
NOPAT:Operating Profit (EBIT) 1,700Notional Tax (500)Net Operating Profit After Tax 1,200
Opening Capital Employed:Net Debt 2,000Minority Interests 500Shareholders' Equity 7,500Capital Employed 10,000
Return on Capital Employed 12.0%
Ann. change in NPV of reserves 250Ann. net investment in reserves (200)Unrealised gains/losses 50
Accounting NOPAT 1,200Unrealised gains/losses 50Adjusted NOPAT 1,250
Opening Capital Employed 10,000Book value of reserves (4,000)Net Present Value of reserves 8,000Adjusted Opening Capital Emp. 14,000
Accounting ROCE 12.0%Adjusted ROCE 8.9%
3/23/2004 25 FORENERGY STUDIES
OXFORD INSTITUTE
Oil Company Historical PerformanceOil Company Historical Performance
We have used a modified EVATM – the main adjustment being substitution of net present value for book upstream values, and the inclusion of net changes in these to profit
The key finding is that the profitability of the industry drops from around 12% to around 9%, slightly above its WACC
3/23/2004 26 FORENERGY STUDIES
OXFORD INSTITUTE
Case Study: Oil Company Case Study: Oil Company PerformancePerformance
1997 1998 1999 2000 2001 AverageBook return on capitalNOPAT 35,560 18,257 25,900 57,650 43,810 36,236Opening book capital employed including goodwill 248,506 258,487 267,086 351,233 351,538 295,370Return on capital employed including goodwill 14.30% 7.10% 9.70% 16.40% 12.50% 12.00%
Adjusted return on capital employedAdjusted NOPAT -37,867 -42,333 141,346 145,775 -109,907 19,403Adjusted opening capital employed 294,191 277,023 225,033 424,443 511,146 346,367Adj return on adj opening capital employed -12.90% -15.30% 62.80% 34.30% -21.50% 9.50%Realised profit/adj opening capital employed 12.10% 6.60% 11.50% 13.60% 8.60% 10.50%
3/23/2004 27 FORENERGY STUDIES
OXFORD INSTITUTE
Why does this matter?Why does this matter?
If investors are misled as to likely future profitability, they will react adverselyIf managers set too high a hurdle rate of return they will under-investIf the profitability of the upstream is overestimated then such investment as is made will be skewed
3/23/2004 28 FORENERGY STUDIES
OXFORD INSTITUTE
Case Study: Royal Dutch/ShellCase Study: Royal Dutch/Shell
The CFROI approach yields very similar results but the detail of the adjustments make it difficult to aggregate across the sector
The following slide shows calculations made for Royal Dutch/Shell
3/23/2004 29 FORENERGY STUDIES
OXFORD INSTITUTE
CFROI Case Study: ShellCFROI Case Study: ShellSummary 1999-2001
Current IRR
Upstream 13.0%
Downstream 5.7%
Chemicals 4.4%
Gas and Power 1.5%
Weighted Average 9.1%
3/23/2004 30 FORENERGY STUDIES
OXFORD INSTITUTE
Profitability ConclusionsProfitability Conclusions
It is essential to develop an internal management accounting system that integrates DCF analysis with performance measurementThis should be transparent enough for presentation to investorsThe financial technology for this is already well developed
Oil Company CrisisWhy managers want to “grow value”The ChallengeChanging Market PressuresWhat do we mean by integration?Operational Integration in 1991Capital Rotation 1990-2001Current State of IntegrationSo why disintegrate?Exploiting the inefficienciesUpstream EfficiencyTaxationFinancial MarketsCost of CapitalAccess to CapitalMuddled Thinking in the Gas ChainStructure ConclusionsOil Company CrisisProfitability, Growth and ValueCase Study: Pipeline EconomicsIntegrating DCF Analysis with Management AccountsMethod: Adjusted EVATMOil Company Historical PerformanceCase Study: Oil Company PerformanceWhy does this matter?Case Study: Royal Dutch/ShellCFROI Case Study: ShellProfitability Conclusions