Oil Company Crisis

Balancing Structure, Profitability

and Growth
Dr Robert Arnott
IAEE Conference Prague
7 June 2003
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Why managers want to grow value

CEO base salary to capital
(O&G companies, 1996-98)
7.50

y = 0.30x + 4.04
2

7.00

Log of
salary

R = 0.59

6.50
6.00
5.50
5.00
4.00

5.00

6.00

7.00

8.00

9.00

10.00

11.00

Log of
capital
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The Challenge
z
z
z
z

A decade of earnings growth has been achieved

largely through cutting costs
The mega-mergers of the late 1990s represent the
end of this process
Companies have not delivered growth
expectations
Vertical disintegration is widely proposed

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Changing Market Pressures

Restricted Supply

POWER AND CONTROL

Control
100%

100%

ate
d

Oil

SQ
UE
EZ
E

SQ
UE
EZ
E

Utilities and Retail

Consumer

Ind
epe
nde
nts
Inte
gr

Resources
0%

Unrestricted Supply

Co
mp
ani
es

SQ
Super Majors
UE
EZ
E
National Oil Companies and Governments

Energy Supply Chain

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0%
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What do we mean by integration?

z

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
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3/23/2004
6
ENERGY

Qatar Petroleum

Adnoc

INOC

NIOC

Saudi Aramco

NNPC

Sonatrach

Libya NOC

Pemex

KPC

Pertamina

PDV

BP

Conoco

Total Fina Elf

Chevron

Repsol-YPF

Royal Dutch/Shell

Exxon Mobil

Petrobras

100.0
80.0
60.0
40.0
20.0
0.0
-20.0
-40.0
-60.0
-80.0
-100.0
Marathon

Nippon Mitsubishi

Operational Integration in 1991

Integration Index:

- 100 (100% Refining)

+100 (100% Upstream)

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Capital Rotation 1990-2001

100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%

CH
RM
GP
EP

90

91

92

93

94

95

96

97

98

99

00

01
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100
80
60
40
20
0
-20
-40
-60
-80
-100

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8
ENERGY

Gazprom

Qatar Petroleum

Adnoc

INOC

Sonatrach

Saudi Aramco

Libya NOC

NNPC

NIOC

Lukoil

Pemex

KPC

Pertamina

PDV

PetroChina

Royal Dutch/Shell

Chevron

BP

Yukos

Repsol-YPF

Conoco

Petrobras

Total Fina Elf

Exxon Mobil

Marathon

Sinopec

Nippon Mitsubishi

Current State of Integration

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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!

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Exploiting the inefficiencies

z

Political
issues of access, differing terms, embargos

Institutional
OPEC, cartelisation

Economic
pricing issues, investment

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Exploiting the inefficiencies

z

Financial
tax, cost of capital, risk mitigation, default risk, markets

Operational
local monopolies, supply chains, project skills,

reputation
z

Technical
information transfer, cost of information

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Upstream Efficiency
FD Costs 1999-2001 ($/boe)

12.00

Spreading the risk

10.00

Access to opportunities

NHY

8.00

STL
6.00

ENI

REP

BP

TOT
CHV

4.00

XOM
RD/SHEL

2.00
2

R = 0.7975

0.00
0

50

100

150

200

250

Market Capitalisation ($bn)

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Taxation
EP contribution to net income (%)

Minimising tax
100%

Cross-border offsets

90%
80%
70%
60%
50%
40%
30%
30.0%

R = 0.024
35.0%

40.0%

45.0%

50.0%

55.0%

60.0%

65.0%

70.0%

75.0%

2001 Tax Rate

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Financial Markets
Access to equity markets
18.0

Higher risk focussed entities

2003 Price Earnings

16.0
14.0
12.0
10.0
8.0
6.0
4.0
2.0
0.0
Pipelines Super-major

Large EP

US
EP
Mid/Small Integrated

EU
Integrated

Refiners

Emerging
Integrated

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Weighted Average Cost of Capital

Cost of Capital
10.0%

Lower cost for larger companies

9.5%

Access to capital a barrier

9.0%
8.5%
8.0%
7.5%
2

R = 0.804
7.0%
0

50000

100000

150000

200000

250000

Market Capitalisation ($mm)

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Access to Capital
Financing
($Bn)
10

Oil Price
($/Bbl)

Cyclical industry financing

30

Invest through the cycle?

8
25

6
2.6

20
4.9

4
1.3

2.1
15

3.3

1.1
2.6

2.3

0.7

3.5
2.4

1.5

1.0
0.6

0
1993

1994

1995

1996

1997

Equity

1998(1)

1998(2)

0.8

10

1999

High Yield
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Muddled Thinking in the Gas Chain

z

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 integration

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Structure Conclusions
z
z
z

Companies should identify and quantify market

inefficiencies operational and financial
Companies should identify the risks that would
accrue from de-integration
Corporate capabilities are not merely energyspecific: they may comprise financial skills or
customer franchise

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Oil Company Crisis

Balancing Structure, Profitability
and Growth
Dr Robert Arnott
7th June 2003
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Profitability, Growth and Value

z
z
z

Companies have concentrated internal and

external attention on one metric: ROACE
Even if accurate, ROACE is too limited, as any
growth at above WACC adds value
Accounting measures compound the problem:
they overstate the profitability of old assets and
understate the profitability of new ones

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Case Study: Pipeline Economics

Year

Cash flow model:

Investment
(1,000)
Cash flow from operations
Free Cash Flow
(1,000)
Internal Rate of Return 13.1%
Accounting results:
Opening Capital
0
Depreciation
0
Closing Capital
1,000
Profit
0
Return on Opening Capital

200
200

210
210

221
221

232
232

243
243

255
255

268
268

1,000
(143)
857
57
5.7%

857
714
571
429
286
143
(143)
(143)
(143)
(143)
(143)
(143)
714
571
429
286
143
0
67
78
89
100
112
125
7.8% 10.9% 15.5% 23.4% 39.3% 87.6%

Economic results:
Opening NPV
0
1,000
931
844
734
599
435
237
Impairment of value
0
(69)
(88)
(110)
(135)
(164)
(198)
(237)
Closing NPV
1,000
931
844
734
599
435
237
0
Profit
131
122
111
97
79
57
31
Economic ROCE (opening)
13.1% 13.1% 13.1% 13.1% 13.1% 13.1% 13.1%
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Integrating DCF Analysis with

Management Accounts
z

z
z

Investments are originally justified with DCFs, but

subsequent performance is monitored and
presented using conventional accounts
Two alternative approaches are improvements:
CFROI and adjusted EVATM
Both permit investment and performance
measurement to be related seamlessly

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Method: Adjusted EVATM

Accounting Method

NOPAT:
Operating Profit (EBIT)
Notional Tax
Net Operating Profit After Tax

Adjusted EVATM Method

1,700
(500)
1,200

Ann. change in NPV of reserves

Ann. net investment in reserves
Unrealised gains/losses

250
(200)
50

Accounting NOPAT
Unrealised gains/losses

1,200
50

Adjusted NOPAT

1,250

Opening Capital Employed:

Net Debt
Minority Interests
Shareholders' Equity
Capital Employed

2,000
500
7,500
10,000

Opening Capital Employed

Book value of reserves
Net Present Value of reserves
Adjusted Opening Capital Emp.

10,000
(4,000)
8,000
14,000

Return on Capital Employed

12.0%

Accounting ROCE
Adjusted ROCE

12.0%
8.9%

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Oil Company Historical Performance

z

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
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Case Study: Oil Company

Performance
1997

1998

1999

2000

2001 Average

Book return on capital

NOPAT
35,560 18,257 25,900 57,650 43,810 36,236
Opening book capital employed including goodwill 248,506 258,487 267,086 351,233 351,538 295,370
Return on capital employed including goodwill 14.30% 7.10% 9.70% 16.40% 12.50% 12.00%
Adjusted return on capital employed
Adjusted NOPAT
Adjusted opening capital employed
Adj return on adj opening capital employed
Realised profit/adj opening capital employed

-37,867 -42,333 141,346 145,775 -109,907 19,403

294,191 277,023 225,033 424,443 511,146 346,367
-12.90% -15.30% 62.80% 34.30% -21.50% 9.50%
12.10% 6.60% 11.50% 13.60% 8.60% 10.50%

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Why does this matter?

z
z
z

If investors are misled as to likely future

profitability, they will react adversely
If managers set too high a hurdle rate of return
they will under-invest
If the profitability of the upstream is
overestimated then such investment as is made
will be skewed

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Case Study: Royal Dutch/Shell

z

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

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CFROI Case Study: Shell

Summary 1999-2001
Current IRR
Upstream

13.0%

Downstream

5.7%

Chemicals

4.4%

Gas and Power

1.5%

Weighted Average

9.1%
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Profitability Conclusions
z

z
z

It is essential to develop an internal management

accounting system that integrates DCF analysis
with performance measurement
This should be transparent enough for presentation
to investors
The financial technology for this is already well
developed

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