oil company crisis - oxford institute for energy studies...return on capital employed including...

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


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


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


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


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


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


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


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!


OXFORD INSTITUTE

Exploiting the inefficienciesExploiting the inefficiencies

Political– issues of access, differing terms, embargos

Institutional– OPEC, cartelisation

Economic– pricing issues, investment


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


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


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


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


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


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


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


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


OXFORD INSTITUTE


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


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%


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


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%


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


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%


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


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


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%


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

oil company crisis - oxford institute for energy studies...return on capital employed including...

Documents