Oil Presentation3 OilCompanyCrisisBalancingStructureProfitabilityandGrowth RArnott 2003

8/9/2019 Oil Presentation3 OilCompanyCrisisBalancingStructureProfitabilityandGrowth RArnott 2003

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3/23/2004 FORENERGY STUDIES

OXFORD INSTITUTE

Oil Company CrisisOil Company Crisis

Balancing Structure, ProfitabilityBalancing Structure, Profitabilityand Growthand Growth

Dr Robert ArnottIAEE Conference Prague

7 June 2003


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3/23/2004 2 FORENERGY STUDIES

OXFORD INSTITUTE

Why managers want to grow valueWhy managers want to grow valueCEO base salary to capital

(O&G companies, 1996-98)

y = 0.30x + 4.04

R2 = 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 ofsalary

Log ofcapital


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OXFORD INSTITUTE

The ChallengeThe Challenge

A decade of earnings growth has been achievedlargely through cutting costsThe mega-mergers of the late 1990s represent the

end of this processCompanies have not delivered growthexpectationsVertical disintegration is widely proposed


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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


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OXFORD INSTITUTE

Operational Integration in 1991Operational Integration in 1991Integration 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

N i p p o n

M i t s u

b i s h i

M a r a

t h o n

P e

t r o

b r a s

E x x o n

M o b i l

R o y a

l D u

t c h / S h e

l l

R e p s o

l - Y P

F

C h e v r o n

T o

t a l F i n a

E l f

C o n o c o

B

P

P D

V

P e r t a m i n a

K P C

P e m e x

L i b y a

N O C

S o n a

t r a c

h

N N P C

S a u

d i A r a m c o

N I O C

I N O C

A d n o c

Q a

t a r

P e

t r o

l e u m


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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

CH

RM

GP

EP


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OXFORD INSTITUTE

Current State of IntegrationCurrent State of Integration

-100-80-60-40-20

020406080

100

N i p p o n

M i t s u

b i s h i

S i n o p e c

M a r a

t h o n

E x x o n

M o

b i l

T o

t a l F i n a

E l f

P e

t r o

b r a s

C o n o c o

R e p s o

l - Y P F

Y u

k o s

B P

C h e v r o n

R o y a

l D u

t c h / S h e

l l

P e

t r o

C h i n a

P D V

P e r t a m

i n a

K P C

P e m e x

L u

k o i l

N I O C

N N P C

L i b y a

N O C

S a u

d i A r a m c o

S o n a

t r a c

h

I N O C

A d n o c

Q a

t a r

P e

t r o

l e u m

G a z p r o m


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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!


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OXFORD INSTITUTE

Exploiting the inefficienciesExploiting the inefficiencies

Political issues of access, differing terms, embargosInstitutional OPEC, cartelisationEconomic pricing issues, investment


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OXFORD INSTITUTE

Exploiting the inefficienciesExploiting the inefficiencies

Financial tax, cost of capital, risk mitigation, default risk, marketsOperational local monopolies, supply chains, project skills,

reputation

Technical information transfer, cost of information


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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 50 100 150 200 250

Market Capitalisation ($bn)

F D

C o s

t s 1 9 9 9 - 2

0 0 1 ( $ / b o e

)

Spreading the risk Access to opportunities


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OXFORD INSTITUTE

TaxationTaxation

R 2 = 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

E P

c o n

t r i b u

t i o n

t o n e t

i n c o m e

( % )

Minimising tax

Cross-border offsets


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OXFORD INSTITUTE

Financial MarketsFinancial Markets

Access to equity marketsHigher risk focussed entities

0.0

2.0

4.0

6.0

8.0

10.012.0

14.0

16.0

18.0

2 0 0 3 P r i c e

E a r n

i n g s

US EmergingPipelines Super-major Large EP EP EU RefinersIntegratedMid/Smal Integl rated Integrated


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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)

W e i g

h t e d

A v e r a g e

C o s

t o f C a p

i t a l

Lower cost for larger companiesAccess to capital a barrier


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OXFORD INSTITUTE

Access to Capital Access 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


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OXFORD INSTITUTE

Muddled Thinking in the Gas ChainMuddled Thinking in the Gas ChainDespite losing faith in oil chains, oil companiesare 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


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OXFORD INSTITUTE

Structure ConclusionsStructure ConclusionsCompanies should identify and quantify marketinefficiencies operational and financialCompanies should identify the risks that would

accrue from de-integrationCorporate capabilities are not merely energy-specific: they may comprise financial skills orcustomer franchise


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3/23/2004 FORENERGY STUDIES

OXFORD INSTITUTE

Oil Company CrisisOil Company Crisis

Balancing Structure, ProfitabilityBalancing Structure, Profitability

and Growthand Growth

Dr Robert Arnott7th June 2003


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OXFORD INSTITUTE


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Profitability, Growth and ValueProfitability, Growth and ValueCompanies have concentrated internal andexternal 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 andunderstate the profitability of new ones


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Case Study: Pipeline EconomicsCase Study: Pipeline Economics Year 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 31

Economic ROCE (opening) 13.1% 13.1% 13.1% 13.1% 13.1% 13.1% 13.1%


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OXFORD INSTITUTE

Integrating DCF Analysis withIntegrating DCF Analysis withManagement AccountsManagement Accounts

Investments are originally justified with DCFs, butsubsequent performance is monitored and

presented using conventional accounts

Two alternative approaches are improvements:CFROI and adjusted EVA TMBoth permit investment and performancemeasurement to be related seamlessly


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OXFORD INSTITUTE

Method: Adjusted EVAMethod: Adjusted EVA TMTMAccounting Method Adjusted EVA TM 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 reserve 250

Ann. net investment in reserves (200)Unrealised gains/losses 50

Accounting NOPAT 1,200Unrealised gains/losses 50

Adjusted NOPAT 1,250

Opening Capital Employed 10,000Book value of reserves (4,000)Net Present Value of reserves 8,000

Adjusted Opening Capital Emp. 14,000

Accounting ROCE 12.0% Adjusted ROCE 8.9%


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OXFORD INSTITUTE

Oil Company Historical PerformanceOil Company Historical PerformanceWe have used a modified EVA

TM the main

adjustment being substitution of net present valuefor book upstream values, and the inclusion of net

changes in these to profit

The key finding is that the profitability of theindustry drops from around 12% to around 9%,slightly above its WACC


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OXFORD INSTITUTE

Case Study: Oil CompanyCase Study: Oil CompanyPerformancePerformance

1997 1998 1999 2000 2001 AverageBook return on capital

NOPAT 35,560 18,257 25,900 57,650 43,810 36,236Opening book capital employed including goodwill 248,506 258,487 267,086 351,233 351,538 295,370

Return 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%


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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 isoverestimated then such investment as is madewill be skewed


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Case Study: Royal Dutch/ShellCase Study: Royal Dutch/ShellThe CFROI approach yields very similar results

but the detail of the adjustments make it difficultto aggregate across the sector

The following slide shows calculations made forRoyal Dutch/Shell


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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%


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Profitability ConclusionsProfitability ConclusionsIt is essential to develop an internal managementaccounting system that integrates DCF analysiswith performance measurement

This should be transparent enough for presentationto investorsThe financial technology for this is already welldeveloped

Documents

Oil Presentation3 OilCompanyCrisisBalancingStructureProfitabilityandGrowth RArnott 2003