Challenging the Integrated

Oil and Gas Model

In O&G, do specialist companies create more shareholder value
than integrated companies?
 Authors

Richard Forrest, partner, London

richard.forrest@atkearney.com

Jim Pearce, partner, London

james.pearce@atkearney.com

Tobias Lewe, partner, Dsseldorf

tobias.lewe@atkearney.com

Ingo Schroeter, principal, Dsseldorf

ingo.schroeter@atkearney.com

Joerg Doerler, principal, Moscow

joerg.doerler@atkearney.com

Neal Walters, partner, Toronto

neal.walters@atkearney.com

Vikas Kaushal, partner, New Delhi

vikas.kaushal@atkearney.com

Louis Besland, partner, Middle East

louis.besland@atkearney.com

The report can be downloaded at www.atkearney.com/integratedoilandgas

T
odays oil and gas industry is at a tipping point created by a unique
mix of factors: supplythe scarcity of easy, cheap oil and gas
has spurred a rapid shift to unconventional sources such as oil
sands and shale gas; skyrocketing demand for energy in developing
economies; volatile prices; and multinationalism as in the massive
movement of national oil companies beyond their national borders.
(Page 6 discusses each of these in more detail.) In the face of such
changeand with the strong likelihood of more change aheadwill
the traditional integrated oil and gas company business model hold up?
Or, will it be replaced by new, more innovative models?

In our recent analysis of the oil and gas industry,
we reinterpret the business models that can deliver
better returns on shareholder investment and stake-
holder expectations. As the oil and gas industry
grapples with a new reality, both national oil com-
panies (NOCs) and international oil companies
(IOCs) are being forced to reassess their strategies,
operations and business models, and make difficult
decisions about their future.
Key Drivers for Change
The International Energy Agency projects that
satisfying the worlds energy needs for the next 20
years will require $1 trillion in annual investments.
The question is this: Where should these funds be
invested? The following are some answers.
Discovering new supply sources. The grow-
ing scarcity of easy oil and louder calls for cleaner
energy are driving the shift to gas and unconven-
tional oil. Companies still pursuing conventional
oil are increasingly dependent on technology.
Technology is necessary to improve oil recovery in
maturing fields and more difficult reservoirs; to
make exploration and production profitable and
safe in ultra-deepwater or Arctic conditions; to
monetize remote resources; and to counter the
global impact of increased energy production and
consumption through CO2 capture and storage.
Further, clean-fuels regulations are placing
increased operational constraints on downstream
players, which have to deliver cleaner products
from heavier crudes. Supplies of crude are con-
stantly subject to interruptions due to natural
disasters, geopolitical disruptions and accidents.
Downstream and upstream, technologyespe-
cially in the form of new catalysts and new pro-
cessesis the key enabler.
The strong downstream margins enjoyed
from 2000 to 2008 became a thing of the past
in the global recession, from which many pro-
ducers are still struggling to recover. Meanwhile,
Chinas rapid growth in chemicals production

Challenging the Integrated Oil and Gas Model | A.T. Kearney 1

 Figure 1 construction, thus adding 340,000 bbl/day of
Global oil and gas demand continues to grow capacity in 2011 alone. Only the fittest compa-
nies will be in a position to compete with that
kind of production.
Oil equivalent Gas
(tons, millions) Oil
Matching increasing demand. By 2035,
9,000 global demand for energy is expected to be about
8,000 one-third higher than it is today. Even given
7,000 strong growth in renewables, about three-quarters
6,000
of the increased demand is likely to be filled by
5,000
fossil-fuel sources,1 so it is clear that oil and gas
4,000
3,000
demand will continue to grow (see figure 1).
2,000 The issue will not be simply about matching
1,000 increasing demand, but also about matching that
0 demand where and when it happensno easy
2008 2015 2020 2030
Note: Figures for 2015, 2020 and 2030 are estimates.
task from the current starting point (see figure 2).
Source: International Energy Agency World Energy Outlook 2010 For example, downstream markets are experienc-
ing stronger demand as the recession recedes, but
meeting that demand is challenging. Western
may further skew the global market: Its crude-oil markets have seen little addition to greenfield
processing capacity rose from less than 4.5 mil- refining capacity. By 2015, spare capacity will be
lion barrels a day in 2000 to more than 8 million used to fuel additional demand, which will result
barrels a day by 2010. The country currently in decreasing spare capacity (see figure 3).
has several million-barrel capacity facilities in Moreover, structural imbalances exist in product

Figure 2
Incremental energy demand will vary by sector and region

OE
OECD member countries
Power generation Ch
China
Other non-OECD
Ot
Other energy sector Inter-regional (bunkers)
In

Industry
consumption

Transport
Final

Buildings

Other sectors*
Mtoe
-500 0 500 1,000 1,500 2,000 2,500

Note: *Includes agriculture and non-energy use; OECD is Organization for Economic Cooperation and Development
Source: International Energy Agency World Energy Outlook 2010
1
World Energy Outlook 2010, IEA, pp 77-78.

2 Challenging the Integrated Oil and Gas Model | A.T. Kearney

Figure 3
Spare refining capacity will fall as demand rebounds
MBD
10
9
8 Quarterly
7
6
5
4
3
2
1
0
1996
1998
2000
2002
2004
2006
1Q2008
3Q2008
Note: MBD is millions of barrels per day.
demands, such as automotive diesel oil (ADO)
versus mobility gasoline (MoGas). Essentially,
many assets either are not configured for current
needs or simply are in the wrong place.
Making the right plays in the ownership
landscape. The role of NOCs is going through
a transformation of its own. Once holders of
major resources in their own countriespartner-
ing with independent oil companies that provide
capital, equipment and expertise to bring those
resources to marketmany NOCs are now posi-
tioned as financially and technologically equipped
partners in ventures around the world, both
upstream and downstream.
In another sort of change with competi-
tive implications, more utilities are backward-
integrating. An example of this trend is Centricas
purchase of Venture in the North Sea (as part of
a strategy to prevent exposure in the middle of
the value chain with volatile gas prices upstream
of them and regulated pricing downstream).
Adapting at speed. In the face of such wide-
Challenging the Integrated Oil and Gas Model
Going forward (2011-2015), spare capacity
will be used to fuel additional demand and
thereby result in decreasing spare capacity.
1Q2009
3Q2009
1Q2010
3Q2010
2011
2013
2015
Source: International Energy Agency, Credit Suisse estimates
spread and multifaceted game changing issues,
it is evident that the oil and gas value chain is chang-
ing. Figure 4 on page 4 illustrates how. Within this
context, it is vital to keep in mind two facts of life:
Some things are immutable in the oil and gas
sector: The interplay between capacity, substi-
tution and demand continues; cyclical risks are
not going away; and astute companies will con-
tinue earning superior returns over the cycle,
through excellent business management and
investment in distinct assets.
Speedy response to change is paramount, but
that response cannot be superficial. The oil and
gas sector will never be as it once was, so busi-
ness as usual is not an option.
Our recent analysis helped us formulate urgent
questions that must be addressed, priorities that
will underpin the most successful companies and
what those priorities imply for future oil and gas
business models, particularly the optimal level of
integrated versus specialist company. The follow-
ing sections discuss these in more detail.
| A.T. Kearney 3
 Figure 4
The oil and gas value chain is changing at an unprecedented speed

Resources Upstream Downstream Demand

Game Role of gas in the Development of tech- Alternative sources Emerging market demand
changers energy mix nology (deep water, such as biofuel Powertrain shift
oil shales)
Unconventional Misplaced refining CO2 abatement targets
energy sources Ownership and capacity and alternative energies
participation
The end of oil and Role changes for
(joint ventures) The price of energy
gas dominance IOCs and NOCs
Role changes for
independent and
national oil companies
(IOCs versus NOCs) Source: A.T. Kearney analysis

Creating Shareholder Value: EBITDA, both pure upstream players and pure
Time to Rethink Conventional Wisdom? downstream players achieved nearly 50 percent
The following questions are for oil and gas exec- higher outcomes than integrated players (see figure
utives who want to increase their companies 5). It seems the market does not fully recognize
shareholder value both now and into the future: incremental value from synergies in integrated
What is the best value chain participation model players, and this in turn implies that integrated
for your business? What modus operandi for
IOC-NOC ventures will create the most value?
How can you achieve a better risk-reward bal- Figure 5
Pure players achieve greater value than
ance? With which energy sources should your
integrated players
business engage?
We believe it is time to challenge the conven-
tional industry wisdom that integrated is best. EV/EBITDA ratio
(2000-2009) 9.5 9.4
Our analysis of the top 20 integrated players (by
market capitalization) pure exploration and
production (E&P) players, and pure refining and 6.6

marketing (R&M) playersleads to the conclu-

sion that specialist companies have the potential
to create more shareholder value than integrated
companies.
Our analysis looked at three aspects of com-
pany performance: enterprise value and earnings Integrated Upstream Downstream
before interest, taxes, depreciation and amortisa- players pure players pure players

tion (EV/EBITDA), the risk-return balance, and Note: EV/EBITDA is the ratio between enterprise value and earnings before
interest, taxes, depreciation and amortization.
reserves replacement. On the basis of average EV/ Source: A.T. Kearney analysis

4 Challenging the Integrated Oil and Gas Model | A.T. Kearney

companies could release value to their sharehold-
ers by spinning off those upstream and down-
stream activities with limited integration value.
Indeed, many IOCs are already divesting non-
strategic downstream assets.
In the market view of risk-return, we looked
at the share price average risk-return by segment
(integrated, pure upstream and pure down-
stream) and by player. The by-segment analysis
indicates that the market values the integrated
business model as less risky than the upstream
or downstream models. On a pure risk-return
basis, however, the shares of upstream players
have enjoyed the highest return of the three
segments. Downstream players appear to shoulder
the most risk.
But when we looked at the companies
reserves-replacement ratioa vital indicator of
future valueit was clear that pure upstream
players were more successful than their integrated
counterparts (see figure 6).
Figure 6
In reserves replacement, upstream pure players
are more successful than integrated companies
Average yearly reserves
replacement ratio 210%
(2000-2009)
123%
Not
applicable
Integrated Upstream Downstream
players pure players pure players
Source: A.T. Kearney analysis
Challenging the Integrated Oil and Gas Model
Big Oil Priorities for the Future
Given the changes taking place within and outside
the industry, and based on our market analysis
and decades of experience in the sector, we believe
oil and gas companiesparticularly large inte-
grated companiesmust reassess their priorities.
The NOCs should gauge the appropriate level
of integration in their overseas expansions to ensure
all integrated assets are strategic. The following
four issues should be considered top priorities
especially relevant to the future of global energy.
Increased role of specialization in the
value chain. We expect to see more disaggrega-
tion of the value chain in the years ahead. Every
step in the chain, and every region, will not be
equally attractive. Regionally different growth
dynamics also will demand different operating
models. In this highly competitive industry, com-
panies will need to play to their strengths like
never before.
Competitive advantage will come from tech-
nology specialization and leadership, leveraging
scale, better management of financial risk, and
increasing access to the global talent pool and
other resources.
In the upstream, success is likely to come
from focusing on innovation in difficult raw-
materials exploration. In the downstream, compa-
nies that focus on regions rather than countries
will create more value, and here the need for oper-
ational excellence will be ever greater. Operational
excellence is also a major factor in avoiding cata-
strophic incidents, which can account for half of
refinery operational losses. Upstream and down-
stream integration will continue to pay off, but
not as a global philosophy. Integration will pay
off only when it is applied after a thoughtful
review of opportunities.
New face of NOC-IOC relationships. The
nature of the NOC-IOC relationship may be
| A.T. Kearney 5
 Whats Causing the Oil and Gas Tipping Point?
A unique mix of factors has pushed
the oil and gas industry to a tipping
point that is forcing companies to
rethink their business models.
Supply. In 2000, shale gas
accounted for 1 percent of U.S.
energy supply. By 2010, its share
of supply had reached 20 percent
and may well climb to 50 percent
by 2035.2 Experts estimate that
unconventional sources of oil
extra heavy oil, oil sands and oil
shalewill add 8.6 trillion barrels
to world resources.3 In terms of
proven reserves, the Canadian oil
sands alone account for almost
10 percent of the world total.4
Production of conventional sources
is shifting to more remote, challeng-
ing and expensive deepwater and
sub-Arctic locations, as well as
focusing on advanced technolo-
gies for improving recovery in
maturing fields.
Demand. China consumes more
than 10 percent of the worlds oil
and is expected to account for more
than one-third of the 1.32 million
barrels per day increase in oil demand
in 2011.5 Meanwhile, with more
governments and consumers seeking
a less carbon-intense energy mix, the
renewable share of global electricity
generation is likely to increase
faster3 percent a yearthan any nomic crisis took hold. Today it is
other source rising from 18 percent
in 2007 to 23 percent in 2035.6
Biofuels consumption is also on
the rise, spurred on by government
incentives and rising oil prices: By
2035, world consumption of bio-
fuels could exceed 8 million barrels
a dayseven times todays usage
level.7
Prices. Demand, supply, geo-
political instabilities (most recently
in North Africa and the Middle East)
and heightened environmental and
safety risk premiums (especially fol-
lowing the Macondo disaster in 2009)
have all contributed to price volatility.
The Brent price of crude oil, which
was a bit less than $20 a barrel in late
2001, peaked at $136 in July 2008
and then fell to less than half that
seven months later as the global eco-
edging back above $120.
Multinationalism. Many national
oil companies (NOCs) have trans-
formed their global role from local
major resource holder to multinational
player. The interests, influence and
exposure of NOCs outside their own
countries have increased dramatically
over the past 15 years (see figure).

Figure: National oil companies have increased their foreign holdings

Number of countries with acreage holdings 1995
25 24 2005
21
20
15 14 15
15
12 11
10
7 7
5 4
5 3 3
1 2 1 2 1
0
CNPC Sinopec CNOOC PetroChina Petronas ONGC KNOC Pertamina Petrobras
(China) (China) (China) (China) (Malaysia) (India) (So. Korea) (Indonesia) (Brazil)
Source: A.T. Kearney analysis

2
Fueling North Americas Energy Future, An IHS CERA Special Report, 2010
3
http://www.etsap.org/E-techDS/PDF/P02-Uncon%20oil&gas-GS-gct.pdf
4
BP Statistical Review of World Energy, 2010
5
www.upstreamonline.com/live/article241904.ece
6
http://www.eia.doe.gov/oiaf/ieo/world.html
7
World Energy Outlook 2010, IEA, Paris, 2010, p 358

6 Challenging the Integrated Oil and Gas Model | A.T. Kearney

changing, but neither side can be complacent for
both face the threats and opportunities that increas-
ing globalization poses to their businesses. Ten
years ago, who would have predicted so many
Chinese or Indian NOCs entering partnerships
with local and global organizations to develop
African and South American oil? Who would have
thought that Brazilian NOC Petrobras would be
sharing its deepwater expertise in so many coun-
tries across the Americas, Africa, Asia and Oceania?
Or that a giant like ExxonMobil would be rejected
as an upstream partner in Ghana in favor of a niche
company such as Tullow.
The right upstream partnerships will extend
the life of reserves, enable national governments
to better prepare for the post-oil era, and ensure
affordable energy prices for net oil-consuming
countries. For IOCs, this means increased compe-
tition for resources. The results are likely to include
forced restructuring of upstream operations into
leaner, less complex entities with a culture of inno-
vation, and finding partners in more difficult and
unconventional oil with the technological
strengths to optimize recovery in mature fields.
In this reshaping, upstream operations can
benefit from the experiences of downstream col-
leagues, already leaner after years of operating
under margin pressures. In the downstream, the
main value driver contributing to the attractive-
ness of an individual refinery asset will continue to
be location and operational excellence. The cost of
inbound and outbound logistics, and competitive
intensity, help to quantify that attractiveness.
Thus, a prime location is one that offers access to
the sea and to retail channels in rapidly growing
markets. Small wonder, then, that some of the
majors have already announced plans to reduce
their retail presence in Europe and Africa while
expanding in Asia, where Chinas vehicle fleet is
8
World Energy Outlook 2010, IEA, p 107.
Challenging the Integrated Oil and Gas Model
predicted to overtake that of the United States
by 2030.8
Examples of recent activity include Shells
increased cooperation with Gazprom in the
Russian and European oil-products business, and
negotiations with China National Offshore Oil
Corporation about participation in the second
phase of CNOOCs Huizhou refineryall of this
while selling or closing refineries in Germany,
Sweden and Finland. In mature markets, refining
and retail opportunities are being separated, as
illustrated by BP and Conoco Phillips signifi-
cantly reducing their involvement in retail and
refining operations in the United States.
Risk management. The risk profile of the oil
and gas sector is on an upward trajectory.
Integrated players are exposed in both upstream
and downstream operations to rising environ-
mental and financial concerns. The causes are
legion: the financial, environmental and safety
implications of working in more challenging
locations and with harder-to-extract, harder-to-
process resources; increased government and
societal expectations about cleaner operations
and cleaner products; competition from substi-
tute products; and, in many regions, underlying
geopolitical and fiscal instability. Meanwhile, a
growing trend exists for contractors to push risk
back onto operators.
There is no template for value chain partici-
pation that fits every company. Each must deter-
mine its desired risk profile and create alignment
between that profile and the companys participa-
tion model. Understanding and managing risk
largely through controlling complexity and
improving sustainabilitywill separate the lead-
ers from the followers in the volatile years to come.
An example is ExxonMobil, which has created an
operational integrity management system (OIMS)
| A.T. Kearney 7
 to respond to the issues of reliability and integrity
management.
Alternative energy sources. As demand for
alternative energy continues to grow among con-
sumers and governments, major players are under
pressure not only to rethink their locations but
also to establish their vision of beyond oil.
Some companies that had begun to include alter-
native energy in their portfolios have since
changed direction due to economics and other
factors. Take, for example, Shells move away
from solar energy in 2006, when it closed its
crystalline silicon production sites and sales and
marketing operations. Investors, meanwhile, are
pondering whether it is wiser to invest in more
difficult (and expensive) oil, or in alternative ener-
gies that are currently subsidized. IOCs are also
under intense scrutiny from their stakeholders
private individuals, shareholders, governments,
financial institutions and non-governmental
organizationsthat want a credible, feasible
alternative energy.
Here, understanding the primary motivators
is crucial. Those who scrutinize such areas are far
too sophisticated to tolerate corporate window
dressinga mere nod to alternative energy but
no strategy or finances to pursue it. What is
needed is an alternative-energy vision that makes
economic, environmental and societal sense and
which, ideally, maximizes the potential for skills
transfer, such as a company with extensive plat-
form expertise getting into offshore-wind energy.
Emerging Business Models
In our work with oil and gas companies, we have
identified a number of business models that have
8 Challenging the Integrated Oil and Gas Model
viability for the future. Each model requires spe-
cific capabilities to compete successfully. The
most interesting include:
Operations specialists. Specialists enter up-
stream, where development and lifting costs are
minimized, and where the most flexible, efficient
and reliably run refineries will prosper; capital
project excellence is a key capability in both
exploration and production refining.
Landowners. These NOCs or host govern-
ments own oil and gas resources and are able to
choose their partners from the best in the business.
Passengers. Passengers engage in multiple
joint ventures, not seeking operator status but pro-
viding funding and benefiting both from the rela-
tionships established and the returns on investment.
Prospectors. These niche explorers are agile,
using relationships and exploration skills to
acquire and prove reserves in new basins.
We all recognize these models in our busi-
nesses. More often than not, more than one is
applied, particularly in an IOC.
Preparing for the Game Changers
After the bumpy ride of the past few years and at a
tipping point today, players in the oil and gas sector
must take another look at the assumptions and
business models they have been working withand
at whether or not they are truly prepared for what
the future holds. We believe the future includes an
energy landscape where numerous game chang-
ers will occur across the value chain at an unprec-
edented speed. Industry leaders must take bold
steps if they are to adapt fast enough to build the
deep, specialized capabilities required to compete
in whatever models they choose to apply.
| A.T. Kearney
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