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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, Technology is necessary to improve oil recovery in
we reinterpret the business models that can deliver maturing fields and more difficult reservoirs; to
better returns on shareholder investment and stake- make exploration and production profitable and
holder expectations. As the oil and gas industry safe in ultra-deepwater or Arctic conditions; to
grapples with a new reality, both national oil com- monetize remote resources; and to counter the
panies (NOCs) and international oil companies global impact of increased energy production and
(IOCs) are being forced to reassess their strategies, consumption through CO2 capture and storage.
operations and business models, and make difficult Further, clean-fuels regulations are placing
decisions about their future. increased operational constraints on downstream
players, which have to deliver cleaner products
Key Drivers for Change from heavier crudes. Supplies of crude are con-
The International Energy Agency projects that stantly subject to interruptions due to natural
satisfying the worlds energy needs for the next 20 disasters, geopolitical disruptions and accidents.
years will require $1 trillion in annual investments. Downstream and upstream, technologyespe-
The question is this: Where should these funds be cially in the form of new catalysts and new pro-
invested? The following are some answers. cessesis the key enabler.
Discovering new supply sources. The grow- The strong downstream margins enjoyed
ing scarcity of easy oil and louder calls for cleaner from 2000 to 2008 became a thing of the past
energy are driving the shift to gas and unconven- in the global recession, from which many pro-
tional oil. Companies still pursuing conventional ducers are still struggling to recover. Meanwhile,
oil are increasingly dependent on technology. 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 Going forward (2011-2015), spare capacity


will be used to fuel additional demand and
10
thereby result in decreasing spare capacity.
9
8 Quarterly
7
6
5
4
3
2
1
0
1996

1998

2000

2002

2004

2006

1Q2008

3Q2008

1Q2009

3Q2009

1Q2010

3Q2010

2011

2013

2015
Note: MBD is millions of barrels per day. Source: International Energy Agency, Credit Suisse estimates

demands, such as automotive diesel oil (ADO) spread and multifaceted game changing issues,
versus mobility gasoline (MoGas). Essentially, it is evident that the oil and gas value chain is chang-
many assets either are not configured for current ing. Figure 4 on page 4 illustrates how. Within this
needs or simply are in the wrong place. context, it is vital to keep in mind two facts of life:
Making the right plays in the ownership Some things are immutable in the oil and gas
landscape. The role of NOCs is going through sector: The interplay between capacity, substi-
a transformation of its own. Once holders of tution and demand continues; cyclical risks are
major resources in their own countriespartner- not going away; and astute companies will con-
ing with independent oil companies that provide tinue earning superior returns over the cycle,
capital, equipment and expertise to bring those through excellent business management and
resources to marketmany NOCs are now posi- investment in distinct assets.
tioned as financially and technologically equipped Speedy response to change is paramount, but
partners in ventures around the world, both that response cannot be superficial. The oil and
upstream and downstream. gas sector will never be as it once was, so busi-
In another sort of change with competi- ness as usual is not an option.
tive implications, more utilities are backward- Our recent analysis helped us formulate urgent
integrating. An example of this trend is Centricas questions that must be addressed, priorities that
purchase of Venture in the North Sea (as part of will underpin the most successful companies and
a strategy to prevent exposure in the middle of what those priorities imply for future oil and gas
the value chain with volatile gas prices upstream business models, particularly the optimal level of
of them and regulated pricing downstream). integrated versus specialist company. The follow-
Adapting at speed. In the face of such wide- ing sections discuss these in more detail.

Challenging the Integrated Oil and Gas Model | 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- Big Oil Priorities for the Future
ers by spinning off those upstream and down- Given the changes taking place within and outside
stream activities with limited integration value. the industry, and based on our market analysis
Indeed, many IOCs are already divesting non- and decades of experience in the sector, we believe
strategic downstream assets. oil and gas companiesparticularly large inte-
In the market view of risk-return, we looked grated companiesmust reassess their priorities.
at the share price average risk-return by segment The NOCs should gauge the appropriate level
(integrated, pure upstream and pure down- of integration in their overseas expansions to ensure
stream) and by player. The by-segment analysis all integrated assets are strategic. The following
indicates that the market values the integrated four issues should be considered top priorities
business model as less risky than the upstream especially relevant to the future of global energy.
or downstream models. On a pure risk-return Increased role of specialization in the
basis, however, the shares of upstream players value chain. We expect to see more disaggrega-
have enjoyed the highest return of the three tion of the value chain in the years ahead. Every
segments. Downstream players appear to shoulder step in the chain, and every region, will not be
the most risk. equally attractive. Regionally different growth
But when we looked at the companies dynamics also will demand different operating
reserves-replacement ratioa vital indicator of models. In this highly competitive industry, com-
future valueit was clear that pure upstream panies will need to play to their strengths like
players were more successful than their integrated never before.
counterparts (see figure 6). Competitive advantage will come from tech-
nology specialization and leadership, leveraging
scale, better management of financial risk, and
Figure 6 increasing access to the global talent pool and
In reserves replacement, upstream pure players
other resources.
are more successful than integrated companies
In the upstream, success is likely to come
from focusing on innovation in difficult raw-
Average yearly reserves materials exploration. In the downstream, compa-
replacement ratio 210% nies that focus on regions rather than countries
(2000-2009)
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-
123%
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
Not
applicable off only when it is applied after a thoughtful
Integrated Upstream Downstream review of opportunities.
players pure players pure players New face of NOC-IOC relationships. The
Source: A.T. Kearney analysis nature of the NOC-IOC relationship may be

Challenging the Integrated Oil and Gas Model | A.T. Kearney 5


Whats Causing the Oil and Gas Tipping Point?
A unique mix of factors has pushed gies for improving recovery in Prices. Demand, supply, geo-
the oil and gas industry to a tipping maturing fields. political instabilities (most recently
point that is forcing companies to Demand. China consumes more in North Africa and the Middle East)
rethink their business models. than 10 percent of the worlds oil and heightened environmental and
Supply. In 2000, shale gas and is expected to account for more safety risk premiums (especially fol-
accounted for 1 percent of U.S. than one-third of the 1.32 million lowing the Macondo disaster in 2009)
energy supply. By 2010, its share barrels per day increase in oil demand have all contributed to price volatility.
of supply had reached 20 percent in 2011.5 Meanwhile, with more The Brent price of crude oil, which
and may well climb to 50 percent governments and consumers seeking was a bit less than $20 a barrel in late
by 2035.2 Experts estimate that a less carbon-intense energy mix, the 2001, peaked at $136 in July 2008
unconventional sources of oil renewable share of global electricity and then fell to less than half that
extra heavy oil, oil sands and oil generation is likely to increase seven months later as the global eco-
shalewill add 8.6 trillion barrels faster3 percent a yearthan any nomic crisis took hold. Today it is
to world resources.3 In terms of other source rising from 18 percent edging back above $120.
proven reserves, the Canadian oil in 2007 to 23 percent in 2035.6 Multinationalism. Many national
sands alone account for almost Biofuels consumption is also on oil companies (NOCs) have trans-
10 percent of the world total.4 the rise, spurred on by government formed their global role from local
Production of conventional sources incentives and rising oil prices: By major resource holder to multinational
is shifting to more remote, challeng- 2035, world consumption of bio- player. The interests, influence and
ing and expensive deepwater and fuels could exceed 8 million barrels exposure of NOCs outside their own
sub-Arctic locations, as well as a dayseven times todays usage countries have increased dramatically
focusing on advanced technolo- level.7 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 predicted to overtake that of the United States
both face the threats and opportunities that increas- by 2030.8
ing globalization poses to their businesses. Ten Examples of recent activity include Shells
years ago, who would have predicted so many increased cooperation with Gazprom in the
Chinese or Indian NOCs entering partnerships Russian and European oil-products business, and
with local and global organizations to develop negotiations with China National Offshore Oil
African and South American oil? Who would have Corporation about participation in the second
thought that Brazilian NOC Petrobras would be phase of CNOOCs Huizhou refineryall of this
sharing its deepwater expertise in so many coun- while selling or closing refineries in Germany,
tries across the Americas, Africa, Asia and Oceania? Sweden and Finland. In mature markets, refining
Or that a giant like ExxonMobil would be rejected and retail opportunities are being separated, as
as an upstream partner in Ghana in favor of a niche illustrated by BP and Conoco Phillips signifi-
company such as Tullow. cantly reducing their involvement in retail and
The right upstream partnerships will extend refining operations in the United States.
the life of reserves, enable national governments Risk management. The risk profile of the oil
to better prepare for the post-oil era, and ensure and gas sector is on an upward trajectory.
affordable energy prices for net oil-consuming Integrated players are exposed in both upstream
countries. For IOCs, this means increased compe- and downstream operations to rising environ-
tition for resources. The results are likely to include mental and financial concerns. The causes are
forced restructuring of upstream operations into legion: the financial, environmental and safety
leaner, less complex entities with a culture of inno- implications of working in more challenging
vation, and finding partners in more difficult and locations and with harder-to-extract, harder-to-
unconventional oil with the technological process resources; increased government and
strengths to optimize recovery in mature fields. societal expectations about cleaner operations
In this reshaping, upstream operations can and cleaner products; competition from substi-
benefit from the experiences of downstream col- tute products; and, in many regions, underlying
leagues, already leaner after years of operating geopolitical and fiscal instability. Meanwhile, a
under margin pressures. In the downstream, the growing trend exists for contractors to push risk
main value driver contributing to the attractive- back onto operators.
ness of an individual refinery asset will continue to There is no template for value chain partici-
be location and operational excellence. The cost of pation that fits every company. Each must deter-
inbound and outbound logistics, and competitive mine its desired risk profile and create alignment
intensity, help to quantify that attractiveness. between that profile and the companys participa-
Thus, a prime location is one that offers access to tion model. Understanding and managing risk
the sea and to retail channels in rapidly growing largely through controlling complexity and
markets. Small wonder, then, that some of the improving sustainabilitywill separate the lead-
majors have already announced plans to reduce ers from the followers in the volatile years to come.
their retail presence in Europe and Africa while An example is ExxonMobil, which has created an
expanding in Asia, where Chinas vehicle fleet is operational integrity management system (OIMS)
8
World Energy Outlook 2010, IEA, p 107.

Challenging the Integrated Oil and Gas Model | A.T. Kearney 7


to respond to the issues of reliability and integrity viability for the future. Each model requires spe-
management. cific capabilities to compete successfully. The
Alternative energy sources. As demand for most interesting include:
alternative energy continues to grow among con- Operations specialists. Specialists enter up-
sumers and governments, major players are under stream, where development and lifting costs are
pressure not only to rethink their locations but minimized, and where the most flexible, efficient
also to establish their vision of beyond oil. and reliably run refineries will prosper; capital
Some companies that had begun to include alter- project excellence is a key capability in both
native energy in their portfolios have since exploration and production refining.
changed direction due to economics and other Landowners. These NOCs or host govern-
factors. Take, for example, Shells move away ments own oil and gas resources and are able to
from solar energy in 2006, when it closed its choose their partners from the best in the business.
crystalline silicon production sites and sales and Passengers. Passengers engage in multiple
marketing operations. Investors, meanwhile, are joint ventures, not seeking operator status but pro-
pondering whether it is wiser to invest in more viding funding and benefiting both from the rela-
difficult (and expensive) oil, or in alternative ener- tionships established and the returns on investment.
gies that are currently subsidized. IOCs are also Prospectors. These niche explorers are agile,
under intense scrutiny from their stakeholders using relationships and exploration skills to
private individuals, shareholders, governments, acquire and prove reserves in new basins.
financial institutions and non-governmental We all recognize these models in our busi-
organizationsthat want a credible, feasible nesses. More often than not, more than one is
alternative energy. applied, particularly in an IOC.
Here, understanding the primary motivators
is crucial. Those who scrutinize such areas are far Preparing for the Game Changers
too sophisticated to tolerate corporate window After the bumpy ride of the past few years and at a
dressinga mere nod to alternative energy but tipping point today, players in the oil and gas sector
no strategy or finances to pursue it. What is must take another look at the assumptions and
needed is an alternative-energy vision that makes business models they have been working withand
economic, environmental and societal sense and at whether or not they are truly prepared for what
which, ideally, maximizes the potential for skills the future holds. We believe the future includes an
transfer, such as a company with extensive plat- energy landscape where numerous game chang-
form expertise getting into offshore-wind energy. ers will occur across the value chain at an unprec-
edented speed. Industry leaders must take bold
Emerging Business Models steps if they are to adapt fast enough to build the
In our work with oil and gas companies, we have deep, specialized capabilities required to compete
identified a number of business models that have in whatever models they choose to apply.

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


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