NEWS Petro-Canada emerging as a model of state oil company privatization

Governments shopping for a privatization model for a national oil company could do worse than take a hard look at Canadas state owned Petro-Canada.

Ottawa completed a public share offering of a 50% interest in the Calgary company last September. The sale, along with smaller share sales in 1991 and 1992, placed 80% of the company in the hands of Canadian and foreign investors. The federal government will keep its remaining 20% stake for 3 years but could sell earlier if market conditions are right.

Last Septembers massive offering of 118 million common shares, worth a net $1.725 billion (Canadian) to Ottawa, was such a success with institutional investors that Ottawa had to take steps to ensure that small investors got some of the issue.

Underwriters for the issue reported they could have sold seven times as much stock to investors in the U.S. and twice as much to Canadian buyers. About 76% of the issue was sold in Canada, 20% in the U.S., and 4% elsewhere.

Company beginnings

The new interest in the investment community is based on the successful turnaround of a state company that was debt-heavy and inefficient only 4 years ago and unloved and resented within the domestic petroleum industry in its first decade of its life.

Company management at the time said they were required to follow a government mandate that included evolution into an integrated company and spending on frontier development.

Petro-Canada, established in 1975, began operations in 1976. Federal legislation set it up as Ottawas window on the industry and the instrument of a nationalistic energy policy spelled out in a National Energy Program (NEP).

The company was given an unearned 25% back-in right on federal acreage, including arctic and offshore frontier tracts. The right was widely resented by the industry and seen by some as expropriation.

Ottawa helped bankroll its rapid growth as an integrated company with a number of large takeovers in the late 1970s and 1980s, including Atlantic Richfield Canada Ltd., Pacific Petroleums Ltd., Petrofina Canada Ltd., and the downstream assets of BP Canada Ltd. The BP purchase in 1985 was the state companys last major acquisition.

Petro-Canadas mandate began to change in late 1984, when a federal Conservative government with a free enterprise mindset came to power. The company still obtained its funding from Ottawa but was told to begin a transition toward becoming a private sector operation. The last remaining elements of the former NEP were scrapped several years ago.

That change has accelerated rapidly in the past 4 years as a result of a major downsizing and restructuring program across all the companys operations.

A new beginning

Petro-Canada is now a largely privatized integrated operation with a game plan targeted for growth.

Investors have responded to a strong bottom line track record the past 2 years and to positive assessments for its future from the investment industry.

Robert Robinson, an analyst with a national brokerage firm, ScotiaMcLeod Ltd., recently said Petro-Canada has the strongest growth potential of Canadas integrated companies for the next 3-5 years. His opinion was based on projected upstream growth and continued development and reengineering of downstream business opportunities.

Most other analysts have issued positive reports on the companys prospects.

Robinson said two key issues that caused concern for investors considering Petro-Canada have eased considerably. One was the continuing large holding in the company by Ottawa prior to the September share sale. The other was the risk of the Hibernia oil field development project off Newfoundland in which the company holds a 25% interest.

The analyst said the main risks surrounding Hibernia have passed with launch of the projects gravity base structure and delivery of all topside modules for the platform. The remaining risk is the 200 mile tow-out of the giant production base to Hibernia field. Thats scheduled in 1997.

Downstream success

The ScotiaMcLeod analyst also was impressed by the companys downstream performance, including greater efficiency, reduced costs, and refinery utilization now at about 97%.

These strong results demonstrate the turnaround impact of earlier downstream rationalization and strategic initiatives, Robinson said.

Key strategic initiatives have been the reconfiguration and reduction of refining capacity, integration of the wholesale and distribution businesses, rationalization of 40% of wholesale and over 35% of retail operations since 1991, and numerous consumer targeted marketing initiatives.

Robinson said Petro-Canada has tackled four critical problems faced by the downstream industry: Overcapacity in refining and marketing, too much capital employed in the business, a need for greater efficiencies, and a requirement for growth opportunities and niche marketing.

Robinson noted the companys downsizing has resulted in half the maintenance capital and $1 billion less capital employed in its downstream operation.

Financial problems

Petro-Canada hit a low point in 1991 with a loss of $603 million and accumulated debt that topped $2 billion.

Shareholders in May 1992 at the companys first annual meeting after going public in 1991 demanded changes and improved performance.

Wilbert (Bill) Hopper, the companys chief executive officer since its inception, left the company in January 1993. Prior to his departure, Hopper made the first moves in a company-wide rationalization program. The changes were continued and accelerated by Pres. Jim Stanford, who succeeded Hopper as CEO.

The company recorded a profit of $9 million in 1992 after slashing operating costs by $306 million and debt by $695 million. Profits rose to $160 million in 1993 and $262 million in 1994. Cash flow more than doubled to $701 million during 1991-94 as restructuring continued. But the 1994 profit represented a return of only 6% on capital employed. The target is to increase that to 10.5% or more.

The companys debt to cash flow ratio has fallen significantly, and the company has adopted and will continue a policy of aligning capital spending with cash flow. The debt to cash flow ratio has remained below 2:1 since 1992.

All operations are now judged on a value based approach by management. To receive funding, all business units and new projects must show they will create value. The general rule of thumb is that rates of return must exceed the companys cost of capital.

Continuing restructuring

Despite stronger performance, Petro-Canada said earlier this year it must cut as many as 700 more jobs during the next 12-18 months.

The reorganization will cost $52 million but save more than $40 million/year. The staff cuts will include reductions at its ICG Propane Inc. unit, which had a payroll of about 1,050 at the first of 1995.

Petro-Canadas reorganization gives it two operating sectors supported by a shared services unit. The upstream division operates as Petro-Canada Resources and the downstream business as Petro-Canada Products.

The upstream sector is divided into four strategic business units: western Canada oil, natural gas, natural gas liquids, and frontier/international. The downstream sector is split into western, central, and eastern regions and a lubricants unit.

Stanford said Petro-Canadas business plan is geared for profitability in each of its businesses, and compensation for senior executives is now tied directly to the companys financial and share price performance.

A top objective of the reorganization since 1992 has been to make the company more efficient and profitable in preparation for a share sale and privatization Ottawa had planned for some time. The companys largest share issue remained on hold until this fall, while the economy recovered from a recession and market prospects improved.

Throughout the company, more than $300 million/year in operating costs was cut by a combination of asset sales, rationalization of operations, and staff cuts of more than 30% in the parent company and its units.

Shaving more than $1 billion from long term debt since 1990 cut Petro-Canadas annual interest costs by two-thirds. Its return on capital employed rose from -8.2% at yearend 1991 to 6.7% at yearend 1994.

Asset sales

Sale of noncore upstream assets in western Canada netted about $350 million. Sales included a 37% interest in Westcoast Energy Ltd., interest in the Wolf Lake heavy oil project in Alberta, and TroCana Resources Ltd., a unit set up to hold Petro-Canadas noncore upstream assets. TroCana produced about 6,700 b/d of oil and 36 MMcfd of gas in 1993 prior to its sale.

Petro-Canada earlier sold 5 percentage points of its 17% interest in the Syncrude Canada Ltd. oilsands group to Mitsubishi Corp. The $132.5 million sale included a provision that Petro-Canada could receive as much as an additional $50 million within 10 years if cash flow exceeds a set level.

The company sees Syncrude as a significant cash generator but not a major growth area for its business. It would consider selling 7% of its remaining 12% interest if the right deal came along.

Oilsands operations in Alberta are expected to expand as a result of recent improvements in the royalty structure and anticipated improvements in 1996 to federal tax treatment (OGJ, Dec. 18, p. 30).

Petro-Canadas share of production at Syncrude in 1994 was 22,900 b/d. The companys reserves share increased by 65 million bbl as a result of an extension of Syncrudes operating permit to 2025.

Upstream improvement

A steady improvement in upstream operations has put Petro-Canada consistently among the top five Canadian oil and gas producers.

The company increased its upstream earnings to $77 million in first half 1995 from $70 million in first half 1994. Increased crude oil production and prices offset low natural gas prices. Leases located mainly in Alberta and British Columbia are producing an average 78,000 b/d of liquids and 547 MMcfd of gas.

The company participated in drilling 323 gross and 193 net wells in 1994 with a result of 129 gross (90 net) oil and 160 gross (89 net) gas wells. Horizontal drilling was used increasingly and added significantly to gas and liquids reserves.

Proved reserves booked at yearend 1994 were 411 million bbl of crude oil and natural gas liquids, including 260 million bbl of synthetic crude. Natural gas reserves at yearend 1994 stood at 2.1 tcf. Reserves figures do not include proved but unconnected reserves held by the company in frontiers such as the East Coast offshore.

At yearend 1994, Petro-Canadas upstream operation had a land inventory of 18.4 million gross acres and 14.5 million net acres. That included 3.4 million gross and 1.8 million net in western Canada, 900,000 gross and 200,000 net in oilsands, 900,000 gross and 400,000 net off the East Coast, 11.2 million gross and 10.1 million net in other frontier areas, and 2 million gross acres international.

Downstream progress

Petro-Canada also has made progress on downstream operations after a rationalization program that mothballed two of its five refineriesat Port Moody, B.C., and Mississauga, Ont. That removed more than 78,000 b/d of refining capacity.

The service station network across Canada was reduced to 1,950 outlets from 3,200. Retail sales volume has been maintained despite the closures, and throughput per unit has significantly increased. Throughput increased from 1.7 million l./site in 1991 to 2.5 million l./site in 1994. The company says throughput has averaged 2.8 million l. the first 9 months of 1995, and it set a a target of 3.5 million l. by 1997.

The company is working on a marketing program that will include addition of convenience goods and car washes at more outlets to increase nonpetroleum revenue. It is also implementing an incentive program that allows motorists to accumulate points for rewards such as a car wash, tires, and batteries.

The program, under development for 2 years, has been tested in several cities. It also is a response to marketing ploys by major competitors in a retail market where some analysts say there will be continued downsizing.

There also have been major improvements in performance of the companys wholesale operation, which accounts for more than 60% of volume in direct sales to customers and more than 200 bulk plant operations. Sales average almost 12 million l./year/wholesale outlet.

Processing capacity at the three remaining refineries is more than 280,000 b/d, with throughput averaging 254,000 b/d for a utilization rate of more than 90% earlier this year. Refineries are now operating at close to 95% efficiency, and Stanford says refining is achieving record earnings for the company.

Petro-Canada accounts for 18% of Canadian refining capacity, 17% of the refined products market, and claims the highest retail throughput per site among national companies. It is revamping its refining and supply processes and expects significant savings from the changes.

The company also is expanding its Mississauga lubricants plant to enter the world market for white oils and to begin making high viscosity index (HVI) lubricants. Sales of lubricants were up 11% in 1994 from 1993 at 452 million l.

A 2 year, $135 million expansion program in 1995-96 will double capacity of the Mississauga plant and reduce unit costs.

Petro-Canada was able to use some surplus equipment from one of its mothballed refineries to expand at a significantly lower cost than if it had been a grassroots site. It says this will make it the lowest cost producer of HVI products on the world market by a significant margin. The company says it will become the largest base oil producer in Canada and the fifth largest in the world when the expansion and new technology and process equipment go on stream in late 1996.

Capital spending

Petro-Canada significantly in- creased its capital budget in 1995 to fund projects in growth areas of its businesses.

Capital spending for 1995 is budgeted at $900 million and includes $230 million (net of grants) for Hibernia field development, $340 million for other conventional oil and gas exploration, development, and acquisitions, $180 million for refinery and marketing network upgrades, and an initial $45 million for lubricants plant expansion. It expects capital spending to remain in that range the next few years, funded largely from cash flow.

A total of about $366 million was spent in first half 1995.

Capital spending in 1994 was $700 million, including $234 million for its share of Hibernia development.

Upstream strategy

The company sees upstream as its major area for growth.

A key element of upstream strategy will be aggressive development of frontier assets to create a large, sustainable production base of light crude. Petro-Canadas objective is to become the preeminent player in Canadas East Coast offshore development, where the company is a major interest holder in the Avalon basin.

The company holds a 25% interest in Hibernia oil field and a 49% interest, subject to unitization, in Terra Nova field in the Jeanne DArc basin adjacent to Hibernia. It sees these as building blocks for development of a string of other fields in the area.

Petro-Canadas share of Hibernia will be at least 165 million bbl, and it expects that to replace 70% of its current western Canada production and significantly boost cash flow.

Hibernias production platform will have capacity of 150,000 b/d and is expected to average 125,000 b/d when maintenance and environmental considerations are factored in. Petro-Canada is looking to a 31,000 b/d share of Hibernia oil and 50,000 b/d from Terra Nova, subject to regulatory approval of final unitization and development plans.

It will be operator for Terra Nova, which has reserves of 400 million bbl. The field will be developed using a floating system with an on stream target date of 2001 that could be advanced if conditions warrant.

Contrary to popular belief, Stanford says, Petro-Canada did not get a back-in to Hibernia because of legislation. He says the company farmed in to the project and has paid its full share of costs.

Petro-Canadas share of construction costs from 1988 until production start-up are estimated at $1.3 billion after grants and before related investment tax credits and guaranteed loans. It had spent about $750 million on Hibernia by the end of June 1995. It expects to spend $230 million in 1996, $200 million in 1997, and $100 million in 1998.

Petro-Canada says oil from Hibernia and Terra Nova represents major growth in production and cash flow in the medium and long term but sees much more potential to come. These include a number of 100-200 million bbl fields found near Hibernia. These will be brought on stream through the Hibernia production platform using subsea completion technology. Petro-Canada has participated in 14 fields in the area.

We see the Avalon basin as one of our core areas of activity, Stanford said. We have been involved in the Avalon basin for a number of years. We carried out the exploration program that discovered Terra Nova.

We are part of just about every discovery that has been made in the area. It is going to unfold very much as the North Sea is unfolding, where operators are developing 20 million bbl heavy oil pools because they are adjacent to an existing production facility that has essentially been depreciated. The Avalon offers very significant reserve replacement that has a life to it. It is not just a one-project wonder.

Hibernia update

Stanford says Hibernia, as the first major field in the area, established a lot of milestones and put a lot of unease among investors to rest in 1994.

Prior to that, the project had experienced serious cost overruns, scheduling delays, and withdrawal of major partner Gulf Canada Resources Ltd. There was growing skepticism that the project could be economically developed.

Dry dock work was completed last year on the massive gravity platform at Bull Arm, Newf. The unit was towed to an inshore deepwater site where construction is moving to completion. Four topside supermodules built by foreign contractors were delivered to Bull Arm on time and on budget for mating to the production platform.

During the next 12 months work will be completed on the gravity platform. Piping, electrical, and instrumentation work will be done to join the modules to the production base. One module was built at Bull Arm, two in Italy, and two in South Korea.

The timetable calls for topsides to be mated to the production platform by early 1997 in preparation for the tow to Hibernia. The unit would be on-site by the summer of 1997. Approval has been obtained to drill while ballasting, and Stanford expects production to begin late in 1997.

Orders were placed recently for tankers to shuttle oil from the production platform on the Grand Banks to refineries. Samsung Heavy Industries Co. Ltd. was hired to build two 127,000 dwt, 850,000 bbl capacity arctic class tankers for delivery in October 1997.

One tanker will be owned by Atlantic Shuttle 1 Ltd. and leased to Petro-Canada and state-owned Canada Hibernia Holding Corp. The second will be owned by Mobil Oil Canada Ltd., Chevron Canada Resources Ltd., and Murphy Atlantic Offshore Co.

Stanford says there are no technological issues left to be dealt with on Hibernia. He says the only thing some people might wonder about is the tow-out to the production site, an operation that takes place all the time in the North Sea.

Petro-Canada also considers its sole remaining international venture, in Algeria, as an important part of its upstream growth strategy.

The company made a 40-45 million bbl oil discovery on the Tinrhert block about 620 miles south of Algiers in 1994. State oil company Sonatrach has a 30% interest.

Awaiting approval is a development plan that would give Petro-Canada a 10,500 b/d share of production in 1996. Five prospective targets were identified by seismic before the discovery well was drilled last year, and more drilling is planned.

Stanford says Algeria is a stable environment for foreign oil companies despite political unrest in parts of the country.

The petroleum industry is very important to Algeria, he said. It accounts for about 97% of foreign currency that Algeria gets. Whoever might form the government would look to that industry to be strong. The oil industry has not been the subject of any political action, and most of the concerns have been in the northern part of Algeria.