Common financial strategies found among top 10 oil and gas firms

PIRA Energy Group
New York City

PIRA Energy Group is an international consulting firm that conducts market analysis on global crude oil, refined products, natural gas, and electric power.

In the first half of the 1990s, the world's 10 leading oil and gas companies narrowed their focus to the core areas of oil, gas, and chemicals. This refocusing on core businesses and an emphasis on implementing strategies to improve near-term financial performance have dramatically improved the top 10 firms' financial results.

The financial strategies these companies implemented consisted primarily of restructuring their asset bases and downsizing to reduce fixed costs. As a result, debt ratios are down, while rates of return are sharply up.

The firms set at least 5-year highs in 1996. More important, all but the two recently privatized French companies are exceeding the cost of capital.

The group's newly restored financial health is projected to be sustained or improved further, with the critical parameter now being growth rather than downsizing to reduce costs. Oil and gas production for the group, for example, is conservatively expected to grow at an average 5%/year during 1997-2001.

Although meeting financial objectives is not primarily dependent on increases in oil and gas prices, risks of underperformance remain and are disproportionately greater for the companies at the bottom of the list of 10, which are struggling to become truly global, than they are for Shell and Exxon Corp., at the top and an order of magnitude larger.

This expansionist leap into the 21st century is being accompanied by some expansion of the top 10's newly focused business activities.

All except British Petroleum plc and ARCO are making the same portfolio addition-the power sector-to further integrate downstream gas. In addition, BP and Shell each are adding a new "core" business based on renewables.

All 10 companies are basing their plans for profitable growth on the same common set of strategic business principles successfully adopted in the first half of the 1990s. These principles seek to identify and concentrate on businesses with superior performance potential, maximize margins, and minimize fixed costs.

Universal strategy

The strategy shared by all 10 firms includes the following general business tactics:

Be a global, geographically diversified, functionally organized oil and gas company, capitalizing on high-tech ability and financial strength.
Aggressively manage the asset portfolio, restructure the asset base, focus on core strengths, and leverage them to obtain a competitive advantage.
Expand high-return core businesses and improve the performance of underperforming businesses primarily by cutting costs.
Reduce fixed costs by downsizing across all business segments.
Improve the organization by adopting best practices and benchmarking, reengineering the process, and restructuring the organization.

Upstream, the following strategies are employed:

Focus target activity outside of the U.S. Lower 48 and primarily on obtaining impact reserves, particularly in the deep water and in areas previously off limits to private capital and technology.
Increase the role of gas, moving rapidly down the supply chain both to monetize reserves and to ensure capturing integrated margins.
Downstream, the top 10 have adopted these tactics:
Be a leader in each retained market; make established, underperforming assets competitive through rationalization, continued cost reduction, and use of synergistic links such as joint ventures (JVs) with third parties.
Make selective investment in refining that emphasizes light and specialty products, but target capital mainly on retail.
Focus there on brand, speed, and convenience; aim to increase nonfuel earnings through multiple product offerings; and partner with established franchises.
Put specialty products in the front line as downstream markets around the world are opened.

Variations

At the "micro" level, the similarities between the companies' strategies are less pronounced, because their assets are different. Relative success often will depend on how companies leverage their inherent strengths to expand and extend existing core businesses as well as develop new ones.

BP has introduced a new twist to reducing costs, based on corporate citizenship as "the new fulcrum of competition." The company has adopted the stance that genuine consultation with nongovernmental organizations (NGOs) is a cost-effective way of reducing the risks of project delays and redesigns while capturing the synergies between NGOs and the industry.

If correct, BP will be a trailblazer; if not, the extra costs will leave it competitively disadvantaged.

Vertical integration is the predominant strategy for natural gas. This is driven by companies either: creating new markets and infrastructures to ensure that reserves are monetized rather than becoming "stranded"; or seeking access to supposedly less-commoditized margins further downstream in mature markets with newly-opened "downstream" segments, such as the U.S. power sector.

Preferences for commercializing gas reserves vary. The companies with the largest gas plays favor major international pipelines and liquefied natural gas (LNG) if they believe they have the financial muscle to shoulder the associated risk and extended payback periods.

Thus Mobil Corp., Royal Dutch/ Shell, Exxon, and Total all aim to be giants of LNG production and marketing. Most others, with ARCO as the pacesetter, favor non-U.S. assisted pipeline development of gas for previously unestablished, usually local markets.

The Asian crisis will clearly have a broad impact for two reasons. First, oil demand in many key countries has dropped and is not expected to recover quickly. Second, currencies and domestic banking systems have weakened.

The result of these events is squeezed margins from existing oil operations. Meanwhile, financing new projects, both upstream and downstream, will be more difficult and more expensive.

Many of the top 10 companies are exposed to problems in Asia. Seeing Asia as the preferred high-growth, low-risk region, these companies have targeted investment over the past decade both in Asia and in Middle East ventures that target exports to Asia.

Another new wild card in the longer term is gas-to-liquids processing, which seven of the 10 companies are pursuing. An economic breakthrough could complement their gas commercialization efforts and potentially challenge downstream margins in the oil market, although likely in localized market niches.

Downstream

The integrated oil industry does not have natural gas's need for new end-use market development. It is experiencing some dismantling of the vertical integration between the upstream, downstream, and chemicals segments as major differences emerge among the companies about integration's value.

Over half of the companies explicitly plan to exploit the synergy between the refining and chemical businesses. Texaco Inc., however, has withdrawn from the chemicals sector-a move that is consistent with its increasing role as owner of a portfolio of shares in regional refining and marketing businesses.

Now, in a more direct challenge to conventional wisdom about downstream oil, Unocal Corp. has exited entirely, unable to find enough value from the synergy, or from stand-alone cost cutting measures, to make its underperforming downstream assets attractive.

The downstream sector's merger-and-acquisition fever potentially can put downward pressure on long-run refining margins by rapidly increasing the scale, efficiency, and sophistication of the organizations that are, in effect, price setters by virtue of their benchmark status. The reduction in margins could be greater than can be matched by the companies with mature assets, even with JVs bolstering their other cost-cutting efforts.

Also, the large capital investment being made in the retail sector is in almost indistinguishable, costly, brand-promoting strategies.

Are there further synergies to uncover that will allow the almost universal goal of significantly increased downstream profits to be met, even if the practice of establishing nonoil brands-such as hypermarkets (supermarkets that use gasoline as a loss leader)-spreads aggressively beyond France and the U.K.?

Or, in a world ruled by active portfolio management, will Unocal's move be repeated by a top 10 company once the refinery capacity cycle makes its inevitable move beyond its current tightening phase back toward surplus in the longer term?

Refocusing

There is a high degree of homogeneity between the leading oil and gas companies, at least at the overview level. With diversification discredited, there has been a scramble to refocus on core oil and gas.

All of the top 10 firms operate in both the upstream and downstream for oil, and in the upstream and at least the midstream for gas, with nine of them going fully downstream there too.

Also, nine of them have significant chemical businesses. The one exception, Texaco, completed its exit last year.

For the majority, that is it-they have no core businesses outside of the oil, gas, and chemicals sectors any more.

Only Elf Aquitaine is different. Sanofi, its health and beauty subsidiary, is regarded by Elf as one of its four core businesses. It accounted for around a tenth of Elf's revenue and net income, and an even higher share of its assets. Elf predicts that, of all its businesses, Sanofi will have the highest rate of return on capital employed (ROCE) during the next 5 years.

Thus, the refocusing is almost complete. The largest coal producer remaining in the group, ARCO, reclassified its interest as noncore early in 1997 and is actively looking to divest. Four other companies still have coal interests, but their contributions to the companies' financial well being are immaterial.

The top 10's newly focused vision, however, is poised to widen again, in the form of further vertical integration into related business, as the industry moves into the expansion phase of its next cycle in response to its vastly improved financial situation.

As has frequently been the case in the past, almost all the companies are making the same business portfolio adjustment roughly simultaneously. This time, it's the addition of power generation, not typically as a new core business but as a natural and complementary extension of the downstream gas business that helps to avoid stranded gas by guaranteeing a market.

There is also a more individualistic adjustment beginning in Europe. First BP and then Shell have turned to renewable energy as the basis for a new, self-styled core business.

Outlook

The top 10 companies have always been large; they have not always been financially strong.

For example, in the first half of the 1990s, their typical ROCE lagged well behind the sector's cost of capital, and both dividends and asset bases shrank as a consequence. But, for now at least, that has changed.

Across the board, in 1996 returns were the best in at least 5 years, and for several of the companies they were the best in a decade or more. This improved profitability has gone hand-in-hand with a dramatic improvement in debt ratios.

These improved results owe much to the shift in strategic focus that has occurred in the oil industry in the last decade, but most particularly in the last 4-5 years.

The norm is now to enhance financial performance through "self-help" measures-actions they can instigate themselves, such as portfolio management, cost cutting, and restructuring.

Guided by the twin mantras of improving profitability and enhancing shareholder wealth, the major integrated companies now routinely set explicit financial targets. Although they still set physical targets based on production volumes, market share, reserves growth, etc., these play a secondary, supporting role. The companies' primary objectives are now financial.

The chosen financial targets are diverse. The most popular are rates-of-return or earnings growth, with all except Exxon committing to some explicit number for at least one of these.

The companies are projecting that the industry's newly restored, strong financial performance will be maintained or further improved over the medium term, and that the laggards will largely catch up with the main pack.

Goals and trends

The companies' confidence about their ability to deliver stronger financial results depends neither on ill-founded optimism about rising oil and gas prices nor on substantial, additional cutting of fixed costs-that staple of the slate of corporate goals for the industry over the last few years. However, because the ability to cut costs directly without cutting muscle diminishes over time, explicit goals in this area are starting to give way to more general commitments to continuing to contain and control costs.

The industry's new primary key to improving financials is growth. As long as total costs are being contained, then growth can extend the downward trend in unit costs.

Three of the five corporate slogans that were adopted for 1997-ARCO's "growth," Chevron Corp.'s "dimensions of growth," and Texaco's "aligned for growth" are based on it.

What strategies are the companies relying on to achieve their primary objective of strong financials? The same ones that they all adopted in the first half of the 1990s, albeit starting at different times and with different degrees of enthusiasm and success.

The basis of these strategies is a set of business operating principles, heavily promoted in recent years, that has become the conventional wisdom for running a successful company in most sectors of the economy. These principles have been so widely quoted that their soundness is in danger of being masked by their becoming clich?s.

The threefold thrust of these principles-identify and concentrate on businesses with superior performance potential, maximize their margins, and minimize fixed costs-is not new; the originality lies with the concepts that guide how these goals are accomplished.

One of the most visible signs that the industry has adopted these strategic principles is that it is engaged in its most radical corporate restructuring in living memory, with respect to both its assets and its organizational structure.

Restructuring

The leading petroleum companies already have divested themselves of the great majority of what they have identified as noncore assets. Thus, the asset-focusing step of the industry's approach to achieving enduring financial strength is largely complete, at least until some change in perspective leads to a revised assessment of what is core and what is not.

The companies, therefore, now are: concentrating on the core assets that will form the basis of their future performance; investing aggressively in high-return businesses, such as most of the upstream sector; and further streamlining or reducing costs in those that are underperforming, such as refining.

It is JVs that now dominate portfolio-restructuring activity. Most of the significant, unilateral, direct cuts in fixed costs have been achieved. In the drive for leadership in cost and efficiency, JVs therefore have become the preferred way to maximize the return on underperforming assets.

All the leading companies are participating in joint ventures, but not all to the same extent. At the low end of the spectrum are Exxon and Total; at the other end is Shell.

Shell has established six substantial JVs: two upstream, both with majors; one mid-stream, in natural gas marketing; and three downstream, each either with a major or a national oil company. Each of Shell's refineries is involved in one of its three downstream JVs.

Some of the corporate structures resulting from downstream JVs are quite revolutionary, at least in terms of who is involved. For example, although JVs are common upstream, the Shell/ Amoco Corp. JV that created Altura Energy Ltd. from a pooling of the companies' long-established interests in the U.S. Permian basin broke new ground.

Similarly, the drive to achieve cycle-long cost reductions in the downstream sector that outstrip the fall in the long-term margin has produced some unexpected, large-scale bedfellows, such as BP and Mobil in Europe and Shell, Texaco, and Saudi Aramco in the U.S.

All are clear examples of the power of the bottom line to overcome the long-entrenched dogma that the ability of the majors to be partners upstream could not successfully be transferred to the downstream.

Internal changes

The quest for financial wellbeing has resulted in restructuring occurring as actively within the companies as between them, as many thousands of ex-oil industry employees can attest. Benchmarking quickly and clearly demonstrated that the top companies' fixed costs were too high.

Job losses are the most visible aspect of internal corporate restructuring, and they reduce costs. But the essence of active organizational management is unlocking the full potential of a company through engaging all the talents and energy of its workforce and fully exploiting any synergies between the various business streams and between the company and its business partners.

It is difficult to judge whether companies are doing this successfully. While all companies use terms such as empowerment, teams, profit centers, mutual advantage, and alliances, it is hard to discern who gains the most from implementing these concepts.

This is a critical question, because all the leading companies stress that achieving their goals is people-dependent.

Unocal has openly challenged the conventional wisdom on vertical integration between upstream and downstream oil. Like the majors, Unocal sees a dramatically changed global energy environment, with exciting new options for multinational, cross-border resource development projects, and it plans to participate in the entire energy value chain.

However, it defines this value chain as extending from the exploration and development of resources to pipelines, power generation, and even fertilizer production. It explicitly excludes oil refining and marketing, which it characterizes as a "volatile and low-return" business.

Putting its money where its mouth is, Unocal recently exited from the downstream entirely. This strategy is 180 degrees different from that of many national oil companies. It is also much more extreme than anything the other companies have adopted.

On the surface, Texaco appears to challenge the value of vertical integration between refining and petrochemicals. Over half of the leading companies explicitly include exploitation of the synergy between their refining and their chemical businesses in their strategies, yet Texaco has withdrawn from petrochemicals completely.

This could be viewed, however, as consistent with its move toward largely holding-company status, with respect to downstream refining and marketing. Perhaps Texaco's real message is that it does not see any value from vertical integration in oil at all.

Differences

Because the companies are all basing their business plans on a common set of strategic business principles, there is significant overlap between these plans. At the "macro" level, it is hard to distinguish one from another.

This can be illustrated by combining all the strategies being followed by every top 10 company into a single "universal strategy."

This strategy is couched in terms that apply directly to these sectors. It does not repeat the underlying strategic concepts, such as cost cutting, which were spelled out earlier. These are taken as "givens" that have shaped the decisions about how to operate in the petroleum sector.

Differences between the companies and their strategic intentions are mostly differences of degree, arising mainly from relative strengths and weaknesses inherited from past decisions. With such overlapping intentions, relative success within the group will depend critically on implementation-and luck.

Within the top 10, there is one striking example of a company being driven by a different vision. BP has designated corporate citizenship and being "forward-thinking about the environment, human rights, and dealing with people and ethics" as "the new fulcrum of competition between oil companies in the late 1990s."

Several of the other leading companies have adopted parts of this approach, with Shell probably going the furthest. But none has been as explicit or committed as BP.

Companies are therefore constantly looking to leverage their existing strengths to gain competitive advantage and thereby improve their bottom line. Thus, Amoco, which has long-established upstream positions in Trinidad and Egypt, is focusing its plans for natural gas expansion on the Atlantic basin and eastern Mediterranean.

In contrast, most of its peer group have Middle East and Asian reserves and are oriented toward Asia and the Pacific Rim.

General focus

Almost all the top 10 companies have been geographically diversified and global for many years. In many cases they are too diversified, according to current views; therefore, much of the restructuring has been aimed at pulling back to focus on the areas in which one has a competitive advantage.

The opening up of both the upstream and downstream sectors, the rapid economic growth in many of the emerging economies, and the increased pressure on companies to monetize their reserves all are combining to make a much tighter link between the business streams, with respect to new core markets.

The companies' expectations for growth are at their most eye-catching in the upstream sector.

The top 10 accounted for just over 16 million boed of production in 1996-roughly 15% of the world total of almost 110 million boed. By 2001, they expect to add nearly 5 million boed, based on identifiable projects (i.e., with no allowance for new discoveries) and on projected prices that are significantly below 1996 levels. Thus, this expected growth of more than 5%/year over the 5-year period could be viewed as conservative.

Subsequent announcements by other companies suggest a trend. The leading companies have all targeted continuous improvement of their health, safety, and environmental performance as one important contribution to managing this risk.

There are some important differences, however, in how companies are responding to environmental risk.

The risks associated with oil spills have risen exponentially. The most typical top 10 response has been to intensify the move to cut back tanker ownership, which was already under way.

Mobil's response has been the reverse. It reaffirmed its commitment to ownership for greater operational control-an important consideration when the overwhelming majority of spills result from human error.

Although, on the surface, Mobil appears to have a high exposure to oil spill liability, this is unlikely to be the case in practice.

Upstream

Most of the leading companies have geographically focused their upstream activity. Amoco is the most extreme example of this. Since the early 1990s, it has cut its exploration portfolio from a startling 100 countries to just 19, making it now the second most focused of the leading companies, instead of the least focused.

Only ARCO operates in fewer countries, but it is moving in the opposite direction from Amoco as it strives toward its goal of becoming global.

At the other end of the scale is Shell, which is still exploring or producing in 45 countries-10 more than its closest rival in geographical diversity.

As technology challenges have steadily been met, and as ultradeepwater leasing has picked up speed, the offshore has become the fastest growing segment of the upstream oil sector. It is widely expected to retain that role.

The universal choice of deep water as a core activity is not a problem, with respect to potential. Two hundred forty deepwater basins have been identified worldwide, but only about 1,000 deepwater wells have been drilled so far.

Some of the top 10 companies have been able to use technology to carve out a niche more distinct than deepwater activity provides. Texaco stands out, with its extensive involvement with heavy oil.

It has heavy oil projects in five regions. No other company is in more than two, although there is a cluster of five companies involved in heavy oil upgrading projects in Venezuela.

Another common upstream strategy is that almost all the other leading companies have made at least one move in the 1990s to restructure, and in most cases shrink, their upstream presence in the onshore Lower 48 U.S. states. The Lower 48 onshore is now a noncore area for three of the top 10 companies, and akin to a cash cow for most of the others. But the physical withdrawal is slowing.

Establishing profit centers and alliances in the pursuit of lower costs has shown companies that they can, after all "be like an independent."

Natural gas

All of the companies except BP are explicit about gas being the main key to their future growth.

The composition of their reserves shows why developing gas is critical to their financial health. For most of the companies, and dramatically so for Total, gas's share of total reserves at the end of 1996 was higher than its share of current production.

The top companies are helping to monetize their reserves by participating in LNG schemes or pipelines, and they are creating demand by being a partner in gas-fired power plants or by lining up a nucleus of energy-intensive end-users. Amoco has done all of the above, in many cases in connection with its gas reserves in Trinidad.

Also creating momentum in this move toward vertical integration is the opening up of electricity and gas markets around the globe. Nonutilities are able to participate in the downstream markets for gas and electricity and thus actively encourage their development or, in the case of the U.S., capture added margins.

Moving beyond production in the gas sector is not a game for the fainthearted. In addition to the technological and project management challenges they offer, LNG projects, major international pipelines, and even many of the grassroots power-generation schemes require large amounts of up-front capital that are remunerated slowly, usually in an environment exposed to the vagaries of both international and domestic politics and, increasingly, public opinion.

One company, Exxon, has had a stand-alone power business for some time. Seven of the other nine (if BP's solar commitment is excluded) have already taken their first significant steps in this sector, and their intended growing commitment is reflected in their restructuring.

Downstream competition

The strategic parallels between companies are even greater in the downstream oil industry than in the upstream sector. Mergers, acquisitions, rationalizations, and alliances are rampant, and the price-setting operation is increasing quickly in scale, in efficiency, and in sophistication.

Amoco especially has highlighted its working-capital savings from its established assets and its resultant "extreme inventory reductions," which amounted to 11 million bbl, or 14%, in 2 years.

Chevron, the only other top 10 firm to quantify its inventory savings in volume rather than value terms, cut its inventory by 16 million bbl over the same period.

All the companies have identified at least one specialty product as a niche market, projected to achieve above-average margins, compared with mainstream products.

In many instances, this categorization as a lucrative niche is, or has a reasonable chance of being, justified. Examples of such products are:

ARCO's calcined coke
Elf's low-emissions Diesel Evolution
Total's ethyl tertiary butyl ether.

There are some other instances where a degree of caution is justified. Almost every one of the companies has identified lubricants as one of their chosen specialty products. Almost as many have picked LPG and bitumen. Exxon's retail strategy includes the use of fast food outlets and convenience stores.

All the other leading companies are doing the same. The companies' brand-promoting strategies seem almost indistinguishable, running the risk that returns on the capital flooding into this sector could be less than stellar.

Also, all the top companies have now set goals that directly or indirectly seek higher profitability downstream. Chevron aims to double its downstream ROCE to 10%, as does Total, while Shell and Mobil each have set targets of 15%.

Others talk about competitive returns or cutting-edge cost structures. These goals will not be met unless the returns from existing operations improve sharply and are sustainable, and today's large retail investments pay off.