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  • 1. The oil downstream: vertically challenged?
  • 2. Introduction: the theory and the challenges Introduction: the theory and the challenges Inside cover Investor appetites and preferences 1 9ehd] _dgZYd j]Õfaf_ capacity 2 Location-disadvantaged capacity 3 Emerging strategies: trends and implications 4 Integrated structures and strategies 4 Downstream M&A activity 6 Af[j]Ykaf_ jgd] g^ ÕfYf[aYd players 8 Logistics linkages and MLPs 9 NOC objectives and strategies 10 Marketing and retail 11 Our perspective going forward 15 Ernst & Young capabilities 17 In this publication we look at the integrated operating model for oil companies, which has served the industry well and was the predominant and most successful operating model of the 20th century. However, recent industry developments are seeing that model come under challenge and new models emerging, with new players focusing gf kh][aÕ[ afmkljq k]_e]flk Z][geaf_ more common. The original logic for the integrated model was premised on the belief that it would provide a natural hedge, balanced funding and market access. Integration would allow a company to optimize the value chain and at the same time, the downstream could be seen as a source of long-term cash Ögo Yf ÕfYf[aYd klYZadalq$ af [gfljYkl lg more risky upstream activities. Integration enabled companies to balance their upstream and downstream activities, reducing risk and volatility. But sharply higher oil prices have shifted value creation decidedly to the upstream, often leaving downstream with low (or ]n]f f]_Ylan]! eYj_afk Yf a^Õ[mdl$ n]jq competitive markets. In markets where petroleum product prices to consumers are controlled and/or subsidized (e.g., as in much of the Middle East and Asia) j]Õf]jk `Yn] Ydkg Z]]f ka_faÕ[Yfldq challenged. Moreover, amid increasing macroeconomic uncertainty, as capital markets fail to recognize the value of integration, investors are increasingly anxious to see the gap between the value of the underlying assets and the market rating narrowed. And notably, equity markets have been increasingly discounting integrated companies below their absolute value. Quite simply, economies of scale and access to technology and capital haven’t been enough. Recent challenges to the integrated models have come from both investors and from the structure of the downstream itself.
  • 3. Peer group valuations: 2000 – 2011 Investor appetites and preferences (median values) 12 Integrated Non-integrated 20 10 20 11 20 10 20 11 20 09 20 10 20 09 20 08 20 07 20 06 20 05 20 04 20 03 20 02 20 01 20 00 0 Source: Ernst & Young calculations from IHS Herold data Peer group returns: 2000 – 2011 (median values) 60 40 20 0 -20 Integrated Non-integrated -40 20 09 20 08 20 07 20 06 20 05 20 04 20 03 -60 20 02 These trends are broadly supported by data from analysts at Deutsche Bank Research for their group of 14 “global integrated gadk&Ê L`] <]mlk[`] :Yfc YlY k`go l`] ka_faÕ[Yfl a^^]j]f[]k in annual Returns on Average Capital Employed (ROACE) in the upstream and downstream segments. Total returns for integrated companies are therefore reduced by the relatively poorer downstream performance, and thus by implication, the companies could release value to shareholders by spinning off or divesting those activities with limited integration value. 4 20 01 Similarly, comparing Total Shareholder Returns for these two peer groups shows the sharp year-to-year volatility of returns, but on average, the non-integrated companies performed slightly better than the integrated companies. 6 20 00 Comparing valuation metrics (Enterprise Value in relation to Operating EBITDA) for two peer groups — the IHS Herold, Inc. group of 35 global integrated companies and the Herold group of the 45 largest international non-integrated companies, including af]h]f]fl =H [gehYfa]k Yk o]dd Yk af]h]f]fl j]Õf]jk$ marketing and transportation companies — shows generally higher valuations for the non-integrated companies in most years, particularly so in recent years with sharply higher oil prices. 8 2 Total shareholder return (%) On average over the last twelve years, non-integrated or independent/pure-play companies have generally delivered better returns than their larger, integrated competitors and they have generally shown higher valuation metrics. Investors have tended to believe that ‘specialist’ companies, particularly upstream-focused ones, are likely to have a greater potential to create shareholder value than do integrated ones. EV/Operating EBITDA 10 Source: Ernst & Young calculations from IHS Herold data Annual returns on average capital employed (Global Integrated Oils) 40 Upstream Downstream ROACE (%) 30 20 10 20 08 20 07 20 06 20 05 20 04 20 03 20 02 20 01 20 00 0 Source: Ernst & Young calculations from Deutsche Bank Research data The oil downstream: vertically challenged? 1
  • 4. 9ehd] _dgZYd j]Õfaf_ capacity 9 kljm[lmjYd _dgZYd j]Õfaf_ kmjhdmk ak j]%]e]j_af_$ oal` ka_faÕ[Yfl [YhY[alq _jgol` ]ph][l] gn]j l`] f]pl Õn] q]Yjk$ particularly in Asia (China and India), the Middle East (Saudi Arabia and the United Arab Emirates), and in Latin America (especially Brazil). In general, on a global basis, the net impact will be reduced mladarYlagf jYl]k Yf _]f]jYddq o]Yc j]Õfaf_ margins. Net capacity growth (additions d]kk [dgkmj]k! gn]j l`] f]pl Õn] q]Yjk [gmd be as much as 25 – 28 million barrels per day (b/d) or 25% – 30% higher than existing capacity, with a compound annual growth rate (CAGR) of more than 4% per year. However, not all of the planned expansions will be sanctioned, nor will they necessarily be completed on schedule. Nevertheless, the key factors of this growth include: 2 The oil downstream: vertically challenged?  The vast majority of the planned expansions are national oil company (NOC) sponsored and thus less-sensitive to return pressures, with governmentsponsored mandates with other objectives (e.g., increasing domestic employment and inward investment, import reduction, value-added capture and/or extended foreign policy reach).  Much, if not most, of the new capacity will Z] _j]]fÕ]d e]_Y%j]Õf]ja]k$ ]ka_f] to capture economies of scale with high degrees of sophistication.  Gd j]Õf]ja]k jYj]dq a]3 jYl`]j l`Yf close, international oil company (IOC) owners tend to try to ”wait it out” or oadd ljq lg Õf f]o gof]jk ^gj eYj_afYd plants, or convert to terminals or storage facilities. In addition, particularly in Europe and America, environmental and social costs of closure can be very high.  Other new owners may have strategies that sustain marginal plants. Depreciation will be reset, with different strategic objectives and time horizons, e.g., private equity that sees other option value. Similarly, some new market ]fljYflk eYq Z] ]paklaf_ j]Õf]jk dggcaf_ for access to new markets.  Sluggish oil demand growth in developed economies will result in the marginalization of some Organisation for Economic Co-operation and Development G=;<! j]Õfaf_3 l`]j] oadd Z] dg[Ylagf YnYflY_]k lg j]Õfaf_ af j]_agfk oal` strong demand growth.  At the same time, alternative fuel kmZklalmlagf Yf'gj j]Õf]jq ZqhYkk is increasing, with more and more renewable fuels, biofuels, gas to liquids (GTLs) and natural gas liquids (NGLs) coming into the supply pool from nonj]Õf]jq kgmj[]k&
  • 5. Location-disadvantaged capacity As of 1 January 2011, the 10 largest integrated, international oil majors had more than *+ eaddagf ZYjj]dk h]j Yq g^ j]Õfaf_ [YhY[alq$ oal` egj] l`Yf /( g^ l`Yl [YhY[alq dg[Yl] af either the US or Europe,1 regions where oil demand is expected to grow minimally, if at all, over the next 20 to 25 years. In addition to increasing competition for local market share, US and =mjgh]Yf j]Õf]jk oadd Z] ^mjl`]j Zmj]f] Zq Yf Y_] af^jYkljm[lmj]& ;gfn]jk]dq$ em[` g^ l`] capacity in the developing countries, where oil demand will grow relatively strongly, is newer, with much of the planned new capacity expected to be world-scale, both in terms of size and kgh`akla[Ylagf& 9l l`] kYe] lae]$ MK Yf =mjgh]Yf j]Õf]jk [Yf ]ph][l lg [gflafm] lg ^Y[] j]dYlan]dq `a_` j]_mdYlgjq [Yh]p j]imaj]e]flk j]dYl] lg la_`l]faf_ hjgm[l kh][aÕ[Ylagfk Yf operational/environmental constraints. Af Yalagf$ l`] YlljY[lan]f]kk g^ l`] G=;<%geafYl] j]Õfaf_ hgjl^gdag lg j]kgmj[] `gd]jk Yk a way to access the (then) dominant consumer energy markets has sharply declined, as those OECD markets matured and the non-OECD markets grew more strongly. Summary As noted in Petroleum Intelligence Weekly (PIW), the high levels of consolidation activity in the late 1990s/early 2000s was driven by a belief that size would offer a distinct advantage, hYjla[mdYjdq af l]jek g^ Y[[]kk lg j]kgmj[]k Yf af l]jek g^ l`] YZadalq lg ÕfYf[] Yf `Yfd] Za_ projects. But a decade or so later, the supermajors face as many challenges as their smaller rivals. Size hasn’t protected against project management problems, nor has it solved the access puzzle. Higher prices have encouraged more resource nationalism, further limiting access to inexpensive, easy-to-develop resources in many countries. The supermajors have instead had to turn to megaprojects in remote/harsh locations, with demanding technological and/or environmental challenges, which have challenged the sector’s project management capability.2 Additionally, the supermajors have fallen out of favor with the stock market. They were established in an era of low prices and were seen as good defensive investments in the early years of the 2000s. But as prices have risen, investors have moved on, bypassing most of the biggest companies, often investing directly into commodities as an asset class. In broad terms, the higher the oil price, the more the share performance of the independents has outshone l`Yl g^ l`] afl]_jYl] eYbgjk& L`ak `Yk d] eYfq eYbgjk lg k`] kge] gj ]n]f Ydd! j]Õfaf_ Ykk]lk af gj]j lg [gf[]fljYl] gf l`]aj egj] hjgÕlYZd] mhklj]Ye gh]jYlagfk& <]khal] l`] kljYl]_a[ ja^l YoYq ^jge j]Õfaf_$ 9kaY ak kladd k]]f Yk l`] gf] hdY[] jah] ^gj downstream expansion. But increasing competition from strong regional NOCs and their Y__j]kkan] j]Õf]jq [gfkljm[lagf hdYfk$ Yk o]dd Yk ^jge l`] [gfkljYaflk gf hgl]flaYd hjgÕlYZadalq from government-controlled retail prices in many markets, will make that strategy challenging. Several of the major integrated companies, including ExxonMobil, Shell, and Total SA, are hdYffaf_ gj [gfka]jaf_ j]Õfaf_ Yf'gj h]ljg[`]ea[Yd bgafl n]flmj]k oal` ;`af]k] FG;k& 1 2 ÉOgjdoa] J]Õfaf_ Kmjn]q$Ê Oil & Gas Journal, . <][]eZ]j *()(3 Yf [gehYfq j]hgjlk& “Supermajor model in need of a makeover,” Energy Intelligence Group, Petroleum Intelligence Weekly (PIW), *- K]hl]eZ]j *((.3 Yf ÉKmh]jeYbgj eg]d dYa dgo Zq `a_` gad hja[]k$Ê )0 Bmdq *())& The oil downstream: vertically challenged? 3
  • 6. Emerging strategies: trends and implications Integrated structure and strategies The last decade and a half has been one of consolidation and retrenchment by the major IOCs, a period characterized by the megamerger era and the creation of the industry _aYflk$ Yf l`]f Zq k]ddaf_ Yf'gj [dgkaf_ j]Õf]ja]k af dgo%_jgol` lqha[Yddq G=;<! eYjc]lk and looking to establish toeholds into heavily state-controlled, high-growth markets, typically in Asia. Drawn from data published by PIW in its annual supplement on the Top 50 Companies, l`] [`Yjl Z]dgo hdglk l`] kljm[lmj] g^ l`] afmkljq Zq dggcaf_ Yl j]Õfaf_ [YhY[alq g^ l`] major companies in relation to their upstream oil production and their downstream product sales. In the chart, the data for the 11 largest international oil majors (ExxonMobil, Shell, BP, Chevron, ConocoPhillips, Total SA, Marathon, Hess, Eni, Repsol and Statoil) and their predecessor companies are aggregated, showing a gradually decreasing commitment to afl]_jYlagf$ Zgl` af l]jek g^ Êj]Õfaf_ [gn]jÊ Yf Êhjgm[l [gn]j&Ê The current perspective for the major IOCs, using data as of the end of 2010, is depicted af l`] [`Yjl Z]dgo& >gj ]a_`l g^ l`] )) [gehYfa]k$ j]Õfaf_ [YhY[alq ak _j]Yl]j l`Yf gad hjgm[lagf$ oal` gfdq @]kk$ =fa Yf KlYlgad oal` j]Õfaf_ [YhY[alq d]kk l`Yf hjgm[lagf& 9dd Zml gf] [gehYfq$ J]hkgd$ `Y lglYd hjgm[l kYd]k _j]Yl]j l`Yf alk j]Õfaf_ [YhY[alq& Note that Marathon, historically one of the smaller integrated majors, has ”de-integrated” in 2011, splitting into separate upstream and downstream companies. One of the supermajors, ConocoPhillips, has also split in 2012. Big oil’s commitment to integration 2.00 1.00 1.90 0.95 J]Õfaf_ [gn]j2 j]Õfaf_ [YhY[alq af j]dYlagf lg gad hjgm[lagf d]^l Ypak! 0.90 1.80 1.70 0.85 0.80 1.60 0.75 1.50 Trend line 0.70 1.40 0.65 1.30 Hjgm[l [gn]j2 j]Õfaf_ [YhY[alq af j]dYlagf lg hjgm[l kYd]k ja_`l Ypak! 0.60 1.10 0.55 1.00 0.50 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 1.20 Source: Ernst & Young calculations from Energy Intelligence Group, Petroleum Intelligence Weekly data. 4 The oil downstream: vertically challenged? Product cover J]Õfaf_ [gn]j Trend line
  • 7. The industry had in fact witnessed an earlier disintegration or de-integration wave in the 1980s and 1990s.  G[[a]flYd H]ljgd]me oYk Zja]Öq ^mddq afl]_jYl]$ gofaf_ l`] ;ala]k K]jna[] j]Õfaf_ and marketing assets from 1982 to1983. (OXY is still a somewhat hybrid integrated [gehYfq3 o`ad] geafYl] Zq alk af]h]f]fl afl]jfYlagfYd =H hgjl^gdag$ al Ydkg gh]jYl]k some chemical production assets.)  Sun and Diamond Shamrock both split off their upstream and downstream operations into separate companies in the late 1980s. (In Sun’s case, the upstream company became Gjqp =f]j_q Yf l`] gofklj]Ye [gehYfq Z][Ye] Kmfg[g3 <aYegf K`Yejg[cÌk mhklj]Ye [gehYfq Z][Ye] EYpmk =f]j_q$ o`ad] l`] gofklj]Ye Zja]Öq j]lYaf] l`] Diamond Shamrock name before its merger with Ultramar Petroleum and its acquisition by Valero.)  ;Yda^gjfaY eafa%eYbgj Mfg[Yd oYk ^mddq afl]_jYl] Z]^gj] k]ddaf_ g^^ alk j]Õfaf_ Yf marketing assets in 1987.  L]kgjg oYk `aklgja[Yddq Y keYdd afl]_jYl] hdYq]j$ Z]^gj] ÕfYddq k]ddaf_ alk keYdd =H hgjl^gdag af )111 lg Z][ge] Yf af]h]f]fl j]Õf]j'eYjc]l]j& EYbgj afl]_jYl]k2 j]Ôfaf_ af [gfl]pl Ç *()( Hjgm[l ]phgkmj] j]Õf_af_ [YhY[alq'hjgm[l kYd]k! (Circle size = relative capacity) 1.4 1.2 ExxonMobil Repsol 1.0 ConocoPhillips Eni 0.8 Statoil Total SA Chevron Marathon 0.6 Hess Shell BP 0.4 0.2 0.0 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 J]Õfaf_ [gn]j j]Õfaf_ [YhY[alq'gad hjgm[lagf! Source: Ernst & Young calculations from Energy Intelligence Group, Petroleum Intelligence Weekly data. The oil downstream: vertically challenged? 5
  • 8. Notable among the major integrated companies, Royal Dutch Shell has reduced alk _dgZYd j]Õfaf_ [YhY[alq Zq Ydegkl gf]% third since 2002, through divestitures and closures. BP is shifting its downstream focus to Eastern Hemisphere growth markets and ak ]%]eh`Ykaraf_ MK j]Õfaf_ m] lg hggj afl]_jYlagf ghhgjlmfala]k3 log g^ alk dYj_]kl MK j]Õf]ja]k Yj] mh ^gj kYd]& :gl` LglYd SA and Chevron are undertaking selective divestitures and are geographically refocusing, notably de-emphasizing activities in Europe. KeYdd]j afl]_jYl] hdYq]j Emjh`q Gad `Yk kgd alk log MK j]Õf]ja]k Yf dggck lg akhgk] g^ alk MC j]Õf]jq Yf l`mk Z][ge] Y hmj]%hdYq af]h]f]fl =H [gehYfq& O`ad] Zgl` =ppgfEgZad Yf K`]dd Yj] an]klaf_ fgf%[gj] j]Õfaf_$ l`]q Zgl` j]eYaf YYeYfldq [geeall] lg dYj_]%k[Yd] j]Õfaf_'h]ljg[`]ea[Yd afl]_jYlagf$ o`]j] l`]q dggc lg optimize production in order to capture the highest value output, while realizing lower costs l`jgm_` ^]]klg[c Ö]paZadalq Yf k`Yjaf_ g^ af^jYkljm[lmj]$ Yk o]dd Yk l`] ghlaearYlagf g^ marketing assets. Af dYl]%*())$ al Yhh]Yj] l`Yl l`j]] H`adY]dh`aY%Yj]Y j]Õf]ja]k$ gf] gof] Zq ConocoPhillips and two owned by Sunoco, would shut down, closing almost 700,000 b/d of crude distillation unit or CDU capacity. Closing that much capacity would mean that ]kk]flaYddq -( g^ lglYd =Ykl ;gYkl j]Õf]jq gh]jYlaf_ [YhY[alq ogmd Z] dgkl È Y[[gjaf_ lg the Oil & Gas Journal, total East Coast CDU capacity as of 1 January 2012 was 1,399,700 Z' È hmllaf_ mhoYj hj]kkmj] gf j]_agfYd j]Õf] hjgm[l hja[]k af gj]j lg jYo km^Õ[a]fl supplies from Gulf Coast suppliers, given some pipeline and shipping constraints, and/or from imports. However, in early-2012, in a deal that surprised many industry veterans and observers, Delta Airlines, one of the world’s largest airlines, announced that it would purchase the ad] LjYaf]j j]Õf]jq ^jge ;gfg[gH`addahk'H`addahk ..$ l`]j]Zq afl]_jYlaf_ ZY[c mh alk critical jet fuel supply chain. A few months later, Sunoco reached an agreement to continue lg bgafldq gh]jYl] alk Za_$ Z]d]Y_m]j] H`adY]dh`aY j]Õf]jq oal` l`] ;Yjdqd] ?jgmh$ gf] g^ l`] dYj_]kl an]jkaÕ] hjanYl] ]imalq H=! Õjek& Downstream M&A activity Over the period 2001 – 2011, reported downstream M&A transaction value averaged about MK** Zaddagf h]j q]Yj$ oal` Ydegkl `Yd^ g^ l`Yl af l`] j]Õfaf_ kmZk]_e]fl& L`] fmeZ]j g^ downstream deals averaged about 150 per year over the period, with deal activity ramping up sharply in the 2006 – 2008 period before falling back.1 (Notably, biofuels transactions became more fully covered by IHS Herold starting in 2006.) Integrated buyers and sellers have accounted for a relatively small portion of the downstream transactions, with integrated companies more likely to have been sellers than buyers. 3 6 “M&A Database,” IHS Herold, Inc. website, accessed 5 January 2012. The oil downstream: vertically challenged?
  • 9. Downstream oil transactions (Reported deal value) Biofuels $45 Propane distribution Reported deal value (US$ billion) $40 Terminals and storage Retail and marketing $35 Gasoline stations $30 <an]jkaÕ] gofklj]Ye J]Õfaf_ $25 $20 $15 $10 $5 20 11 20 10 20 09 20 08 20 07 20 06 20 05 20 04 20 03 20 02 20 01 $0 Source: Ernst & Young calculations from IHS Herold data. Downstream oil transactions (Number of deals, including deals without reported value) 300 Biofuels Propane distribution Number of deals 250 Terminals and storage Retail and marketing 200 Gasoline stations 150 <an]jkaÕ] gofklj]Ye J]Õfaf_ 100 50 20 11 20 10 20 09 20 08 20 07 20 06 20 05 20 04 20 03 20 02 20 01 0 Source: Ernst & Young calculations from IHS Herold data. The oil downstream: vertically challenged? 7
  • 10. Af[j]Ykaf_ jgd] g^ ÕfYf[aYd hdYq]jk >afYf[aYd hdYq]jk$ fglYZdq afn]kle]fl ZYfck Yf hjanYl] ]imalq H=! Õjek$ `Yn] hdYq] Y tangential role in the downstream for a long time, but their presence has been increasing in recent years. Goldman Sachs, through its J. Aron subsidiary, has long taken an interest in É`YjÊ j]Õfaf_ Ykk]lk lg d]n]jY_] kge] g^ alk commodity trading activities. Louis Dreyfus and Morgan Stanley have similarly taken smaller interests. Major global commodity ljYaf_ Õjek$ km[` Yk Nalgd Yf ?d]f[gj]$ `Yn] Ydkg `]d keYdd j]Õfaf_ Ykk]lk'afl]j]klk as leverage for their trading operations. Egj] j][]fldq$ k]n]jYd H= Õjek `Yn] lYc]f egj] kmZklYflaYd afl]j]klk af j]Õfaf_ Yf marketing assets. These have included:  9 [gfkgjlame d] Zq Jan]jklgf] Yf ;Yjdqd] Y[imajaf_ l`j]] j]Õf]ja]k ^jge =mjgh]Yf af]h]f]fl j]Õf]j$ H]ljghdmk  Backed by Blackstone and First Reserve, the creation of a new large US independent j]Õf]j$ oal` l`j]] j]Õf]ja]k$ cfgof Yk H:> =f]j_q  Cd]k[`]  ;g&Ìk hmj[`Yk] g^ K`]ddÌk @]a] ?]jeYfq! j]Õf]jq Downstream oil transactions (Deals with selected buyers/sellers) 225 Total deals Integrated sellers 200 Integrated buyers NOC Buyers 175 150 125 100 75 50 25 Source: Ernst & Young calculations from IHS Herold data. 8 The oil downstream: vertically challenged? 20 11 20 10 20 09 20 08 20 07 20 06 20 05 20 04 20 03 20 02 20 01 0
  • 11. Logistics linkages and MLPs Over the last decade, there has also been a substantial increase in the application of taxadvantaged corporate structures, known as Master Limited Partnerships (MLPs) in the eaklj]Ye k]_e]flk g^ l`] gad Yf _Yk Zmkaf]kk& L`] hjaeYjq Z]f]Õl g^ l`Yl Zmkaf]kk structure is that an MLP is able to pass through its net income to the limited partners or unit holders without paying federal or state income tax, thereby eliminating the double lYpYlagf g^ akljaZmlagfk$ af[j]Ykaf_ ^j]] [Yk` Ögo Yf dgo]jaf_ alk [gkl g^ [YhalYd& L`] principal goal of an MLP is to maintain and/or increase cash distributions to unit holders. Therefore, the assets that make the most sense in the MLP structure are those that are j]dYlan]dq kdgo%_jgol`$ `a_`%[Yk`%Ögo%_]f]jYlaf_ Zmkaf]kk]k l`Yl g fgl j]imaj] ka_faÕ[Yfl maintenance capital. These broadly include fee-based businesses like oil and natural gas pipelines, natural gas processing plants, as well as some coal production and some longlived crude oil or natural gas producing assets that are close to fully developed and/or in kl]Yq%klYl] ][daf]& ?an]f l`] É[Yk` Ögo klYZadarYlagfÊ eYfljY g^ Yf EDH$ jYhadq ]hd]laf_ Ykk]lk l`Yl j]imaj] ka_faÕ[Yfl [Yh]p Yf o`gk] nYdm] Öm[lmYl]k oal` [geegalq hja[]k Yj] not ideal MLP candidates. FglYZdq$ MK af]h]f]fl j]Õf]jk @gddq$ L]kgjg$ Yf NYd]jg [mjj]fldq `Yn] eaklj]Ye MLPs in their consolidated structure, with those MLPs typically holding crude oil and/ gj hjgm[l klgjY_] Yf hah]daf] Ykk]lk& H`addahk ..$ l`] f]o j]Õfaf_'eYjc]laf_ khaf%g^^ from ConocoPhillips, has interests in two MLPs, as part of its midstream joint venture with Spectra Energy, known as DCP Midstream. Newly-split Marathon Petroleum is planning a similar MLP move for its midstream assets. Downstream oil transactions (Includes deals without reported transaction values) 35 External Home country Number of deals 30 25 20 15 10 5 20 11 20 10 20 09 20 08 20 07 20 06 20 05 20 04 20 03 20 02 20 01 0 Source: Ernst & Young calculations from IHS Herold data. The oil downstream: vertically challenged? 9
  • 12. NOC objectives and strategies Downstream transaction activity by the NOCs increased sharply in the 2006–2008 period but has tapered off in the last few years. Af [gfljYkl lg l`] AG;k$ o`a[` Yj] k[Ydaf_ ZY[c kge]o`Yl ^jge j]Õfaf_ Yf eYjc]laf_$ many of the largest NOCs are internationalizing and integrating. Several of these have Z]]f afngdn] af afl]jfYlagfYd j]Õfaf_ ^gj Y dgf_ lae]$ Zml l`] n]l]jYfk Yj] ]phYfaf_ l`]aj presence and are increasingly joined by newcomers. The leading international integrated FG;k oal` j]Õfaf_ afl]j]klk gmlka] l`]aj `ge] [gmfljq af[dm]2  KYma 9jYe[g KYma 9jYZaY!2 ]paklaf_ afl]j]klk af MK$ BYhYf Yf Kgml` Cgj]Y3 hdYff] interest in China  CNPC (China): existing interests in Algeria, Sudan, Singapore, Scotland, France, Japan Yf CYrYc`klYf3 hdYff] afl]j]klk af ;`Y Yf KqjaY  Sinopec (China): planned interest in Saudi Arabia  CmoYal H]ljgd]me CmoYal!2 ]paklaf_ afl]j]klk af AlYdq$ F]l`]jdYfk Yf AfaY3 hdYff] interest in China  PdVSA (Venezuela): existing interests in US, Jamaica, Dominican Republic, Curacao, Brazil and Sweden  Pemex (Mexico): existing interest in US  Petrobras (Brazil): existing interests in US and Argentina  Petronas (Malaysia): existing interests in Italy and South Africa  Jgkf]^l JmkkaY!2 ]paklaf_ afl]j]klk af ?]jeYfq3 hdYff] afl]j]kl af ;`afY :]qgf j]Õfaf_$ egkl g^ l`]k] FG;k Yf eYfq gl`]jk Yj] Ydkg afngdn] oal` nYjagmk wholesale and retail product marketing activities (including service station ownership and operation) outside their home country. Notably, Saudi Aramco, the world’s largest oil producer, has plans to dramatically increase its integrated footprint by expanding alk j]Õfaf_ [YhY[alq lg Ydegkl . eaddagf Z' ^jge l`] [mjj]fl ,&* eaddagf Z'! Yf alk petrochemical capacity to more than 17 million tons/year (from the current 10 million tons/year). Like ExxonMobil and Shell, Saudi Aramco’s long-term strategy is premised on dYj_]%k[Yd] j]Õfaf_ Yf h]ljg[`]ea[Yd afl]_jYlagf& 10 The oil downstream: vertically challenged?
  • 13. Marketing and retail The principal historic reason major oil companies integrated in the other direction as well — that is, by developing service station and retail marketing networks — was to secure access to the consumer market. This was in the days before global international trading markets had fully developed, and the major Western oil companies needed to secure outlets for their [jm] gad Yf j]Õf]jq hjgm[lagf& L`] [gfljgd g^ l`] kmhhdq [`Yaf lg l`] [gfkme]j _Yn] gad companies the opportunity to develop brands with distinctive propositions, many of which remain the leading brands in today’s market. In many European countries, this integration may have come as part of the domestic monopoly or oligopoly enjoyed by a state-owned national oil company, with security of supply being a primary concern of national governments. The growth of international trade and the development of modern trading markets have created a degree of transparency in the global supply chain that was not evident a generation ago. Yet many oil companies remain integrated across the downstream supply chain. Fuels marketing businesses can be highly valuable parts of the portfolio, so they may remain in an oil company’s portfolio in some countries simply Z][Ymk] l`]q Yj] _gg$ hjgÕlYZd] Zmkaf]kk]k& @go]n]j$ l`] ]n]dghe]fl g^ Yf af]h]f]fl j]Õfaf_ k][lgj challenges the need for full integration. In the US in hYjla[mdYj$ l`] af]h]f]fl j]Õfaf_ Yf eYjc]laf_ segment has long had an important role, and with the ]ph][l] [`Yf_]k af l`] j]Õfaf_ dYfk[Yh]$ k`gmd kggf kmjhYkk l`] afl]_jYl] Õjek af l]jek g^ lglYd j]Õfaf_ [YhY[alq& The growth of international trade and the development of modern trading markets have created a degree of transparency in the global supply chain that was not evident a generation ago. One of the arguments sometimes put forward for j]Õfaf_%eYjc]laf_ afl]_jYlagf ak l`] eYj_af `]_af_ ]^^][l$ a&]&$ o`]f j]Õfaf_ eYj_afk Yj] kim]]r]$ eYjc]laf_ eYj_afk jak]$ Yf na[] n]jkY& Kg Z]af_ afl]_jYl] hjgna]k klYZadalq g^ [Yk` Ögok& When the crack spread spikes, the retail margin typically falls sharply. Hence an integrated hdYq]j k`gmd Z]$ lg kge] ]pl]fl$ afkmdYl] ^jge eYjc]l Öm[lmYlagfk& @go]n]j$ Yk Ogg Mackenzie1 fgl]k$ l`] c]q h`jYk] ak Êlg kge] ]pl]fl$É Z][Ymk] j]Õfaf_ eYj_afk Yj] em[` more volatile than marketing margins, and this volatility has increased since 2004. This e]Yfk l`Yl l`] afn]jk] j]dYlagfk`ah g^ l`] j]Õfaf_ eYj_af Yf eYjc]laf_ eYj_af oadd fgl Z] ]fgm_` lg keggl` gml l`] gn]jYdd afl]_jYl] eYj_af& Kg o`ad] `]_af_ Yk Y bmklaÕ[Ylagf ^gj integration has always been a relatively weak argument, this has become even more the case since 2004. 4 “A perspective on M&A activity in the European fuels marketing arena,” Wood Mackenzie Limited, Fgn]eZ]j *()(3 Yf É*()( j]lYadaf_ eYj_afk2 [gfkgdaYlagf Y c]q l`]e]$Ê EYj[` *())& The oil downstream: vertically challenged? 11
  • 14. “Best-in-class” downstream: key competitive advantages for acceptable returns J]Õfaf_ Retailing Lubricants  Scale: >150 kb/d  Respected brand: customer loyalty  Established brand: customer loyalty  ;gehd]palq2 ^]]klg[c Yf gmlhml Ö]paZadalq  Incumbency: ideally top three  Brand support: effective advertising  Location: access and infrastructure (water, pipelines, terminals, storage)  Location: high throughput   Location: real estate optionality Streamlined product suite: capture trade-up potential  Location: low-cost labor, tax concessions  Market dynamic: fuel demand growth  Synthetic lube offering: premium market  Location: close to demand centers  Differentiated fuels: premium pricing  Global reach: scale economies  EYjc]l qfYea[2 hjgm[l ]Õ[al  Non-petroleum sales: high margin, low tax   Construction cycle timing: cycle bottom R&D program: sustained product development   Asset integrity and reliability: maximized availability Ownership: dealer rather than companyowned   Regulation: no pricing controls Original equipment manufacturer G=E! j]dYlagfk`ahk2 Õjkl Õdd nYdm]$ G=E endorsement  Petrochemical integration: feedstock and infrastructure  Planning controls: barriers to entry  Blending capacity  Strong trading function: maximize feedstock/product arbitrage, routing and placement  Biofuels capability: growth options  Energy intensity: cogeneration capacity  Emissions footprint: minimized  Best people: incentivized for operational and health, safety and environment (HSE) excellence  :]kl [gfljY[lgjk2 af[]flanar] ^gj gh]jYlagfYd ]p[]dd]f[]3 Y]imYl]dq kmh]jnak] oal` [d]Yj hgda[a]k Yf hjg[]mj]k  9kk]l [gfljgd2 ]p]j[ak] ]^Õ[a]fldq  ;gjhgjYl] hdYffaf_2 dgf_%l]je `gjargf3 klYqaf_ hgo]j  Gof]jk`ah Ö]paZadalq2 ghlaear] [YhalYd j]]hdgqe]fl Y[jgkk [q[d] Corporate Source: J.P. Morgan 12 The oil downstream: vertically challenged?
  • 15. JYl`]j$ Yk ^mjl`]j fgl] Zq Ogg EY[c]fra]$ al ak l`] j]dYlan] klYZadalq g^ [Yk` Ögok ^jge retail service station networks that act as the key attraction for integrated companies, jYl`]j l`Yf l`]aj YZadalq lg `]_] j]Õfaf_ eYj_af ngdYladalq& 9f l`ak ak o`]j] k[Yd] j]eYafk particularly important, with those companies achieving market leadership positions Z]f]Õlaf_ ^jge dgo]j mfal [gklk Yk o]dd Yk eYl]jaYd$ j]dYlan]dq klYZd] [Yk` Ögok& L`] ]^Ymdl hgkalagf ^gj Y j]Õf]j k`gmd Z] lg gof alk gof j]lYad eYjc]laf_ Ykk]lk$ gfdq o`]j] al `Yk Y dYj_] k[Yd] Yf hjgÕlYZd] klYf%Ydgf] Zmkaf]kk$ oal` [d]Yj$ kmklYafYZd]$ [geh]lalan] advantages. From a retail perspective, there is little rationale for a marketing company lg afl]_jYl] ZY[c aflg j]Õfaf_& <]dlY 9ajdaf]Ìk n]flmj] aflg h]ljgd]me j]Õfaf_ oadd g^ course test the strategic logic of hedging your largest variable cost (i.e., jet fuel) through ownership of assets to produce the fuel. In addition, the growing contribution from non-oil income in the service station network is taking the fuels retailing business further away from many oil companies’ traditional core competencies. At the same time the integrated model is being challenged in many developed economies, the retail fuels business continues to move away from the traditional oil company competencies as non-oil income becomes ever more important. Should the service station network or retail business actually be part of the oil business at all? Should it really be seen as a real estate business, with the aim being to use the plot of land to maximize revenues regardless of the actual products sold? Or should it be seen as a utility business, with some classes of retail assets simply providing services to customers (e.g., highway or motorway services areas), or seen as simply ”infrastructure,“ just providing staple needs to a large and secure customer base? Again, as Wood Mackenzie suggests, the combination of these trends — an unbundling of the supply chain and continued growth of convenience retailing — could be leading to a ”third age” of petroleum retailing, which will be characterized by the appearance of new investors, new brands or brand partnerships, and less direct involvement by integrated oil companies.1 The development of brand licensing concepts will most likely play a growing role in this ”third age.” Although oil companies are not as protective of their brands as they historically were, there ak kladd ka_faÕ[Yfl nYdm] af eYfq ljYalagfYd ^m]d ZjYfk& Af Yalagf$ dYj_] gad [gehYfa]k [Yf kmhhgjl ka_faÕ[Yfl j]k]Yj[` Yf ]n]dghe]fl hjg_jYek that smaller marketing companies or jobbers cannot. Therefore, oil companies that are willing to license their brand to independent operators may be able to continue to capture some of the retail margin, and secure the supply chain to the end consumer, without the need to invest their own capital. This is particularly true in the US, where j]Õf]j gof]jk`ah g^ j]lYad gmld]lk `Yk Z]]f af k`Yjh ][daf] o`ad] eglgj ^m]d kYd]k j]eYaf overwhelmingly branded. The development of brand licensing concepts will most likely play a growing role in the “third age”. 5 “Is a third age for petroleum retailing emerging?” Wood Mackenzie Limited, October 2007. The oil downstream: vertically challenged? 13
  • 16. In this ”third age,” there are different considerations for the various participants:  In developed markets, the IOCs should identify which of their networks are world-class assets that can consistently meet internal return on capital employed (ROCE) targets. Otherwise they should be looking to shift to a jobber type model, consider brand partnerships or exit, with the possibility of brand licensing. @go]n]j$ af ]n]dghaf_ eYjc]lk$ Yhhda[Ylagf g^ Õjkl%ogjd retailing techniques can be the basis of a market entry strategy, ]kh][aYddq a^ j]Õfaf_ ghhgjlmfala]k Yj] [mjj]fldq daeal]&  Meanwhile, many NOCs are increasingly becoming interested af ]n]dghaf_ afl]jfYlagfYd j]Õfaf_ ghhgjlmfala]k Yf f]] lg ][a] o`a[` Õl l`]aj [jal]jaY& L`]q f]] lg bmkla^q o`q Yf integrated approach should be adopted. Retail marketing does fgl hjgna] Y kaehd] `]_] lg j]Õfaf_$ kg kge] FG;k eYq Zmq service station assets only to make money, not as an adjunct to a j]Õfaf_ gh]jYlagf&  On the other hand, PE investors will look to identify retail assets that may have utility or infrastructure characteristics, or have potential to extract hidden value from control over the real estate. Highway or motorway outlets are the classic example, but gl`]j Ykk]l [dYkk]k eYq Z] a]flaÕ]& >gj ]pYehd]$ al ogmd Z] possible to identify potential carve-outs from existing IOC retail networks.  Hypermarkets and grocery retailers can be expected to expand their market reach as long as supply can be obtained and permits/land to build on can be secured. In any case, they will Z] Y ka_faÕ[Yfl hdYq]j af l`] l`aj Y_]& Af Yalagf$ ]n]dghe]fl of independent European jobbers akin to the US market is increasingly probable. Wood Mackenzie sees the emergence of large scale jobber networks in Europe as IOC’s increasingly focus their capital toward the upstream, creating opportunities for others with specialist skills and experience in convenience retailing and/or property development.6 1  Af l`] MK$ j]Õf]jk `Yn] Z]]f _jYmYddq oal`jYoaf_ ^jge j]lYad gad markets as is shown in the chart below. MK j]Ôf]j kYd]k g^ hjgm[lk lg ]f%mk]jk (Retail sales as % of total sales) 30% 28% All products 26% Percent of total sales 24% 22% 20% Gasoline 18% 16% 14% 12% 19 83 19 84 19 85 19 86 19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 10% Source: Ernst & Young calculations from US Department of Energy/Energy Information Administration (EIA) data. 6 14 “Is a third age for petroleum retailing emerging?” Wood Mackenzie Limited, October 2007. The oil downstream: vertically challenged?
  • 17. Our perspective going forward As a result of these trends and developments, we see continuing pressures on the sector’s existing integrated model, with those pressures arising from:  Scale needed for meaningful growth, in contrast to the scarcity of cheap, easy oil and gas, and the push to the frontier and to the unconventional  Sustained and sustainable energy demand growth in the developing world but not in the YnYf[] [gmflja]k3 l`mk$ Y _]g_jYh`a[ k`a^l af ]eYf  NgdYlad] Yf `a_`]j hja[]k3 af[j]Ykaf_ [gfkme]j k]fkalanalq lg `a_`]j hja[]k  Implicit or explicit retail price controls in many developing countries, spurring demand growth  La_`l]j hjgm[l kh][aÕ[Ylagfk Yf eYfYl] ^m]d ]^Õ[a]f[a]k$ j]m[af_ ]eYf _jgol`  Jakaf_ eYafl]fYf[] Yf ]fnajgfe]flYd [gklk3 hgl]flaYddq `a_` [YjZgf [gfkljYafl Yf'gj avoidance costs  Rising power of the NOCs, both in terms of resource nationalism from the ”resource keepers” and international competition from the ”resource seekers,“ with a resulting need for new IOC/NOC partnership models and, notably, a need to recognize some NOCs as new international, integrated companies  Aggressive NOC capacity expansion and slow IOC closure of marginal capacity  9nYflY_] f]o j]Õfaf_ [YhY[alq È [dgk]j lg ]eYf []fl]jk [`]Yh]j lg k`ah [jm] than products, more responsive to seasonal demand shifts), often built with key economic incentives of cheaper labor, tax considerations and lower environmental costs and constraints  ?jgoaf_ kmhhdq g^ fgf%j]Õf]jq%ZYk] daima ^m]dk$ kge] eYfYl] gj af[]flanar]  @]a_`l]f] jakc hjgÕd]k$ Zgl` mhklj]Ye Yf gofklj]Ye3 l`] f]] ^gj ^g[mk] jakc management L`] jakc hjgÕd] g^ l`] gad Yf _Yk k][lgj ak gf Yf mhoYj ljYb][lgjq$ Zgl` ^jge Yf mhklj]Ye Yf gofklj]Ye h]jkh][lan]$ oal` ÕfYf[aYd$ ]fnajgfe]flYd Yf gh]jYlagfYd kY^]lq aehda[Ylagfk g^ egj] [`Ydd]f_af_ Y[lanala]k Yf dg[Ylagfk3 j]kgmj[]k l`Yl Yj] egj] a^Õ[mdl lg ]pljY[l Yf'gj hjg[]kk3 `a_`]j _gn]jfe]fl Yf hmZda[ ]ph][lYlagfk j]dYl] lg ]fnajgfe]flYd Yf gh]jYlagfYd h]j^gjeYf[]3 af[j]Ykaf_ [geh]lalagf ^jge Yf kmZklalmlagf 7 Zq gl`]j ]f]j_q kgmj[]k3 Yf ^j]im]fl _]ghgdala[Yd Yf Õk[Yd afklYZadalq&1 7 9&L& C]Yjf]q$ É;`Ydd]f_af_ l`] Afl]_jYl] Gad Yf ?Yk Eg]d$Ê mfkh][aÕ] Yl] *()(& The oil downstream: vertically challenged? 15
  • 18. However, the old model is not likely to be jettisoned but rather adapted, as companies look for more creative ways to unlock value. We are seeing some radical restructuring — for example, with ConocoPhillips and Marathon — a path that some others may also follow. Nevertheless, we do expect further portfolio optimization or rightsizing, as companies take a more rigorous view of core/non-core activities and look to reduce their exposure to lower-return assets. And similarly, we can expect to see continuing focus on innovation and operational excellence, and clearly the NOC/IOC partnership model will likely dominate the downstream in much of the growth markets. Thus, we can outline a ”new” yet ”old” case for integration, based on the following:  Competition — a broader array of competencies and operational strengths  Innovation — technological leadership and access to larger R&D resource capabilities — c]q ^gj Ydl]jfYlan] Yf mf[gfn]flagfYd ]f]j_q ]n]dghe]fl Yf egf]laraf_ ghhgjlmfala]k  Control — the ability to develop the entire value chain enables a level of control that helps in delivering economic returns  Capital — particularly given the risks in upstream (unconventional, frontier, leading-edge technologies), access to capital is crucial 16 The oil downstream: vertically challenged?
  • 19. Ernst & Young capabilities Ernst & Young has a long track record of: Divesting an asset — key phases Ernst & Young services  Assisting clients to achieve a smooth exit from non-core businesses within the oil and gas sector  Strategic analysis  M&A strategy advisory  Transaction structuring  Financial and business modeling  Carve-out planning  Valuation  Supporting buyers with acquisitions and managing the challenges of operating and integrating the acquired company  Carve-out execution  International tax structuring  Sales execution  Sell-side M&A lead advisory  Completion  Commercial due diligence — sell-side  Financial, operational, pensions, HR, IT, real estate, due diligence  Transaction carve out services  Debt and capital advisory  Restructuring and legal entity rationalization services ;da]flk Z]f]Õl ^jge2  Our breadth of experience within the oil and gas sector — our professionals have worked with many of the leading and emerging organizations around the world and across the upstream, midstream, gofklj]Ye Yf gadÕ]d k]jna[]k k][lgjk  Our broad range of service offerings across the sales and asset separation process  Our geographic coverage — Ernst & Young has more than 9,200 oil and gas professionals dedicated to serving our clients in more than 100 countries  The strength and breadth of our client relationships across the sector Acquiring an asset — key phases Ernst & Young services  Strategic analysis  Buy-side M&A advisory services  Due diligence  Commercial due diligence — buy-side  Transaction structuring  Financial and business modeling  Sales execution  Pre-acquisition buy-side due diligence services  Completion  Organization and governance advisory  Post-acquisition integration  Debt and capital advisory  Post-acquisition rationalization  >afYf[aYd$ gh]jYlagfYd$ h]fkagfk$ @J$ AL$ j]Yd ]klYl]$ due diligence  >afYf[] ljYfk^gjeYlagf Yf [gfkgdaYlagf  >afYf[aYd j]hgjlaf_ Yf AL Ynakgjq  >afYf[aYd j]hgjlaf_ nYdmYlagfk  KGP'BKGP'afl]jfYd [gfljgdk Ynakgjq  Kmhhdq [`Yaf ghlaearYlagf  KlYlmlgjq Ymal Yf j]hgjlaf_  LYp kljm[lmjaf_  LYp [gehdaYf[] Yf Ynakgjq  Afl]jfYd Ymal  Kmhhdq [`Yaf Yf lYp ]^Õ[a]f[q  K`Yj] k]jna[]k hdYffaf_  H]j^gjeYf[] eYfY_]e]fl  AL ]^^][lan]f]kk  Restructuring and legal entity rationalization services  Working capital services We support clients through the divestment or acquisition process with subject matter j]kgmj[] Yf Õjkl%`Yf ]ph]ja]f[] Y[jgkk Y broad range of issues. The oil downstream: vertically challenged? 17
  • 20. Ernst & Young’s Global Oil & Gas Center contacts Dale Nijoka Global Oil & Gas Leader +1 713 750 1551 Sanjeev Gupta 9kaY%HY[aÕ[ +65 6309 8688 Marcela Donadio Americas +1 713 750 1276 John Avaldsnes Europe, Middle East, India and Africa (EMEIA) +47 51 70 67 40 Elias Pungong Africa +237 33 42 51 09 KC Yau China +86 10 5815 3339 Enrique Grotz Argentina +54 11 4515 2655 David Barringer Middle East +973 3961 7303 Russell Curtin Australia +61 8 9429 2424 Jeff Sluijter Netherlands +31 88 407 8710 Beth Ramos Brazil +55 21 2109 1400 9d]p]q DgrY Russia +7 495 641 2945 Barry Munro Canada +1 403 206 5017 Andy Brogan United Kingdom +44 20 7951 7009 Ernst & Young Assurance | Tax | Transactions | Advisory About Ernst & Young Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 152,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential. Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit How Ernst & Young’s Global Oil & Gas Center can help your business The oil and gas industry is constantly changing. Increasingly uncertain energy policies, geopolitical complexities, cost management and climate change all present significant challenges. Ernst & Young’s Global Oil & Gas Center supports a global practice of over 9,000 oil and gas professionals with technical experience in providing assurance, tax, transaction and advisory services across the upstream, midstream, downstream and oilfield service sub-sectors. The Center works to anticipate market trends, execute the mobility of our global resources and articulate points of view on relevant key industry issues. With our deep industry focus, we can help your organization drive down costs and compete more effectively to achieve its potential. © 2012 EYGM Limited. All Rights Reserved. EYG no. DW0176 WR no. 1201-1322111 This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither EYGM Limited nor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor. ED None