Downstream – In or Out of Formation?
A Perspective from Wood Mackenzie Consulting
A Point of View on the Drivers of Integration Value
Although the downstream oil industry may be perceived by some as an equity
market ‘evil’, it is a highly necessary evil for the world’s consumers of finished oil
products. Regardless of current rates of return in the segment, it is axiomatic that
the world will need the downstream to turn crude oil into useful products for
consumers for at least a few more generations.
The recent moves by Marathon and ConocoPhillips to demerge downstream from
upstream have prompted much discussion and analysis on whether downstream
should be ‘In’ or ‘Out’ of integrated oil company formation. To facilitate the debate,
Wood Mackenzie has examined some of the history and the arguments for and
against vertical integration.
Confusing Signals
Based on Wood Mackenzie analysis
of selected portfolios, the stock
market appears to have spoken on its
assessment of the value of integration,
with market values trading at significant
discounts to ‘sum-of-the-parts’
valuations, as shown in Figure 1 overleaf.
Arguably, John D. Rockefeller began
integrating the oil industry as long ago as
the 1870s; however, given the valuation
analysis and investor patience that is
reaching limits, do the current demergers
signal the beginning of the end of the
integrated oil company?
At least two of Rockefeller’s legacy Majors
do not seem to agree. Chevron CEO John
Watson recently opined, ‘There’s never
been a time when I have felt it was more
important to be an integrated company.’
ExxonMobil reiterated this view in a
recent earnings call.1
However, despite the generally
poor financial performance of the
downstream sector in the past few
decades, today’s executives and investors
will be rewarded by their analysis and
decisions going forward, rather than for
their assessment of the past. As such, it is
essential to examine the drivers of value
in merged companies and test whether
Strategy with substance
Downstream – In or Out of Formation?
or not they will sustain the integrated
model in the future.
– processing capability to absorb equity
oil and market channel control.
What are the drivers of
integration value?
Oil producers historically found
challenges in placing non-fungible
crude oils (e.g., heavy, sour oil finds)
profitably within a refiner if there wasn’t
integration. Investments such as the
repositioning of the Shell Deer Park
Refinery with Pemex, and most recently
the joint venture between ConocoPhillips
and Cenovus illustrate examples of
intervention to overcome this.
1
While these drivers are the main business
model value levers, there is a second
layer of considerations that also need to
be analysed to determine the extent of
integrated value:
›
Value of ‘merchant refining’ versus the
‘refining and marketing’ model
›
Synergies of ‘ideal sites’ with refining,
lubes, specialties and petrochemicals
›
Roles of trading and logistics as cost
centres or entrepreneurial hubs
It could be argued that, given the
environment of seemingly endless
pressure on fuels margins, these
additional sources of value are now in fact
fundamental to acceptable return levels.
Demerge or not demerge?
The question marks around the
continuation of the historical value
drivers between the upstream and
downstream demand attention. In a
complex industry and environment, the
different choices being made by focused
and knowledgeable organisations
suggest that the different points of view
call for examination. Thus, what are the
cases for and against the downstream
separating from the integrated model?
60%
46%
Major
‘Pure’ Downstream
‘Pure’ Upstream
40%
27%
30%
20%
15%
10%
10%
4%
0%
0%
-10%
-7%
-20%
-20%
-30%
-23%
‘Every time we look at this, we conclude that our integrated model combined with our global
functional organization just delivers what we’ve referred to in the past as sum of the part plus kind
of valuation.’ David S. Rosenthal - VP, Investor Relations, ExxonMobil
BP
Shell
Total
ConocoPhillips
Source: Wood Mackenzie
ExxonMobil
-33%
SUN
-40%
-23%
Chevron
50%
2. Demand Security
Demand security consists of two aspects
Additional Sources of Value
Figure 1
Premium (Discount) to Net Asset Value – Majors and ‘Pure Play’ competitors – 2010
Talisman
The use of the integrated offerings to
enable resource access was at a peak in
the middle of the 20th century, when
Governments with resource potential
needed the expertise and funding
muscle from the Majors to monetise
their ‘black gold’. However, over the
past decades the expertise level and
commercial options of oil rich nations
has increased and various service and
engineering companies offer broad
capabilities for a more transparent fee.
As the oil industry developed, there
was a need for substantial amounts
of capital and specialised professional
resources to enable both upstream and
downstream growth. The integrated oil
company model provided a flywheel for
money and people, drawing from healthy
cash flows and talented international
organisations to fund and manage
growth. However, in today’s globalised
and sophisticated capital and human
markets, project financing and access to
professional talent is no longer solely in
the reach of the oil ‘Majors’, with efficient
Apache
Market power was most pronounced
when independent retailers were under
structural supply pressure from Majors
with the latter’s domination of forecourt
acreage. This domination began to
crumble with the emergence of the
hypermarket model 20 years ago and
still continues, as evidenced by a further
reduction in the West European market
share of the top seven global refiners
from 57 to 47 percent in the past decade.
3. Resource Leverage
VLO
An important driver of value capture
has been ‘wellhead to wheels’ margin
consolidation and the use of integrated
muscle to gain preferred partner status
to access markets and resources.
TSO
1. Value Capture
Market channel influence may be
illustrated at the resource holder level by
Saudi Aramco’s investment in S-Oil and
for IOCs through continuing investment
in global fuels brands such as Shell, Esso/
Exxon and BP.
Assessed EV / NAV Premium (Discount)
The evolution of the integrated model
since the establishment of the industry
150 years ago has been complicated.
There have been a wide range of factors
– economic, strategic and regulatory
– which, at different times, have
influenced the choices of integration
versus independent operation of the
downstream. However, at the highest
level, there have been three main drivers
behind the evolution to the current
structure:
markets offering developers money and
people to compete with established
firms.
Downstream – In or Out of Formation?
The Case For Demerger:
›
›
›
›
›
Equity markets will reward nonintegrated downstream and upstream
companies on their own merits,
rather than discounting them as
components of a more complex
organisation;
›
›
›
In the modern oil industry, there is
limited need for the downstream,
including petrochemicals, as a
bargaining chip to secure access to
upstream opportunities and markets;
The fundamentals of today’s human
and capital markets imply that
focused firms can attract growth
capital and talent appropriate to their
needs without integrated scale;
Access to serve downstream
consumer markets and segments will
be easier for nimble independent
competitors than as the poor-relations
of integrated Majors; and,
Consumers will benefit from
leaner, hungrier firms focused on
operational excellence in their chosen
downstream portfolio rather than the
fight for attention in complex Majors
dominated by upstream economics.
The Case Against Demerger:
›
›
The capability to maximise value from
integrated activities is scale-related
and changes over time, given industry
structure evolution and asynchronous
business cycles – only integrated firms
can maximise harvest of value from
the value chain over the long-term;
Integrated scale and value chain
participation, and the associated
capabilities, will once again be valued
as national resource holders look for
partners to help them face a more
challenging technical and commercial
environment;
Demerger creates a one-time profit
pool for current equity holders and
transaction participants, but does
not create a sustainable platform
for value creation – it also creates
cash flow weakness in low oil price
environments;
The geographic and segment
complexity of downstream activities
facilitates value creation through
selective optimisation of the portfolio,
rather than exit from the general
category of downstream; and,
The aftermath of the global economic
recession will, in time, create
opportunities in downstream that will
favour those with integrated scale
given scarcity of external funding for
large capital projects.
What’s best for you?
Pressures to demerge highlight the
tension between the need to deliver
short-term performance to shareholders
and the creation of long-term value. For
leaders of integrated companies and
investors, this tension is a particular
challenge now; equity markets
desperately are seeking pockets of latent
value while the initiatives required to
satisfy the world’s energy needs are
increasingly long-term, technologically
complex and capital intensive. Key issues
to consider in resolving this tension
include:
›
›
›
As in any relationship, there are no ‘silver
bullet’ answers to questions of whether
oil companies should be living with or
without the downstream. Some have
made the partnership a rewarding one
over the years, while others have failed
to reach that level of valuable harmony.
What is the right answer for you?
Wood Mackenzie’s consultants provide
strategic advice based on real substance
to clients in the global energy, mining
and metals industries. We have been
helping clients understand the energy
and natural resource industries for four
decades with industry leading research
and are now leveraging that knowledge
to offer advisory services across the energy
value chain. With established presence in
the Americas, Europe, Asia/Pacific and the
Middle East, our consultants offer a truly
global view for questions that must be
considered in a global context.
Authors
Chris Shepley
Vice President
Downstream Consulting
In a dis-integrated world, newly
independent refiners will face a
‘survival of the fittest’ environment
that may be very different from their
heritage. How will they respond,
and how will their entry impact
incumbents?
T +44 (0)131 243 4483
E [email protected]
Would a merged or demerged
world suit NOCs and other national
champions? Will they follow suit by
separating downstream businesses
as their domestic markets evolve or
can they take advantage of the new
structure to become new integrated
Majors?
T +65 6518 0869
E [email protected]
Satvinder Roopra
Head of Asia
Downstream Consulting
Would a series of demergers cause
a structural shift, moving profit back
to the downstream as the markets
belatedly recognise the long-run
importance of turning crude oil into
products people can actually use?
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