12 FUTURE REFINING & STORAGE
BUSINESS MANAGEMENT
The
three
golden
rules
Ogan Kose, Managing Director,
Global Strategy, Accenture,*
outlines the golden rules that
could help refiners survive
market cycles.
B
oth market instability and long
investment timelines mean that
refiners need to take more than just
a narrow focus on optimising static top
or bottom-line earnings to satisfy the
sophisticated investor’s expectations. This
issue is exacerbated by losses outpacing
profits during the extended downturns,
which leads to expensive refining assets
being frequently sold on or shut down not
long after major investments have been made.
At the same time integrated oil and
gas companies face pressures in trying
to manage capital intensive investment
programmes across their upstream
and downstream operations. Further
complicating the situation is the potential
for mistimed investments, such as project
delays (resulting in a facility coming online
during less favourable conditions), capacity
creep and the issue of holding on to losses
for too long.
Apart from an increasingly complex
environment, driven by the development
of large refineries together with elaborate
capital and commercial structures, there
is also the issue of national oil companies
prioritising supply security over return
optimisation.
Other challenges include government
regulation that impact trade and capital
SOURCE: SHUTTERSTOCK/DOCSTOCKMEDIA
flows and productivity such as the US
export ban, environmental standards and
floors on cost optimisation, such as limits
imposed on lay-offs.
Overall, these factors lead to pricing
pressures and the potential for product
over-capacity. Over the period 2004 to 2014,
the refining industry suffered valuation
discounts against its global peers on an
enterprise value/earnings before tax,
interest, depreciation and amortisation
(EV/EBITDA) and a price/cash flow (P/CF)
basis of over 40% and 35%, respectively.
This prompted the need to define strategies
for enhancing shareholder returns.
However, while profit provides insights
into expected earnings or cash flow growth,
value can only be achieved if adequate
compensation exists for the incremental
capital needed to generate that growth.
This underlines the need to optimise return
on invested capital (RoIC), rather than
pursuing strategies linked solely to growing
top- or bottom-line earnings.
When pursuing RoIC value enhancement
strategies, integrated players shouldn’t
just focus on higher-RoIC generating assets
such as exploration and production (E&P)
projects and neglect or discard refining
operations. Indeed, integrated portfolios
come with the ability to drive synergies
and perform risk mitigation strategies
which leverage the downstream, including
supply security, portfolio level commercial
optimisation and integrated margin
management.
On the refining side there are three
‘golden rules’ that owners can apply to
ensure the long-term commercial viability
of their refining operations.
• Achieve commercial optimisation
through asset-backed trading to enhance
unit margins.
• Optimise the balance sheet to reduce
operator capital intensity.
• Expand portfolios through sophisticated
investment and mergers and acquisitions
(M&A) structuring to grow a productive
asset base and overall output.
Commercial optimisation
Achieving commercial optimisation
through asset-backed trading to enhance
unit margins involves making sure that
procurement of feedstocks, such as oil,
are fully aligned with the trading and
marketing function, and is imperative for
extracting synergies from refining assets.
There are three ways asset-backed trading
can contribute to an uplift of production
and marketing net operating profit after
tax (NOPAT). First, asset owners should
BUSINESS MANAGEMENT 13
develop an enhanced portfolio trading
and commercial optimisation strategy
to capture incremental unit net margin
in accordance with risk limits set out for
the business unit. Additional margin can
be extracted through fundamental and
arbitrage trading advanced supply and
demand forecasting, and a portfolio
strategy with a mix of long-term and spot
contracts. This can add between 2% and 4%
to NOPAT. Hedging and risk management
strategies can also be used to lock in
margins on select trades.
The second is to use advanced contract
structuring techniques to maximise the
value of long-term contracts through
pricing, delivery, timing and optionalities
on volumes. This can be done using
option pricing models and advanced price
forecasting models. This approach can
give a 2–4% uplift to NOPAT.
The third approach, which can add
1–3% to NOPAT, is to optimise logistics
to maximise the flexibility and control
required to execute advanced trading and
marketing strategies. This can be achieved
through midstream assets contracting a
mix of owned and contracted out capacity,
with the latter helping to reduce the need
for capital investment, and chartering
portfolio management, for example freight
market forecasting models.
Balance sheet optimisation
The second ‘golden rule’ is to optimise
the balance sheet through alternative
capital structures to reduce unit return
capital intensity. There are three ways
for refiners to optimise their balance
sheets in terms of reduction of risk,
long-term and working capital.
First, asset owners should develop
advanced enterprise or portfolio-level risk
management capabilities. Sophisticated
market participants have portfoliointegrated stochastic risk models that
incorporate multiple correlations, such
as credit, market, operational, liquidity,
regulatory and others, to accurately
quantify cash flow at risk (CFaR) from
commercial agreements, and support
ongoing stress-testing of balance sheet
positions. Optimised value at risk (VaR)
to equity ratios will enable firms to
reduce risk capital tied up with trading
positions and free up liquidity for target
capital investments.
The second approach comes down to
commercial structuring capability. This
involves developing an advanced asset
underwriting capability to structure all
pricing and optionality commercial terms
for asset investments. Examples include
1) infrastructure divestments with usage
rights or tolling structures to segment
or transfer the asset owner’s risk profile,
2) off-balance sheet transactions such as
offtakes, leasing and outsourcing to reduce
long-term capital requirements, and
3) structured contractual terms to increase
optionality in capacity utilisation or
reservation rights to reduced fixed usage
commitments and payments.
Finally, asset owners should invest in
developing sophisticated capital structuring
capabilities. This involves the use of capitalefficient financing solutions such as
leasebacks, inventory asset collateralisations
or special purpose vehicle (SPV)-sourced
trade financing to broaden financing
sources for the treasury function and
leverage structured capital terms.
These strategies can reduce capital
requirements by 2–12%. Lower capital
demands generated by balance sheet
optimisation support stronger credit ratings,
which in turn lead to lower financing costs
and improved investor confidence.
Expanding portfolios
The third ‘golden rule’ is to expand the
portfolio through sophisticated investment
and M&A structuring to grow the
productive asset base and overall output.
Much of the recent M&A activity has been
cross value chain and intra-segment with
large transactions concentrated in E&P
and processing assets such as refineries.
Market participants should focus on
two key initiatives to grow production and
processing capacity – achieve excellence
in pre-final investment decision (FID)
transactions execution, and achieve
excellence in pre-deal M&A transactions
execution.
Value engineering is a key lever in preFID deal excellence. Integration of the
asset technical configuration, for example,
crude slate distillation unit type, with
commercials and anticipated market
conditions will optimise asset production
yield and utilisation. In addition, the need
to leverage commercial arrangements and
capital structuring is vital to maximise
absolute return and minimise project
risk exposures. Asset owners should also
develop integrated risk and sensitivity
analysis capabilities such as stochastic
risk models to maximise the risk-adjusted
returns (Sharpe ratio) at a portfolio level.
With respect to pre-deal M&A
transactions execution, asset owners
should structure the commercial and
operational terms, such as exit options,
seniority and convertibility, to increase
deal optionality and optimise structures
based on their risk-return profile. A range
of risk-adjusted outcomes should be
calculated using a probabilistic valuation
approach which factors all commercial
and capital terms. Finally, a detailed due
diligence on the investment is imperative
to quantify all the associated risks.
Mitigating downturns
Recently, many refineries have seen healthy
profit margins due to low oil prices – for
example in North America. US refiners are
now at a crossroads, having invested large
sums in heavy crude processing capabilities
over the past decade to process the heavier,
more sour feedstock, which typically trades
at a discount. However, the shale boom and
crude over-supply have reduced heavy-light
spreads, forcing asset owners to re-think
and evaluate their next steps as margins
come under pressure.
Surviving such changes and being
positioned to benefit from the upturn
will depend on integrating sourcing with
production and trading and marketing.
Using the three ‘golden rules’ involving
asset backed trading techniques, optimised
balance sheets and smart investment
allocation strategies by maximising risk
adjusted returns will give refinery owners
a fighting chance over the long-run.
* Ogan Kose is also the Global Lead for
Accenture Trading, Investment Valuation
and Optimisation Strategy.
The financial and pricing calculations in
this article were sourced from data from
Enerdata and Thomsons Reuters.