Oil and Gas: Dealing with Complexity

It is a subject that is scarcely out of the news, which is hardly surprising when the oil and gas sector powers the modern economy – how much it is at the pump, is there enough left or has ‘peak oil’ hit, can the price justify exploring new technologies to reach hard to find new fields, and why are coffee counters appearing on the forecourt? All these are common questions often seen in the media. However for the treasurer in the sector, how to finance new projects, pay staff and partners in long, typically cross-border supply and payment chains, and ensure enough working capital to keep the show on the road is the more immediate concern. 

Natural resources are needed for modern 21st century life. How we preserve those resources, optimise their use, determine their price and limit their abuse are topics constantly in discussion, but financing a continuing supply of energy is also crucial. There’s no doubting the relevance of a sector that is broad, far-reaching and expanding, as China and other growing countries continue to add to global demand. 

Oil and gas represents a significant chunk of the natural resources space, alongside mining and other sub-sections. It is an industry that has a strong track record of innovation and harnessing technology to access untapped resources, wherever they may be in the world. These are key defining elements as oil and gas are invariably found in challenging geographies, in deep oceans or in inhospitable parts of the world. 

The sector is diverse and comprises of the international oil majors, national oil companies, independent exploration and production firms, oil and gas trading specialists, refiners, retailers and oilfield service providers. Each has a role to play in the sector and many look to banking and other partners to literally help them oil the modern economy. 

The importance of the sector, and a desire to deepen knowledge in other industry areas, has caused Deutsche Bank’s Global Transaction Banking (GTB) division to reconfigure its coverage of target clients with an industry-sector approach. Natural Resources, with oil and gas one of the key sub-sets in this grouping, was one of seven key sectors that has emerged in the bank’s recent reorganisation, which is designed to improve internal knowledge and assist clients more deeply. In common with other banks which have made this move, each of the various sector groups chosen has different characteristics and idiosyncrasies, but by focusing on these relentlessly the bank expects it can enhance its service. 

Ensuring stability and funding across disparate supply chains is of course the key concern for treasuries, but if an increased sector focus from a partner bank can help oil and gas companies do this it should be welcome, particularly if additional funding is needed to finance huge engineering projects that cannot be paid for internally (even in an era of high oil prices and profitability). Conversely, some smaller players may require additional funding to survive if the gathering global downturn causes a dip in oil sales, a common enough occurrence when recession hits. 

Financial Performance

Many corporations in the industry are benefiting from high oil prices and robust consumption. The result of this is strong earnings. Most of the large oil companies have very healthy balance sheets and current operating cash flow growth of around 25% or more (according to DB research, 2011). Corporations are also investing more money in exploration and production, to the tune of almost 50% sometimes of available non-shareholder dedicated profits. 

Typically, 80% of operational budgets are assigned to supply chain-related activity in the field, illustrating its central position. From a finance perspective, however, topics on the treasury’s priority list include soaring working capital requirements and negative cash flow trends, as well as increased shareholder requests for dividend payouts and share buyback, especially when other sectors aren’t necessarily paying out as reliably as they used to. With global capital expenditure at an all-time high and new ‘frontier plays’ requiring significant long-term investment, ‘value destroyers’ such as operations in markets where a company lacks a sustainable presence need to be addressed, either by forming joint ventures, renewing focus on secure supply chains or by linking up with strong banking partners.

Leading global banks can play an important role in improving a corporation’s key financial performance indicators. Visibility, transparency and integrated reporting of cash flows will create value and reduce risk – two key treasury concerns. In the case of oil and gas companies, this is particularly pertinent as they need to manage all daily operational finance activity, as well as joint ventures and trading relationships. A complex web of networks and payment streams is often necessary. 

It is clear where the greatest opportunities lie for the industry at present – namely, in the emerging markets, particularly given the relatively stagnant economic state of the developed world at the moment. This means that exploration and production takes place in some of the earth’s most remote places, such as in the far south of Latin American, Russia and African countries. Offshore and deep water drilling are also common. In the downstream part of the industry, a lot of change is taking place in the refinery and retail sub-segments, due to low margins, the difficult economic environment and changing company strategies.

Risks

With these changes come a multitude of risks for the industry. Recent events, such as oil spills and unexpected nationalisations, have commanded countless column inches in the media, focusing on the economic, ecological and political impact of such incidents. In the current climate, counterparty, sovereign, project and credit risk have all become major areas of concern, requiring constant monitoring and clear risk mitigation strategies. As well as regulatory pressures and geopolitical issues, the industry has to contend with structural overcapacity (for refiners and gas producers), the long-term changing dynamics between international oil majors and national oil companies and the ongoing migration to cleaner and renewable energies. 

One aspect of the industry under the microscope is further vertical integration, but on a selective basis. Vertical integration means that the management of the entire process around oil and gas – from raw materials to the marketing and retailing of the end product – comes under the control of a single company. This is a structure that has historically been adopted by the oil majors such as ExxonMobil, Royal Dutch Shell and BP. The main drivers for the integration typically are lower production costs, more effective synchronization of supply and demand along the value chain, and a fair degree of strategic independence. 

Over the years, this model has been fine-tuned and modified. For example, when the oil industry started in the 19th century, producers, refiners and sellers were very different, but with the establishment of the oil majors, these three primary disciplines became closely-linked and controlled. In recent years, this trend has been reversing, however, with several companies selling their refining and/or retail operations to concentrate on higher margin exploration and production operations. Oil and gas is not the only industry that is experiencing changes in its operating model. Metals and mining – another of Deutsche Bank’s industry coverage groups – is seeing a similar trend of greater vertical integration, as observed in Russia’s steel sector. 

Global banks work with their oil and gas clients in many areas related to working capital and process optimisation. Integration of acquired companies, support of joint ventures, access to liquidity and supply chain initiatives are areas where banks, such as Deutsche Bank, can add expertise and insights. The value of a genuine global network is critical for companies, especially smaller players, to gain emerging markets access. It can help to access deep local knowledge and to have available a palette of solutions, ranging from global liquidity management solutions, to local banking services, technology integration services and trade/supply chain financing. 

Even for a mature industry with on-going strong revenue growth and deep capital investments, the economic backdrop is requiring some companies to be more diligent across their supply chain and to consider best-in-class working capital management solutions. While this is typically a capital intensive industry, thus requiring large credit facilities and structured trade finance solutions, technology, risk and cash management, along with supply chain finance, will remain high on the agenda for treasurers in the coming years.

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