The oil downstream: vertically challenged?

Introduction: the theory and the challenges

Introduction: the theory and the challenges Investor appetites and preferences 9ehd] _dgZYd j]faf_ capacity Location-disadvantaged capacity Emerging strategies: trends and implications Integrated structures and strategies Downstream M&A activity Inside cover 1 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][a[ af\mkljq 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 go Yf\ fYf[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^[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]f]jk `Yn] Ydkg Z]]f ka_fa[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 havent been enough. Recent challenges to the integrated models have come from both investors and from the structure of the downstream itself.

Af[j]Ykaf_ jgd] g^ fYf[aYd players Logistics linkages and MLPs NOC objectives and strategies Marketing and retail

10

11

Our perspective going forward Ernst & Young capabilities

15

17

Investor appetites and preferences

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. 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]f]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. 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. These trends are broadly supported by data from analysts at Deutsche Bank Research for their group of 14 global integrated gadk& L`] <]mlk[`] :Yfc \YlY k`go l`] ka_fa[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.

Peer group valuations: 2000 2011

(median values)
12 10 EV/Operating EBITDA 8 6 4 2 0
20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 10 20 09 20 11 20 10 20 11

Integrated Non-integrated

Source: Ernst & Young calculations from IHS Herold data

Peer group returns: 2000 2011

(median values)
60 Total shareholder return (%) 40 20 0 -20 -40 -60
20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 08

Integrated Non-integrated

Source: Ernst & Young calculations from IHS Herold data

Annual returns on average capital employed

(Global Integrated Oils)
40 Upstream Downstream 30 ROACE (%)

20

10

0
20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07

Source: Ernst & Young calculations from Deutsche Bank Research data

The oil downstream: vertically challenged?

9ehd] _dgZYd j]faf_ capacity

9 kljm[lmjYd _dgZYd j]faf_ kmjhdmk ak j]%]e]j_af_$ oal` ka_fa[Yfl [YhY[alq _jgol` ]ph][l]\ gn]j l`] f]pl n] 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]faf_ margins. Net capacity growth (additions d]kk [dgkmj]k! gn]j l`] f]pl n] 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: 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]]f]d\ e]_Y%j]f]ja]k$ \]ka_f]\ to capture economies of scale with high degrees of sophistication. Gd\ j]f]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 f\ 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]f]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]faf_3 l`]j] oadd Z] dg[Ylagf Y\nYflY_]k lg j]faf_ af j]_agfk oal` strong demand growth. At the same time, alternative fuel kmZklalmlagf Yf\'gj j]f]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]f]jq kgmj[]k&

The oil downstream: vertically challenged?

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]faf_ [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]f]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]f]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_ hjg\m[l kh][a[Ylagfk Yf\ operational/environmental constraints. Af Y\\alagf$ l`] YlljY[lan]f]kk g^ l`] G=;<%\geafYl]\ j]faf_ 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 fYf[] Yf\ `Yf\d] Za_ projects. But a decade or so later, the supermajors face as many challenges as their smaller rivals. Size hasnt 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 sectors 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]faf_ Ykk]lk af gj\]j lg [gf[]fljYl] gf l`]aj egj] hjglYZd] mhklj]Ye gh]jYlagfk& <]khal] l`] kljYl]_a[ \ja^l YoYq ^jge j]faf_$ 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]f]jq [gfkljm[lagf hdYfk$ Yk o]dd Yk ^jge l`] [gfkljYaflk gf hgl]flaYd hjglYZadalq 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]faf_ Yf\'gj h]ljg[`]ea[Yd bgafl n]flmj]k oal` ;`af]k] FG;k&

1 2

Ogjd\oa\] J]faf_ Kmjn]q$ 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\ Kmh]jeYbgj eg\]d dYa\ dgo Zq `a_` gad hja[]k$ )0 Bmdq *())&

The oil downstream: vertically challenged?

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]f]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`] af\mkljq Zq dggcaf_ Yl j]faf_ [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^ j]faf_ [gn]j Yf\ hjg\m[l [gn]j& 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]faf_ [YhY[alq ak _j]Yl]j l`Yf gad hjg\m[lagf$ oal` gfdq @]kk$ =fa Yf\ KlYlgad oal` j]faf_ [YhY[alq d]kk l`Yf hjg\m[lagf& 9dd Zml gf] [gehYfq$ J]hkgd$ `Y\ lglYd hjg\m[l kYd]k _j]Yl]j l`Yf alk j]faf_ [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 oils commitment to integration

2.00 1.90 J]faf_ [gn]j2 j]faf_ [YhY[alq af j]dYlagf lg gad hjg\m[lagf d]^l Ypak! 1.80 1.70 Trend line J]faf_ [gn]j 1.60 1.50 Trend line 1.40 1.30 Hjg\m[l [gn]j2 j]faf_ [YhY[alq af j]dYlagf lg hjg\m[l kYd]k ja_`l Ypak! 1.20 1.10 1.00
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

1.00 0.95 0.90 0.85 Product cover 0.80 0.75 0.70 0.65 0.60 0.55 0.50

Source: Ernst & Young calculations from Energy Intelligence Group, Petroleum Intelligence Weekly data.

The oil downstream: vertically challenged?

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]q ^mddq afl]_jYl]\$ gofaf_ l`] ;ala]k K]jna[] j]faf_ 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 Suns case, the upstream company became Gjqp =f]j_q Yf\ l`] \gofklj]Ye [gehYfq Z][Ye] Kmfg[g3 <aYegf\ K`Yejg[ck mhklj]Ye [gehYfq Z][Ye] EYpmk =f]j_q$ o`ad] l`] \gofklj]Ye Zja]q 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]faf_ Yf\ marketing assets in 1987. L]kgjg oYk `aklgja[Yddq Y keYdd afl]_jYl]\ hdYq]j$ Z]^gj] fYddq k]ddaf_ alk keYdd =H hgjl^gdag af )111 lg Z][ge] Yf af\]h]f\]fl j]f]j'eYjc]l]j&

EYbgj afl]_jYl]\k2 j]faf_ af [gfl]pl *()(

(Circle size = relative capacity)

Hjg\m[l ]phgkmj] j]f_af_ [YhY[alq'hjg\m[l kYd]k!

1.4 1.2
ExxonMobil Repsol

1.0
Eni ConocoPhillips

0.8
Statoil Chevron Hess BP Total SA Marathon

0.6
Shell

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]faf_ [gn]j j]faf_ [YhY[alq'gad hjg\m[lagf!

Source: Ernst & Young calculations from Energy Intelligence Group, Petroleum Intelligence Weekly data.

The oil downstream: vertically challenged?

Notable among the major integrated companies, Royal Dutch Shell has reduced alk _dgZYd j]faf_ [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]faf_ \m] lg hggj afl]_jYlagf ghhgjlmfala]k3 log g^ alk dYj_]kl MK j]f]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]f]ja]k Yf\ dggck lg \akhgk] g^ alk MC j]f]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]faf_$ l`]q Zgl` j]eYaf Y\YeYfldq [geeall]\ lg dYj_]%k[Yd] j]faf_'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 ]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]f]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]f]jq gh]jYlaf_ [YhY[alq ogmd\ Z] dgkl Y[[gj\af_ lg the Oil & Gas Journal, total East Coast CDU capacity as of 1 January 2012 was 1,399,700 Z'\ hmllaf_ mhoYj\ hj]kkmj] gf j]_agfYd j]f]\ hjg\m[l hja[]k af gj\]j lg \jYo km^[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 worlds largest airlines, announced that it would purchase the a\d]\ LjYaf]j j]f]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]f]jq oal` l`] ;Yjdqd] ?jgmh$ gf] g^ l`] dYj_]kl \an]jka]\ hjanYl] ]imalq H=! jek&

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]faf_ 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

M&A Database, IHS Herold, Inc. website, accessed 5 January 2012.

The oil downstream: vertically challenged?

Downstream oil transactions

(Reported deal value)

$45 $40 Reported deal value (US$ billion) $35 $30 $25 $20 $15 $10 $5 $0
20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11

Biofuels Propane distribution Terminals and storage Retail and marketing Gasoline stations <an]jka]\ \gofklj]Ye J]faf_

Source: Ernst & Young calculations from IHS Herold data.

Downstream oil transactions

(Number of deals, including deals without reported value)

300 250 Number of deals 200 150 100 50 0

20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11

Biofuels Propane distribution Terminals and storage Retail and marketing Gasoline stations <an]jka]\ \gofklj]Ye J]faf_

Source: Ernst & Young calculations from IHS Herold data.

The oil downstream: vertically challenged?

Af[j]Ykaf_ jgd] g^ fYf[aYd hdYq]jk

>afYf[aYd hdYq]jk$ fglYZdq afn]kle]fl ZYfck Yf\ hjanYl] ]imalq H=! jek$ `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 `Yj\ j]faf_ 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 ljY\af_ jek$ km[` Yk Nalgd Yf\ ?d]f[gj]$ `Yn] Ydkg `]d\ keYdd j]faf_ Ykk]lk'afl]j]klk as leverage for their trading operations. Egj] j][]fldq$ k]n]jYd H= jek `Yn] lYc]f egj] kmZklYflaYd afl]j]klk af j]faf_ Yf\ marketing assets. These have included: 9 [gfkgjlame d]\ Zq Jan]jklgf] Yf\ ;Yjdqd] Y[imajaf_ l`j]] j]f]ja]k ^jge =mjgh]Yf af\]h]f\]fl j]f]j$ H]ljghdmk Backed by Blackstone and First Reserve, the creation of a new large US independent j]f]j$ oal` l`j]] j]f]ja]k$ cfgof Yk H:> =f]j_q Cd]k[`]  ;g&k hmj[`Yk] g^ K`]ddk @]a\] ?]jeYfq! j]f]jq

Downstream oil transactions

(Deals with selected buyers/sellers)
225 200 175 150 125 100 75 50 25 0
20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11

Total deals Integrated sellers Integrated buyers NOC Buyers

Source: Ernst & Young calculations from IHS Herold data.

The oil downstream: vertically challenged?

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 ea\klj]Ye k]_e]flk g^ l`] gad Yf\ _Yk Zmkaf]kk& L`] hjaeYjq Z]f]l 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` go 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`%go%_]f]jYlaf_ Zmkaf]kk]k l`Yl \g fgl j]imaj] ka_fa[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]Y\q%klYl] \][daf]& ?an]f l`] [Yk` go klYZadarYlagf eYfljY g^ Yf EDH$ jYha\dq \]hd]laf_ Ykk]lk l`Yl j]imaj] ka_fa[Yfl [Yh]p Yf\ o`gk] nYdm] m[lmYl]k oal` [geeg\alq hja[]k Yj] not ideal MLP candidates. FglYZdq$ MK af\]h]f\]fl j]f]jk @gddq$ L]kgjg$ Yf\ NYd]jg [mjj]fldq `Yn] ea\klj]Ye MLPs in their consolidated structure, with those MLPs typically holding crude oil and/ gj hjg\m[l klgjY_] Yf\ hah]daf] Ykk]lk& H`addahk ..$ l`] f]o j]faf_'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 30 25 20 15 10 5 0
20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11

External Home country

Source: Ernst & Young calculations from IHS Herold data.

Number of deals

The oil downstream: vertically challenged?

NOC objectives and strategies

Downstream transaction activity by the NOCs increased sharply in the 20062008 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]faf_ Yf\ eYjc]laf_$ many of the largest NOCs are internationalizing and integrating. Several of these have Z]]f afngdn]\ af afl]jfYlagfYd j]faf_ ^gj Y dgf_ lae]$ Zml l`] n]l]jYfk Yj] ]phYf\af_ l`]aj presence and are increasingly joined by newcomers. The leading international integrated FG;k oal` j]faf_ afl]j]klk gmlka\] l`]aj `ge] [gmfljq af[dm\]2 KYm\a 9jYe[g KYm\a 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`]jdYf\k Yf\ Af\aY3 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]faf_$ 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 worlds largest oil producer, has plans to dramatically increase its integrated footprint by expanding alk j]faf_ [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 Aramcos long-term strategy is premised on dYj_]%k[Yd] j]faf_ Yf\ h]ljg[`]ea[Yd afl]_jYlagf&

10

The oil downstream: vertically challenged?

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]f]jq hjg\m[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 todays 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 companys portfolio in some countries simply Z][Ymk] l`]q Yj] _gg\$ hjglYZd] Zmkaf]kk]k& @go]n]j$ l`] \]n]dghe]fl g^ Yf af\]h]f\]fl j]faf_ k][lgj challenges the need for full integration. In the US in hYjla[mdYj$ l`] af\]h]f\]fl j]faf_ Yf\ eYjc]laf_ segment has long had an important role, and with the ]ph][l]\ [`Yf_]k af l`] j]faf_ dYf\k[Yh]$ k`gmd\ kggf kmjhYkk l`] afl]_jYl]\ jek af l]jek g^ lglYd j]faf_ [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]faf_%eYjc]laf_ afl]_jYlagf ak l`] eYj_af `]\_af_ ]^^][l$ a&]&$ o`]f j]faf_ eYj_afk Yj] kim]]r]\$ eYjc]laf_ eYj_afk jak]$ Yf\ na[] n]jkY& Kg Z]af_ afl]_jYl]\ hjgna\]k klYZadalq g^ [Yk` gok& 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 m[lmYlagfk& @go]n]j$ Yk Ogg\ Mackenzie1 fgl]k$ l`] c]q h`jYk] ak lg kge] ]pl]fl$ Z][Ymk] j]faf_ 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]faf_ 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 bmkla[Ylagf ^gj integration has always been a relatively weak argument, this has become even more the case since 2004.

A perspective on M&A activity in the European fuels marketing arena, Wood Mackenzie Limited, Fgn]eZ]j *()(3 Yf\ *()( j]lYadaf_ eYj_afk2 [gfkgda\Ylagf Y c]q l`]e]$ EYj[` *())&

The oil downstream: vertically challenged?

11

Best-in-class downstream: key competitive advantages for acceptable returns J]faf_ Retailing Lubricants

Scale: >150 kb/d ;gehd]palq2 ^]]\klg[c Yf\ gmlhml ]paZadalq Location: access and infrastructure (water, pipelines, terminals, storage) Location: low-cost labor, tax concessions Location: close to demand centers EYjc]l \qfYea[2 hjg\m[l \][al Construction cycle timing: cycle bottom Asset integrity and reliability: maximized availability Petrochemical integration: feedstock and infrastructure Strong trading function: maximize feedstock/product arbitrage, routing and placement Energy intensity: cogeneration capacity Emissions footprint: minimized

Respected brand: customer loyalty Incumbency: ideally top three Location: high throughput Location: real estate optionality Market dynamic: fuel demand growth Differentiated fuels: premium pricing Non-petroleum sales: high margin, low tax Ownership: dealer rather than companyowned Regulation: no pricing controls Planning controls: barriers to entry Biofuels capability: growth options

Established brand: customer loyalty Brand support: effective advertising Streamlined product suite: capture trade-up potential Synthetic lube offering: premium market Global reach: scale economies R&D program: sustained product development Original equipment manufacturer G=E! j]dYlagfk`ahk2 jkl dd nYdm]$ G=E endorsement Blending capacity

Corporate

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]\ ]^[a]fldq ;gjhgjYl] hdYffaf_2 dgf_%l]je `gjargf3 klYqaf_ hgo]j Gof]jk`ah ]paZadalq2 ghlaear] [YhalYd j]\]hdgqe]fl Y[jgkk [q[d]

Source: J.P. Morgan

12

The oil downstream: vertically challenged?

JYl`]j$ Yk ^mjl`]j fgl]\ Zq Ogg\ EY[c]fra]$ al ak l`] j]dYlan] klYZadalq g^ [Yk` gok ^jge retail service station networks that act as the key attraction for integrated companies, jYl`]j l`Yf l`]aj YZadalq lg `]\_] j]faf_ eYj_af ngdYladalq& 9f\ l`ak ak o`]j] k[Yd] j]eYafk particularly important, with those companies achieving market leadership positions Z]f]laf_ ^jge dgo]j mfal [gklk Yk o]dd Yk eYl]jaYd$ j]dYlan]dq klYZd] [Yk` gok& L`] \]^Ymdl hgkalagf ^gj Y j]f]j k`gmd\ Z] lg gof alk gof j]lYad eYjc]laf_ Ykk]lk$ gfdq o`]j] al `Yk Y dYj_] k[Yd] Yf\ hjglYZd] 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]faf_& <]dlY 9ajdaf]k n]flmj] aflg h]ljgd]me j]faf_ 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_fa[Yfl nYdm] af eYfq ljY\alagfYd ^m]d ZjYf\k& Af Y\\alagf$ dYj_] gad [gehYfa]k [Yf kmhhgjl ka_fa[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]f]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.

Is a third age for petroleum retailing emerging? Wood Mackenzie Limited, October 2007.

The oil downstream: vertically challenged?

13

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^ jkl%ogjd\ retailing techniques can be the basis of a market entry strategy, ]kh][aYddq a^ j]faf_ ghhgjlmfala]k Yj] [mjj]fldq daeal]\& Meanwhile, many NOCs are increasingly becoming interested af \]n]dghaf_ afl]jfYlagfYd j]faf_ ghhgjlmfala]k Yf\ f]]\ lg \][a\] o`a[` l 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]faf_$ kg kge] FG;k eYq Zmq service station assets only to make money, not as an adjunct to a j]faf_ 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\]fla]\& >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_fa[Yfl hdYq]j af l`] l`aj\ Y_]& Af Y\\alagf$ \]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 IOCs 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]f]jk `Yn] Z]]f _jY\mYddq oal`\jYoaf_ ^jge j]lYad gad markets as is shown in the chart below.

MK j]f]j kYd]k g^ hjg\m[lk lg ]f\%mk]jk

(Retail sales as % of total sales)
30% 28% All products 26% 24% Percent of total sales 22% 20% Gasoline 18% 16% 14% 12% 10%
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

Source: Ernst & Young calculations from US Department of Energy/Energy Information Administration (EIA) data.

Is a third age for petroleum retailing emerging? Wood Mackenzie Limited, October 2007.

14

The oil downstream: vertically challenged?

Our perspective going forward

As a result of these trends and developments, we see continuing pressures on the sectors 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 Y\nYf[]\ [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 hjg\m[l kh][a[Ylagfk Yf\ eYf\Yl]\ ^m]d ]^[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 9\nYflY_]\ f]o j]faf_ [YhY[alq [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]f]jq%ZYk]\ daima\ ^m]dk$ kge] eYf\Yl]\ gj af[]flanar]\ @]a_`l]f]\ jakc hjgd]k$ Zgl` mhklj]Ye Yf\ \gofklj]Ye3 l`] f]]\ ^gj ^g[mk]\ jakc management L`] jakc hjgd] 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` fYf[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^[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\ k[Yd afklYZadalq&1

9&L& C]Yjf]q$ ;`Ydd]f_af_ l`] Afl]_jYl]\ Gad Yf\ ?Yk Eg\]d$ mfkh][a]\ \Yl] *()(&

The oil downstream: vertically challenged?

15

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?

Ernst & Young capabilities

Ernst & Young has a long track record of: Assisting clients to achieve a smooth exit from non-core businesses within the oil and gas sector Supporting buyers with acquisitions and managing the challenges of operating and integrating the acquired company ;da]flk Z]f]l ^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\ gad]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 We support clients through the divestment or acquisition process with subject matter j]kgmj[] Yf\ jkl%`Yf\ ]ph]ja]f[] Y[jgkk Y broad range of issues.
Divesting an asset key phases Ernst & Young services

Strategic analysis Transaction structuring Carve-out planning Carve-out execution Sales execution Completion

M&A strategy advisory Financial and business modeling Valuation International tax structuring Sell-side M&A lead advisory 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

Acquiring an asset key phases

Ernst & Young services

Strategic analysis Due diligence Transaction structuring Sales execution Completion Post-acquisition integration Post-acquisition rationalization

Buy-side M&A advisory services Commercial due diligence buy-side Financial and business modeling Pre-acquisition buy-side due diligence services Organization and governance advisory Debt and capital advisory >afYf[aYd$ gh]jYlagfYd$ h]fkagfk$ @J$ AL$ j]Yd ]klYl]$ due diligence >afYf[] ljYfk^gjeYlagf Yf\ [gfkgda\Ylagf >afYf[aYd j]hgjlaf_ Yf\ AL Y\nakgjq >afYf[aYd j]hgjlaf_ nYdmYlagfk KGP'BKGP'afl]jfYd [gfljgdk Y\nakgjq Kmhhdq [`Yaf ghlaearYlagf KlYlmlgjq Ym\al Yf\ j]hgjlaf_ LYp kljm[lmjaf_ LYp [gehdaYf[] Yf\ Y\nakgjq Afl]jfYd Ym\al Kmhhdq [`Yaf Yf\ lYp ]^[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

The oil downstream: vertically challenged?

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Ernst & Youngs Global Oil & Gas Center contacts

Dale Nijoka Global Oil & Gas Leader +1 713 750 1551 dale.nijoka@ey.com Marcela Donadio Americas +1 713 750 1276 marcela.donadio@ey.com Sanjeev Gupta 9kaY%HY[a[ +65 6309 8688 sanjeev-a.gupta@sg.ey.com John Avaldsnes Europe, Middle East, India and Africa (EMEIA) +47 51 70 67 40 john.avaldsnes@no.ey.com

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2012 EYGM Limited. All Rights Reserved. EYG no. DW0176 WR no. 1201-1322111
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