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12 FUTURE REFINING & STORAGE 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 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 Ogan Kose, Managing Director, Global Strategy, Accenture,* outlines the golden rules that could help refiners survive market cycles. The three golden rules BUSINESS MANAGEMENT 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 SOURCE: SHUTTERSTOCK/DOCSTOCKMEDIA

The Three Golden Rules - Accenture€¦ ·  · 2016-04-27‘golden rules’ that owners can apply to ... through asset-backed trading to enhance ... export ban, environmental standards

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12 FUTURE REFINING & STORAGE

Both 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

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

Ogan Kose, Managing Director, Global Strategy, Accenture,* outlines the golden rules that could help refiners survive market cycles.

The three golden rules

BUSINESS MANAGEMENT

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

SOURCE: SHUTTERSTOCK/DOCSTOCKMEDIA

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 optimisationThe 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 portfolio-integrated 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 capital-efficient 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 pre- FID 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 downturnsRecently, 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.