Risk And Return Analysis Of Vertical Integration

Published Date: 02 Nov 2017

The aim of this chapter is to introduce the research project and to outline the research themes that guide this study. This research is rooted within the existing decision theories and oil industry literature. It contributes to the current debates in these literatures by providing evidence of linkages between

Background

For over a century and a half, oil has brought out both the best and worst of our civilization. It has been both boon and burden. Energy is the basis of our industrial society. And of all energy sources – oil has loomed the largest and the most problematic because of its central role, its strategic character, its geographic distribution, the recurrent pattern of crisis in its supply – and the inevitable and irresistible temptation to grasp for its rewards. Its history has been a panorama of triumphs and a litany of tragic and costly mistakes. It has been a theatre for the noble and the base in the human character. Creativity, dedication, entrepreneurship, ingenuity, and technical innovation have coexisted with avarice, corruption, blind political ambition, and brute force. Oil has helped to make possible mastery over the physical world. It has given us our daily life and, literally, through agricultural chemicals and transportation, primacy. It has also fuelled the global struggles for political and economic primacy. Much blood has been spilled in its name. The fierce and sometimes violent quest for oil – and for the riches and power it conveys – will surely continue so long as oil holds a central place since every facet of our civilization has been transformed by the modern and mesmerizing alchemy of petroleum.

The above paragraph has been adapted from the closing remarks made by Daniel Yergin in his book, (Yergin, 1991), which chronicles the development of the world’s oil industry. Three themes are used to structure the book and these clearly illustrate the global impact of the oil and gas industry. The first of these is that oil is a commodity intimately intertwined with national strategies, global politics and power as evidenced by its crucial role in every major war in the last century. The second is the rise and development of capitalism and modern business. According to (Yergin, 1991, p. 13):

"Oil is the world’s biggest and most pervasive business, the greatest of the great industries that arose in the last decades of the nineteenth century."

A third theme in the history of oil illuminates how ours has become a "hydrocarbon society" (Yergin, 1991, p. 14). Oil has become the basis of the great post-war sub-urbanization movement that transformed our way of life.

Globally, the industry has evolved from primitive origins through two world wars, the Suez Canal crisis, the Gulf War and significant fluctuations in supply and demand, all with their subsequent impact on the oil price, to become a multi-billion pound business comprised of some of the world’s biggest and most powerful companies. It is now recognised as an essential national power, a major factor in world economies, a critical focus for war and conflict, and a decisive force in international affairs (Yergin, 1991, p. 779). However, the global oil and gas industry is changing now.

Oil and gas industry has a colorful history filled booms and busts - all of them magnified by the huge scale of the fortunes won and lost. Edwin Drake drilled the first commercial oil well in Oil Creek, Pennsylvania in 1859.  Its production was considered staggering at the time, and the amount of kerosene it could produce changed the lamp oil market. People rushed into this industry as oil was considered a free for all commodities.  Some entrepreneurs found oil in the most unlikely places based on the most unlikely methods and some others used the most rational approaches but were not successful.

Oil trading, refining, and sales also not well coordinated.  Products were not refined to uniform standards making the use and storage of petroleum fuels a dangerous preposition.  Even when they were safe, their performance was unpredictable.  Government regulations did not exist.  Competing companies seldom agreed upon product standards.  Crude oil prices dropped precipitously when large new fields were found and soared when shortages were rumored.  In that day of unbridled capitalism, sales tactics included everything imaginable, including many which would be considered criminal today.

However, one person visualized the opportunity that this new industry offered, if only it could be well coordinated. John D. Rockefeller began investing in oil refining in Cleveland in 1863 and within nine years controlled 21 of the 26 refineries in Cleveland. He realized that he could control the industry by controlling refining.  He sought to integrate and control all phases of the business, eliminating wasteful duplication and competition in the process.  He expanded his hold on refining as he expanded to other cities and states.  He bought out his competitors then expanded into production, transportation, and marketing, consolidating his control over each one.

When Rockefeller combined Standard Oil and 39 affiliated companies to create Standard Oil Trust in 1882, his goal was not to form a monopoly, because these companies already controlled 90% of the kerosene market. His real goal was economies of scale which was achieved by combining all the refining operations under a single management structure. Thus, we see the roots of vertical integration since the very beginning of the oil and gas industry.

The Sherman Anti-Trust Act and federal litigation eventually broke up Rockefeller’s control of the industry, but by the time it did Standard Oil monopolized virtually every facet of the industry, from searching for crude oil to home delivery of kerosene.

When the Standard Oil Company was broken up in 1911, it was broken into regional companies which remained vertically integrated but the Rockefellers were forbidden to exercise any control on them.  Those companies began competing with each other and expanding into each other’s territories.  Today the ones that remain operate virtually worldwide.  They no longer monopolize regions, but they are still vertically integrated.

As the big oil companies expanded beyond the United States, however, they found a different environment. In the United States, every landowner controlled the minerals under his property and could drill oil wells if he wanted to.  However, the refining industry required specialized knowledge and a huge investment to build a refinery large enough to be efficient enough to be profitable. 

In other countries, the rulers or governments controlled access to the minerals.  Compared to the number of corporations in the world large enough to build a refinery, there were only a few rulers and governments.  The control point for the international industry was thus crude production, not refining.  For many years the seven largest international oil companies , known as the "Seven Sisters" – five of them American - controlled the world’s supply of crude oil by negotiating market share among themselves and by balancing production among the countries which had surplus oil to export.

But in October 1972 this balancing mechanism broke. The principal exporting countries in the Middle East had been gaining wealth, power, and expertise from the enormous royalties they had been collecting since the first half of the 1900s. First, they formed the Organization of Petroleum Exporting Countries (OPEC) and began formally consulting each other on oil prices and policies.  Several countries had tried to take control of their production and oil sales away from the Seven Sisters in the 1940s and 1950s, but they could not sell enough of their production to avoid severe economic problems.  During 1970 and 1971, OPEC negotiated price increases with the Seven Sisters but was still not able to take control of their production.

In 1972, Libya dramatically nationalized its oil fields, took control of its own production, raised its prices, and was able to find its own buyers.  The Seven Sisters’ reign was now over.  The other major exporters quickly followed Libya, and over the next few years, the Seven Sisters were reduced to being customers of the producing nations.

Since Libya broke the hold of the Seven Sisters, the concentration of power in the oil industry has continued ebbing.  The national oil companies of the major exporting countries have been growing more vertically integrated, investing their profits from production in expanding into refining, transportation, and marketing.

The Western oil companies, meanwhile, have been retrenching, specializing in some functions and areas and giving others up.  They continue to grow and be profitable, but the domination of the industry by the largest companies keeps ebbing. 

Mergers, acquisitions and joint ventures continue in the petroleum industry at a record pace.  Mergers are motivated by industry official’s desires to achieve synergies i.e. benefits from the combined strengths of different companies, diversify their assets, reduce costs, enhance stock values, and respond to price volatility.  According to a report issued by the GAO in May 2004, over 2,600 merger transactions have occurred since the 1990’s involving all three segments of the petroleum industry.  Almost 85 percent of the mergers occurred in the upstream segment (exploration and production), while the downstream segment (refining and marketing of petroleum) accounted for about 13 percent, and the midstream segment, specifically pipelines (transportation), accounted  for over 2 percent. The vast majority of the mergers—about 80 percent—involved one company’s purchase of a segment or asset of another company, while about 20 percent involved the acquisition of one company’s total assets by another so that the two became one company. Most of the mergers occurred in the second half of the decade, including those involving large partially or fully vertically integrated companies.

The oil and gas industry is one of the largest and important global industries. The price of crude and natural gas are the most closely watched commodity prices in the global economy. The International Energy Agency (IEA) predicts that energy demand will rise by an average of 1.5% each year through 2030. The organizations which have dominated the global oil and gas industry for more than a century have changed dramatically over time.

There are many ways to look at the oil and gas industry. From a personal perspective, oil and gas provide the world's 6.9 billion people with 60 percent of their daily energy needs. The other 40 percent comes from coal, nuclear and hydroelectric power, and renewables like wind, solar and tidal power, and biomass products such as firewood. As fuels, they keep us warm in cold weather and cool in hot weather; they cook our food and heat our water; they generate our electricity and power our appliances; and they take us by car, bus, train, ship or plane to places near and distant. We all feel the economic pinch when the prices of gasoline, home heating fuel or electricity increase sharply, even though in many developed countries, they still cost less than some brands of bottled water. As petrochemical feedstock, oil and gas are the raw materials used to manufacture fertilizers, fabrics, synthetic rubber and the plastics that go into almost everything we use these days, from toys to personal and household items to heavy-duty industrial goods.

From a business perspective, oil and gas represent global commerce on a massive scale. World energy markets are continually expanding, and companies spend billions of dollars annually to maintain and increase their oil and gas production. Over 200 countries have invited companies to negotiate for the right to explore their lands or territorial waters, hoping that they will find and produce oil and gas, create local jobs and provide billions of dollars in national revenues.

From a geopolitical perspective, large quantities of oil and gas flow daily from exporting regions such as the Middle East, Africa and Latin America to importing regions such as North America, Europe and the Far East. This creates political, trade, economic and even national security concerns on both sides. Oil and gas exporters want to maximize their revenues and improve their trade balances while maintaining control and sovereignty over their natural resources. At the same time, importing nations want to minimize trade deficits and ensure a steady, reliable oil supply. China, for example, has recognized that it must obtain access to oil in order to continue its long-term sustained growth and is actively seeking new sources of supply in the major producing companies.

From an internal policy perspective, producing countries continually wrestle with questions of how best to develop their resources and attain long-term sustainable benefits for their people. At the same time, consuming countries are always considering how to reduce their dependence on imported oil, either by imposing higher energy taxes to spur conservation, tapping into domestic resources such as coal (less costly but more polluting than imported oil) or developing alternative energy sources such as nuclear power. These issues have major long-term impacts, both within individual countries and on the world at large, even affecting such fundamental issues as war and peace.

Finally, from a health, safety and environmental (HSE) perspective, there is a continuous concern for safety in oil and gas operations, the impact that new projects have on surface environments, the possibility of oil spills and the effect of pollutants such as carbon dioxide, a product of hydrocarbon combustion, on global climate change and air quality

The oil, gas, refining and petrochemical industries generally fall into either the upstream or downstream category.

Upstream

This relates to obtaining crude oil and gas from natural resources and includes the:

exploration of potential new oil and gas reserves using seismic and geophysical surveys and prospective drilling

development of oil or gas fields, including constructing the well head and production facilities

Downstream

This relates to processing crude oil into products that your business can market. It includes:

the transportation of crude oil and gas, including pipelines and pumping systems

liquefied natural gas systems, including the liquefaction and re-gasification plant and machinery

oil refineries, petrochemical plants and gas processing

Key drivers in the oil, gas, refining and petrochemical sector include:

increasing demand for oil and gas

increasing demand for refined and petrochemical products

new discoveries of oil and gas in increasingly complex geological structures, eg deep water, and/or inhospitable locations - requiring developments in technology and materials

environmental impact concerns, again requiring specialist technology developments

new regulations, which have driven the development and expansion of the oil refining industry

The industry consists of international oil and gas operating companies, national oil and gas corporations, major contractors, and large numbers of equipment manufacturing and service companies in many different countries. The value of the investment and operating activity in the sector runs to several hundred billion pounds a year, although not all of it is internationally traded. Regulations, charges or other restrictions may apply to oil, gas, refining and petrochemical exports and imports.

Challenges in oil and gas industry are continually evolving and the stakes are getting higher. Global economic uncertainties may tamper earlier forecasts for world oil demand to double by 2030 according to Cambridge Energy Associates, Inc. However, all this may in no way alleviate the pressure on oil and gas companies to improve operational efficiency and overall performance. Competing political and economic pressures are complicating regulations and access to the new reserves. New implications for sustainability and energy efficiency create operating challenges and increase costs. Operating pressures are increasing the pressure on refiners and petrochemical manufacturers to reduce margins that are already tight.

Oil and gas industry is a risky capital intensive business. Companies are working hard to execute projects on a global scale to find, produce and deliver hydrocarbons. It has become critical for organizations to efficiently manage their capital projects to control expenditure, manage priorities and resources and get assets productive as quickly as possible. It is also important to upgrade these assets throughout their life cycle. Organizations would be able to overcome all these challenges when they are in the position to manage their risks and returns effectively.

In the Upstream sector, the major risks are:

Exploration and recovery risks

Crude Oil supply risks

In the Downstream sector, the major risks are:

Refining & marketing risks

Price & Demand Derivative risks

Besides these, the National Oil and gas companies face some other risks like risk of natural disaster, risk of terrorism and criminal activities, risk of availability of oil and gas resources, risk relating to political, regulatory or environmental issues etc.

The major challenge faced by oil and gas companies is to manage their risks and the returns. Global oil and natural gas producing companies as well as original distributors heavily engage in all stages of the value chain of oil and gas production. Export projects, a long time dominated by state-owned entities, are increasingly developed by private oil and gas companies. Traditional markets are being challenged by the intrusion of oil and gas majors integrating downstream into import markets.

Risk and return plays a key role in oil and gas companies’ decision making process. Every company wants to avoid risk and maximize returns. In general, risk and return go hand in hand. If a company wishes to earn higher returns then they have to accept a commensurate increase in risk. Risk and return are positively correlated - an increase in one is accompanied by an increase in the other. Heavy capital investment decisions, therefore, involve a tradeoff between risk and return, which is considered to be central to the decision making process of any oil and gas company. This necessitates for optimization of risk and return. One way of managing this is by Vertical Integration of oil and gas companies.

All firms integrated or not, earn at best long-term returns that approximate their respective costs of capital. Any management action that by chance caused a positive deviation from the expected level of return is soon to be eroded by competition’s counterattack (Coase R. , "The Firm, the Market and the Law", 1988). The causes of vertical integration and its consequences on market outcomes and consumer welfare have been extensively researched and discussed in industry and academics. According to these theories, vertical integration can on one hand promote efficiency by eliminating successive monopoly mark-ups, internalizing service, and mitigating contractual problems between firms (Williamson, 1971) (Grossman, S.J., Hart, O.D., 1986)

Vertical integration can facilitate the strategic practice of market foreclosure, whereby an integrated firm denies rivals access to markets in order to gain greater market power. The first effect results in lower prices, higher sales, and greater consumer welfare, while the second raises the prices of final goods, thereby harming consumers (Chipty, 2001)

Vertical integration can occur in two directions: upstream and downstream. Upstream or backward vertical integration, involves ownership and production of the raw materials that might otherwise be supplied from independent, external producers. A firm would thus integrate upstream in order to ensure that the supply of its own raw materials is always available. Downstream or forward vertical integration, involves controlling the final or finishing steps of semi-fabricated products and the wholesaling and retailing operations that deliver goods to consumers (Scherer, F.M. & Ross, D., 1990)

The industrial organization or strategic management perspective, as put forward by (Porter, "Competitive Strategy: Techniques for analyzing industries and competitors", 1980) and others, argues that vertical integration can create competitive advantages in imperfect markets. Porter defined vertical integration as "Vertical integration is the combination of technologically distinct production, distribution, selling and/or other economic processes within the confines of a single firm" (Porter, "From competitive advantage to corporate strategy", 1987). The strategic purpose of vertical integration is to utilize different forms of economies, i.e. cost savings, like economies of combined operations, economies of internal control and coordination, economies of information, and economies of stable relationships (Porter, "Competitive Strategy: Techniques for analyzing industries and competitors", 1980). Porter argues, in the same way as (Pfeffer, J. & Salancik, G.R., 1978), that vertical integration is an important instrument for reducing uncertainty and securing supply for critical input.

Vertical integration is used as a device to change the industry cost structure to the benefit of the firm making the integration decision. The theory states that integration removes all conflicts of interest inside the firms, which enables them to focus on the strategic interaction with other market participants (Vickers, 1985) (Bonanno, Giacomo and John Vickers, 1988) (Salinger, 1988) (Hart, O., J.Tirole, 1988) (Ordover, J.A., Saloner, G. & Salop, S.C., 1990) (Gal-Or, 1992).

The analysis of the existing literature shows that the choice of whether or not to vertically integrate upstream or downstream involves a complex series of economic tradeoffs. The tradeoffs generally pit the costs or benefits of transacting business across firms against the efficiencies associated with doing business in-house (Randall A., Stroll J.R., 1980) (Randall A., Hoehn J.P., 1996)

Extensive internal vertical transfers allow the creation of various synergies between the individual stages of the firm’s internal value chain (Arrow, 1970). Synergies can be realized by a coordination of administrative tasks that are common to several internal departments. Such tasks include production and inventory scheduling that can substantially reduce a firm’s cost by reducing unused capacity and inventory carrying costs (Harrigan, "Strategies for vertical integration", 1983). Forward integration also allows for synergies to be created between the advertising and marketing efforts of different stages (Porter, "Competitive Strategy: Techniques for analyzing industries and competitors", 1980). Synergies can also be gained from the exploitation of technological interdependencies. Through vertical integration, suppliers can exercise direct control over the customer interface. This enables the firms to supply their customers without the costly services of an intermediary, and in addition allows them to obtain more timely and accurate information about customer demand (Holmstrom, B.R. & Roberts, J., 1998).

Researchers agree that uncertainty is a significant determinant of vertical integration (Balakrishan, S., Wernerfelt, B., 1986) (Harrigan, "Matching vertical integration strtegies to competitive conditions", 1986). Economists have suggested that vertical integration reduces environmental uncertainty and associated risks (Blair R. K., 1983). Discussions on uncertainty in vertical integration literature address several types and forms of uncertainty ranging from demand uncertainty to technological uncertainty (Mahoney, 1992).

Globalization has further strengthened the trends towards industry consolidation and vertical ownership as exemplified by the growth of integrated oil and gas companies whose activities span most geographic and product segments of the industry. Conventional wisdom implies that the bigger the size of a company and its market share, the more successful the company is (Mahadok, 1999), (O'Regan, 2002). In order to develop a sustainable competitive advantage, unique resources and capabilities must be acquired, built, combined, maintained and utilized superiorly (Teece, 1980). Size effects can be exploited by improving the utilization of these resources and capabilities and these effects consist mainly of economies of scale and scope (Baumol. W., Panzar, J., & Willig, R., 1982), (Scherer, F.M. & Ross, D., 1990), (Teece, 1980).

This study would try towards closing the gap in our knowledge of the effects of vertical integration on risk and return management of oil and gas companies. Our overarching hypothesis is that balancing vertical integration in a prudent manner helps to minimize the risk and optimize returns. This would result in an increased firm performance.

Purpose

The largest oil and gas companies in the world have for long been vertically integrated, participating in almost all the activities in the supply chain ranging from extraction and refining to transportation and retailing. The oil and gas industry has been one of the most rapidly growing industries in the world.

(Cook, 1997) investigated vertical integration in brewing and petrol industries in UK during 1964-1988 considering three stages: production, wholesale distribution and retail. Vertical relationships were established in these industries in the form of ownership or exclusive dealing contracts. With respect to petrol industry he finds that vertical integration in oil industry was on upward trend – share of sales through ‘managed’ sites increased from 25% in 1964 to 53.1% in 1988; sales proportion for owned petrol premises was equal in 1964 to 0, rising to 32.3% in 1988.

Vertical integration becomes a widespread form of firms’ organization in transition economies, yet there is lack of papers on incentive and description of it. Economists have not been able to provide complete theory of vertical integration that could incorporate transaction cost in neoclassical microeconomic theory (Marchak, 2003).

(Coase R. H., 1992) noted ‘….incorporating transaction costs into standard economic theory…would be very difficult, and economists who, like most scientists…are extremely conservative in their methods, have not been inclined to attempt it’. This necessitates that each case of vertical integration be given a different and specific approach as theoretical models often fail to explain it fully. Due to this reason, the industry specific studies are being undertaken.

By using vertical integration as a business strategy, some of the risks in the oil and gas sector could be mitigated. In a competitive market, the transactions between firms could be executed with arm’s length contracts. But market frictions can lead to a rationale for integration and mergers (Stigler, "The division of labour is limited by the extent of the market", 1951). The modern era has been characterized by integration and strategic partnerships which have become a common behavior in the industry.

This study analyses the corporate strategies in the emerging oil and gas sector to provide an empirical study of the factors which can push companies towards vertical integration. It also addresses the risks of a strategy of vertical integration for the oil and gas sector and assesses their effect on the firm’s performance. It would through light on the corporate dynamics of the world's largest oil and gas companies and on their vertical integration strategies.

Vertical integration in response to market deregulation features several drivers:

Upstream producers aiming to benefit from downstream margins

Reduces transportation costs if common ownership results in closer geographic proximity

Ownership of transportation capacities to exploit arbitraging opportunities

Captures upstream and downstream profit margins

Improves security of supply in case of Downstream companies

Improves utilization of logistics assets

Improves supply chain coordination

In its theoretical part, the study would first analyze the structural characteristics oil and gas sector, and explain the market and firm-specific trends that can currently be observed in each of the oil and gas value chain segments. Secondly, static and dynamic models of vertical integration are to be compared and critically discussed, and a set of influencing variables that are applicable to the specific characteristics of the oil and gas industry in general and the oil companies in particular, is to be derived from the presented theories.

In its empirical part, the study would present some cases from the oil and gas sector. The study would also find the direction of vertical integration i.e. either upstream to downstream or downstream to upstream. The performances are explained by considering the internal and external influence factors. This study, tries to identify the risk factors which can either be eliminated or if not eliminated, can at least be minimized as a result of vertical integration.

The objectives of the proposed research are as follows:

To identify the risks associated with oil & gas sector

To have a stream wise (upstream and downstream) comparative analysis of risk in oil and gas sector

To study the effect of vertical integration on these identified risks in oil and gas sector

Thesis Structure

Chapter 2 Literature Review

The treatment of concepts is essential within scientific research, especially to designate terms (words and linguistic definitions) to concepts, so that what we speak of – and how we speak of it – is in accordance with what is intended (G. Zaltman, 1973). Before discussing the various concepts, it is important to assign meaningful content to the terms so that the various terms are understood in context to the concepts.

Risk

Risk, in traditional terms, is viewed as a ‘negative’. Webster’s dictionary, for instance, defines risk as "exposing to danger or hazard".

The concept of risk is subjective and invented by humans in order to understand and handle many hazards and uncertainties of life. Hazard is real, but no such claim is made about risk, which is established as neither real nor objective as all evaluations of risk are founded upon theoretical models. (Solvic, 2000). (Renn O. , 2008) refers to risk as a complex concept that has instigated many debates in various academic disciplines. His emphasis that perspectives and classifications on how to describe and understand risk in general originate from scientific theories and claims it is possible to argue that all risk concepts have one element in common: the distinction between reality and possibility (Renn O. K., 1992).

The economics perspective of risk is closely related to that of technical science, while psychological science gives the concept a more substantial and complex meaning (Krimsky, 1992). All judgments involve risk to some extent as the decision maker has to consider the possibility of uncertain consequences or losses (Breakwell, 2007).

(Plous, 1993) explains how human decision making process about risk usually portrays two aspects:

What and who does it concern, and

What and how to choose

But human decision making process tends to be influenced by bias and predictable irregularities as people tend to overestimate rare incidents like plane crashes and nuclear accidents while minor, more frequent events, which often happen at home or at the office, are underestimated (Garland, 2003).

"Since risk is essentially a mathematical construct, not an emotional one, the ability to properly understand and assess risk is critical" (Pablo, 1997).

Uncertainty

A situation in which one has no knowledge about which of several states of nature has occurred or will occur (Anderson, B.F., Deane, D.H., Hammond, K.R., & McClelland, G.H., 1981). A situation in which one knows only the probability of which several possible states of nature has occurred or will occur (Anderson, B.F., Deane, D.H., Hammond, K.R., & McClelland, G.H., 1981).

Uncertainty is the inability to assert with certainty one or more of the following: (a) act-event sequences; (b) event-event sequences; (c) value of consequences; (d) appropriate decision process; (e) future preferences and actions; (f) one’s ability to affect future events (Humphreys, P., Berkeley, D., 1985). Uncertainty is the potential for deleterious consequences and lack of information available concerning what the impact of an event might be and exposure to the chance of loss in a choice situation (Lathrop, J.W. and Watson, S.R., 1982).

Uncertainty is a situation where the decision-maker can identify each possible outcome, but does not have the information necessary to determine the probabilities of each of the possibilities (Holmes, 1998).

Vertical Integration

Vertical Integration is most commonly believed to involve common ownership of two or more successive stages in the value creating system and has been considered a strategic device in order to cope better with the competitive environment (Isaksen, 2007). Vertical Integration is defined as "…the organization of two successive production processes by a single firm." (Riordan, 1990).

Risk & Uncertainty

Here risk and uncertainty is being viewed from three angles:

Conceptualization of risk and uncertainty in the academic literature.

Conceptualization of risk and uncertainty by oil and gas companies in both upstream and downstream sectors.

Effect of vertical integration on risk and uncertainty specifically in the oil and gas sector.

Conceptualization of risk and uncertainty in the academic literature

These questions are framed by an observation by (Lipshitz, R. and Strauss, O.), that decision-makers conceptualize risk and uncertainty differently and it also affects their methods of coping with it. Risk and uncertainty are inherent in all industries and is a major obstacle to effective capital investment decision-making (Simpson, G.S., Lamb, F. E., Finch, J.H., Dinnie,N.C., 2000), (Simpson, G.S., Finch, J.H. and Lamb, F.E., 1999), (Brunsson, 1985), (Corbin), (Lamb, F.E., Simpson, G.S., Finch, J.H., 1999), (Murtha, 1997), (Newendrop, 1996), (Oransanu, J., and Connolly, T., 1993), (McCaskey, 1986), (Rose, 1987), (P., 1998), (Thompson, 1967).

Uncertainty and risk has been defined in several ways by different researchers. Uncertainty and risk are both defined as a situation in which one has no knowledge about which of several states of nature has occurred or will occur (Anderson, B.F., Deane, D.H., Hammond, K.R., & McClelland, G.H., 1981). It is a situation in which one knows only the probability of which several possible states of nature has occurred or will occur (Anderson, B.F., Deane, D.H., Hammond, K.R., & McClelland, G.H., 1981). Uncertainty is defined as the inability to assert with certainty one or more of the following (Humphreys, P., Berkeley, D., 1985):

act-event sequences;

event-event sequences;

value of consequences;

appropriate decision process;

future preferences and actions;

One’s ability to affect future events.

Risk is the potential for deleterious consequences and uncertainty is the lack of information available concerning what the impact of an event might be (Lathrop, J.W. and Watson, S.R., 1982). Risk is a common state or condition in decision making characterized by the possession of incomplete information regarding a probabilistic outcome (Harrison, 1995). Uncertainty is an uncommon state of nature characterized by the absence of any information related to a desired outcome (Harrison, 1995).

Risk is a situation which refers to a state where the decision-maker has sufficient information to determine the probability of each outcome occurring (Holmes, 1998) and uncertainty is a situation where the decision-maker can identify each possible outcome, but does not have the information necessary to determine the probabilities of each of the possibilities (Holmes, 1998).

Conceptualization of risk and uncertainty by oil and gas companies in both upstream and downstream sectors

Risk and uncertainty are inherent in petroleum exploration (Simpson, G.S., Lamb, F. E., Finch, J.H., Dinnie,N.C., 2000), (Simpson, G.S., Finch, J.H. and Lamb, F.E., 1999), (Lamb, F.E., Simpson, G.S., Finch, J.H., 1999), (P., 1998), (Newendrop, 1996), (Rose, 1987), (Ikoku, 1984), (Megill R. , 1971), (Megill R. , 1979). The circumstances that led to the generation of oil and gas are understood only in a very general sense (Newendrop, 1996), (Ikoku, 1984).The existence, or more particularly the location of traps, cannot be predicted with certainty. Even when a trap is successfully drilled, it may prove barren for no immediately discernible reason (Ikoku, 1984). The economic factors that ultimately affect the exploitation of the resources are subject to capricious shifts that, it has been claimed, defy logical prediction (Ikoku, 1984); an effect that is exacerbated in the oil and gas industry since exploration projects require a large initial capital investment without the prospect of revenues for ten to fifteen years (Simpson, G.S., Finch, J.H. and Lamb, F.E., 1999). These observations led (Newendrop, 1996) to conclude that risk and uncertainty are frequently the most critical factors in decisions to invest capital in exploration. In reality he argues, each time the decision-maker decides to drill a well, he is playing a game of chance in which he has no assurance that he will win (Newendrop, 1996).

Effect of vertical integration on risk and uncertainty specifically in the oil and gas sector

Academic literature shows that uncertainty is a significant determinant of vertical integration (Balakrishnan, S., Wernerfelt, B., 1986), (Harrigan, "Matching vertical integration stategies to competitive conditions", 1986). It is suggested by economists that vertical integration reduces environmental uncertainty and the associated risks (Blair R. &., 1991). (Coase R. , "The Nature of the firm", 1988) was the first to argue that the creation of the firm is essentially a response to environmental uncertainty and risk. (Anderson, E., Schmittlein, D., 1984) and (Walker, G., & D. Weber, 1984) have brought about a positive correlation between demand uncertainty and vertical integration.

Uncertainty is very high in nascent industries and an adoption of vertical integration is expected by firms that want to build a strong position in the new market or industry (Stigler, "The Division of labour is limited by the extent of the market", 1951). This was perhaps the case with the oil and gas industry. When Rockefeller combined Standard Oil and 39 affiliated companies to create Standard Oil Trust in 1882, his goal was not to form a monopoly, because these companies already controlled 90% of the kerosene market. His real goal was economies of scale which was achieved by combining all the refining operations under a single management structure. Thus, we see the roots of vertical integration since the very beginning of the oil and gas industry.

Strategic motivations for vertical integration may be mainly due to the following drivers:

To remain competitive amidst changing regulatory and technological trends, and

To create and exploit quasi-monopolistic market power through vertical foreclosure.

(Ordover, J.A., Saloner, G. & Salop, S.C., 1990) and (Salop, S.C. & Scheffman, D.T.) have reported that most vertical mergers fall in the latter category, as a means to create barriers to new competition or to exclude rival firms from the market by reducing their access to supplies or distribution outlets. Vertically integrated oil and gas companies can control the quality and the timing of the supply of all components of their value chain. Convergence and globalization have strengthened the trends towards industry consolidation with activities spanning across different nations and product segments of the industry.

Euan Baird of Schlumberger in The Economist, 1998, p74 quoted "....the changes unleashed by the mergers look unstoppable". While there may be always be a role for the "scrappy entrepreneur" (The Economist, 1998), size is becoming increasingly important in oil industry.

Return

Risk & Return

Return is the gain or loss of a security during a particular period. The return consists of the income and the capital gains relative on an investment. It is usually quoted as a percentage. The general rule is that the more risk undertaken, the greater is the potential for higher return or loss. Total return accounts for two categories of return: income and capital appreciation. Income includes interest paid by fixed income investments, distributions or dividends. Capital appreciation represents the change in the market price of an asset.

Vertical Integration

As per the neoclassical economic theory, in a world characterized by perfectly competitive product markets, transaction costs should be non-existent and no sustainable advantages can therefore be generated from being vertically integrated. Transaction costs are the costs associated with each transaction that a firm makes (Picard, 2002, p. 66). All firms, integrated or not, earn at best long-term returns that approximate their respective costs of capital. Any management action that by chance caused a positive deviation from the expected level of return is soon be eroded by competition's counterattack (Coase, 1988).

But the assumptions of perfect competition and perfectly transparent market are impossible to in the real world, therefore vertical integration has been a recurring and often dominant strategy for enterprises in many different industries. The causes of vertical integration and its consequences on market outcomes and consumer welfare have been extensively researched and discussed by academic and industry scholars. According to these theories, vertical integration can on the one hand promote efficiency by eliminating successive monopoly mark-ups, internalizing service, and mitigating contractual problems between firms (Williamson, 1971; Grossman and Hart, 1986).

On the other hand, it can facilitate the strategic practice of market foreclosure, whereby an integrated firm denies rivals access to markets in order to gain greater market power. The first effect results in lower prices, higher sales, and greater consumer welfare, while the second raises the prices of final goods, thereby harming consumers (Chipty, 2001).

There are various definitions of vertical integration that have been formulated by almost every scholar in this field of study.

Riordan, states that "vertical integration is the organization of successive production processes within a single firm, a firm being an entity that produces goods and services" (Riordan, 1990, p. 2). Eckard (1984, p. 105) defined vertical integration as "a range of activities involved in producing and selling products which take place within the firm rather than within supplying firms". Temin (1988, p. 892) went slightly further by stating that "vertical integration is the elimination of contractual and market exchanges, and the substitution of internal exchanges within the boundary of the firm".

And Harrigan (1986, p. 536) defined vertical integration as "a pattern of diversification that combines lines of business in a way that allows a company to use the outputs of one line of business as inputs for another line of business".

According to the economists Scherer & Ross (1990, p.93), "vertical integration in the static sense describes the extent to which firms cover the entire spectrum of production and distribution stages".

Vertical integration can occur in two directions: upstream and downstream. Upstream, or backward vertical integration, involves ownership and production of the raw materials that might otherwise be supplied from independent, external producers. A firm would thus integrate upstream in order to ensure that the supply of its raw materials is always available.

Downstream, or forward vertical integration, involves controlling the final or finishing steps of semi-fabricated products and the wholesaling and retailing operations that deliver goods to consumers (Scherer & Ross, 1990). Downstream integration is expected to improve performance through achieving greater influence over the nature and level of demand.

Chapter 3 Research Strategy

Chapter 4 Data Analysis and Interpretation

Typical Risks in Oil & Gas Industry (Al-Thani F. , 2008):

Products Offtake

- Gasoline

- Diesel

- Heating Oil

- Propane

- Other

Operations & Maintenance

- Supply of material

- Labour issues

- Environmental Risk

-Interruption of Refinery Process Risk

- Liquidity Risk

- Debt Service Risk

Price & Demand Derivatives

- Demand Risk

- Marketing Risk

- Commercial Risk

Upstream Exploration & Recovery - Exploration risk

- Design Risk

- Facility Risk

- Technology Risk

- Recovery Risk

- Environmental Risk

- Transportation Risk

Refining & Marketing

- Planning Design risk

- Construction Risk

- Commissioning Risk

- Regulatory Risk

- Permits & License Risk

- Availability of materials

- Financing Risk (instruments)

- Delay Risk

- Decommissioning Risk

Crude Oil Supply: Type/Time/Quality

- Delay risk

- Price Risk

- Quality Risk

- Quantity Risk

- Transportation Risk

National Oil Companies

(Refining)

Risks Identified and Explained

Upstream – Exploration & Recovery

S.No.

Risk

Author

Title

Meaning

1

Exploration risk

Rüdiger Schulz, Reinhard Jung, Sandra Pester and Rüdiger Schellschmidt (Rüdiger Schulz, 2007)

Quantification of Exploration Risks for Hydrogeothermal Wells

Exploration risk concerning hydrogeothermal wells is the risk of not achieving a geothermal reservoir by one (or more) well(s) in sufficient quantity or quality.

Exploration risk is the risk of not successfully achieving (economically acceptable) minimum levels of thermal water production (minimum flow rates) and reservoir temperatures

2

Drilling risk

Rüdiger Schulz, Reinhard Jung, Sandra Pester and Rüdiger Schellschmidt (Rüdiger Schulz, 2007)

Quantification of Exploration Risks for Hydrogeothermal Wells

Drill risk means all technical risks concerning well rig and drilling operation. These are risks of the drilling company; they can be covered by insurance contracts.

3

Design risk

Business Dictionary

http://www.businessdictionary.com/definition/engineering-risk.html#ixzz2N9q0gYzr

Effect of deficiencies or flaws in design or engineering of project on its cash-flow.

4

Operation risk

Rüdiger Schulz, Reinhard Jung, Sandra Pester and Rüdiger Schellschmidt (Rüdiger Schulz, 2007)

Quantification of Exploration Risks for Hydrogeothermal Wells

Operation risk means all changes of quantity (flow rate, temperature) or quality (composition) of the fluid during the geothermal lifetime of

the well(s). This risk includes changes in the technical installations of the geothermal cycle caused directly or indirectly by the fluid, e.g. corrosion or scaling.

5

Geological Risk

Rüdiger Schulz, Reinhard Jung, Sandra Pester and Rüdiger Schellschmidt (Rüdiger Schulz, 2007)

Quantification of Exploration Risks for Hydrogeothermal Wells

This term is normally used in petroleum exploration. It is more comprehensive than the exploration risk. It also contents the risk, whether a certain geological underground structure interpreted by seismic exploration exists or not. Geological risk also contains geological problems during drilling, e.g. not expected layers, in-situ pressure or fluids.

6

Geotechnical risk

Evert Hoek and Alessandro Palmeiri (Palmeiri, 1998)

Geotechnical risks on large civil engineering projects

Geotechnical risks, in the form of unforeseen geological conditions, are a serious factor in cost and schedule control on all major civil engineering projects. The amount of money, involved in claims arising from these geotechnical problems, is enormous and needs to be taken very seriously by financing agencies and engineering organizations. Inadequate site investigations rank as one of the major contributors to geotechnical risk. More realistic

allocations of time and money have to be made to these site investigation programs

7

Technology risk

Business Dictionary

http://www.businessdictionary.com/definition/technical-risk.html#ixzz2N9eGYT2b

Exposure to loss arising from activities such as design and engineering, manufacturing, technological processes and test procedures.

8

Recovery risk

Petroleum Production (htt1)

Encyclopedia Britannica

Facts matter

Petroleum reservoirs usually start with a formation pressure high enough to force crude oil into the well and sometimes to the surface through the tubing. However, since production is invariably accompanied by a decline in reservoir pressure, "primary recovery" through natural drive soon comes to an end. In addition, many oil reservoirs enter production with a formation pressure high enough to push the oil into the well but not up to the surface through the tubing. In these cases, some means of "artificial lift" must be installed. The most common installation uses a pump at the bottom of the production tubing that is operated by a motor and a "walking beam" (an arm that rises and falls like a seesaw) on the surface. A string of solid metal "sucker rods" connects the walking beam to the piston of the pump. Another method, called gas lift, uses gas bubbles to lower the density of the oil, allowing the reservoir pressure to push it to the surface. Usually, the gas is injected down the annulus between the casing and production tubing and through a special valve at the bottom of the tubing. In a third type of artificial lift, produced oil is forced down the well at high pressure to operate a pump at the bottom of the well.

With the artificial lift methods described above, oil may be produced as long as there is enough nearby reservoir pressure to create flow into the well bore. Inevitably, however, a point is reached at which commercial quantities no longer flow into the well. In most cases, less than one-third of the oil originally present can be produced by naturally occurring reservoir pressure alone, and in some cases (e.g., where the oil is quite viscous and at shallow depths) primary production is not economically possible at all.

The recovery rate of a hydrocarbon deposit is the proportion of oil or gas that can be recovered from the deposit during mining, as compared to the total amount of hydrocarbons contained. Depending on the sites worked, the recovery rate of crude oil varies between 10 and 50%. (htt2)

9

Environmental risk

Chapter 1

Environmental Risk (htt)

Environmental Risk

Environmental risk arise in, or are transmitted through, the air, water, soil or biological food chains, to man. Their causes and characteristics are, however, very diverse. Some are created by man through the introduction of a new technology, product or chemical, while others, such as natural hazards, result from natural processes which happen to interact with human activities and settlements. Some can be reasonably well anticipated, such as flooding in a valley or pollution from an industrial smelter. Others are wholly unsuspected effects at the time the technology or activity was developed, such as the possible effects on the earth's ozone layer of fluorocarbon sprays or nitrogen fertilizers.

10

Financial risk

Business Dictionary (htt3)

Black’s Law Dictionary (htt4)

Financial Risk

What is Financial Risk?

The probability of loss inherent in financing methods which may impair the ability to provide adequate return.

The loss that occurs in financing. It impairs profit to cover loss.

 

11

Credit risk

Edgar R Fiedler (Fiedler, 1971)

Meaning & Importance of Credit Risk

The term "credit risk," is a forward-looking concept, focusing on the probable incidence of credit difficulties in the future.

12

Transportation risk

Institute for the Analysis of Global Security (htt5)

Threat to Oil Transport

Getting oil from the well to the refinery and from there to the service station requires a complex transportation and storage system. Millions of barrels of oil are transported every day in tankers, pipelines and trucks. This transportation system has always been the Achilles heel of the oil industry but it has become even more so since the emergence of global terrorism.

Pipelines, through which about 40% of world's oil flows, are no less vulnerable. They run over thousands of miles and across some of the most volatile areas in the world.

Upstream – Crude Oil Supply

13

Delay risk

Construction Management Guide (htt6)

Managing the risk of delay in projects

Delay means different things to different parties. From the outset of a project, therefore, it is important to identify the problems that the risk of delay creates for the different parties involved. If a building cannot be used when intended, all manner of problems are potentially created for the client. Realization of an income from the asset maybe postponed, alternative accommodation costs may be incurred, financing costs may increase, and depending upon how risk is allocated in the contract and the nature of the delay events, the client maybe faced with claims from the contractor.

For a contractor, a delay means an increase in overheads, potential liabilities to the supply chain and a liability for damages to the clients if such a provision has been included in the contract.

14

Price risk

Investopedia (htt7)

Definition of Price Risk

The risk of a decline in the value of a security or a portfolio. Price risk is the biggest risk faced by all investors. Although price risk specific to a stock can be minimized through diversification, market risk cannot be diversified away. Price risk, while unavoidable, can be mitigated through the use of hedging techniques.

15

Quality risk

Energy & the Environment (htt8)

Crude Quality Issues

Crude oil is a highly variant natural resource. The quality ranges are similar to coal and depending on the maturation of the crude the quality can be high or low (younger crude's are of lower quality). One of the first indications of quality is color. The variations in oil color can be dramatic, and very indicative of the quality of that crude. Not all crude oil is black - higher quality oils can be a golden or amber in color.

16

Quantity risk

The Free Dictionary by Farlex (htt9)

Quantity Risk

Occurs when the quantity of an asset to be hedged is uncertain.

17

Transportation risk

Institute for the Analysis of Global Security (htt5)

Threat to Oil Transport

Getting oil from the well to the refinery and from there to the service station requires a complex transportation and storage system. Millions of barrels of oil are transported every day in tankers, pipelines and trucks. This transportation system has always been the Achilles heel of the oil industry but it has become even more so since the emergence of global terrorism.

Pipelines, through which about 40% of world's oil flows, are no less vulnerable. They run over thousands of miles and across some of the most volatile areas in the world.

Downstream – Refining & Marketing

18

Planning Design risk

Risk Management in Design (htt10)

The design process has numerous areas of potential risk which must be managed or mitigated to protect the designer and his business entity. In today’s construction climate, a wise owner also wants his designer to have appropriate risk management skills as a signal of the designer’s attention to, and control of those little details which can later become major problems. While risk avoidance looms large in the eye of the design professional, there is an even bigger objective – to provide value-added service to clients and operate at a profit. Proper design performance is the first and largest step a firm can make towards successful risk management.

19

Construction risk

Business Dictionary (Bus)

Probability of loss associated with the physical (construction) phase of a construction project.

20

Commissioning risk

Business Dictionary (Bus)

Reduce risk in commissioning (Landry)

Process by which an equipment, facility, or plant (which is installed, or is complete or near completion) is tested to verify if it functions according to its design objectives or specifications.

Commissioning prepares a facility or platform for operation prior to its opening for production. The performance of the facility is compared to design, operating and regulatory specifications. Operating and safety equipment, systems and inter-system functions are tested, and areas that need correction are identified. Commissioning has also been extended into the design process, where it works (in part) as a peer-review process. 

21

Regulatory risk

Investopedia Financial Dictionary (Investopedia Financial Dictionary)

Business Dictionary (htt11)

The risk that a change in laws and regulations will materially impact a security, business, sector or market. A change in laws or regulations made by the government or a regulatory body can increase the costs of operating a business, reduce the attractiveness of investment and/or change the competitive landscape.

Exposure to financial loss arising from the probability that regulatory agencies will make changes in the current rules (or will impose new rules) that will negatively effect the already-taken trading positions

22

Permits & License risk

A permit or licence is required to perform high risk work requiring work with high risk equipment or plant.

23

Availability of materials

This risk relates to regular supply of materials. If there are disruptions in supply due to various reasons, then a risk is involved.

24

Financial risk

Business Dictionary (htt12)

The risk that the cash flow of an issuer will not be adequate to meet its financial obligations. Also referred to as the additional risk that a firm's stockholder bears when the firm uses debt and equity.

25

Delay risk

Managing the Risks of Delay in Construction Projects (Pillay)

Mohan Pillay

Delay in any construction project is a common occurrence.

The first step in any risk management strategy is to identify the problems the risk of delay creates for the different parties involved in the project.

For the owner, delay means that the asset cannot be used when intended, causing alternative accommodation costs to be incurred or a delay in receiving income from the asset. The cost of financing the project could also increase, and depending upon the contractual allocation of risk and the events causing the delay, the delay could give rise to claims by the contractor

For the contractor, delay means an increase in overheads, such as site staff and facilities, potential liabilities to the supply chain and depending on the reason for the delay it can mean a liability for delay damages to the owner. The delayed recovery of payments and the tie up of resources in the project can also create cash flow problems and the risk of insolvency

26

Decommissioning risk

Merna, Tony & Al-Thani, Faisal F. (Al-Thani T. M., 2005)

Corporate Risk Management: An Organisational Perspective

The purpose of decommissioning is often to return a former operational plant back to brown- or greenfield site status. Over the course of operations, many industries (mining, quarrying, chemical industries, nuclear) have to plan for the end of lifetime costs for their plants, whether dismantling or reconditioning the sites. These characteristics of the project have financial consequences in regard to cost estimating and financing, for which there does not exist one single answer to date, and thus by definition creates risk.

Downstream – Operations & Maintenance

27

Steady supply of material

This risk relates to the regular supply of material for operation and maintenance purposes. Supply may be disrupted due to various reasons which may be avoidable or unavoidable.

28

Labour risk

Employees represent the greatest asset of almost every business, and attracting and retaining the right people is a cornerstone of business success for most enterprises. While

the ability to hire and keep the right people can be based on many diverse factors

29

Environmental risk

Business Dictionary (htt13)

Actual or potential threat of adverse effects on living organism and environment by effluents, emissions, wastes, resource depletion, etc., arising out of an organization's activities.

30

Resource risk

Business Resource Definition (Thornton)

Shane Thornton

Business resources are anything and everything that helps a company operate and do business. This can include the use of human capital, natural resources, tangible resources such as property or production machinery, intangible resources such as brand image and knowledge, financial resources and anything else a particular business may use to make a profit. Every business resource used to produce goods or to serve customers has an economic value.

31

Liquidity risk

Business Dictionary (htt14)

Probability of loss arising from a situation where (1) there will not be enough cash and/or cash equivalents to meet the needs of depositors and borrowers, (2) sale of illiquid assets will yield less than their fair value, or (3) illiquid assets will not be sold at the desired time due to lack of buyers.

32

Debt-service risk

Definition of ‘Debt service’ (htt15)

Investopedia

The cash that is required for a particular time period to cover the repayment of interest and principal on a debt. Debt service is often calculated on a yearly basis. Debt service for an individual often includes such financial obligations as a mortgage and student loans. Companies may have outstanding loans or outstanding interest on bonds or the principal of maturing bonds that count towards the company's debt service. An individual or company that is not able to make payments to service the debt can