H17picoursetext PDF

Strategic
Planning
for the
Oil and Gas Industry
Dr Craig Robinson
Professor Alex Scott
PI-A1 1/2017 (1052)

This course text is part of the learning content for this Edinburgh Business School course.
In addition to this printed course text, you should also have access to the course website in this subject,
which will provide you with more learning content, the Profiler software, and past examination questions
and answers.
The content of this course text is updated from time to time and all changes are reflected in the version
of the text that appears on the accompanying website at http://coursewebsites.ebsglobal.net/
Most updates are minor, and examination questions will avoid any new or significantly altered material for
two years following publication of the relevant material on the website.
You can check the version of the course text via the version release number to be found on the front
page of the text and compare this to the version number of the latest PDF version of the text on the
website.
If you are studying this course as part of a tutored programme, you should contact your centre for
further information on any changes.
Full terms and conditions that apply to students on any of the Edinburgh Business School courses are
available on the website www.ebsglobal.net, and should have been notified to you either by Edinburgh
Business School or by the centre or regional partner through whom you purchased your course. If this is
not the case, please contact Edinburgh Business School at the address below:
Edinburgh Business School

Heriot-Watt University
Edinburgh
EH14 4AS
United Kingdom
Tel + 44 (0) 131 451 3090

Fax + 44 (0) 131 451 3002
Email enquiries@ebs.hw.ac.uk
Website www.ebsglobal.net
The courses are updated on a regular basis to take account of errors, omissions and recent
developments. If you'd like to suggest a change to this course, please contact us:
comments@ebs.hw.ac.uk
Strategic Planning for the Oil and Gas
Industry
Craig Robinson BA (Hons) MBA PhD FHEA
Craig Robinson leads the Strategy teaching team and is a Senior Teaching Fellow at Edinburgh Business
School. He runs on-campus Strategic Planning and Competitive Strategy seminars, and is the examiner for
Strategic Planning and Competitive Strategy.
Craig’s research interests are focused on strategy-making processes. His PhD research involved examina-
tion of strategy processes and environmental scanning techniques in small, medium and large
organisations. He is also interested in oil prices and management processes in the energy industry. He has
presented conference research on oil prices and their relationship with management behaviour, and has
run strategy development workshops for middle and senior management of large organisations in the oil
and gas industry. He is currently writing a series of research papers concerned with environmental
scanning and various aspects of strategy.
Craig delivers seminars and simulation exercises for the School at various locations in Europe, Asia, Africa
and the Middle East. He is a contributor to the Economics course text, and co-author of two of the oil
and gas management courses.
Craig spent most of 2013 as Acting Head of Edinburgh Business School Malaysia at the Heriot-Watt
University Campus in Putrajaya. While there, he oversaw the establishment and development of the
Edinburgh Business School MBA programme.
Professor Alex Scott MA MSc PhD
Alex Scott is Professorial Fellow and Director of Learning and Teaching at Edinburgh Business School. He
is an economist, and has published two books and more than 30 research papers on efficiency in educa-
tion, efficient use of energy, energy and the environment, and the cost to the taxpayer of government
industrial aid programmes.
Alex is a pioneer in developing and carrying out research into new educational techniques, particularly in
business simulations. His executive teaching includes running strategic planning sessions for groups of
senior managers, widening the perspectives of functional managers, and teaching financial specialists how
economies function in today’s highly complex and interdependent world.
First published in Great Britain in 2010
© Craig Robinson, Alex Scott 2010, 2016
The rights of Craig Robinson and Alex Scott to be identified as Authors of this Work have been asserted
in accordance with the Copyright, Designs and Patents Act 1988.
All rights reserved; students may print and download these materials for their own private study only and
not for commercial use. Except for this permitted use, no materials may be used, copied, shared, lent,
hired or resold in any way, without the prior consent of Edinburgh Business School.
Contents
Module 1 The Oil and Gas Industry: A Strategic Perspective 1/1
1.1 Introduction 1/1

1.2 How to Use This Course 1/2
1.3 The Context: Defining the Oil and Gas Industry 1/3
1.4 Strategic Issues in the Oil and Gas Industry 1/6
1.5 The MythicOil Company 1/7
1.6 Course Outline 1/13
Learning Summary 1/14
Module 2 Strategists and Their Characteristics in the Oil and Gas Industry 2/1

2.2 Decision-Maker Types 2/3
2.3 Human Resource Management Culture 2/5
2.4 Strategists in the Oil and Gas Industry 2/7
2.5 Applying the Process Model 2/14
Module 3 Strategic Objectives in the Oil and Gas Industry 3/1

3.2 Deciding on Business Definition 3/1
3.3 Mission, Vision and Objectives 3/7
3.4 Business Unit and Individual Objectives 3/17
3.5 Corporate Social Responsibility 3/21
3.6 Business Ethics in the Oil and Gas Industry 3/24
3.7 Objectives in Practice 3/26
Module 4 Macro-environment Issues in the Oil and Gas Industry 4/1

4.2 Revisiting the Cost and Revenue Model 4/2
4.3 Oil Prices 4/7
4.4 Peak Oil 4/13
4.5 Renewable Energy 4/19
4.6 The Economy 4/21
Strategic Planning for the Oil and Gas Industry Edinburgh Business School v
Contents
4.7 PEST Analysis 4/30

4.8 Environmental Threat and Opportunity Profile 4/38
Module 5 Competitive Environments in the Oil and Gas Industry 5/1

5.2 The Nature of Demand in the Industry 5/2
5.3 Oil and Gas Prices 5/7
5.4 Market Structures in the Oil and Gas Industry 5/17
5.5 The Industry Supply Chain: Sectors and Stages 5/19
5.6 Upstream Sector Market Analysis 5/27
5.7 Crude Oil Trading Market Analysis 5/40
5.8 Downstream Oil Market Analysis 5/44
5.9 Natural Gas Processing and Trading Market Analysis 5/59
5.10 Downstream Gas Market Analysis 5/61
5.11 Implications of the Supply Chain Analysis 5/67
5.12 Environmental Threat and Opportunity Profile 5/69
Module 6 Strategic Analysis of Historical Company Accounts 6/1

6.2 Analysing Historical Published Accounts 6/2
6.3 Strategy and Business Definition 6/3
6.4 Company Finances 6/6
6.5 Divisional Performance and Operating Efficiency 6/11
6.6 Overall Company Finances 6/18
6.7 Value Chain 6/18
6.8 Scope and Scale 6/24
6.9 Competences and Strategic Architecture 6/34
6.10 Strategic Advantage Profile 6/35
6.11 Shell in 2015 6/36
Module 7 Strategic Options in the Oil and Gas Industry 7/1

7.2 Strengths, Weaknesses, Opportunities and Threats 7/2
7.3 Corporate Strategy Options 7/6
7.4 Business Strategy Options 7/12
7.5 Strategy Variations: Directions and Methods 7/14
vi Edinburgh Business School Strategic Planning for the Oil and Gas Industry
Contents
7.6 From SWOT to Strategy 7/29

Module 8 Implementation and the Oil and Gas Strategic Process 8/1

8.2 Organisational Structure 8/2
8.3 Resource Allocation 8/9
8.4 Evaluation and Control 8/11
8.5 Feedback 8/13
8.6 The Augmented Process Model 8/15
8.7 Conclusion: Strategic Thinking in the Oil and Gas Industry 8/17
Appendix 1 Practice Final Examinations A1/1

Practice Final Examination 1 A1/2
Practice Final Examination 2 A1/7
Examination Answers A1/12
Index I/1
Strategic Planning for the Oil and Gas Industry Edinburgh Business School vii
Module 1
The Oil and Gas Industry: A Strategic

Perspective
Contents
1.1 Introduction.............................................................................................1/1
1.2 How to Use This Course ........................................................................1/2
1.3 The Context: Defining the Oil and Gas Industry ................................1/3
1.4 Strategic Issues in the Oil and Gas Industry ........................................1/6
1.5 The MythicOil Company ........................................................................1/7
1.6 Course Outline ..................................................................................... 1/13
Learning Summary ......................................................................................... 1/14
Learning Objectives
When you have completed this module, you should be able to:
 define the oil and gas industry from the strategic perspective;
 demonstrate the types of industry-specific strategic problem encountered on a
day-to-day basis; and
 identify the role of structured thought in tackling industry-specific strategic
issues.
1.1 Introduction
The core Strategic Planning (Core SP) course developed the generic structure within
which concepts and models are applied in analysing the strategic process. This
generic structure, the strategic process model for which is shown in Figure 1.1, is
designed to be applied to any organisation in any industry. The idea behind the Core
SP course is that strategy is a complex issue that requires a structured approach to
be better understood. Students should have emerged from the course with a more
comprehensive and structured understanding of the business world.
What, then, is the role of an industry-specific course such as this? This course,
concerned exclusively with the oil and gas industry, takes the generic framework
developed in the Core SP course and applies it to a number of different issues in the
oil and gas industry. It tackles strategic issues that are relevant to the industry today,
and introduces new models, tools and concepts that are uniquely relevant to
companies and individuals operating in the oil and gas industry.
Strategic Planning for the Oil and Gas Industry Edinburgh Business School 1/1
Module 1 / The Oil and Gas Industry: A Strategic Perspective
The outcome of studying this Strategic Planning for the Oil and Gas Industry course
should therefore be a wider and deeper understanding of the industry itself, of its
peculiarities and of the key strategic issues facing the industry today.
Strategists Objectives Who decides

to do what
The macro The industry Internal Competitive Analysis and

environment environment factors position diagnosis
Feedback
Generic strategy Strategy Strategy Choice

alternatives variations choice
Resources and Resource Evaluation Implementation

structure allocation and control
Figure 1.1 The strategic planning process model

The remainder of this introductory module is concerned with the industry con-
text and background information on strategic issues in the oil and gas industry. A
brief outline of how the course should be used is provided. This is followed by the
introduction of a working model of the oil and gas industry supply chain. This
model, alongside the strategic process model introduced in the Core SP course,
forms the backbone of this industry-specific course. A number of strategic issues in
the industry are then examined, some of which are considered in the context of an
oil company decision-making example.
1.2 How to Use This Course

Because this course articulates from the Core SP course, many of the concepts and
tools used will be familiar to the reader. We assume from the outset that you recall,
understand and are able to use the concepts contained in the augmented process
model provided in Core SP Module 8. That said, we also acknowledge that you may
wish to refer to the original exposition of a model to refresh your memory from
time to time. Thus, rather than repeat the exposition of a particular model or
concept, the course has been cross-referenced, citing the module and section in the
1/2 Edinburgh Business School Strategic Planning for the Oil and Gas Industry
Core SP text that is of relevance at a particular time. (Those using electronic

versions of the text will find that these cross-references are ‘clickable’ links.)
As an example, several generic issues that were dealt with in Core SP Module 1
are not repeated here, but are relevant to an exposition of strategy in the oil and gas
industry. If you feel that you are unsure of the implications of these, you should
review the following topics:
1. The definition of strategy (Core SP Sections 1.2.1, 1.2.2).
2. The three approaches to strategic planning (Core SP Section 1.2.3).
3. The distinction between ‘tame’ and ‘wicked’ problems (Core SP Section 1.2.4).
4. The difference between strategy and tactics (Core SP Section 1.2.5).
5. The problem of applying the scientific approach to understanding strategic
outcomes (Core SP Section 1.2.6).
6. The definition of strategic thinking (Core SP Section 1.2.7).
7. The distinction between corporate and business strategy (Core SP Section 1.4).
8. The historical development of strategic ideas (Core SP Section 1.5).
These background ideas apply across all industries, whether oil and gas, electronics,
banking, restaurants or voluntary organisations. Reviewing the issues briefly, it needs
to be borne in mind that there is a great deal of confusion regarding what strategy is
(topics 1, 2 and 4), that strategy poses some intractable conceptual issues not
typically recognised (topic 3), that statistically based research into strategy is largely
pointless (topic 5), that strategic thinking involves integrative and evaluative skills
that need to be developed (topic 6), that different strategic issues emerge at corpo-
rate and business levels (topic 7), and that advances in strategic thinking have been
driven mainly by major changes in economic activity (topic 8). The rest of this
module is concerned with how some of these ideas apply to the oil and gas industry
in particular.
1.3 The Context: Defining the Oil and Gas Industry

The purpose of this section is to explicitly define the oil and gas industry for the
purpose of this course and for the other courses in the MBA Oil and Gas Manage-
ment specialism. The model discussed in this section is the result of a significant
amount of research by the authors, involving looking at technical and management
data from governments and speaking to those working in and around the industry.
Often, the initial response of those involved in the industry is that it is patently
obvious what the industry is: it comprises upstream and downstream activities (i.e.
oil and gas is extracted upstream and processed and sold downstream). But that is
merely a description; it says nothing about the difference between upstream and
downstream markets, what contributes to success upstream and downstream, and
why some companies straddle both activities.
As strategists, we are interested in the industry supply chain that identifies the
markets through which the product passes on its journey from discovery through to
final consumption. This question is initiated by application of the concept of
‘vertical integration’ (Core SP Section 6.12.3): a company that covers the whole
supply chain is vertically integrated and a major strategic issue is the relatedness of
the various stages of the industry supply chain. Therefore, the first step is to
construct a model of the industry supply chain that identifies the relevant markets at
each stage. This model might not accord with the interpretation of a technologist,
who will focus on the physical processes involved.
The oil and gas industry supply chain model, presented in Figure 1.2, shows the
main business areas of the oil and gas industry as a whole. Anything not represented
in this figure is not taken to be part of the industry for the purposes of this course.
UPSTREAM
Exploration
Unconventionals Development
Production
Crude oil trading Gas processing
DOWNSTREAM
OIL Gas trading
Transport
DOWNSTREAM
GAS
Refining Gas marketing
LNG
Petrochemicals Storage Transmission

and storage
Marketing and Distribution

distribution pipeline
Figure 1.2 The oil and gas industry supply chain model
Managers in the industry often talk of upstream, midstream and downstream
activities, but this level of division is not detailed enough for our purposes. Here, we
divide the industry into three sectors as follows:
 the upstream sector, concerned with the finding, extraction, initial processing and
trading of both oil and gas;
 the downstream oil sector, concerned with transporting, refining and marketing a
large variety of oil-based products; and
 the downstream gas sector, concerned with marketing and transporting gas to end
consumers.
Each of these three sectors contains various stages that group together logically.
Thus our model of the oil and gas industry contains only three sectors but 16
distinct stages that are of interest. The details of each sector, along with its strategic
characteristics, are examined further in Module 5 of this course. The sectors and
stages of the model will be referred to consistently throughout the remainder of the
course.
What will emerge later in the course about this model is that the stages in each
sector can in some ways be very similar, while their strategic characteristics are
markedly different. This means that the characteristics of the individual stages of the
supply chain, and how the product moves from one to the next, become more
important than the distinction between more general upstream, midstream and
downstream issues. Specific questions that now emerge, developed by thinking
quickly through the strategic process model, include the following.
 What chief executive officer (CEO) characteristics are most appropriate for each
stage?
 How does the impact of certain political, environmental, social and technological
(PEST) factors vary along the chain?
 Are there different competitive forces at each stage?
 Are market growth rates similar across stages, or do they differ?
 Is extending operations across more than one stage likely to result in economies
of scope?
 What are the returns at each stage of the supply chain and what determines
these?
 Which generic strategy is most appropriate at a given stage?
 What company structure is most appropriate at each stage?
 How should performance be measured at different stages?
Already, by looking at this by-no-means-comprehensive list of questions, it can be
seen that, by applying structure to a complex question, a deeper level of insight can
be found.
By way of an example, in Core SP Section 1.1 it was demonstrated that a new
product launch would be liable to fail if any of the six core disciplines were not
applied effectively. This generic example related to any industry, but an industry-
specific interpretation of the roles of the core disciplines can be gained by consider-
ing a new product launch in two stages of the oil and gas industry supply chain: one
from the upstream sector and another from the downstream oil sector (see Table
1.1).
Table 1.1 Core business disciplines in the oil and gas industry
Core course Introduce new exploration technique Launch a new petrol variant
Organisational Convince operatives of need to change Ensure that salespeople have the
Behaviour technology; employ different scientists incentive to promote it
Economics Is this the right time in the oil price cycle What is the price elasticity of demand?
to invest?
Marketing Does the new technology enhance the How will the product be positioned in
brand image? the portfolio?
Finance What is the effect on gearing? What is the effect on rate of return?
Accounting What is the breakeven? Can the relevant costs be identified?
Project There can be no quality trade-off Ensure it is available countrywide
Management
The two product launches exhibit different arrays of critical factors relating to
each discipline. No doubt industry specialists would think of other factors, but the
importance of the generic disciplines is again highlighted. The important issue is that
while the answers may be industry-specific, the questions are generic. The rest of
this course will use the supply chain model developed in this section, in conjunction
with the strategic process model, to propose and answer useful and, we hope,
interesting strategic questions about the oil and gas industry.
1.4 Strategic Issues in the Oil and Gas Industry

If you were to ask oil industry managers what they think are the strategic issues
facing companies in the industry, you would get a list of questions that might
include the following.
 When will the oil price stop being so volatile?
 Where is the oil price likely to go next?
 How will the increasing importance of unconventional resources affect the
industry?
 What are the advantages of being vertically integrated?
 How will concerns about the environment and the increasing prevalence of
renewable energy affect the industry?
 What are the characteristics of a successful oil CEO?
 What impact is the increasing difficulty of access to resources likely to have on
the industry?
 Why are margins so different upstream and downstream?
These are clearly important issues, but where did they come from? Are they really
the most important issues facing companies in the oil and gas industry? What
criteria can be used to determine which of these are strategic questions? The student
with an understanding of the Core SP course might frame a series of questions in a
more structured form, such as the following.
 What objectives do different companies have?

 What CEO characteristics are optimal for different companies?
 What are the major likely events in the macro environment?
 What is happening to competition?
 What are a company’s strengths and weaknesses?
 What strategy is likely to result in competitive advantage?
 How can strategy be implemented effectively, given industry conditions?
 Do companies learn, or are they always in reactive mode, given market volatility?
This list will be immediately recognisable as comprising questions derived from the
strategic process model. It does not consist of randomly selected issues (partly
influenced by current events), but addresses the robustness of the strategic process
in individual companies. It is a structured set of questions that recognises that the
important issues facing a company in the industry relate not so much to the indus-
try-specific ones, such as price volatility, as they do to the capability of the company
to perform effectively in the particular economic environment.
If this student were then to be asked for a more detailed set of issues, it would be
a simple matter for him or her to refer to the augmented process model and
produce a list, possibly of overwhelming magnitude, that included the original list
and many more. Then the scene would be set for finding something out about
strategic planning in the industry.
1.5 The MythicOil Company

In Core SP Module 1, the Mythical company portrayed a series of events that are
typically encountered in everyday business. Without an understanding of strategic
planning, it was impossible to impose a structure on the events or to identify
analytically what was going on. A similar series of events can be characterised for
the MythicOil company, but this time it should be possible to have insight into what
has happened and be equipped to interpret the events.
The MythicOil company comprises:
 ten production-sharing agreements in different parts of the world, four of which
are operated and six of which are non-operated;
 a small seismic exploration vessel (the Medusa), which is typically leased out;
 a large refinery in a medium-sized city; and
 a local chain of filling stations in that same city.
The CEO has the same three questions as did Mythical’s CEO.
 How well are we performing?
 What should we be doing in the future?
 How can we achieve successful change?
This time, do not read the events like a story, but attempt to identify relevant
concepts and ideas, and think in terms of the process model structure. The scenario
presented is fictional but serves as a useful introduction to strategic thinking in the

industry.
1.5.1 How Well Are We Performing?

CEO’s statement to the board
The company has been making a profit for the past three years, but a recent fall
in the oil price has led to reduced margins. Three of the operated production
platforms need upgrading and are costly to run, while it is becoming increasingly
difficult to lease out the Medusa because of the run-down in exploration general-
ly, and the tendency for the on-board hardware to fail. But our refinery and
filling stations are making as much money as ever. I need more facts before de-
ciding what to do, so I am instructing the top team to prepare brief executive
reports.
Accounting report
The company is currently making a 10% return on assets. The Medusa is draining
cash and profitability would be increased by selling it. We became cash-rich over
the last few years because of the high oil price, but now we are dependent on our
downstream business to generate cash. In fact, our cash-flow position is not
good because of current expenditure on upgrade investment. Our gearing is now
60% and so I feel we should suspend investment.
Marketing report
My main function is to maintain the brand image of our filling stations, and find
customers for the excess production of our refinery. Our margins are continually
being squeezed and we did not seem to benefit much from the high oil price
over the past few years.
Economic report
The oil price increase in recent years was caused by increased growth in India
and China – but now that India and China have stalled, and production has in-
creased in both the USA and the Middle East, the future for oil looks more
settled. I predict that the oil price will now remain relatively low for several years
at least. There will be a reduced demand for exploration, but it is a good time to
invest in more production platforms at a reduced price.
Production report
The main production effort is to get the oil out of the ground and feed it to our
refinery; it cannot take all our production, so we have to sell about half our out-
put on the world market. We shall not be able to keep production at current
levels for much longer because of the maintenance issues that we have not yet
dealt with.
Manpower report
There is a shortage of production engineers, which is a further threat to future
production; not enough new graduates are interested in being thought of as oil
people. The staff turnover in the filling stations is very high and we are constant-
ly struggling to get sufficient people just to keep the business operating.
CEO’s summary
A year ago, we were all upbeat because of the high oil price, but now it looks like
we have a lot of weaknesses.
1.5.2 What Should We Be Doing in the Future?

CEO’s statement
There are three broad strategies that we could follow: first, we could carry on
doing the same things as in the past, and hope that the oil price recovers; second,
we could expand all our activities and look for scale economies; and third, we
could combine the second option with expansion into new markets to diversify
our activities. I have had some informal discussions with Easy Distribution, who
carry the output of our refinery and would welcome a friendly takeover because
of cash-flow problems. This would give us a relatively painless entry into trans-
portation.
Accounting report
If we try to follow a strategy of diversification, we shall quickly run out of cash,
because the payback period of buying Easy Distribution is quite long. Further-
more, return on investment and capital employed will be adversely affected, and
this is likely to affect our share price, perhaps making us susceptible to takeover,
never mind our taking over Easy Distribution. Because of our high gearing, it
will be very expensive to raise additional debt. I think the idea of taking over
another company is far too speculative and is not a realistic option. Instead, I
think we should cut back on all unnecessary expenditure in order to trim costs.
Marketing report
Acquiring Easy Distribution will improve our distribution channels, but I think
our real future lies in establishing a new filling station chain in another city using
our established brand.
Economic report
Given the prediction on the oil price, this is not a good time to undertake expan-
sion.
Production report
Acquiring a transport company does not help. It simply adds more complexity to
our operations.
Manpower report
We shall need to learn how to manage a different type of employee.
CEO’s summary
We are in danger of doing nothing other than react to changes in the market. I
see the acquisition of Easy Distribution as a real opportunity, because it stands
to reason that the more of our supply chain we control, the better off we shall
be. The notion of expanding the filling stations is attractive, because it capitalises
on the brand.
There are clearly different views on what course the company should pursue. For
example, the accountant is opposed to expansion because of the weak financial
structure; the marketing department is in favour of expansion because of optimism
concerning future prospects for a diversified company; the economics department is
averse to expansion because of macro conditions. The CEO’s job is to arrive at a
decision that will be supported by the functional managers, since without them
nothing can be made to work; the CEO must acknowledge the fact that while each
of the functional managers is able to offer a reasoned exposition of how things are
and what the company should do, each is preoccupied with his or her own view-
point. The process by which the decision is arrived at would be a story in its own
right, but suffice it to say that the management team is persuaded by the CEO’s
vision and agrees to pursue an expansionary, diversified strategy.
1.5.3 How Can We Achieve Successful Change?
The CEO sets the functional managers to work to prepare a programme for change.
Based on their understanding of what needs to be achieved in their individual areas,
the team arrives at a five-point plan, as follows.
1. Attempt to attain a higher degree of competitive advantage in existing products
and step up replacement investment.
2. Improve resource planning by introducing ‘just in time’ techniques and coordi-
nating more closely with marketing.
3. Improve market intelligence and improve economic analysis.
4. Introduce more rigorous control systems to monitor company performance.
5. Communicate company goals to everyone; develop an incentive system and
company culture, so that individuals can identify with the company’s objectives.
1.5.4 Strategy and Crises
Why do managers in the oil industry find it so difficult to get together to devise and
implement company strategy? Imagine that the outcome of the strategy discussions
is circulated on Wednesday. By Friday, the following incidents have occurred.
Cash flow
Production on two of our operated joint ventures has been disrupted. This
means that cash flow for the next six months will be negative.
Memo from Accounting Department to CEO: In view of the additional cash-flow

strains that the proposed strategy changes will involve, the strategy changes
should be shelved.
Filling station invasion
One of the oil majors has announced its intention to expand its filling station
chain into MythicOil’s market.
Memo from Marketing Department to CEO: All marketing resources will have to be
diverted to meet this challenge for the next few months; the strategy changes
should be shelved.
Headhunted
The finance director has been headhunted.
Memo from Finance Department to CEO: In view of the many complex financial
issues that will be raised by the proposed strategy, we must have a finance direc-
tor of experience and vision. Until we can recruit a replacement, the strategy
changes should be shelved.
Upgrade investment cost overruns
Memo from Production Department to CEO: The investment required in the obsolete
platforms is much more than originally estimated. We need to re-evaluate our
options, but, given the turmoil in the Finance Department, this will not be pos-
sible for some time. The strategy changes should be shelved.
Labour relations
The first attempt at communicating the new strategy was disastrous. No one was
willing to buy into the notion of expansion at a time when costs are being cut.
Memo from Personnel Department to CEO: We need the active cooperation of key
personnel and it will take time to get them on side. The strategy changes should
be shelved until such time as we can achieve progress on this front.
Experiences such as this are common in the oil and gas industry. This is partly due
to the fact that it is a volatile industry, with significant fluctuations in short-term
returns, while there is a dominant task culture that leads to a focus on short-term
issues. In Core SP Module 1, a similar scenario was presented as being more or less
intractable. But it should be immediately apparent that the underlying problem for
MythicOil is that the strategic process is not robust.
A brief application of the process model shows the following.
 Strategist. The strategist prevaricates and is reactive.
 Objective. There is no clear business definition.
 Macro environment. The economist focuses on the oil price only.
 Industry environment. There is little understanding of competitive forces.
 Internal analysis. Internal strengths and weaknesses are poorly understood.
 Competitive position. There is no discussion of competitive advantage accruing
from vertical integration.
 Generic options. A corporate generic choice of expansion has been taken on

dubious grounds; the basis of competition at the business level is branding, but
the advantage of the branding is vague.
 Variations. The acquisition is based on shaky logic.
 Choice. The choice process is focused on the CEO, who does not pay much
attention to analysis.
 Resources and structure. The structure of the organisation is not well understood in
terms of a unified supply chain.
 Resource allocation. There are no criteria for allocating resources.
 Monitoring and evaluation. Only vague reference is made to control systems.
 Feedback. The memos all give the same message: abandon the plan.
Strategy occurs in a dynamic setting, but despite the almost breathless succession of
events, it is possible to structure what has happened and start to identify how to
resolve the problems that emerged in the strategic process. The fact that the agreed
strategy could be so easily thrown off course by any one of several events is
indicative of how sensitive the organisation is to external or unexpected events.
1.5.5 Elements of Strategic Planning

A number of necessary elements of strategic planning were identified in Core SP
Section 1.3.7, as follows.
 Structure. The team did not think in terms of concepts, but focused on events and
description.
 Analysis. There was no attempt to understand what any factor really meant by
applying concepts or models. Conclusions were arrived at on the basis of per-
sonal opinion.
 Integration. The CEO made no attempt to take account of trade-offs and con-
straints, such as the problem of gearing, when arriving at his strategy.
 Control. There was no mention of how it would be known whether the strategy
was working or not.
 Feedback. There was plenty of feedback, but no mechanism for making construc-
tive use of it.
It emerges clearly that MythicOil’s managers need education in strategic planning.
The potential benefits from strategic planning education were outlined in Core SP
Section 1.6; it is probably easier to see when something is missing than when it is
present.
 Fit with organisational objectives. The individual managers could not see where they
fitted into the business definition and there was little evidence of cooperation
among the management team members: each focused on his or her own area.
 Contribution to plan. None of the managers had any idea of how they could
contribute to the overall plan once they ran into a problem.
 Understand the role of strategy. Changes in their own circumstances led the managers
to suggest abandoning the strategy rather than how to keep it on track.
This is indicative of a need to embed some understanding of strategic planning in

the organisation, so that managers can gain an understanding of their role and can
make valuable contributions from their perspective.
It also emerges from the example that there is a requirement to understand the
oil and gas industry as a whole. The CEO proposed to expand into unfamiliar areas
of the industry supply chain without realising that the characteristics of the distribu-
tion business are different. Therefore, there is a need for managers in the industry to
understand the entire industry supply chain, the types of company operating in the
industry and the relationship between the different supply chain stages. That is the
primary purpose of this course.
1.6 Course Outline

The discussion in this module has raised a number of strategic issues that are
relevant to managers in the oil and gas industry. All of these, and many more, will be
addressed in the remaining seven modules of this course. A brief outline of each is
as follows.
 Module 2 is concerned with the type of strategists one comes across in the
industry. The core of this module is a comparison of the characteristics of two
famous former CEOs of international oil and gas companies, chosen for their
contrasting characters and approaches to strategic management.
 Module 3 examines company objectives in the oil and gas industry, dealing with
ideas such as business definition, mission statements and corporate social re-
sponsibility (CSR). The discussion in this chapter uses Centrica, the UK
integrated gas company, as the core example.
 Module 4 is concerned with the macro environment in the oil and gas industry.
A historical examination of the oil price, leading indicators and industry drivers
are examined. PEST analysis is used to pick up on salient aspects of the oil and
gas industry macro environment.
 Module 5 looks at competitive conditions in the oil and gas industry, using the
industry supply chain model provided in Section 1.3 of this module as a basis for
a detailed analysis of competitive conditions in different parts of the industry.
The dynamics of the oil price and the gas price, and the relationship between the
two, are examined in detail because of their importance throughout the industry
supply chain.
 Module 6 provides a detailed analysis of a set of historical annual accounts from
a large integrated oil and gas company. This is an attempt to apply financial and
strategic analysis to an integrated company to demonstrate how internal analysis
can be carried out on one’s own organisation and on competitors using pub-
lished information.
 Module 7 sets out the strategic options open to organisations in the oil and gas
industry. The choice of generic business strategy is constrained by the nature of
the industry supply chain stage in which the company operates; corporate strate-
gy and strategic variations, in terms of both directions and methods, are not.
Common approaches in the industry, such as vertical integration and acquisition,

are examined in detail.
 Module 8 is concerned with strategy implementation in the industry. Structures,
feedback systems and control mechanisms are all examined in detail. Towards
the end of this module, the strategic process is used to pick up common issues
and observations by the authors about the industry.
The general approach in all modules is to analyse real companies and situations, to
demonstrate how to apply models and develop strategic analysis in the oil and gas
industry. It is not claimed that the answers provided are definitive; industry special-
ists may interpret information in a different way or may arrive at different
conclusions – which is, of course, perfectly acceptable provided that the underlying
logic is sound.
To make things more difficult, the external environment is continually changing,
so today’s questions may not be the same as tomorrow’s. It is necessary, then, to
bear in mind the fundamental problem of strategic analysis: there is no definitive
answer to any strategic question. That is what makes the world so perplexing and
causes many people to shy away from strategy and concentrate instead on questions
to which answers can be found. That said, it is this complexity that makes strategy
such an interesting topic for study.
There is a structure of thought embodied in the process model that can be ap-
plied to another structure – the industry supply chain – to address the many
strategic issues that confront decision-makers. That is the thinking behind this
course.
Learning Summary
This module has introduced the ideas, philosophy and approach to be taken in the
Strategic Planning for the Oil and Gas Industry course. The industry supply chain
model has been developed and will be discussed in further detail throughout the rest
of the course. Some key strategic issues in the oil and gas industry have also been
introduced.
Module 2
Strategists and Their Characteristics

in the Oil and Gas Industry
Contents
2.1 Introduction.............................................................................................2/1
2.2 Decision-Maker Types ............................................................................2/3
2.3 Human Resource Management Culture ..............................................2/5
2.4 Strategists in the Oil and Gas Industry ................................................2/7
2.5 Applying the Process Model ............................................................... 2/14
Learning Objectives
 apply the process model to the oil and gas industry;
 show how company culture can affect strategic decision making; and
 demonstrate how decision-maker type can affect all aspects of the strategic
process.
2.1 Introduction
The Core SP course demonstrated the difficulty inherent in imposing a model on a
complex, dynamic process, but also the importance of developing a model to make
sense of the world. On the one hand, any model is bound to be a simplification of
what actually happens in the real world. On the other, the lack of an intellectual
framework within which information can be analysed and the implications of
decisions followed through is likely to result in random behaviour generated as a
reaction to ongoing events. These actions may appear to be highly effective at the
time, but if they are not aligned with the overall strategy, they may be counterpro-
ductive in the long run.
The strategic planning process model in Figure 2.1 was shown to be a powerful
tool for understanding company strategy and is the foundation for the Core SP
course. There are two main features of the process model that need to be borne in
mind.
 It is not a causal model in the sense of a scientific process or an economic
relationship – a point that is particularly important for those with an engineering,
scientific, mathematical, economic or other quantitative background who are
familiar with models being expressed in the terminology of dependent and inde-
Module 2 / Strategists and Their Characteristics in the Oil and Gas Industry
pendent variables. There is a rough chronological order to the strategic planning

sequence (for example, it is necessary to have done the analysis in order to arrive
at a choice), but to some extent the setting of objectives depends on knowledge
of the competitive environment, and that is why there is a feedback loop.
 It is not a plan of action or a prescriptive process for making a ‘strategic plan’;
rather, it is a framework for analysing and constructing company strategy. The
selection and application of ideas from the augmented process model make it
possible to systematise the mass of available information and assess the robust-
ness of the strategic process in a company.
Strategists Objectives Who decides

to do what
The macro The industry Internal Competitive Analysis and

environment environment factors position diagnosis
Feedback
Generic strategy Strategy Strategy Choice

alternatives variations choice
Resources and Resource Evaluation

Implementation
structure allocation and control
Figure 2.1 The strategic planning process model

The process model is a tool for identifying strengths and weaknesses in a company’s
strategic process, and hence for explaining success and failure. An important lesson
from the Core SP course is to avoid attempting to explain strategic outcomes in
terms of a single cause or event; the holistic view taken by the process model is that
success or failure can be explained only in terms of the robustness of the strategic
process. This is partly because of the difficulty of establishing the root cause of
strategic outcomes – Rittel and Webber’s (1973) ‘tame’ and ‘wicked’ problems, as
examined in Core SP Section 1.2.4 – and partly because of the dynamic nature of
everyday life.
For example, the process model generates a series of questions about industry
giants, such as ExxonMobil, BP and Shell, which straddle the entire oil and gas
industry.
 Who decides in which business areas the company operates?

 What is the basis of a company’s competitive advantage?
 What is the rationale for the choices that have been made?
 How are strategic choices implemented and monitored?
 Does the organisation learn from its mistakes?
The answers to these questions reveal the strengths and weaknesses in the strategic
process. The same set of questions can be posed regarding the service supplier
Halliburton, which specialises in upstream activities; the answers to these questions
provide insights into why these different companies are the way they are and how
effective they are, in their chosen sectors.
Core SP Module 2 deals with the role of strategists in the organisation and their
potential influence on the strategic process of the company. This module applies the
generic ideas to the oil and gas industry: first, different decision-maker strategies and
the different human resources management (HRM) cultures found in firms are
examined; and second, the strategic process model is applied to two extremely well-
known former oil and gas industry CEOs. In Core SP Section 2.2.2, the role of the
CEO in managing the strategic process was discussed; the five major roles approxi-
mate to the ‘eggs’ of the process model and the CEO has to deal with the conflicts
among the roles. The fact that the role of the CEO is pervasive throughout the
strategic process explains why a change in CEO can lead to profound changes and
why different CEOs in charge of companies in the same industry can lead to
significant differences in the way they are run.
2.2 Decision-Maker Types

It is a commonly held view that, to run a big oil company successfully, you have to
be an ‘oil person’. This is a view held in most industries: in banking, retailing and
transport, for example, it would be unusual for a CEO to be appointed from
another industry. A striking exception was Andy Hornby, group CEO of Halifax
Bank of Scotland (HBOS): his background was consulting and retailing, and he had
no formal training in banking. The bank, of course, crashed in 2008 because of its
strategy: to specialise in the domestic mortgage market and to build a financial
structure based on increasing house prices. Was this outcome because of poor
strategy or because of lack of industry experience? The fact that Sir Fred Goodwin,
CEO of the Royal Bank of Scotland Group (RBS) and a lifelong banker, fared little
better leaves the issue open to debate.
This analysis abstracts from CEO experience and focuses on characteristics; this
does not imply that industry experience is totally irrelevant, but it is how the role of
CEO is exercised in the oil and gas industry that is important. Decision-maker types
– as classified by Miles and Snow (1978), and discussed in Core SP Section 7.3.3 –
are as follows.
 Prospector. The prospector is concerned with the identification and exploitation of
new market opportunities: the Cairn Energy discoveries in Rajasthan, India, for
example, required a great deal of risk-taking in an uncertain environment.
 Analyser. The analyser is characterised by sophisticated internal information

systems and detailed investigation of options prior to action: Shell, for example,
is famous for its development of the analytical ‘scenario’ approach.
 Defender. The defender is concerned with maintaining and defending the current
market share and position of the company, and does not give a high priority to
exploiting new market opportunities.
 Reactor. The reactor deals with circumstances as they arise and may be effective in
a fast-changing, competitive environment.
The dominant characteristic of the CEO is a fundamental determinant of the course
that the company takes over time. The oil and gas industry is no exception to this.
The dominant characteristic may change over time as CEOs are replaced. There is
no one type of decision-making strategy that can be classified as ‘the best’, but there
are situations in which one decision-making strategy would be preferred over
another. But the dominant characteristic cannot readily be altered in response to the
ever-changing competitive environment, because it is embedded within individuals;
to change the dominant characteristic, it is necessary to change the CEO, and this is
very difficult to do on the basis of characteristics alone. The characteristics of the
CEO are likely to be revealed only after appointment. For example, the board of a
company may decide to appoint either the current finance director or the marketing
manager as CEO; because of the current problems facing the company, the board
may feel that an analyser, rather than a prospector, is required. It could be argued
that the finance director is more likely to behave as an analyser than is the marketing
manager, but there is no way of predicting how either will actually act in the role
until he or she actually takes over.
Consider Table 2.1, which illustrates an example of problems facing an upstream
oil company operating in the onshore US market in 2002. Facing the forecast
decline in production in the area, how would each decision-maker type approach the
situation?
Table 2.1 Decision-maker types I

Strategist Action Outcome
Prospector Looks for new market opportunities Exits from the current market; finds new
areas of operation
Analyser Investigates different scenarios; figures out Slow to commit to change; loses first-mover
a course of action advantage
Defender Aggressively defends market position; Commits resources to current market; will
searches for a niche in which to operate be in trouble if no niche available; remains in
zero-sum game
Reactor Only acts when issue becomes immediate Unpredictable response: may act as
prospector or defender
Now consider the fictional company 10 years later in the same market. At the
time, development of shale gas is increasing rapidly, owing to rising prices, techno-
logical improvements and the US having significant shale gas reserves. The way in
which the opportunities presented by this are pursued depends on the dominant
characteristic, as illustrated in Table 2.2.
Table 2.2 Decision-maker types II

Strategist Action Outcome
Prospector Immediately invests in new technology Company establishes large operations in
to capture some of the new market shale gas technology
Analyser Conducts research into fracking Arrives as later entrant to market and
technology to assess business viability finds it difficult to match the prospectors
Defender Continues to defend core markets in the Misses opportunity to access vast
US reserves of shale gas
Reactor Takes the view that this is not the May or may not enter the business
company’s business
In each case, the dominant characteristic leads to three recognisable responses

and one random. The normal response is to ask which outcome is most appropriate
in the two circumstances – but that is not the issue here. What is important is that,
faced with the same situation, different decision-maker types take different deci-
sions. When trying to figure out why a particular decision was made, it is necessary to
have some insight into the characteristics of the decision-maker.
2.3 Human Resource Management Culture

The HRM culture that dominates a company affects the strategic process. People
are a resource like any other and need to be managed effectively in order to maintain
competitive advantage. The workforce should be able to react in a dynamic fashion
to external change and should be adaptable to new strategies as they are implement-
ed. A major determinant of the level of this ability is the dominant culture of the
company. The four main cultures identified in the Core SP module are as follows.
 Power culture. The organisation revolves around one individual, or a small group
of individuals, who dominate(s) decision making and determine(s) how things
are done. In an organisation with a power culture, there is unlikely to be a specif-
ic strategic plan, because strategy will reflect the interests of the dominant party
at the time. Major companies such as Exxon typically have a high-profile CEO
who projects the company ethos.
 Role culture. The organisation relies on committees, structure, analysis and the
application of logic. Final decisions are made at the top, but they rely on proce-
dures, systems and clearly defined rules of communication. This is a bureaucratic
culture, which may be slow to react to changes in the external environment.
 Task culture. The organisation is based on multidisciplinary teams that come
together to tackle assignments. Power rests within the team structure. Manage-
ment at all levels is seen as a series of tasks and no one takes responsibility for
the wider view of company strategy.
 Personal culture. The individual pays little attention to the organisation and is most
concerned with self-gratification. All strategic activities depend on the inclination
of the individual and are unpredictable. Small consultancies or service compa-

nies, for example, tend to be based on personalities; clients select them on the
basis of personal knowledge of the people.
Consider again the example of a US-based onshore production company facing
decline in the early 2000s (Table 2.3) and consider what would happen under each
of the different HRM cultures.
Table 2.3 Human resource management cultures

Culture Action Outcome
Power CEO demands action to find new markets If decision is made, company falls rapidly
in which to operate if that is in his/her into line behind CEO
interest at the time
Role Committees are established to look into Recommendations are eventually made
external events through proper channels; workforce is
reluctant to change
Task Change in the external environment is Company misses an opportunity to exit a
overlooked because organisation is so declining market
focused on current activities
Personal No one realises what is going on until it is Missed opportunities
too late or until company is forced into a
course of action
It is not only the characteristics of the CEO that impact on strategy decisions and
implementation; to a large extent, the dominant culture is dictated by the CEO, who
in turn acts in accordance with his or her dominant characteristic.
Different cultures can develop in different divisions of a large organisation. For
example, a large, vertically integrated firm that consists of many different divisions is
unlikely to exhibit a single HRM culture throughout. Chevron, the US oil and gas
company, employs around 65 000 people worldwide and is organised into three
businesses:
 exploration and production;
 manufacturing, products and transportation; and
 other businesses, which includes power generation and a ‘technologies’ business
that conducts research on alternative energy sources.
Within the manufacturing, products and transportation division, which comprises
activities contained in the downstream oil sector of the industry, there is likely to be
a research and development (R&D) department, a finance department and an
operations department. Consider the type of HRM culture likely to be found in each
of those departments, as illustrated in Table 2.4 (although, of course, this is open to
individual interpretation).
Table 2.4 Departmental cultures

Department Function HRM culture
R&D Develop new technology for the Personal culture will develop; likely that
company to implement; prospecting ‘pet projects’ will be pushed through that
activity are not aligned with objectives
Finance Monitor and control the revenues and Role culture will prevail; finance person-
expenditures of other divisions; make nel are unlikely to authorise an
investment decisions based on financial investment project unless it exactly meets
criteria required criteria – internal rate of return
(IRR), net present value (NPV), etc. – and
goes through necessary checks
Operations Perform day-to-day running of the Task culture will prevail; day-to-day
company, involving refining, activities are focus of the department and
manufacturing and logistical activities employees will not see beyond these
CEOs need to be aware of the different cultures in divisions of their organisation

if they are to implement and control strategy effectively, given that it is difficult to
change culture in the short term. While the four classifications are models of
organisational culture, and cannot reflect all the differences and nuances apparent in
real life, in the context of strategy they are useful for interpreting actions and can
help to determine reasons for the success or failure of a particular strategic move. In
Chevron, the combination of personal, role and task cultures could make the
implementation of a strategic move into a new geographical market difficult to
achieve. For example:
 the R&D department might consider the move irrelevant;
 the finance department might insist on detailed cash-flow analysis; and
 the operations department might see the move as detracting from the orderly
running of the business.
To the CEO, these departments’ behaviour might appear obstructive, but in fact
their reaction is greatly determined by their culture and generates a principal–agent
problem.
2.4 Strategists in the Oil and Gas Industry

The ‘Who decides to do what’ section of the process model is concerned with how
the business is defined and deciding how it will develop. Clearly, this does not
happen in a vacuum; it is greatly influenced by the market environment and the
resources available to the company. But unless there is a clear understanding of the
business definitions, backed by strategists with the appropriate characteristics, there
will be a tendency for the company to drift from one perceived opportunity to
another. Core SP Module 2 develops the idea that it is individuals, not companies,
who make decisions. That is why the CEO is appointed in the first place and is
given scope to direct the organisation down his or her chosen path, subject to the
constraints imposed by the board. Ideally, the roles of chairman and CEO are split
to ensure a degree of accountability, but when the roles are combined, there is a
potential for a significant principal–agent problem. In practice, the power of the

CEO varies greatly among companies, depending on the corporate governance
structure.
The role and influence of the strategist in a large international oil company is
examined here as case studies of Lee Raymond of ExxonMobil and John Browne of
BP. The two CEOs have been chosen for their renown, their long tenure, the fact
that they were (more or less) contemporaries of one another and their different
characteristics. Both CEOs had to deal with the low-oil-price environment in the
late 1990s, the increasing awareness of environmental issues in the early 2000s and
the relatively benign industry environment running up to the global financial crisis in
2008.
The impact of the known characteristics of Mr Raymond and Lord Browne, and
the activities of the companies under their direction during their time as CEOs,
demonstrate how personality and beliefs impacted on the organisations’ strategies;
whether the positions they took were right or wrong is another matter. This also
provides additional perspective on the extent to which the CEO needs to be an ‘oil
person’.
Exhibit 2.1: Lee R. Raymond, CEO of Exxon (later

ExxonMobil), 1993–2005
Lee Raymond was well known for various reasons during his tenure as
Exxon’s CEO. He was most renowned for his rejection of scientific theory
concerning climate change and his general reluctance to talk to the press. He
was also known as a ruthlessly efficient manager, pursuing cost savings and
efficiency improvements whenever possible.
Raymond operated out of a fortress-like building, in an office at the end of a
long series of anterooms known in the industry as the ‘God Pod’. In his office,
there was a large painting of a ferocious tiger behind the desk. Raymond was
a self-styled micro-manager who wanted personal control of operations.
With a PhD in chemical engineering, he intimidated colleagues with his
intelligence, and often was seen as arrogant by his peers (Bianco, 2001).
In the early 2000s, Raymond became renowned for his passionate defence of
the fossil fuels industry and his refusal to accept the existence of climate
change. He was ‘a vehement campaigner on behalf of the fossil fuel lobby
[and] has argued for years that limiting the greenhouse emissions from fossil
fuels believed to cause global warming will have a devastating impact on world
economic growth’ (Oil Daily, 2000).
Until his retirement at the end of 2005, Raymond maintained this stance
towards the environmentalists, seeking instead methods to improve Exx-
onMobil’s efficiency and bring larger returns to its shareholders.
Raymond’s appetite for efficiency quickly became apparent after he took over
as Exxon CEO in 1993. He stopped expenditure on new oilfield exploration
and concentrated on optimising company processes, managing to save money
in the marketing, production and transportation businesses. An analyst stated

at the time: ‘Exxon has proven itself to be very stingy. They just don’t piss
away money the way other integrated companies do’ (Teitelbaum, 1997).
This put Exxon in an ideal position to take over petroleum giant Mobil in
1999. Mobil was purchased for $83 billion – at the time, the largest oil and
gas industry acquisition ever. The company then stepped up its exploration
operations again. However, this was pursued at a much more cost-effective
level than previously. Finding costs in 2000 amounted to just 65 cents per
barrel, compared with $4 in 1980.
In 2000, Raymond stated that ExxonMobil would continue to focus only on
the oil and gas industry and would stay out of renewable energy development.
At the same time, the other major oil companies, Royal Dutch Shell and BP-
Amoco, were entering the renewables business in the belief that half the
world’s energy would come from renewable sources by 2050. While other
large oil companies banded together to spread the risk of exploration
projects, Exxon remained solo.
By the time Raymond retired in 2005, it was estimated that ‘more than $130
billion (£73 billion) of economic value [had] been created for shareholders’
(Roberts, 2005). At that time, ExxonMobil was the world’s largest company
by market capitalisation.
Measure 1993 ($bn) 2005 ($bn)
Revenue 103 271
Profit 5 25
Market capitalisation 80 393
Exhibit 2.2: John Browne, CEO of British Petroleum (later

BP), 1995–2007
John Browne created the world’s third ‘supermajor’ when he merged BP with
Amoco in 1998. This was the first of a wave of mega-mergers that followed in
the integrated oil and gas industry. By 2007, BP had transformed from
essentially a British company with interests in the Middle East to a global oil
and gas giant with interests all over the world. In 2007, Fortune magazine
named BP plc the fourth largest company in the world, after Walmart,
ExxonMobil and Royal Dutch Shell (Demos, 2007).
Browne was a private individual, known to be meticulous and thorough.
Originally destined for an academic career as a research physicist, he gave up
a PhD place at Cambridge to follow a career in well engineering at BP. As
CEO, he was known to be a calm and quiet individual who frightened subor-
dinates with his cool, penetrating assessment of their work. He was a
workaholic and worked very long hours. Industry insiders stated that his
office was always so tidy that it looked unused, even though he worked
continuously. He was well presented, softly spoken and coldly ruthless in
managing the affairs of the company.
From the start of his term as CEO, Browne instituted changes to increase the
efficiency and competitiveness of the company. First, he sold off businesses he
deemed to be non-core, including some refining operations in the US and
Canada. He then introduced a system to improve communication between
geologists, petroleum engineers and drillers when analysing potential drilling
sites. This effectively halved the required drilling time for each well between
1995 and 1997. He also brought more accountability to managers, initiating
monthly performance reviews for each operating division, while still leaving
them direct control of their operations. Luck also played a part in the rise of
BP, in the form of the finds of the Neptune and Crazy Horse fields in the
deep-water Gulf of Mexico in 1995, setting the company up as more than just
a British company with few foreign interests.
After building up the company’s core operations, Browne went looking for
potential acquisition targets. In August 1998, BP purchased Amoco for $57
billion, doubling the company’s global coverage and access to reserves. This
was swiftly followed by the $27 billion acquisition of ARCO.
Browne was the first oil industry executive to speak out on global warming,
arguing as early as 1997 that the evidence that carbon emissions were causing
climate change was credible. He suggested that the demand for alternative
energy would eventually outstrip demand for conventional fuels. In keeping
with his belief, he set targets for BP to reduce its carbon emissions by 10% by
2010. The company had achieved this target by 2002 (Browne, 2002).
BP installed solar panels in its service stations, planted new forests and set up
the new division BP Alternative Energy in 2005. The company was rebranded
in 1999 as BP, with a new green logo and the slogan ‘Beyond Petroleum’. This
was intended to reposition the company as a global energy company con-

fronting difficult issues including the conflict between energy and
environmental needs. The company wished to be seen as going beyond what
was required of an oil company. At one point during Browne’s period in
charge, BP was the largest solar power provider in the world.
Lord Browne was voted Britain’s most respected businessman on more than
one occasion and was once credited by the British prime minister as being
one of the few individuals in the country more powerful than him. Despite
later problems concerning a tragic accident in Alaska and missed production
levels for several years running, John Browne is credited as the man who
turned BP from a two-pipeline company into a world leader (Morgan, 2007).
Measure 1995 ($bn) 2007 ($bn)
Revenue 133 284
Profit – 20
Market capitalisation 40 212
It is apparent that the two strategists had different views of the competitive envi-
ronment, the world and their organisations. Table 2.5 is an analysis of the two
strategists using the components of the strategic process model to demonstrate the
extent to which the ‘Who decides to do what’ section of the model impacts on the
rest of the strategic process. The analysis is not necessarily definitive, because
different interpretations of the information are possible, but it does provide insights
into the functioning of the strategic process in both companies.
Table 2.5 Who decides to do what

Lee Raymond John Browne
Strategists Defender: Raymond was determined to Analyser: Browne intended to make the
maintain the company’s key markets and core more efficient but at the same time
was not interested in new markets. wished to expand into new markets.
His reputation was one of ruthless
efficiency.
Objectives Raymond’s objective was to maintain the Browne’s objective was to reposition BP
company’s position as a leading integrated as an energy company that was doing
oil and gas company. more than expected of an oil company.
He also aimed to cut costs and improve
company processes.
The two CEOs were both trying to do the same thing – to improve the company’s competitive
advantage – but had different approaches: Raymond focused on the existing company,
whereas Browne diversified.
Given that the CEO’s role is to manage the strategic process, in what way did the
two strategists influence the rest of the process? Table 2.6 assesses their impacts at
each stage.
Table 2.6 Analysis and diagnosis

Macro Raymond believed that climate change Browne believed that the oil industry had
environment was a myth; therefore, Exxon did not a duty to act on climate change; therefore,
invest in renewables. BP invested in renewables.
The environmental scanning and subsequent analysis of trends was heavily influenced in both
cases by the perceptions and biases of the strategist, as exemplified by the climate change
issue. Environmental scanning is not value free, because information can be interpreted in
different ways depending on attitudes.
Industry Exxon produced superior returns in an Browne’s programme of divestment and
environment oligopoly by pursuing the objectives of subsequent diversification into alternative
cost efficiency and a focus on oil and gas. energy was a result of his belief in the
It was Raymond’s perceptions and vision need to deploy alternative energy
that caused the company to follow this sources to combat climate change.
line.
The two CEOs had different approaches to competing in an oligopoly, although they were
faced with the same competitive conditions.
Internal Exxon exhibited a power culture, in BP exhibited a task culture, in which
factors which control radiated from the centre. employees were combined in
Raymond was a micro-manager who multidisciplinary teams and expected to
wanted to be personally involved in be flexible. Responsibility was devolved to
everything. Internal cost-cutting was divisional chiefs, who were accountable to
driven from the top. Browne.
The strategist’s power is also apparent in the way the two men pursued efficiency gains within
their organisation. Raymond was ruthless in his cost-cutting, stopping all exploration expendi-
ture when the oil price was low in 1993; Browne’s approach was more holistic, getting teams
to work together more efficiently and divesting unprofitable refining assets in North America.
The internal cultures of both companies derived from the characteristics of the relevant CEO:
Raymond, with his micro-management and intimidating manner, was at the centre of a
power culture, whereas Browne, a workaholic with a more cerebral approach, presided over
a task culture.
Competitive Raymond’s outlook and actions enhanced Browne’s vision and actions brought BP
position the company’s competitive position as into a new era in its history. The company
the largest oil and gas company in the became a general energy company with
world. His lack of interest in alternative significant interests in solar power and
energy contributed to delivering superior other renewables.
returns to shareholders.
Both men had strong characteristics that influenced their company’s competitive position in
the markets in which they operated, but by different means: Raymond exemplified what has
come to be known as ‘Big Oil’, whereas Browne attempted to involve a wider group of
stakeholders by repositioning BP.
The impact that Raymond and Browne had on the ‘analysis and diagnosis’ pro-
cess within their respective companies was that the companies analysed different
things because they focused on different definitions of competitive advantage (Table
2.7).
Table 2.7 Choice and implementation

Strategy choice Raymond chose stability and a focus on Browne chose an initial strategy of
the core of the business when he took retrenchment, by means of divestment
over. He followed this with related and internal restructuring, before
expansion by acquisition of Mobil, following expansion by acquisition. He
creating the largest oil company in the followed this up with unrelated
world. diversification in the early 2000s into
alternative energy projects.
It appears that both men chose the main strategy more or less on their own.
Implementation In terms of the planning and control In the same terms, BP’s control was
matrix (Core SP Section 8.4), Exxon’s strategic, exhibiting a medium-to-high
control type was tight financial, with a degree of forward planning and tight
low degree of planning. strategic control.
The control systems were heavily influenced by the strategist and his objectives:
Raymond’s cost-cutting preferences were evidenced by tight financial controls, whereas
Browne’s wider objectives were embodied in BP’s more strategic system.
Feedback Raymond was physically isolated in the Browne improved communications
‘God Pod’ and was a micro-manager, and initiated monthly reviews. He
but it is unknown whether he paid attempted to build a learning organisa-
attention to differing opinions. tion.
It is not surprising to find that the feedback systems reflect the strategists’ personalities.
The process model reveals that the two men were both trying to increase their
company’s competitive advantage – but while they were both trying to achieve the
same thing, they went about it in different ways because of their personal character-
istics. These influenced how they interpreted their industry and macro environment,
how they organised their company internally, what strategy choices were made and
when, and the method used to implement and control their chosen strategy.
The critical importance of the strategist within the wider strategy process should
now be clear. For those who still need a little convincing, try to answer the following:
would things have been different if John Browne had been CEO of Exxon and Lee
Raymond, CEO of BP?
The process model allows the analyst to see through the information available
and reduce it to what is important. To the untrained eye, Lee Raymond and John
Browne were at opposite ends of the spectrum: most people would pick up on their
environmental attitudes and the stark contrast between them. It is not the fact that
they had different attitudes that is important, however, as much as the fact that their
personal differences had significant impacts throughout the strategic process.
These impacts occur because the role of the CEO is to manage the strategic
process. If part of the strategic process goes wrong, then it is possible for the whole
edifice to collapse: a mistake made in the choice section, for example, whereby the
company embarks on unrelated diversification that it cannot implement successfully,
is a classic reason for company failure. In this case, it is an open question whether
the degree of (un)relatedness resulting from Browne’s desire to invest in alternative

energy sources significantly weakened BP.
2.5 Applying the Process Model

This module has shown, using industry examples, the importance of the strategist
within the strategy process. You should also now be fully aware of the power of the
process model in analysing information. The purpose of framing ideas around the
strategy process model is to teach you to think in a rigorous, logical manner, and to
apply ideas learned from Core SP Module 2 specifically to the oil and gas industry.
Can it be concluded that only an ‘oil person’ can run a big oil company? While
the experiences of Raymond and Browne in the industry no doubt influenced what
they did, the fact is that their different personalities were reflected in the objectives
they set and the way they organised and ran their companies. Did they do what they
did on the basis of careful and rational analysis, or were most of their actions
determined by their personal characteristics?
From the viewpoint of strategic decision making, the fact that both had spent
their working lives in the oil industry pales into insignificance in relation to the
difference in their characteristics combined with the dominant culture. Consider the
potential impact on the strategic process of a prospector in a power culture com-
pared with an analyser in a task culture, as illustrated in Table 2.8.
Table 2.8 Decision-makers and the strategic process

Process model Prospector power culture Analyser task culture
component
Who decides to do what Clear directive from the top Business definition less precise
Analysis and diagnosis Detail not important Nothing done without exhaustive
analysis
Choice No consultation Involvement at many levels
Implementation Clear lines of command Careful management of supply chain
Feedback Not a learning organisation Significant resources spent on
communication
The impacts are clearly a matter of judgement, but it is to be expected that there
will be significant differences in the strategic process. Other combinations of
decision-maker types and cultures would lead to different impacts again. Would
some knowledge of the characteristics of their proposed successors provide insights
into how they might run the companies? You now have some basis on which to
form your own judgement on that.
For interest’s sake, it is worth noting at this point that it was John Browne’s
chosen successor, Tony Hayward, who was at the helm of the company in 2010
when it was involved in the Deepwater Horizon incident in the Gulf of Mexico.
This safety-related incident resulted in significant loss of human life, not to mention
damage to both marine and land habitats, and loss of tourism revenue for nearby
areas, and cost BP billions of US dollars in compensation claims. (A detailed

discussion and strategic analysis of this incident can be found in the exercise ‘BP –
Beyond Petroleum’ in the Self-Test area of the course website.)
Also of interest is the fact that Rex Tillerson, who took over as CEO of Exx-
onMobil after Lee Raymond’s retirement, has maintained a similar position to that
of his predecessor with regard to renewable energy investments. Indeed, he said at a
shareholder meeting in mid-2015 that Exxon had avoided renewable energy
investments because ‘we choose not to lose money on purpose’ (AP in Dallas,
2015).
Learning Summary
This module has examined the role of the strategic process in understanding the oil
and gas industry. Decision-maker types, and their appropriateness and likely
prevalence in different parts of the industry supply chain, have been examined,
along with the influence of different HRM cultures on strategy. Finally, the role of
the strategist in the oil and gas industry has been examined with reference to two
well-known former CEOs of integrated oil and gas companies.
References
Associated Press (AP) in Dallas (2015) ‘Exxon Shareholders Reject Proposals to Set Goals
for Greenhouse Gas Emissions’, The Guardian, 27 May.
Bianco, A. (2001) ‘Exxon Unleashed’, Business Week, 9 April.
Browne, J. (2002) ‘Beyond Petroleum: Business and the Environment in the 21st Century’,
Speech to Stanford University Graduate School of Business, Stanford, CA, 11 March.
Demos, T. (2007) ‘Global 500: The World’s Largest Corporations’, Fortune, 11 July.
Miles, R., and Snow, C. (1978) ‘Organization Strategy, Structure and Process’, Academy of
Management Review, 3(3), 546–62.
Morgan, O. (2007) ‘Fallen Idol Who Fuelled BP’s Rise’, The Observer, 6 May.
Oil Daily (2000) ‘Exxon Turns Its Back on Renewable Energy to Focus on Strengths in
Traditional Areas’, 16 February.
Rittel, H. W. J., and Webber, M. M. (1973) ‘Dilemmas in a General Theory of Planning’,
Policy Sciences, 4, 155–69.
Roberts, D. (2005) ‘Tillerson to Succeed Raymond at ExxonMobil’, Financial Times, 5 August.
Teitelbaum, R. (1997) ‘Exxon: Pumping up Profits for Years’, Fortune, 28 April.
Module 3
Strategic Objectives in the Oil and

Gas Industry
Contents
3.1 Introduction.............................................................................................3/1
3.2 Deciding on Business Definition ............................................................3/1
3.3 Mission, Vision and Objectives ..............................................................3/7
3.4 Business Unit and Individual Objectives............................................ 3/17
3.5 Corporate Social Responsibility ......................................................... 3/21
3.6 Business Ethics in the Oil and Gas Industry ...................................... 3/24
3.7 Objectives in Practice.......................................................................... 3/26
Learning Objectives
 apply the concepts of objective-setting to a diversified gas company; and
 identify whether industry-specific differences lead to particular problems in
setting objectives.
3.1 Introduction
A company without clear objectives is at a disadvantage, because managers must
know what they are meant to achieve if they are to compete effectively. The oil and
gas industry is no exception. By having clear objectives, managers can allocate
resources and focus their efforts so that they are aligned with corporate-level
objectives. This module examines the types of issue that can arise when setting
strategic objectives. The discussion in this module is framed around Centrica, the
UK integrated gas company that is the parent company of British Gas. Extracts
from the company’s 2008 and 2015 online corporate profiles are used to illustrate
the complexities of deriving meaningful and consistent objectives, and how these
might change over time.
3.2 Deciding on Business Definition

In order to determine objectives, it is necessary to define the business that the
company is actually in. With the model of the industry supply chain in Section 1.3 in
Module 3 / Strategic Objectives in the Oil and Gas Industry
mind, it is clear that a company that defines its business as ‘oil and gas’ provides
very little information regarding its business definition.
 In what part of the supply chain does it operate?
 Is it focused on oil or gas, or both in equal measure?
 Where does the company operate geographically?
These deceptively simple questions can be hard to answer, but the answers have
profound implications, both for how the business is run and for how it might grow.
In Core SP Section 3.2.1, it was demonstrated how the definition ‘soft drinks
company’ can mean many things, partly depending on its scope within the soft
drinks supply chain. In the case of oil and gas, the location of the company within
the industry supply chain is a determining factor: typically, companies tend to
describe themselves as ‘upstream’ or ‘downstream’, but (again referring back to
Section 1.3) even these are broad classifications that do not define the business with
any degree of precision. This section looks at how one might set about defining the
business of a large integrated company in the oil and gas industry, using Centrica,
the UK-based integrated gas company, as a case study.
3.2.1 Understanding Centrica’s Business Definition

Centrica is the parent company of British Gas, a utility provider in the UK. It was
created in 1997, when British Gas plc was demerged into upstream and downstream
sections. At that point, Centrica was the downstream section of the company, with
operations only in the downstream gas sector of the oil and gas industry. Since the
demerger, however, Centrica has expanded significantly into other parts of the
industry and now has operations in various parts of the upstream sector as well.
Centrica is a useful example because of its origins and subsequent expansion. The
company has periodically published a corporate profile on its website in recent
years. Here, we use extracts from two of these – from 2008 and from 2015 – to try
to better understand Centrica’s business definition at two points in time, using the
section called ‘Our business’. For readers who are interested, the most recent
version of these documents can be downloaded from the company’s website.
Exhibit 3.1: Centrica Corporate Profiles, 2008 vs 2015
Centrica is a top 30 FTSE100 company with growing energy businesses in the

UK, North America and Europe.
We secure and supply gas and electricity for millions of homes and businesses
and offer a distinctive range of home energy solutions and low-carbon
products and services.
Experts in energy…
We source it …by finding and producing new gas reserves across the world
We generate it …through our highly-efficient [sic] gas-fired power stations
and wind farms
We process it …at our onshore gas terminals to make it safe for our
customers to use
We store it …at our Rough gas storage facility – the largest storage
operation in the UK
We trade it …in the UK, North America and Europe and sign contracts to
secure gas for our customers
We supply it …to millions of residential and commercial customers in the
UK, North America and Europe
We service it …through our energy services and installations businesses in
the UK and North America
We save it …by offering innovative low-carbon products and services to
our customers
(Centrica, 2008, p 2)
Our business
We are active at every stage of the energy chain from sourcing energy to
saving it
Source it. We invest in gas and oil exploration and production in the
Atlantic basin, particularly in the North Sea and Canada.
Generate it. We generate power through our wind farms, nuclear and gas-
fired power stations.
Process it. Our onshore gas terminals ensure high quality gas enters the
transmission system.
Store it. Our gas storage facility at Rough is the largest of its kind in the UK.
Trade it. In the UK and North America, we trade gas and power to ensure
our customers have a reliable and competitive energy supply.
Supply it. We supply energy to homes and business in the UK, North
America and the Republic of Ireland.
Service it. We provide peace of mind with central heating, boiler and
cooling maintenance and breakdown cover products.

Save it. We offer innovative low carbon, energy efficient products and
services to help our customers better manage their energy.
The astute reader will notice that there is little difference between the two de-
scriptions despite them being published seven years apart. The lists of activities
describe what Centrica actually does. That said, they do not amount to a business
definition as such, which can be seen by applying the four characteristics of a
business definition outlined in Core SP Section 3.2.1.
1. Does the company control all stages of production, or does it purchase its
inputs and merely sell them on?
This question concerns the productive scope of the company. Centrica is heavily
involved in downstream operations. Since seven of the eight points listed are
concerned with downstream activities and only the sourcing of gas is an up-
stream activity, Centrica could be defined as a downstream company with some
upstream interests. The move upstream started in 1998 and was intended to help
Centrica become independent of the volatile wholesale market, but Centrica still
buys in most of its supplies on the open market. This has implications for the set
of skills that the company requires to carry out its operations. A manager in the
energy installation servicing business will have little knowledge of sourcing new
gas reserves and his or her skills will not be readily transferable between the two
activities.
The eight points describe what is intended to be an integrated operation, but it is
open to question whether there are significant linkages among the elements of
the chain of operations. It is not obvious that there is a benefit from a single
company sourcing, generating, processing, storing and trading rather than focus-
ing on only one element of the supply chain. The issues of scale and scope will
be analysed more fully in Module 6.
2. Does the company control all distribution and marketing channels?
This question concerns market positioning. Centrica serves the residential UK,
North American and European markets for power – both electricity and gas. It
serves the business market in the UK and North America, and also provides
energy installation services to businesses and households in the UK and US. So
Centrica is sometimes selling to individuals or households and sometimes selling
on a business-to-business basis. One of the company’s divisions, Centrica Ener-
gy, is involved in trading gas on the wholesale market. One interpretation is that
the structure is opportunistic, rather than the outcome of a design based on
linkages in the supply chain.
Centrica is positioned as a service provider, a power provider for households and
businesses, a wholesaler, a processor and an extraction company (through alli-
ances). It can be argued that this positioning lacks coherence, because the
company appears as different things to different market sectors.
This has implications for how the company markets itself to its customers. In
selling to businesses, the company can increase its revenues only by finding larg-
er customers or when existing customers expand. Additionally, the product it
sells to businesses is likely to be chosen by the customer purely on the basis of
price – especially in markets such as the UK and the US, where reliability is less
of an issue, and gas and electricity markets are open to competition. In selling to
individuals or households, the company can expand by following more aggres-
sive marketing campaigns. However, the final choice that the consumer makes is
again likely to be solely based on price, because gas is a homogeneous product
and it is very difficult to differentiate the supply of gas between different suppli-
ers.
3. Which markets does the company compete in?
This concerns the breadth and focus of the business. The ‘experts in energy’ state-
ment implies that Centrica has a fairly broad focus and competes in many
different markets. Interpreting the eight areas of the extracts, the company com-
petes in the following markets:
 gas exploration and production;
 electricity generation, including gas-fired power stations and wind farms;
 gas processing;
 gas storage;
 wholesale commodity trading;
 household gas and electricity supply;
 business gas and electricity supply;
 boiler and appliance servicing;
 low-carbon products.
At each level of the supply chain, the company is competing in a different market.
The key phrase ‘experts in energy’ suggests that Centrica is expert in all these areas,
which is a bold claim. It is not explicitly stated which markets Centrica competes
in, so it is difficult to answer this question on the basis of these statements with
any degree of certainty.
4. Is the product a standalone product or is it combined with other prod-
ucts?
This relates to the target market of the company. The target markets are differ-
ent at each stage of the supply chain. The supply of gas and electricity to
households and businesses can be marketed alongside the servicing of applianc-
es, but commodities wholesaling cannot.
So what business is Centrica actually in? Centrica is clearly in the business of selling
energy to customers – but it is also in the installation-servicing business, which may
or may not be directly related to selling energy. It is clear at this point that a compa-
ny defining itself as an ‘integrated energy company’ is not sufficient for business-
definition purposes.
3.2.2 Business Definition and Creeping Scope

When companies expand over time, it is possible for their business definition to
become blurred. It was noted in Section 3.2.1 that Centrica started out as the
downstream gas operations of British Gas, but quickly expanded into upstream
markets as well. The scope of the company’s initial operations crept up the industry
supply chain into the upstream sector.
What is not mentioned in the corporate profile are instances of the company’s
scope creeping out of the industry altogether. Some examples include:
 OneTel, a telecommunications company purchased in 2001 and sold in 2005;
 the AA (Automobile Association), a roadside assistance company purchased in
1999 and sold in 2004;
 Goldfish, an Internet bank started in 2000 and sold in 2003; and
 Dyno (formerly Dyno-Rod), a drain-cleaning company purchased in 2004.
Centrica had been in existence for only two years when it acquired the AA in 1999.
(The acquisition is analysed in detail in the Core SP Profiler case ‘Where is the Road
Leading?’) Centrica management claimed that the acquisition of the AA in 1999 was
part of an identifiable growth strategy:
 To sell a wide range of goods and services with strong brand names to a
large customer base using shared support functions such as call centres and
billing.
 Offer discounts on many of its other services to AA members.
 Both organisations operate large fleets of vans which provide customer
support and emergency services; the fact that one is roadside based and the
other is domestic is a matter of detail.
 Centrica has identified £30 million of potential savings by sharing back office
functions with the AA.
None of the elements in this ‘identifiable growth strategy’ relates to being ‘experts in
energy’, so at some point after 1999 Centrica must have changed its focus. In fact,
by 2001, Centrica was not just an energy company but a telecommunications
company, a roadside breakdown company and a bank; by 2015, Centrica was an
energy company and a drain-cleaning company. It is hard to see the relationship
between any of these businesses and the company’s claimed core activity of provid-
ing gas and electricity to businesses and households in the UK. Both Dyno and the
service division, which provide emergency and routine services to households and
businesses, probably generate little synergy between each other, because different
skills are required for unblocking a toilet and servicing a gas boiler.
It is unclear why Centrica bothered with these relatively small acquisitions in the
past, being a company with a turnover of about £10 billion. The projected savings
of £30 million with AA operations came to about 0.3% of turnover, the acquisition
of OneTel, about 0.5% of turnover, and the sale of the share in Goldfish, about
1.5% of turnover.
It is therefore easy to become confused about the business definition. What

appear to be relatively straightforward questions can be difficult to answer. Centrica
has operated, and continues to operate, in several different businesses at the same
time, but has not identified the commonality that binds them together in its business
definition.
3.2.3 Business Definition over Time

It is of interest that the items listed in Exhibit 3.1 have hardly changed between the
2008 publication and the 2015 publication. This raises the question, ‘How do
business definitions change over time?’ Empirical observation suggests that overall
business definitions, as articulated by organisations in the oil and gas industry, tend
not to change significantly over time – barring some major crisis or a change in
senior management. For example, companies such as Shell, Chevron and Exx-
onMobil have always been integrated major oil and gas companies with operations
covering the entire industry supply chain, but the emphasis on particular sectors and
stages has changed over time.
Centrica has always defined itself as an energy company, but its scope has crept
up the supply chain and even outside the supply chain. The important thing to
remember is that a business definition should be clear; if a particular activity is
outside that business definition, then it is likely to be difficult to manage. Blurring
the original business definition, or strategic intent, is likely to cause problems
associated with unrelated diversification, difficulties in understanding unfamiliar
industry environments and trouble managing different value chains.
3.3 Mission, Vision and Objectives

In Module 2, it was demonstrated that the strategist can impose a vision on the
company and that this will direct the company’s strategy. It is necessary to translate
the vision of the strategist into a meaningful set of objectives. These can then be
used by employees to direct their efforts in a consistent manner throughout the
company. In Core SP Section 3.2, the steps necessary to achieve this were developed
as follows.
1. Develop the mission statement.
2. Disaggregate the mission.
3. Derive objectives.
There is no ‘best’ way to set objectives, but to have any kind of impact they must be
logically thought out. Again using Centrica as an example, this section moves
through the company’s vision and stated strategy to demonstrate the process of
moving from vision to mission to objectives, along with some of the difficulties that
might arise.
3.3.1 Vision
A company’s vision tends to be abstract, and is often no more than the CEO’s long-
term view of where the company is heading. Exhibit 3.2 provides Centrica’s vision
from 2008 and 2015. Both of these statements are certainly abstract.
Exhibit 3.2: Centrica’s Vision and Purpose, 2008 vs 2015
Vision
Our vision is to be a leading integrated energy company in our chosen
markets.
Our purpose
We are an energy and services company. Everything we do is focused on
satisfying the changing needs of our customers.
The 2008 statement provides no explicit ideas of where and in what markets the
business operates, other than that they have been ‘chosen’, and there is no distinc-
tion between product and geographic markets. It is difficult to attribute any meaning
to the statement, because there are several undefined terms: ‘leading’, ‘energy’ and
‘chosen’.
The 2015 statement, which has been refashioned as a ‘purpose’, provides perhaps
a little more clarity, acknowledging the fact that the company is both an energy
company and a service provider. It also articulates a desire to satisfy customers, but
does not detail how this might be accomplished.
At best, both statements are a vague aspiration and therefore provide little guid-
ance on how objectives can be developed.
3.3.2 Strategy or Mission Statements

Exhibit 3.3 illustrates Centrica’s strategy on two separate occasions, extracted from
the company’s corporate profiles in 2008 and 2015.
Exhibit 3.3: Centrica’s Strategy, 2008 vs 2015
Strategy
Our strategy is to create a leading integrated energy company, sourcing and
supplying gas and electricity, and providing energy services, using our strong
brands to succeed in our chosen markets in the UK, North America and
Europe.
Our strategy
Our strategy is about satisfying the changing needs of our customers.
Serving our customers is what we are known for, what we are good at and
where we have distinctive capabilities.
The strategy is more specific than the mission statement in that it contains in-
formation about the structure of the company (‘integrated’) and the geographical
markets. It could be argued that it is a mission statement rather than a strategy,
because it gives an indication of where the company would like to be and how it is
going to achieve that – by means of ‘strong brands’.
In Table 3.1, the three criteria that a mission statement should exhibit are used to
assess Centrica’s mission and strategy statements in 2008.
Table 3.1 Centrica’s mission in 2008

Criterion Vision Strategy
Defines the business Vague: ‘leading energy company’ Defined Centrica as an ‘integrated
energy company’, operating in three
areas; clear, but omits Dyno-Rod
Is clear to employees Vague: ‘best value’ Although ‘leading’ and ‘succeed’ are not
defined, broad intention is clear
Provides focus for None Although general, it identifies activities
activities and areas of activity
So Centrica’s vision and strategy from 2008 can be combined and interpreted as a
mission statement, in that, together, they meet the three criteria to some extent. It is
always difficult to write a concise mission statement for a diversified company, and
Centrica appeared to tackle this by ignoring parts of the business, such as Dyno-
Rod, which did not fit with the business definition.
Table 3.2 examines the purpose and strategy statements from 2015 using the
same criteria. The results are somewhat different.
Table 3.2 Centrica’s mission in 2015

Criterion Purpose Strategy
Defines the business Clearer than 2008: both Centrica not defined, but focus of
‘energy’ and ‘services’ are strategy entirely on service delivery
mentioned
Is clear to employees Vague: focus on customers Focus on service and customers, but is
vague
Provides focus for None Again, mention of service and custom-
activities ers is vague
The purpose and strategy published in 2015 are actually of less use than those
from 2008. While the business is more clearly defined as both an energy and services
company, the statement about focus on customers fails to be clear to employees and
does not really provide a focus for activities.
3.3.3 Disaggregating the Mission into Strategic Priorities

Exhibit 3.4 continues on from Centrica’s strategy or mission. It is a disaggregated
version of the company’s strategies, as published in 2008 and 2015, and is specific to
the company’s individual businesses.
Exhibit 3.4: Centrica’s Strategic Priorities, 2008 vs 2015
Transform British Gas

We will deliver sustainable profitability and consistently attractive products
and services across our British Gas businesses
Reduce costs
We will sharpen the focus of our organisation and reduce the cost base
across the whole of the business
Secure energy supplies
We will reduce our exposure to risk through increased integration
Deliver growth
We will maximise the growth potential of our businesses outside of our core
UK residential business
Energy Supply
[…] We will grow our Energy Supply business by improving customer
service, developing the right offers to retain and win customers, and improv-
ing efficiency across all our businesses.
Services
[…] We will grow Services through developing new products to meet our
customers’ changing needs.
Distributed Energy and Power
[…] We will maintain a more focused Central Power Generation business
and combine its capabilities to create a new Distributed Energy and Power
team.
The Connected Home
[…] We will create a new global Connected Home business, investing in
innovation to build on our leadership position and expand beyond our
current markets.
Energy Marketing and Trading
We have expanded our presence and capabilities in Liquefied Natural Gas
(LNG) …
We will build on this foundation to create an international Energy Marketing
and Trading capability, growing our role in LNG trading, optimisation and
risk-management.
This splits Centrica’s strategy from each period into strategic priorities, providing
a clearer picture of how the company intends to achieve its vision. But there is
confusion between means and ends (Core SP Section 3.9). For example, consider
each of the strategic priorities from 2008 in turn.
 ‘Transform British Gas’. Delivering sustainable profitability is an end, whereas
delivering consistently attractive products and services is a means by which to
achieve the end. This confusion between means and ends leads to a muddled
statement that provides no guidance for employees. If the statement had read
‘deliver sustainable profitability by means of consistently attractive products’, it
would have made some operational sense. At this point, muddled causality ap-
pears and subsequently permeates the definition of strategy.
 ‘Reduce costs’. This is a means by which to achieve the end of sustainable profita-
bility. Going back to the company’s vision, this is a means of achieving superior
‘value’ for shareholders and customers – but the connection between ‘sharpen
the focus’ and ‘reduce the cost base’ is not clear. It raises the question of focus
on what: customers, products costs or something else? Furthermore, the inten-
tion to reduce the cost base ‘across the whole of the business’ would penalise
those businesses that are already efficient.
 ‘Secure energy supplies’. Increased integration is clearly viewed by the company as a
means to an end: lowered risk. But whose risk is being lowered? Shareholders
can simply diversify risk through their portfolios, so it is management risk that is
being reduced through integration. This is an example of the principal–agent
problem.
 ‘Deliver growth’. Again, there appears to be confusion over means and ends. Is
growth outside the UK a means of achieving an objective or is it an objective in
itself? This is the first mention of the core business, which is defined as ‘UK
residential’. This is only a small part of the scope outlined in Exhibit 3.3.
Although there is clear confusion between means and ends, and inconsistencies, the
company has disaggregated its mission into four subheadings; this then provides the
basis for objective-setting under each of the four headings. But these then raise
another issue: the aim is to achieve attractive products, lower cost and risk, and
maximise growth – yet ‘attractive products’ suggests higher, not lower, cost, while it
is difficult to see how growth can be maximised at the same time as minimising cost.
The disaggregated objectives are not consistent, so it will be necessary to make
trade-offs among them, which is not explicitly recognised.
Another point to note is how the company’s strategic priorities have changed over
the seven-year period between publications. The priorities in 2015 are all concerned
with downstream gas activities and related service activities, while the 2008 priorities
were more balanced. It was noted in Section 3.3.1 that the company’s vision had
changed over the period in question, with the initial statement referring to the
company as an ‘energy company’, while the most recent statement referred to the
company as an ‘energy and services company’. It is possible that there has been some
recognition that the company is, in fact, a downstream gas company with some related
and unrelated service interests. This is then reflected in the strategic priorities, which
are very much focused on the end consumer and have nothing to do with accessing or
securing supplies in the upstream sector of the industry.
It is worth acknowledging the role of the external environment at this point. Ex-
ternal conditions changed markedly between these two periods: in 2008, oil and gas
prices were moving to an all-time high, making upstream supplies harder to access; in
2015, the price of oil was at a 10-year low, with significant oversupply in upstream
sectors. This may have influenced Centrica’s strategic priorities and caused it to look
for different sources of growth. The external environment, and its role, influences and
main components, are addressed fully in Module 4 and Module 5.
3.3.4 Deriving Objectives from Strategy

At this point, the mission of the company has been clarified and a number of
strategic priorities set out. These priorities represent a disaggregated mission, which
can then be used to set objectives for divisions, departments, managers and individ-
ual staff. At each level, the objectives should be relevant to the persons concerned
and aligned to the company’s strategic direction. By following the process from the
company’s mission down to disaggregated objectives, it is possible to keep individu-
al objectives consistent with the company’s goals. This section is intended to
demonstrate how that might be achieved.
Objectives – even those derived from the company’s mission – need to be both
credible and achievable. In Exhibit 3.5, Centrica takes the first strategic priority from
its 2008 corporate profile, ‘Transform British Gas’, and sets out some more specific
objectives.
This further disaggregates the strategic priority and explains, to a certain extent,
how the company plans to achieve the goal. The reasoning behind the desire to
transform British Gas is also set out. The statement on objectives can be assessed
on the basis of its credibility, logicality and the extent to which its component parts
are achievable.
Exhibit 3.5: Transform British Gas
Why?
British Gas Residential is the core of our business.
We need to deliver a competitive service level, product offer and price.
Historically our profitability and service levels at BGR have been low and
volatile.
How?
Improve our price competitiveness, service levels and product offer.
Reduce costs and drive greater efficiency and productivity.
Ensure we remain a great place to work.
Achieve long-term margins of 6–7%.
Future focus
Focus on service to customers while delivering sustainable returns.
Deliver a further £60m in cost savings in 2008.
Modernise the British Gas brand to demonstrate our expertise and customer
focus.
(www.centrica.com, 2008, no longer available)
‘Why?’
The ‘Why?’ section restates that British Gas Residential is the core of Centrica’s
business. This is consistent with the reference in the disaggregated mission that
UK residential is the core, although different terminology is used.
The ambition to deliver a competitive service, product and price is merely a
statement of the obvious. It is true that, since the deregulation of the UK house-
hold energy market, competition has increased, and householders are free to
choose who supplies their electricity and gas, thus limiting the potential profit of
competitors – but that is well known in the industry. The problem is that state-
ments of the obvious detract from the credibility of the statement and managers
may regard the whole exercise as irrelevant.
It is impossible to understand the statement on historic volatility, because it re-
fers to both profitability and service levels. The notion of ‘low and volatile’
service levels can mean little to a manager in the absence of some objective
measure of service levels. It is not clear whether ‘low’ profitability means the
average over some period, or that ‘volatile’ means that it has been highly positive
and negative from time to time.
Taken together, the lack of definition, the statement of the obvious and the lack
of logic deprive the ‘Why?’ section of credibility. But the fact is that this is not
usually obvious to those who develop such statements (otherwise they would not
make them); hence senior management are taken by surprise when their attempts
to define objectives are often met with amused scepticism.
‘How?’
The ‘How?’ section details what the company plans to do in order to transform
British Gas, and again commits a number of logical errors that undermine credi-
bility and achievability.
Improving price competitiveness and service levels is merely a restatement of the
‘Why?’ answer; a statement of the obvious is followed by a recommendation to
achieve the obvious. Not only does this lack credibility, but also it cannot be
regarded as achievable, because it still lacks measurement.
The reduction of costs through efficiency drives and productivity improvements
confuses means and ends. Increased productivity and efficiency drives are the
means by which the end of cost reduction is achieved. The ‘How?’ is not framed
in this logical way: it says ‘reduce costs and drive greater efficiency and produc-
tivity’. The causation from efficiency to costs is missed, so it is unclear what is
meant to be achieved. This statement therefore does not pass either the credibil-
ity or achievability tests. Once more, misunderstanding causality has the effect of
both being confusing and rendering the objective meaningless.
‘Remain a great place to work’ can be interpreted as an end in that, by achieving
it, the company will be able to operate farther up its experience curve and further
reduce its costs. The objective is not ‘to be a great place to work’, but in fact to
reduce costs through reduced attrition. Once more, the problem of causality
emerges: the link between being a great place to work and productivity or costs
is not made explicit, while managers are well aware that an unpleasant workplace
will suffer high attrition and general aggravation; in other words, no one wants to
work in an unpleasant environment anyway. Again, this is a statement of the
obvious. No direction is provided on how to make Centrica a ‘great place to
work’. It could be through higher wages, reduced hours of work or provision of
sports facilities – none of which can be achieved at zero cost.
Achieving a long-term margin of 6–7% is the objective, while the previous three
statements are means of achieving this. This is probably the most serious exam-
ple of confusion between means and ends, and the fact that it appears at the end
of the list of responses to the question ‘How?’ is another causal flaw. If the
statement of ‘why’ had read something like ‘We need to achieve a long-term
margin of 6–7% to improve our historically low profitability’, managers might
have been able to see the relevance, but as it stands, it looks like an afterthought
and is therefore unlikely to be credible.
‘Future focus’
The intention to deliver a further £60 million in cost savings in 2008 is specific,
compared with the general ‘reduce costs’ objective in the ‘How?’ section, but
there is no indication of how the figure is arrived at nor how it is to be achieved.
For example, if it is a blanket requirement, then it could penalise those divisions
that have already been effective in reducing cost. It is also fairly meaningless to
quote an absolute figure rather than a percentage; if £60 million were to imply a
cost reduction of 10%, managers might well regard it as unachievable, whereas if
it were to be a cost reduction of less than 1%, then it might be regarded as irrel-
evant because of normal cost variations. British Gas revenue is about £10 billion,
so the desired cost saving is actually about 0.6% of total cost. In any case, total
cost could not be predicted to such a level of accuracy, so any cost reduction
efforts on this scale are liable to be swamped by the normal variability arising
from dynamic market factors.
‘Focus on service to customers’ is a restatement of ‘improve our service levels’
and it is not clear why different terminology is used. The added constraint ‘while
delivering sustainable returns’ presumably means returns consistent with the 6–
7% long-term margins, because otherwise ‘returns’ could mean anything. This
third mention of service is still devoid of measurement.
It is difficult to make sense of the statement of intent to modernise the brand. It
could be argued that the causation is the wrong way round: that it is expertise
and customer focus that develop the brand. It is likely that managers will have
different interpretations of ‘modernise’, with the result that this statement will
fail the credibility test.
While the precise levels of credibility and achievability are open to question, it is
informative to summarise the argument as in Table 3.3, where ‘×’ indicates that a
statement has failed the test.
Table 3.3 Analysis of British Gas objectives

Statement Credible Achievable
Why?
BGR is the core ×
Deliver a competitive service ×
Historically × ×
How?
Improve price competitiveness × ×
Reduce costs × ×
Great place to work ×
Long-term margins 6–7% ×
Future focus
Focus on service × ×
Deliver further £60m cost saving ×
Modernise brand ×
Every single statement fails either one or both tests. Despite the fact that senior
management may have felt that it was saying something important to employees that
would provide them with an understanding of what the company was trying to
achieve and their role in it, the lack of logic results in a meaningless jumble of
incredible and unachievable objectives.
Core SP Section 3.4 examines the need for credible and non-contradictory objec-
tives. A credible objective is one that employees feel is actually achievable. An
objective that cannot be achieved is likely to be ignored by management and staff,
and will have little or no operational significance. This is also the case if objectives
are not consistent. For example, a British Gas service engineer may feel that it is not
possible to reduce costs through higher productivity and at the same time improve
customer service. If this is the case, then he or she is unlikely to attempt to do both,
and will most probably opt for the one that he or she perceives to be more im-
portant at the time.
It should be clear at this point that the process of deriving objectives from a
company’s mission statement is not easy. Typically, mission statements are confused
or meaningless and it is only at deeper levels of detail that the company’s objectives
become clearer. It has been demonstrated here that there is little internal logic to the
various statements of ‘Why?’, ‘How?’ and ‘Future focus’.
At the same time, the Centrica corporate profile provides a relatively coherent
approach to the problem of defining company objectives. The company’s approach
has also been quite consistent over a number of years, allowing the comparison of
two similar texts published seven years apart. Thus while this review of Centrica
appears to be highly critical and may appear to deride Centrica’s attempt to make its
objectives explicit, it is simply the outcome of asking questions such as ‘Is this a
mean or an end?’ and ‘What is the causality involved?’ Visit any company website
and you will find similar lists of platitudes and non sequiturs – now that you know
what to look for.
3.4 Business Unit and Individual Objectives

The setting of objectives cannot be done in isolation from the day-to-day operations
of the company. Targets are dependent on past decisions, the current state of affairs
and perceived market opportunities. For this reason, the setting of objectives should
be a dynamic process that is continuously reviewed. ‘Stretch objectives’ are some-
times applied to push employees and managers beyond what they originally thought
possible. This section looks at SMART objectives in the case of Centrica, then
applies the ‘stretch’ notion in the case of a fictional manager working in the British
Gas Residential business unit.
3.4.1 SMART Objectives

As discussed in Core SP Section 3.16, the SMART acronym is often used in forming
objectives for a division or individual. This framework is useful in setting objectives
and can also be applied in the setting of stretch objectives. In Table 3.4, the SMART
criteria are applied to the strategy statements; as before, ‘×’ denotes that the
statement does not fulfil the criterion.
Table 3.4 Analysis of British Gas objectives

Statement Specific Measurable Achievable Relevant Time-
bound
Why?
BGR is the core × ×
Deliver a competitive service × ×
Historically × × ×
How?
Improve price competitiveness × × ×
Reduce costs × ×
Great place to work ×
Long-term margins 6–7% ×
Future focus
Focus on service × × × × ×
Deliver further £60m cost saving ×
Modernise brand × × × × ×
It is a matter of judgement at times whether an ‘×’ is the correct interpretation,

but the fact is that all of the objectives fail at least some of the SMART criteria. The
fact that this emerges suggests that management did not think in terms of SMART-
type criteria when devising the objectives in the first place.
To visualise how this might work out in practice, consider the example of a ficti-
tious manager from British Gas Residential. He is the manager for the company’s
North-West England division, which has underperformed over the past two years.
He is responsible for sales and customer service at a number of different locations.
He is aware that the company wishes to ‘transform British Gas’, and has some idea
of how and why it intends to do this. For example, he can see from the statement
that he is part of the company’s core business and that business performance in the
past has been volatile. He knows also that the company wants to reduce costs and
the attrition rate.
Our manager then receives the following objectives for the next financial year on
his annual performance review. These have been derived from the disaggregated
objectives:
To be achieved by the end of the coming financial year:

 bring attrition rate down to 3%;
 increase divisional operating profit by 5%;
 increase divisional customers to 3 million;
 design and start a training programme for customer services staff as part of
brand modernisation programme;
 reduce customer complaints by 25%.
These objectives are all in line with the company’s mission to transform British Gas.
The manager will by now be fully aware what this initially bland-sounding statement
actually means. The company will transform British Gas through cost savings, better
customer service and lower labour attrition.
It is useful to examine the validity of the objectives in terms of SMART.
 Specific. All of the objectives are specific on what is to be achieved, except for the
training programme: there is no guidance on what to include in the training pro-
gramme, or on when or how it should be conducted.
 Measurable. All of the objectives are measurable, apart from the training pro-
gramme. Each objective has an end-target number to which the manager and his
division can aspire.
 Achievable. An increase in divisional operating profit is achievable provided that
the division has been underperforming in the past – but achieving this depends
on achieving the other objectives, which relate to both demand and supply. For
example, reducing the attrition rate will reduce cost, while enlarging the customer
base will increase both costs and sales. Reduction of the attrition rate is achieva-
ble, but is not set out in meaningful terms. If the attrition rate is currently 10%,
then 3% is an unreasonable target. This highlights another common error – the
lack of a base – which typically renders quantitative objectives meaningless.
The same goes for customer-complaint reduction. If the division has been expe-
riencing unusually high levels of customer complaints, then this is not an
unreasonable goal. The training programme and reduced attrition will help to
achieve this. But if complaints are already very low, it might be impossible to
reduce them further. The use of actual numbers in this case gives a mistaken
impression of precision.
 Relevant. All of the objectives are relevant to the company’s mission. They are
clearly aligned to the company’s operational strategy. The one possible exception
is the training programme, which is a precondition for achieving better perfor-
mance.
 Time-bound. All of the goals are bound to the end of the next financial year.
The SMART acronym is therefore useful for seeing whether objectives are likely to
have operational significance. A manager with the above goals would be motivated
to achieve them, given the clear link that they have with the organisation’s success.
A deficiency of the SMART approach, however, is that it tends to focus on the
individual objectives, rather than considering them in sum. Thus while each of the
objectives may be achievable individually, they may not all be achievable at the same
time, because they are in conflict. The impact of each objective on costs for the
financial year compared with three years in the future is as shown in Table 3.5.
Table 3.5 Impact of objectives on revenue and cost

Objective Impact on Impact on Impact on Impact on
cost now revenue cost in 3 yrs’ revenue in 3
now time yrs’ time
Bring attrition rate down to 3% + 0 – 0
Increase divisional operating profit by 5% ? ? ? ?
Increase divisional customers to 3 million + + 0 +
Design and start a training programme + 0 + +
for customer services staff as part of
brand modernisation programme
Reduce customer complaints by 25% – + – +
Since the impact of the measures on operating profit is a residual, the outcome
both in the first and the third years is uncertain, because there are positive and
negative effects on cost and revenue, both now and in the future. The most likely
outcome is that, in the first year, the net impact of the measures on operating profit
will be negative; therefore the full set of objectives is not achievable in the first year.
Three years from now, it is more likely that operating profit will be increased, but it
is not guaranteed. This introduces the classical time trade-off: will the manager be
willing to incur costs now – which will definitely mean that the operating profit
objective cannot be achieved in the current year – in the uncertain expectation that
operating profit will be increased in three years’ time?
Much of the difficulty here arises from the underlying lack of understanding of
causality: it was not appreciated at the outset that operating profits depend on the
success of the other objectives and, being a residual, are therefore hard to predict
with any degree of accuracy.
3.4.2 Applying ‘Stretch’ to Objectives

The principle of stretch objectives ties in closely with the idea that objectives should
constantly be under review. If objectives are reviewed at regular intervals, then they
can be reassessed and ‘stretched’ if they are being achieved.
Let us return to our fictional British Gas manager, who, six months into the year,
has hit his target of 3 million customers for the division. Both he and his superiors
attribute this to increased incentives and a lower attrition rate, but it has actually
occurred because of an event outside his control (the withdrawal of a major
competitor). To get the most from the manager, the British Gas chief operating
officer (COO) decides to increase the target customer base for the end of the year.
In assessing how to set the new objective, the COO again uses the SMART criteria,
as follows.
 The objective will need to include a new specific target number of customers.
 We know that it will be directly measurable by looking at the company’s records.
 To set an achievable new target, the COO can use benchmarking against other
divisions or assess the number of available customers.
 The objective is relevant to the company’s strategic direction.
 The objective will be time-bound to the end of the financial year.

This process looks convincing, but the trouble is that the COO has fooled himself
by focusing on the wrong variable. Instead of finding out why the improvement
occurred, it was assumed that it was the result of the actions undertaken, while in
fact it had nothing to do with them. In this case, the causality error was to assume
the cause and effect factors rather than to establish what they actually were. It is
difficult to predict the outcome of stretch objectives devised under these circum-
stances, but they are likely to be perverse.
The setting of stretch objectives and their usefulness in pushing people further
than they thought possible depends on whether the ‘stretched’ objective is achieva-
ble. A manager who has achieved his objective after six months and is then set a
further, more distant, objective may quickly become disillusioned. In the most
extreme cases, objectives may come to be ignored. If it becomes generally known
that achieving an objective early simply leads to the bar being raised, managers will
have an incentive to delay reports and may even slow their efforts. It is clearly
important not to generate a principal–agent problem, with the attendant unintended
consequences.
3.5 Corporate Social Responsibility

One of the changes in business over the past 30 years has been the proliferation of
corporate social responsibility (CSR) policies. The question of whether the only
objective of a company should be profit maximisation has been asked frequently
since the 1980s, and now most companies have some sort of policy dedicated to
objectives other than profit and shareholder wealth maximisation. Indeed, it would
be unusual for a company listed on a stock market not to have some kind of policy
related to CSR.
The oil and gas industry is of particular interest in relation to CSR. The industry
is characterised in the media as being a large contributor to pollution, and ‘Big Oil’
has developed as a derogatory term for large, vertically integrated oil and gas
companies. But what does CSR achieve? A brief history of the economic theory of
externalities and its relation to CSR follows.
3.5.1 Externalities and CSR

The problem with CSR is that there is little to define what it actually means or even
whether it is appropriate in the first place. From an economist’s perspective, CSR is
an attempt to ‘internalise the externality’. Externalities occur when costs or benefits
from an economic activity accrue to an individual who is, or group of individuals
who are, not involved in the activity. The most widely used example in energy
production is pollution.
Consider the example of a refining plant that operates near a river. It uses the
river to dispose of its waste, which consequently kills all the fish that live down-
stream. This annoys local fishermen, who depend on the fish for a living, and they
demand compensation. However, in the absence of government intervention, will
the refining plant pay for the dead fish? Of course not; it will attempt to maximise
profit. The problem is that, by not taking all costs of production into account, the
price of the plant’s good – refined petroleum products – will not reflect the true
cost of producing that good. Only by internalising the externality, for example
through allocating the fishing rights to the company, will the misallocation of
resources be resolved. This is because the company will now include the marginal
benefits of fishing into its calculation of profitability. Advocates of CSR hope that
companies will take responsibility for externalities without necessarily acquiring
property rights because of the moral imperative attached to ‘doing good’. This
clearly causes a conflict of interest when it interferes with profit maximisation. In
order to counter this, advocates of CSR claim that policies to deal with externalities
can also increase profit through mechanisms such as employee satisfaction and
brand awareness; as yet, however, there is a lack of empirical support for these
contentions.
In one way, CSR policies can be seen as an attempt to at least appear to be deal-
ing with negative externalities created by the company’s operations. The problem is
that it is accepted by many economists that the best way to deal with externalities is
through government regulation. Proposed carbon-trading systems are an attempt to
deal with negative externalities caused by carbon emissions: by making polluters take
the full costs of their activity into account, the expectation is that they will look for
ways in which to reduce their emissions and thereby reduce their costs. This is in
conflict with the philosophy that companies themselves can deal with externalities
effectively; the economists’ view is that, left to their own devices, companies will do
what is best for their shareholders and this is unlikely to be consistent with maximis-
ing the welfare of society as a whole.
3.5.2 CSR in the Real World

A company must decide how much of its scarce resources should be allocated to
social and environmental ends. Given the lack of efficiency criteria, this is likely to
be a difficult task. There may well be genuine returns associated with acting in an
environmentally friendly manner: if the effect is to increase sales, for example, it
could be argued that the resources used are really a form of marketing expenditure.
Another issue is that companies often wish to be seen as operating in a socially
responsible way. A relevant example from the oil and gas industry has already been
touched upon in Module 2. BP followed an apparently socially and environmentally
responsible policy under the stewardship of John Browne in the late 1990s. The
company withdrew from climate change sceptic groups and promoted transparency.
The company also started to invest in renewable energy sources.
In 2004, Browne said:
BP’s social responsibility is good business, driven by practical commercial reality

and hard-headed business logic. The company’s good deeds are in our direct
business interest, not acts of charity but of what could be called enlightened
self-interest. The fundamental test for any company is good performance. That
is the imperative (cited in Bakan, 2004, pp 44–45).
This actually states that ‘good deeds’, or dealing with negative externalities, takes
second place to profit maximisation and that any ‘good deed’ must be justifiable in
business terms. The statement was interpreted by many to imply that BP had a
commitment to CSR, but it could be interpreted as the opposite.
After making this statement, BP came under the media spotlight for a different
reason. An oil spill at the company’s Prudhoe Bay facility in Alaska and an accident
at one of the company’s refineries in Texas that left 15 people dead painted the
company in an entirely different light. Thus the policy of ‘good CSR’ backfired,
because the company was accused of attempting to ‘greenwash’ its activities. Yet
Browne’s original statement could be interpreted such that BP had calculated that
the costs of preventing a potential oil spill and additional safety measures were
higher than the potential benefits.
One of the first actions taken by Tony Hayward, Browne’s successor, in 2007
was to scale back investment in alternative energy and social responsibility pro-
grammes. It was Tony Hayward who was at the helm of the company during the
Deepwater Horizon, or Macondo, incident, in which 11 people died, and billions of
US dollars’ worth of damage was caused to surrounding land and marine habitat,
business and homes. It emerged that, despite incidents like that at Prudhoe Bay, the
safety culture of BP was lacking and that poor management decisions had led to the
explosion. It is possible, but far from certain, that the company’s focus on non-core
objectives and businesses in the early 21st century had been at the expense of its
traditional activities. Whatever the root cause, however, the company paid dearly for
its mistake, with liabilities approaching $50 billion by mid-2015.
Contrast BP with ExxonMobil, which was widely criticised in the early part of the
21st century for its support and funding of climate change sceptics. At the time, the
company came under fire from government, environmentalists and scientists, yet
refused to invest in alternative energy projects or social responsibility programmes.
Yet ExxonMobil’s approach was also consistent with Browne’s ‘enlightened self-
interest’ policy: both were attempting to act in the best interests of shareholders as
each perceived them.
Another factor that must be borne in mind with regard to CSR is the regulatory
environment in which the company operates. It is common now for governments
and national oil companies to insist, when dealing with international operators or
service companies, on a certain level of local employment being generated or a
certain amount of investment in local infrastructure being carried out as part of a
production or development project. In such cases, the company has no choice but
to comply with government demands in order to access resources, so it is in the
company’s interest to undertake such social programmes.
Overall, it appears that there is a fine balance between internalising externalities
and companies appearing more responsible than they are. A company that pursues
social objectives incurs costs that it would not otherwise have; this makes competi-
tion with companies whose objectives are pure profit maximisation more difficult.
As a rational shareholder, whose shares would you purchase? The answer would
depend, of course, on your own personal objectives when investing.
3.6 Business Ethics in the Oil and Gas Industry

The concept of business ethics is directly related to CSR. It is difficult for a compa-
ny to impose a code of ethics on all its employees, especially when the company has
operations in several different countries. This is particularly important in the oil and
gas industry, in which companies often have large operations in areas where cultural
and social norms are different from those of their operating base. This makes the
question of business ethics in the international marketplace exponentially more
complex. A company such as Halliburton, the international oilfield services operator
based in the US, will have more ethically complex decisions to make than a purely
local operator.
Centrica publishes a ‘guide to sound business practice’, which details eight busi-
ness principles that the company adheres to. These are similar to a code of ethics.
Exhibit 3.6: Centrica’s Business Principles, 2008 and 2015

Eight principles were provided in both the 2008 and 2015 versions of the
company’s corporate profile, and were identical in both documents.
1. Demonstrating integrity in corporate conduct

2. Ensuring openness and transparency
3. Respecting human rights
4. Enhancing customer experiences and business partnerships
5. Valuing our people
6. Focusing on health, safety and security
7. Protecting the environment
8. Investing in communities
(Centrica, 2008, p 6; Centrica, 2015, p 9)
Each of these principles is addressed in Table 3.6, which asks the question ‘What
does it mean?’
Table 3.6 Centrica’s business principles

Principle Meaning
Demonstrating integrity in This could mean acting within the laws of the countries in which the
corporate conduct company operates. This is required anyway if the company wishes to
remain operating in those countries.
It could also mean fairness in hiring, firing and promotion; it is difficult to
draw the line between good business practice and ethically correct
behaviour.
Ensuring openness and This is demanded to a certain extent by accounting standards and
transparency disclosure laws. Few companies will reveal more than the bare minimum
necessary to competitors.
Since the limits are not disclosed, it is not possible to determine
whether Centrica is more or less transparent than similar companies.
Respecting human rights In most of the areas Centrica is operating in, human rights records are
good.
The company states that it will not be ‘complicit in human rights abuses’
– but it would be a strange company that would be knowingly complicit
in human rights abuses.
Enhance customer experiences Treating customers fairly and delivering good customer service are
and business partnerships musts when operating in a competitive market. The company also says
that it will not engage in any false advertising – but if it were to do so, it
would face prosecution.
Valuing our people A company that does not attempt to value its people will experience
high attrition rates and never benefit from cost savings at the top of the
experience curve. Again, this is necessary if it is to compete.
Valuing people can take many forms. For example, a company may be
anti-union yet pay above-market rates; some may regard this as not
‘valuing people’.
Focusing on health, safety and Health and safety procedures are required by law. Where they are not,
security the situation with human rights also applies. A poor health and safety
record for Centrica in Egypt is likely to have a negative effect on the
company’s operations in the UK and US.
Protecting the environment This is not defined.
Investing in communities This concerns the question of ‘fuel poverty’. Fuel poverty – whereby a
household cannot afford to keep warm – damages the health of those
living in cold homes and affects their quality of life. The old, the young
and those who are disabled or have a long-term illness are especially
vulnerable. The main cause of fuel poverty in the UK is a combination of
poor energy efficiency in homes, low incomes and high energy prices.
Centrica invests in programmes to alleviate this throughout the UK.
So the business principles or ethics of Centrica do not actually say much more
than that the company will do what is required of it in order to remain competitive
in its markets and to avoid litigation or prosecution. If the company had no ethical
code and if it were to contravene any of the principles set out above, serious harm
would be done to its reputation and hence to its competitiveness. Again, these
criticisms might appear unduly derogatory, but it is important to recognise that high-
sounding aspirations often amount to no more than statements of the obvious.
Moral behaviour at the company level is difficult to define. At first glance, Cen-
trica’s business principles seem to be highly ethical and moral, but they are in fact no
different from what one would expect of any multinational company based in
similar geographical locations. The lesson is that ethical considerations do not
differentiate most multinational oil and gas companies; codes of ethics and similar
tend only to underline activities that the company undertakes in order to remain in
competition with rivals.
3.7 Objectives in Practice

There are many difficulties inherent in assigning meaningful objectives. It has been
demonstrated that the oil and gas industry is no different from other industries
when addressing objectives in a rigorous, rational fashion. The problems that have
become apparent in the case of Centrica are common to all industries. But there is a
distinctive characteristic of the oil and gas industry that impacts significantly on
objective-setting: the supply chain, as depicted in Figure 1.2. As will become
apparent in the following modules, the markets vary greatly from the start to the
end of the supply chain, making it imperative to be clear about the business defini-
tion; to define the company as an ‘oil supply business’ can obscure the fact that it
needs to pay close attention to radically different competitive conditions in different
divisions.
There is another lesson to be drawn from this analytical dissection of a particular
company’s published mission and objectives. The authors have often been briefed
by senior executives on companies’ confidential strategies, which are not to be
disclosed to competitors. What may appear at first sight to be the identification of a
company’s direction and a clear set of objectives for management falls apart on
rigorous analysis, and often turns out to be banal, illogical, conflicting and likely to
distort management effort through the creation of principal–agent conflicts. The
problem is that the executives themselves do not recognise these deficiencies and it
is a monumental task to teach them the error of their ways. So if you are involved in
a mission and objective-building exercise, try to keep your powers of logic to the
fore and be prepared to enter into conflict with your colleagues. You have been
warned.
Learning Summary
This module has examined the definition, development and disaggregation of
company objectives, using Centrica as an example throughout. The way in which a
business is best defined has been examined, as has the usefulness or otherwise of a
company’s vision and mission statement. The process of developing objectives from
company strategy statements has been examined and the way in which a manager
might employ ‘stretch’ objectives to achieve strategic goals has been demonstrated.
Finally, the relevance of CSR and ethical issues in objective-setting have been
discussed, and the peculiarities of the oil and gas industry in this regard identified.
References
Bakan, J. (2004) The Corporation: The Pathological Pursuit of Profit and Power, New York:
Simon & Schuster.
Centrica (2008) Corporate Profile 2008, July.
Centrica (2015) Corporate Profile 2015, July. Available online at www.centrica.com/sites/
default/files/centrica_corporate_profile_2015.pdf
Module 4
Macro-environment Issues in the Oil

and Gas Industry
Contents
4.1 Introduction.............................................................................................4/1
4.2 Revisiting the Cost and Revenue Model ...............................................4/2
4.3 Oil Prices..................................................................................................4/7
4.4 Peak Oil................................................................................................. 4/13
4.5 Renewable Energy ............................................................................... 4/19
4.6 The Economy ....................................................................................... 4/21
4.7 PEST Analysis....................................................................................... 4/30
4.8 Environmental Threat and Opportunity Profile .............................. 4/38
Learning Objectives
 demonstrate the impact of macro variables on oil and gas companies;
 analyse the prospects for the oil price;
 assess the arguments for and against peak oil;
 apply the concept of the competitive advantage of nations to the oil and gas
industry;
 assess the role of leading indicators and scenarios in the oil and gas industry;
 apply PEST analysis globally and by geographical area; and
 integrate the analysis into an environmental threat-and-opportunity profile.
4.1 Introduction
Before a company can start to identify its strategic options, it must assess the
environment in which it operates. This environment can be broadly split into the
macro environment, which determines the overall level of demand, and the industry
environment, which determines competitive conditions. This module analyses the
macro environment in which the oil and gas industry operates, and shows how
macro-economic variables might affect different parts of the industry.
Module 4 / Macro-environment Issues in the Oil and Gas Industry
4.2 Revisiting the Cost and Revenue Model

The objective of profit maximisation is achieved by maximising the difference
between revenue and costs. Continual reference to the basic model of revenue and
costs helps to align revenue generation with other objectives. Clearly, there are
issues of short-run versus long-run profit maximisation, but in the first instance the
basic model of revenue and costs identifies the main variables as follows.
Revenue = Total market × Market share × Price

Costs = Number of workers × Wage rate
+ Units of capital × Price
+ Units of material × Price
This is a simplified view of how a company generates revenues and incurs costs, but
it is a useful tool in focusing attention on the important factors.
4.2.1 Revenue
Some of the factors that affect revenue in the upstream industry are listed in Table
4.1. This is not a comprehensive list, but identifies many factors that managers
operating in the upstream sector should monitor. It also serves as a way of identify-
ing relevant questions; one reason why companies find it difficult to interpret the
environment is that they do not know what questions to ask in the first place.
One of the outcomes in Core SP Section 4.8.2 was that revenue volatility was not
only the result of significant changes in price. On the one hand, the combined
impact of relatively small changes in market size, market share and price is relatively
large. On the other, a significant rise in price can conceal the fact that market share
has fallen significantly in a mature market, which can undermine competitive
advantage, for example by shifting a cash cow in the dog direction in terms of the
Boston Consulting Group (BCG) growth–share matrix. When price increases
significantly, such as the increase in oil prices between 2010 and 2014, there is a
natural tendency for companies to lose sight of the components of revenue. It is not
a difficult mathematical feat to see that if price increases by 50%, then revenue will
also increase by 50% if market size and market share are unchanged. If revenue does
not increase by about 50%, questions should be asked: what has happened to the
market size and market share?
This may seem patently obvious, but it is a step that companies often fail to take.
This is because the implications of price changes are not followed through logically.
Again, it is a case of asking the right question: attention is typically focused on the
impact of price changes on profit (that is, the difference between revenue and cost,
rather than on revenue itself).
Table 4.1 Revenue drivers in the upstream oil and gas industry
Variable Determining factors Relevant issues
Total market Global gross national product (GNP); Reliability of short- and long-term
GNP growth rate predictions
Global energy demand GNP elasticity?
Growth rate in developing countries Sustainability of current growth rates
Price of oil; price of gas; relative prices Trends in prices of substitutes for oil and
gas: coal, nuclear, renewables and energy
efficiency
Availability of substitutes for oil and gas Pace of technological change
Capacity; product life cycles Trends in end-consumer demand
Extent of reserves depleted/available Reliability of estimates of reserves
Carbon control systems in place Whether oil and gas burning can be
made ‘clean’
Market share Marketing expenditure Do we understand the customers we are
targeting?
Reputation Are we living in the past or investing for
the future?
Pricing Are we making a profit on all deals?
Ties with customers Do customers have an incentive to
renew contracts?
Geographical presence in local ‘boom’ Are we positioned in the markets of the
areas; access future?
Price of product Demand What is the likely long-term trend? (See
supplied ‘GNP elasticity’ above)
Supply What is the prospect for extraction
rates?
Expectations What is the relationship between spot
and futures prices?
Nature of competition regionally or What government regulations affect
internationally competition?
Cost of inputs Are these likely to move in line with
end-user prices?
4.2.2 Costs
While costs are, in principle, independent of revenue, sudden changes in revenue
can affect how costs are controlled. For example, when revenues suddenly increase,
companies often cease to pay attention to cost control; when revenues suddenly fall,
there is often a knee-jerk reaction and easily targeted costs are cut immediately –
whether economy measures impact on competitive advantage or not.
Industry capacity at various stages of the supply chain can also play a part. It is
common to find, in the upstream stages of the oil and gas industry, that increased
revenues are accompanied by increased costs because increased demand results in

capacity constraints for service providers or companies further up the supply chain.
Downstream demand tends to be more stable and seasonal, and less subject to the
shortages that drive up costs when revenues rise.
Table 4.2 is a summary of costs that are generic to all sectors and stages of the oil
and gas industry, and can be refined for specific cases.
Table 4.2 Cost drivers in the upstream oil and gas industry
Variable Determining factors Relevant issues
Workforce Skill sets required Identification of core business
Supply of trained and experienced Requirement for highly mobile workforce
personnel
Compensation offered Attractiveness of total remuneration
package
Unemployment rates locally Local or international wage rates
Wage rate Supply vs demand for qualified personnel Transferability of skills
Skills required vs skills available Investment in training programmes
Capital Capacity of capital goods Availability of equipment at short notice
producers
Capital price Supply vs demand for capital goods; Predictability of prices of different types
backlogs of equipment
Consider the example of a one-product company operating in the production

stage of the upstream sector. The company manufactures and sells artificial lift
equipment to oil producers; the company’s product is an electric submersible pump
(ESP). The company’s cost and revenue model will look something like this:
Revenue = Total market for ESPs × Market share × Price of pump

Costs = Number of workers × Wage rate
+ Units of capital × Price
+ Units of material × Price
Table 4.3 breaks down some of the factors that may affect the variables in the
model. This is not a definitive analysis of determining factors and main drivers, and
could be elaborated by specialists with more detailed knowledge of the sector, but it
does indicate the variables that need to be taken into account.
Table 4.3 Costs and revenue for an ESP producer

Variable Determining factors Main drivers
Total market Energy demand Oil price
Number of wells in secondary production Level of investment
phase Percentage of wells in decline
Rig count Energy demand
Oil price
Substitutes for ESPs
Market share Price vs perceived quality Level of differentiation during up cycle
Marketing Relative cost during down cycle
Customer relationships
Geographical presence
Price Input prices Level of investment in services
Demand conditions Level of investment in oil and gas industry
Supply conditions Energy demand
Wage rate Supply vs demand in labour market Energy demand
Skilled vs unskilled labour Demographics
Ageing population
Materials input Industry specific materials supply vs Oil price and energy demand impact on
demand input prices and end price
It is apparent that the driving forces behind many of the variables in the costs
and revenue model are the oil price and the demand for energy. These two drivers
are interrelated, in that the demand for energy drives the demand for oil, which will,
relative to supply, affect the oil price. In the case of the total market, the size of the
market depends on the rig count and the number of fields requiring secondary
production methods; in turn, the driving forces behind these factors are the demand
for energy and the oil price. As the demand for energy rises, more rigs are required.
As the price of oil rises, more fields become economically viable.
The same applies to the price of the company’s product. On the one hand, if the
demand for energy slows and the oil price falls, then the company will not be able to
charge as much for its product, all other things being equal. A falling oil price will
also mean that it is not economically viable to extend the life of some wells with
secondary recovery techniques. On the other hand, rising demand for energy
coupled with a high oil price will mean that the company will be able to charge more
for its product.
This also applies to the costs side of the equation. The wage rate for qualified
workers trained in producing equipment for the upstream sector will also be
affected by the oil price and energy demand. When energy demand is strong and the
oil price is high, demand for qualified labour will be higher than it otherwise would
be. Assuming that it takes time for supply to adjust because of training and qualify-
ing times (the supply of skilled labour is inelastic in the short run), the going rate in
the labour market will rise.
4.2.3 Profits
Having identified the factors influencing revenue and cost, it is then possible to
analyse what is likely to happen to net revenue (that is, revenue less cost), which is
approximately profit. The first, and most obvious, point is that net revenue is a
residual that depends on the relative changes in revenue and cost. Consequently, any
profitability target needs to be formulated in terms of what is likely to happen to
revenue and cost. The fact that the same two factors, energy demand and oil price,
are the main drivers of both revenue and cost does not imply that they will move in
step.
For example, we can track the events arising from a sudden increase in oil price
that is expected to be permanent, but actually lasts for, say, one year, as follows.
1. The impact on revenue will be immediately apparent, if both market size and
market share are unchanged; as a result the difference between revenue and cost
increase will increase.
2. Wage rates and other input prices will not react immediately, because, for
example, it takes time for wage rates to adjust in response to shortages; as a re-
sult, cost will remain unchanged initially.
3. Wage rates and input prices will increase with a lag, and the initial increase in
profit will be eroded as the factors described above come into effect.
4. By this time, cost control will have been relaxed and, as a result, cost will
increase more than it otherwise would have done. This increase could be so large
that it is disproportionately greater than the rise in revenue, with the result that
profit is reduced below its previous level.
5. Subsequently, the oil price will fall – but input prices do not fall significantly,
because of the lagged effects; wage rates are notoriously ‘sticky’ downwards, so
the company may find that it experiences financial problems in the period fol-
lowing a temporary increase in price.
The fact that revenue and cost do not move in tandem, although both are influ-
enced by the same factors, explains why a windfall gain can turn into a windfall loss.
The lag in cost increases means that the impact of the price increase on profit is
greatly exaggerated, because it is actually a one-off temporary effect rather than
permanent.
The experience of this hypothetical upstream company would apply equally to
the downstream oil or gas sectors. The total market for refinery equipment, for
example, is also driven by the demand for energy and the price of oil, as is the
demand for gas-processing services. While the precise factors influencing demand
and cost are different at each level of the supply chain, the same lesson applies: in a
volatile market, do not focus on net revenue, but on the factors (and the timing of
those factors) affecting revenue and cost individually. Detailed analysis of demand,
supply and prices is contained in Module 5, but it is well known that the price of oil
dominates the behaviour of all players in the industry. In order to carry out PEST
analysis and produce scenarios, it is always necessary to take an informed view of
what is happening and is likely to happen to the oil price.
4.3 Oil Prices

Oil prices affect different parts of the industry supply chain in different ways, the
details of which are dealt with in Module 5. No matter the stage or sector of the
supply chain, a large change in the oil price is likely to have some effect and so
companies in the industry need to have an understanding of how they work. This
section deals with oil prices over the long run. It deals exclusively with oil prices,
which are part of a global market. Gas prices tend to be regional in nature and are
dealt with in more detail in Module 5.
4.3.1 Oil Price History

The all-time high for oil came in July 2008, when its price reached almost $150 per
barrel. This sparked expectations of the start of a new era of high oil prices that
would continue over the long term because of the growth of economies such as
China and India. This was further reinforced by fears that ‘peak oil’ had arrived, or
would arrive soon (see Section 4.4). From a longer historical perspective, however, it
seemed possible that the price increase was a short-term phenomenon that would be
remedied by the operation of market forces. For example, the oil price increase in
the 1970s did not lead to an era of high oil prices, because the high price provided
incentives to use oil more efficiently on the demand side and the rate of exploration
was increased on the supply side.
By the end of 2008, the oil price had fallen to $35 per barrel; by the end of 2009,
it was back at $80. A similar pattern was observed a few years later when, in 2011,
political unrest in the Middle East resulted in prices increasing back to more than
$100 per barrel, where they remained until mid-2014, when the price began to
decrease. Increases in supply from US unconventional production, along with
slowing demand in China and other parts of the world, resulted in the price of oil
falling from $100 to around $45 in a matter of months. The increased production
from unconventional resources in North America also had the effect of making
peak oil a less popular topic for discussion than it had been before.
Such fluctuations in the oil price tend to cause consternation in the industry and
it tends to be the periods of high prices that result in discussion of peak oil resurfac-
ing. As will be shown in Module 5, however, short-term ‘overshooting’ and
‘undershooting’ like that observed in the early 21st century are a natural outcome of
the way the oil market operates.
The intention here is to establish the behaviour of the oil price over a long peri-
od, during which many exogenous shocks have disturbed the underlying equilibrium
of the market. Figure 4.1 and Figure 4.2 show the oil price for time series of
approximately 60- and 40-year periods. These prices are ‘real’, as opposed to
‘nominal’: they are given in 2015 US dollars (USD), so are numerically higher in the
early part of the series than the nominal price would have been.
140
World oil price
120
Price per barrel (2015 USD)

Average price during period
100
80
60
40
20
0
1946
1948
1950
1952
1954
1956
1958
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
Year
Figure 4.1 World annual oil price, 1947–2014

Source: EIA (undated)
140
World oil price
120
Average price during period
100
80
60
40
20
0
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
Year
Figure 4.2 World annual oil price, 1970–2014

Source: EIA (undated)
A cursory inspection of the time series suggests that there is a marked tendency
for the oil price to revert to a long-term figure of around $40. This is actually what
happened, at least for a short time, at the end of 2008 and 2014. But, given the
volatility of the oil price, is it possible to establish from these time series the long-
term equilibrium price of oil around which the price fluctuates?
The first problem is to decide on the relevant time period. For the period 1970–
2014, shown in Figure 4.2, the world mean was $55; for the period 1947–2014, in
Figure 4.1, it was $41. These are surprisingly close given the influences on volatility
(to be developed in Module 5, to include elasticities, expectations, cobweb and
overshooting), together with the impact of disruptive exogenous shocks. Taking a
shorter time series still, the 11 years from 1974 to 1985, the oil price always exceed-
ed $40 and peaked at about $65. During that time, it would have been natural to
conclude that the equilibrium price was at least $40 and to make investment plans
accordingly. But, during the next 15 years, from 1986 to 2000, the price fluctuated
around $20 or so. By the late 1990s, the perception of the equilibrium price would
have been much lower than it was during the early 1980s.
It is therefore not possible to establish the equilibrium price from historical time
series. But it is possible for the price to rise to a historically high level and remain
there for some time – as in the decade 1974–85, when price exceeded $40. It
therefore follows that it was quite possible that the 2008 price would be maintained
for a long time in business terms – a decade or so – even though in fact it reverted
back to around $40 after economic changes. Economic and technological changes in
2014 brought about the rapid fall to around $50, which is seen by some as the ‘new
normal’ in the industry.
The difficulty is that past history may not repeat itself, because economic, tech-
nological and social conditions will have changed, so the type of market adjustments
that have occurred in the past may not have the same impact in the future.
So is it possible to draw conclusions about what a ‘normal’ oil price might look
like? In theory, the first step would be to estimate the industry long-run marginal
cost (LRMC) curve. In a competitive industry, the price would tend to revert to
LRMC; hence LRMC provides a benchmark against which to assess current price.
But it is doubtful whether the concept of LRMC can be meaningfully applied to the
supply side, because of the strategic behaviour of low-cost producers such as Saudi
Arabia. In a perfectly competitive industry, profit-maximising behaviour would
result in oil fields being exploited incrementally according to their cost. But oil is not
extracted in response to normal profit-maximising criteria: the cheapest oil comes
from Saudi Arabia, for example, but it has not been exploited first. Suppliers within
the Organization of the Petroleum Exporting Countries (OPEC) release their
output on a strategic basis and act like monopolists, rather than competitors. Thus
the notion of LRMC does not figure in their decision making. This is abundantly
clear from OPEC behaviour in response to the oil-price drop in late 2014 and 2015:
rather than lose market share to US-based shale producers, OPEC suppliers have
continued to produce similar amounts of oil at low prices. They are able to do this
because their production decision is not purely market-based and because of low
production costs. Given the scale of low-cost reserves, it is unlikely that the LRMC
equilibrium will emerge for many years – certainly for a period well outside the
planning of current oil companies.
A major problem in attempting to construct the industry LRMC curve is that it
depends on current stocks and technology. Despite aborted efforts in 2015 by Shell,
exploration efforts combined with changes in technology may uncover, for example
in the Arctic, fields that are relatively low cost compared with deep-water fields in
places such as Brazil. A decade is a long time in technological terms and it is
possible that new techniques for recovering oil out of existing fields will be devel-
oped that will significantly reduce costs. Thus predicting the future equilibrium price
is bound to be speculative.
4.3.2 Possible Oil Price Scenarios

It is clear that oil prices are subject to a high degree of uncertainty. It is therefore
necessary for any organisation operating in any part of the industry supply chain to
develop an informed view of the future and to act accordingly. Consider an explora-
tion company, in mid-2014 when the oil price was around $100 per barrel,
developing scenarios for future oil prices. Figure 4.3 shows four possible scenarios
over an unspecified period.
Price
S1
Current price
S2
S3
Long run price S4
Time
Figure 4.3 Oil price scenarios, mid-2014

In these scenarios, ‘indefinitely’ means outside the company’s planning horizon.
 Scenario 1 (S1). The price remains at a high level indefinitely.
 Scenario 2 (S2). The price falls to the long-run price, then rebounds to regain the
current price, where it remains indefinitely; the precise timing is not important.
The lowest price reached can be interpreted as the turning point in an under-
shoot.
 Scenario 3 (S3). The price falls to a level halfway between the current price and
the long-run price, and remains there indefinitely.
 Scenario 4 (S4). The price falls to the historical long-run price and remains there
indefinitely.
The impact of each of these scenarios on current activities and investment plans will
depend on the position of activities within the supply chain. The exploration
company would react to each as illustrated in Table 4.4.
Table 4.4 Oil price scenarios and responses

Scenario Response Generic
strategy
1 Invest in capacity Expansion
2 Invest in capacity and be prepared for short- to medium- Expansion
term cash-flow problems
3 Invest less than for S1 and be prepared for possible Expansion,
short-term cash-flow problems then stability
4 Scale down operations Retrenchment
If the exploration company were to act now in the expectation of a particular

scenario, there would be severe penalties for being wrong. For example, if Scenario
4 were expected and Scenario 1 occurs, it would lose market share and be unable to
pursue opportunities. If Scenario 1 were expected and Scenario 4 occurs, then the
company would have significant unused capacity and high costs, and may go out of
business. If Scenario 1 were expected and Scenario 2 occurs, the financial structure
may not have sufficient reserves to cope with the cash-flow problems and it may go
out of business.
Given that the future cannot be predicted with certainty and that the costs of
being wrong are so high, what should the company do? The following are some
possibilities.
 Delay. The problem is that Scenarios 2, 3 and 4 are indistinguishable once the price
begins to fall. Scenario 2 represents most closely what happened to the oil price
after mid-2014.
 Delay until it can be concluded that Scenario 3 is right. Endemic volatility makes it
difficult to arrive at a conclusion.
 Delay until it can be concluded that Scenario 3 is wrong. The problem is that Scenarios 2
and 4 remain as possibilities.
The natural reaction is to delay, but that does not mitigate the decision problem,
which amounts to being wrong now or being wrong in the future. It may appear
counter-intuitive, but the probability of making the right investment decision is not
actually much improved by delay.
4.3.3 The Backstop Price of Oil

A different approach to the determination of current and future prices is based on
the notion of opportunity cost (that is, the current price of implementing the next-
best substitute for oil). The economist Harold Hotelling (1931) examined oppor-
tunity cost and substitutes with regard to non-renewable resources, and came up
with the following theoretical proposition, known as ‘Hotelling’s Rule’:
[W]ith enough competition in producing oil at low extraction costs, for oil to
be sold gradually rather than kept in the ground or all be extracted immediate-
ly, its price must increase at the rate of interest until it hits the choke or
‘backstop’ price where the oil is no longer ever used (Clarke, 2006).
This is best illustrated with an example. Imagine that a substitute for oil is available
at $200 per barrel equivalent and the current price is $82 per barrel. Assuming a real
interest rate of 3%, $82 is the present value of $200 in 30 years’ time. So, for 30
years, the oil price would increase at 3% per annum, each year making oil the same
price as the backstop in present terms. After 30 years, the backstop would take over.
One outcome of this analysis is that the price of oil is highly dependent on the price
of the backstop. Figure 4.4 shows the growth of oil price from now up to the
backstop price PB at time T3.
Price
PB
PBNEW
H2
P(T1)
H1
P(T1)NEW
Time
T1 T2 T3
Figure 4.4 The backstop price of oil

When the price of a backstop substitute such as tar sands or shale gas is PB, then
the figure illustrates what theory predicts. Oil price increases from the current price
at the interest rate along its Hotelling price trajectory H1. It increases up to PB, the
choke price, at which consumers switch to a backstop at time T3 at price PB. Now,
suppose that, at T1, there is a discovery – perhaps a new technology – which lowers
the backstop price to PBNEW. The effect is to cause an immediate collapse in current
oil prices from P(T1) to P(T1)NEW, whereupon a new lower Hotelling price path H2
results, with higher use at each time than would have been the case before the
shock. The conventional oil resource ceases to be exploited at T2, which is earlier
than before.
One way of reducing current oil prices is thus to invest in the efficient provision
of backstop supplies. But this is unlikely to work in practice, because the Hotelling
condition of ‘enough competition in producing oil’ is not met. The monopoly
power of OPEC results in current oil prices being significantly higher than backstop
levels. (This is consistent with the argument in Section 4.2 that oil is not extracted
on the basis of LRMC.) So what determines the price that monopoly producers set
at the moment? In theory, they will set the profit-maximising price, which is well
above the extraction cost. The extraction costs of many oilfields in the Middle East
are, in fact, so low that suppliers can cut prices heavily to protect their market and
still remain viable; it may even be that OPEC suppliers are dealing strategically with
alternative energy suppliers by stressing their own low marginal costs. What matters
to alternative energy suppliers is not the price OPEC charges now, but the price that
it would charge were alternative energy supplies to come on-stream.
This helps to explain why oil price increases in 2008, and even the sustained price
above $100 after 2011, did not immediately result in a huge increase in investment in
alternative energy: the fear is that, having incurred high fixed development costs,
alternative energy suppliers will ultimately face oil prices set to make sure they are
uneconomic. Producers of alternative fuels are concerned that oil prices may again fall
to a level that pushes the backstop far away into the future. In terms of the figure, the
current price is reduced – say, by half – and the new Hotelling trajectory will not meet
PB until some distant time T4.
Apart from the issue of market imperfection (monopoly power), there are other
reasons why the backstop price is unlikely to have any bearing on the oil price.
 Information on alternative energy costs is constantly changing. The cost of
electricity produced by wind turbines, for example, depends on location, number
of turbines, technology and so on.
 It is unlikely that one alternative source will be able to meet all demand currently
supplied by oil, so a number of backstops would have to be taken into account,
including wind, solar, fuel cells, wave, tidal, shale and so on. Many options are
still speculative, so even the options likely to be available are not fully under-
stood.
 The cost of conversion to the backstop needs to be included in the calculation,
but this is largely unknown; it could be that this is relatively costless, for example
as electric motors are substituted for internal combustion engines as the stock of
cars ages, but the fact is that it is yet another unknown.
 Energy sources are not adopted for purely economic reasons: some governments
are opposed to nuclear power, for example, and environmental pressure groups
are opposed to wind turbines.
From the company perspective, it can safely be concluded that research into
alternative energy sources will have little impact on the oil price for the foreseeable
future. It may be that an earth-shattering discovery will be made that changes
everything, in which case the uncertainties of cost, scale and technology will cease to
be important – but that seems unlikely.
4.4 Peak Oil

It was noted in the preceding section that peak oil had become a less popular topic
of conversation in the context of the increase in unconventional hydrocarbon
production in North America in recent years. Nevertheless, the notion of peak oil is
intuitively attractive and it is likely to transpire at some point in the future: there will
come a time when reserves have been exhausted to the point at which current
production cannot be maintained. After peak oil, there will be a gradual decline in
production, coupled with an increase in both cost and price because only the more
inaccessible oil fields are available.
Industry observers suggest that few companies take a rational view of the pro-
spects for peak oil and there is a pronounced lack of serious analytical modelling on
the subject. Estimates of peak oil have consistently receded farther into the future as
exploration has discovered more oil fields and technology has advanced. At the
moment, there is wide diversity of opinion on the prospects for peak oil, despite the
fact that it will bear upon the long-term equilibrium price of oil and the need to
uncover alternative sources of energy.
The difficulty lies in predicting peak oil, understanding its impact and deciding
what, as an organisation in the oil and gas industry, one might do about it. That is
the focus of this section.
4.4.1 Why Is It Difficult to Predict Peak Oil?

Clearly, any prediction of peak oil is dependent on estimates of oil reserves. But
there is very little agreement about oil reserves, and it is worth bearing in mind why
such an important issue has not been resolved in the past and is unlikely to be in the
future.
Confusion between reserves and the total recoverable oil

Reserves are the amounts of oil expected to be produced from known fields, com-
monly stated under defined degrees of probability. By contrast, the total recoverable oil
includes oil recoverable in fields that have not yet been discovered. Many people still
confuse these two quantities, saying things such as: ‘Thirty years ago, we had 30
years of supply remaining; now, we have 40 years remaining.’
Confusion between proved reserves and probable reserves

Proved reserves are defined to reflect a conservative value of what a field contains; they
are the oil and gas ‘reasonably certain’ to be produced under current technological,
political and economic conditions. This includes production from current wells and
production that would require some capital investment, for example installing
artificial lift technology or drilling a new well. These are also known as ‘P90’
reserves, in that the probability of extraction is 90% or higher. Probable reserves are
defined as ‘reasonably probable’ to be produced under current economic and
technological conditions. These are also known as ‘P50’ reserves, because there is a
50% probability of their being produced. As time moves on and more of the oil
within the field is accessed, such proved estimates naturally grow towards the
(proved and probable) estimate, which is usually close to the original geological
estimate of what the field was likely to yield.
In economic terms, as the price of oil rises, more reserves that are classified P50
fall into the P90 category, meaning again that reserve estimates are subject to further
fluctuations. Examples of this include the oil sands in Alberta, Canada, and the shale
gas reserves in the US. Only because of technological advances and rises in the price
of oil have these vast reserves come to be considered as recoverable.
Possible reserves are more speculative, being the oil and gas reserves with a chance
of being developed under favourable economic circumstances or if there is an
advance in technology.
The fact is, however, that not even ‘proved’ reserves are guaranteed and the
measure can vary as reserves shift from possible to probable to proved.
Atrocious reporting of proved reserves

Taken together, the spurious reported proved reserves data and the way in which
these are quoted by analysts who have access to better information, but do not
appear to be able to discriminate among estimates, constitute a major impediment to
the public understanding of the future of oil.
Danger of using the reserves-to-production ratio

Most analysis of the security of oil supply still relies on using the global oil ‘reserves-
to-production’ (R/P) ratio. This ratio indicates that current oil reserves are enough
to provide 40 years of supply at current rates, and since more oil will certainly be
found, the R/P ratio would seem to place any risk of oil supply difficulties well
beyond 40 years into the future. But this ignores the fact that in, say, 20 years’ time
the remaining 20 years’ worth may all be located in the Middle East.
Past forecasts
It is adamantly held in many quarters that all past hydrocarbon forecasts have been
wrong, so the conclusion is drawn that uncertainties – primarily of technology and
the effects of price – make the forecasting of hydrocarbon production impossible.
Industry experts
It is reasonable to assume that industry experts should be able to provide an
informed estimate of reserves. However, that is not the case and the fact that
estimates are produced by experts adds to the confusion.
Exploration geologists
Exploration geologists should be able to warn us of increasing discovery difficulties
– but most geologists have concentrated on their own patches and have not had the
global overview that would allow them to see that world find rates were declining.
So, despite backdated oil find rates having declined since the mid-1960s, it is only in
the last few years that many exploration geologists have begun to see the difficulties
ahead.
Oil companies
It is assumed that the oil companies are doing large amounts of quantitative
modelling, but observers have found that this is not the case overall, with only one
or two exceptions. As a result, oil companies are not much better informed than
anyone else.
Various agencies
The United States Geological Survey (USGS), the International Energy Agency
(IEA) and the US Department of Energy (DoE) Energy Information Administra-
tion (EIA) have all produced different estimates of reserves. The USGS, for
example, uses ultimately recoverable reserves to define the total amount of conven-
tional oil reserves deemed to be eventually recoverable from a given geographical
area. This adds to the confusion because it is natural to assume that such prestigious
sources are reliable.
Where does that leave us?

The term ‘oil reserves’ is vague and misleading. Most countries refer to proven
reserves and disclose their methods for calculating them, for example the US and
Canada. Many, however, keep their reserve calculations out of the public domain.
Furthermore, the exact definition of proven reserves varies from country to country.
On the one hand, the Central Intelligence Agency (CIA) estimated at the start of
2015 that the world had around 1.6 trillion barrels of oil in proved reserves (CIA,
undated). At current consumption levels (around 90 million barrels per day), this is
just over 40 years’ supply. On the other hand, OPEC states that the world has
around 3 trillion barrels in ultimately recoverable reserves (Al-Zayer, 2007).
Many estimates rest on the assumption that current technological, political and
economic conditions will prevail. This means that they are subject to constant
revision in light of new information becoming available. Given that many special-
ised oilfield services companies have their own R&D divisions, the state of
production technology is far from static. New enhanced recovery systems are
continually being developed and used in more mature fields.
It is unlikely that predictions will improve over time, leaving company decision-
makers in a situation of complete uncertainty. In fact, it would appear that there is
unlikely to be any agreement on peak oil until it unambiguously arrives.
4.4.2 What Will the Impact of Peak Oil Be?

Industry observers have found that companies do not pay much attention to the
possibility of peak oil – as evidenced, for example, by the lack of quantitative
modelling. This leads to a lack of understanding generally about what its impact
might be. Possible explanations for this situation include the following.
 There are too many conflicting predictions to make it worth worrying
about. The sources of the many conflicting predictions outlined in Section 4.4.1
could lead to the conclusion that it might as well be ignored – but it was also
pointed out there that it is possible to offer a rational response to even a highly
uncertain outcome.
 Even if peak oil were to become imminent, it would have little impact on
individual companies. In fact, it could be argued that the only observable im-
pact will be an increase in price, while for many sectors, such as exploration, the
demand for services would increase. This may be true, but a proper evaluation of
its impact can be assessed only by carrying out a full analysis of strengths, weak-
nesses, opportunities and threats (SWOT). It could be that peak oil will present
opportunities for some companies and threats to others, so the alignment be-
tween these and company strengths/weaknesses has to be investigated before
any conclusions can be drawn.
 There is a belief that market forces will take care of shortages. That may be
the case, but again it is important to be aware of changes in the competitive envi-
ronment in developing a SWOT analysis.
 Peak oil lies outside most companies’ planning horizons. Given that
predictions of peak oil vary from the present to several decades in the future,
that may well be the case – but, again, it is worth investigating the symmetrical
nature of the risks.
 The attitude is yet another symptom of the general short-termist approach
to strategy. Many companies merely pay lip service to strategic planning and
focus on reacting to whatever is happening. For these companies, peak oil is yet
another remote possibility that does not impinge on decision making.
Lack of concern could simply be a rational response to the fact that the threat of
peak oil has always been with us and has tended to shift into the future each time it
is quantified. Companies may well feel that there are more immediate problems to
deal with.
4.4.3 What Should Companies Do?

Peak oil is likely to affect different sectors of the industry supply chain in different
ways and, because of investment lags, the implications may not be as remote as
people tend to think.
The following is a view on the implications for oil refining offered in 2008, pre-
dicting a peak in oil production in 2010. In actual fact, while global oil production
dropped in 2009 because of the financial crisis, it has grown every year since then:
Oil companies won’t be building more refineries, because there won’t be

enough oil left to refine by the time new refineries could pay for themselves.
There hasn’t been a new refinery built in the US since 1976. In 1982, there
were 301 operable refineries in the US and they produced about 17.9 million
barrels of oil per day. Today there are only 149 refineries, and they’re produc-
ing 17.4 million barrels. This increase in efficiency is impressive but not a
miracle. As with everything these outputs are carefully calculated to optimize
profitability. Let me explain.
Truth be told, new refineries require tremendous financial commitments which
take anywhere from 15 to 25 years to amortize. With record oil prices it
would make perfect sense to invest in a few refineries today, except … for the
lack of oil to be refined 20 years from now.
Trends have predicted that peak oil production, where the production of oil
starts to decline, will be reached around 2007–2010. After that, there will be
less and less oil to refine no matter where drillers look. In this context, building
expensive new refineries does not make a lot of sense as existing ones will be
sufficient to process whatever little oil is left.
So forget about new refineries, except for a few in the northern midwest to
process the heavy oil from Canada. Crude oil is a finite resource more and
more depleted. As such, an increasing demand put on this finite supply necessi-
tates careful management in order to stretch its lifespan and profitability
(Marconi, 2008).
How valid is this argument?

Because peak oil is such an elusive concept, as demonstrated in previous sections, it
is difficult to make this argument with such force. The changing technological and
economic situation means that the prediction of peak oil in 2010 is highly uncertain.
Marconi (2008) assumes that there will be a shortage of oil to refine in 20 years, but
this rests on the assumption of peak oil occurring in 2010.
The building and placement of refineries is the result not only of the amount of
oil being produced, a supply-side influence, but also of demand for oil products.
The influence of demand is ignored in this argument. A more convincing argument
is that there may be no more refineries owing to decreased demand for oil products
in the US. This decreased demand may be the result of a demand reduction caused
by future price spikes, technological innovation resulting in better fuel efficiency, or
other exogenous factors.
The amortisation argument can be reformulated in terms of discounting. Net
present value (NPV) appraisal places relatively more importance on the earlier cash
flows. For example, if constant cash flows of $1 million for 25 years are discounted
to the present at 7%, then 60% of the present value is returned in the first 10 years
and 8% is returned after year 15; if the discount rate is increased to 10%, then the
percentages are 68% and 9%, respectively. Marconi’s extreme position is that there
will be no oil to refine in 20 years because there is sufficient capacity in existence
now to deal with the declining output after peak oil. If a refining company were to
accept this, it would reduce the expected life of the asset and work out the NPV
using its hurdle rate; if the NPV were positive, it would be worthwhile going ahead.
Therefore the prospect of peak oil does not necessarily mean that no more refiner-
ies will be built.
So can companies make a rational response to such uncertainty? There are, in fact, a
few pointers that might be of use.
 Don’t believe anyone. Do not be swayed by a seemingly plausible conclusion
on peak oil from a reputable source. It might give you confidence to act in ac-
cordance with the prediction, but it is likely to turn out wrong.
 Hedge your bets. Do not commit one way or the other and do make sure that
you have adequate contingencies to take account of sudden changes in predic-
tions.
 Assess whether risks are symmetrical for your company. If you decide that
there is no such thing as peak oil, then what will be the consequences of being
wrong? If you decide to accept a prediction that peak oil will occur in 10 years’
time, what will be the consequences of being wrong? Your assessment is clearly
not going to be exact, but it should be possible to arrive at orders of magnitude,
which is better than nothing.
4.5 Renewable Energy

This section is concerned with renewable energy sources, and their possible role as a
substitute for oil and gas products in the short and long runs. Much is made in
certain media outlets – for an example, see The Guardian’s ‘Keep It in the Ground’
campaign (The Guardian, 2016) – on the possible role of renewable energy as a
substitute for fossil fuels, but the reality is that existing technology and resource
types are not yet positioned to be used in place of hydrocarbons.
4.5.1 Substitutability of Renewable Energy

Various forms of renewable energy are often proposed in the political arena as
substitutes for hydrocarbons. In economic terms, however, energy sources such as
solar, wind and hydroelectric power are not perfect substitutes for hydrocarbons.
The majority of oil products are used for transportation, and while alternatives such
as electricity-powered vehicles are starting to appear on roads around the world,
there are major difficulties in substitution. For example, an infrastructure akin to the
global network of fuelling stations is required for mass adoption of the electric car,
which would require significant investment. Such infrastructure exists only in certain
parts of the world and, certainly in Europe, is largely confined to major cities. In
Asia and Africa, electric car infrastructure is more or less non-existent. A critical
mass of users is required before investment in such infrastructure becomes econom-
ically viable – an adverse ‘network effect’ that holds back the adoption rate with
consumers.
In addition to this, a battery takes a long time to charge, which does not fit with
the needs of motorists on longer journeys. This is especially problematic in coun-
tries such as the US, where there are large distances to be travelled between towns
and cities. Companies such as Tesla have pioneered battery technology that combats
some of the difficulties inherent in running and charging an electric car, but the
investment involved means that such cars tend to be priced at a point at which they
are not accessible to most consumers. So when does renewable energy become a
substitute for hydrocarbons?
It is interesting to note that, despite advances in technology and increases in the
prevalence of renewable energy sources, the overall energy mix is relatively stable
over time. Figure 4.5 illustrates global energy consumption by different fuel types
since 1990 and shows projections up to 2030. It is clear from the figure that there
has been, and is expected to be, an increase in consumption of all fuel types in
recent and future periods.
250
Oil
Annual consumption (quadrillion BTU)

Natural gas
200 Coal
Nuclear
Renewables
150
100
50
0
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
2020
2022
2024
2026
2028
2030
Year
Figure 4.5 Global energy consumption by fuel type, 1990–2030

Source: EIA (2008)
But what about the energy mix over the longer term? Figure 4.5 shows the global
energy mix as it was in 2015 and a forecast for the energy mix in 2030. It is clear
from the figure that very little change is forecast in terms of the relative weights of
different fuel types over the period.
100
Contribution to global energy consumption %
90
80
70
60
Renewables
50 Nuclear
40 Coal
Natural gas
30
Oil
20
10
0
2015 2030
Figure 4.6 Global energy mix, 2015 and 2030

Source: EIA (2008)
4.5.2 Strategic Reaction to Renewables

How should a company in the oil and gas industry deal with the question of
renewable energy? Issues of CSR and ethical issues have already been addressed in
Module 3. Some oil and gas companies have invested in various forms of renewable
energy in an attempt to assuage negative public opinion. Both Shell and BP have
invested in wind and solar technology; at one point, BP Solar was the largest solar
power company in the world. ExxonMobil has taken a different stance, making a
commitment to reducing its carbon emissions, but not investing in a renewable
energy division. Indeed, in the latter half of 2008 and the early part of 2009, various
large oil and gas companies pulled out of numerous renewable projects owing to the
falling price of oil. This trend was again reversed in subsequent years.
Many commentators stress the importance of renewable energy; indeed, it is diffi-
cult to find information on the oil and gas industry without coming across news
websites and blogs that are anti-oil and pro-renewables. A lot of government rhetoric
focuses on the need for green fuels and the use of renewables. However, it is unlikely
that this will have an immediate impact on the energy mix, owing to the limited
substitutability of renewables for hydrocarbons and the relative costs of the different
types of fuel in the energy mix. If only economic factors are considered, then the
impact of renewables as substitutes for hydrocarbons is unlikely to be significant until
well after peak oil, by which time backstop measures would be starting to come into
effect. Despite government intervention, then, it is likely to be economic, not idealis-
tic, considerations that result in a dramatic change in the global energy mix.
Nevertheless, renewable energy is an important factor in the macro environment
in the oil and gas industry, and a response to renewables needs to be formulated
within the context of a full PEST analysis. That will be pursued in Section 4.7.
4.6 The Economy

It is important for any practising manager in the oil and gas industry to have an
understanding of the economy, and of how changes in the economic environment
can affect day-to-day operations. There are several reasons for analysing and
attempting to understand the economy.
 It is necessary for a manager to be able to distinguish between events or influ-
ences that are within his or her control and those that are outside his or her
control. An example is the general decline in the oil and gas industry in 2001–2,
brought about by poor global economic conditions. At the same time, however,
many oil and gas companies exacerbated the situation by diversifying into unre-
lated businesses. So the problems faced by the industry in the early 21st century
resulted, in some cases, from both internal and external influences.
 It important to be aware of changes in the economy that may present opportuni-
ties or pose threats. The decline in value of the US dollar up to 2008 is an
example of an economic factor that had an impact on the oil and gas industry. A
company buying crude oil wholesale, but operating in Europe, found that it
could get more dollars – and therefore more oil – for its euros. Conversely, a
company that operated in dollars and wished to buy goods or services from a
European company found that it had to spend more dollars than it did before.
Of course, the general increase in the dollar’s value after about 2011 would have
had the opposite effect.
 An understanding of how the economy works makes it possible to understand
and interpret predictions. Forecasts and predictions can be found in many differ-
ent places, including from newspapers, magazines, television and online, and
those made by consultancy agencies and by politicians. These are often contra-
dictory and, in the case of politicians, there may be an alternative agenda at play,
so having some knowledge of how the economy works is useful for deciding for
yourself which predictions are useful and which are not.
 Managers may indulge in wishful thinking and select those forecasts that fit their
preferred plans. Ignorance can lead to irrational behaviour, with predictably cata-
strophic consequences.
Macro-economic factors particularly important to the oil and gas industry are those
concerned with the global economy. This section examines the difficulty of operat-
ing in a number of different currencies, the influence of location on competitive
advantage and the role of leading indicators in understanding the economy.
4.6.1 Exchange Rates, Inflation and Competitive Advantage

Companies that operate in the oil and gas industry have to deal with international
economic factors. There are three main factors that a company must monitor on the
international front:
 relative inflation rates;
 fluctuations in exchange rates; and
 the impact of economic conditions on competitive advantage.
These factors can alter the ratio between costs and revenue. For example, a Europe-
an oil company that has refining operations in Australia will be collecting revenue in
euros and incurring costs in Australian dollars. So if eurozone inflation is running at
2% and Australian inflation is running at 5%, then costs will be rising faster than
revenue – and what looked like an attractive project may end up being a financial
disaster.
Similarly, if an US-based oil services company, such as Halliburton, is working
for Pemex, the Mexican national oil company (NOC), it must be careful how it sets
its contract price. If US inflation is running higher than inflation in Mexico, then a
straight conversion at the going exchange rate would result in too high a price being
charged, and the longer the contract period, the more pronounced will be the effect.
Exchange rates are determined by the supply and demand for currencies, which is
determined by imports, exports and international capital flows (see Core SP Section
4.3.4). When the value of the US dollar falls, goods and services paid for in dollars
become more attractive to foreign customers; at the same time, costs incurred in
other currencies by a company that operates in dollars become higher than they
otherwise would be. Some understanding of the factors affecting exchange rates
makes it possible to make at least an educated guess at what is likely to happen; it
must be borne in mind that all forward transactions imply prediction of exchange
rate movements, whether they are hedged or not.
Oil is priced in dollars internationally and this impacts upon the price of oil from
the perspective of different countries. From the start of 2014 to late 2015, the US
dollar gained around 20% in value against the euro. Since a European company
must convert its cash to dollars to buy oil, although the price of oil decreased by just
over 60% in that period, pricing in dollars made the decrease look smaller than it
actually was to these non-US companies; the real price decrease for eurozone
companies was actually 50%.
No matter what part of the supply chain a company operates in, foreign ex-
change is likely to have some impact because of the prevalence of dollar pricing in
the oil market and by international companies. Some service companies try to price
their contracts in dollars and even a local company, such as a refining company that
has operations in only one country, will need to concern itself with exchange rates
because its main feedstock is priced in dollars.
4.6.2 The Competitive Advantage of Nations

The role of national location in competitive advantage is based on the observation
that competitive advantage is often strongly concentrated in only a few locations
(Porter, 1990): consider the concentration of hi-tech computer companies in Silicon
Valley, of engineering and manufacturing companies in Germany, and of electronics
companies in Korea. These concentrated areas are known as ‘clusters’.
These ideas can be applied to the oil and gas industry as well. Porter (1990) found
that a firm’s home nation plays a critical role in shaping its managers’ perceptions
about the opportunities that can be exploited. It does so by supporting the accumu-
lation of valuable resources and capabilities, and creating pressures on the firm to
innovate, invest and improve over time.
It is the existence of conditions that contribute to sustaining competitive ad-
vantage in a dynamic sense that is important. The four conditions that are important
for international competitive advantage together make up the ‘Diamond Frame-
work’ (Porter, 1990), as follows.
1. Domestic factor conditions. Specialised resources may develop in a localised area over
time.
2. Related and supporting industries. Internationally competitive industries do not tend
to emerge in isolation, but are associated with other internationally competitive
industries from the same region.
3. Domestic demand conditions. The quality and sophistication of domestic demand can
influence the competitiveness of companies abroad. Being used to dealing with
sophisticated buyers in the home market gives companies an advantage when
dealing with competition abroad.
4. Strategy, structure and rivalry. Strong competition at home is likely to breed compa-
nies that are robust and able to compete on an international level.
So is there an example of this for the oil and gas industry? Some in the industry
would say that Houston, Texas, is a good example of a cluster. Indeed, there are no
fewer than 36 major companies in the oil and gas industry that have either their
headquarters or large regional offices in Houston. Some big names include Weather-
ford International, Baker-Hughes and ConocoPhillips. A major oil services
company, Halliburton, recently established a second headquarters location in Dubai
in the United Arab Emirates (UAE). Porter’s (1990) four factors help to identify the
rationale behind this move (see Table 4.5).
Table 4.5 Halliburton and the competitive advantage of nations

Point Domestic factor conditions
In Houston In the Middle East
Oil While many of the companies based in The Middle East holds the majority
Houston do a lot of their work of the world’s oil reserves. By 2030,
abroad, the relatively recent advent of it is expected that OPEC will control
shale gas production in the US has 60% of the world’s oil production; it
resulted in a huge boom in the currently controls around 75% of
industry. proven reserves.
Skilled labour Oil and gas is a ‘greying’ industry, with International educational establish-
many skilled personnel set to retire ments are being established in the
within the next 10 years. However, Middle East and labour is in abun-
Texas does have good educational dance, owing to high migration from
assets for the industry and Houston is areas such as the Philippines and
an international city. southern India.
Related and In Houston, there are many companies, In the Middle East, the customer
supporting industries all operating in different parts of the base for companies such as
supply chain. Halliburton is extensive. The NOCs
are becoming more important for
companies that offer services to the
industry. Halliburton is well placed to
take advantage of joint-operation
opportunities.
Domestic demand The oil and gas industry has built up The industry in the Middle East has a
conditions over many years, and with the number long history and customers (NOCs)
of companies competing, it is likely are becoming more demanding as
that customers will be fairly demand- their relative importance on a global
ing. scale increases.
Firm strategy, Houston is home to a dynamic group All service companies are aware that
structure, rivalry of companies in a growing market that future business is likely to come from
have been competing with each other NOCs in areas such as West Africa
for a long time. This is cut-throat and the Middle East. By establishing
market capitalism in its most pure itself in Dubai, Halliburton has put
form, meaning that only companies itself in an advantageous position for
that are efficient and have sustainable the future compared with companies
competitive advantage are able to headquartered in Houston.
exist.
A cluster develops over a long period of time. It appears that the group of related
companies in Houston is still just that, rejuvenated by the advent of shale gas as a
viable resource. Halliburton has used the impetus gained from being in this cluster
as a springboard into the Middle East. It is possible that, over time, a new cluster
will develop in the Middle East, mirroring or rivalling the Houston cluster. Why are
the majority of international oil services companies American? The reason is the
beneficial factor conditions, demand conditions, structure and abundance of related
industries in the oil-producing states. From a strategic perspective, the Halliburton
move to the UAE can be interpreted as the outcome of an evaluation of the
developing competitive advantage of the Middle East in relation to the US.
What is important to note is that Halliburton’s international success has – in
some ways, at least – been because of its competitive and dynamic home environ-
ment. A company that is considering an international move must consider the state
of its home environment in terms of Porter’s (1990) Diamond Framework. This is
particularly important for NOCs that are thinking of moving outside their home
country.
There has been an increasing trend since the start of the 21st century for NOCs
to move outside their home base of operations, seeking resources and operations in
a similar way to an international oil company (IOC). Companies such as Petronas
(the Malaysian NOC), Petrobras (the Brazilian NOC) and KNOC (the South
Korean NOC) spend significant resources on international moves. The difficulty
that can arise is that the diamond conditions at home are weak and the company has
been used to favourable treatment at home as an extension of government. The
NOC often struggles when trying to compete on the international stage because of
weak diamond conditions at home.
4.6.3 Leading Indicators

The amount of information available to the manager in the oil and gas industry who
wishes to make forecasts is overwhelming. There is also likely to be an abundance of
forecasts already available, some of which may be misleading or contradictory. It is
therefore sensible to select a small number of important variables and to track them
over time. These are known as ‘leading indicators’. A leading indicator can be
defined as an economic or other indicator that changes in advance of a new trend or
condition and can be used in prediction.
What are the leading indicators for the oil and gas industry? While they will vary
for different parts of the supply chain, there will be a number of indicators that
apply to the whole chain. Moreover, the supply chain is interconnected, so it can be
expected that an influence at the top of the chain will also have an impact at the
bottom.
A hypothetical integrated IOC can be used to explain the effect of one part of
the chain on another. On the one hand, this company’s downstream business is
faring well where it is selling its products for a high price: profits improve, and this
will feed through to the exploration and production arm of the company, which will
see its exploration budget increase and more marginal fields come into operation.
On the other hand, if the company is getting a poor price downstream and its
margins are being squeezed, then this will feed through to the upstream operation,
which will find its investment cut and marginal fields shut down or not considered.
We can take the leading indicators for the oil and gas industry as a whole to be as
follows.
 The price of oil and gas. As discussed previously, the price of oil and gas behaves in
a volatile manner, but is the main indicator of the state of the industry. It deter-
mines how much revenue is generated by sales at each stage of the supply chain.
It also determines the ‘stock level’ of raw material in the ground, because proved
reserves are defined as those extractable under current economic conditions. The
current price of oil can therefore be used to forecast the future state of the in-
dustry, subject to short-run volatility.
 The demand for energy compared with its supply. The demand for energy dictates the
demand for oil. Growth in the demand for energy has pushed the price of oil
higher since 2000 because the increases in demand exceeded increases in supply.
It is predicted that, with the rapid growth of many economies that were develop-
ing throughout the 1990s and 2000s expected to continue, the demand for
energy will continue to rise. The IEA forecasts that if all governments around
the world persist with their current energy policies, then by 2050 the demand for
energy will be 50% higher than in 2015, with 45% of this growth coming from
India and China, and 74% from rapidly growing industrialising countries as a
whole. The demand for energy is an important indicator of the state of the in-
dustry and is an important factor to consider when forecasting the future state of
the industry.
As was seen in the discussion on the revenue and costs model, the price of oil and
the demand for energy can be seen as the two leading indicators for the oil and gas
industry. How does each of these affect the three sectors in the industry and what
leading indicators are there that are unique to the sector? The analysis in Table 4.6 is
not definitive but the important issue is that it focuses attention on the type of
factor that needs to be taken into account.
Table 4.6 The effect of leading indicators on different parts of the chain
Sector Indicator Effect
Upstream
Price of oil or gas High price of oil will mean that revenue available for
investment is higher than otherwise; may also mean
that upstream is operating at capacity for some time,
leading to rising costs and backlogs
Likely to be followed by period of overcapacity as
businesses invest heavily in capital goods
Sustained low price of oil will cause industry to suffer
from underinvestment and restrict activities in
marginal areas
Demand for energy Demand for energy drives the demand for upstream
activity; feeds back into higher oil price
Downstream oil
Price of oil Higher oil price means higher input costs for refining
and marketing-only businesses
Demand for transportation and distribution services
likely to be high
May lose margins at fuel pumps, depending on
elasticity of final local demand
Lower oil price means lower input costs for refining
Transportation and storage likely to decrease
Demand for energy Demand for energy drives demand for fuel products
Downstream gas
Price of gas High gas price means that producers will want to
process and sell more gas; storage and transport
sectors will see high demand for services
Low gas price means that margins will be lower on gas
sold to consumer, and therefore storage and
transport prices and demand will be lower
Demand for energy Demand for energy drives demand for gas in the
home and for business use; also, for power genera-
tion
Each sector has leading indicators that are unique and are not relevant to the rest
of the industry. Some examples of these are as follows.
Upstream
 Rig count growth. The health of the upstream industry can be measured by the
number of rigs in operation around the world. Rigs are built in the expectation
of future returns; rig count growth reflects these expectations, which may or may
not be correct.
 Development costs and rate of new finds. The cost to a company of adding new
reserves will have consequences for the rest of the chain, but primarily shows the
relationship between demand for new finds (amount of exploration) and supply
of new finds (the amount of recoverable oil left in the ground).
Downstream
 Refining and processing capacity utilisation. Large additions to refining capacity can
affect the margin per barrel refined because of increased competition among
refiners. Also, the level of capacity utilisation will have implications for the fu-
ture state of the industry.
It is likely that there are other leading indicators for each sector and even more for
each subsection of the chain, but the important thing to note is that a small number
of indicators can be used to make forecasts. The important next step is to act
accordingly, because there is little point in making predictions if they are not going
to be integrated into the decision-making process. It may appear puzzling that
companies expend efforts to generate forecasts that they then ignore, but in fact
there are several reasons why forecasts might not be acted on, as follows.
 Investment plans may already have been drawn up and it may be extremely
costly to abandon projects that have already been started.
 It is possible that no one really believes the predication. It is a truism that
forecasts are rarely accurate and bad experiences in the past can lead to a high
degree of scepticism, meaning that leading indicators can be dismissed as irrele-
vant.
 They may not be aligned with groups’ interests – that is, powerful decision-
makers may have already decided what direction the company is going to take
and may therefore downplay the importance of this type of information.
4.6.4 Using Leading Indicators to Construct Scenarios

Scenarios can be constructed from leading indicators to derive implications from
different combinations of conditions. The information offered above on leading
indicators is useful for attempting to see what might happen in the future. Different
scenarios based on leading indicators can be used to assess how the company will
perform under different conditions.
By way of an example, Table 4.7 represents three different scenarios for the
upstream industry.
Table 4.7 Leading indicator scenarios

Leading indicator Scenario 1 Scenario 2 Scenario 3
Oil price High Low Low
Demand for energy High High High
Costs High High High
Rig count growth High High Low
 In Scenario 1, the oil price remains high, as do the demand for energy, costs and
rig count growth. In this scenario, there is likely to be a high demand in the up-
stream sector and, most probably, a lack of capacity. The lack of capacity will
lead to higher costs and high rig count growth as companies attempt to increase
capacity to meet high demand, which in turn will result in a higher oil price. This
may be the first stage of a cobweb model movement (see Section 5.3.2) and even-
tually the addition to capacity will lead to a fall in price. However, if the global
demand for energy remains high enough, a fall in upstream activity is less likely.
 In Scenario 2, the oil price has fallen, but costs, demand and rig count growth
remain high. This presents a scenario in which too much capacity has been add-
ed in the upstream industry, causing the oil price to fall. However, the fact that
the rig count is still growing suggests that capacity is still being added. This
would suggest a different situation: a destructive price war has started in the
industry, which is likely to lead eventually to companies going out of business, or
a wave of consolidation throughout an already highly concentrated and consoli-
dated industry.
 In Scenario 3, both the oil price and rig count growth have fallen, but costs and
demand for energy remain high. An explanation for such a scenario is the grow-
ing use of alternative energy, and a reduced reliance on oil and gas for fuel. This
would cause oil price and rig count to fall. It is possible that this combination of
factors represents the situation in which oil reserves are depleted, and the only
reserves left are the very hard to reach and non-conventional reservoirs.
It is possible to examine all different combinations of indicators in turn, but that is
not the point of this exercise. The point is to demonstrate one way of looking at
possibilities for the future.
The next step is to consider what impact each of the different scenarios would
have on an upstream company and on the industry in general.
 In Scenario 1, demand for exploration and production may exceed capacity. If
the cobweb model plays out, however, there may be significant decreases in price
if demand reverts to its original level. Scenario 1 is consistent with conditions in
early 2008.
 In Scenario 2, destructive competition between oil companies will lead to
decreased margins and negotiations will become tougher as competition spreads
throughout the chain. A wave of consolidation could mean that many independ-
ent operators are swallowed up by larger companies. Scenario 2 is consistent
with conditions in late 2015.
 In Scenario 3, it is most likely that margins will be driven down throughout the
whole supply chain.
These are sample scenarios of what might happen in the future. They may appear
naive and improbable to some, but it is important to remember that scenario-
building is not an attempt to predict what will happen in the future; rather, it is a
method for looking at things that might happen and their potential impact on the
company. After all, nobody in the industry predicted the extent of the oil price drop
in late 2014 at the beginning of that year.
The next step is to assess what action a company would wish to take if the sce-
narios were to occur in the near future (the short run) and how to be prepared for
each in the long run (Table 4.8).
Table 4.8 Scenario planning: Short-and long-run courses of action

Scenario Short run Long run
1 Invest in assets, but try not to Try to identify turning points in
overshoot capacity needs the business cycle
Monitor competitor and industry
capacity levels and prices
2 Monitor competitive environment Invest in assets to prepare for a
Retrenchment may be necessary to period of consolidation
remain competitive
3 Divest unprofitable businesses Increase R&D and diversify into
Look for other areas to which alternative energy sources
competences will transfer
This is only an example, but it illustrates the usefulness of scenarios, because the
three possible futures have different implications for what the company should do
now. While it may not be willing to act on any of them at the moment, it is neces-
sary to bear in mind that something will happen in the future, even if it is
unpredictable. Further, the usefulness of scenarios depends on their relevance to the
company’s operations, rather than detail or presentation: scenarios backed up with
pages of statistics and graphs are irrelevant unless they can be shown to have
implications for decision making.
4.7 PEST Analysis

The preceding analysis has identified a range of factors that affect decision making
at the macro level. While not necessarily comprehensive, these include prospects for
the oil price, the backstop price, peak oil, renewables, the performance of the
economy, the competitive advantage of nations and leading indicators. The implica-
tions of each for strategic decision making have been investigated, but the analyses
are not complete, because each has been treated in isolation. The message from
Core SP Section 4.5 is that focusing on a single dimension, such as economic
factors, can result in a failure to identify a range of potential threats and opportuni-
ties. Further, the combination of PEST factors can have a joint impact that is not
reflected in the analysis of factors individually.
There is no doubt that it is a useful exercise for a company to construct a PEST
analysis. But it can be argued that there should be no surprises in a PEST analysis,
because the company should be aware of what is happening in the environment
anyway; given that the world is continually changing, the PEST profile should also
be monitored and updated as a matter of course. But, as discussed in Core SP
Section 4.6, environmental scanning is a difficult function to define and allocate to
individuals, while there rarely exists a feedback mechanism that enables ongoing
changes in the profile to be incorporated into strategic decision making. To compli-
cate matters, a senior executive who has formulated a particular strategic move is
unlikely to listen to bad news from a subordinate: a classic example of the principal–
agent problem at work, whereby a manager acts in his or her own best interest
rather than that of shareholders.
Because of the international nature of the oil and gas industry, and the complexi-
ty of the supply chain, it is to be expected that different companies will be faced
with different PEST profiles. The following PEST analysis is for the oil industry in
general. It is intended to reflect the factors that impact on a company that has
operations dispersed through the entire supply chain, such as Shell or Exxon.
Factors will vary by geographical subregion and these will be examined separately.
First, it is useful to present a global analysis of environmental influences on the oil
and gas industry, using a hypothetical IOC as the basis for the example.
4.7.1 Global PEST Analysis for an International Oil Company in 2015

Political
The IOC is subject to different political pressures and regulatory environments,
depending on which country it is operating in. At the extreme, political risk to
the company includes confiscation (seizure of assets without compensation),
expropriation (seizure with some compensation) and domestication (requiring
transfer of ownership to the host country, and local management and sourcing).
In some politically unstable areas, it is impossible to predict future conditions
with any accuracy. The degree of involvement in politically unstable countries
has a significant impact on the company’s risk profile and must be taken into
account in the construction of its portfolio.
In upstream markets, the company will be constrained by the type of agreement
it has with the host government, be it concession, a production-sharing agree-
ment or a service-contact-type agreement. Tax regimes vary from country to
country, resulting in an entire profession of accountants devoted to dealing with
tax laws. Volatility and changes in tax law may influence strategy decisions, espe-
cially when considering whether to enter a specific country or not. There has
been a general trend over the past 30 years to move away from concession-type
agreements whereby the IOC owns all production, and pays a royalty on output
and a profit tax on net revenues. Production-sharing agreements of various
kinds, under which the IOC is forced to enter into a joint venture or partnership
with the local NOC, are far more common. While these types of agreement can
be less favourable to an IOC, they tend to be more favourable for the country
that owns the resources, and they do a better job of aligning the incentives of the
IOC and the NOC, thus reducing scope for principal–agent issues to arise.
Another important issue is climate change concerns in the political sphere. The
Intergovernmental Panel on Climate Change (IPCC) publishes periodic reports
that provide conclusive proof that human activity is actively contributing to-
wards climate change. The emergence of legislation such as carbon emissions
taxing could have a substantial effect on the profitability of the oil sector, and on
the attractiveness of using non-renewable energy sources for industry and society
in general.
In mid-2015, senior executives at BG Group, ENI, Total, Royal Dutch Shell and
Statoil came together to call for a global tax on carbon emissions. While this
might seem strange, there is a certain logic to these companies making such a
demand because it would reduce the level of uncertainty for their future opera-
tions, allow them to factor in the true cost of their operations within things such
as NPV analyses and, in the end, result in better value for shareholders. It is of
note that all of these companies are based in Europe, where a carbon emissions
trading scheme has already been introduced. US-based companies were notable
by their absence from the announcement and their silence in response.
The Kyoto Protocol, an international agreement between countries to reduce
carbon emissions and which came into force in 2005, was eventually signed by
83 countries around the world. The replacement for this, the Paris Agreement,
negotiated at the United Nations Climate Change Conference (COP21) in late
2015, was agreed by 195 of the 196 participating countries. While its full impact
is not yet understood, an agreement from the largest polluting countries in the
world to limit carbon emissions and to reduce the level of global warming to just
1.5 degrees is likely to have some impact on the oil and gas industry in the fu-
ture.
Economic
Much of this module has dealt with economic issues in detail. The demand for
energy around the world is growing, especially in developing countries. India and
China generated historically high growth rates during the 2000s, while the devel-
oped world was also growing. This contributed to historically high oil prices in
2008, but could not account for the volatility. The real questions are whether
world economic growth will continue at the same rate and what the implications
are for the absolute demand for oil.
With recent economic issues in China and a large increase in US hydrocarbon
output, the question is whether the oil price of $40–60 that has existed since late
2014 is the ‘new normal’. Companies across the industry have seen profits fall,
dividends and share values plummet, and large layoffs of staff as the industry
adjusts to the new business climate. Some small companies at the ‘sharp end’ of
the industry, such as Afren, a London-listed exploration company with opera-
tions in Africa, have gone bankrupt.
Social
Demographic changes in the developing world are expected to continue for the
foreseeable future. In both India and China, there is growth among the middle
classes and therefore growth in demand for energy. Also, as industry in this part
of the world expands and develops, demand for energy will continue to increase.
There is growing pressure from environmental groups for companies and gov-
ernments to act on climate change; in the long run, there is the possibility that
the world will eventually become less dependent on oil and other fossil fuels for
energy. However, as discussed in Section 4.4, it will be a very long time before
the energy mix changes significantly and the IEA predicts that, unless radical
change in government policy happens immediately, reliance on fossil fuels will
remain at least up to 2030. Even if solar and wind power were to grow by 20%
per year until 2050, they would cover only a third of the world’s energy needs by
that time.
Technological
Advancements in sources of renewable energy will continue as the market for
these fuels grow. Significant developments would result in substitutes becoming
available for fossil fuels, which will eventually affect oil and gas markets. While it
is impossible to predict technological progress, past experience suggests that the
possibility of a major technological breakthrough is remote in the absence of
significant investment allowing the technology to achieve critical mass and econ-
omies of scale. This is unlikely to occur without sustained high prices for
hydrocarbons to encourage the search for substitutes.
Technology for extracting and refining oil is continuously improving, and this is
bringing more marginal fields into production, and extending the life and pro-
duction volume of existing fields. In recent years, significant progress has been
made in the technology concerned with unconventional resources. The oil sands
of Alberta, Canada, for example, were added to the country’s proved reserves
total in the early 2000s, because they became viable under current economic and
technological conditions. While many projects concerned with the tar sands shut
down or were suspended when the oil price dropped in 2008, the same did not
happen when the oil price dropped by 60% in the second half of 2014. This is
because the marginal cost of production had reduced significantly in the seven-
year period between crashes.
Shale gas reserves around the world have become viable in recent years because
of high prices and improvements in technology. It is of interest that the fall in oil
prices in 2014 was attributed in part to the rapid increase in US production of
unconventionals. While these resources are costly to produce, the relatively short
life cycle of a well (18 months to two years) results in a situation in which it is
much easier to introduce new technology into the system and learn from previ-
ous mistakes when drilling new wells. This means that the marginal cost of
production of shale in the US (and other large shale producers, such as Australia)
has dropped rapidly in recent years. This, in turn, means that producers are bet-
ter able to withstand lower oil prices than they could in the past.
Table 4.9 summarises the risk factors that can be extracted from this PEST analysis.
Table 4.9 PEST risk factor assessment

Factor Issue +/– Change
over next
10 years
Political Complex, diverse political environment – –
Operations in unstable areas set to increase – –
Move towards less favourable tax regimes upstream – –
Climate change legislation – –
Economic Growing demand for energy worldwide + +
Volatile oil price – ?
Low oil price after 2014 crash – ?
Exploitation of marginal fields + –
Reliance on movements in a volatile commodity price for – –
business performance
Social Climate change concerns – –
Slowly increasing popularity of renewable energy sources – –
Technological Advances in technology for well exploitation + –
Increasing viability of ‘difficult’ wells owing to technology + –
advances
Advances in technology for using unconventional oil + +
sources
Advances in technology for renewables – –
Increasing viability of renewables – –
Increasing availability of substitutes for fossil fuels – –
A common mistake with regard to PEST analysis, made by senior managers and
students of strategy alike, is to think that it is sufficient to develop a list of items
under each heading and then present the analysis. As is the case with the application
of any strategic model, the question an experienced strategic thinker should ask
when presented with a list such as that shown in Table 4.9 is, ‘So what?’ Of course,
the question has been answered in this example by categorising factors as positive
(+), negative (–) or unknown (?).
Here, there are both positive and negative factors in the environment, which
have been categorised as immediate and long-term concerns. This whittles down the
options into those that have to be dealt with now, including political instability and
volatile oil price, and those that can be built into future plans, including climate
change legislation and renewable energy. As far as the long-term issues are con-
cerned, the fact that they will become problematic only in several years’ time does
not mean that they can be ignored. There is a great deal of difference between
saying ‘We don’t have to worry about that now’ and ‘We have identified long-term
issues, which we shall build into our vision of what the company should be in 10
years’ time’. Short-term action to deal with price volatility might be to retain
earnings to guard against cash-flow problems, while long-term action to deal with
political factors and renewables might be to reconsider the portfolio. It is therefore

necessary to project whether the factors are likely to change for the better or worse
over, say, the next 10 years, as estimated in the final column of Table 4.9.
The issue is whether factors will continue to become more favourable (+), less
favourable (–) or stay the same ( ). The entries made are unlikely to conform with
everyone’s perception of the world, but it emerges that a static view of the PEST
analysis could be misleading. Some of the factors change sign, so the response to
these in the long term needs to take this into account.
While the overall PEST analysis provides general guidance on risk exposure and
company vision, it may be largely irrelevant for decision making in specific geo-
graphic areas, so it is necessary to disaggregate the analysis.
4.7.2 PEST Analysis by Geographic Area

The PEST profile in Section 4.7.1 was from a global perspective, but because many
oil and gas companies operate across international borders, they will also be
interested in the PEST profile in different geographical areas. A brief commentary
on each reveals some of the factors specific to each area.
North America
The economic conditions in the US were difficult in 2015. The pump margins of
IOCs were squeezed by the dual forces of a low oil price and rising costs. Also,
drilling and production activities in the area were in decline, and some upstream
services had become commoditised. Oil sands operations in Canada were a po-
tential area for further expansion and marginal fields in areas such as Alaska were
looking more attractive. Shale producers in the US were under pressure from
low oil prices. Many companies operating shale drilling and production projects
in mid-to-late 2015 were struggling, with some facing bankruptcy because of
high debt burdens and low profit margins.
Latin America
After the industry recovered from the financial crisis in 2009, an increased inter-
est in deep-water drilling developed. This led to more activity in the Gulf of
Mexico and offshore in Brazil. Indeed, more than 90% of Brazil’s resources are
categorised as ‘very deep-water’ and are heavy in nature. This presents opportu-
nities for an IOC as its technological skill becomes more in demand.
As the US part of the Gulf becomes less operable, the Mexican side still has a lot
of potential. The largest discoveries in recent years have been in Brazil. This
points to IOCs having to collaborate with NOCs such as Pemex and Petrobras,
and it is unlikely that they will be able to control majority stakes in many jointly
operated assets. Recent falls in the oil price might make investment in these areas
less attractive.
Increasing resource nationalism is becoming an issue in this area, with countries
less inclined to get IOCs involved with their own projects. The most notable
example was forced expropriation of assets in Venezuela in the early 2000s. This
could impact on the business of IOCs as the NOCs turn to oil services compa-
nies to give them the expertise that they lack. Effectively, the oil service
companies give the NOCs technical capabilities: the one thing that they lack
compared with the IOCs.
The Middle East and Asia-Pacific
Political instability in the Middle East means that operations in the area carry
with them an extra risk premium. Since the 9/11 attacks, there has been a
marked increase in the number of terrorist attacks on oil facilities in the Gulf,
including attacks on the Abqaiq oil facility in Saudi Arabia, where two-thirds of
the country’s oil is processed. Also, violence in Libya, Iraq and Syria has been
directed at energy facilities, including pipelines and oil installations. This, coupled
with the fact that more than 60% of the world’s proved oil reserves are in the
Middle East, has served to make operations in the area riskier.
There is, however, the possibility of Iranian production increasing as sanctions
are lifted after a nuclear deal with the US. This could provide an opportunity for
IOCs to enter the market and partner with Iranian companies to assist in in-
creasing production. The Iranian government, sorely in need of new revenue
sources, has indicated that it is keen to increase production rapidly despite the
low oil price.
Europe
The operating environment within the European Union is set to become more
difficult. Employment legislation in Western and Central Europe is much tough-
er than in the US, making workforce maintenance an issue. The introduction of
carbon trading laws, although criticised by some groups, may make operations
less attractive. The low oil price, coupled with the relatively high-cost oil and
abundance of mature fields, could make Europe a less attractive prospect over
the longer term. Societal objections to ‘fracking’ to extract shale gas reserves has
resulted in legislative issues, and even moratoriums on the extraction of these
resources in places such as Germany, Scotland and France.
Russia and Central Asia
Moscow’s volatile approach to the energy sector has had far-reaching conse-
quences. In the past, decades of Soviet mismanagement meant that, by applying
modern methods and technology to existing poorly developed sites, good results
would be seen fairly quickly. Add to this the introduction of high tax rates for
independent companies on new fields, rather than allowing a period of grace for
recovery of upfront capital costs, and the environment looks less attractive. The
state companies Gazprom and Rosneft have a large advantage in the area, and
are indicative of the rising tide of resource nationalism being seen in the area.
Companies dealing in this part of the world may find themselves in breach of
sanctions given political developments between Russia and the Ukraine; even
before this, companies operating in the area found it very difficult to make any
money. The TNK–BP venture is a case in point.
Africa
Political instability, perhaps most notably in Nigeria, is an issue. That said, the
first democratic handover of presidential power occurred in mid-2015 without
violence. In the north of the country, there has been an increase in violence be-
tween ethnic groups fighting for control of oil reserves, leading to the militarisa-
tion of the area. Also, there have been a number of high-profile kidnappings of
oil workers and their families in the area.
Table 4.10 shows some of these geographical factors listed under the PEST head-
ings.
Table 4.10 PEST by geographical area

Factor North Latin America Middle East Europe,
America and Asia- Africa,
Pacific Russia and
Central Asia
Political Resource – Political instability –Tough –
nationalism: looks set to regulatory
IOCs no longer continue environment in
welcome Europe
Iran set to come + Political –
out of sanctions instability in
Africa
Economic Low oil price – Low oil price in – Hostility of –
and rising costs high cost area Russian
government to
Western
companies;
sanctions
Social Different social norms and customs in each area and within areas
Technological Improved + Deep-water and – Regional –
technology for very deep-water companies in
shale and tar becoming less Russia
sands extrac- viable
tion
Even a brief analysis of the different geographic areas serves to illustrate the
complexity of the macro environment in which an international oil and gas company
operates. Strategic tools such as PEST, however, make analysis and observation of
the environment more structured and less confusing. Another factor that the
analysis reveals is that influence and power in the industry appear to be shifting
from IOCs to NOCs, and look set to continue to do so. The NOCs now control a
larger proportion of reserves than the IOCs. Increasing resource nationalism looks
set to help this shift to continue.
The difficulty of keeping a PEST analysis up to date is enhanced at the country
level, at which the communication of potential problems to corporate decision-
makers becomes increasingly difficult. The question then arises: who should
undertake environmental scanning at the country level and how is this coordinated
by the centre? Should environmental scanning be a corporate centre responsibility
or is it more useful to delegate it? The centre may be too far away to do the job
efficiently, while the power structure at the centre may render country analyses
irrelevant to decision making. This is a difficult choice, to which there is no defini-

tive answer, but it is important to recognise that the problem exists.
4.8 Environmental Threat and Opportunity Profile

A profile of how changes in the external environment are likely to present threats
and opportunities is a useful method for systematising the impact that changes in
the environment are likely to make. A full environmental threat and opportunity
profile (ETOP) will involve factors specific to the markets in which the company
operates and, at this point, only the part concerning the macro environment will be
developed. The following framework, as described in Core SP Section 4.9, has been
used.
1. Use the PEST approach as a checklist.
2. Apply macro-economic ideas to economy-wide influences.
3. Consider international factors in terms of exchange rates and international
competitive influences.
4. Use environmental scanning to think beyond the immediate situation.
5. Construct scenarios to put factors into context.
6. Build a profile of opportunities and threats.
Once these steps have been carried out, each factor is assessed in terms of whether
it is likely to have a positive or negative impact on the company’s operations. Then,
the relative importance of each factor is estimated.
Table 4.11 uses information from the preceding analysis of the oil and gas indus-
try to construct the first part of an ETOP for an IOC. The second part will be
constructed at the end of Module 5.
Table 4.11 ETOP 1: IOCs

Sector Factor Threat (–) /
opportunity (+) /
unknown (?)
International Volatile exchange rates and unclear economic situation in China –
Diverse political climates to deal with –
Trend towards less favourable tax regimes –
New climate change treaty negotiated late 2015 –
Shift in power from IOCs to NOCs –
Macro- Low, volatile oil price –
economic Increasing R&D into alternative energy ?
Rising finding and development costs –
Rising demand for energy expected to grow a further 50% by +
2030
Unconventional sources of oil becoming more viable, with +
technology improving and costs falling owing to innovation
Resource nationalism rising as countries look for energy –
security, forcing out IOCs
The classification of factors is fairly subjective, but it does bring the macro issues
facing a company into focus. It provides the basis for identifying opportunities and
threats, and is part of the SWOT analysis upon which decision making ultimately
depends. One of the subjective factors is categorising a factor as an opportunity or
threat. For example, a consistently high oil price will stimulate investment and
research into alternative energy: is this a threat or an opportunity? Some IOCs will
see this as an opportunity for them to capitalise on, while others will see it as a
threat to their core markets.
The factors identified in the ETOP can be grouped and ranked, as in Table 4.12.
Table 4.12 Ranking threats and opportunities

Threats Opportunities
Volatile exchange rates and unclear economic Unconventional sources of oil becoming more
situation in China viable, with technology improving and costs
falling owing to innovation
Trend towards less favourable tax regimes Rising demand for energy expected to grow a
further 50% by 2030
Diverse regulatory and political climates to deal with
New climate change treaty negotiated late 2015
Shift in power from IOCs to NOCs
Rising finding and development costs
The ranking is subjective, but it does attempt to be explicit about what external
factors the company has to deal with and it provides broad guidelines for future
action. In this case, the most immediate and important threats are the issues of
volatile economic climate and the trend towards less favourable tax regimes. The
other factors are ranked below these two, because it is believed that there is nothing
that can be done about them at the moment. The two main opportunities are
presented by the potential of unconventional energy sources and the increasing
demand for energy in the future.
The ranking therefore provides a focus for allocating resources – but imagine
that one of the non-executive directors is shown the analysis and forcibly disagrees.
He points out that the world is actually changing quite rapidly and that, unless action
is taken in relation to the shift in power from IOCs to NOCs, then the company
will have lost its market position in another five years. This would involve changing
the focus from resource allocation to relationship management. In fact, the impact
of a forceful and knowledgeable director could be to alter everyone’s perception of
the environmental profile. While it is natural to have reservations about the role of
subjective judgements, there is no information available that can improve on the
interpretation; the point is that the decision to focus on resource allocation or
relationship management is taken explicitly and not by default.
Learning Summary
This module has examined macro-environment issues in the oil and gas industry in
detail. The cost and revenue model has been used to demonstrate how environmen-
tal factors might influence an organisation in different parts of the industry supply
chain. The nature and volatility of the oil price over time has been discussed, and
ideas about where the ‘real’ oil price might be and how backstop measures might
influence the oil price have been examined. The emotive idea of peak oil has been
found to be less relevant to organisations in the industry than is a robust scenario-
based approach to oil prices and other variables. The viability or otherwise of
renewable energy sources has been discussed, and the role of competitive advantage
of nations and the importance of leading indicators has been demonstrated. The
preceding analyses have been pulled together into PEST and ETOP analyses for a
hypothetical international oil company to demonstrate the types of factor that might
be of interest to such an organisation and how such an analysis could be carried out.
References
Al-Zayer, F (2007) ‘The Petroleum Industry: New Realities Ahead?’, Keynote address
delivered at the Offshore Technology Conference, Houston, TX, 30 April–3 May. Avail-
able online at www.opec.org/opec_web/en/867.htm
Central Intelligence Agency (CIA) (undated) ‘The World Factbook: World’. Available online
at www.cia.gov/library/publications/the-world-factbook/geos/xx.html
Clarke, H. (2006) ‘Investing in Backstops & Current Oil Prices’, Blog entry, 19 April.
Available online at http://kalimna.blogspot.co.uk/2006/04/investing-in-backstops-
current-oil.html
The Guardian (2016) ‘Keep It in the Ground’. Available online at www.theguardian.com/
environment/ series/keep-it-in-the-ground
Hotelling, H. (1931) ‘The Economics of Exhaustible Resources’, Journal of Political Economy,
39(2), 137–75.
Marconi, G. (2008) ‘There Will Be No New Refineries’, Oil-Price.Net, 23 July. Available
online at www.oil-price.net/en/articles/oil-refineries.php
Porter, M. (1990) The Competitive Advantage of Nations, New York: Free Press.
US Energy Information Administration (EIA) (undated) ‘Petroleum & Other Liquids: Data’.
Available online at www.eia.gov/petroleum/data.cfm/
US Energy Information Administration (EIA) (2008) International Energy Outlook 2008,
DOE/EIA-0484(2008).
Module 5
Competitive Environments in the Oil

and Gas Industry
Contents
5.1 Introduction.............................................................................................5/1
5.2 The Nature of Demand in the Industry................................................5/2
5.3 Oil and Gas Prices...................................................................................5/7
5.4 Market Structures in the Oil and Gas Industry ................................ 5/17
5.5 The Industry Supply Chain: Sectors and Stages............................... 5/19
5.6 Upstream Sector Market Analysis ..................................................... 5/27
5.7 Crude Oil Trading Market Analysis ................................................... 5/40
5.8 Downstream Oil Market Analysis ...................................................... 5/44
5.9 Natural Gas Processing and Trading Market Analysis .................... 5/59
5.10 Downstream Gas Market Analysis ..................................................... 5/61
5.11 Implications of the Supply Chain Analysis ........................................ 5/67
5.12 Environmental Threat and Opportunity Profile .............................. 5/69
Learning Objectives
 apply the concept of derived demand;
 explain the observed volatility of oil prices;
 explain what is meant by oil price overshooting and undershooting;
 identify the characteristics of market structures within the industry supply chain;
and
 apply strategic models to each stage of the industry supply chain.
5.1 Introduction
The characteristics of the market determine how the company interacts with its
environment and competitors. In Section 1.3, the industry was defined in terms of
the overall supply chain. Some initial questions were posed regarding the differences
in market forces at each stage and it was observed that these have potentially
important implications for strategy. Discussion up to this point has focused on
macro factors or objective-setting for large integrated companies, but there are
many other types of organisation that operate in the oil and gas industry. Many of
these companies specialise in certain stages of the supply chain or cover only one of
Module 5 / Competitive Environments in the Oil and Gas Industry
the three sectors in the industry. A good understanding of both the conditions
under which one is operating and the conditions along the wider chain are im-
portant for managers working in the industry who aspire to operate at the strategic
level.
This module starts by looking at the nature of demand in the oil and gas industry,
then examines in detail how both gas and oil prices are determined. This is followed
by a detailed study of the industry supply chain models first presented in Module 1.
Each component of the industry supply chain is analysed using the models devel-
oped in Core SP Module 5; this is important because many companies operate in
several parts of the supply chain, while some major companies operate across the
complete supply chain and therefore compete in several markets. The model and the
differences between stages are an important step in developing a strategic under-
standing of the industry.
5.2 The Nature of Demand in the Industry

Students of economics will know that the demand curve depicts the relationship
between the price of a good or service and the quantity purchased, with all other
factors held equal. The nature and shape of the demand curve facing a firm has
important implications for strategy. It is easier to visualise the demand curve for
goods sold to final consumers than that for oilfield services supplied by tender or
for intermediate inputs that are part of a production process: individual bids and
inputs are considered in relation to many variables, of which price is only one.
Consequently, the notion of offering a ‘lower price’ is difficult to define.
Core SP Section 5.2 demonstrated some of the applications of the demand curve:
the connection between pricing and total revenue; the relationship between demand
and market share; the factors that affect the position of the demand curve; the role
of marketing; and the difficulty of estimating the demand curve in practice. All of
this may appear to be so complex that there is little point in pursuing the issue. But
the important aspect of the demand curve is that it focuses attention on the central
issue: what would be the effect, in general terms, of offering lower prices than our
competitors? Would market share increase? Would total revenue increase or
decrease? The answers are likely to depend on the nature of the demand curve in a
specific case.
5.2.1 The Firm’s Demand Curve

A salient characteristic of many upstream markets is that there are few major
competitors – that is, the markets are oligopolies. (More detail on sector- and stage-
specific market structures is provided in Sections 5.6–5.10.) An oligopolistic market
structure has one significant implication for pricing: the demand curve is kinked at
the competing price (Core SP Section 5.2). If the price is set either above or below
the competing level, then total revenue is reduced. Further, any attempt to set a low
price may result in undercutting by competitors, leading to a price war in which the
only beneficiary is the customer. There are, of course, difficulties in defining the
competing price, but if it becomes known that a company is likely to bid for any
contract with a very low price, then this can trigger competitive reaction.
In some markets, the services offered may be fairly homogeneous and there may
be little to differentiate the offerings of bidders other than price. When there is a
large number of bidders, then the focus can be specifically on price – but it becomes
immediately apparent that it is necessary to understand the market structure before
deciding whether or not to focus on price. Simply posing the question ‘Is the market
an oligopoly?’ can reveal where attention should be focused.
Different factors affect the demand for a product in different ways (see Table
5.1). Some factors will influence the market as a whole, while others will typically
affect only the sales of the specific company.
Table 5.1 Determinants of market size

Determinant Some factors
Product life cycle Oil price movements; rig count; refined product demand
Business cycle Oil price (see Section 4.2)
Exogenous shocks PEST (see Section 4.7)
GNP elasticity Impact of oil prices on energy use
Exchange rates International economy (see Section 4.6)
Some of the factors have long-run effects, such as the contentious issue of peak
oil and the impact of energy prices on the efficiency of energy use. Others are
immediate, such as the impact of the 2008 global financial crisis or a sudden change
in exchange rates. Most people’s view of the market tends to be dominated by
current newspaper headlines, but it is important to distinguish between short- and
long-term factors and to think in terms of the net impact of many factors. That is
why environmental scanning is so important. The obstacles to carrying out effective
environmental scanning are discussed in Core SP Section 4.6; it is well worth
considering at this point whether, in your organisation:
 anyone has this function; and
 anyone else listens to him or her.
5.2.2 A Model of Derived Demand

The demand for goods and services in any part of the industry supply chain is
derived from the end-consumer demand for fuel. This is known in economics as
‘derived demand’. Derived demand is a particularly important concept for the oil
and gas industry, because demand for everything from wireline logging to petro-
chemicals processing to tanker distribution services and refinery output derives
from the demand for petroleum and gas end products.
Various economists have attempted to explain derived demand, but perhaps the
easiest to understand is one of the earliest attempts, made by J. M. Clark in the
Journal of Political Economy in 1917. He focused on the volatile nature of intermediate
industries when faced with a rise and fall in consumer demand for the related end
product. Empirical observation showed that intermediate goods fluctuate more

wildly in terms of both price and volume of business than do consumer goods, and
that wholesale prices tend to fluctuate more wildly than retail prices.
Each producer of intermediate goods and services has two types of demand to
satisfy. Consider the example of a company operating in the tanker business. The
company builds and operates oil tankers, transporting crude oil from processing
station to refinery. It sells its services to the upstream sector and its customers are
refineries. The two types of demand that the company faces are as follows (and we
will refer to them as ‘type 1’ and ‘type 2’ demand):
1. maintaining equipment and services already deployed, and routine operations to
replace worn-out assets; and
2. providing new equipment and services required when the refining business
expands because of a surge in consumer demand for petrol.
Type 1 demand is determined by the past and the demand for the final product,
while type 2 demand depends on the rate of growth of sales. In the long run,
demand is steadily growing because of world economic growth, but in the short run,
it is prone to volatility.
Consider the following (much simplified and hypothetical) example of derived
demand. The curves in Figure 5.1 represent total global demand for oil and oilfield
services. The primary demand curve represents the demand for fuel; the derived demand
curve represents the demand for oilfield services such as drilling, enhanced produc-
tion techniques, logging and exploration.
Level of demand for finished product
Primary demand
Level of demand for intermediate

goods and services
Derived demand
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
Period
Figure 5.1 Derived vs primary demand

In periods 1–3, primary demand is constant, as is the derived demand. The oil-
field services sector is operating normally, carrying out maintenance and installing
replacement equipment and services. In period 4, there is an increase in demand for
petrol, which continues to grow until period 11. This increase in final demand
results in an immediate and higher proportionate increase in derived demand as oil
companies attempt to build more capacity, find new oilfields and maximise the
production from older sites. The demand for the intermediate product grows faster
than the final demand for petrol.
When primary demand levels off, in period 12, demand in the intermediate mar-
ket immediately drops back to the replacement level as oil companies stop their
investment in more capital goods and finding new sites. The only derived demand
left is the ‘normal’ level required to keep production at the same level and to replace
depleting reserves; because of the higher level of activity, this is now higher than in
periods 1–3.
In summary:
 between periods 1 and 3, derived demand consists of type 1 demand only;
 between periods 4 and 12, derived demand consists of both type 1 and 2
demand; and
 when final demand settles down in period 12, all type 2 derived demand disap-
pears, leaving only type 1 demand.
So, in a derived-demand industry, the demand for intermediate products is highly
volatile, depending on final demand fluctuations. Growth in final demand causes a
greater proportionate growth, and when that growth stops, the derived demand
drops immediately.
While the theory of derived demand is applied here in a highly simplified way, it
does help to explain the behaviour of the intermediate parts of the oil and gas
industry supply chain, and goes some way towards explaining the volatility seen in
certain parts of the industry over the past 20 years. The upstream service sector is a
particularly volatile part of the oil and gas industry largely because of derived
demand considerations.
Figure 5.2 shows annual growth rates in the total oilfield services market and the
average price growth for a barrel of oil between 2000 and 2007 – the period before
the first large oil price spike in 2008.
80%
70%
60%
50%
40%
30% Oilfield market

20% Oil price
10%
0%
2000 2001 2002 2003 2004 2005 2006 2007 2008
–10%
–20%
–30%
Figure 5.2 Oil price growth vs oilfield services market growth, 2000–8
It can be seen from Figure 5.2 that the pattern of oilfield services market growth
over the period follows the pattern of oil price growth, but with a lagged effect. The
sharp drop in oil prices in 2001 was reflected in the oilfield services market in 2002;
the peak growth in oil price in 2004 was not reflected in market growth until two
years later. More recent data were not available at the time of writing, but a cursory
look at public statements made by large service companies such as Halliburton and
Weatherford suggest that the same has been true over the boom and subsequent
bust of 2011–15.
The implications of the derived demand model for strategic decision making in
the services segment of the industry supply chain are as follows.
 An increase in final demand will have a disproportionate impact on the demand
for services.
 Not only will the growth in demand for services end suddenly when final
demand flattens, but also actual demand may fall immediately.
 A high rate of growth for services cannot be extrapolated indefinitely, because it
is highly sensitive to changes in final demand.
 The pattern of growth of final demand (as reflected in the oil price) is a powerful
leading indicator for the services sector.
In practice, the relationship is not going to be precise: it depends, for example, on
existing excess capacity and the time it takes companies to make decisions. But an
appreciation of the potential impact of derived demand means that decision-makers
should always be prepared for volatility. Being prepared for volatility is a potential
source of competitive advantage. If the oil price surges, it makes sense to build
capacity now in the expectation of a significant increase in the demand for services
resulting from the lagged effect; when the oil price levels off, it makes sense to be
prepared in turn for a significant decrease in demand and the consequent implica-
tions for cash flow. A lack of insight into volatility would lead to insufficient
capacity in the upturn and potential financial problems in the downturn. It would
also lead to a sense of helplessness, whereby managers feel that they are at the mercy
of unpredictable volatility rather than predictable volatility.
5.3 Oil and Gas Prices

The price of oil and the price of gas are directly relevant to many companies
operating in the industry; indeed, they are indirectly relevant to most other compa-
nies. This section deals with the dynamics of both oil and gas prices, and looks at
how supply and demand determine prices and cause increased volatility. The idea of
dynamic market analysis is also introduced and the role of the speculator in exacer-
bating what is already a volatile price series is explained.
5.3.1 Oil Prices versus Gas Prices

The market prices of oil and gas have repercussions throughout the length of the
industry supply chain. Figure 5.3 and Figure 5.4 illustrate, respectively, the West
Texas Intermediate (WTI) crude oil and Henry Hub natural gas benchmark average
annual prices since 1949.
140
WTI price per barrel (nominal US$)
120
100
80
60
40
20
0
1949
1951
1953
1955
1957
1959
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
Year
Figure 5.3 Average annual WTI crude oil spot price, 1949–2015
The well-known OPEC-related price increases of the 1970s were followed by a
very high (in historical terms) price increase in the early 1980s. The subsequent
sharp decline in the oil price, which returned to pre-1970s levels, contributed to
what is now considered to be a decade of underinvestment in assets and new field
development in the 1990s. In the early 21st century, the 9/11 terrorist attacks and
the US-led invasion of Iraq led to supply fears, but the impact on price was not
unusual in historical terms. The price of oil then climbed steadily, leading to a boom
in investment running up to 2008.
It is well known that, in 2008, the price of oil reached an all-time high of $147
per barrel and then fell rapidly in the latter part of the year, hitting $38, before
eventually stabilising around $80 per barrel in mid-to-late 2009. This period of
relative stability continued until 2011, when political upheaval in the Middle East
resulted in fear over supplies from the area. The sustained high price after 2011
encouraged further investment in technology and unconventional fields. The large
increase in supply from North American unconventional resources, coupled with
sustained high output from OPEC and a dampening of economic growth in Asia,
contributed to a further crash in the latter part of 2014, bringing the price below $50
per barrel by the end of the year.
Gas prices have followed much the same pattern as oil prices over the past 65
years, abstracting from the OPEC oil price increase in the 1970s, spiking in the early
1980s and then following an upward trend after 2003 (see Figure 5.4).
10
9
Henry Hub MBTU (nominal US$)
8
7
6
5
4
3
2
1
0
1949
1951
1953
1955
1957
1959
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
Year
Figure 5.4 Average annual Henry Hub natural gas spot price, 1949–2015
So why should there be such a close similarity between the two graphs? Conven-
tional wisdom suggests that the two prices move in tandem, and a cursory
examination of Figure 5.3 and Figure 5.4 suggests that this is broadly true. However,
this is not always the case: the price of one unit of Henry Hub dropped in 2006 and
recovered in 2007, for example, while the price of a barrel of WTI continued its
upward trend. In a similar vein, the Henry Hub price did not follow the climb in oil
prices from 2011 to 2014.
A linear regression analysis of the data for prices of WTI and Henry Hub over
the period 1949–2015 suggests that around 60% of the variation in natural gas
prices can be attributed to changes in the price of oil. The correlation coefficient is
0.77, which suggests a strong positive relationship between the two variables.
The assumption that the direction of causation is from oil price to gas price has
been verified by various researchers in different parts of the world, to the extent that
oil prices have been found to influence the price of natural gas in the long run; yet
the relationship does not hold for the short run. One possible reason for this is the
relative size of the two markets. On the one hand, the market for crude oil is global,
with prices set by exchange-traded benchmarks and over-the-counter (OTC)
contracts based on the benchmark price (see Section 5.5.2 on crude oil trading). The
market for natural gas, on the other, is more regionally fragmented. The nature of
gas as a commodity is different from crude oil: it is gaseous, less dense and much
more difficult to transport. Therefore the markets for natural gas tend to be purely
domestic, as in the US, or at most regional, as in central and eastern Europe. Thus
while events and influences in the global oil market have an influence on natural gas
markets, it is unlikely that the events in the domestic gas market will have an effect
on the oil market.
From an economic perspective, there are a number of factors that link the mar-
kets for oil and natural gas, which can be summarised as in Table 5.2.
Table 5.2 Demand-side and supply-side links for oil and gas prices
Demand-side links Supply-side links
Substitutability Coproduction of the commodities
According to an EIA survey, 18% of natural gas Associated gas that comes from oil wells makes up
usage can be readily switched to petroleum around 30% of the global production of natural gas.
products in the US. Other studies estimate that An increase in the price of crude oil that encour-
20% of power generation can be switched from gas ages higher production levels may therefore result
to oil readily. in increased production of associated gas, putting
The percentage may be smaller than this in downward pressure on the price of gas.
practice and these figures apply only to the US, but Similar extraction activities and equipment
it is clear that there is some degree of substituta- Increased oil prices will lead to increased demand
bility between the two commodities. A rise in the for services and equipment relating to the extrac-
price of crude oil may therefore encourage some tion of hydrocarbons. The price of such goods and
industrial consumers to switch to natural gas, services will rise, pushing up extraction costs for
which in turn increases demand for natural gas, natural gas because the resources required are
pushing up prices, all other things held equal. similar, e.g. labour, rigs, pipelines.
Investment in hydrocarbon production
Increased cash flow from higher oil revenues will
tend to be invested in both oil and natural gas
production.
Liquefied natural gas (LNG) contracts
Most LNG contracts are directly indexed to the oil
price, creating a direct link between oil prices and
natural gas prices.
Source: Adapted from Villar and Joutz (2006)
The factors in Table 5.2 help to explain the long-run relationship between the
price of oil and the price of gas, but what about the short run? In some periods,
there has been a marked decoupling of the two prices over a short time horizon.
This may be the result of a number of factors, but the most important of these are
as follows.
 Weather conditions. A particularly hot or cold spell will result in increased electricity
consumption, causing increased consumption of natural gas. This tends to be
localised and will have an impact on the domestic gas market, but will not affect
the crude oil market.
 Supply disruptions. A disruption in gas supply will put upward pressure on the
price in the short run, but is unlikely to influence the oil price.
 Stock levels. Different stock levels for the two commodities will result in short-
term decoupling of price movements. High levels of gas stocks and low levels of
oil stocks will result in downward pressure on gas prices and upward pressure on
oil prices.
Despite short-run differences, a model produced by the Dallas Federal Reserve that
included these reasons for decoupling in the short run found a very strong relation-
ship between the two commodities (Brown and Yücel, 2008). The two markets are
linked and the oil market exerts a heavy influence on the fragmented natural gas
market.
5.3.2 Supply, Demand and Price Determination

The following discussion addresses some of the mechanics of the oil market. Many
of these influences can equally be applied to the natural gas market, but the oil
market is the focus of this section because, as identified above, it tends to lead the
gas price.1
Demand for oil is price inelastic in the short run – that is, as its price moves up
or down, the quantity demanded changes at a slower rate than does the price. This
means that large price rises are unlikely to cause a large drop in the quantity de-
manded in the short run. The reason for short-term price inelasticity is that it is
difficult to make immediate reductions in oil use when the price increases. Domestic
consumers can travel less, or turn their thermostats down, but that takes time and is
unlikely to have a significant impact on consumption. Industrial consumers can
attempt to economise, but not to the extent of disrupting production. When the
price falls, there is likely to be little short-term impact on the behaviour of domestic
or industrial users.
The revenue from selling oil is price multiplied by quantity – that is, Price (P) ×
Quantity (Q); thus, because of demand inelasticity, when the price increases, the
revenue increases, but when the price falls, then revenue also falls. Moreover,
because of price inelasticity, short-term revenue is almost entirely dependent on the
price. As a result, oil companies are liable to find that a healthy cash flow can
evaporate very quickly as the result of a price fall; indeed, many oil companies have
reported cash-flow problems since the oil price fell in late 2014.
In the long term, the demand for oil appears to be highly price elastic: it did not
take long for the major economies to adjust to a significantly lower energy input per
unit of GNP after the oil price hike of the 1970s. This accounts for the fact that oil
prices fell back to pre-1970s levels for the period up to 2000. Similarly, the level of
energy intensity in OECD countries has dropped significantly since the two periods
of sustained high oil prices in 2005–8 and 2011–14.
The supply of oil is also inelastic in the short run and so cannot adjust quickly to
movements in demand. This is partly because the oil market is controlled largely by
1 The authors thank Professor Neil Kay for the inspiration in this section. In 2011, Neil ran an ‘oil price
watch’ series of articles on the Edinburgh Business School Blog, using simple supply-and-demand
analysis to tackle day-to-day and week-to-week price movements. It is still available online for those
interested (Kay, 2011).
cartels, such as OPEC, which is currently in control of around 45% of the world’s
oil production. OPEC attempts to influence the price of oil by setting production
quotas for each country in the group, although with limited success, for the follow-
ing reasons.
 It does not have total control over the global supply of oil: more than half of
global production was controlled by non-OPEC countries as of 2015.
 It has no way of enforcing the quotas that it sets for members. Some states often
exceed their production quota if they feel that it is in their interests to do so.
Venezuela, for example, has been adding capacity in excess of its OPEC quota
for some time.
 The availability of timely, precise data on demand, stocks and flows of oil is
limited.
However, while OPEC’s ability to actually control the price of oil is debatable, it
does restrict the response of the supply side and introduces a further political driver
of volatility into the equation. In any case, the supply of oil cannot be varied in the
same way as turning a water tap to a higher or lower pressure; it takes time to
increase the flow. Thus while an increase in price will lead to some increase in
output in the short run, it will tend to be by a much lower proportion than the price
increase.
The inelastic demand (D) and supply (S) curves are shown in Figure 5.5. Here, an
increase in demand, which might be caused by an increase in consumer confidence,
causes the curve to shift from D to DD. Because of the relative elasticity of supply
and demand, the change in the equilibrium price is relatively large. Thus the
interaction between short-run inelastic supply and inelastic demand leads to
volatility, in the sense that price adjustments to short-term changes tend to be
relatively large. This can be observed in relation to WTI crude oil in Figure 5.3 after
2008, when price fluctuated significantly from year to year.
Price S
P2
P1
D DD
0
Quantity
Figure 5.5 A market with inelastic supply and demand

In the long run, production can be increased, new fields brought on line and so
on, leading to a more elastic curve than in the short run. Thus, in Figure 5.5, the
supply curve will flatten out, contributing to the levelling of the oil price. This
suggests that, other things being equal, an increase in price will be followed by a
gradual reduction as supply and demand conditions adjust in the long term. The
rough downward drift in oil price after 1980 is consistent with this.
The demand and supply curves are based on the assumption that other things
remain equal, but of course that is rarely the case in real life. Expectations are
variable, and can influence the supply and demand schedule for the oil market in
two ways. Figure 5.6 shows the effect of expectations that the oil price is going to
rise in the near future. If the price of oil is expected to rise, this will encourage
buyers to buy more now at every given price – that is, it will shift the demand curve
to the right, from D to DD. The expectation will have a different effect on suppli-
ers. Suppliers, expecting the price to go up, will withhold some of their stocks from
the market and will be willing to supply less at every given price, thus shifting the
supply curve to the left, from S to SS. The pre-emptive action by both suppliers and
buyers will push the equilibrium price of oil higher than it otherwise would have
been, from P1 to P2.
Price
DD SS
D
S
P2
P1
SS DD
D
S
0
Quantity
Figure 5.6 The effect of expectations on the market for oil I

While the joint effect of an increase in demand and a reduction in supply inevita-
bly leads to an increase in price, the actual quantity traded may increase, decrease or
remain much the same. If the demand curve shift had been smaller, the quantity
traded would have been less: it might have coincided with the original quantity or it
could have been less. This helps to account for the erratic behaviour of the quantity
of oil traded, as well as its price.
The reverse is true if it is expected that the price of oil will fall in the future. In
this case, suppliers wish to sell as much as possible now at the current (higher) price;
therefore the supply curve will shift to the right. Consumers, meanwhile, expecting
the price to fall, will want to put off as much of their purchasing as possible until
the price falls. The consequence of this is that the demand curve shifts to the left –
that is, the actions of buyers and suppliers will cause the equilibrium price of oil to
fall. The joint effect of an increase in supply and a reduction in demand is always a
reduction in price, but, as in the opposite case, the quantity traded may increase,
decrease or remain the same.
Price
D S
DD
SS
P1
P2
D
S
DD
SS
0
Quantity
Figure 5.7 The effect of expectations on the market for oil II

Expectations can become a self-fulfilling prophecy, leading to overshooting and
undershooting (see Section 5.3.3). This is amplified by the use of futures contracts
for oil. Futures contracts serve to quantify the expectations in the market and
further reinforce positive or negative price expectations.
The discussion of short- and long-run demand and supply elasticities in relation
to Figure 5.5 suggested that short-term price adjustments would be relatively large,
but would dampen over time as both consumers and suppliers made adjustments to
their behaviour. But a different view of the mechanism by which adjustments take
place leads to the opposite conclusion: that long-run adjustments will add to
volatility rather than dampen it. Figure 5.8 depicts a market over four time periods,
1–4. In the first period, the supply curve is S1 and the demand curve is D1, which
produces an equilibrium price of P1. A sudden surge in demand causes the demand
curve to shift to the right, to D2. The supply of oil is inelastic in the short run and
the price jumps up to P2.
Price
S1 S3 , S4
P2
P3
P1
D2
P4
D1, D4
0
Quantity
Figure 5.8 The cobweb model
The higher price encourages suppliers to build more refining capacity, and to
invest in new exploration and develop marginal fields. Consequently, in the next
period, supply has shifted to S3. Demand remains at its previous level and therefore
the new equilibrium price falls to P3. So far this is consistent with the discussion on
Figure 5.6. But when demand falls back to its original level, supply remains at
position S3 and the equilibrium price falls to P4, which is lower than the original
price P1. If the demand shift from D1 to D2 had been caused by expectations rather
than an increase resulting from economic activity, the result would be a self-induced
cycle over the four periods: price would increase significantly, then fall, then
collapse.
The cobweb model can help to explain the spike in the oil price in the early
1980s. Because of the loss of production at the start of the Iran–Iraq War, the
supply curve shifted to the left – that is, from S4 to S1 in Figure 5.8, resulting in
increased price from P3 to P2. Demand fell to D1 as consumers found ways of using
oil more efficiently – houses were fitted with more insulation, for example, cars
were engineered to be more fuel-efficient and speed limits were reduced in the US –
and price fell from P2 to P1. When supply eventually expanded back to its previous
level S4, the price fell further to P4 – well below the original level of P3.
Having an understanding of the interaction of supply and demand in the market
can shed a lot of light on what is actually going on. The cobweb model demon-
strates that fluctuations in price are likely to be a permanent feature of the oil
market, owing to lagged adjustments.
This is partly what economists mean by ‘understanding your market’ – that is,
demand and supply conditions, and how they interact to determine prices. Typically,
discussions about ‘the market for oil’ are vague, but this framework enables the
discussion to be structured in such a way that logical conclusions can be drawn. In
this case, some knowledge of demand and supply elasticities, and of the factors that
cause shifts in demand and supply curves (expectations), reveals the inherent
volatility of prices, making it possible to interpret the ‘predictions’ that are continu-
ally made about oil prices and the demand for oil services.
Another important aspect of this analytical structure is that it does not depend on
a high degree of quantification. There is a huge amount of information available on
oil prices, but all that can really be deduced from them is volatility; the economic
analysis explains this volatility and, just as importantly, demonstrates that volatility is
a feature of the market that is unlikely to disappear. This does not mean that there
cannot be prolonged periods of stable prices, but once changes in demand or supply
conditions start to happen, it is unlikely that the system will converge quickly
because of expectations.
It has been argued that managers often do not know what questions to ask, and
that even if answers are available, they have little idea of how to use them because of
the lack of a theoretical framework. As a result of this examination, you now have a
checklist of questions, as follows.
 What is the price elasticity of demand? (Elastic or inelastic.)
 What is likely to happen to demand in the medium term? (Shifting the demand
curve.)
 What is the price elasticity of supply in the short term? (Elastic or inelastic.)
 What is the lag in increasing production? (Shifting the supply curve.)
 What are expectations likely to be on the part of both buyers and suppliers?
You can also now interpret reports on oil prices. The following is extracted from a
Bloomberg report published on 22 May 2008, at a time when the oil price was
rapidly approaching its all-time high in July 2008:
Crude oil rose to a record above $134 a barrel in New York as U.S. stockpiles
unexpectedly dropped and banks raised price forecasts because of supply con-
straints and demand growth.
Inventories fell 5.32 million barrels to 320.4 million last week, the biggest drop
in four months, the Energy Department said yesterday. Oil for December 2016
delivery rose more than $20 a barrel, or 17 percent, after Goldman Sachs
Group Inc. on May 16 raised its outlook to $141 a barrel for the second-half
[sic] of the year.
“What we have here is a situation where essentially higher prices aren’t gener-
ating any more supply,” Paul Sankey, an analyst at Deutsche Bank Securities in
New York said in an interview with Bloomberg radio. “What we have to do is
keep pricing the commodity higher until demand starts falling,” which “is
around $150 a barrel.”
Crude oil for July delivery rose $1, or 0.8 percent, to $134.17 a barrel at 9:04
a.m. in Sydney in after-hours trading on the New York Mercantile Exchange. It
touched $134.42, the highest since trading began in 1983. Prices have more
than doubled in the past year.
Yesterday, crude oil for July delivery rose $4.19, or 3.3 percent, to settle at
$133.17 a barrel (Shenk, 2008).
The first paragraph is concerned with changes in expectations: the banks expect
supply to fall in the future and demand to increase. This can be interpreted as a shift
to the left of the supply curve and a shift to the right of the demand curve, as in
Figure 5.6, which inevitably results in a price increase. The second paragraph
confirms that supply is contracting with the fall in inventories, while the futures
price has increased in line with expectations. The third paragraph is about the
inelastic nature of the supply curve: because of inelastic demand, the higher price
will not result in a significant reduction until it reaches $150 per barrel. The last two
paragraphs contain more information on specific futures prices, which is consistent
with the second paragraph.
This application of the cobweb model has a profound implication, because it
converts a commentary into an analysis. The article is a description of what hap-
pened and, as such, does not convey any understanding of what was actually
happening. Cobweb analysis, however, identifies the factors contributing to the
observed events and provides a basis for assessing what is likely to happen next.
5.3.3 Dynamic Market Analysis

The comparative static analysis using supply and demand shifts augmented by
expectations and the cobweb theorem demonstrates that the oil price is volatile
because of market characteristics. But that is not the whole story: comparative
statics compares different situations under certain assumptions, for example that the
demand curve has shifted. Dynamic analysis looks at the time series of events and
allows for the fact that, in real life, all other things do not remain equal. In a
dynamic market, the actions of buyers and sellers contribute to another dimension
of volatility known as ‘undershooting’ and ‘overshooting’. The fluctuations between
high and low prices depicted by the cobweb model are exceeded in a dynamic
market because of rational speculation.
Overshooting and undershooting have been extensively analysed in the econom-
ics literature, particularly in relation to exchange rates and the stock market (but
note that undershooting has a particular meaning in geophysics). The mechanism by
which overshooting occurs can be expressed in highly technical terms or at a more
intuitive level that nevertheless conveys the process quite accurately.
Imagine that the oil price has been relatively stable for some time. An event
occurs, such as a war or a breakdown in relations with a major producer, which
sparks fears of an imminent shortage (in which case, the supply curve is expected to
shift to the left). Rational consumers will purchase as much oil as possible at the
current price in order to avoid paying a higher price in the future; other individuals
(speculators) will purchase oil to hoard for a profit later. The combination of these
causes the price to be bid up higher than it otherwise would have been (as in the
cobweb model). But when other rational purchasers and speculators observe this
significant increase in price, they also enter the market, thus bidding up prices yet
further, and the expectation of further price increases is reinforced. The process
carries on until the expectation of further price increases disappears, at which point
the speculators start to sell. The peak price is typically well above the equilibrium
price that would have resulted in the new supply and demand conditions.
There are many reasons why expectations of further increases disappear: the
threat of war might be averted, for example, or the majority of purchasers may
come to the conclusion that the price is unlikely to increase further. At that point,
purchasers will find it economical to use their stocks and to delay further purchases
until they run out. Speculators will try to sell their stocks; in fact, the speculators
who entered the market incrementally will sell at the same time, with the result that
price will tend to drop even more quickly than it increased. This leads to a glut on
the market and the clearing price will be much lower than the equilibrium price.
This is undershooting. Once the surplus has been cleared, price will start to increase
again, and the whole process is likely to be repeated. One event can then trigger a
period of volatility, which may take some time to dampen, and before this dampen-
ing can occur, it is likely that some other shock will disturb the system, leading to
continuous volatility. The chances are small of the price remaining at the equilibri-
um level for any length of time.
Once this mechanism is understood, it makes sense for speculators to think in
terms of turning points. These cannot be identified with precision, but it is im-
portant to take a view on when the turning point has arrived and to act accordingly
– that is, sell when the market has peaked and buy when it starts to recover. This is
because the costs of acting too early compared with acting too late are not symmet-
rical. For example, imagine that you sell and the market increases by a further 10%.
This means that you have lost 10%. But if you had been right about the market
turning, the price would have dropped quickly, for the reasons given above. The
chances are that you would not have been able to unload your stock before it lost
20%. So when you reckon that the peak has been reached, you balance out the
prospect of being wrong and losing 10%, or being right and avoiding the loss of
20%. Similar reasoning applies at the bottom of the cycle.
The notions of overshooting and undershooting are superimposed on the volatil-
ity generated by shifts in the demand and supply curves. They add to the complexity
of the situation facing decision-makers, but instead of concluding that nothing can
be done because the world is unpredictable, a rational view of when the cycle is
likely to turn has to be developed and actions taken that are consistent with that
view. There is a huge amount of information available to decision-makers that may
or may not be useful in predicting turning points. One way of identifying relevant
information is to focus on the following three questions.
1. What is likely to happen to expectations?
2. Are there sensible leading indicators of demand?
3. Are there sensible leading indicators of supply?
Understanding the operation of the market and the implications for prices has
implications for decision making in companies operating in what appears to be a
totally unpredictable market. Consider decision-makers’ typical reactions to an
increase in price in a volatile market.
 Fall back on experience. That does not help unless the decision-maker can interpret
what has happened.
 Get ready to react. This usually means that action will be taken too late.
 Treat it as a windfall gain. In this case, management bonuses will increase, share-
holder returns will increase temporarily and inefficiencies will creep in.
In 2008, the oil price exceeded $140 per barrel for a time. Should investment have
been immediately undertaken in fields that required a price of, say, $130 per barrel
to be economic? If $140 were regarded as an example of overshooting, then the
answer is ‘no’. The price subsequently dropped to $90 per barrel in a short space of
time. The pattern of rapid price increase and even more rapid reduction fits the
description of the overshooting process. The question then was whether $90 was an
undershoot price. That was another difficult question, but by interpreting $140 as an
overshoot price, a company would have been spared the consequences of acting too
soon. Some companies had to learn this lesson the hard way and found, in a climate
of falling oil prices, that they struggled with falling revenues and high costs.
5.4 Market Structures in the Oil and Gas Industry

Market structures vary markedly among industries and between segments of the
same industry. Most managers are not aware of the structure of the markets in
which they operate, because they have not been exposed to economics as a disci-
pline; they may even feel that the issue is conceptual, with little bearing on practical
management. Market structure is, however, the main determinant of long-term
profitability and an understanding of it is central in developing strategy.
Perfect competition (see Core SP Section 5.10.1)

In economics, the ‘perfect market’ is the base scenario in which the product is
homogeneous, there are no barriers to entry and no economies of scale, there is
universal availability of information on prices and quantities, and there is a very
large number of buyers and sellers. Firms in the industry are price-takers in that
they can sell all they want at the market price and none at any other price. The
demand curve facing the firm is perfectly elastic (that is, horizontal), to represent
the fact that all firms in the industry are price-takers. In a perfect market, no
monopoly profit exists and firms can make only the opportunity cost of capital
(which is included as a cost, although in accounting terms it is never identified).
Competition forces costs down to the minimum.
While the conditions for perfect competition rarely exist fully in real life, it is a
useful starting point for market analysis. For example, an exploration company
may be in a monopoly position at the start of a new product life cycle caused by
the development of a new technology; as more and more competitors enter the
market, some characteristics of perfect competition start to emerge, exerting
downward pressure on profit. This happens as the technology becomes dissemi-
nated or copied, as more firms enter the market, and as customers become
increasingly familiar with the new technology and can make rational choices
among competing suppliers.
The strategic issue is to determine what factors prevent the market from becom-
ing perfect. To a large extent, this comes down to identifying the barriers to
entry and whether they are likely to be permanent. It is important to be explicit
about what these barriers are, because they have important implications for ac-
tion. For example, if the barrier is technological, it is logical to allocate resources
to R&D; if barriers are legal and political, the emphasis should be on the devel-
opment of negotiating skills.
Monopoly (see Core SP Section 5.10.2)
At the other end of the competitive spectrum is monopoly. In this instance, the
firm is the only operator in the market and consequently faces the total market
demand curve, which is downward-sloping. The monopolist earns profits above
the opportunity cost of capital. While monopoly profit may be earned at a point
in time, the real issue is whether the conditions that led to monopoly in the first
place are likely to continue. These are the same factors that result in the market
becoming more perfect, as discussed above. It is therefore important to under-
stand how barriers to entry operate at different stages in the industry supply
chain.
Oligopoly (see Core SP Section 5.10.5)
The implications of oligopoly for the demand curve were discussed in Section
5.2.1. Competitive reaction is the main preoccupation. The giant major oil com-
panies exert oligopolistic influences at various stages of the industry supply
chain, of which the next section is a reminder.
It is clear that market structures vary along and within sectors of the supply chain,
and that market structure can have a major bearing on the dynamics, level of
competitiveness, focus of activities and level of returns in a specific business. The

difficulty with the oil and gas industry is that it is actually rather diverse. While
things such as oil and gas prices are important to all businesses operating both
within and around the industry, a more detailed lens is required to gain a deeper
understanding of the constituent parts of the industry. That is the topic of the
remainder of this module.
5.5 The Industry Supply Chain: Sectors and Stages

In Section 1.3, a model of the industry was proposed, consisting of the following
three sectors:
 upstream, involving the exploration, production and trading of raw hydrocarbons;
 downstream oil, involving transportation, refining and marketing of petroleum-
based products;
 downstream gas, involving the transmission and distribution of natural gas to
consumers.
It was also noted in Section 1.3 that divisions commonly used, such as ‘upstream’,
‘downstream’ and the ill-defined ‘midstream’, are of little use to those trying to
develop a more robust and structured understanding of the industry. The 16-stage
breakdown provided in Figure 5.9 represents a more granular approach to each of
these three sectors, allowing the strategist to consider similarities and differences
within sectors and between stages. The remainder of this module is devoted to a
detailed examination of the industry supply chain and the way in which competitive
conditions change differ between stages. This section examines the types of
company and the main markets found at each stage of the supply chain.
UPSTREAM
Exploration
Unconventionals Development
Production
Crude oil trading Gas processing
DOWNSTREAM
OIL Gas trading
Transport
DOWNSTREAM
GAS
Refining Gas marketing
LNG
Petrochemicals Storage Transmission

and storage
Marketing and Distribution

distribution pipeline
Figure 5.9 The oil and gas industry supply chain

It is clear that companies compete in different markets at different stages. Petrol
retailing in cities, for example, displays characteristics of perfect competition (many
competitors, a homogeneous product, ease of entry and knowledgeable consumers),
whereas exploration exhibits monopoly characteristics (few competitors, a differenti-
ated product, entry barriers and uncertainty about the product). The differences in
markets throughout the supply chain will now be analysed after a review of each stage.
5.5.1 The Upstream Sector

In the upstream sector, companies take different forms: large integrated companies
that have interests in all parts of the oil and gas industry; companies that produce
oil; and companies that produce only gas. Independent companies, often referred to
as ‘exploration and production’ (E&P) companies, operate in only one or two stages
in the upstream sector. Some only manage producing assets; others purchase rights
to explore in the hope that they can find viable resources and sell the concession on
at a profit. Others are full E&P companies, maintaining a balanced portfolio of
assets in different stages of the life cycle.
Further, at each stage of the upstream chain, there are companies that operate
only at that part of the supply chain. Many of these are service companies. Some
service companies operate throughout the upstream chain, providing geophysical
exploration services, drilling, evaluation and completion services, whereas other
companies provide only drilling, or only enhanced recovery techniques. Most of
these service companies take no equity stake in fields and do not share in produc-
tion revenues; instead, they are contracted for a fee.
The key activities in the upstream sector are as follows.
Exploration
In the market for exploration services and exploration data, companies tend to
be highly specialised, using hi-tech methods to assess potential drilling sites.
Major producers also operate in this area, but are likely to contract a specialist
for the technical aspects of the exploration activity.
Development
In the service market for development, companies specialise in completions,
drilling and evaluation, and contract out their services to producers. Some major
producers carry out these activities internally; this is a classic ‘make versus buy’
situation. Specialists tend to be used when there is complex geology to deal with
or when oil has been discovered in adverse conditions.
Unconventionals
While unconventional resources can be managed within the traditional supply
chain, and still need to be found, developed and produced, they are mentioned
separately here because of their increasing prevalence and sometimes unusual
characteristics. The tar sands resources in Canada, for example, are not drilled
for; instead, they are strip-mined and then processed into synthetic crude oil, at
which point they re-enter the conventional supply chain. Shale resources in the
US and Australia are indeed found, drilled for and produced, but require special-
ised techniques to extract them. Another interesting characteristic of shale
resources is that the field life cycle is very short, usually lasting around 18
months. This is in stark contrast to conventional shallow-water drilling, for ex-
ample, where it is not uncommon to expect a field to produce upwards of 25
years. The short life cycle means that marginal costs fall quickly as new technol-
ogy and innovation is introduced each time a well is drilled. Since about 2005, a
large number of companies that specialise in certain types of unconventional
resource have arisen, thus warranting the acknowledgement here of a separate,
but parallel, stage.
Production
Project management of well development and production is offered by service
companies. At this stage, many fields are operated in cooperative joint ventures
between NOCs, IOCs and independents. There is also a growing market for
secondary recovery techniques such as artificial lift. Service companies are now
increasingly working with NOCs, providing them with the technical expertise
and experience that most lack. The field processing of oil is carried out at or near
the wellhead, normally by the company that is doing the production, and gas is
sent to a processing facility nearby. After this point, gas and oil follow different
paths to the end consumer.
Some salient market characteristics of these upstream activities can be summarised
as in Table 5.3.
Table 5.3 Upstream market characteristics

Characteristic Exploration Development Production Unconventionals
Competitors Few Few Many Variable
Investment High Low Low Low
Risk High Medium Low Medium
Entry barriers High High Low Low
Although these are only a few of the market characteristics, there is sufficient
information to indicate that the main stages in the upstream sector are significantly
different from each other. From this perspective, the definition of a company as an
‘upstream business’ does not say much about the strategic approach that it will have
to adopt.
5.5.2 Trading: The Transition Point

The transition between upstream and downstream is the most important financial
point in the chain, because this is where crude oil and natural gas is converted to
cash. This cash enters the supply chain and moves upstream. Oil trading and natural
gas trading are treated separately here because of their different characteristics.
Crude oil trading

Crude oil, once processed, can go two ways: it can continue down an individual
company’s supply chain, or it can be traded on the open market. The vast majority
of crude oil is traded. The main reason for this is that refining operations tend to be
closer to the end consumer, so oil is traded in its raw form across countries and
continents. This is partly because of the disparity and geographical distance between
producing and consuming nations.
There is a ‘going rate’ for crude oil, but not all barrels sell for the same rate. Dif-
ferent grades of crude have different properties, so they sell at a premium or a
discount to the going rate. Benchmark prices tend to be obtained from ‘light’ grades
– that is, those that contain a higher quantity of light hydrocarbons – such as
gasoline. Other crudes of differing grades are priced relative to these benchmark
products, depending on their density and sulphur content, as shown in Figure 5.10.
The lighter the oil, the more high-value will be the products of refining. Also, light
crudes are easier, and therefore less costly, to refine, meaning that the buyer will
generally make higher margins on light crude.
Sweet
Discounted Benchmark
Sour Discounted Discounted
Heavy Light
Figure 5.10 Crude oil quality matrix

Most oil is not exchange-traded; rather, the specific grade, of which there are
hundreds, is sold in OTC deals and priced at a premium or at a discount to bench-
mark crude. This will depend on where the oil comes from and different
benchmarks are used for different geographical locations. Some of the more
common are:
 Brent Blend, the benchmark for oil flowing west from the Middle East, Africa
and the North Sea;
 WTI, the benchmark for North America;
 Dubai, the benchmark for oil flowing from the Middle East to Asia-Pacific;
 Tapis, a Malaysian blend used as a benchmark for light crude from the Far East;
and
 Minas, an Indonesian crude used as reference for heavy Far Eastern oil.
The benchmarking of crudes relative to a few well-known and extensively traded
grades, and the fact that information on different grades of crude is freely available,
means that the markets for different grades are linked and, within a narrow bound,
it is possible to identify the ‘price of crude’. This is consistent with the notion of the
‘law of one price’ (that is, the principle that homogeneous products will sell for the
same price in a competitive market). Thus the fact that crude oil is not a totally
homogeneous commodity does not contribute to volatility, because of the infor-
mation available on differences in quality and continuous updates of prices in the
exchanges.
Natural gas processing, trading and LNG

Gas processing is undertaken near the wellhead and it is at this point that produced
gas is separated into its constituent components. Natural gas liquids are then refined
into their components (butane, propane, etc.) and natural gas (made up mainly of
methane) is separated out.
Again, this is the transition point between upstream and downstream, and repre-
sents the point at which cash enters the supply chain. Many of the considerations
are the same as for crude oil trading. Gas is traded in the same way as crude oil: on
commodity exchanges and through OTC contracts. There is also a distinct market
for butane, propane and other heavier hydrocarbons, and another for wholesale
natural gas contracts.
The market for natural gas, however, operates differently from the global crude
oil market because it is fragmented geographically. The nature of natural gas – it is
low density, gaseous and difficult to transport – means that the final market tends to
be a lot closer to the wellhead than is the case for crude oil. Some notable bench-
marks for natural gas are:
 Henry Hub, which is located in Louisiana and acts as pricing benchmark for the
US;
 British National Balancing Point, which refers to a ‘virtual location’, but acts as
benchmark for pricing gas in the UK; and
 Zeebrugge Hub, which is another virtual location that acts as benchmark for
Belgium and northern Europe.
Over-the-counter contracts are priced relative to these benchmarks. However, the
pricing of a given contract depends on the location for delivery relative to the
benchmark location, or ‘hub’, rather than on the quality of the product. A hub is a
point at which major pipelines intersect or a point at which gas can enter a transmis-
sion pipeline network. The increasing prevalence of LNG technology over the past
30 years has, to some extent, allowed a more global market for natural gas. LNG is
growing in use and this means that gas can be transported further than is feasible
through a pipeline. When LNG arrives at its destination, it is processed through a
regasification terminal and then enters the high-pressure transmission network in
the same way that gas produced locally would do.
The existence of LNG and the advent of floating LNG terminals mean that so-
called stranded gas fields that are in the middle of the ocean or very far from an area
in which consumers are based can now be exploited and transported. There has thus
been a boom in gas use in countries such as Japan and South Korea since 2000
because of the growing use of LNG, much of which is produced in Qatar, a country
with very large gas reserves and a small population.
5.5.3 The Downstream Oil Sector

The downstream oil sector takes crude oil from the wellhead to the end consumer
and comprises companies that carry out the following functions.
Transport
The transport of crude oil to refineries or to a storage facility is done either by
tanker or pipeline. The choice of pipeline or tanker will depend on the distance
that the oil is required to travel. There are two markets in operation here: the
market for tanker services, and that for oil pipeline services. Some companies
operate only in this section of the supply chain, whereas integrated companies
often operate their own transport. There is an obvious difference between the
market for transport by tanker, in which competitive conditions determine char-
ter rates, and that for pipeline, which is a local monopoly.
Refining and petrochemicals

There has been a trend since the late 1990s for large, integrated oil companies to
sell off various refining interests to smaller companies. BP, for example, sold
many of its large North American refining operations in the mid-1990s and its
Grangemouth refinery in the UK in 2005. Since 2010, Royal Dutch Shell has
sold refineries in Australia, the UK and Japan. The market in this part of the
supply chain is the market for wholesale fuel products. Companies may also sell
on or process petrochemical feedstock, or other non-fuel products such as in-
dustrial lubricants and asphalt.
Refineries typically have a monopoly within a geographic area and are construct-
ed to deal with certain types of crude oil input. A refinery in an area where crude
is of a certain specific gravity and has heavy, sour characteristics will be con-
structed to deal with such output. In the southern US, the output from shale is
light and sweet, but many of the refineries are built to deal with heavier crude
imported from Mexico. This has resulted in a lot of light-sweet production from
shale being traded for heavier crude that the refineries are able to process.
Storage
Oil terminals are used to store the finished product and it is from these that road
tankers take the fuel to its final destination. These tend to be either owned by a
large oil company, operated by a consortium or independently owned. In the
case of an independently owned oil depot, the owner is in the market for storage
space and pick-up rights.
Marketing and distribution
Marketing and distribution is the most diverse stage of the supply chain, and
deals with the end customer. The markets at this stage are for finished fuel prod-
ucts to business or retail customers. The most obvious are petrol stations selling
fuel to motorists, but other outputs, such as lubricants, petrochemicals as an
input into plastics manufacturing and bitumen for road repairs, are all sold at this
point in the chain as well.
A comparison of some salient market characteristics of downstream activities is
presented in Table 5.4.
Table 5.4 Downstream oil market characteristics

Characteristic Transport Refining and Storage Marketing and
(tanker) petrochemicals distribution
Major competitors Many Few Few Many
Investment High High High Low
Risk High Low Low Low
Entry barriers Low Low High Low
As in the case of ‘upstream’, the term ‘downstream’ does not imply commonality
among the markets in which the activities are carried out. The skill sets differ signifi-
cantly between stages and this opens up the issue of whether vertical integration can
be justified: is there a benefit to a company from operating in more than one stage of
the supply chain? This is, of course, a central issue in the oil and gas industry, and will
be elaborated next.
5.5.4 The Downstream Gas Sector

Downstream gas involves moving gas from the processing facility to the end
consumer. Companies market, move and distribute natural gas products in this
sector.
Marketing
Sales of natural gas are to two main types of consumer: the retail consumer,
which includes home and business users; and/or wholesale, to power-generation
or other large-scale industrial operations.
Transmission and storage
Gas can either be transported via transmission networks that are close to the
production site or liquefied and transported via tanker to another country or
continent.
Gas can also be stored near its end market, so that it can be used when needed.
It is at this point in the chain that gas is distributed to electricity generators,
through high-pressure pipelines.
Distribution
Commercial pipeline operators handle the final distribution to the end consumer
of natural gas. There are often state monopolies or companies that control the
pipeline and charge gas companies a fee to distribute gas to their customers. This
is exclusively gas for household and small business use, distributed through local
low-pressure pipeline networks. In countries where no distribution pipeline in-
frastructure exists, it is still possible for consumers to cook and power their
homes with gas using canisters.
As in the case of downstream oil, there are quite distinct activities within the
downstream gas market, with implications for skill sets and other characteristics.
The salient market characteristics are as shown in Table 5.5.
Table 5.5 Downstream gas market characteristics

Characteristic Marketing Transmission and Distribution
storage/LNG
Major competitors Few Single or few operators Local monopoly
Investment Low High High
Risk Low Low Low
Entry barriers High High High
5.5.5 Industry Supply Chain Overall

This section has examined the detailed components of the three industry sectors
identified in Module 1. It should be clear, at this point, that the characteristics of
each stage are different, resulting in different competitive conditions, different
product and market life cycles, different value-chain configurations in companies

and different strategies that are appropriate.
5.6 Upstream Sector Market Analysis

The next stage in developing a strategic understanding of the oil and gas industry is
to analyse each of the stages using models discussed in Core SP Module 5. The
description of the industry supply chain in Section 5.5 identified differences in the
characteristics of the sectors within upstream, downstream oil and downstream gas.
From the strategic viewpoint, the division between upstream and downstream is too
broad at the macro level, so each individual stage is examined separately here in
terms of market structure, price and differentiation, product life cycle and Porter’s
‘Five Forces’ (Porter, 2008).
This section deals with upstream stages; Section 5.7 deals with crude oil trading;
Section 5.8, with downstream oil stages; Section 5.9, with gas processing and
trading; and Section 5.10, with downstream gas stages. This feeds into the construc-
tion of a full ETOP, in conjunction with the macro-environment analysis developed
in Module 4, at the end of this module.
5.6.1 Exploration
Exploration is a speculative and uncertain activity for which returns can be high, but
losses can be equally large. Exploration techniques range from basic to highly
technical; these two extremes can be broadly interpreted as homogeneous and
differentiated, thus providing the basis for segmenting the market. Companies
differentiate their services on the basis of the technology they use and the data
libraries they own. The market is dominated globally by a few large players, such as
Western Geco, CGG Veritas and Petroleum GeoService. Customers at this stage are
IOCs, NOCs, independent E&P companies and governments themselves.
Market structure
The market for highly technical exploration services can be broadly classified as an
oligopoly, owing to the high degree of differentiation and the small number of
major players.
The market is segmented between the large operators and the smaller independ-
ent operations, whose products and services tend to be more homogeneous. The
market for services such as exploratory drilling, for example, is likely to be charac-
terised by a higher degree of competition, because there are many relatively small
companies. Some segments display the characteristics of perfect competition.
These two activities in the exploration sector can be compared as in Table 5.6.
Table 5.6 Competitive characteristics in the exploration sector

Characteristic Hi-tech exploration Exploratory drilling
Number of competitors Few Many
Product Differentiated Homogeneous
Consumer knowledge Medium High
Entry barriers High Low
Consequently, competitive conditions vary significantly within the sector: to

describe a company as ‘exploration’ does not tell us a great deal about the market
structure within which it competes. Competition for exploration licences among
international and independent E&P companies tends to be based on price.
Perceived price and differentiation

The salient characteristic of the price and differentiation matrix is that it is based on
perceptions. The position in the price–differentiation matrix (Figure 5.11) for
successful oligopolistic competitors is somewhere in the high-differentiation and
high-price sector. But the volatile nature of the upstream sector affects these
perceptions; therefore the position of the company in the matrix is partly affected
by current conditions.
High
Perceived differentiation vs competitive brands
Success likely
Success highly uncertain
Failure likely
Low High
Perceived price vs competitive brands
Figure 5.11 Price–differentiation matrix

Exploration services that are highly technical in nature, involving proprietary
assets such as specialised marine vessels and software, are primarily competitive on
price differentiation, when oil prices are high and capacity in the exploration market
is fully utilised. This positions the company in the top-right sector of the matrix.
Conversely, when the oil price is low, or when the industry is going through a
phase of overcapacity, companies will be able to compete only on price. Indeed, in
times of low oil prices, some integrated companies have stopped exploration
activities altogether in favour of optimising production and cutting costs across
operations. This can be characterised as a shift down to the right in the matrix,
possibly from ‘success likely’ to ‘success uncertain’. This suggests that it is necessary
to be on the lookout for conditions under which competition will shift from
differentiation to price – and to be prepared to deal with those conditions.
Small competitors must be positioned in the low-price and low-differentiation
sector if they are to be successful. When market conditions deteriorate, they have
less room for manoeuvre than the large companies, because they cannot switch
from differentiation to low price and their margins will be significantly reduced.
Product life cycle

Exploration, as a generic activity, is greatly affected by the oil price in the short run.
This volatility makes it difficult to determine whether the underlying product life
cycle is in the growth, maturity or decline phase. The debate about peak oil suggests
that the industry is in late maturity, although this ignores the cyclical nature of the
upstream business. However, for individual products such as IT, seismic equipment,
vessels, and other products and services that require substantial technical input, the
product life cycle is likely to be short, because new products are continually intro-
duced. Figure 5.12 gives an example of how these hi-tech end-product life cycles
might look.
Market size
Time
Figure 5.12 Multiple product life cycles for hi-tech products

Just to keep up with the competition, it is apparent that companies in the explo-
ration services business need to keep a constant stream of new products coming to
market, which in turn requires substantial R&D expenditure. During times of rising
oil prices and capacity constraints, when competition is based on differentiation,
exploration will be a source of cash; in times of low prices and overcapacity,
exploration will run at a loss resulting from the proportionately large R&D expendi-
ture. This presents the company with a dilemma: if it does not continue to spend on
R&D in the downturn, then, because of the short life cycles, it may lag behind
competitors when the upturn arrives – but maintaining R&D spending may cause it
short-term cash-flow problems and losses.
Thus short product life cycles, together with the need to maintain differentiation,
are the drivers of R&D expenditures. The product life cycle rationale for high R&D
expenditures is that technical obsolescence is unpredictable and there is a constant
threat of being left behind. In Core SP Section 6.10.2, innovation was depicted as a
process and it was concluded that it is not only the management of each step in the
process, such as invention of new products, but also the transition from one step to
another, such as invention to prototype, that must be managed effectively. Effective
management of the internal R&D supply chain involves, among other things,
specifying criteria to determine when an invention moves from one stage to the
next.
Five Forces profile
The power of competitive forces has a significant impact on potential margins and
hence on profitability. An understanding of how the forces have evolved and are
likely to evolve provides insights into effective strategy development (see Table 5.7).
Table 5.7 Five Forces analysis for exploration

Force Exploration Conclusion
Threat of new Structural barriers
entrants Size of market: market is large enough to support several competi- Low, on
tors balance
Capital requirements: high for some items, such as large vessels, but
lower for activities such as data processing
Exit barriers: some high, owing to sunk costs of acquiring specialist
knowledge and purchasing specialist equipment such as exploration
vessels
Legislative barriers: affect all companies equally
Economies of scale: uncertain; difficult to determine unit costs
Experience effects: increasing shortage of skilled workers
Strategic barriers
Reputation: slow to acquire because of time taken to establish a Low, on
track record balance
Pricing: competition based on differentiation
Distribution channels: uncertain; majors already have them
Supplier power Suppliers are manufacturers of vessels and other seismic equipment High or low,
Given long construction lead time, likely to be a considerable depending on
backlog of orders when demand for exploration is high; hence external
suppliers will have a lot of bargaining power conditions
Many assets are essential for operations; hence increasing supplier
power
In times of low oil prices, supplier power declines
Force Exploration Conclusion

Buyer power Customers of exploration companies are either independent Low or high,
operators, NOCs or IOCs requiring specialised work depending on
Most important buyers are NOCs, which need specialists to external
continue producing; hence their bargaining power will be low conditions
However, if oil price is low and exploration is not in high demand,
then buyers will have high bargaining power
Threat of Threat of innovation leads to high R&D spending by the market High
substitutes leaders
Industry rivalry Oligopoly in volatile industry leads to low rivalry when demand is Low or high,
high and high rivalry when demand is low depending on
external
conditions
Having identified the current profile, the next step is to assess what is happening
to competitive conditions and how the profile is likely to change in the future.
Because of volatility, it is difficult to predict how competition is likely to develop in
the near future, because it emerges from the analysis that the profile is dependent on
prevailing external conditions. Table 5.8 relates to scenarios of high and low oil
prices, which reflect the two extremes of external conditions. The experience of
history is that the transition from high to low prices is abrupt.
Table 5.8 Five Forces summary for exploration

Force Oil price high Oil price low
Threat of new entrants Low Low
Supplier power High Low
Buyer power Low High
Threat of substitutes High High
Industry rivalry Low High
There is a clear need to adapt competitive behaviour when the oil price goes
from low to high. For example, when price is low, the focus is on buyers and the
behaviour of competitors; when price is high, the focus is on suppliers. A significant
change in the oil price thus leads to changes in competitive conditions and this
means that companies should adjust their behaviour accordingly. Given the volatility
of the oil price, however, competitive conditions are liable to change relatively
quickly, so oil companies need to be able to react quickly – and yet companies
typically react blindly to changes in the oil price without giving thought to the
implications for competitive behaviour, so by the time they realise that conditions
have changed, it is a case of playing catch-up with competitors. A typical reaction
during times of high price is that companies start taking their customers for granted,
because buyer power has fallen. When the inevitable fall in oil price arrives, buyer
power increases, and companies that have made the mistake of taking their custom-
ers for granted will pay the price.
Competitive profile
A broad summary of competition and strategic concerns for the exploration sector
is derived in Table 5.9. By constructing a summary for each stage of the supply
chain, it is possible to build up a picture of the different competitive environments
and strategic concerns.
Table 5.9 Exploration sector competitive profile

Model Variable Competition Strategic concern
Market structure Hi-tech Oligopoly Competitive action
Services Perfect competition Efficiency
Price and differentiation High oil price Differentiation R&D
Low oil price Price Cost control
Product life cycle Hi-tech Short R&D
Services Variable Customer relations
Five Forces High oil price Supplier Supply chain
Low oil price Buyers; rivalry Competitive action
This illustrates the competitive environment depending on the level of technolo-

gy and the oil price. A common reaction to a table like this is, ‘That was a lot of so-
called analysis to arrive at what we already know.’ The fact is that decision-makers
do know about these things in their own industry, but rarely approach them in a
structured, proactive way. A typical response when the oil price falls is to cut costs
across the board, for example, and this usually means acting on the easy targets,
such as travel budgets, and cutting back on what is perceived as non-essential
expenditure, such as management development. A proper understanding of the
change in competitive conditions makes it possible to address the problem of
protecting both cash flow and competitive advantage.
5.6.2 Development
The development stage is concerned with bringing a new field into production.
After the field is deemed to be viable, the reservoir characteristics have been
assessed and exploratory drilling undertaken, development needs to take place. The
drilling phase involves the use of specialist drilling services, drill bits, drilling fluids
and monitoring systems, all of which are provided by service companies, or done in-
house in the case of larger integrated companies. After drilling comes completion,
which involves preparing the well for the production phase using various specialist
techniques and tools, depending on the requirements of the individual well.
In this market segment, there are many dedicated service companies, while some
large integrated companies perform their own development activities. Some service
companies perform the whole range of development activities right up to the start
of production, whereas other, smaller companies specialise in only one of the
activities, for example casing or centralisers.
Market structure
Integrated companies buy in services when there are difficult conditions to deal with
or when highly technical input is required. There are many specialist operators in the
global development market, while a small number of large players dominate the hi-
tech, full-service end of the market. There is also a growth market for the full
spectrum of development work for NOCs, which are increasingly utilising specialist
companies to provide the full range of development inputs.
In some areas, such as North America, there are many companies that operate
only in localised areas. Competition in these small local markets is likely to approxi-
mate to imperfect competition, whereby there is a small degree of differentiation
between companies’ offerings and therefore the companies have some degree of
control over what price they charge. These companies will most likely operate on a
contract basis with small independent production companies. This is how develop-
ment and drilling for shale gas tends to operate in the US.
The large global companies tend to compete on quality when tendering to NOCs.
Aggressive price reduction may lead to an oligopolistic price war. Small, specialist
operators will tend to compete on the basis of price. As in exploration, large and
small companies are located in different sectors of the price–differentiation matrix:
the large companies aim for high differentiation and high price, while the small
companies aim for a price low enough to position them in the ‘success likely’ sector
of the matrix.
Product life cycle
Product life cycles for technologically advanced equipment and systems are short,
similarly to those of exploration equipment, because new products are quickly
adopted. The fact that product life cycles are short in both the exploration and
development stages means that companies that operate in both are in a constant
state of change as they adapt to new techniques and processes.
The fact that NOCs are increasingly using service companies and appear less
keen to work with IOCs suggests that production is in the growth stage. This has
strategic implications for building capacity ahead of demand, ensuring that pricing is
competitive and allocating resources to marketing. These activities have an impact
on margins; therefore it is likely that production will be less profitable than explora-
tion, which was argued to be in the late maturity stage.
In a service industry, it is difficult to build capacity ahead of demand, because the
development of the appropriate skills is partly done on the job. There are two main
ways of tackling the capacity problem, as follows.
 Buy in skills as they are required. The problem with this solution is that highly
trained manpower is scarce and other companies will be competing for them.
This will lead to significant increases in wage rates, coupled with the develop-
ment of a ‘poaching’ culture in the labour market. It will become difficult to
retain personnel, resulting in high turnover rates.
 Invest in structured training programmes. While investment in training and development

is attractive in principle, because it gives the company control over its supply of
skills, it is not widely appreciated that the design, planning and implementation of
any training programme is time-consuming and expensive, nor that it may not
deliver the desired results. There is also the concern that personnel who have been
trained will subsequently be ‘poached’ by competitors. Thus it is not only the train-
ing programme that is important, but also the subsequent management of career
expectations.
There are many issues involved in human resource development (HRD) and
knowledge management that must be tackled to grow successfully in a service
market requiring high levels of education and expertise. Standard procurement
policies are unlikely to fulfil the needs of the organisation.
Five Forces profile

The interpretation of the Five Forces in Table 5.10 is not definitive, but it demon-
strates that competition in the exploration and development stages may differ
significantly.
Table 5.10 Five Forces analysis for development

Force Development Conclusion
entrants Size of market: plenty of scope for new entrants in a growing Low global;
market high local
Capital requirements are high on a global scale, but not at a small
local level
Exit barriers: sunk costs are high at the global level
Legislative barriers: affect all companies equally
Economies of scale: none at local level
Experience effects: increasing shortage of skilled workers
Strategic barriers
Reputation: slow to acquire Low global;
Pricing: competition based on differentiation high local
Distribution channels: uncertain; majors already have them
Supplier power Many suppliers; hence no reason why they should have particular Low
leverage
Buyer power NOCs lack expertise of development companies to develop their Low
wells profitably, so their power is probably low
Threat of Innovation leads to new products High
substitutes
Industry rivalry Oligopoly in a volatile industry; when oil price is high and NOC Low or high,
demand is high, there will be little rivalry and vice versa depending on
external
factors
The profile can be constructed using various criteria, such as ‘large versus small’
companies or ‘hi-tech versus low-tech’. Table 5.11 shows the potential profiles for
periods of low and high oil price, to capture how the forces are likely to change with
economic conditions.
Table 5.11 Five Forces summary for development

Threat of new entrants Low global Low global
High local High local
Supplier power Low Low
Buyer power Low Low
Threat of substitutes High High
Industry rivalry Low High
It emerges that the development stage is characterised by low forces for global
companies when the oil price is high – except for the need to invest, because of the
emergence of substitutes as a result of technological progress. When the oil price
falls, then the actions of competitors should become the focus. Local companies are
always subject to the threat of new entrants and, because of this, it is to be expected
that their margins will be lower than for global companies.
This interpretation of the Five Forces leads to a different profile compared with
that at the exploration stage. This has clear implications for a company operating in
both sectors: the focus needs to be on different competitive issues and the same
reaction to changing external factors may be inappropriate.
Competitive profile
A snapshot of the competitive environment, as in Table 5.12, enables managers to
compare their preoccupations with the areas of strategic concern that emerge from
market analyses. Vertically integrated companies need to assess whether they are
distinguishing adequately between the two markets.
Table 5.12 Development sector competitive profile

Market structure Global Oligopoly Differentiation
Local Imperfect competition Price
Price and differentiation Global Differentiation R&D
Local Price Efficiency
Product life cycle Short R&D
Five Forces High oil price Substitutes R&D
Low oil price Substitutes, rivalry Competitive action, R&D
5.6.3 Production
The production stage differs from the exploration and development stages in that
the output is sold directly on the market; exploration and development are under-
taken in the expectation of future returns. The production stage is more immediately
affected by changing economic conditions, because the objective is to extract as
much oil as possible economically – that is, up to the point at which the marginal
cost of extraction is equal to the price – and therefore changes in the oil price mean
that the quantity of oil that is economically recoverable from a given well is variable.
In economic terms, the rational producer will keep producing until the marginal
revenue from the last barrel produced is equal to the marginal cost of producing it.
In times of high oil prices, the company’s marginal revenue will increase, thus
increasing the demand for recovery systems and production management services.
In times of lower oil prices, the marginal revenue from each barrel produced is
much lower, causing production companies to employ fewer services and recovery
products.
Another source of variability in oil yields is technological progress, which is less
related to changes in economic conditions. Although R&D spending is affected by
the business cycle, there is not a close connection between current R&D spending
and innovation, so its impact is unpredictable.
Market structure
Most large integrated companies carry out their own production activities, either on
their own or as part of a jointly operated field, but there is a market for management
services aimed primarily at NOCs and independent producers. Also, as more wells
mature, there is an enhanced need for secondary and tertiary recovery techniques.
The market analysed here is that for management services and specialist recovery
techniques. The integrated companies that carry out their own production are
participants in the market to the extent that they have made an explicit buy-or-make
decision, but in practice it is unlikely that they will enter or exit the market in the
short term.
The market for management services is dominated by a few global players, ap-
proximating to oligopoly. The market for recovery techniques, rig workovers and
monitoring systems comprises both large and small operators, and is characterised
by concentrations of localised operators, for example in Aberdeen in the UK. This
market is closer to perfect competition than the management services market.

Companies providing project management for production compete largely on the
quality of the service. They need to build a reputation for good working practices,
including completing projects on time and on cost, and to the desired standard.
Many global service companies are vertically integrated to the extent that they cover
all upstream stages, so they may benefit from their overall reputation, which adds to
their perceived differentiation. It takes a long time to establish the track record and
reputation that gets a company into the ‘success likely’ sector of the price–
differentiation matrix, however, and that is why companies jealously protect their
reputations.
In the market for enhanced recovery systems, if a company is to maintain its
position as ‘success likely’, it needs continually to develop its products, because it is
quite common for innovations to be quickly superseded. It is also constrained in its
pricing, because of the number of competitors.
Product life cycle

The product life cycles for techniques such as enhanced recovery systems are very
short, owing to continuous innovation.
Project management for production is a growth market, with NOCs increasingly
turning to service companies so that they can operate their own fields without
involving IOCs, who are increasingly being forced out of the more resource-
nationalistic countries. Because OPEC members produce a significant proportion of
the world’s oil and gas, and it is these countries that tend to be more reluctant to let
the IOCs in, the market for management services looks set to grow further in the
coming years.
As in the development sector, being in the growth stage of the market life cycle has
important implications for strategy: in general terms, the company should be building
capacity ahead of demand to ensure that market share does not fall; if possible, it
should look to increase market share, with the objective of creating a cash cow when
market growth ceases.
Five Forces profile

The production stage is directly affected by the oil price, and the balance of the Five
Forces is thus even more sensitive to oil price changes than during the exploration
and development stages. The Forces identified in Table 5.13 are for companies
providing specialist services, rather than the production divisions of integrated
companies that operate in an internal market.
Table 5.13 Five Forces analysis for production

Force Production Conclusion
entrants Size of market: currently in growth stage Low
Capital requirements: high for recovery systems and monitoring
Sunk costs: high
Economies of scale: uncertain
Experience effects: important in management consultancy
Strategic barriers
Reputation: difficult to generate Low
Pricing: differentiated services
Distribution channels: difficult to develop
Supplier power Many companies supply raw materials and project management Low
software
Force Production Conclusion

Buyer Buyers are companies that require equipment or services High or low,
power When the oil price is low (excess supply), buyers’ bargaining power depending on
is high; when the oil price increases (excess demand), buyer power oil price
is reduced
Threat of Companies may embark on DIY project management when oil price Low or high,
substitutes is high depending on
Technological progress is continual in recovery systems oil price
Industry Rivalry in equipment market is high when oil price is low, but Low or high,
rivalry becomes less intense as oil price rises and market expands depending on
external
factors
Project management services are growing long term, but with Low or high,
short-term fluctuations caused by oil-price changes depending on
oil price
As in the previous parts of the chain, the balance of competitive forces varies
with the oil price (Table 5.14). When the price is high, the main threat is of substi-
tutes, but this typically takes some time to become apparent. When the oil price is
low, the threats come from buyer power and rivalry, both of which tend to drive
down margins. Moreover, in times of low oil prices, not only is profitability reduced
by a reduction in demand for services, but also this is exacerbated by the change in
competitive conditions.
Table 5.14 Five Forces summary for production

Threat of new entrants Low global Low
High local
Supplier power Low Low
Buyer power Low High
Threat of substitutes Low Low
Industry rivalry High High
Competitive profile
There are some differences in the competitive profiles of management services and
recovery services, and both profiles are liable to change with the oil price (Table
5.15).
Table 5.15 Production sector competitive profile

Market structure Services Oligopoly Competitive, reaction
Recovery Perfect competition Cost control, innovation
Price and differentiation Services Differentiation Reputation
Recovery Price and differentiation Efficiency
Fast reaction
Product life cycle Services Long-term growth Building skill sets
Recovery Long-term growth Technological change
Five Forces Services Changeable Anticipate oil price
Recovery Changeable Fast reaction
Are these differences significant enough to make a difference to strategic action in a

company that does both? That is a matter of judgement, but it is sensible to be
aware of the implications of the differences in market structure, positioning in the
price–differentiation matrix, impact of the product life cycle and competitive forces.
The same actions are unlikely to be equally effective in both.
5.6.4 Unconventionals
Unconventionals have been treated separately as part of the supply chain model
because of their sometimes peculiar characteristics. It is not possible to develop a
competitive profile here for unconventional resources because of their diversity, but
it is worth considering some of the resource types and their technical characteristics.
 Tar sands in Canada and heavy oil in places like Venezuela are often strip-mined
rather than drilled for. These resources are extremely viscous and have to be
processed in order to turn them into usable crude.
 Shale oil and shale gas require development work, but this is likely to be com-
bined with production because of the short life cycle of a given resource. There
is less of a market for services with shale, because companies want to drill, pro-
duce and recoup their costs quickly.
 Other resources, such as tight gas and coal bed methane, behave differently and
are subject to environmental legislation in different parts of the world, resulting
in different market environments and different competitive profiles.
Unconventional resources have become more popular and more common in the
past 15 years because of the increasing difficulty of finding conventional resources,
and because of the period of increased oil prices, allowing higher production costs
up to 2008 and from 2011 to 2014. Readers who operate with unconventionals will
find it a useful exercise to consider how their company and the markets in which it
operates fit with the three competitive profiles presented in Sections 5.6.1, 5.6.2 and
5.6.3.
5.6.5 Conclusion
The recurring theme in the upstream industry is the high influence that the oil price
has on the competitive landscape. On the one hand, when oil prices are high, the
market grows for exploration, development and production in money terms, and in
terms of marginal fields being brought online. Rivalry among competitors is low,
because there is plenty of work available for all companies. Products and services
are highly differentiated, and customers will look for a good-quality service.
On the other hand, when the oil price is low, companies are loath to invest their
capital in new exploration or development projects, because of the lack of potential
returns. Also, competition changes, becomes more intense and is concerned with
price rather than quality. Those customers who are investing in development and
production wish to get the work done for the lowest possible price.
While there is no doubt that the oil price tends to be the dominant variable,
focusing only on the oil price can lead to ignoring a whole set of underlying
competitive factors that impact on the achievement of competitive advantage. The
impact of changing oil prices is felt partly because it alters the balance of competi-
tive factors and it is crucial to understand how these can affect sustainable
competitive advantage.
It is impossible to summarise the analysis in a single dimension, but Table 5.16
illustrates some of the different strategic concerns identified for each stage, depend-
ing on the variables used.
Table 5.16 Strategic models and concerns

Model Exploration Development Production
Market structure Competitive action Differentiation Competitive, reaction
Efficiency Price Cost control
Price and differentiation R&D R&D Reputation
Efficiency
Fast reaction
Product life cycle R&D R&D Building skill sets
Technological change
Five Forces Supply chain Competitive action Anticipate oil price
Competitive action R&D Fast reaction
Imagine if you were to be asked to ‘prepare a report on the current strategic

concerns in the upstream industry, taking into account market structures, product
positioning, stage of the life cycle and balance of competitive forces’. You would
now know where to begin.
5.7 Crude Oil Trading Market Analysis

Trading is the stage in the supply chain at which the price of crude oil is determined,
with all of its implications for both upstream and downstream activities. It is here
that changes in demand and supply conditions result in changes in price. But it is
also here that volatility occurs, including overshooting and undershooting, which
seems to far exceed any changes in demand and supply conditions. To what extent
is this volatility the result of the behaviour of traders?
The trading market has characteristics of perfect competition: freely available
information; many participants; few barriers to entry; and no economies of scale.
This suggests that the returns to oil trading are independent of the price of oil – that
is, that, during times of high prices, traders’ margins do not increase significantly.
There may be an increase in the volume of trades, which leads to higher returns, but
that is a different thing.
The oil exchanges constitute a relatively efficient market-clearing device, similar
to the stock market, to which the efficient markets hypothesis applies to a certain
extent. It is thus likely that the similarities with the stock market explain volatility
rather than the unique characteristics of the oil exchanges. The fact of operating in a
near-perfect market suggests that traders are simply the mechanism by which oil is
exchanged and that volatility is the result of market forces.
It is sometimes claimed that cartels such as OPEC, which currently controls
around 45% of the world’s oil output, control the oil price. The problem with this
assessment, however, is twofold: first, prices are determined by both supply and
demand, and OPEC is able to influence only one of these variables; and second,
OPEC’s limited control over its members, and lack of influence over non-members,
constrains its influence.
There is no doubt that the actions of OPEC resulted in large price increases in
the 1970s, but there is a difference between a supply-side adjustment, which leads to
a higher price than before, and volatility. As discussed in Section 4.3, the increase in
the real oil price was temporary, because the market adjusted on both the demand
and supply sides. OPEC had little to do with the oil price increase and subsequent
fall in 2008; in fact, OPEC attempts to control the supply of oil to keep the oil price
within a target range. It could be argued that OPEC tends to dampen, rather than
exacerbate, volatility. The fall in the oil price in the second half of 2014, while in
part owing to OPEC action, was also the result of increasing levels of supply from
the US, combined with a reduction in global demand for energy.
The reason for relatively large changes in the oil price in the short term is ex-
plained in Figure 5.5, which shows the impact of the combination of inelastic
demand and supply curves: relatively small shifts in either lead to relatively large
changes in price. This was further developed in Figure 5.8 to show the impact of
long-run adjustments to both demand and supply: the cobweb process can lead to
an endless process of adjustment. But this does not explain short-term volatility,
because changes in demand and supply do not happen instantaneously. Demand
increases because of industrialisation and increased incomes, while supply increases
because of the discovery of new oil fields and of more efficient extraction tech-
niques. Neither of these occurs overnight.
The short-term explanation is contained in Figure 5.6 and Figure 5.7, which show
the impact of changes in expectations. The rational reaction of both buyers and
sellers to expected price changes results in a self-fulfilling prophecy, and ultimately
leads to overshooting and undershooting, as discussed in Section 5.3.3. It is the

reaction of traders to changes in expectations that causes volatility, and not sudden
and dramatic changes in underlying demand and supply conditions. It needs to be
stressed that it is rational behaviour in response to changes in expectations, rather
than a ‘frenzy’, which results in volatility; the expectations themselves may be
irrational, but that is another matter. It then becomes a matter of determining
whether predictions of changes in expectations are possible; the outcomes of
changes in expectations are more or less inevitable, as discussed above.
5.7.1 What Affects Expectations?

Strategic models help to provide some insight into how expectations are formed,
thus enabling a logical response to changes in market conditions that are often
obscured by oil price volatility. The point to bear in mind in the following discus-
sion is that strategic models are being used to explain not market conditions, but
traders’ perceptions of market conditions and hence their expectations.
The most obvious reason for changes in expectations is a change in demand
conditions. In the years leading up to 2008, for example, concern was voiced at the
rapid growth rates of India and China; in 2008, this suddenly loomed large in public
awareness. But the fact was that there was no new information in 2008, so the
abrupt doubling of the oil price was initially the result of a misinterpretation of
information on the demand side. It could be argued that a similar misinterpretation
happened on the supply side in late 2014, when the oil price ended up undershoot-
ing its equilibrium level when it was getting close to $40 per barrel. Why should
traders ignore or misinterpret changes in demand conditions? This probably relates
to the way in which traders operate: they are so busy making deals that they mostly
react to what is happening, rather than actively acquire information.
The product life cycle would at first appear to have little to do with immediate
expectations. The issue of peak oil was discussed in Section 4.4, where it became
evident that the information available on peak oil is very poor. There is always the
possibility that a ‘definitive’ answer on peak oil from a well-respected source will
suddenly gain common currency: if it were to be ‘discovered’ that peak oil is long
past and that we are actually in the decline stage, for example, there would be an
immediate change in expectations, with the predictable consequence – that is, a
sharp rise and overshooting, with the high likelihood of a subsequent fall. At the
same time, the increasing technical viability of unconventionals and the opaque
nature of hydrocarbon reserves reporting, in combination with increased investment
in better exploration, development and production technology encouraged by
periods of higher prices followed by lower prices, means that peak production may
not arrive for many years to come.
A change in the backstop price of oil, as discussed in Section 4.3.3, might have an
effect on expectations. A technological advance in renewables might bring the
backstop date closer, which, referring to Figure 4.4, would in principle have an
immediate impact on the current price. The fact that backstop prices have a high
degree of uncertainty and that the impact is likely to be well within the normal
variation in prices is not the point: if enough traders believe that the latest news
about renewables implies a lower price, then it may be sufficient to trigger an

expectation-led cycle.
Another factor to consider is the relative importance, volatility and interest in the
oil price globally. Because oil is relatively volatile, it is interesting for commodities
columnists to write about it in financial papers, and because it provides important
inputs into almost every industry in the world, it is seen as an important indicator of
economic activity. One must remember, when reading reports about the oil price in
the press, that the primary goal of the writer is to sell an interesting story, and not to
provide a detached assessment of conditions and future expectations. Thus sensa-
tionalist reporting can influence expectations and may result in increased volatility or
a higher propensity for the oil price to overshoot or undershoot than less ‘interest-
ing’ commodities such as soya beans.
Changes in the industry Five Forces can have significant effects on expectations,
depending on how the market is perceived. Table 5.17 and Table 5.18 are two
extreme profiles in which changes in the forces resulting from ‘breaking news’ have
either a positive or a negative impact on expectations.
Table 5.17 Five Forces: Everything is getting worse

Force Breaking news Impact on price
expectation
Threat of new entrants New fields discovered Negative
Supplier power OPEC disintegrates Negative
Buyer power World recession Negative
Threat of substitutes Electric cars Negative
Industry rivalry Anti-trust laws break up majors Negative
Table 5.18 Five Forces: Everything is getting better

Force Breaking news Impact on price
expectation
Threat of new entrants Peak oil has passed Positive
Supplier power Russia joins OPEC Positive
Buyer power Energy awareness increases Positive
Threat of substitutes Environmentalists oppose wind Positive
farms, etc.
Industry rivalry BP and Exxon form alliance Positive
In each case, the ‘breaking news’ points in the same direction, leading to either
positive or negative expectations. But real life is never so simple, and it is more
likely that ‘breaking news’ will be a combination of both negative and positive items.
What would be the likely net impact of a particular combination of ‘breaking news’
items? There is no way of telling until the balance of expectations starts to impact
on the price.
5.7.2 Market Dynamics

Because of the nature of trading, changes in prices are important, rather than
absolute, values. This has implications for the balance of competitive forces
between buyers and sellers (see Table 5.19): when prices are increasing, bargaining
power lies with sellers; when they are decreasing, bargaining power lies with buyers.
This obvious fact has implications for margins: in a rising market, sellers benefit,
and vice versa. This means that returns do not necessarily accrue to the most
efficient, but depend on market dynamics. There is very little that can be done to
alleviate the impact, because in a rising market, the buyer who delays ends up paying
a higher price, while in a falling market, the seller who delays will end up receiving a
lower price. It might appear unfair that the returns are distributed randomly as the
outcome of mistaken expectations, but it is important to recognise that this is the
way the market operates. Otherwise, there is a danger of being misled by the illusion
of control when things are going well, which can have serious consequences,
because actions that are mistakenly considered to be causes of success may, in fact,
be misguided.
Table 5.19 Crude oil trading sector competitive profile

Market structure Fast information flows Perfect Trading at best price
Price and differentiation Crude oil grade Differentiation Benchmark pricing
Price and differentiation
Product life cycle Backstop pricing Expectations Rapid response
Five Forces Direction of price Expectations Balance of buyer and
changes seller power
In the hectic environment of oil trading, ‘things happen’ and traders react, so
does an analysis of competitive influence really help? Some understanding of the
underlying influences can help rational decision making in relation to whether to
accept or reject deals and when is the best time to act. An understanding of what
has caused a change in expectations and whether it has led to undershoot, for
example, would lead to a different response than if the decision-maker were simply
blindly following the market because it was falling.
At this point, the module continues along the oil supply chain, analysing the
stages contained in the ‘downstream oil’ sector. The analysis then resumes with gas
processing and trading, before moving on to the ‘downstream gas’ sector.
5.8 Downstream Oil Market Analysis

There is a clear distinction between upstream and downstream activities in the
minds of industry participants: broadly speaking, ‘upstream’ refers to oil extracted
from the ground, while ‘downstream’ involves products made from oil and sold to
end consumers. Is the distinction merely a convenient way of describing the
industry or does it have some operational significance? When questioned, oil
industry executives typically say that the production processes are different, as are
the skill sets. But this is not a convincing argument, because the three main stages of
upstream activities – exploration, development and production – also require
different skill sets. It could be argued that the manager of an offshore production rig
has skill sets more in common with the manager of an oil refinery than an explora-
tion scientist. When questioned further about specific differences in the upstream
and downstream markets, some references will typically be made to differences
between trading oil and selling oil products, and the higher uncertainty upstream.
This is unsatisfactory to the strategist, who needs to examine the downstream
stages using the battery of strategic models applied to the upstream industry, before
arriving at conclusions regarding the differences, or similarities, in the markets. Why
does it matter? The answer is that similarities and differences in upstream and
downstream markets help to make sense of the logic of vertically integrated compa-
nies that straddle the entire supply chain, and of whether it might be more profitable
in the long run to focus on specific parts of the chain.
The following observations suggest that there is a lot to explain in terms of the
difference between upstream and downstream markets. In the US state of California
in April 2008, when the oil price was over $100 per barrel, the average cost of a
gallon of gasoline before federal, state and sales tax was $3.24. Of this, $2.83 was the
cost of the crude oil input, which covered upstream costs and margins. This left
$0.41 per gallon to cover the costs and profits of all the activities in the downstream
sector. In January 1999, when the oil price averaged about $16 per barrel and
actually hit a low of $8 per barrel, the pre-tax price of a gallon of gasoline was $0.88.
The crude oil input cost at that time was $0.51, leaving $0.37 available to cover
downstream margins and costs.
The crude input cost had increased by about six times between 1999 and 2008,
roughly in line with the increase in the price of a barrel. But the downstream margin
was virtually unchanged in monetary terms, which implies a significant reduction in
real terms after nine years of inflation is taken into account. The upstream costs did
not increase by six times during the nine years, so the implication is that upstream
margins had greatly increased, while downstream margins had declined. The obvious
question that needs answering is: why did downstream activities not share in the
bonanza of the high oil price?
5.8.1 Transportation
The following discussion refers solely to the transportation of crude oil from field
or terminal to refinery – that is, the first stage in the downstream sector. Tankers
and pipelines are also used in the transportation of refined products, but this is
subsumed into the later stages; the final distribution of finished products can be
viewed as part of the marketing activity, while the intermediate transport of finished
products operates in the same manner as the crude transport stage. Transport
involves the use of pipelines or tankers to get the crude oil to the refinery, which
tends to be geographically close to the end consumers. Pipelines tend to be used for
intra-continental transport, while tankers are used to transport oil across oceans.
The tanker market is highly competitive, with around 75% of tankers being operated
independently by companies that charter out their vessels to companies wishing to
transport oil. Large companies such as Exxon also have interests in tankers, but
these are part of their supply chain and are not chartered out. As of 2015, Iranian
company NITC owns the largest fleet of supertankers, with 42 very large crude
carriers (VLCCs) – that is, vessels with capacity in excess of 2 million barrels.
Pipelines move most oil from the well to a refinery or to a tanker for long-haul
transport. According to the US Economic Census, in 2012 there were 64 pipeline
operators in the US alone (US Census Bureau, 2012); a large number of suppliers is
a feature of a highly competitive industry.

Product quality in the transportation stage depends on speed and reliability. New
tankers may have some speed advantage, but the difference is marginal, because the
charter rate is determined by demand and supply in the tanker market rather than by
operating cost. The following is extracted from a typical report on the tanker
business:
With about $100 million of crude oil in its hold, the tanker Front Page will
leave Kuwait in a few weeks, heading for Louisiana via the Suez Canal. When it
arrives 30 days later, its two million barrels will feed refineries throughout the
[American] Midwest with crude they will turn into heating oil for the winter.
The trip will be an expensive one. ExxonMobil is paying Frontline, the ship’s
Norwegian owner, $6.95 million to make the journey. Last year, the shipping
company charged $2.4 million for a similar haul.
With global oil demand surging and prices hitting record levels, the world’s
1,500 oil tankers are all booked up, and their owners are charging hefty premi-
ums. The shortage of tankers is one sign of how strong demand and a lack of
investment have left the oil industry’s infrastructure stretched thin…
(Mouawad, 2004)
Charterers are price-takers and thus have no control over the cost of transport. All
tankers have to meet strict maritime operational standards, so differences in
reliability are also likely to be marginal.
It is worth noting that there are different types of charter, with different prices.
The three main types of charter are as follows.
 Bareboat charter. The tanker is chartered for a fixed period of time, during which
the customer is responsible for all operating costs and also for arranging a crew.
The vessel is the only thing that is chartered.
 Time charter. The vessel owner is paid a per-day rate, and is responsible for
manning the vessel and for all operating costs.
 Voyage charter. The vessel owner is paid according to the amount of cargo being
transported, and assumes responsibility for operating costs and crew.
The attractiveness of the three types of charter to individual companies will depend
on the circumstances, for example a time charter may be preferable to a bareboat
charter for a company that has cash-flow problems. Given the competitive nature of
the charter market, however, the costs to the owners of providing the different
types of charter will be reflected in the price; therefore chartered vessels can be
regarded as homogeneous.
Pipelines are differentiated by their location only and are cheaper to operate than
tankers. If there is a crude pipeline between the field and the refinery – for example
the Forties pipeline in the North Sea, which leads to the Grangemouth refinery on
the east coast of Scotland, or the Keystone pipeline in North America, which leads
from Canada across the US to refineries in Texas and Illinois – it will be used in
preference to tankers. If there is no pipeline available, then a tanker will be used.
The two modes of transport are therefore not in competition with each other.
Market structure
Mouawad (2004) suggests that there was a high degree of price volatility. This is
generally true still, owing primarily to the inelastic supply curve, as shown in Figure
5.5, and the cobweb model in Figure 5.8. In fact, the shipping business as a whole is
characterised by proportionately large changes in both vessel prices and charter rates
from year to year. As a result, tanker owners make relatively high profits during
times when demand exceeds supply, but these will be eroded as capacity catches up
with demand. When demand falls, tanker owners make losses as charter rates fall
below average cost. This raises the question of whether the tanker fleet makes
monopoly profit – that is, achieves a higher rate of profit than the other stages in
the downstream chain.
Five Forces profile

The Five Forces model helps to reveal whether monopoly profits are made in this
stage (Table 5.20).
Table 5.20 Five Forces analysis for transportation

Force Transportation Conclusion
entrants Tankers: capital requirements are relatively high; sunk costs are low, Medium
because assets can be sold off and have a long life; there is a con-
struction lag
Pipelines: main barrier is finding a place where a pipeline is needed,
then obtaining a licence for the pipeline
Capital requirements are not a barrier for large companies with
access to debt finance
Strategic barriers
Companies compete; reputation is unlikely to deter new entrants Medium
Supplier Suppliers are shipbuilders and pipeline manufacturers; while tankers Low
power take years to construct, they are manufactured all over the world by
many companies
Buyer Many tanker companies; choice can be constrained when demand is Low or high
power high
Pipelines have a local monopoly
Threat of No other feasible method of transporting oil Low
substitutes
Industry Depends on demand conditions Low or high
rivalry
The tanker profile that emerges is of low competitive forces when demand is
high – caused primarily by the inelastic short-run supply curve – and highly compet-
itive when there is excess capacity. As a result, the windfall gains that accrue during
times of excess demand are likely to be lost when supply and demand are in balance.
Competitive profile
The competitive profile (Table 5.21) is the first step in explaining the lower margins
in the downstream stage. The lack of differentiation and ease of entry in principle
bid away monopoly profit. Combine this with the volatility caused by short-term
supply inelasticity and the capacity adjustment lag, and a troublesome competitive
environment emerges: the tendency to earn the opportunity cost of capital in a
volatile market.
Table 5.21 Transportation sector competitive profile

Market structure Cobweb Lagged response Capacity utilisation
Price and differentiation Speed Price Price volatility
Five Forces Low oil price Intense Cash flow
Low Maximise earnings
5.8.2 Refining and Petrochemicals

Refining turns the raw input, crude oil, into products for end consumers or for
industries further down the chain, such as the petrochemical industry. Characterised
by complex processes and numerous end products, refining takes crude oil as the
input and separates it into component hydrocarbons, which are then shipped on
through the supply chain. Refineries are typically large-scale operations covering a
large area, with interrelated plants nearby. Refineries are geographically dispersed.
For example, in Spain there are 10 refineries: four operated by Repsol; three by
CEPSA; one by BP; and two by specialist refining companies. In Malaysia, there are
seven refineries, operated by Petronas, Shell and two independent companies. In the
Republic of Ireland, there is one refinery, which is operated by Conoco-Phillips.
Refineries vary according to the processes they can handle. The simplest refining
operations perform fractional distillation and separate crude oil into some of its
different components, but there will be a lot of waste (known as ‘residuum’) left
over. This waste can then be put through more complex refining processes to be
turned into more high-value products. The grade of crude oil input has implications
for production cost, because different grades require different production methods.
Heavier, sour grades require more processing in order to yield high-value products,
whereas lighter grades require less. These cost differences are compensated for by
the discounts for more difficult grades from the benchmark price. Consequently, the
economics of different refineries are broadly similar. A generally accepted measure
of refinery complexity is the Nelson complexity index, which measures a refinery’s
secondary processing capacity compared with primary distillation of crude oil, based
on the cost and complexity of the processing technique. The primary distillation
process has a complexity factor of 1.0. The US has the highest average Nelson
rating at 9.5, while Europe has an average rating of 6.5.
Product life cycle

Refining product life cycles are long, the industry being characterised by industrial
processes and continuously operating assets, which are replaced and maintained
over many years. There is always scope for innovative new processes that will yield
more high-value hydrocarbons from a barrel of oil, but once these new processes
are installed, they remain in place for a long time. An example of process innovation
in the industry is the capability developed for processing oil sands into synthetic
crude oil, which can then be refined into petroleum products.
The US Energy Information Administration (EIA) recorded 136 operational
refining facilities across the US (EIA, undated). The 2012 US Economic Census
recorded refining industry employment at 62 540 workers that year, with inputs
valued at around $168 billion and output valued at around $195 billion (US Census
Bureau, 2012). Also, a total of $7.5 billion was invested in capital assets for the
industry that year: a relatively small amount of investment compared with the
upstream industry, in which the amount invested in capital assets in the same year
was $24 billion (US Census Bureau, 2012).
Some of the output from refining is then taken to petrochemicals processing
plants, which are often situated next to or near refining operations. Petrochemicals
provide inputs into many manufacturing processes and various types of plastic are
produced for use in manufacturing products, from cars to laptops to syringes for
medical use. In the US, petrochemical feedstock output from refineries represents
around 3% of total output (EPA, 1995). Figure 5.13 shows a breakdown of refinery
output by type for the US petroleum refining industry. Other countries will vary
according to the type of refineries and the grades of crude used as input, but the US
data, given the large number of refineries and volume of throughput provides an
indicative breakdown.
US
refining industry
Petrochemical
Fuel products Coke Non-fuel products
feedstocks
87.5% 4% 5.2%
3.3%
Gasoline
43% Naptha
Ethane
Propane
Asphalt
Diesel, heating Butane
Road oil
oil Ethylene
Lubricants
20.2% Propylene
Waxes
Butylene
Miscellaneous
Benzene
Jet fuels
10% etc.
Residual fuel oil

6%
Refinery fuel
4%
LPG
4%
Kerosene
0.3%
Figure 5.13 The US petroleum refining industry

Source: Based on EPA (1995)
Market structure
While refineries tend to be reasonably close to the end consumer market and serve a
specific geographical area, they are unable to act as local monopolists, despite the
fact that they may also own local retail outlets. Consider the case of fuel for cars and
commercial vehicles (petrol or diesel): the product is homogeneous, because any
difference in performance among brands is impossible for the average motorist to
detect. Loyalty schemes are intended to tie customers to a particular brand, but
these give the company little discretion over pricing. In addition, the refinery’s retail
filling stations do not have a monopoly in the sense that they own all filling stations
in a particular area. Finally, information on prices is freely available to consumers:
you need only to drive along the road and see the signs. Thus, at the point of sale,
the market has perfect characteristics: homogeneous product; many competitors;
and available information leading to intense competition among filling stations. The
only cost advantage the local refinery has is the additional cost of transport from a
more distant refinery. This is a very low proportion of total cost, so the local
refinery is not insulated against competition by transport cost.
Every motorist notices that, as densely populated areas are left behind, pump
prices increase. It is an apocryphal story that the most expensive litre of fuel in the
UK is to be found in the filling station outside the giant oil terminal at Sullom Voe,
in the Shetland Islands, where North Sea oil is piped ashore. These higher prices are
partly the result of transport costs over longer distances, but are also a reflection of
the local monopoly power of retailers. Refineries benefit from these local retail
monopolies only to the extent that they own the filling station, but this is a very
small proportion of their total business.
Five Forces profile

The points made in the discussion of the market structure can be incorporated into
a Five Forces analysis as in Table 5.22.
Table 5.22 Five Forces analysis for refining

Force Refining Conclusion
entrants Building near existing refinery would lead to excess capacity Low
Takes many years to build a refinery
Strategic barriers
Reputation is unimportant Low
Supplier power Refineries must purchase oil at market rate and crude oil is only input High
into their operations
Manpower is critical to overall supply chain (consider impact of 2008
union strike)
Buyer power Homogeneous product: buyers have plenty of choice High
Pipelines have local monopoly
Threat of Electric and steam power far away Low
substitutes
Industry rivalry ‘Law of one price’ prevails High
It emerges that the forces are not affected by current economic conditions as
reflected in the oil price, unlike the earlier stages in the supply chain. Because
refineries have to pay the going price of oil, it may in fact take some time to restore
margins by passing the cost increase on to consumers. But the reverse also applies,
in that there is likely to be a lag before oil price reductions are reflected in lower
prices.
At first sight, it might appear that there is little competition among refineries,
because of the low threat of new entrants. But the profile reveals high supplier
power, high buyer power and intense rivalry among the sellers of refinery products.
All three have a negative effect on margins, so, as in the transportation stage,
competitive forces are likely to result in low margins over time. This is corroborated
in Figure 5.14, which shows BP’s quarterly refining margin versus the crude oil price
between 2013 and 2015.
100
90 World crude price

Refining margin
80
70
60
50
40
30
20
10
0
2013 2013 2013 2013 2014 2014 2014 2014 2015 2015 2015 2015
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
Year
Figure 5.14 Refining margin vs crude oil price, 2013–15

While the price of a barrel of crude oil more than halved, refining margins re-
mained relatively stable. In fact, the margin in Q3 2015 was higher than at any other
time in the series. It appears from these data that refineries tend to make higher
margins in periods with relatively low oil prices and are more or less unaffected by
swings in the oil price. The main driver of refining margins is the season and global
refining margins tend to peak in Q3 each year – the US ‘driving season’. It may
come as a surprise that refineries do not benefit from a high oil price, but the data
are consistent with the analysis of competition.
Competitive profile
Refineries are price-takers in a volatile environment and the overriding concern is to
maintain competitiveness at all times (Table 5.23).
Table 5.23 Refining sector competitive profile

Market structure Low seasonal margins Perfect characteristics Efficiency
Price and Apparently different Price-taker Align technology with
differentiation positioning input type
Product life cycle Mature in developed First mover
countries
Growth in developing
countries
Five Forces Intense rivalry Cash flow
Refinery managers have no opportunity to benefit from market imperfections,

such as monopoly power, product positioning or product life cycle stages. Because
of the intensity of competition, it is difficult to be proactive.
5.8.3 Storage
Storage of petroleum products before they reach the end consumer usually takes
place at an oil depot. An oil depot – not to be confused with an oil terminal, such as
Sullom Voe in Shetland, which stores crude oil near the field until it can be trans-
ported by tanker – stores finished fuel and petrochemical products ready for
distribution to retail or business customers. These are usually situated either near a
refinery or near the coast, so that they can take on fuel from product tankers. An oil
depot is served by road or rail tankers that transport the fuel on to its final destina-
tion, which may be a fuelling station (gasoline), an airport (jet fuel) or another
distribution depot (home heating oil).
Storage depots are operated in several different ways; many are owned or jointly
operated by companies that refine, transport or market oil products. There are some
independent operators of storage facilities, which rent storage space and pick-up
rights to companies. The stocks in oil depots are periodically reported: when the
financial press refers to ‘US inventories’, for example, it is referring to the amount
of refined product held in storage facilities across the US.
Government strategic reserves, such as the US Strategic Petroleum Reserve
(SPR), are held in case of emergency. Many governments around the world have
some kind of strategic reserve that they can use in times of short supply. For
example, in the UK, when refineries and depots were blockaded by protestors in
September 2000, strategic reserves were used to keep emergency services such as
police and ambulance services running. However, strategic reserves are not consid-
ered here as part of the industry supply chain.
Market structure
There are two main factors that affect the demand for storage, as follows.
 Inventory optimisation. Companies have an incentive to minimise storage costs, and
need to strike a balance between cost and holding sufficient reserves to ensure
that unexpected spikes in demand can be met.
 Speculation. The impact of expectations on the supply side was shown in Figure 5.6
and Figure 5.7. When price is expected to increase, then inventories will be in-
creased, and vice versa.
It is therefore to be expected that storage prices will increase and decrease with the
oil price.
Most large companies operate their own facilities, or their own interests in jointly
operated depots. There are several independent storage companies: for example, the
Dutch company Vopak is the largest independent operator of storage facilities, with
35 storage networks around the world. The independent market for storage space is
likely to have the appearance of local monopolies. Companies that do not have
storage facilities, or which do not have storage facilities located conveniently near to
their end market, must rent space from an independent operator.
Five Forces profile

It emerges from the Five Forces profile (Table 5.24) that independent companies
are faced with a low level of competition. This is consistent with the fact that
Vopak’s return on capital employed (ROCE) in 2015 was around 50%. This is the
first downstream stage in which there is a prospect of earning more than the
opportunity cost of capital in the long term.
Table 5.24 Five Forces analysis for storage

Force Storage Conclusion
Threat of Structural barriers
new entrants Building near existing storage facility would lead to excess capacity Low
Takes many years to build a storage facility
Strategic barriers
Reputation is unimportant Low
Supplier power Once built, only supplier of inputs is unskilled labour Low
Buyer power Buyers have no choice locally Low
Threat of None Low
substitutes
Industry rivalry Local monopoly Low
This example raises a central strategic issue: if the return is so high, why do com-
petitors not enter? In other words, to what extent are these high returns sustainable?
The answer lies in the Five Forces: the barrier to entry is insurmountable, in that it is
not worthwhile to construct a storage facility to attract, say, 50% of the existing
market. Once built, the product is homogeneous, so the only basis of competition is
price. Given that it is a zero-sum game, the end result would be bankruptcy for both
entrant and incumbent. A possible strategy would be to enter the market and then
wait until the incumbent left; in that case, the entrant would be faced with the
prospect of an unpredictable return (depending on how long the incumbent could
hold out). Such a strategy is unlikely to work against a multinational such as Vopak.
Competitive profile
Once the storage company has established itself in a geographical area, it has little to
fear from competition, so long as barriers to entry are maintained (Table 5.25).
Table 5.25 Storage sector competitive profile

Market structure Local monopoly Maximise profit
Price and Homogeneous Cost control
differentiation
Product life cycle Speculation Short-term business cycle Optimum inventories
fluctuations
Five Forces Low Maintain barrier to entry
Obviously, the price that can be charged is constrained by the contestability of

the market, but that is low because of the size of the local market. This is the first
downstream stage so far that has the potential to generate returns higher than the
opportunity cost of capital.
5.8.4 Marketing and Distribution

It is at the marketing and distribution stage that the end product is sold on to the
final customer. The markets are diverse, and deal with many different customers and
industries, including:
 gasoline for individual motorists;
 jet fuel;
 non-fuel products such as asphalt and motor oil; and
 refined petrochemicals.
The following analysis focuses on the market for gasoline, which was touched on in
the analysis of refineries.
Market structure
Refineries sell gasoline to filling stations, whose buying behaviour is determined by
their own competitive situation. Consider the case of a city: there are many filling
stations; it is relatively easy to enter the market; information is freely available to
motorists; and there are few economies of scale. These are the characteristics of a
perfect market; hence filling stations can expect to earn the opportunity cost of
capital. This is therefore another downstream stage that has low margins.

Fuel companies attempt to differentiate by advertising and inventing slogans. Since
everyone knows that petrol is homogeneous, it is doubtful whether advertising has
any impact. Filling stations have diversified and typically now sell a range of goods
in competition with supermarkets – but the problem of competing with supermar-
kets is that the typical supermarket stocks about 30 000 different products, which is
clearly impossible for the filling station. The best that filling stations can do is
attempt to align their stock with the needs of motorists. Given that all filling stations
will attempt to do the same thing, reducing the reliance of filling stations on petrol
sales by diversification probably makes rivalry even more intense.
Five Forces profile

The Five Forces acting on filling stations are as outlined in Table 5.26.
Table 5.26 Five Forces analysis for marketing and distribution

Force Gasoline Conclusion
entrants Finding a site can be difficult High
Strategic barriers
Little brand loyalty High
Supplier power Gasoline can be purchased from any refinery Low
Buyer power Homogeneous product High
Motorists have plenty of choice; price information freely available
Threat of None Low
substitutes
Industry rivalry Many filling stations check prices of competitors and match them on High
a daily or weekly basis
The profile of high threat of entrants, high buyer power and intense rivalry is
consistent with the characteristics of perfect competition. In this case, the fact that
suppliers have low bargaining power and there is no threat of substitutes does not
lessen the impact of the other forces.
Outside the cities, it is possible to reduce competitive forces. In some cases, the
bargaining power of buyers is reduced: in UK motorway service stations, for
example, fuel is consistently 5% more expensive per litre than in towns.
Competitive profile
In competitive terms, the final stage of the industry supply chain is similar to other
consumer goods markets (Table 5.27).
Table 5.27 Marketing and distribution sector competitive profile

Market structure Filling stations Perfect Diversification
Price and Homogeneous product Attempt to differentiate Branding and loyalty
differentiation
Product life cycle Mature Cost control
Five Forces Geographical location Intense React quickly to
competitive pricing
It is difficult to make more than the opportunity cost of capital because of the
intensity of rivalry and the difficulty of differentiating. This is yet another down-
stream stage in which margins are low.
5.8.5 Conclusion
The downstream sector of the oil industry is subject to different competitive
pressures compared with the upstream sector (as illustrated in Table 5.28) and this is
reflected in profit levels. As we move down the industry supply chain, the product
on offer becomes increasingly similar, the degree of competition intensifies and the
level of uncertainty diminishes. Broadly speaking, the level of returns diminishes the
closer the analysis gets to the end customer. It is a common perception that oil
companies benefit at the expense of the end consumer when prices are high, but in
fact this does not appear to be the case: high prices are realised in the upstream
sector, while the downstream oil sector in general behaves more like a manufactur-
ing, production and distribution business.

Model Transport Refining Storage Marketing
Market structure Competitive action Differentiation Competitive reaction Pricing
Efficiency Price Cost control
Innovation
Price and R&D R&D Reputation Advertising
differentiation Efficiency
Fast reaction
Product life cycle R&D R&D Building skill sets No impact
Technological change
Five Forces Supply chain Competitive action Anticipate oil price Fast reaction
Competitive action R&D Fast reaction
With the exception of the storage stage, margins tend to be relatively low and
stable. There is little scope for any of the downstream stages to benefit from
variations in the oil price, because it is an input cost at each stage, the price of which
is determined at the trading stage.
To the outside observer, it might appear that the oil supply chain is monolithic –
that is, that oil is extracted and sold to the end consumer – and that this is why
integrated companies operate a company supply chain from exploration to final
consumer. But closer examination demonstrates that market conditions at each
stage of the supply chain are different; hence a vertically integrated company must
adopt a variety of strategic approaches if it is to be successful throughout its supply
chain. It could be that there are value chain benefits from vertical integration, and
this will be investigated in Module 6, but a necessary first step is to fully understand
the varying market characteristics. A general observation is that the further down
the supply chain, the lower and less volatile is the margin; while the observer might
think that this is a banal observation, it is a clue to the strategist that there are
significant differences in the markets at each stage of the supply chain and hence in
strategic decision-making.
Now that the analysis of the oil supply chain is complete, the discussion turns to
the gas supply chain, looking at gas processing and trading in Section 5.9, and the
stages of the downstream gas sector in Section 5.10.
5.9 Natural Gas Processing and Trading Market Analysis

It has already been noted that gas and oil supply chains are different. The two
commodities, while related and often lumped together in the same industry, follow
different paths after being extracted from the oil or gas well. While oil enters the
downstream industry and is refined, gas has to be processed before moving down-
stream. Natural gas is growing in popularity around the world as a source of energy,
as the cleanest of the fossil fuels, relatively rich in energy and now becoming easier
to transport owing to advances in LNG technology. Consumption of natural gas is
expected to grow by 70% by 2025 and electrical power generation is expected to
account for around half of this growth. Gas is also a much cheaper source of energy
than oil for certain purposes. While there are clear differences between oil and gas in
respect of the physical production processes, the strategic issue is whether there are
significant differences in the market characteristics at each stage.
The question is often asked why the wholesale gas price tends to move in line
with the oil price – although while the gas price increased in the years to 2008, it did
not spike to the extent that the oil price did. When oil prices increased in 2011, the
gas price did not follow suit. As discussed in Section 5.3, there is some empirical
evidence of the direction of causation, but there is no agreement on the actual causal
relationship between oil and gas prices.
5.9.1 Gas Processing

Gas processing is similar to oil refining, but takes place immediately after the gas is
produced, near the wellhead, because transporting gas long distances is difficult
owing to its low density. This is in contrast to oil refining, which takes place nearer
the end consumer market, after the commodity is traded on the open market.
Processing is not a market; rather, it is an additional activity that needs to take place
before natural gas is traded on commodity exchanges.
Gas needs to meet certain quality standards before it can enter the transmission
pipeline. It also needs to be processed if it is to be liquefied and put into tankers.
Gas cannot be traded on the open market until it has been purified and processed.
Raw produced gas contains methane and other heavier hydrocarbons, such as
butane, propane and pentane, and is processed to separate it into its constituents.
Natural gas that enters the transmission network, and is used for business and
domestic purposes, is composed almost exclusively of methane.
5.9.2 Liquefied Natural Gas (LNG)

As noted in Section 5.5.2, LNG is cooled to a point at which it takes up around
1/16th of the space of its gaseous state; it is then put into tankers and shipped to a
regasification terminal, from where it enters the high-pressure transmission pipeline.
Gas can also be stored as LNG at a facility before it enters the transmission
network. The LNG tanker market operates in a similar fashion to the oil tanker
market, and once LNG is converted back to its original gaseous form, it enters the
conventional supply chain. LNG technology allows gas to be traded across borders
and transported around the world – yet gas pricing is very much a regional issue,
with benchmarks set by geographical location rather than grade, as is the case with
oil.
5.9.3 Gas Trading

Gas trading works in a similar way to oil trading in that some contracts are ex-
change-traded and this sets a benchmark price against which the rest is sold in OTC
contracts. In this market, however, it is not the grade of gas that sets the difference
between the price paid and the benchmark, but the point of delivery. This is a
competitive commodity market with a homogeneous product.
The analysis of crude oil trading applies to gas trading in its entirety. Inelastic
demand and supply curves, expectations and under- and overshooting all play a role
in determining the volatility of the gas price. This means the competitive profiles of
the two trading sectors are similar (Table 5.29).
Table 5.29 Gas trading sector competitive profile

Market structure Fast information flows Perfect Trading at best price
Price and differentiation Hub vs required location Benchmark pricing
Product life cycle Backstop pricing Expectations Rapid response
Five Forces Direction of price changes Expectations Balance of buyer and
seller power
But if that is the case, why is the price of gas less volatile than the price of oil? It
is clear from Figure 5.15, which shows the percentage price change of the two
commodities over a 65-year period, that the oil price is more volatile than the
natural gas price. One explanation for this is related to the reason why the price of
oil can be seen as leading the gas price: the gas market is regionally fragmented and
regional conditions have a bearing on the gas price; it is possible that while the price
of oil as a global commodity reacts instantly to new information, some of this
information may not be relevant to the price of gas in a given region.
120
Oil price change
100 Gas price change
Percentage change on previous year

80
60
40
20
-20
-40
-60
1950
1952
1954
1956
1958
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
-80
Year
Figure 5.15 Relative price change on previous year, WTI and Henry Hub,
1950–2015
Strategic considerations at this level are the same as for crude oil trading and
there is little point in looking at each of the market models in turn.
5.10 Downstream Gas Market Analysis

The downstream gas industry takes the gas from the processing facility to the end
consumer. The consumer may be a household user, a small business user, an
industrial user or a power station. Downstream gas appears to be different from
downstream oil, mainly because of the physical characteristics of the product. Gas
needs to be transported through pipeline networks to houses and businesses, and it
is often not the company selling the gas that operates the distribution network.
5.10.1 Gas Marketing

‘Gas marketing’ refers to the activity of selling gas to the end consumer. This
consists of many local markets. In some countries, there is a state monopoly on
both the marketing and the distribution of natural gas to consumers; in others, these
markets have been opened up to competition. In the UK, for example, there are
various companies that a household can have supply its gas, but it always comes
through the same pipeline. A similar situation exists in the US. Despite criticism
from consumer groups, the UK utilities market is one of the most competitive in
the world. The following discussion relates to the UK market for that reason.
Market structure
In the UK, there is a small number of suppliers that can supply gas to a person’s
home; they tend to operate only in certain regions of the country. The small number
of large players suggests that the market is an oligopoly and that is consistent with
the observed behaviour of firms. In mid-2008, after reports of considerable pressure
on profits resulting from increased gas prices, it was announced that British Gas was
to increase its gas price for residential customers by 35%. This was the signal for
other companies in the market to announce similar increases. The companies
attempt to compete on price, but in reality the margin of difference between their
offerings is negligible; consumers are offered short-term incentives to switch
suppliers, but gains to the consumer are soon lost as the original company introduc-
es its own offers. In the years since 2008, company price movements have often
been observed to be similar and to happen around the same time. Some articles
have been published on this topic by EBS authors on the EBS Blog. These are
available in the ‘Economics’ section, tagged with the word ‘oligopoly’ for those who
are interested.
Product life cycle

The market for domestic gas is mature, although there is marginal growth, for
example when new houses are built to run on gas. Thus the continual competition
between the gas suppliers results in a zero-sum game, so that each time a new
customer is gained, it is at the expense of a competitor. It is an open question
whether an efficient outcome could have been achieved by establishing contestable
markets – that is, markets in which the entry barriers are removed, thus limiting the
ability of the incumbent to charge monopoly prices.

Companies try to compete on product differentiation in a limited fashion, offering a
discount for combined gas and electricity billing, which is also more convenient for
the consumer. Some companies also try to differentiate themselves in terms of their
‘green’ credentials. Given that gas is a homogeneous product, however, there is little
scope for differentiation on the basis of service characteristics.
Five Forces profile

The Five Forces profile for gas marketing can be summarised as in Table 5.30.
Table 5.30 Five Forces analysis for gas marketing

Force Marketing Conclusion
Threat of Structural barriers
new entrants Regulatory: in the UK, a company needs to be licensed by the energy Low
industry watchdog to sell gas
Strategic barriers
Some companies try to differentiate themselves on their green credentials Low
Supplier Companies that market gas to consumers either produce their own, in High
power the case of integrated gas majors, or purchase it on the open market or
through OTC contracts
Suppliers of distribution have a considerable degree of power
Buyer In many areas, both gas and electricity companies supply gas, and High
power customers are encouraged to switch suppliers
Force Marketing Conclusion

Threat of Electricity is a substitute, but with a high switching cost Low
substitutes
Industry The government’s objective was to increase competition by opening the High
rivalry market
The profile suggests an industry in which margins are continually being squeezed,
despite the low threat of entrants and substitutes. The high supplier power, buyer
power and industry rivalry in a mature market mean that a market that appears to be
an oligopoly is unlikely to generate monopoly profits.
Competitive profile
As would be expected, in an industry selling a homogeneous product, the main
concern is with competitive actions in all dimensions (Table 5.31).
Table 5.31 Gas marketing sector competitive profile

Market structure Local Oligopoly Competitive action
Price and differentiation National Price only Competitive action
Product life cycle Mature Zero-sum game Competitive action
Five Forces Regulated High Margins squeezed; control cost
With regard to downstream markets for gas in other parts of the world, a variety
of situations exist, ranging from government-sanctioned monopoly to competition
between many small suppliers. The nature of the market depends to a large extent
on the infrastructure in place. In many European countries and the US, the situation
is similar to that of the UK, where transmission and distribution pipeline systems
operate. In Asia, it is more common for gas to be delivered by canister and be
available from a variety of companies. Markets in such companies tend to be
fragmented locally and represent more of a perfectly competitive market than when
network infrastructure is in place.
5.10.2 Transmission and Storage

Transmission of gas happens through long, high-pressure pipelines in the UK. A
similar transmission network exists across Europe and in parts of the US.
Gas storage facilities operate in much the same way as oil depots. Gas is stored in
its gaseous form at underground locations. The UK company Scottish Power refers
to gas storage as a ‘high-return business’ and reported a 21% return on investment
in one storage facility in the US.
Pipelines take two forms: either high-pressure pipelines that run for long distanc-
es across countries, known as ‘transmission pipelines’; or low-pressure local pipeline
systems that transport the gas to households, known as ‘distribution pipelines’. At
this stage in the chain, we shall focus on the large, high-pressure systems that travel
across countries. It is through such networks that gas is sent to electrical generation
plants and other large industrial users. The low-pressure pipeline will be dealt with
separately as the final stage of the gas supply chain.
Market structure
In the UK, the high-pressure pipeline system is operated by a single company,
National Grid. This is used to distribute gas from seven terminals, where the gas is
pumped in from offshore fields after being processed. After travelling through the
high-pressure pipeline to the required region, the gas enters one of 12 local distribu-
tion zones. Gas marketing companies pay the National Grid to use the high-
pressure pipeline network, so this is a state-sanctioned monopoly.
Five Forces profile

A Five Forces analysis confirms that the transmission network operator has a
considerable degree of power (Table 5.32).
Table 5.32 Five Forces analysis for transmission and storage

Force Transmission and storage Conclusion
Threat of Company needs government permission and an established pipeline Low
new entrants network to enter the market; only one pipeline required at every
given location – natural monopoly
Supplier power Suppliers build pipelines; often done by the operator Low
Buyer power Buyer is gas marketing company, which has no alternative but to send Low
gas through transmission network
Threat of None Low
substitutes
Industry rivalry Sole operator Low
Given the high degree of power, only government regulation will prevent the
company from making monopoly profits. Even in larger countries in which there is
more than one transmission operator, the gas marketing company still has to use a
single pipeline to deliver its gas. This stage of the supply chain is therefore a natural
monopoly.
It can be deduced that this is a highly profitable stage of the gas supply chain,
because transmission and distribution costs, as a percentage of the final cost to the
consumer, depend to only a small extent on the price of natural gas itself. In winter
2001–2, transmission and distribution costs made up 66% of the total. This fell in
percentage terms as the price of gas as a commodity rose, but in absolute terms has
remained at around $6 per 1000 cubic feet (Mcf) since 2000. This was squeezed
down to around $4 when the price of gas rose in 2002–3, but moved back to its
historic level the following year (Figure 5.16).
$16
Average heating season price ($ per Mcf)

Commodity (the gas itself)
$14 Transmission and distribution costs 36%
$12
$10
47%
$8
48%
43%
$6
63% 64%
$4
53%
57% 52%
$2
37%
$0
2001–02 2002–03 2003–04 2004–05 2005–06
Figure 5.16 Gas price distribution of costs

Source: EIA (2005)
This is an example of the use of regulation to promote efficiency, rather than
attempt to find a market solution. It is an open question as to whether regulation
has been effective.
Competitive profile
The competitive profile for gas transmission and storage is summarised in Table
5.33. Note the important role that regulation plays in three of the four models.
Table 5.33 Transmission and storage sector competitive profile

Market structure Regulation Monopoly Cost control
Price and differentiation Regulation None Customer perception
Product life cycle Electricity Substitute Relative price
Five Forces Regulation High power Margins
5.10.3 Distribution
Distribution to the end consumer is achieved through domestic low-pressure
pipelines, known as the ‘distribution network’. In the UK, the distribution network
is operated by a different company from that which supplies the gas, similarly to the
transmission network.
Market structure
There are 12 distribution networks in the UK, operated by five different companies:
 Scotia Gas Networks, supplying Scotland;
 Northern Gas Networks, supplying the North of England;
 National Grid (again), supplying the Midlands and London;

 Southern Gas Networks, supplying the South of England; and
 Wales and West Utilities, supplying Wales and the West Country.
These companies were formed, or bought an interest in the distribution network,
when National Grid Transco sold off most of its interests in distribution. Gas
marketing companies have to pay the distributor to use the pipeline and act as local
monopolies. Distribution costs constitute around 15% of the total transmission and
distribution costs in the price of gas.
Five Forces profile

It comes as no surprise that the Five Forces for distribution (Table 5.34) are similar
to the Five Forces at the transmission stage.
Table 5.34 Five Forces analysis for distribution

Force Distribution Conclusion
Threat of new Company needs government permission and established pipeline Low
entrants network to enter the market; only one pipeline required at every given
location – natural monopoly
Supplier power Suppliers build pipelines; often done by operator Low
Buyer power Buyer is gas marketing company, which has no alternative but to send Low
gas through distribution network
Threat of None Low
substitutes
Industry rivalry Sole operator in geographic segments Low
As in the case of distribution, the Five Forces reflect the monopoly power of
suppliers based on the natural monopoly argument. As before, the interests of
consumers are dependent on the effectiveness of the regulator.
Northern Gas Networks, National Grid, and Wales and West Utilities are in-
volved solely in the distribution of gas, but the other two companies, Scotia Gas
Networks and Southern Gas Networks, have the same parent company, Scottish
and Southern Energy. This is the parent company of gas suppliers for Scotland and
the South of England, Scottish Hydroelectric and Southern Electric. This may lead
to a conflict of interest and may result in these gas suppliers having an unfair
competitive advantage over rivals in the two areas.
Competitive profile
The competitive profile for gas distribution (Table 5.35) is the same as that for gas
transmission. The market is subject to considerable regulation despite efforts to
deregulate over the past 20 years. This is again the result of the physical nature of
natural gas as a commodity.
Table 5.35 Distribution sector competitive profile

Market structure Regulation Monopoly Cost control
Price and differentiation Regulation None
Product life cycle Electricity Substitute Relative price
Five Forces Regulation High power Margins
5.10.4 Conclusion
Downstream gas is different from downstream oil in that distributors of gas can
make high returns by operating their pipelines. This is because there is no alternative
to sending gas to end consumers first through the transmission network and then
through the local distribution network, leading to monopoly power. As a result,
increases in the gas price put pressure on the gas marketing companies, while
increases in the oil price put pressure on the whole of the downstream industry.
Table 5.36 summarises these concerns.

Model Marketing Transmission, Distribution
storage, LNG
Market structure Oligopoly Regulated monopoly Local monopoly
Price and differentiation Product is homogeneous, Customer has no Customer has no
but cannot compete on choice – no marketing choice – no marketing
price required required
Product life cycle Mature market Mature market Mature market
Five Forces High supplier and buyer Low buyer power and Owners of marketing
power puts price under no rivalry company and pipelines
‘squeeze’ can benefit
5.11 Implications of the Supply Chain Analysis

The oil and gas industry is a vast, diverse supply chain in which some stages are
dependent on the price of oil or gas for profitability, while others make small, steady
profits irrespective of the price. This has been explained by the application of a
range of models to identify how competitive forces operate.
Given that the supply chain comprises a series of different markets, it might be
expected that companies would focus on certain stages of the supply chain at which
they can develop a competitive advantage. In the event, it is found that there are
companies that only operate in one or two stages and large integrated companies
that operate in all stages, together with some sectors outside oil and gas. Some
companies focus on another industry entirely, but have one or two divisions
operating at different stages.
Table 5.37 represents the value-generating activities in the oil and gas industry
chain during times of high and low commodity prices. This has already been
discussed in some detail, but a summary provides a broad perspective on the

industry.
Table 5.37 Impact of oil prices on the industry supply chain

Oil Gas How is value High price Low price
generated?
Exploration Providing services to High returns Low returns
other companies Growing market Compete for work
Development Providing service to High returns Low returns
other companies Growing market Compete for work
Production Producing oil Management in high Low returns –
Management services demand – high returns management not
required
Trading Selling commodity Very high returns Low returns
Cash enters upstream Cash available for Upstream investment
upstream investment less attractive; also
less cash available
Processing Conversion to usable Keep costs to a
form minimum
Trading Selling commodity High returns Low–average returns
Cash enters upstream
Transport Charter rates for Steady returns Steady returns
tankers Charter rates cyclical; Charter rates cyclical
Pipeline charges squeezed by high oil
prices
Refining Processing to finished Margins are low and Margins are low and
product steady; squeezed by steady
higher oil prices
Storage Inventories Storage rates as low
as possible
Marketing Selling diverse Pressure on margins Low, steady margins
products to end from high input costs
consumers
Marketing Selling to consumers Squeezed between Low returns
high input prices and
distribution costs
Transmission Charging for use of Natural monopoly can
fixed asset charge a premium
Distribution Local monopolies can
charge a premium
Upstream stages comprise high-value-generating activities when the price of oil

and gas is high. When the price is low, the upstream makes little or no returns, and
companies providing differentiated services to the industry find themselves in a
shrinking and increasingly competitive market.
Downstream stages are characterised by businesses that make a steady, but un-
substantial, profit whether oil and gas prices are high or not. These businesses find
that their margins are squeezed between higher input costs from the high commodi-
ty prices and the reluctance of consumers to pay more for their fuel products. The
exception to this rule for downstream is gas transmission and distribution, which is
characterised by local and national monopolies that have a high degree of power
over their customers.
5.12 Environmental Threat and Opportunity Profile

The first part of an ETOP for an IOC was developed at the end of Section 4.7.
Developing the second part of an ETOP for the same company would run to
several pages of text and is too complex to present here, given the preceding
strategic analysis of the oil and gas industry supply chain.
The purpose of this section is to present an ETOP in 2015 for a US-based ser-
vice company that operates in the upstream sector, in the exploration, development
and production markets. The company provides products and services to both
IOCs and NOCs. Much of what was identified at the end of Section 4.7 still applies.
The threats and opportunities identified in Table 5.38 are based on the analysis of
the supply chain presented in Section 5.6.
Table 5.38 ETOP II: Upstream service company

Sector Factor Threat (–) /
opportunity (+) /
unknown (?)
International Volatile exchange rates and unclear economic situation in –
China
Diverse political climates to deal with –
Trend towards less favourable tax regimes –
New climate change treaty negotiated late 2015 –
Shift in power from IOCs to NOCs +
Macro- Low, volatile oil price +
economic Increasing R&D into alternative energy ?
Rising finding and development costs –
Rising demand for energy expected to grow a further 50% by +
2030
Unconventional sources of oil becoming more viable, with +
technology improving and costs falling owing to innovation
Resource nationalism rising as countries look for energy security, +
forcing out IOCs
Micro- Increasing competition for new resources –
economic Overcapacity services markets –
Increasing competition for skilled manpower – poaching –
Rising dominance of NOCs means new type of customer ?
Unconventionals under pressure –
‘New normal’ of lower oil prices –
Derived demand implications –
Socio- Negative Western perceptions of oil industry –
economic
Market Growing market for production management services +
Growing market for secondary extraction equipment +
Five Forces across markets affected by level of oil price –
Long-run possibility of NOCs acquiring skills internally –
Again, the classification of factors is fairly subjective, but a number of market-

level issues facing the company have been identified. The growing markets for
production management and for secondary extraction techniques are clearly
opportunities for the company; what appears to be a period of low oil prices could
well be a threat. Other factors are more difficult to classify: is the fact that the Five
Forces are highly changeable, depending on the oil price, a threat or opportunity?
Note that, now that we are looking at a service company, the rise of resource
nationalism and the power shift to NOCs in recent years has been classified as an
opportunity. The rationale for this is that NOCs often have a lower skill base than
IOCs and service companies can ‘bridge the gap’ where technical knowledge is
concerned. As IOCs are pushed out of some areas, opportunities to provide services
to companies such as PdVSA and Pemex appear. However, the rise of NOCs leads
to the company having to deal with a new type of customer: is this a threat or
opportunity? Without delving deeply into the specifics of whom the company is
dealing with, and where, it is difficult to come to a definitive conclusion.
The final step in such an analysis would be to rank the opportunities and threats
in order of magnitude. Once both macro and industry environments have been
addressed, and the opportunities and threats articulated and ranked, the part of the
analytical process concerned with the external environment is complete. The ranked
opportunities and threats provide one half of the company’s SWOT profile, which
is the basis for making rational strategic decisions.
There is, however, further analysis required before a full SWOT profile can be
developed. That analysis is concerned with an organisation’s strengths and weak-
nesses, and involves using analytical techniques concerned with internal factors. The
next module provides a detailed example of internal analysis, using real historical
information from Royal Dutch Shell’s published accounts.
Learning Summary
This module has introduced much of the core learning content of the course –
namely, the activities, characteristics and competitive conditions in the oil and gas
industry, broken down by sector and stage.
The idea of derived demand, which is an issue in much of the industry, has been
introduced. The volatile nature of the oil price in the short run has been explained,
using basic supply and demand analysis, and the cobweb model has been used to
show how oil price cycles might work over longer periods of time. Dynamic
analysis, and the ideas of overshooting and undershooting, have been used to
augment the traditional comparative statics approach.
The industry supply chain has been discussed in detail, and the differences be-
tween and within sectors have been demonstrated using a number of models
concerned with the external environment. The final outcome of this module is a
map of characteristics for each part of the oil and gas industry – a valuable
knowledge resource for any manager operating in any part of the industry.
References
Brown, S. P. A., and Yücel, M. K. (2008) ‘What Drives Natural Gas Prices?’, Energy Journal,
29(2), 45–60.
Clark, J. M. (1917) ‘Business Acceleration and the Law of Demand’, The Journal of Political
Economy, 25(3), 217–35.
Environmental Protection Agency (EPA) (1995) Profile of the Petroleum Refining Industry, EPA
Office of Compliance Sector Notebook Project, Exhibit 1. Available online at
http://archive.epa.gov/sectors/web/pdf/petrefsn.pdf
Kay, N. (2011) ‘Oil Price Watch Overview’, ebsglobalblog.net, 12 October. Available online at
http://ebsglobalblog.net/oil-price-watch-overview/
Mouawad, J. (2004) ‘Not a Ship to Spare’, The New York Times, 20 October. Available online
at www.nytimes.com/2004/10/20/business/not-a-ship-to-spare.html?_r=0
Porter, M. (2008) ‘The Five Competitive Forces that Shape Strategy’, Harvard Business Review,
Jan, 86–104.
Shenk, M. (2008) ‘Oil Rises above $134 on U.S. Supply Drop, Bank Price Forecasts’, Finance
News, 21 May. Available online at http://financenews1.blogspot.co.uk/2008/05/oil-
rises-above-134-on-us-supply-drop.html
US Census Bureau (2012) ‘Transportation and Warehousing: Geographic Area Series –
Summary Statistics for the U.S., States, Metro Areas, Counties, and Places: 2012’, 2012
Economic Census of the United States, Table EC1248A1. Available online at
http://factfinder.census.gov/faces/tableservices/jsf/pages/productview.xhtml?src=bk
mk
US Energy Information Administration (EIA) (undated) ‘Petroleum & Other Liquids: Data’.
Available online at www.eia.gov/petroleum/data.cfm/
US Energy Information Administration (EIA) (2005) Natural Gas Monthly, September.
Available online at www.eia.gov/naturalgas/monthly/archive/2005/2005_09/ngm_2005
_09.html
Villar, J. A., and Joutz, F. L. (2006) ‘The Relationship between Crude Oil and Natural Gas
Prices’, US Energy Information Administration (EIA) Office of Oil and Gas, October.
Available online at www.uprm.edu/aceer/pdfs/CrudeOil_NaturalGas.pdf
Module 6
Strategic Analysis of Historical

Company Accounts
Contents
6.1 Introduction.............................................................................................6/1
6.2 Analysing Historical Published Accounts .............................................6/2
6.3 Strategy and Business Definition ..........................................................6/3
6.4 Company Finances..................................................................................6/6
6.5 Divisional Performance and Operating Efficiency ........................... 6/11
6.6 Overall Company Finances ................................................................. 6/18
6.7 Value Chain .......................................................................................... 6/18
6.8 Scope and Scale ................................................................................... 6/24
6.9 Competences and Strategic Architecture ........................................ 6/34
6.10 Strategic Advantage Profile................................................................ 6/35
6.11 Shell in 2015.......................................................................................... 6/36
Learning Objectives
 apply the analytical tools developed in Core SP Module 6 to a fully vertically
integrated major oil and gas company; and
 construct a strategic advantage profile for an oil and gas company.
6.1 Introduction
A variety of analytical tools were developed in Core SP Module 6, ranging from
quantitative accounting measures of efficiency to difficult-to-identify conceptual
attributes such as core competence. It was found that every tool, no matter how
seemingly precise, has to be used with judgement and cannot be applied in isolation.
The aim is to build up a picture of the current and potential operations of a compa-
ny that shows how effectively resources have been deployed in the past, what the
source of a company’s competitive advantage is and what the company’s strengths
and weaknesses are. This is a complex task, but it is crucial, because many strategic
mistakes can be attributed to the fact that decision-makers did not understand their
own company’s internal strengths and weaknesses properly, and were taken in by
the latest management fad.
Module 6 / Strategic Analysis of Historical Company Accounts
There is no optimum set of internal operations for an oil and gas company, and
the point of performing an internal analysis is not to decide whether a company’s
structure is right or wrong; rather, the analysis is an attempt to see how the company
competes and where its competitive advantage lies. It is difficult to identify the
source of competitive advantage and often decision-makers themselves are uncer-
tain about the competitive advantage of their own organisation, leading to the
pursuit of vertical integration or core competence without a proper understanding
of what such strategies involve. But competitive advantage is not determined by
internal factors alone; it is necessary to combine internal and external analyses to
generate a complete picture of how well a company competes within its environ-
ment. This picture is the basis for making strategic decisions.
6.2 Analysing Historical Published Accounts

The analysis in this module is based on a case study of Royal Dutch Shell plc, using
the company’s 2007 annual report (Royal Dutch Shell plc, 2008) and other public
sources of information, and is intended to demonstrate:
 the value of an internal analysis of one’s own company, and how it can highlight
strengths and weaknesses; and
 the amount of information that can be extracted from public sources.
With regards to this last point, a company can use public information on its compet-
itors to develop competitor profiles, which may be of use when deciding whether to
enter a specific market or pitch for a certain contract. What may seem like bland
disclosures based on legal requirements can be revealing to the trained eye.
Shell has been chosen as the case study for two reasons. First, the company is a
large, integrated major with operations in all parts of the oil and gas industry supply
chain, and by looking at Shell’s operations, we can gain insight into the workings of
the industry as a whole and, most importantly, how the different parts interact with
one another in practice. For example, how does a company spanning the full range
of oil and gas activities define its business, and how does it ensure that value
creating linkages are maintained throughout the length of the supply chain, from
exploration to final consumer? Second, Shell is well known for the clarity and
frankness of its accounting reports. In various reports on oil company revenue
clarity by Transparency International, Shell was ranked top of the international oil
companies for financial disclosure.
A historical report, covering the period up to December 2007 and published in
early 2008, has been chosen as the basis of this module for a number of reasons.
When this report was published, the industry had undergone a sustained, yet stable,
period of growth and investment. The report does not cover the volatile period
running up to the 2008 spike nor does it cover the period of volatility after 2011.
Thus it allows the reader to see how an oil and gas company might operate during
periods of relative stability in the industry. At the time of the report, CEO Jeroen
van der Veer had been in charge of the company since 2004; he did not step down
until 2009. Thus one would expect a relatively stable set of strategic objectives to
have been in place for a number of years at this point.
A final reason for using the historical report, as opposed to the most recent, is
that it allows the strategist, after conducting the analysis, to see how things turned
out. It is of note that the reporting segment breakdown in the 2007 report is
different to that in more recent reports, which report only upstream and down-
stream activity. The view from 2015 is addressed in Section 6.11.
This module follows an outline that would serve any strategist looking to conduct
an internal analysis, looking at the following factors:
 Shell’s strategy and business definition;
 corporate-level financial indicators;
 divisional financial indicators;
 the value chain;
 scope, scale and vertical integration; and
 strategic architecture.
Information from these analyses feed into the strategic advantage profile (SAP)
presented in Section 6.11. The SAP is one half of the company’s SWOT profile.
It is worth noting that if one were conducting an analysis of one’s own organisa-
tion, the level of detail and amount of information available would be much greater.
That said, the analysis presented in this module demonstrates the level of detail that
can be gathered from published sources on an organisation.
6.3 Strategy and Business Definition

A brief look at Shell’s stated strategy follows before we examine the company’s
internal characteristics. Shell’s strategy, as it was published in 2008, is outlined in
Exhibit 6.1.
Exhibit 6.1: ‘More Upstream, Profitable Downstream’ –

Shell’s Strategy in 2008
Against the background of high energy prices, competition for access to

resources will remain intense. Cost inflation continues at a high rate, in
certain cases exacerbated by a weakening US dollar. Capital cost inflation
impacts upstream and downstream projects alike. Continued focus on project
delivery and on operational excellence will be key for success.
In our upstream businesses, we will continue to focus on developing major
new projects with long, productive lives. In the downstream businesses, our
emphasis will be on sustained cash generation and on continuing to reshape
our portfolio with a focus on the faster growing markets of Asia Pacific. We
create further value by managing our portfolio and leveraging our proprietary
technology and the quality of our people.
(Royal Dutch Shell plc, 2008, p 10)
This financial analysis focuses on alignment between the company’s operations

and structure with the stated strategy of ‘More Upstream, Profitable Downstream’.
The first step in the internal analysis of a company is to define the business.
Shell’s business is large and complex, but can be broken down in terms of the
company’s divisions, with reference to the industry supply chain. Shell has opera-
tions across the supply chain and is divided into the following divisions, or
segments.
 Exploration and Production. This division deals with exploration, development and
production activities. This is the oil upstream part of the supply chain.
 Gas and Power. Shell defines this as another upstream business, but it deals with
the company’s large LNG interests and other gas infrastructure development
activities. While Shell refers to this as upstream, it is actually part of the down-
stream gas sector. It also includes Shell’s interest in various renewable energy
projects around the world.
 Oil Sands. This segment processes and upgrades oil sands from Alberta, Canada,
into synthetic crude oil, which is then put together with other refinery feedstock.
 Oil Products. This is the company’s oil downstream business, and both the biggest
revenue generator and the most intensive of the company’s activities. Here, oil is
processed into its constituent products, which are then sold on to either business
or retail customers.
 Chemicals. This is a subsection of the oil downstream industry that takes petro-
chemical feedstock produced from the refining process and turns it into various
chemical inputs for customers, who are usually manufacturing companies of
some description.
 Corporate. This comprises the activities that are not of a day-to-day nature:
interest income and gains from hedging and currency exchange, for example, are
not reported as part of the other segments, but separately under the heading
‘Corporate’. This is a non-operating segment and will not be examined in detail.
Shell’s business, then, comprises five main operating segments, which are overseen
by Corporate. But it is difficult to capture Shell’s ‘business’ in a single, concise
statement. For example, one definition could be ‘Shell finds oil, extracts and
processes it, and sells it to consumers’. The problem with this definition is that it
subsumes a mixture of service and manufacturing activities that may or may not be
related, but which certainly require significantly different skill sets. This initial
difficulty in identifying Shell’s ‘business’ has ramifications for all of the following
analyses, and leads to many of the difficulties in relation to vertical integration,
relatedness of diversification and the identification of a robust value chain (Figure
6.1).
The rationale behind this structure will be provided later, but first there are a
number of other points to consider regarding Shell’s business.
Royal Dutch Shell Corporate
Exploration and
Gas and Power Oil Sands Oil Products Chemicals
Production
Exploration LNG Extraction Trading Processing
Upgrading Supply and

Production GTL Chemicals R&D
Distribution
Exploration and Gas

Production Refining
Infrastructure
Technology
Gas and Power Marketing
R&D
B2B Retail Lubricants
Oil Products
R&D
Figure 6.1 Royal Dutch Shell divisional layout

 What is the relationship between the company’s products?
Within each operating division, there is a clear relationship between the compa-
ny’s products. For example, within its Oil Products division, the company sells
various fuel products that all come from the same source. However, when prod-
ucts from different divisions are compared, there is much less linkage. For
example, there is likely to be little synergy between renewable energy and petro-
chemicals, as presented in Table 6.1.
Table 6.1 Synergy at Shell

Synergy component Renewable energy and petrochemicals
Corporate management No shared resources
Economies of scale Activities are completely independent of each other
Vertical integration Two divisions are part of different supply chains
Capacity utilisation Different human and physical resources required
Joint production Different processes
Innovation Process engineering vs new product engineering
Even the synergy between upstream and downstream oil is debatable, because
the nature of the markets and the skills required at each stage are different.
 What are the current products, and what will be the future products?
In early 2008, Shell had 55 years’ worth of reserves at current production rates,
according to CEO Jeroen van der Veer. However, world oil demand is growing,
so the company that merely maintains its production at the same level will lose
its market share. If, in the long run, IOCs such as Shell were to continue to drop
production levels and their proved reserves continue to shrink, then their influ-
ence and importance in the industry would diminish. Therefore adding to
reserves and finding ways of increasing production are imperative for Shell in the
short run, if it is to maintain its position in the long run. This is becoming in-
creasingly difficult for Western oil majors, which now have difficulty accessing
new reserves in politically hostile areas.
Fossil fuels are set to dominate the world energy stage for a long time to come,
as demonstrated in Module 4, but the company still needs to look to the future.
Whether hydrocarbons are replaced or users economise, this will have an effect
on Shell. The company has investments in various renewable projects and has its
future fuels business, but these will not replace its core oil and gas operations.
However, this is a less important issue than reserves replacement and production
growth.
 What is its operational risk level?
The fact that Shell is a large, integrated oil major means that it is exposed to risk
at every level of the oil and gas supply chain. However, as discussed in Module 5,
external events affect different parts of the supply chain in opposite ways. In
general, a profitable and booming upstream means that the downstream margins
are put under pressure, and when upstream activity is low, the downstream be-
comes more profitable. Thus it could be argued that Shell’s risk level is balanced
across the industry. But risk diversification is a weak rationale for unrelated di-
versification, because it conceals the risk exposure of shareholders. For example,
some shareholders may not be willing to bear the risks of exploration and would
prefer to hold shares in a refining company only, while others may be willing to
accept the risks and potentially high returns of an exploration company.
So Shell is a large, integrated oil major that is capable of meeting short-term demand
fluctuations, but may have trouble maintaining supply in the long run, for example
owing to political tensions arising from the geographic location of most of the
world’s unexploited reserves. While its operational risk may be balanced across its
segments, Shell’s corporate risk level is high, because its entire core operations are to
do with hydrocarbons and therefore its financial performance relies to a large extent
on the behaviour of volatile commodity prices.
6.4 Company Finances

The first step is to analyse the corporate accounts to assess the performance of the
company as a whole. The questions that can be addressed include the following.
 How much financial flexibility does the company have to react to the volatile
market?
 What returns are shareholders receiving and are they being adequately compen-
sated for their risk?
 What are the company’s key ratios?
Table 6.2, Table 6.3 and Table 6.4 are extracted from the Shell 2007 annual report.
Table 6.2 Shell consolidated statement of income

Consolidated statement of income $ million
2007 2006 2005
Revenue 355 782 318 845 306 731
Cost of sales 296 697 262 989 252 622
Gross profit 59 085 55 856 54 109
Selling, distribution and administrative expenses 16 621 16 616 15 482
Exploration 1712 1562 1286
Share of profit of equity-accounted investments 8234 6671 7123
Interest and other income 2698 1428 1171
Interest expense 1108 1149 1068
Income before taxation 50 576 44 628 44 567
Taxation 18 650 18 317 17 999
Income from continuing operations 31 926 26 311 26 568
Income/(loss) from discontinued operations – – (307)
Income for the period 31 926 26 311 26 261
Income attributable to minority interest 595 869 950

Income attributable to shareholders of Royal 31 331 25 442 25 311
Dutch Shell plc
Source: Royal Dutch Shell plc (2008, p 113)
Table 6.3 Shell consolidated statement of cash flows (summarised)

Summary consolidated statement of cash flows $ million
2007 2006 2005
[…]
Cash flow from operating activities 34 461 31 696 30 113
[…]
Cash flow from investing activities (14 570) (20 861) (8 761)
[…]
Cash flow from financing activities (19 393) (13 741) (18 573)
Currency translation differences relating to cash and cash 156 178 (250)
equivalents
Increase/(decrease) in cash and cash equivalents 654 (2 728) 2 529
Cash and cash equivalents at January 1 9002 11 730 9201
Cash and cash equivalents at December 31 9656 9002 11 730
Table 6.4 Shell consolidated balance sheet

Consolidated balance sheet $ million
Dec 31, 2007 Dec 31, 2006
ASSETS
Non-current assets
Intangible assets 5366 4808
Property, plant and equipment 101 521 100 988
Investments:
equity-accounted investments 29 153 20 740
financial assets 3461 4493
Deferred tax 3253 2968
Prepaid pension costs 5559 3926
Other 5760 5468
154 073 143 391
Current assets
Inventories 31 503 23 215
Accounts receivable 74 238 59 668
Cash and cash equivalents 9656 9002
115 397 91 885
Total assets 269 470 235 276
LIABILITIES
Non-current liabilities
Debt 12 363 9713
Deferred tax 13 039 13 094
Retirement benefit obligations 6165 6096
Other provisions 13 658 10 355
Other 3893 4325
49 118 43 583
Current liabilities
Debt 5736 6060
Accounts payable and accrued liabilities 75 697 62 556
Taxes payable 9733 6021
Retirement benefit obligations 426 319
Other provisions 2792 1792
94 384 76 748
Total liabilities 143 502 120 331
EQUITY
Ordinary share capital 536 545
Treasury shares (2392) (3316)
Other reserves 14 148 8820
Retained earnings 111 668 99 677
Consolidated balance sheet $ million

Dec 31, 2007 Dec 31, 2006
Equity attributable to shareholders of Royal Dutch Shell 123 960 105 726
plc
Minority interest 2008 9219
Total equity 125 968 114 945
Total liabilities and equity 269 470 235 276
To try to answer the questions, we first consider a few key ratios (Table 6.5) to cut
through what can appear to be a daunting amount of information.
Table 6.5 Corporate accounts ratio analysis

2007 2006 2005
Revenue change 12% 4% –
Cost of sales change 13% 12%
Selling, etc., change 0% 7%
Gross profit change 6% 3%
Net profit change 21% 0%
Gross profit return on sales (ROS) 16% 17% 18%
Net profit ROS 9% 8% 8%
Net cash flow 654 (2728) 2529
Current ratio 0.80 0.76 –
Quick ratio 0.60 0.57 –
ROE 25% 24% –
Return on total assets (ROTA) 12% 11% –
Gearing 10% 9% –
Interest cover 45 times 39 times 42 times
6.4.1 Corporate Revenues, Costs and Profits

Company revenues increased by 12% in 2007 and 4% in 2006; given the diversity of
Shell’s activities over the industry supply chain, it is not possible to attribute this to
any one factor, such as an increase in the oil price or an increase in market share.
The cost of sales changed in line with revenues in 2007, although it had grown by
12% in 2006 compared with revenue growth of only 4%. This could be a symptom
of poor cost control up to 2006, but it may be relevant that the cost of selling
increased by 7% in 2006 and then remained static in 2007. In aggregate, there is no
reason why revenues and costs should change precisely in step – for example there
may be lags between increased selling effort and the impact on revenues, but these
changes are indicative of differences in overall resource allocation. The impact on
gross profit growth of a higher growth in cost of sales than in revenues is quite
marked: gross profit grew by only 6% in 2007 and by 3% in 2006. This is where it
becomes difficult to interpret corporate accounts, because net profit (taken as
income from continuing operations) increased by 21% in 2007, but was static in
2006.
Reported profits bore little relation to cash flows. Over the three years, net cash
flow varied between 1% and –1% of revenues. Investing and financing activities
were about equal to net profits over the period, suggesting that Shell was not
significantly increasing debt.
6.4.2 Profit Ratios

These percentage changes in the aggregates are indicative of changes in the scale of
the company, but actually tell us little about the efficiency of resource allocation.
The gross profit ROS (that is, Gross profit ÷ Revenue) declined slightly, from 17%
to 16%. The fact that gross profit grew at a lower rate than revenues might be a
cause for concern, but it had little impact on the efficiency with which goods were
produced. In fact, the net profit ROS actually increased from 8% to 9%, which is
indicative of the fact that it is always possible to extract good news from accounting
data. The net profit ROE and ROTA both increased slightly, suggesting that, in
aggregate, resource allocation had become more efficient over the period.
The salient feature of the profitability results, whether expressed in absolute or in
ratio terms, is their lack of variability. The analysis in Module 5 identified a high
degree of volatility, particularly in upstream stages, but the corporate picture that
emerges of Shell is of relative stability over the three-year period. The impact of
volatility may become more apparent by disaggregating the accounts to divisional
level.
6.4.3 Financial Structure

Shell’s gearing ratio (that is, Long-term debt ÷ Equity) is low, at 10%. This gives the
company scope to raise further cash on the capital markets if required. Shell had a
‘positive’ outlook from credit ratings agency Standard & Poor’s and an AA1 rating
from Moody’s. It is therefore very unlikely that Shell would have struggled to raise
debt on the market at a favourable interest rate. In addition, interest cover is 45
times, having increased from 39 times in 2006. Shell was not exposed in its long-
term obligations.
The short-term situation is different. The current ratio is very low, at only 0.80.
The quick ratio, which ignores inventory, is even lower, at only 0.60. A quick ratio
of 1.0 or more suggests short-term financial stability; less than that means that the
company would not be able to meet all of its short-term obligations if it were to be
required to do so immediately. There is thus a higher level of risk in Shell’s short-
term situation than in its long-term situation.
The current and quick ratios tie in with Shell’s cash position, which was volatile
over the three-year period. The company’s cash position deteriorated significantly
between 2005 and 2006, owing to a large share repurchase. In 2005 and 2007, the
company returned around $4 billion to shareholders through repurchases, but in
2006, this totalled almost $9 billion. Also, large capital expenditure in 2006 contrib-
uted to make the cash flow for the year negative. At the end of 2007, the company
had $9.5 billion cash in hand, amounting to around 3% of total assets. The compa-
ny’s cash position is reflected in the current and quick ratios.
The rationale for Shell’s financial management is not clear. It is possible that it
did not wish to expand using retained earnings; hence the share repurchase. But the
share repurchase, combined with the low gearing ratio, suggests that Shell could not
identify investment opportunities. This leads to something of a paradox: a period of
low investment, followed by share repurchase and low gearing, but a weak cash
position.
Shell’s financial position can be summarised as follows:
 a low gearing level;
 increasing revenues and net profit; and
 a poor cash position, emphasised by low quick and current ratios.
In relation to the company’s ‘More Upstream, Profitable Downstream’ strategy, the
financial position presents a mixed picture and does not appear to be explicitly
aligned with the overall objective. The combination of share repurchase with low
gearing is not consistent with a major investment programme.
6.5 Divisional Performance and Operating Efficiency

The divisional results (Table 6.6) make it possible to assess the extent to which the
market characteristics of the different stages of the supply chain analysed in Module
5 impact on profitability.
Table 6.6 Shell divisional performance
$m Revenue % of Profit % of % Cost % of
($m) total ($m) total margin cost
Exploration and Production 53 308 13% 14 686 48% 28 38 622 10
Gas and Power 17 038 4% 2 781 9% 16 14 257 4
Oil Sands 2 854 1% 582 2% 20 2 272 1
Oil Products 286 072 71% 10 439 34% 4 275 633 74
Chemicals 45 911 11% 2 051 7% 4 43 860 12
Source: Royal Dutch Shell plc (2008, p 127); authors’ own calculations
The divisional results provide a first indication of where resources are deployed and
value is created. While these figures are approximate, there are clearly significant
differences between resource inputs and value creation. Exploration and production
consumed 10% of resources and generated 48% of profit, while oil products con-
sumed 74% of resources and generated 34% of profit. This can be interpreted in
terms of the shareholder value analysis in Core SP Section 7.5.1, taking profit as a
proxy for wealth creation, in which the typical mismatch between resource allocation
and wealth creation was displayed. The same mismatch is found here and the rationale
for ‘More Upstream, Profitable Downstream’ now becomes more apparent: value
creation per dollar of input is eight times higher upstream than downstream.
While the Shell divisional structure does not map precisely onto the industry supply
chain, the expectation emerges of lower margins the nearer the consumer. The 28%
margin in Exploration and Production compares with the 4% margin in Oil Products
– which raises the strategic question of why Shell continued to devote three-quarters
of its business to oil products for so long. It also provides a perspective on Shell’s
business definition: from the resource allocation viewpoint, Shell is an oil products
company, but from the wealth creation viewpoint, it is an exploration and production
company.
Shell’s capital expenditure across divisions shows how it had been allocating its
capital resources and whether this is in line with its ‘More Upstream, Profitable
Downstream’ strategy. Table 6.7 shows capital expenditure across the various
businesses in relation to the total and to a year earlier.
Table 6.7 Shell divisional capital expenditure

Segment $bn % of total Change from
2007 2007 2006
Exploration and Production 13.7 66% –13%
Gas and Power 3.0 14% 47%
Oil Sands 1.9 9% 123%
Oil Products 3.7 18% 9%
Chemicals 1.4 7% 265%
As expected, capital expenditure was heavily weighted in favour of upstream

activities. Exploration and Production capital expenditure accounted for 66% of
total investment. The year-on-year changes are not particularly important because,
by its nature, investment contains indivisible items; hence relatively small expendi-
tures can vary greatly from year to year. The absolute pattern of investment is thus
aligned with the stated strategy as far as ‘More Upstream’ is concerned.
An indication of investment is as follows.
 Upstream investment involved starting several major new projects in 2007. Shell
was also going through a process of sustained portfolio rationalisation, divesting
assets in mature fields in Norway, the UK and the US. New projects were locat-
ed in locations such as Malaysia, Qatar, the Gulf of Mexico and Oman.
 Gas and power investment was focused on gas to liquids (GTL) and LNG
projects, and also one wind-power project in the US. Oil sands investment con-
centrated on expanding the capacity of the Athabasca Oil Sands Project (AOSP).
 Investment in downstream activities was focused on refining and marketing, with
the refining investment concentrated on maintaining and upgrading manufacturing
facilities. The marketing investment was mostly allocated to the company’s global
retail network, which was expanded through acquisitions in Malaysia and Ukraine.
Investments were also made in petrochemicals facilities – most notably, the Shell
Eastern Petrochemicals complex in Singapore. This is consistent with the strategic
intent to develop in Asia-Pacific downstream markets. But it is an open question as
to whether the ‘Profitable Downstream’ strategy is achievable in emerging markets,
given the market analysis of Module 5. The market characteristics are unlikely to
be different in emerging markets, because of the underlying problem that the
product is homogeneous; hence it is difficult to generate monopoly profits and
higher margins.
6.5.1 Exploration and Production

The data for 2005–7 (Table 6.8) show how difficult it is to translate a strategy
statement into increased profit.
Table 6.8 Shell Exploration and Production

Exploration and Production $ million
2007 2006 2005
Revenue (including intersegment sales) 53 308 52 546 43 281
Purchases (including change in inventories) (3 935) (2 710) (1 121)
Exploration (1 712) (1 562) (1 286)
Depreciation (9 338) (8 672) (7 973)
Operating expenses (11 458) (11 000) (8 631)
Share of profit of equity-accounted investments 3 583 3 075 4 112
Other income/(expense) (390) (316) (282)
Taxation (15 372) (16 817) (14 523)
Segment earnings from continuing operations 14 686 14 544 13 577
Income/(loss) from discontinued operations – – –
Segment earnings 14 686 14 544 13 577
Shell’s operations in this area are complex: the company has many joint venture
partnerships and production-sharing agreements with governments and state oil
companies. Sustained expansion and development of exploration and production
activities are essential to Shell’s profitability, given the low margins in downstream
segments, but the company’s proven reserves have actually declined. Shell’s reserves in
wholly owned and joint venture entitlements decreased from 11 807 million barrels in
2006 to 10 826 million barrels in 2007. Shell’s global production levels decreased from
2 million barrels per day in 2005 to 1.8 million barrels per day in 2007.
This reduction in output was accompanied by an increase in operating cost. The
annual report states that the company’s average production cost per barrel of oil
equivalent increased from $5.54 per barrel in 2005 to $8.27 per barrel in 2007. But
such increases in cost are minor compared with the volatility of the oil price;
therefore it is to be expected that the earnings from this segment would also be
highly volatile. This is not confirmed by the year-on-year results, however, which
leaves the question open: why did segment earnings remain virtually static between
2006 and 2007 when the oil price increased significantly?
It would appear that the high capital expenditure in this segment had not, as yet,
resulted in the desired outcome. Segment earnings had not increased, while there
had been declining production volumes and reserves.
6.5.2 Gas and Power

Shell classifies Gas and Power as part of its upstream activities. The Gas and Power
division has a large LNG business, an R&D section, a renewables business and a gas
marketing business. In terms of the industry supply chain, the Gas and Power division
encompasses the gas midstream and downstream operations. This segment contribut-
ed 4% of Shell’s revenue, but 9% of its profits (Table 6.9).
Table 6.9 Shell Gas and Power

Gas and Power $ million
2007 2006 2005
Depreciation (315) (284) (372)
Other income/(expense) 739 230 221
Taxation (197) (299) 15
Note: As from 2007, the Gas and Power earnings include earnings generated by the wind and solar
businesses, which were previously reported as part of ‘Other’ industry segments. For comparison
purposes, the 2006 and 2005 earnings have been reclassified accordingly, resulting in a reduction
of $17 million in 2006 and $195 million in 2005.
The Gas and Power revenue decreased between 2006 and 2007, while operating
costs increased. This was, however, offset by an increase in ‘Other’ income, taking
the segment’s net profit margin from 15% to 16% in 2007. This other income
derived from the divestment of an interest that Shell owned in a US gas-processing
and LNG company. Without the proceeds of this sale, profit for Gas and Power
would have been 6% lower between 2006 and 2007.
Shell reported a 9% increase in LNG volume and had five more LNG ‘trains’
under construction. The company was targeting LNG as one of its main growth
areas, expecting 8–10% annual growth in the market ‘for the next few years’. Most
of this activity was focused on Asia-Pacific, where LNG was making gas accessible
to countries such as Korea and Japan, which had previously not been able to access
natural gas in its conventional form. Shell’s stated aim was to become one of the
world’s largest natural gas and LNG suppliers. This was not reflected in revenue
growth in 2007, but at 16% the margin is much higher than the 4% in oil down-
stream.
This segment also includes Shell’s renewables business, consisting of solar and
wind projects, which were previously reported in a different segment. The note
under the summary income statement states that these figures have been transferred
into the Gas and Power historical data, resulting in a loss of $195 million in 2005
and $17 million in 2006. It is not possible to access the figures for renewables for
2007, but there is an opportunity cost involved with the renewables business, which
may not be in shareholders’ interest. While it may be necessary to look for alterna-
tives to oil and gas in the long term, it is an open question whether that search
should be undertaken by the integrated oil companies.
This is another example of the difficulty of converting strategic intent into reve-
nue and profit. Revenues and profits have fallen since 2006, but there were
numerous major projects that the company was hoping to bring online over the
coming few years. It may be that lags in the system are quite long, but there is
always the problem that shareholders may not be willing to wait.
6.5.3 Oil Sands
Oil Sands is the division that deals with Shell’s unconventional oil operations in
Canada (Table 6.10). The subsidiary that deals with this activity, Shell Canada, was
previously only 78% owned by Royal Dutch Shell, but has since been taken in as a
wholly owned subsidiary. Shell owns 60% of the Athabasca oil sands project in
Canada and also has interests in the other two large oil sands projects in the area.
Bitumen is extracted and then is upgraded into synthetic crude oil. The synthetic
crude is used as refinery feedstock, and typically is light and sweet.
Table 6.10 Shell Oil Sands
Oil Sands $ million
2007 2006 2005
Purchases (including change in inventories) (1 010) (830) (623)
Operating expenses (967) (722) (664)
Share of profit of equity-accounted investments – – –
Other income/(expense) (5) (1) 10
Taxation (124) (123) (347)
Segment earnings from continuing operations 582 651 661
Segment earnings 582 651 661
Converting oil sands to synthetic crude oil is expensive and complex. The margin
in 2007 was 20%, compared with 28% for Exploration and Production, which
possibly reflects the process involved; however, the margin in 2005 was 27%, while
in 2006, it was 26%, which was much the same as for Exploration and Production.
The reduction in margin in 2007 was primarily a result of the 34% increase in
operating expenses, in spite of the fact that the output of barrels per day fell from
95 000 in 2005 to 81 000 in 2007 – a reduction of 15%. It is therefore not clear
whether Oil Sands can be scaled up without further reductions in margins, raising
doubt as to the profitability of the venture in the long run. Given that Oil Sands
contributed only 1% of revenue and 2% of profit, it may not be worth keeping it in
the Shell portfolio. The reduction in output is not consistent with the strategy of
‘More Upstream’.
It is worth noting that Oil Sands is not a new project that Shell ventured into as
part of its new strategy; the rights to the oil sands reserves had been acquired in
1956, although Shell did not start its first mine there until 2003. The acquisition was
therefore serendipitous, because at the time of purchase no one had any idea
whether unconventional resources would become economically viable.
6.5.4 Oil Products

The Oil Products segment (Table 6.11) consists of all Shell’s downstream oil
operations, including trading, manufacturing, marketing and a future fuels business.
Table 6.11 Shell Oil Products

Oil Products $ million
2007 2006 2005
Depreciation (2 440) (2 580) (2 622)
Other income/(expense) 13 7 69
Taxation (3 113) (1 972) (3 408)
In 2007, this was the largest of Shell’s divisions, employing 63 000 people out of
a total workforce of 104 000. It was also the least profitable division. While the
margin remained at 3–4% over the period, the absolute earnings were volatile:
segment earnings fell by 29% in 2006 and then increased by 47% in 2007. Because
of the low margin – that is, because there is a small difference between revenue and
cost – relatively small changes in revenue and cost lead to fluctuations in earnings.
For example, if revenue had remained static in 2007 and operating expenses had
risen by another 14%, the division would have lost about $25 billion.
There was a reduction in sales volume after 2005. In 2007, Shell sold the equiva-
lent of 6 625 000 barrels per day of oil products, whereas in 2005 the company sold
7 057 000 barrels per day. This illustrates how difficult it is to achieve the ambition
of ‘Profitable Downstream’; profitability increased in 2007, but this was partly a

recovery from the huge reduction in 2006. Because of the magnitudes involved, the
47% increase in earnings in 2007 had little impact on the margin. In addition, capital
expenditure was only 15% of the total, which may be indicative of how the long-
term prospects for ‘Profitable Downstream’ are perceived. If Shell were to divest
this massive low-margin division, ROTA and ROE would increase significantly.
6.5.5 Chemicals
The Chemicals segment (Table 6.12) is Shell’s petrochemical arm and the second
part of Shell’s downstream business. The Chemicals segment produces and sells
petrochemicals to industrial customers around the world. Shell deals only in base
chemicals and first-line derivatives, and leaves the more complex petrochemical
manufacturing to its customers. Petrochemicals have a diverse range of applications,
including plastics, coatings and detergents.
Table 6.12 Shell Chemicals

Chemicals $ million
2007 2006 2005
Share of profit of equity-accounted investments 694 494 423
Other income/(expense) (21) (13) (9)
Taxation (396) (119) (335)
Income/(loss) from discontinued operations – – (307)
Segment earnings 2 051 1 064 991
The Chemicals division is similar to the Oil Products division, in that it has a low
margin and earnings that are sensitive to changes in revenue and cost. The earnings
from continuing operations fell by 18% in 2006 and increased by 93% in 2007. In
addition, the annual report states that Shell has 2500 industrial customers globally
for its petrochemicals and that 25 customers make up around 60% of total sales in
the division (Royal Dutch Shell plc, 2008, p 55). Thus the loss of only a few
customers would have a significant impact on revenue, adding to the competitive
pressures identified in Module 5. Given the competitive characteristics of the
market, it is doubtful whether margins and profitability can be significantly increased
in the future, adding to the difficulty of achieving ‘Profitable Downstream’.
6.6 Overall Company Finances

The snapshot of finance for 2007 might appear to be perplexing at first sight: why
are there such enormous differences in margins among divisions? And is there any
prospect of increasing the margins of the low-margin divisions? The first question is
answered by the analysis of the industry supply chain in Module 5: the further down
the supply chain, the more intense the competition. The second question is also
answered by the analysis in Module 5: unless competitive conditions change, the
strategy of ‘Profitable Downstream’ is unlikely to impact significantly on overall
profitability, except to the extent that there are inefficiencies that can be eradicated.
The limited time series of three years demonstrates how difficult it is to achieve
increased profit downstream.
At the corporate level, Shell’s capital expenditure is aligned with its strategy,
although Shell still has plenty of scope for expansion, as evidenced by the relatively
low gearing. There is, however, a significant degree of short-term exposure shown
by the quick and current ratios.
6.7 Value Chain

The oil and gas industry has been characterised as a supply chain that starts with
exploration and ends with the sale of products to the end consumer. A company
can also be characterised as a supply chain starting with inputs and ending with sales
and service. The problem with depicting a company as a supply chain is that there
are many activities, particularly in a multiproduct company, which cannot be related
directly to individual processes. For example, support activities such as HRM and
management systems are essential, but it is impossible to allocate them to specific
parts of the supply chain. Shell’s divisional structure was mapped onto the industry
supply chain to identify where its activities lay in terms of upstream and down-
stream, so that its financial results could be interpreted by reference to the market
analysis presented in Module 5. Michael Porter’s insight was that all activities
contribute to the creation of value – otherwise, they should not exist – so he
classified them as ‘primary activities’, which approximate to the physical supply
chain, and ‘support activities’, which enable the supply chain to operate efficiently
and make strategic decisions (Porter, 1985).
Because of the variety of organisations, there is no single universal value chain
that can be applied in all cases, but Porter identified a generic value chain that can
be used as a starting point. This is set out in Table 6.13, together with the type of
activities it might involve in an exploration company and a refining company.
Table 6.13 Value chain analysis

Value chain component Exploration Refining
Primary activities
Inbound logistics: receiving, storing and Data acquisition Supply crude oil
handling inputs to the production process
Operations: transforming inputs into outputs Feed data into analytical Convert crude oil to
programs petrol and diesel
Outbound logistics: bringing the product to Analyse the results Put output into storage
the buyer or, in the case of services, bringing
the buyer to the product
Marketing and sales: providing the buyer with Make a case for Branding
information, inducement and opportunities to development
buy the product
Service: maintaining the value of the product Check that predictions are Ensure adequate
confirmed in development inventories maintained
stage
Support activities
Procurement: process by which resources are Ensure logging devices and Traders purchase crude
acquired computer hardware/ oil
software up to date
Technology development: technology associ- Develop software Incorporate latest refining
ated with each of the value activities, including techniques
learning, product design and process devel-
opment
HRM: managing human capital Deal with highly educated Deal with mainly semi-
knowledge workers skilled workers
Management systems: quality control, finance, Prepare tenders for Focus on efficiency
operational planning, etc. exploration contracts;
carry out risk analysis
Despite the fact that it is not possible to attribute value creation directly to each
activity, it is usually possible to identify where the chain is particularly strong or
weak: a sudden drop in profit, for example, suggests that something has gone
wrong. The value chain can thus be used as a diagnostic tool. Porter (1985) had the
additional insight that it was not only how effectively each component of the value
chain operates that determines profitability, but also the linkages among the
activities, for example those responsible for service activity may not have a line of
communication to technology development to inform that team of an increase in
the number of faults reported. The construction and maintenance of an effective
value chain are not easy.
Shell’s value chain is constructed as illustrated in Table 6.14 and Table 6.15,
which derives from information in the company’s 2007 annual report and the
organisational chart in Porter (1985). Once the value chains have been derived, the
relationship and links between the stages will be discussed as an example of vertical
integration.
Table 6.14 Shell upstream value chain

Activity Exploration and Production Gas and Power Oil Sands
Primary activities
Inputs Skilled labour and engineering Gas produced by Exploration and Oil sands mined by the division are
Exploration and development Production and from open market processed and upgraded to synthet-
ic crude oil
Operations Production of equipment for Processing of gas, LNG activities are Mining and upgrading of bitumen
exploration, development and important in this sector
production of oil and gas Wind-power operations
Production activities
Marketing and sales Handled by Shell Trading Handled by Shell Trading Handled by Shell Trading
71% of division’s production sold to 94% of division’s production leaves 63% of the division’s production
Oil Products division internal chain at this point sold on to Oil Products division
Outputs Crude oil and natural gas Gas and electricity Synthetic crude oil
Support activities
Technology Each segment has its own technology development function; can lead to problems with duplication of effort and
development principal–agent issues
Management systems Support functions such as finance, HR, IT and legal are all managed centrally by Corporate; costs for Corporate
are spread across segments using accounting conventions
Table 6.15 Shell downstream value chain

Activity Oil Products Chemicals
Manufacturing Trading Marketing
Supply distribution Refining
Primary activities
Inputs Ships, storage facilities, Crude oil from markets Crude oil and natural Finished products Petrochemical
road and rail tankers and from Exploration and gas from Refining feedstock from
Crude oil and finished Production, Oil Sands Unknown propor- Refining
products 16% produced internally tion purchased
from third parties
Operations Diverse; shipping is a Complex processing of Trades produced Three sections: Processing
global activity, while raw materials into various hydrocarbons on the Business-to- feedstock into
many local distribution finished products open market and business (B2B); base chemicals
networks are also provides feedstock Lubricants; Retail and first-line
necessary optimisation for Refining derivatives
Marketing Not a value-generating Handled by Marketing This is the marketing Marketing and Handled by
and sales activity as such and sales activity for sales for Shell’s Shell Trading
Shell’s upstream downstream
operations (Exploration operations
and Production, Gas
Products, Oil Sands)
Outputs Products to destination Fuels, lubricants, petro- – – Petrochemicals
chemicals
Support activities
Technology Each segment has its own technology development function; can lead to problems with duplication of effort and
development principal–agent issues
Management Support functions such as finance, HR, IT and legal are all managed centrally by Corporate; costs for Corporate are
systems spread across segments using accounting conventions
A composite picture can be built up of all the activities using a variation on Por-
ter’s original schemata (Figure 6.2). The supply chain activities are spread along the
bottom of the chain, with support activities along the top. For ease of presentation,
chemical processing is included within the refining activity.
Support activities Exploration
Field development
Research and development
LNG transportation and gas infrastructure

Profit
Supply and distribution
Shell corporate, company infrastructure
Shell Marketing
Production Trading
added
Value
Gas
Crude oil Refining B2B
liquefaction
Gas products Retail
Oil sands Chemicals Lubricants
Figure 6.2 Porter value chain for Shell

Support activities
 Exploration is necessary to find new assets to exploit.
 Field development is required before production of hydrocarbons can start. The
first two support activities support the Production primary activity.
 Research and development is necessary to keep up with the increasingly complex
demands of production environments, and to optimise refining and processing
capabilities. It provides support for Production, Oil Sands, Gas Liquefaction and
Refining.
 LNG transportation and infrastructure is necessary to transport LNG to customers.
This provides support for the Gas Liquefaction primary activity.
 Supply and distribution supports all activities, moving outputs along the chain,
connecting the value-generating activities of the company together.
 Shell Corporate and infrastructure supports all activities and provides central func-
tions such as HR, finance, legal and administration.
Primary activities
 Production/Oil Sands produces the commodities on which all the company’s sales
and products are based.
 Trading trades the commodities, and some finished products, generating a return
on the company’s production activities.
 Refining turns the raw product into various end products for diverse markets.
 Marketing sells most of the company’s end products to diverse customers.
This tentative model of Shell’s value chain has been derived from public sources.
Having established the relationship between each of the company’s different
activities, it is possible to assess how rational the company’s divisional structure is

and the extent to which the structure complements the linkages among the different
activities.
The first step is to establish how Shell groups its divisions together. Shell consid-
ers Oil Sands to be part of its downstream business. Clearly, this is not the case,
because the activity has a lot more in common with Production than it does with
Oil Products or Chemicals. Also, Shell considers its Gas and Power division to be
part of the upstream business, while in actual fact it crosses the upstream and
downstream boundary.
It also appears that the divisions are not structured entirely in line with value-
generating activities. The fact that the Oil Products division is so large and encom-
passes so many of the company’s activities means that it appears at various points
along the chain. Taking each stage in turn, there seems to be confusion between the
company’s structure and the value chain. This has implications for the implementa-
tion phase of the strategic process.
The activities can thus be mapped as in Table 6.16, along with the divisions in
which they take place.
Table 6.16 Value chain vs organisational structure

Division Exploration Oil Gas Chemical Oil
and Sands and Products
Production Power
Production, Oil Sands × ×
Trading ×
Gas Liquefaction ×
Refining × ×
Marketing ×
 Production, Oil Sands. This involves two divisions: Exploration and Production,
and Oil Sands.
 Trading. The first time that this appears in the value chain is within Oil Products.
 Gas Liquefaction. This activity involves only Gas and Power.
 Refining. Part of Oil Products, this a different activity from trading or marketing.
The Chemical division is involved in chemicals processing.
 Marketing. Part of Oil Products, this is a different activity from the other parts of
the chain.
But simply disaggregating the company into its component activities and mapping it
onto a chain does not give the whole picture. From Table 6.16, it is difficult to see
how the different divisions combine to make the value chain operate effectively.
The linkages between the activities contribute to sustainable competitive advantage
because while it is possible to copy successful parts of an organisation, it is very
difficult, or impossible, to replicate the way in which the organisation fits together.
From this analysis, however, it is difficult to determine whether the divisions are
linked in such a way as to be responsive to changes in the competitive environment

and to work together efficiently.
The preceding analysis suggests that there is little value chain rationale for Shell’s
divisional structure. Problems with the relatively large Oil Products division, which
encompasses many more activities than the rest of the divisions, are likely to cause
problems in strategy. Trading activity acts at a different part of the supply chain from
the rest of the division, so it may be more effective to manage it separately. (Note that
some of Shell’s activities have not been included in the value chain; they will be
discussed as examples of diversification, in Section 6.8.3.)
The fact that it is difficult to impute a value chain rationale to the divisional struc-
ture may be symptomatic of an organisation that should not exist as an integrated
entity. In Core SP Section 6.12 and Table 6.10, British Gas was analysed in terms of
its potential valuation after break-up during the 1990s, which appeared to be
significantly greater than its corporate value. This is an application of shareholder
wealth analysis developed in Core SP Section 3.12.6. So the central question
remains: in what way does the Shell corporate structure add value to the individual
businesses?
6.8 Scope and Scale

Across the oil and gas industry, there are many different shapes and sizes of firm,
ranging from upstream companies involved only in the exploration and production
of hydrocarbons, and oil service companies that set up a production site or manage
exploration activities, to refining companies that only refine crude oil. There are also
companies like Shell, whose activities cover all of these, and more. The decision
regarding which activities to focus on, and which products and services to include in
the portfolio, is essentially a decision on diversification, and raises a number of
issues, including those of economies of scale and economies of scope.
6.8.1 Economies of Scale
The concept of scale economies relates to the unit cost at different levels of output.
Economies of scale exist when, as the scale of output increases, the cost per unit
falls. Economies of scale can occur for a number of reasons, including the follow-
ing.
 Indivisibilities. This instance arises when increases in size and capacity come in
discrete amounts only. It is normally associated with machinery, but can also
apply to human resources. For example, the company may require a new engi-
neering team, but hiring one will generate excess capacity. In the oil industry, this
is exemplified by the fact that oil refineries tend to be very large-scale operations
with high fixed costs. To operate a refinery at half-capacity would produce a
higher cost per unit than operating the same plant at full capacity.
The potential for indivisibilities varies along the industry supply chain, and this
has implications for market entry and vertical integration. Where indivisibilities
are high, the entrant would need to be fairly certain of the likely level of demand;
otherwise, it may end up with significant excess capacity and hence higher unit
cost than competitors. Table 6.17 outlines two different scenarios for indivisibili-
ties along the oil industry supply chain for two different locations.
Table 6.17 Scenarios for indivisibilities

Supply chain Scenario 1 Scenario 2
Exploration High: extra exploration vessel Low: buy specialist services as required
Development High: total infrastructure required Low: companies specialise, e.g. drilling
Production High: wellhead processing Low: NOCs contract out specific
processes
Trading Low: additional traders can be hired Low: additional traders can be hired
Transport High: additional tanker High: additional pipeline
Refining High: service specific area Low: focus on certain products
Storage High: local monopoly High: local monopoly
Marketing and High: infrastructure Low: additional filling station
distribution
The precise classification depends on many factors, but the two scenarios have
different implications for a company that integrates the entire supply chain.
 In Scenario 1, the company would experience significant problems in aligning
capacity with demand throughout the supply chain and at each stage is likely
to have excess capacity, or to be selling a significant proportion of intermedi-
ate output on the market.
 In Scenario 2, the company would be able to align resources with output
much more closely.
 Technical relationships. The oil and gas industry, being capital-intensive, benefits
from a declining relationship between capacity and unit cost. It would not re-
quire double the capital goods to produce twice the amount of oil from the same
field, for example: it is not always necessary to build a second rig; instead, pro-
duction might be enhanced through artificial lift of other production-
optimisation technologies.
 Specialisation. This is an important factor in scale economies, in the sense that a
particular team or group of employees can develop extensive experience of per-
forming their operational activity, such as petroleum engineers.
Economies of scale are likely to have different characteristics at different stages of
the industry supply chain.
 Exploration. It is not immediately apparent that there are economies of scale in
exploration. Each geographic area needs to be explored separately, using sepa-
rate equipment and a separate team of scientists. It is possible that there are
economies of scope arising from spillover from one area of R&D to another;
such spillovers, however, are notoriously difficult to plan for and typically tend
to be recognised only after the event. The quest for synergy is, as ever, a tenuous
basis for diversification. It is certain that there are accumulated experience bene-
fits and that firms will develop a significant intangible asset in the form of tacit
knowledge. Whether this confers a significant competitive advantage is an open
question, because all R&D teams undergo the same learning-by-doing. Further-
more, it is possible that this tacit knowledge can be achieved simply through
attracting experienced individuals by offering attractive compensation.
 Development. Economies of scale are unlikely to occur in service activities. A

company may be able to reap the benefit of economies of scope by undertaking
all of the development activity – that is, it may cost less for one large service
company to develop a drilling site than it would to get a separate company to
perform each activity separately. Again, experience benefits are likely to manifest
themselves in the form of tacit knowledge built up within an organisation.
 Production. Economies of scale may arise in the manufacturing of recovery
systems or production assets, but are unlikely to be apparent in management
services. However, there are potential economies of scope in project manage-
ment services if the management company can run several projects concurrently
for the same client or in close proximity to one another, or run development and
production projects together. Significant experience effects will be gained by the
company that is able to move up its experience curve quickly in project man-
agement, and this combined experience and knowledge built up within a division
or company will contribute significantly to competitive advantage.
 Transportation. There may be significant economies of scale within the tanker
market, depending on the size of the vessel. By transporting a larger volume of
oil at the same time, a company can save on some costs, including labour and
fuel. Economies of scope may also exist between pipelines and tankers, and a
company that operates both may be able to save on transport costs. Experience
effects are not obvious; the main skills required are less technical and more gen-
eral than in the upstream industry.
 Refining. Economies of scale characterise this stage of the supply chain and small
refineries do not exist; rather, refineries form the centre of large industrial pro-
cessing plants and, up to a certain point, the cost of operations reduces with size.
However, this is unlikely to give any one refinery a competitive advantage in
terms of lower costs, because all refineries are very large in size. Economies of
scope may also be derived from having petrochemical processing plants nearby
that turn petrochemical feedstock into saleable petrochemicals. There is also
scope for significant experience effects to build up within a workforce, although
the effect will be less pronounced than in the upstream sector, because much of
the labour required is not skilled.
 Storage. Storage is a relatively uncomplicated activity, in that all the processing has
already been done, and it is unlikely that there are significant economies of scale
in the sector. Economies of scope may be derived from operating a refinery and
a storage depot.
Shell may benefit from economies of scale for some of its activities, but this in itself
is not sufficient to confer competitive advantage on the company. Economies of
scale confer competitive advantage only in the following instances.
 If they are significant. This is likely in the case of Shell’s refining operations,
although it is not possible to identify the benefit that the company derives from
scale efficiency. For example, it may be that unit cost decreases significantly up
to some output beyond which there is no additional cost advantage. Relatively
small refineries would be at a cost disadvantage, but very large refineries would
have no cost advantage over large refineries. Often, economies of scale are pur-
sued in the belief that they are significant, but it is difficult to generate empirical
evidence that economies of scale are always so.
 If the company is operating on the production frontier. Shell’s ‘Profitable Downstream’
objective could be interpreted as an attempt to shift closer to the production
frontier – that is, that the company is not operating as efficiently as it could. The
scale of operations will not generate economies in the absence of appropriate
incentives and control systems.
 If the company is larger than its competitors. Shell is one of the top three integrated oil
companies in the world, along with ExxonMobil and BP. In 2008, Shell had a
market capitalisation of $249 billion and BP, $209 billion. So Shell had the po-
tential for some economies of scale advantage over BP. However, ExxonMobil
had a market capitalisation of $457 billion – almost twice the size of Shell. While
Exxon had the potential for economies-of-scale advantage over both Shell and
BP, it is not known whether doubling a company the size of Shell confers any
scale advantages. It could be that the three companies are dominant because they
have the scale to achieve economies that their smaller rivals cannot, but whether
Exxon has a cost advantage over Shell and BP is an open question.
The difficulty in arriving at an estimate of the impact of scale is that size and scale
are not necessarily the same thing. For example, when it comes to size, ExxonMobil
may have a ‘longer’ and more complex supply chain, so its size may not necessarily
confer cost advantage. Further, there are potential diseconomies of scale, such as
the costs of coordinating an extended supply chain. In this case, management is the
ultimate fixed resource, which cannot be increased, even in the long run.
6.8.2 Economies of Scope

The idea of economies of scope refers to a reduction in unit cost as the number of
products is increased. The argument is that if two companies that produce different,
but somehow related, goods were to merge, their resulting unit costs would be
lower. Reasons for the existence of economies of scope include the following.
 The sharing of inputs among several outputs. These inputs might be physical resources,
including skills and competences. Shell is unlikely to benefit here, because the
skill sets required in each division – and within different parts of the same divi-
sion – are different.
 Reputational spillover. The good reputation for one product may spill over into
another. While Shell has a well-known brand name, it may not benefit from rep-
utational spillover, because its final products are essentially homogeneous. The
company’s reputation may be an advantage when entering production-sharing
agreements with NOCs, but it may also be a disadvantage if an NOC is prone to
resource nationalism.
 R&D spillover. R&D at Shell is handled within the different operating divisions,
and while there may be spillover within the divisions, technical requirements are
different in each division.
 Enhanced ability to compete within a range of related industries with a coordinated strategy.
Shell may benefit from this because it competes at all levels of the oil and gas
supply chain. This could bestow competitive advantage on Shell over companies
that compete at only one stage of the supply chain. However, it will not give the
company an advantage over the other integrated majors. In any case, the mecha-
nism by which this effect might operate is unclear, It is difficult to see how a
strategy on exploration can be coordinated with marketing and distribution: the
two activities are at opposite ends of the industry supply chain and operate under
different competitive conditions.
Economies of scope are concerned with the company’s portfolio, and are closely
related to diversification and synergy; it was discussed in Core SP Section 6.12.2
how the quest for synergy is based on a questionable hypothesis and that synergy, if
it exists, is an unpredictable phenomenon. At first appearance, Shell, as an integrated
oil company, appears to be focused on its business definition ‘oil and gas’. However,
the following section will demonstrate that Shell’s operations are quite diverse.
6.8.3 Diversification
In the pursuit of economies of scale and scope, how far from the core business
should the company stray? Some companies in the industry are little more than
holding companies. Centrica, as considered in Module 3, is an example of a diversi-
fied company. After being demerged from British Gas’s upstream business in the
late 1990s, Centrica was a downstream energy provider to homes and businesses in
the UK. By 2008, however, Centrica had operations in upstream gas production and
electricity generation, equipment servicing and drain-cleaning services. In 1999,
Centrica acquired the AA, a major UK motor vehicle breakdown company. The
strategic rationale for this acquisition was analysed in Core SP Profiler case study
‘Where is the Road Leading?’ The case analysis at the time concluded that this was
replication-based diversification, but that Centrica’s diversification strategy lacked
coherence over time. The AA was divested in 2004.
Centrica moved into the servicing of boiler equipment under the impression that,
as a gas and electricity provider, it was related diversification. In actual fact, it was
unrelated, because the skill sets required for gas and electricity provision and to
operate a breakdown service business are different. The move into drain-cleaning
services, with the acquisition of the Dyno-Rod business, is also questionable. It is
possible that relatedness was perceived between the gas-servicing business and the
drain-cleaning business, in that they are both service companies, but the products
that they service are completely different. It would be impossible for employees to
switch between activities, because the skills required are again different.
In Shell, the ideas about diversification can be applied to assess how related each
of the company’s businesses are, starting with an examination of the routines and
resources (Core SP Section 6.12 and Figure 6.7) needed for each business (Table
6.18).
Table 6.18 Shell and competence-based diversification

Business Routines Resources
Exploration and Exploration is speculative; production Capital goods, human resources, large
Production routines involve knowledge built up initial investment required; specialised,
within the division non-transferable equipment
Gas and Power Logistics management Specialised, non-transferable equipment;
output taken from Exploration and
Production
Oil Sands Similar to Exploration and Production, Capital goods, human resources, large
but processes are different initial investment required; specialised,
non-transferable equipment
Trading Feedstock optimisation; knowledge of Human resources; very different from
commodity markets/finance other activities
Supply and Logistics management Shipping resources; land transport
Distribution network
Refining Process management and optimisation Specific assets; highly complex chemical-
processing facilities
Marketing Customer service; service management Human resources; marketing effort;
brand name
Chemicals Process management and optimisation Specific assets; highly complex chemical-
processing facilities
The classification in Table 6.18 demonstrates that, in terms of resources and

routines, there is little relationship between Shell’s different businesses. While one
or two divisions may share similar routines, the resources required at each stage are
specific to that activity and cannot be transferred among divisions. The lack of
relationship between Shell’s businesses is common among vertically integrated firms
that have operations at different points along an industry supply chain. ‘Oil and gas’
as a business definition is vague, and can encompass many different, unrelated
activities.
The expansion trajectory through the industry supply chain, from exploration to
final sales, can be plotted against a competence-based diversification matrix (Figure
6.3).
Acquired Routine based Unrelated
Resources
Current Replication based Resource based
Current Developed
Routines
Figure 6.3 Competence-based diversification matrix

The following is the outcome.
 Exploration to Development is routine-based: many routines are common, but the
resources are different.
 Development to Production is resource-based: many resources are common, but
the routines, such as project management, are different.
 Production to Trading is unrelated: different routines and resources are required.
 Trading to Transport is unrelated: different routines and resources are required.
 Transport to Refining is unrelated: different routines and resources are required.
 Refining to Storage is routine-based: some routines are common, but the resources
are different.
 Storage to Marketing and Distribution is unrelated: different routines and re-
sources are required.
The exploration company that expands throughout the industry supply chain
therefore expands farther and farther into the unrelated sector. The precise trajecto-
ry depends on where the company starts: a refining company might integrate
vertically both forward and backward to cover the entire supply chain, for example,
in which case the trajectory would still shift predominantly into the unrelated sector.
The industry supply chain does not contain the full story of the diversification
trajectory for Shell, because some other businesses that Shell is involved in have not
been discussed so far, including the following.
 Shell Global Solutions (part of Oil Products). This segment provides business and
operational consultancy to the ‘energy’ and ‘processing’ industries – the defini-
tions of which are wide and non-specific. On its website, Shell Global Solutions
states that the business:
… delivers top-tier technical services and licensed technologies. By draw-

ing on the Shell Group’s extensive global operating experience, we
leverage our technologies and technical service offerings for clients ranging
from major international corporations through to national oil companies,
government agencies and independent refineries (Shell Global Solutions,
undated).
There are some skill sets residing in the business that would be useful for con-
sulting, but the routines needed to manage a consulting business would need to
be developed independently of the rest of the company’s activities, and resources
such as skilled consultants and stakeholder managers would need to be acquired.
Therefore this is routine-based diversification.
 Renewable Energy (part of Gas and Power). Shell has interests in various wind-power
projects around the globe and is also developing more efficient solar power
technology. The routines and resources required here are different from those
intrinsic to the company’s core businesses, so this is unrelated diversification.
 Future Fuels and CO2 (part of Oil Products). This business is concerned with the
development of biofuels, coal-to liquids (CTL) and GTL technology, and with
energy efficiency and CO2 management across the rest of Shell’s activities. This
division may be able to draw on some of the knowledge built up in Shell’s vari-
ous R&D branches and is most likely managed in the same way as an R&D
operation, so in terms of routines, this is a familiar operation. However, re-
sources will need to be acquired. This is routine-based diversification.
 Jiffy Lube (part of Oil Products). This arm provides basic oil-change and engine
maintenance checks, along with servicing and windscreen repair. Jiffy Lube also
performs maintenance on air conditioning systems and air filtration systems for
motorists across the US. The division is currently expanding into China. Most of
the service centres are franchised, but Shell operates around 10% of the compa-
ny’s 2200 US centres directly. The lack of suitable routines or resources in Shell’s
oil and gas business means that this is unrelated diversification in an extreme
form; it can be argued that Shell has moved into another supply chain altogether.
Shell manages this as part of its lubricants business.
These businesses have a limited relationship with the rest of Shell’s activities and do
not fit within Shell’s value chain. They are separate chains in themselves and the
rationale for including them in the portfolio is not clear: the only advantage that
Shell gets from owning Jiffy Lube, for example, is that the servicing centres can use
Shell lubricant products. This is unlikely to give Shell a competitive advantage in the
global lubricants market.
6.8.4 Vertical Integration

Companies such as Shell are classic examples of vertical integration. In Shell’s case,
the company started off as a transportation and trading company, and slowly
expanded its operations up and down the supply chain, merging with Royal Dutch
Petroleum, an exploration and production company, in 1907.
Shell’s original operations did not involve hydrocarbons; it exported textiles and
machinery, and imported rice from the Far East. It started operating in Baku,
Russia, and negotiated deals with oil producers in the region. The merger with Royal
Dutch was undertaken to facilitate better competition with the American company
Standard Oil, which later became Exxon. It is not clear when, if ever, a decision was
made to aim for a fully integrated company that straddled the entire industry supply
chain. Perhaps a detailed analysis of the company history would reveal the extent to
which vertical integration was pursued, based on the potential value chain linkages
or the conviction that vertical integration was bound to be ‘a good thing’.
Figure 6.4 shows Shell’s operations set out as a product flow diagram, indicating
the extent and nature of the company’s vertical integration. Where available, product
flow percentages are indicated.
Exploration and Production

Oil Sands division
division
94% of GP output
29% of Crude Oil output Shell Trading
37% of Synthetic Crude
Chemicals output
Supply and Gas and Power

Distribution division
Refining
Supply and Petrochemicals

Feedstocks Chemicals division
Distribution
Business to
Retail Lubricants
business
Jiffy Lube
Oil Products division
Figure 6.4 Shell’s vertical chain
There are a number of benefits and costs associated with vertical integration,
whereby a company is choosing between using the market to obtain inputs and
performing the activity itself. Problems with vertical integration, however, include
the following.
 There can be a mismatch in the optimal scale of production between stages. This
is evident in Shell’s case, because 29% of the company’s crude oil output is sold
on the open market, along with 37% of the company’s synthetic crude oil.
 Businesses at each stage can be radically different and can present different
strategic problems. This has already been demonstrated, in that Shell has different
routines and resources at each level of the supply chain, and is also faced with
different competitive conditions.
 The risks at each stage are compounded, because one part of the supply chain
affects all the others.
However, vertical integration can help to overcome other difficulties, as discussed in
Core SP Section 6.12.3, such as the hold-up problem, asymmetric information and
the difficulty of drawing up contracts that cover every eventuality.
The potential benefits that are claimed for vertical integration are evaluated in
Table 6.19 by suggesting a reason why each benefit might fail to be realised in an
integrated oil company.
Table 6.19 Possible rationales for vertical integration

Potential benefit from vertical integration Why it might not come to fruition
Vertical integration gives access to more powerful The length and complexity of the supply chain
governance structures and disputes can be settled weaken governance.
internally.
The certainty of the internal relationship and its Major oil companies are continually divesting and
continuity give more incentive to get things right. acquiring businesses, and buying in services, so there
is no continuity.
Vertically integrated divisions are more likely to This does not take into account the principal–
behave in a cooperative manner, because they see agent problem.
themselves bound together in a common purpose.
Coordination of the complex product flows It is unlikely that planning is more efficient than
experienced in the industry is made easier by market forces.
overall internal control.
Sensitive information is less likely to be leaked to That is an empirical issue with no foundation in
competitors. fact.
Some transaction costs can be avoided. The absence of market forces can make internal
pricing inefficient.
So do the component parts of Shell benefit from vertical integration? Even a

cursory inspection of its structure raises doubts: for example, Shell is not able to
process all of its production, so it sells some on the open market, and 37% of
synthetic crude produced by the Oil Sands division is sold to other companies.
Perhaps the problem can be best summed up by posing a question: why do inte-
grated companies sell the petrol? This is identical to the question of whether
brewers should run pubs to sell their beer. A filling station sells more than petrol,
just as a pub sells more than a single brewery’s beer. The investment issue to be
resolved is whether there is a higher return from building and operating filling
stations than from selling petrol to filling stations. There is a significant principal–
agent issue to be resolved, because the incentives for the independent filling station
owner are different from those for the salaried filling station manager. This perhaps
explains why franchising is a popular method of operating filling stations for many
integrated companies.
6.9 Competences and Strategic Architecture

The discussion of competences in Core SP Section 6.14 emphasised that compe-
tences are not obvious, such as having a large R&D operation or vertical integration;
rather, a core competence has to exhibit certain characteristics.
 It must be difficult to identify.
 It must be difficult to imitate.
 It must not reside within a single strategic business unit.
 It must be relatively rare.
Given the problems of unrelated diversification and the dubious benefits of vertical
integration, perhaps this intangible factor is the only way of explaining why Shell
may have a competitive advantage. It could be argued that, in Shell’s case, value
chain management (that is, how the different divisions fit and work together) can be
considered as a core competence. The competence would be spread across several
managers and is therefore difficult to identify. The group of managers is a unique set
of individuals and the group characteristics will be difficult to imitate. Strategic
architecture management involves the value chains of all strategic business units of
the company and the way in which it is managed may have the potential to generate
competitive advantage over competitors. But because of the characteristics of a core
competence, it is very difficult to identify how the architecture generates competi-
tive advantage and the structure of the company may well be the outcome of
wishful thinking.
Table 6.20 offers a critical view of the potential for core competence in Shell.
Table 6.20 Shell and core competence

Characteristic of core competence Why it may not be evident
It must be difficult to identify. In complex businesses, it is often not clear to managers
where their advantage lies.
It must be difficult to imitate. It is a necessary, but not sufficient, criterion.
It must not reside within a single strategic It is difficult to visualise the competence that is common to
business unit. exploration and transport.
It must be relatively rare. The same competence is unlikely to be relevant to both
upstream and downstream activities, so Shell would need
more than a few.
As discussed in Core SP Section 6.15, strategic architecture typically develops

over a long period of time and in a random fashion. This is most likely what has
happened to Shell, given that the company’s current structure is the result of more
than 100 years of operation. The internal strategic architecture is unique to Shell, but
it is not clear whether it confers any competitive advantage on the integrated
company. It could be that 100 years of competitive action has resulted in the
evolution of a highly effective strategic architecture. But if it is the outcome of
evolution, it becomes virtually impossible to disentangle cause and effect, and to
extract useful lessons from Shell’s experience.
6.10 Strategic Advantage Profile

The strategic advantage profile (SAP) pulls together the analysis of the company and
classifies important factors as strengths or weaknesses. This can then be used in
conjunction with an ETOP developed in Section 5.12 for making strategic deci-
sions.
Table 6.21 Royal Dutch Shell strategic advantage profile in 2008

Internal area Competitive strengths Competitive weakness
R&D Each division has individual R&D section, Lack of central control may lead to
providing quicker knowledge transfer principal–agent problem
Human Large diverse workforce; tacit knowledge Large size and geographical diversity can
resources built up within divisions be cumbersome in dynamic environment
Financial Low gearing and good credit rating; Oil Rising revenues are result of volatile
Products’ profit margin increased external factors; costs are rising; weak
short-term financial position
Production Upstream and downstream operating Declining production levels across all
close to capacity divisions; renewables are running at a
loss
Marketing Large global chain of fuel retailers Diverse customer industries; Jiffy Lube
reinforces brand venture is unrelated
Structural Divisions are highly specialised and can Value chain rationale for the divisional
build up a knowledge and experience structure is confused
base; can take advantage of economies of
scale within divisions
This array of strengths and weaknesses is not comprehensive or definitive, but

even this short list shows how perplexing it can be to identify what gives a company
competitive advantage. Focusing on the strengths gives a totally different impression
from focusing on the weaknesses, so clearly it is important to carry out the analysis
to identify the profile fully. It is also necessary to rate the various strengths and
weaknesses. Only then it is possible to move to the next stage of the strategic
process model – namely, choice of strategy. Module 7 will demonstrate how the
ETOP and the SAP can be combined to reach conclusions and make choices
among strategies.
6.11 Shell in 2015

While some aspects of Shell’s operations have changed in the years since the annual
report analysed was published, the supply chain coverage and business definition of
the organisation remain much the same. That said, a number of changes have
occurred in the intervening years – not least the two oil price crashes of 2008 and
2014. After Jeroen van der Veer stepped down as CEO in 2009, Peter Voser was
appointed until the end of 2013, at which point Ben Van Beurden took over.
Despite changes in the external environment, Shell’s overall strategy is still con-
cerned with growth in the upstream areas of the industry supply chain and more
focused management of downstream assets. It is of note that the company’s website
now talks of focused growth in selective downstream markets, in contrast to the
statements made in the 2007 annual report. This is perhaps because of the uncer-
tainty surrounding riskier upstream operations, given lower oil prices throughout
2015.
In terms of structure, addressed in Section 6.5, the company now divides itself
into:
 Upstream Americas;
 Upstream International;
 Downstream; and
 Projects and Technology.
Shell now divides financial performance into reports on only Upstream and Down-
stream, meaning that it is not possible to track the performance of businesses such
as Oil Sands and Gas and Power over time. It must be noted, however, that this
change does not represent a reorganisation of the company structure; it means only
that there has been a change in how the company reports its results. This division of
the financial reports in fact allows less insight into Shell’s operations than the earlier
report that has been analysed in this module.
The lack of change in overall direction, similar coverage of the industry supply
chain and relatively similar structure, albeit with different reporting standards, means
that, in strategic terms, Shell’s objectives and approach have not changed. Its value
chain is likely to be similar, as are its architecture and sources of competitive
advantage. That does not mean, however, that the company has stood still, or that
little has happened.
We know from the analyses in Module 4 and Module 5 that there has been a
significant amount of change in the external industry, and we have noted too that
there has been two changes of CEO in the intervening period. A change in CEO
can often result in a significant strategy shift, especially when a company has been
underperforming. In Shell’s case, however, the CEOs have been internal appoint-
ments who have served their full terms in office before retiring, meaning that the
company’s culture, approach and strategic intent may have been ‘hardwired’ within
each candidate before taking over. It was noted in Section 6.4.3 that the company’s
financial structure was very conservative; the same might be said for its strategy and
general approach. Indeed, being an integrated oil and gas company is a rather
conservative – some might even say old-fashioned – approach to organising in the
oil and gas industry. The lack of change over the period covered in this module
might be explained by the conservative nature of the company specifically, or of
integrated oil and gas companies in general. The question then arises: why do
vertically integrated oil and gas companies exist, and why do they choose to stay that
way?
Of course, the strategist knows that being an integrated company with coverage
of the whole supply chain is but one option for companies operating in the industry.
It is fortuitous, then, that the next module deals with strategic options and strategic
choices in the oil and gas industry.
Learning Summary
This module has demonstrated a detailed application of some of the internal analysis
techniques outlined in Core SP Module 6. The use as a case study of Shell, an
integrated company with coverage of the entire industry supply chain, has shown
how businesses in different parts of the industry might fit together. Corporate and
divisional finances have been analysed, along with the value chain, architecture and
SAP of the organisation.
References
Porter, M. (1985) Competitive Advantage: Creating and Sustaining Superior Performance,
New York: Free Press.
Royal Dutch Shell plc (2008) Delivery and Growth: Annual Report and Form 20-F for the Year
Ended December 31, 2007. Available online at www.shell.com/content/dam/shell/static
/investor/downloads/financial-information/reports/2007/2007-annual-report.pdf
Shell Global Solutions (undated) ‘About Shell Global Solutions’. Available online at
www.shell.com/business-customers/global-solutions/about-shell-global-solutions.html
Module 7
Strategic Options in the Oil and Gas

Industry
Contents
7.1 Introduction.............................................................................................7/1
7.2 Strengths, Weaknesses, Opportunities and Threats ..........................7/2
7.3 Corporate Strategy Options .................................................................7/6
7.4 Business Strategy Options .................................................................. 7/12
7.5 Strategy Variations: Directions and Methods................................... 7/14
7.6 From SWOT to Strategy .................................................................... 7/29
Learning Objectives
 apply the SWOT framework in the oil and gas context;
 apply generic strategies to the industry supply chain; and
 analyse how strategic variations have been deployed in the oil and gas industry.
7.1 Introduction
The choice of a strategy can be made in many ways. Sometimes, no explicit choice is
made, but a company may end up dominant in a market because of external events
or a series of unconnected decisions, and will then capitalise on its good fortune.
Alternatively, a choice is made, but there is no structured reasoning behind the
course of action, so the choice is arbitrary. A problem with identifying why a course
of action was selected is the difficulty in identifying how choices were made
retrospectively, because managers are as prone as anyone else to rationalising
decisions after the event.
In the previous modules, a great deal of analysis has been carried out. In Module
2, strategists were analysed, together with the potential impact that they can have on
the strategy process. This was followed in Module 3 by an examination of objectives
and how they should be constructed. In the modules that followed, the macro
environment has been analysed at various levels, using economic and strategic tools;
the industry has been subjected to extensive analysis in all the sectors and stages of
the oil and gas industry supply chain; an in-depth analysis of an oil company has
been carried out, with the aim of identifying the elusive basis for competitive
advantage. These analyses demonstrated:
Module 7 / Strategic Options in the Oil and Gas Industry
 the quantity of information available;

 how to sift through it to distinguish the important from the unimportant; and
 how to derive conclusions from the application of models.
This module is concerned with bridging the gap between analysis and choosing a
strategy from the various options available. One thing that a rigorous strategic
analysis will not produce is an automatic course of action. What it does provide is a
snapshot of many relevant factors and estimates of their relative importance,
providing a basis on which sound choices can be made. The intention is to lay out
the strategic options available, and to examine them in the context of the oil and gas
industry. Certain strategic directions, such as vertical integration and unrelated
diversification, and certain strategic methods, such as acquisition and joint venture,
are common in the oil and gas industry, and thus warrant special attention.
This module sets out the process of moving from analysis to strategic decision,
first looking at SWOT analysis, and then examining the strategic options available to
an organisation. This starts with generic strategies, first at the corporate level and
then at that of business. Next, the variations in ways in which generic strategies can
be pursued are explored in terms of both directions and methods. Finally, the link
between analysis and choice is explored.
7.2 Strengths, Weaknesses, Opportunities and Threats

A SWOT profile brings together the analysis of the internal and external environ-
ments to provide a basis for rational choice. The problem with strategy making is that
the course of action that is taken often emerges gradually over time (that is, the
emergent approach in Core SP Section 1.2.3). The company may undertake a major
shift in strategic direction, but this may be the outcome of a stream of seemingly
unrelated decisions rather than an explicit choice. SWOT analysis generates a compre-
hensive picture of where the company stands now in relation to its internal and
external environment. The profile helps decision-makers to make rational judgements
about strategy rather than passively reacting to events as they occur.
The fact, for example, that Shell and BP have invested in renewable technology,
while Exxon has not, has already been alluded to: was this because renewable
technology was identified as an opportunity by Shell and not by Exxon? If so, why?
Perhaps the choice was simply the personal preference of the CEO in each case. It
is important to understand the rationale for decisions of this nature: if a strategy
starts going wrong, then contributing factors can be identified, but if it was based
entirely on personal preference, it is not clear what action should be taken. In a
power culture organisation, many decisions may be taken on the basis of personal
preference rather than analysis.
7.2.1 Alignment
The analysis stage of the strategic process generates the ETOP and SAP from which
the SWOT entries are derived. The importance of alignment was discussed in Core
SP Section 7.2. Consider the SWOT in Table 7.1 for a (fictitious) example of a
refining and distribution company in China in 2012.
Table 7.1 SWOT analysis for China in 2012

Strengths Opportunities
New, more efficient, refining technique developed Expanding demand for fuel across continent
and patented
Low gearing ratio Rapid industrialisation, creating new markets for
distribution activities
Large domestic distribution network Artificially undervalued currency makes Chinese
exports more attractive
Weaknesses Threats
Refining operations at full capacity Competitors with larger capacity developing new
techniques
Lack of skilled personnel Competitors well up the experience curve
High labour turnover rate
This SWOT has a ‘type A’ alignment (see Figure 7.1) because the strengths can
be used to exploit opportunities, while the weaknesses expose the company to the
threats.
Weaknesses Threats
Figure 7.1 Type A

The implications of this SWOT analysis are as follows.
 The strengths are aligned to take advantage of the opportunities.
The company can mobilise its financial resources to take advantage of rising
demand for both refining and distribution activities. The new technique that
yields more fuel per barrel of oil can be rolled out to take advantage of national
and international opportunities, and the domestic distribution network can facili-
tate getting the product to the customers.
 The weaknesses need to be addressed to counter the threats.
The company needs to address its low productivity and lack of capacity in order
to counter the large capacity, new techniques and experience effects that rival
companies have.
The alignment of this SWOT analysis has thus identified implications for action that
are not necessarily obvious from inspecting the contents of each box in isolation.
Now consider the SWOT analysis in Table 7.2 of a fictitious offshore drilling
company in North America in 2008.
Table 7.2 SWOT analysis for North America in 2008

Comprehensive safety system in place Offshore market predicted to grow quickly over
the next five years
Good reputation and low number of accidents Many drilling contracts currently up for tender
Large, loyal workforce and very low attrition rate
Weaknesses Threats
Poor quality assets because of underinvestment for Government legislation due to take effect, requir-
the past five years ing higher safety standards in offshore activities
Currently operating at full capacity Skilled labour shortage in the offshore sector
This set of factors constitutes a different alignment from that for the Chinese
refining business (see Figure 7.2).
Weaknesses Threats
Figure 7.2 Type B

The ‘type B’ alignment leads to a different set of actions.
 The strengths are aligned to counter the threats.
The strong safety record and comprehensive system mean that new safety legis-
lation will not adversely affect operations. The good safety reputation may also
be a factor that contributes to the stable workforce and low attrition rate, which
protects the company from the skilled labour shortage in the offshore sector.
 The weaknesses prevent the company from taking advantage of the
opportunities.
If it is to take advantage of the contracts coming for tender and the forecast
growth in the market, the company must first sort out its underinvestment in
assets and add capacity for further growth.
Again, this profile of strengths, weaknesses, opportunities and threats provides
direction for the company, but the implications are different from those of the first
example. Focusing on the type A alignment would miss the fact that addressing the
weaknesses will enable opportunities to be exploited. This demonstrates that SWOT
analysis is not mechanistic and, to be effective, requires a degree of imagination.
7.2.2 Difficulties with SWOT Analysis

There are complications to bear in mind when applying SWOT, as follows.
 SWOT is often used for purposes other than strategic decision making.
(a) To familiarise managers and executives with the operations and structure of a company. In
this context, the SWOT may be used as part of a training day and there may
be little analytical depth to the process. Remember the considerable amount
of analysis that goes into an assessment of the external and internal environ-
ment. But this type of SWOT analysis can be useful in focusing on particular
issues, such as the current skill set in the organisation and how this might
change in the near future.
(b) To generate an understanding of the basis on which a company competes and its strengths
and weaknesses. In this context, SWOT is used as a diagnostic tool for identify-
ing reasons for past failures.
(c) To provide a basis for strategic moves and the allocation of resources. It is in this context
that we use SWOT on this course. In this case, the analysis is the outcome of
rigorous analytical review, and may involve input from specialists and con-
sultants.
(d) As a tool for reflection. A company may ask each employee to develop a SWOT
for himself or herself. This can foster the view that SWOT is totally subjec-
tive.
Many managers have come across SWOT analysis used only in a superficial man-
ner, such as in example (a) above. If managers have come across SWOT used only
in non-rigorous ways, they may have difficulty accepting its credibility as a basis for
strategy choice.
 SWOT can be ambiguous based on the perception of individual manag-
ers.
A factor may appear as both an opportunity and a threat. Consider, for example,
whether the rising oil price is an opportunity or a threat to the industry in general.
It is an opportunity in the sense that companies can charge more for their prod-
ucts; it is also a threat in the sense that costs are also rising and that oil-related
products are inputs into certain activities, such as plastic pipelines. It is also a threat
in that it may encourage increased use of alternative fuels. It may be regarded as an
opportunity upstream and a threat downstream. When tackling a problem, the
team leader may say, ‘Let’s start with a SWOT.’ One team member may identify a
particular product as a weakness, because it has a low margin; another member
may identify it as a potential star because it is in a growing market with an increas-
ing market share. This is the common type of disagreement that results between an
accountant and a marketer.
 SWOT is only a snapshot.
The world is dynamic and a SWOT produced at any point in time is only a snap-
shot. It suffers the same limitations in this regard as the comparative static analysis
of oil prices in Module 5. To be a useful tool, then, SWOT needs to be dynamic,
because external factors are constantly changing and companies must be ready to
react to these changes in their competitive environments. The problems with try-
ing to predict the future were examined in Module 4.
 Imagination is required.
It is not always easy to visualise opportunities – this is often referred to as ‘en-
trepreneurial activity’ – and threats that may or may not materialise. One of the
challenges is to identify opportunities and threats that have not arrived yet, for
example the identification of the oil price increases after 2011 as a threat rather
than an opportunity resulted in an overshoot that was followed by an under-
shoot in late 2014.
7.3 Corporate Strategy Options

A generic strategy is a broad classification of strategy that a company may pursue.
At the corporate level, this is concerned with scope and direction, for example
increasing the product portfolio through acquisition. The generic strategies dis-
cussed in this section are concerned with the scale and scope of a company’s
operations; they are the means by which a desired end is achieved.
7.3.1 Expansion
An expansion strategy can take several forms, including increase the market share of
a given product, increase the portfolio, or increase revenue by focusing on high
margin accounts. It may be chosen for one or more of the following reasons.
 To diversify risk. An increased portfolio of products may diversify the risk of the
company as a whole. However, this diversifies management risk, not shareholder
risk. This motive for expansion is apparent in the oil and gas industry during
downturns. In the late 1990s and early 2000s, for example, many companies
expanded their product portfolios to include unrelated businesses: Halliburton
went into the construction and engineering sector with its purchase of Dresser
Industries in 1998; Shell and ExxonMobil both offer credit cards. The notion of
diversifying risk is deeply rooted in the theory of finance, whereby the fully di-
versified portfolio ensures that a loss on one item is not catastrophic. But the
addition of one or two products to a portfolio may or may not reduce risk: the
credit card business may move in step with the oil price, so that the risk is in-
creased rather than decreased.
 A search for competences. A line of business may be identified that fits well with
perceived competences, so in management’s eyes it will contribute to long-run
competitive advantage. Standard Oil, the long-defunct predecessor to Exx-
onMobil, started as a refining company in 1870; Shell was originally conceived as
the Shell Transport and Trading Company, a company that was involved in all
manner of trading and exports in the 19th century. Operations may expand over
time into other areas complementary to the core business or, in the case of Shell,
may shift in focus completely.
 Economies of scale. There may be significant economies of scale to be exploited in
certain parts of the oil and gas industry. In the early 2000s, with the emergence
of the ‘supermajors’ through mergers and acquisitions, the potential for econo-
mies of scale was believed to be significant. In Module 6, some doubt was cast
on the significance of scale effects in the industry. It is more likely, in fact, that
economies of scale exist within particular stages of the industry supply chain. For
example, the emergence of larger and larger oil tankers in the second half of the
20th century reduced carrying costs of crude oil significantly.
 Experience effects. These are similar to economies of scale, but the advantage is
experienced for a limited time only. Experience effects are typically associated
with first-mover advantage, which is difficult to achieve in a mature industry.
 Building advance capacity. Many companies build capacity in times of recession in
order to be able to take advantage of future economic growth. In the oil and gas
industry, it is more complicated: conditions in the oil market dictate capital ex-
penditure and investment requirements. Low investment in times of low oil
prices has been followed by massive investment in times of high oil prices and
bottlenecks throughout the industry. A possible exception to this is ExxonMobil,
which went on an acquisition spree in 2009, buying up assets at prices much
reduced in the wake of the financial crisis and oil price crash. Partly because of
this, ExxonMobil became the largest company by market capitalisation a number
of times, exchanging places with Walmart on a regular basis until Apple sur-
passed both in 2012.
 Managerial motivation. Many managers think that a growing company is a healthy
one. Managers associated with growing companies benefit from the reputation
of success. There is always a marked reluctance on the part of management to
break up a company, irrespective of what the analysis might conclude. The in-
centive structure for senior executives can lead to the pursuit of growth at the
expense of company value – but a company that is pursuing an expansion strate-
gy for the wrong reasons may weaken its long-term competitive potential.
While a number of motivations exist for pursuing an expansion strategy, continuous
growth and expansion into new markets or new activities may not always be the best
option. Sometimes, environmental or internal factors dictate that a company must
pursue other strategies. Often, an element of ‘managing expectations’ needs to occur
using carefully crafted signals to the stock market.
7.3.2 Retrenchment
While it may appear to be the opposite of expansion, retrenchment does not always
involve making the company smaller; rather, it involves reorganising the firm in
search of increased efficiency. It may take the form of downsizing, delayering or
restructuring. Retrenchment may involve shedding businesses that are not part of
the company’s core competence or enhancing labour productivity by removing
management layers. For example, the restructuring undertaken by BP after Tony
Hayward took over the company was in response to poor operating results and a
lack of accountability; Shell restructured in 1998 in response to difficult market
conditions and again in 2005, when the two boards of Royal Dutch and Shell
Trading were merged to form Royal Dutch Shell plc.
Reasons why a company may follow a retrenchment generic strategy include the
following.
 Dogs in the portfolio. A company may diversify into unrelated businesses and those
businesses may turn out to be ‘dogs’ (that is, low growth and low market share)
in terms of the BCG growth–share matrix.
 Overextended markets. At the margin, it is possible for a company to lose money on
some customers. If this is the case, it is rational for the company to reduce oper-
ations to a level at which the marginal revenue exceeds the marginal cost of
doing business. This may result in a drop in market share combined with a rise in
profits. It is notoriously difficult to identify marginal cost, but it is crucial when
tendering for projects.
 Product life cycles. If products are nearing the end of their life cycles and there are
no replacements available, it may be better to wait to develop products in which
the company has expertise rather than to diversify into unfamiliar areas.
So retrenchment is a perfectly rational choice as a drive for greater efficiency in
response to market conditions and does not automatically imply that there has been
a failure on the part of the company. It is common to observe some form of
retrenchment strategy being put into place after a downturn in the oil and gas
industry. Major companies tend to trim their capital expenditure budgets, directly
affecting many upstream service companies that rely on capital expenditure of oil
and gas producers for their own market growth. National oil companies tend to
continue current production and slash investment because their objective is not only
concerned with profit or shareholders. When a downturn in the oil and gas industry
is coupled with a wider economic downturn, NOCs find themselves in a difficult
position in which they need to maintain production in order to fund increased
government spending designed to offset the wider economic downturn.
All of the above differs from retrenchment resulting from a series of poor deci-
sions, which is effected by imposing economies that are no more than a short-term
solution to a long-term problem: many readers will be familiar with the sudden
edicts from head office that travel must be reduced and fewer paper clips purchased.
While this example might appear facetious, it is typical of the types of knee-jerk
response of a management that fails to recognise a weakness in the strategic
decision-making process. A wider consequence of a series of poor decisions might
even be a change in the CEO and senior management. This often results in a radical
change in the company’s strategic intentions, resulting in a period of retrenchment
that must be endured before an expansion strategy is put in place.
7.3.3 Stability
Stability does not imply doing nothing; on the contrary, stability may be desirable in
a rapidly changing competitive environment, when even maintaining market shares
and revenues requires considerable effort. An example of seeking stability is the oil
majors investing heavily in renewable and alternative energy sources. Currently, Shell
invests the most in these new technologies of all the major oil and gas companies,
and is doing so to maintain its stability as an energy company after the eventual
decline in the production and use of oil. This may be a distant prospect, but the
company that prepares itself now may be better equipped to follow a stability
strategy when oil does decline.
Stability may be chosen for any of the following reasons.

 Markets are mature. If a company has identified that its markets are mature and
not likely to decline for many years, then stability is the best option. The fuel
retail market is mature in the UK and it is rare to see new fuel stations opening.
Each station competes in its local area on price only and demand is stable. A
company operating upstream in a mature area may decide that stability and
maintenance of the present area, as opposed to moving into new geographical
areas or new parts of the supply chain, is the best option.
 Internal weaknesses. A company may have out-of-date processes and a relatively
underproductive workforce, so an expansion strategy would put the company at
considerable risk. This stability strategy is concerned with increasing efficiency,
bringing costs under control and updating old-fashioned technology.
 Competitive threat. If trade barriers are opened, then this increases the likelihood of
competition from foreign companies, which may have more efficient operations
or lower cost structures. A company may need to gather its resources and stabi-
lise its market shares to meet the competitive threat.
In conclusion, it must be borne in mind that pursuing a strategy of stability does not
involve doing nothing. A significant amount of effort may be required to maintain a
company’s present position, dividend, level of market share or level of differentia-
tion.
7.3.4 Combining Corporate Strategies

It is most common to observe changes in the strategic options chosen over time.
Exhibit 7.1 offers a brief history, over a 13-year period, of ENI SpA, the former
NOC of Italy. The various corporate strategies that ENI SpA followed over the
years and the drivers behind each strategy will then be identified and discussed.
Exhibit 7.1: ENI SpA, 1992–2015

In 1992, ENI SpA, Italy’s NOC, started its privatisation programme. The
government’s stockholding went down from 100% to 30% in 2005. Through-
out the 1970s and 1980s, the company – under the direction of the Italian
government – had acquired a diverse set of businesses. This included various
chemical companies from the private sector that had struggled under the
difficult conditions of the time, a newspaper company, a textile division and
33 metallurgy companies.
Throughout the 1990s, ENI continued to expand its operations abroad,
acquiring exploration licences in China, Russia and Kazakhstan, and starting
gas production in Egypt. Further exploration and production agreements
were made in the Caspian Sea in 1998.
It was at this point that a wave of ‘megamergers’ swept across the oil and gas
industry. ENI largely sat these out, instead following a programme of restruc-
turing and divestments, which resulted in the cutting of 42 000 jobs and the
sale of €4 billion of assets, including most of the diversified operations forced
on it by the government in earlier times. A large part of the petrochemicals

business was also disposed of.
ENI then turned its attentions to the exploration sector, acquiring British
Borneo Petroleum and Lasmo, two exploration companies based in the UK.
This increased the company’s global reach, giving new coverage in Asia-Pacific
and Latin America. In 2002, ENI acquired Italgas, the leading gas distributor in
Italy, strengthening its position in the gas business before Europe-wide
deregulation. In 2003, Agip, the company’s fuel retail arm, was merged into
the company, creating the new refining and marketing division. By the end of
2004, ENI was the sixth largest oil and gas company in the world, with a
market capitalisation of €75 billion. In 2005, ENI began to produce from its
large fields in Angola, and at the same time entered a joint venture with the
Indian NOC to explore for hydrocarbons in India. Further expansion up-
stream occurred in 2006, with an agreement with various companies to
manage an offshore oil terminal in Nigeria.
In 2007, ENI opened a dedicated research facility for renewable energy
sources; by 2008, it was a vertically integrated oil company, operating in the
oil and gas, petrochemicals, electricity generation and sale, oilfield services
and engineering industries. In January of that year, the company was valued at
€87 billion and organised into four segments:
 exploration and production;
 refining and marketing;
 gas and power; and
 oilfield services, construction and engineering.
Despite this broad set of segments covering most of the oil and gas industry
supply chain, ENI continued to sell off refining and marketing businesses
outside Italy after 2008. In 2009, ENI acquired Distrigas, a Belgian natural gas
company, and at the same time began a rebranding exercise. Alongside
acquisitions, the company made a number of strategically important finds in
its exploration business, including oil in Venezuela in 2010 and, in 2011, a
large natural gas find in Mozambique, the largest discovery in the company’s
history. A further large gas find in Egypt in 2015 was projected to turn the
country into a net exporter of gas by 2020 – a boost for ENI in a time of
falling oil prices.
The company’s CEO announced a strategic plan in 2015 covering the next
three years. It proposed an adjustment of the company’s activities to make it
more robust for a period of lower oil prices, involving expanding upstream
production using the finds of recent years, while rationalising downstream
operations and reducing capital expenditure across the organisation, and
maintaining the level of dividends to shareholders.
(Based on ENI SpA, undated)
During the period, the generic corporate strategies within EMI can be identified
as in Table 7.3, along with some possible drivers of these strategies.
Table 7.3 ENI and generic strategies over time

Year Activity Corporate Method Possible drivers
strategy
Pre-1992 Acquisitions of unrelated Expansion Acquisition Government attempts to
companies (textiles, etc.) protect Italian industry (i.e.
‘management motivation’)
1992–98 Expansion of exploration Expansion Organic Scale economies; experience
and production activities effects; diversification of
into Russia, Kazakhstan, geopolitical risk
Egypt
1998– Rationalisation of business Retrenchment Divestment; Fear of takeover; too many
2002 in response to conditions restructuring dogs in the portfolio;
outside the company; overextended markets;
divestment of textiles, etc. centre destroying value of
some businesses rather than
adding
2002–4 Acquisition of Italgas; Stability Acquisitions; Resolving internal
absorption of Agip; internal weaknesses; future
subsidiary divisional reorganisation competitive threat when
structure finalised European gas markets
deregulated; threat of
takeover; unstable financial
history
2004–8 Expansion of production, Expansion Organic; joint Diversification of risk; taking
exploration and general ventures advantage of growth
upstream operations; markets and high oil prices
investment in renewables
research
2008–10 Selling off downstream Retrenchment Divestment Resolving weaknesses;
assets; rebranding exercise; refocusing on more profita-
acquisition of Distrigas ble businesses
2010–14 Various finds of Stability or Organic Opening up new markets;
strategically important Expansion diversifying risk; taking
reserves advantage of industry
growth
2015 Refocus on profitable Retrenchment Refocusing Possibly overextended
businesses; adjustment to investment markets
the new oil price environ-
ment
By setting out the corporate strategies in this form with possible associated driv-
ers, it might be deduced that management explicitly pursued the strategies in
response to changing conditions. But there are two important caveats to imputing
cause and effect in strategy choice:
 management may have thought it was choosing different generic strategies, but
in fact it was mostly reacting to changing external influences; and
 each generic requires a different approach and mindset, but managers were
probably unaware that these were fundamental transitions.
What is important in the ENI example is that, by looking at the company over a
long period of time, it is possible to see the different corporate strategies that were
put in place because of external events or internal pressures and decisions. ENI
appears to retrench during downturns in the industry and expand during the
upturns. This is a common approach to oil price and resulting industry cycles, but it
does not necessarily represent the best use of resources. The approach of Exx-
onMobil – the opposite of that taken by ENI – was noted in Section 7.3.1 and has
been a significant driver of value creation for the company. It is of note that, in late
2015, after a year of lower oil prices, most major companies such as BP and Shell
were in the process of announcing cuts to capital expenditure in the expectation that
oil prices were to remain low for the foreseeable future.
The core message with regard to choosing among the different corporate strategy
options is that reacting to the oil price cycle, while extremely common, is unlikely to
be the best approach. In Module 4 and Module 5, it became very clear that the oil
price drives the industry cycle by means of derived demand throughout the supply
chain. Planning for such downturns – and not becoming overly euphoric during
upturns – is likely to be a more successful strategy than simply riding the cycle. A
more robust strategic process, part of which involves a sound understanding of the
drivers, volatility and impact of the oil price, is the key here.
7.4 Business Strategy Options

As identified in Core SP Section 7.3.2, the focus at this level is the effective exploita-
tion of individual product markets, which are the responsibility of the strategic
business unit. The focus at the product level is of achieving competitive advantage
in a given market. Michael Porter (1980) identified four main generic strategies –
‘cost leadership’, ‘differentiation’, ‘focus’ and ‘stuck in the middle’ – which will be
discussed next. The question that management needs to answer when selecting from
among these options is ‘what markets should we be in?’, while the question at the
business level is ‘on what basis shall we compete in this market?’ The difficulty in
the oil and gas industry is that the most appropriate business strategy is highly
dependent on the supply chain stage in which a company is operating.
7.4.1 Cost Leadership

Cost leadership is a strategy that focuses on cost, not price. A company pursuing
cost leadership may well charge the same price as its competitors, but its competi-
tive advantage lies in the fact that its unit costs are significantly lower than others in
the market. In order to achieve this, the company must have a large enough market
share that economies of scale can be achieved. The cost leader will be involved in
constant monitoring of resource allocation and research into new cost-reducing

technology.
Oil majors, at the time of the mergers in the oil industry in 1998–99, were at-
tempting to develop cost advantages across all of their business units, and hoped to
generate synergy from vertical integration. As the oil price fell in late 2014, many
companies attempted to increase efficiency. As discussed in previous sections and
modules, the best performer of the ‘supermajors’ tends to be ExxonMobil, well
known for its attention to cost control and its autocratic management style.
The industry supply chain analysis in Module 5 identified that the further down
the industry supply chain, the more homogeneous the product. Therefore cost
leadership tends to be associated with downstream, rather than upstream, activities.
7.4.2 Differentiation
A business following a generic strategy of differentiation is less concerned with
market share, because it is continually redefining its market. The company is able to
charge a price premium for the bundle of differentiated characteristics.
For a company in the oilfield services sector, differentiation is based on the hi-
tech inputs in exploration, development and production. Given the trade-offs that
exist between time, cost and quality, which are part of project planning, companies
compete on varying combinations of these three dimensions. The company that
wins the contract is that which tenders a bid that most closely fits the customer’s
preference for time, cost and quality levels. Based on Module 5, it is to be expected
that upstream companies will compete on the basis of differentiation. It could be
argued that there is an element of differentiation in downstream competition in the
form of branding and product differences, such as ‘super unleaded’ fuel, which has a
higher octane value than regular unleaded. The trouble is that all retailers sell
variations on this theme, so the actual degree of differentiation is minimal.
Petrol retailers put the brand image of their supply company up front – but is
there any attraction in selling petrol under the brand of an integrated oil major? Shell
invests far more in renewable energy and research into renewables than does Exxon,
but it is unlikely that this has any effect on consumer demand for petrol.
7.4.3 Focus
A ‘focus’ strategy typically involves finding a niche in which it is possible to avoid
direct confrontation with competitors. Within its chosen niche, the company can
choose between cost leadership and differentiation. Once a company has established
itself in a niche, it can make a high rate of return, because it can avoid direct
competition with larger competitors; it is then able to earn monopoly profits in its
niche. Many of the small local players in the various sectors of the oil and gas
industry follow a focus strategy, performing only one or a few related activities in a
small geographic area – but does this isolate them from competition from other
companies?
Refining NZ is proud to call itself the only refining-only company in the country
and is the largest provider of refined petroleum products. Refining NZ has nar-
rowed its business down to performing only one operation in the oil and gas
industry supply chain. It has a high market share in its own geographic segment and
probably has a logistical cost advantage over an IOC owing to its proximity to
market. If Refining NZ were to expand its operations across Asia-Pacific and
Oceania, it would then expose itself to potential damaging competition from the
NOCs and IOCs – a situation that it has specifically chosen to avoid. This demon-
strates how a focus strategy can generate returns by focusing only on a narrow
segment and how expansion into other segments may destroy any advantage that
the firm has.
7.4.4 Stuck in the Middle

The ‘stuck in the middle’ generic business strategy is not chosen explicitly, but is
where the company can end up if it lacks purpose. The skill set required to follow
each generic business strategy is different and a switch from one generic strategy to
another has implications for the firm’s value chain. Unless the value chain and the
generic strategy are aligned, there is a real possibility the company will end up stuck
in the middle: a company that pursues a merger because it wants to add revenue, but
does not determine whether the company is a strategic fit, for example, may find
that it has merged a cost leader with a differentiator. This will probably destroy any
cost-leading advantage and any differentiating advantage that the company may
have, leading to the undesirable position of being stuck in the middle. This situation
is symptomatic of a company that does not understand the basis of its own com-
petitive advantage: in the example, the company did not realise that its advantage lay
in differentiation. This may seem far-fetched, but conversations with managers
regarding what constitutes their competitive advantage often focus on ‘things that
we do well’, without any real appreciation of market positioning.
7.5 Strategy Variations: Directions and Methods

A generic strategy provides the framework within which the company formulates its
strategy. The strategy variations are the different tools available to pursue the
desired objective. Consider the example of ENI in the mid-1990s from Exhibit 7.1.
The company wished to follow an expansion strategy, but there were various ways
in which this could have been pursued. Strategy variations can be divided into
directions and methods.
The first consideration is the direction in which the company should move:
should the company move vertically up or down the supply chain and become more
vertically integrated? Should it move horizontally within a supply chain stage and
pursue some form of related diversification? Or should it move out of the industry
altogether and pursue unrelated diversification?
Once a direction has been chosen, the next consideration is the method through
which a particular strategy is pursued: should acquisitions be pursued over organic
growth? Should the company expand its operations abroad? Should cooperative
ventures of some form be set up?
These examples of directions and methods are concerned only with expansion,
but directions in terms of refocusing on a particular segment and methods in terms
of withdrawal, consolidation and divestment are also relevant here. When ENI was
following a strategy of retrenchment in the late 1990s and early 2000s, there were
again a number of options available: should the company downsize or should it
delayer its management structure? Should it divest unprofitable operations or should
it restructure internally to increase efficiency?
The following sections look at the strategy variations available to a company and
the implications of each.
7.5.1 Direction: Related or Unrelated Diversification?

Diversification was discussed in Core SP Module 6 and the difficulty of generating
value from unrelated businesses became apparent. Some examples of unrelated
diversification that have been cited in this course include Centrica and its appliance-
servicing business and Shell’s car-servicing business. Management may have had a
rationale for these acquisitions, but the end outcome was unrelated diversification.
As discussed in Module 6, the competence-based diversification matrix (Figure
7.3) provides a structure for identifying the relationship between a company’s
businesses. In the model, competences are decomposed to the level of routines and
resources. A distinctive capability is a routine and the core inputs to the business are
resources.
Acquired Routine based Unrelated
Resources
Current Replication based Resource based
Current Developed
Routines
Figure 7.3 Competence-based diversification matrix

In Module 6, the trajectory starting from exploration down the industry supply
chain was developed, and it emerged that the further down the industry supply
chain, the less related was the diversification. Now consider the case of a UK-based
refining company wishing to expand its business. The CEO has decided that the
following options are viable:
1. Start another oil refining business in Europe.

2. Set up a fuel wholesale company.
3. Expand refining capacity to include natural gas processing.
4. Expand upstream into the exploration and production business.
Each is an example of a different kind of competence-based diversification.
 Option 1 is replication-based diversification. This is the least risky form of
diversification, because it involves an expansion of current activity. The skills
required are exactly the same as those of the current business, as are the re-
sources.
 Option 2 is resource-based diversification. The company already has the core
inputs, but must establish new routines in order to function properly. The skill
sets from oil refining and from selling fuel are different, so this variation is riski-
er than replication.
 Option 3 is routine-based diversification. The physical systems for processing
natural gas and the oil-refining process are different, but the routines for the
company are quite similar. The relative risks of routine-based and resource-based
diversification depend on the circumstances. In this example, individuals are
doing much the same things, but in a different environment, whereas under
resource-based diversification (option 2), individuals are doing different things in
a similar environment.
 Option 4 is unrelated diversification. None of the company’s current resources
can be used in exploration and production activities. Also, the company will have
to develop a whole new set of routines if it is to operate effectively. This is the
riskiest form of diversification, and the only possible shared asset is the financial
and control system – but even these basic systems may not be compatible. Vari-
ous examples of this type of diversification have been encountered so far, the
most notable of which are Centrica in Module 3 and Shell in Module 6.
It is an open question whether the refining company will recognise each of the
options for what it is: for example, it may appear attractive to set up a fuel wholesal-
ing company rather than to state another oil refinery, but in fact the relatedness and
risks are completely different.
Relatedness is a complex issue and the following potential outcomes may add
value, because it is often not clear what form relatedness may take (Core SP Section
7.4.1):
 to reap economies of scale across strategic business units;
 to use a core competence in the new unit;
 to utilise a core competence to create a new strategic asset in a new business
faster; and/or
 to expand the company’s pool of core competences as it learns new skills.
Managers can convince themselves that diversification can be justified along one or
more of these lines, but it is not possible to generate evidence of an outcome before
it is realised. In any case, it is virtually impossible to find an example of diversifica-
tion that was embarked upon based only on one or more of these criteria. In real
life, the justifications are typically vague and devoid of any consideration of an
expansion trajectory.
Consider the example of a chemicals company that is the world leader in produc-
ing polyolefins, a type of polymer. The CEO of the company is thinking of two
different expansion options:
 expanding into oil refining; or
 starting a plastics division, in which polyolefins are a key input.
At first glance, the plastics business seems more like a related option than oil
refining – but Table 7.4 considers these two moves in terms of the possible value
drivers identified above.
Table 7.4 Determining relatedness

Four factors Oil refining Plastics
Economies of scale across It may be possible to achieve scale This is forward vertical integration
strategic business units economies within units, but no and economies of scale between
reason to expect this across the the two divisions are unlikely
two divisions
Use existing core compe- Skill sets are similar between oil Skill sets are different: core
tence refining and second-line derivative business involves separating out
petrochemicals materials, while plastics involves
putting them together
Use existing core This is backward vertical integra- Markets are different from
competence to create a new tion: make vs buy problem polyolefins and plastics (specialised
strategic asset vs general)
Expand pool of core compe- Some production techniques may Not clear what competences
tences be complementary would be transferable
This analysis suggests that the oil-refining business is more closely related to the
chemicals business. However, there is still no guarantee that such a move will add
value, because relatedness is not the only determinant of success. The point is that
any kind of horizontal move needs to be considered in detail in terms of relatedness.
The competence-based diversification matrix can provide a useful perspective when
doing so. The word ‘synergy’ is used a lot in management practice, but it is rarely
achieved because people do not understand the type of diversification they are
undertaking.
7.5.2 Direction: Vertical Integration

Vertical integration was addressed in Module 6, and Core SP Section 7.4.2. A move
to integrate vertically involves movements into other parts of the industry supply
chain. Some of these activities may be related, while others are totally unrelated.
Vertical moves can be characterised as forward integration, moving down the supply
chain, or backward integration, moving up the supply chain. Vertical integration is a
rather extreme approach to organising in an industry in which alternatives such as
spot contracts for supplies, cooperative agreements or long-term contracts could
also be used. Why, then, is it so popular an approach in the oil and gas industry in
both private and public sectors?
One theory that might explain the prevalence of vertical integration is transaction
cost economics (TCE). This approach suggests that when the costs of using the free
market, known as the ‘transaction costs’, to obtain supplies or find buyers for one’s
output become too high, companies are likely to vertically integrate to avoid these
costs. Transaction costs can arise when three phenomena come into play, as follows.
 Bounded rationality refers to the fact that individuals are not ‘maximisers’ per se,
but rather tend to ‘satisfice’, meaning that they try and make optimal decisions
based on the information they have available to them at the time.
 Asset specificity means that the assets owned by the firm are highly specific to their
current use and cannot easily be used for another purpose. Various types of asset
specificity exist.
 Site specificity exists where physical assets cannot be moved easily to another
location.
 Physical asset specificity comes into play when production equipment is highly
specialised to deal with a particular input or produce a specific output.
 Human asset specificity arises where individuals are highly trained to do a specif-
ic job and cannot easily be redeployed in another role.
 Opportunism refers to the tendency of individuals in an agreed transaction to try
to take advantage of the other side if the one individual perceives himself or
herself to have more leverage than the other.
If all three of the above criteria are met, then a firm operating in one part of the
supply chain is vulnerable to what is known as ‘hold-up’, in the sense that it can be
extorted for more money by either buyers or suppliers. In general, we can assume
that bounded rationality is always extant, because economic theory shows that this is
how individuals make decisions. Opportunism is likely to come into play when
bounded rationality and some kind of asset specificity exist together.
To see TCE in action, consider the case of an independent exploration-and-
production company operating in the production stage of the upstream industry and
an independent company operating a single refinery in Europe. A breakdown is
given in Table 7.5.
Table 7.5 Asset specificity types in upstream and downstream sectors

Asset Production company Refining company
specificity
Site No – assets can be moved and rede- Yes – refining assets are fixed in a specific
ployed easily location and cannot be moved
Physical No – assets can be used in a number of Yes – refining assets tend to be optimised
different ways for particular types of crude oil (usually
the grade produced nearby)
Human No – engineers can be used for different No – chemical engineers have multiple
types of work uses
Vulnerable Unlikely – the company can move its Possibly – refining assets are very specific
to hold-up? operations elsewhere or redeploy assets to their task and location, and tend to
if hold-up arises require specific input type
It is clear from this example that an independent refining company might be
more vulnerable to hold-up than an independent production company – but if that
is the case, why do independent refining companies still exist? The spot market and
futures market for crude oil as an input and refined products as outputs might help
to answer this question, or the fact that more than transaction costs come into play
when making decisions about vertical moves.
So why did Centrica, ostensibly a downstream company, move back into explora-
tion, development and production once it had been spun off from British Gas? Why
did Shell Transport and Trading, a company with assets that could be used to ship
and transport any kind of cargo around the world, integrate with Royal Dutch
Petroleum in the early 20th century? The answer might lie in another explanation.
When companies integrate backwards, they are looking to secure access to sup-
plies. This would have been a concern for both Centrica and Shell at the time
decisions were made, because of the boom in production and demand for final
products. The need to ensure a continuous flow of input and output is important in
a business such as oil refining, which might also assist in explaining some of the
vertical integration that one observes in the oil and gas industry. Vertical integration
also reduces negotiation costs, and tends to result in more stable relationships
between buyers and suppliers if they are all under the umbrella of one organisation.
This might be an important driver of vertical moves in an industry that is subject to
volatility in both economic and political terms, as discussed in Module 4.
Vertical integration is also common in NOCs and, again, some of these motiva-
tions might help in explaining why this is as well. The difficulty with any NOC,
however, is that its strategic intent is not usually governed by profit- and wealth-
maximising objectives alone; a significant amount of NOC activity might be
governed by nationalistic motivations, or social motivations to provide employment
in a particular region of a country or to secure resources for use by the government
in social programmes.
Despite these points, however, vertical integration is an extreme approach to
organising and does not come without costs, inflexibility being one of them.
Consider the case of the petrochemicals company that wishes to expand into oil
refining. While the gas-processing unit will provide input for the petrochemicals
business, it is highly unlikely that all of the product from the refining plant will be
consumed by the petrochemicals unit. If this company were to expand further back
up the chain into storage and transport, it is even less likely that the company would
be supplying to and buying from only itself. Furthermore, the optimum scale for an
oil refinery is unlikely to be compatible with the optimum scale for chemicals
processing. The optimum scale for chemicals is by no means automatically similar to
the optimum scale for distribution activities. This emerged from the analysis of
Shell’s vertical chain in Module 6.
Overall, it can be said that vertical integration, when one removes the supply
chain aspect, is another form of diversification – and this must be borne in mind
when considering whether to undertake a forward or backward move.
7.5.3 Methods: Acquisition or Merger

Instead of undertaking strategic action through the mobilisation of the company’s
internal resources to achieve objectives, the company can make external moves by
merging with or acquiring another company. Empirical evidence suggests that the
majority of acquisitions do not add value for the acquirer and that the most com-
mon outcomes are as follows:
 the combined value of parent and target tends to rise following the announce-
ment of a takeover, but this is usually temporary;
 most returns accrue to the target firm shareholders;
 acquiring firm shareholders eventually receive small, statistically insignificant
returns in terms of additions to shareholder wealth and profitability.
Some possible motivations for acquisitions are given in Core SP Section 7.4.3 and
include:
 recognising unrealised value;
 buying market share;
 reducing competitive pressures;
 synergy;
 balancing the portfolio;
 core competences; and
 strategic fit.
What often happens is that the case for an acquisition is constructed on the basis of
an interpretation of the facts that favours the move, while arguments against are
simply ignored – or not even recognised.
By way of an example, Exhibit 7.2 is concerned with an acquisition undertaken
by a small drilling company operating in the North Sea in 2006.
The acquisition is considered against the list of possible motivations in Table 7.6.
Table 7.6 Drivers for Abbot Group’s acquisition of Songa Drilling

Driver Evidence
Recognising unrealised value Board felt management could be improved and Songa could be
made profitable
Buying market share Buying into a new market, not market share in an existing one
Reducing competitive pressures No – Abbot was a fixed-platform and land drilling operation
Synergy No – Abbot knew that there was little overlap between the two
companies
Balancing the portfolio Possibly added an unrelated star
Core competences Yes – Abbot wanted to expand its core competences to the drilling
sector in general
Was there likely to be a strategic fit between the two operations? The drivers for
acquisition are presented in Table 7.7, along with the factors for and against
achieving them.
Exhibit 7.2: Abbot Group plc, I

Abbot Group was an Aberdeen-based North Sea drilling contractor involved
in offshore, land contract drilling and rig management. In 2006, the company
set out to acquire Songa Drilling, a Norwegian drilling company. Songa was in
possession of three jack-up rigs, which Abbot wanted to add to its portfolio.
This was seen by the directors as the next step in making Abbot a fully
integrated global drilling company.
Abbot’s core business was land and fixed-platform drilling, so the acquisition
was intended to move the company into new markets. Demand was high for
technology such as jack-up rigs and the new assets had the potential to
generate $300 000 per day net earnings between them.
Songa was acquired in April 2006 and Abbot paid a 42% premium over the
average share price from the preceding year. Songa was not a profitable
enterprise and was running at a loss when purchased.
While Abbot foresaw only limited operating synergies and cost savings, it
aimed to capitalise on the growth in demand for jack-up rigs, and was
expecting the acquisition to be significant enhancement for revenue from
2007 and beyond. The intention was to include the company as a separate
division of the parent. When asked about the move, the company stated that
it decreased its market risk through greater diversity of earnings across land,
platform and offshore rigs.
(Based on Abbot Group, 2006)
Table 7.7 Abbot and Songa: For and against

Driver For Against
Recognising unrealised Songa has valuable assets, command- Paying a 42% premium leaves little
value ing a good day rate in the market room for releasing further value
Buying market share Buying into a new market; expanding New product in a new market
operations
Reducing competitive Expand to become a larger player in Still too small to be a serious player
pressures the global drilling sector
Synergy Many synergistic possibilities Little operating overlap between
companies: Songa will be new
division within Abbot, with further
admin costs and new governance
structures
Balancing the portfolio Increases number of services Is portfolio balanced? May be adding
a dog
Core competences Increases areas in which Abbot is Skill set required for mobile offshore
able to operate is different from that for rig man-
agement and onshore
The fact that there are arguments for and against suggests that this may be a case
in which the arguments against the acquisition were ignored by managers and
arguments for were emphasised. Exhibit 7.3 shows what happened to Abbot Group
after the acquisition of Songa.
Exhibit 7.3: Abbot Group plc, II
Abbot Group plc, Financial highlights, 2005 and 2006

31 December 2006 31 December 2005
Revenue £1160m £684m
Gross profit 14% 17%
Net profit 5% 7%
Gearing 170% 101%

ROCE 8% 12%
EPS 2.5p 5p
An overview of Abbot’s financial performance from the two previous years

reveals that:
 the company went from a risky gearing to a riskier gearing;
 revenues increased by 69%;
 gross and net margins both fell; and
 ROCE fell by 4%.
By the end of 2006, the company’s shares had been marked down 20% lower
than when the acquisition was announced. Two of the three jack-up rigs were
idle and awaiting contracts to be signed. According to the Financial Times:
[Abbot Group] saw its profits hit by a sharp rise in financing costs as its debt
almost tripled, partly due to its £247m acquisition of Songa. […] While fi-
nancing costs quadrupled … , the three rigs that came with the Songa deal
did not contribute towards earnings… (Odell, 2006)
In March 2007, Abbot had filled its order book for 2007 and most of 2008,
already signing contracts worth 96% of 2007’s revenue forecast. However,
the shares still continued to trade at a discount to those of its nearest
competitors, Wood Group and Petrofac.
Abbot’s shares traded within the 260–280 pence range until it was announced
that a takeover bid was planned by First Reserve, the energy industry private
equity firm.
In this case, it appears that diversification did not reduce risk, which was one of
the main potential benefits claimed by management. The fact that it was possible to
make as strong a case against the acquisition as for it should have been at least cause
for concern. First Reserve spotted an acquisition target for one of the acquisition
reasons listed above – probably ‘recognising unrealised value’.
Of course, it is easy for those who study strategy to look at historical examples
such as this and see the flaws in management logic after the fact, and the Abbot
Group example has been chosen because of its extremely poor outcome. Neverthe-
less, it is a relatively straightforward task to look around the oil and gas industry – or
any industry, for that matter – and find examples of acquisitions that are in the
process of being agreed, those that have failed and those that have been completed,
but have not added value in the way management might have hoped.
So why do acquisitions tend to perform so badly? A number of different phe-
nomena might assist in explaining the enduring poor performance of acquisitions
over time and across industries.
 The free-rider problem can cause gains to accrue to shareholders of the acquired
company rather than those of the acquirer. Consider a company that sets out to
acquire a target that is currently worth $1 per share, because it thinks it can turn
that target into something worth $2 per share. When a takeover offer of $1.50
per share is announced, designed to tempt shareholders to sell at a premium,
some of the target’s shareholders might decide that they want to resist selling
until a better offer is made. It is then likely that the offer price will increase, per-
haps eroding the potential to release value entirely.
 The winner’s curse can affect the amount paid for a target company if there is more
than one bidder. In the case in which more than one company is looking to ac-
quire a particular target, the contenders can become locked in a bidding war,
which may result in the winner paying more than the company is actually worth.
The company that ends up acquiring is likely to have taken an overly optimistic
view of the target’s value, while those that drop out might have taken a more
realistic or an overly pessimistic view. Such a situation would almost certainly

erode any difference between price paid and intended value.
 Both of the above situations can arise because of hubris – that is, the excessive
self-confidence that comes before some kind of fall. It does not take a large
stretch of the imagination to think that some senior managers have a tendency to
‘believe their own hype’ and that this can influence the rationality of their strate-
gic decision making when caught up in a competitive situation or a public battle
with the target’s shareholders.
 Adverse and unseen cultural issues can also cause all kinds of difficulties. This
comes down to the existence of asymmetric information (that is, the target’s man-
agement is likely to know a lot more about what is going on in the company than
do those managers trying to acquire it). Different kinds of working cultures,
addressed in Module 2, do not always sit well together: a company with a prevail-
ing task culture that acquires an organisation with a role culture, for example, will
find that there is extreme resistance to change and a rather difficult clash with
the newly absorbed employees. The compatibility or otherwise of primary and
support functions, particularly management systems, can also be an issue and is
unlikely to be examined in detail until the deal is done, meaning that value chain
issues can also arise.
One might reflect on the poor performance of the Abbot acquisition of Songa in
light of these factors and consider that the free-rider problem, given the premium
paid, and an element of hubris might have been to blame for the poor performance
and subsequent difficulties.
Despite the observation of enduring poor performance of acquisitions, coupled
with the relatively straightforward explanations for that performance, they continue
to be a popular method of making a strategic move. Given the popularity of
acquisitions in the oil and gas industry, it is worth considering why they might be so
popular.
 The existence of principal–agent problems has been well covered in the Core SP
course, but it is worth noting that some of the most extreme examples of these
can arise in the case of an acquisition.
 If there is information asymmetry, then acquirers will find out the issues only once
the deal has been completed. This, coupled with a tendency towards optimism
from managers who are keen to pursue their good idea, means that managers
tend to think that their acquisition is different from all the others. This optimism
arises because humans are prone to confirmation bias, meaning that they will tend
to place emphasis on evidence that suits their argument, while ignoring or dis-
missing evidence to the contrary.
 Profit and wealth generation might not be the primary motive for an acquisition;
other motives include access to a market, access to a geographic area, access to
information or access to intellectual property.
 In marketing, it is common to talk about companies launching ‘me too’ products
that imitate or mimic the successful products of other companies. The same is
true when it comes to strategic decision making and acquisitions can emerge
because of an element of ‘me too’ strategy. This explains why acquisitions tend to
occur in waves, as was the case in the waves of consolidation in the upstream oil
and gas industry during the late 1990s, and after the 2008 and 2014 crashes.
In the oil and gas industry, acquisitions are a common method of accessing new
markets and new customers. Any management team considering an acquisition
should attempt to remain as objective as possible when assessing its target, lest the
team fall victim to some of the issues identified here.
7.5.4 Method: Alliance and Joint Venture

Alliances and joint ventures can take many forms, including:
 licensing;
 franchising;
 informal cooperation;
 subcontracting;
 alliances; and
 joint ventures.
The strategic rationale for undertaking cooperative activity is what is important. The
oil and gas industry is characterised by a large number of joint ventures and partner-
ships. Some examples are the Fujian Refining and Ethylene Project in China, which
is a joint venture between Exxon, Sinopec and Saudi Aramco, and TNK-BP, which
was a joint venture between BP and Russian NOCs until it was acquired by Rosneft
in 2013. In many cases, oilfields are operated by contractual partnerships among
many different companies: for example, the Kashagan oilfield in Kazakhstan is
operated by at least six different companies working together, joint-venturing with
the Kazakh NOC.
Joint ventures are becoming more characteristic of the oil and gas industry in
general, especially as IOCs find themselves with increasingly reduced proportions of
reserves. This makes joint ventures and partnerships with the NOCs much more
likely, because the NOCs have access to the reserves and cooperative agreement is
the only way for the IOCs to access them. In such cases, the joint venture is not so
much a strategic option as it is a strategic necessity.
Joint ventures with NOCs carry their own risks, an example of which was the
nationalisation of the Venezuelan Orinoco Belt projects in 2007: ExxonMobil,
ConocoPhillips and Total lost billions of dollars when the fields were nationalised
and PdVSA, the Venezuelan NOC, pried a majority stake from the hands of the
IOCs.
The problem facing companies when involved in any of these arrangements is
whether they can trust their partner. The underlying issue is the prisoner’s dilemma,
discussed in Core SP Section 5.3.1: there is always an incentive to cheat, and when the
benefits of cheating become so large, the original agreements stand for nothing. This
will always be a problem for oil companies dealing with government-controlled
organisations in politically volatile areas.
7.5.5 Method: International Moves

International expansion is of particular importance to oil and gas companies. Shell,
for example, is a UK-listed company, but 90% of its operations and profits are
outside the UK. While there is no difference in principle between moving into a
new foreign market and into a new domestic market, international expansion brings
with it a new set of problems. For one thing, competitive conditions may be
different from domestic competitive conditions. The fact that a company has a
competitive advantage in one location does not necessarily mean that it can transfer
this abroad.
In his 1990 book The Competitive Advantage of Nations, developed in Core SP Sec-
tion 4.3.4 and applied in Section 4.6.2, Michael Porter explained that competitive
advantage can be country- or company-specific, and that this determines whether it
is better to export to a foreign market or to shift production there. In Section 4.6.2,
the concept was used to try to explain Halliburton’s decision to set up a corporate
centre in Dubai.
The subsequent analysis of the stages of the industry supply chain put a different
perspective on this. Table 7.8 shows how the stage of the industry supply chain
determines whether competitive advantage is company-specific or country-specific.
Table 7.8 International competitiveness by sector

Supply chain stage Competitive factors Specificity
Exploration Skilled manpower; exploration vessels; computer systems Company
Development Skilled manpower; advanced techniques Company
Production Project management Company
Trading Bargaining skills Company
Transport Local monopoly Country
Refining Proximity to markets Country
Storage Local monopoly Country
Marketing and distribution Local competitive conditions Country
This adds a perspective to the ‘competitive advantage of nations’ analysis in

Section 4.6.2. On the basis of this interpretation, upstream activities are company-
specific and downstream activities are country-specific. As a result, upstream
companies can locate anywhere, because they are not dependent on local conditions;
each project can be interpreted as a location decision. The downstream companies
are dependent on local conditions for their competitive advantage; in principle, they
should export their output, rather than locate abroad, but it is not possible to
export, because the local advantage is based largely on monopoly rather than factor
conditions. The Halliburton location decision took into account many other factors,
such as proximity to customers, oil reserves and so on. It is an open question in
what sense Shell is a UK company; there is no identifiable location advantage
associated with where its headquarters is.
The case of NOCs looking to move international was also addressed in Section
4.6.2. Other than the problem of transferring competitive advantage abroad, there
are other factors that complicate international operations, such as that:
 exchange rates are volatile;
 relative factor costs can vary widely by country;
 productivity varies widely by country;
 governments often protect home industry;
 cultural norms can vary markedly between countries;
 economies of different countries rarely move in step; and
 the environmental scanning task becomes much more complex in the interna-
tional arena (as seen in Module 4).
The complexity of international expansion is also the result of the number of trade-
offs that have to be made. Consider the example of a UK-based vertically integrated
oil company that intends to set up a new refining facility near its newest oilfield in
West Africa. It has identified country 1 and country 2, both of which would be
acceptable, based on the initial screening, and now a choice has to be made between
them (Table 7.9).
Table 7.9 Country profiles

International Country 1 Country 2
factor
Exchange rates Low in terms of purchasing power parity, Massive fluctuations over past three
but stable years
Factor costs Skilled labour requires 30% premium Attractive environment for skilled labour
Productivity No existing pool of labour Oil industry presence for 20 years; hence
ready pool of labour
Government High barriers to fund repatriation No controls on international capital
flows
Culture Suspicious of foreign management Existing oil companies have built good
relations
Economic Low absolute incomes and low growth Potential to be a ‘tiger’ economy in 10
performance years
There are various trade-offs in choosing between countries 1 and 2: is it prefera-

ble to start up in an economy with no history of the oil industry or in a more mature
oil economy that is less stable? There is no definitive answer, because different
companies will relate the conditions to their own strengths and weaknesses: one
company may feel that it can deal better with a ‘greenfield’ site, where there are no
competitors; another may feel that the benefits of an existing labour market
outweigh potential competition. The essential step is to set out the factors in a
comparative fashion, so that a rational choice can be made.
7.5.6 Withdrawal, Divestment and Consolidation

All of the variations, both directions and methods, discussed so far in this section
have been concerned with expanding into new areas. As identified in Section 7.3,
expansion is not the only form of corporate strategy and it is quite acceptable to
choose to withdraw from a particular market or to divest an underperforming
business. Disposing of assets or a particular part of an organisation can take on a
number of different forms.
 Spin-off or sale. A company can spin off or sell off a division, either as an inde-
pendent entity or to another organisation. A spin-off can be achieved through
some form of share split, leaving the shareholder with two shares, one of which
can be disposed of if the shareholder prefers. Selling a division or a facility to
another company is likely to involve some kind of contract. Conoco Phillips
spun off all of its refining, marketing and petrochemicals businesses into the new
Phillips 66 company in 2012. At the time, analysts forecast that this would result
in an overall increase in value of 10% for shareholders.
 Demerger. A split or a demerger is when a company splits itself in two or more
parts to release value. Google did this when it reorganised as Alphabet in late
2015.
 Management buyout. A management buyout occurs when current management gets
together and buys out the shareholders, perhaps because they are able to take
advantage of positive information asymmetry in their direction.
Any of these contractionary options are perfectly legitimate methods of pursuing a
retrenchment strategy, or even a stability strategy, for an organisation. The issue is
that often senior management do not look at these as available strategic options
until it is too late, perceiving them to be a sign of failure, which is not always the
case. A mature or declining market might be enough incentive for a dynamic
organisation to withdraw from a particular set of activities.
7.5.7 Strategy Directions and Methods

There will always be arguments for and against the adoption of any strategic
variation, in terms of both direction and method, depending on the circumstances.
What is important is to examine the pros and cons of each course of action, rather
than just accept a variation at face value. It is not known whether Abbot Group plc
undertook a detailed strategic analysis of its acquisition of Songa, but if it had
mapped the arguments for and against, it might have arrived at a different conclu-
sion and avoided ending up as a takeover target itself. The question can also be
asked of the megamergers that took place in the industry in 2015, the largest of
which was Shell’s acquisition of BG Group, an upstream gas company with large
interests in gas production around the world. Indeed, in Shell’s case, a sizeable
minority of shareholders objected to the merger when it was voted through in
January 2016.
7.6 From SWOT to Strategy

There are many influences on strategic choice and this module has attempted to set
out the main options available to organisations, and to elaborate on the more
popular options in the oil and gas industry. As always, the amount of information
available is so vast that it is impossible to take everything into account. This is where
SWOT analysis comes in, providing a framework for identifying what is important,
to be used as a guide in selecting the most appropriate generic strategy and variation.
There are two basic outcomes from a SWOT analysis.
 Strengths are aligned with opportunities.
This would suggest that the company should pursue a generic strategy of expan-
sion, because its strengths are aligned with its opportunities.
 Threats are aligned with weaknesses.
This points to a strategy of retrenchment; weaknesses must be addressed to
counter external threats before any advantage can be taken of opportunities.
The choices of business-level strategy and variation can be taken together, and will
depend more on the details of particular strengths, weaknesses, opportunities and
threats. If both of the above alignments are identified in the same SWOT analysis,
some difficult choices need to be made.
The inherent usefulness of SWOT lies in the fact that it does not provide only a
picture of what the company is, but also provides scope to look at what it might
become. This is where imagination and inventive thinking are essential if a company
is to achieve competitive advantage. It is also where specific industry knowledge and
experience are brought to bear. The role of strategic analysis is to provide the
framework of models and structure within which decisions can be arrived at. An
external observer can be completely mistaken about issues such as technical
feasibility, and the alignment between strengths and weaknesses; the industry expert
brings the necessary insight and realism upon which sensible decision making is
based.
Learning Summary
This module has discussed the role of SWOT analysis in strategic decision making,
providing the link between the analysis and choice stages of the strategy process.
The main strategic options open to an organisation have been examined in terms of
generic strategies and variations. The generic strategies have been discussed at both
corporate and business unit levels, and some useful examples from different parts of
the oil and gas industry have been examined. Strategy variations have been broken
down into directions and methods. The most popular direction (vertical integration)
and method (acquisition) in the oil and gas industry have been examined in some
detail with regard to benefits and costs. Finally, the link between SWOT analysis and
strategy choice has also been examined.
References
Abbot Group (2006) ‘Abbot Group Makes Offer for Songa Drilling’, Rigzone, 24 April. Available online at
www.rigzone.com/news/oil_gas/a/31488/Abbot_Group_Makes_Offer_for_Songa_Drilling
ENI SpA (undated) ‘ENI’s History’. Available online at www.eni.com/en_IT
/company/history/our-history.page
Odell, M. (2006) ‘Abbot Assessment Fails to Sway Investors’, Financial Times, 8 September.
Available online at www.ft.com/cms/s/0/9714ef1c-3ed7-11db-b4de-0000779e2340.
html#axzz3zD2XAe00
Porter, M. (1980) Competitive Strategy, New York: Free Press.
Porter, M. (1990) The Competitive Advantage of Nations, New York: Free Press.
Module 8
Implementation and the Oil and Gas

Strategic Process
Contents
8.1 Introduction.............................................................................................8/1
8.2 Organisational Structure .......................................................................8/2
8.3 Resource Allocation................................................................................8/9
8.4 Evaluation and Control ....................................................................... 8/11
8.5 Feedback ............................................................................................... 8/13
8.6 The Augmented Process Model ......................................................... 8/15
8.7 Conclusion: Strategic Thinking in the Oil and Gas Industry ........... 8/17
Learning Objectives
 analyse resource allocation in the oil and gas industry;
 evaluate the effective use of resources;
 assess the role of feedback;
 analyse ongoing competitive position; and
 apply the augmented strategic process model in the oil and gas industry.
8.1 Introduction
This stage of the strategy process model involves implementation of the chosen
strategy. It is not sufficient simply to choose a particular strategic direction; re-
sources need to be allocated in line with the chosen strategy, structure and outcomes
must be evaluated, and actions taken, where necessary. Once the chosen strategy is
implemented, there needs to be constant feedback to all parts of the process model.
Feedback highlights the fluid nature of strategy making.
Consider the case of an IOC that has chosen to expand into renewable energy. It
will need to decide on the appropriate organisational structure for its new business
unit and how to integrate the new unit into the overall structure of the organisation.
The decision on structure is closely related to the decision on resource allocation.
Typically, the company will already have procedures for allocating resources among
strategic business units, but these may not be consistent with the new strategic
objective – that is, to diversity into renewable energy. Finally, new control systems
Module 8 / Implementation and the Oil and Gas Strategic Process
need to be developed and relevant data fed back, so that adjustments to the strategy
can be made as new information becomes available.
This module:
 applies the implementation ideas developed in Core SP Module 8 to the oil and
gas industry;
 addresses organisational structure within the industry, with some prominent
examples;
 analyses resource allocation and control systems; and
 applies the augmented process model.
As discussed in Core SP Module 8, at this point in the strategy process, the company
does not necessarily have a plan written down that details strategic intent; reference
to a ‘plan’ in the following therefore refers to managers’ perception of the company
strategy, rather than a written document. At the end of this module, a more general
conclusion to the course is provided, along with a consideration of strategic thinking
and the oil and gas industry.
8.2 Organisational Structure

There are various ways of structuring an organisation, each with its own advantages
and disadvantages; often, there is no strategic rationale for an existing structure,
which may have evolved over time and may not be aligned with the organisation’s
objectives. In order for strategy to be effectively implemented, the structure of the
organisation must give management the control needed over operations, the ability
to allocate resources in line with the chosen plan and the flexibility to deal with
dynamic changes in the external environment.
Exhibit 8.1: Royal Dutch Shell and Organisational Structure I

Royal Dutch Shell plc was formed in 1907 as a merger between Shell
Transport and Trading and Royal Dutch Petroleum. The two companies
retained separate headquarters in London and The Hague, but merged their
operating activities. Both headquarters remained until 2004, after which a
scandal involving incorrect reporting of proven reserves forced a full merger
of the two companies.
By the time Shell finally merged with Royal Dutch, it had gone from being the
largest oil and chemicals company in the world to third largest, behind the
newly merged ExxonMobil and BP-Amoco. In its traditional form, the compa-
ny was not equipped to deal with the wave of mergers that swept the oil and
gas industry in the late 1990s. The company had been slow to react to
external change, in no small part because of what many industry observers
described as its arcane decision-making procedures and top-heavy manage-
ment structure.
The management structure at Shell until 2004 (Exhibit 8.1) was an example of a
structure that had evolved over time without a strategic rationale. Shell had been run
for almost 100 years as an extremely large joint-venture company, which had
evolved a top-heavy management structure, leading to slow decision making. The
reserves reporting scandal in 2004, which damaged Shell’s reputation and destroyed
value for the company’s shareholders, was a symptom of a weak strategic process.
This also resulted in Shell missing out on the industry consolidation of the late 20th
century. By removing the complex management system, the company increased its
chances of becoming more flexible and better able to deal with the volatile external
environment.
There are several structural options available to organisations; it was discussed in
Core SP Section 1.2.4 how the historical development of companies was accompa-
nied by changes in the strategic approach, which were in turn accompanied by
changes in organisational structure. The same evolutionary process occurred in the
oil and gas industry, resulting in the following main types of structure.
 Functional. Employees are grouped according to their specialities, rather than the
products or services they work on. This traditional structure was prevalent in the
oil and gas industry before the large expansion in hydrocarbon production in the
1950s. As companies grew in scale and scope, they became unable to manage the
more diverse range of operations required to meet growing levels of demand.
 Divisional. Employees are grouped around products or geographical areas, and
each division has its own functional structure. This structure is common among
the integrated oil and gas companies that cover a large part of the supply chain,
or service companies with a number of different product offerings. But the divi-
sional structure does not necessarily simplify operations, because sometimes
divisions overlap different stages of the supply chain. The Shell example in
Module 6 showed that the company’s upstream activities were separated out into
three divisions, while the downstream activities were managed exclusively under
the Oil Products division.
 Matrix. The matrix structure involves both vertical and horizontal organisation.
This results in employees having to report to two bosses, which can be a source
of conflict and confusion. Many very large international oil companies organise
themselves into a combination of product divisions and also geographical divi-
sions, which results in a matrix that may not have been intended. Halliburton
organises itself into both product and geographical divisions, which effectively
results in a matrix.
 Network. In a network structure, groups and activities are organised around
common tasks or projects rather than specific hierarchical lines. This can be
flexible, but leads to problems of direction and control, because the task can
come to dominate strategic decision making.
There are advantages and disadvantages to each organisational form, and the
appropriateness of each will depend on the environment, in both macro and
competitive senses. Given the potential impact of the structure on the company’s
performance, it is important to be explicit about why the organisational structure
was selected.
Table 8.1 examines the advantages and disadvantages of different structures for
two different companies in the oil and gas industry:
 a small exploration technology and software project company; and
 a very large international integrated oil and gas company.
Table 8.1 is by no means an exhaustive assessment, but it does demonstrate that
different profiles of advantages and disadvantages can emerge, depending on the
nature of the organisation and the part of the supply chain in which it is operating.
The exploration company is small, and needs to foster efficient team working and
innovation if it is to perform well. The large integrated company, on the other hand,
requires an explicit command structure and clearly defined operating areas, owing to
the size, scope and geographical spread of the company.
Therefore, given the costs and benefits derived for this example, which structure
is most appropriate for each company? Clearly, it depends on the priorities awarded
to the identified advantages and disadvantages – and that, in turn, depends on how
the advantages and disadvantages were identified in the first place, which depends
on:
 perceptions – that is, employees are often committed to ‘their’ structure because
they feel it works for them; and
 the definition of the business, for example as ‘innovative’, ‘marketing’, etc.
Table 8.1 Costs and benefits of organisational structures
Structure Exploration Integrated oil company
Functional + Focused strategic control system – Complex strategic control system spread over supply chain
+ Focused training system + Focused functional training systems
– Separation of engineering and marketing activities leads to lack of – Each functional department very large and geographically dispersed
coordination
– Lack of managers with strategic perspective – Conflicts of interest among business units
– Employees focused only on their own functional tasks – Inflexible because of size
– Many employees in different geographical areas reporting to a single
manager
Divisional + Different divisions for different product lines provides more + Managers can focus on their particular product area, e.g. exploration,
broadly trained managers refining, marketing
+ Performance can be expressed in terms of divisional profit or + Better control of individual activities that make up company supply
economic value added chain
– Engineers too narrowly focused – Cooperation between divisions hampered by ‘organisational silos’
+ Strategic control maintained over relatively few divisional managers – Strategic control lost to divisional managers
– Possibility of R&D duplication of effort in different divisions – Lack of communication between specialised areas
– Product synergies difficult to realise – Duplication of effort in R&D
– Functional activities duplicated across divisions – Functional activities duplicated across divisions
Matrix + Flexibility – able to adapt to changes in the volatile environment + More responsive to changes in environment
quickly
+ Good coordination and communication + Close coordination and communication between geographical and
product divisions
+ Less bureaucratic + More adaptable to different conditions in different geographical
areas
+ Facilitates easier project team working + Better communication between functions
+ ‘Unity of command’ principle approximately maintained – Violates ‘unity of command’ principle
+ Quick decision-making – simple to arrive at consensus – Very slow decision making owing to number of managers involved
and size of organisation
+ Dependent on development of effective teams – Difficult to develop and manage large number of teams
Network + Project teams can be formed quickly from pool of experts + Flexible throughout supply chain
+ Flexible in the most volatile sector of industry supply chain – No explicit command structure
+ Innovation fostered in working groups – Too many different groups working on different projects to control
+ Flat command structure stimulates effective teamwork – Responsibility for strategy unclear
– Lack of direction and control – Many conflicting managers and teams
+ Size makes monitoring of employee effort possible – Lack of functional support
Exhibit 8.2: Royal Dutch Shell and Organisational Structure II

Although Royal Dutch Shell’s management structure was difficult to identify
from outside, it survived until 2004. It involved the company having two head
offices, in London and The Hague, and being run by a committee of managing
directors from both Royal Dutch and Shell (see Exhibit 8.1).
Until the 1950s, Shell was managed as a single functional organisation. Shell
grew very quickly after 1945 as hydrocarbon demand and activity grew
exponentially, and it became difficult to control all aspects of the company’s
operations centrally. The functional structure was no longer fit for purpose.
In 1959, Shell called on the help of management consultancy McKinsey and
Company to restructure. The result was a matrix organisation.
 ‘Operating companies’ covered each geographical area, and were respon-
sible and accountable for operations.
 Five ‘service companies’ were set up to manage and advise the operating
companies: two service companies covered petroleum, one for Royal
Dutch and one for Shell; two companies covered chemicals, again one for
Royal Dutch and one for Shell; and one company was set up to deal with
R&D.
All of this was supplemented by functional support from London and The
Hague. In the 1960s, a further service company was added for natural gas
operations.
After the first oil price shock of the 1970s, there was a push by most major
oil companies to diversify operations away from oil and gas. Royal Dutch Shell
was no exception and it made a number of acquisitions, including Billiton, an
international metals mining company, and various coal companies across
North America. These were added to the matrix as further service compa-
nies, while geographical units maintained responsibility for operations. A joint
venture with Gulf Petroleum involving nuclear reactors was also started. By
1990, Royal Dutch Shell had nine service companies providing service and
advice to its operating companies.
Other large oil and gas companies had pursued restructuring in the late 1980s
to cope with the external environment of low oil prices. This tended to
involve the divestment of unprofitable units and the reduction of excess
capacity. Shell divested its mining and coal operations throughout the 1990s,
and refocused on the oil and gas business. It also restructured the service
companies in line with a global trend for delayering and a flatter management
structure was put in place. The matrix structure has been maintained since,
but is considerably less complex than before.
As is evident in Exhibit 8.2, Shell’s functional structure became too cumbersome

and difficult to manage after the large increase in hydrocarbon activity in the 1940s
and 1950s. The company recognised this and called upon management consultants
to help to restructure the organisation. This is an example of a change in organisa-
tional structure that was made consciously in response to a dynamic external
environment. It was recognised that it would be too difficult to manage the rapidly
expanding operations from a central point, so the company was divided up into
geographical divisions, with product-specific service companies providing the
horizontal aspect of the matrix structure.
The existence of two petroleum and two chemicals companies is a peculiarity of
the Royal Dutch Shell governance structure. Other additions to the matrix, includ-
ing coal and mining, were organic developments of the organisation’s structure that
again happened because of external factors – in this case, the poor economic
environment facing oil companies at the time. This was not part of a restructuring
programme, but was an organic development of the company’s structure, which
again became too difficult to manage by the late 1980s.
This demonstrates how the structure of a company can have a significant impact
on its performance. While each of the structures has advantages and disadvantages,
and it may not be easy to see which structure is best for a given organisation, it is
often clear when a particular structure does not fit the company characteristics.
A different perspective on the role of structure can be obtained by considering
whether particular structures are most appropriate for specific sectors of the
industry supply chain. Table 8.2 is taken from Module 6 and concerns the value
chain of a refining company that has operations in a number of different parts of
the world. The implications of both functional and divisional-geographical struc-
tures are considered, and in the ‘Advantage’ column a ‘+’ is assigned for an
advantage of divisional over functional and vice versa.
Table 8.2 Value chain and organisational structure

Value chain Activity Functional Divisional-geographical Advantage
component
Primary activities
In-bound logistics Supply crude oil Requires central trading and Distribution channels shorter; +
distribution network; requires each division can organise its
feedstock particular to refinery; own feedstock
feedstock grade availability differs
from region to region
Operations Convert crude oil to petrol Refineries with different capabili- Refineries with different +
and diesel ties managed as one centrally capabilities managed as separate
controlled asset entities
Outbound logistics Put output into storage Storage managed from one Storage management takes place +
central point closer to final customers
Marketing and sales Branding and selling product One department dealing with Marketing teams dedicated to +
different markets particular geographical area
Service Ensure adequate inventories Inventory levels controlled from Inventory management closely +
maintained central offices aligned with customer need;
possible to operate just-in-time
Support activities
Procurement Traders purchase crude oil Different grades required for Required grades can be locally +
different refineries; high sourced; transport costs
transportation costs reduced
Technology Incorporate latest refining Technology developed and Technology aligned to regional +
development techniques managed centrally crude grade availability; deci-
sions made locally
HRM Deal with mainly semi-skilled One centrally decided policy Policies can be aligned to local +
workers culture and workforce
Management Focus on efficiency Single management process Management teams focused on +
systems divisional processes
From this perspective, the geographical divisional structure is superior on every

component of the company value chain and is therefore better suited to the needs
of a global refining organisation, because it provides better access to local markets,
better technology development in line with crude grades available in the region,
lower transportation costs for feedstock and better inventory management.
Therefore, in this case, it is clear which structure the company should choose; in
Core SP Section 1.2.5, it is discussed how different company structures may have
evolved over time through divisionalisation and diversification, to restructuring and
downsizing in response to the changing demands of the market and changing
strategic approaches, and how companies may have arrived at new structures in
response to the influence of changing environmental conditions – that is, they may
have adapted rather than made specific choices on structure. It seems obvious from
Table 8.2 that the structure in this example should be aligned to the company
objectives and the competitive environment, rather than allowed to evolve by
default, but historically that was what happened (Core SP Table 1.2): structure
followed strategy rather than led it – and this is particularly marked in the oil and gas
industry. Thus if there were two identical refining companies – one structured
functionally and the other, around geographical divisions – it is likely that the
company structured around geographical divisions would perform better owing to
its more closely aligned value chain. (Having said that, bear in mind the problems of
identifying causality explored in Core SP Section 1.2.6.)
8.3 Resource Allocation

The methods by which resources are allocated within an oil and gas company
depend upon the individual organisation, but typically include competitive internal
bidding, budgeting and using predetermined accounting rules. If resources are not
allocated in line with the organisation’s strategic thrust, then it will be difficult to
implement the chosen strategy. It is not always a lack of available resources that
prevents a particular objective from being achieved; rather, the use of inappropriate
methods of allocation can result in resources not being directed towards their most
efficient use.
8.3.1 Management of Change

Reallocating resources typically involves changing what employees actually do. This
is exemplified by Shell’s changes over the past 50 years. The change in governance
structure in 2004 was forced by external events, and resulted in a reallocation of
resources from the corporate centre to other divisions and a streamlined manage-
ment system. Significant barriers to change often exist within an organisation that
hinder effective resource reallocation.
In Section 2.3, the different HRM cultures were examined in an oil and gas in-
dustry context. It was demonstrated that culture can have a significant impact on
strategy implementation and resource allocation.
Consider the example of an exploration company that has chosen to retrench its
operations by pulling out of unprofitable geographical sectors and focusing its
remaining resources on the areas in which it is creating the most value. This strategic
move will result in significant change for the organisation and for some employees.
If the company has fostered a corporate culture of adaptability and innovation, and
has an incentive system that rewards flexibility, then the proposed strategy can be
implemented and resources reallocated with minimum difficulty. The HRM culture
of the firm will play a large role in the reallocation of resources and strategy imple-
mentation, and their likely impact on strategy implementation in the oil and gas
industry can be summarised as follows.
 Power culture. Once strategy is decided, the whole organisation falls quickly into
line. The ExxonMobil example from Section 2.4 provides a clear example of a
power culture that rested with Lee Raymond: his personality was stamped on the
organisation and employees knew that they needed to toe the company line.
 Role culture. Any strategic move that results in changing job roles or cutbacks will
be met with resistance. If the exploration company trying to relocate operations
to profitable areas were to be permeated by a role culture, then the reallocation
of resources would be likely to be a drawn-out and difficult process.
 Task culture. The power rests within individual team structures and can be
harnessed to enact swift strategic change. The exploration company would bene-
fit from a task culture, because teams could be quickly reassigned to new tasks
and resources could be reallocated quickly to achieve the company’s objective.
 Personal culture. The impact of a personal culture is uncertain: if individuals are
happy in their current roles, then it will be difficult to implement a particular
strategy or to achieve an objective if this is in conflict with their own personal
goals.
Resource allocation often involves the management of change and requires an
understanding of the strategic process. This involves the culture of the company,
the incentive system and awareness of the techniques available to facilitate change.
8.3.2 Management Style

Management style can have an impact on resource allocation and the effectiveness
of strategy implementation. Referring back to the examples of BP and Exxon in
Section 2.4, it was apparent that the two CEOs had different approaches to leader-
ship that had a significant impact on strategy implementation. Browne made
divisional managers accountable, while still giving them decision-making power
within their own areas. Core SP Section 2.2.1 dealt with the evolution of the
company and the implications for the relevant attributes required of a CEO. On the
one hand, Browne recognised that BP had reached the diversified stage and acted
accordingly, by delegating decision making and fostering a task culture that made BP
more adaptable, facilitating the expansion into the renewable energy business.
Raymond, on the other hand, ran ExxonMobil as though it were still at the integrat-
ed stage of the life cycle. To do this, it was necessary to employ a power culture in
order to control the diversified organisation with no inner circle of managers,
resulting in a dictatorial management style that affected strategy implementation
through the whole organisation.
8.4 Evaluation and Control

After a chosen strategy has been implemented, it is necessary to measure and
evaluate performance to see whether objectives are being met. If the plan is clear
and has been made explicit, then it can be used as a benchmark against which actual
performance can be checked. For example, a chemicals company that has launched
a new product needs to continually monitor and evaluate that product’s perfor-
mance against the plan. If, after a survey of the competitive environment and an
examination of market conditions, it were to be decided that the product should
achieve 10% market share in its first year and the product has achieved only 3%
share in six months, then action would be required to bring the product back on
target.
However, the extent to which action can be undertaken depends on the reason
why the objective has not been achieved. If it is the result of value chain defects,
such as a badly designed marketing campaign, poor operations resulting in orders
not being met or human resource problems resulting in lack of skilled employees,
then something can be done. But if it is the result of external influences, such as an
unexpected move by competitors or a sudden downturn in demand, then the scope
for action may be limited and it may be necessary to revise the objective. Gap
analysis, developed in Core SP Section 3.3, can be used to monitor the desired and
actual positions, and the actions required to bridge the gap.
The planning and control matrix (Core SP Figure 8.1) depicts different approach-
es that companies use to control planned outcomes. ExxonMobil, under Lee
Raymond, exhibited tight financial control with a low degree of forward planning;
under Lord Browne, BP exhibited a relatively high degree of forward planning and
tight strategic control, exemplified by the autonomy and accountability given to
division heads. Which is more effective? ExxonMobil consistently produced better
financial performance than BP; it could be argued that this was more the result of
avoiding unrelated diversification into areas such as renewables, which had no
obvious short-term financial return, than of the type of control, but to some extent
the two go hand in hand. The justification for tight financial control is that it does in
fact generate high returns – but it may result in an organisation that is unable to
adapt when core markets contract and new opportunities emerge.
In Core SP Section 8.4, the following steps were identified to make an organisa-
tion’s control process manageable:
1. Select relatively few appropriate objectives.
2. From the objectives, derive suitable targets.
3. Identify a series of milestones to be tracked over time.
4. Include subjective ongoing evaluation for objectives and targets that are not
easily measured.
These steps can be applied to any organisation, but to see how the different
approaches to planning and control affect the control process, consider Centrica,
dealt with in depth in Module 3, and how the control process might unfold under
the different approaches identified in Table 8.3.
Exhibit 8.3: Centrica’s Vision and Strategy in 2008
Vision
Our vision is to be a leading integrated energy company in our chosen
markets.
Strategy
Our strategy is to create a leading integrated energy company, sourcing and
supplying gas and electricity, and providing energy services, using our strong
brands to succeed in our chosen markets in the UK, North America and
Europe.
If we take Centrica’s vision and strategy above as a starting point, it is possible to

see clearly the difference between the various approaches. Table 8.3 provides
examples of how Centrica would follow the process under different planning and
control approaches:
Table 8.3 Planning and control types

Control step Loose Planning Financial Strategic
Few objectives Remain similar to Achieve market Increase ROTA from Achieve competitive
strategy statement; leader position in 8% to 12.5% within advantage in Europe
vague UK and Europe; 5% three years and North America;
market share growth defend position in
in North America; all UK
within three years
Derive targets Imprecise – ‘strong Year 1: #2 in 1.5% increase in Relative market
brands’, ‘leading Europe; 2% share ROTA each year share; actions
energy company’ growth in North consistent with BCG
America; maintain matrix
current position in
UK
Year 2: #1 in
Europe; further 2%
growth in North
America
Milestones None Actual vs desired Allow for 0.5% Assess performance
market variation each year relative to
share/position competitors
Subjective Little understand- None None Is competitive
evaluation ing of what has to advantage being
be achieved achieved? Changing
competitive threat in
the UK?
The differences between the approaches are stark: the loose control approach
leaves much to chance, while the financial control approach expresses goals in terms
of accounting ratios. The strategic control approach uses a combination of measur-
able and subjective criteria to assess actual versus planned performance. While this
is only an interpretation of how a particular approach can skew a company’s
outlook, it recognises that the type of planning and degree of control in an organisa-
tion have a large impact on how and whether chosen strategies are properly
implemented.
It is always possible to justify a particular planning and control approach in retro-
spect. It might be claimed, for example, that:
 loose control allowed the company to seize opportunities when they occurred;
 planned performance allowed the company to maintain clear direction in a
volatile environment;
 financial control allowed the company to avoid disastrous diversification; and
 strategic control allowed the company to fully understand why some initiatives
did not succeed.
As ever, it is necessary to be careful in attributing causality; there is no substitute for
thinking through the implications of different approaches as events unfold.
8.5 Feedback
The final element of the strategic process is feedback. It has been demonstrated that
the strategy process within an organisation is a fluid one, and that activities such as
analysis and diagnosis are not a once-and-for-all activity. The changing environment
and the actions of competitors mean that strategy needs to be continually reassessed
in the light of new information. Comprehensive environmental scanning and the
continuous monitoring of performance are not enough; the organisation needs to be
able to act on changes as they occur.
It was demonstrated in Core SP Section 8.5 that the company must have effec-
tive communication channels – that is, the ability to adapt and then learn from past
experience. Some oil and gas companies conduct extensive market intelligence
exercises, and build up detailed profiles of competitors. This information is useful
for strategic decision making, but if it is not communicated to those who make the
decisions, then it will not be used effectively. It was decided in Section 2.5 that Lee
Raymond’s isolation in the ‘God Pod’ did not facilitate ExxonMobil’s feedback
system, whereas Browne’s monthly reviews and open communication channels
facilitated better feedback to the strategic decision-makers. It can, however, be very
difficult to decide what is important and to get rid of the ‘noise’; it could thus be
argued that more information may have clouded Raymond’s overall vision for
Exxon.
The ability to adapt determines how well an organisation uses feedback. The Shell
example provided at the beginning of this module showed that the company was
unable to adapt to the changing competitive environment, owing to its arcane
management structure, and consequently it slipped from being the largest oil and gas
company in the world to the third largest. The company restructured its manage-
ment and streamlined operations in order to become more flexible and adaptable to
new information as it became available.
Building a learning organisation is not an easy task; it requires that the organisation
be capable of building on, and learning from, past mistakes. Certain individuals
within an organisation may develop these skills, but the crucial point is that the
whole organisation needs to be able to learn and to capitalise on this learning.
Browne attempted to do this at BP by establishing autonomy and accountability for
divisional managers, and providing good communication channels between the
divisions and the corporate centre.
The fictional MythicOil company, at which we looked in Module 1, can be exam-
ined in terms of feedback factors, as follows.
 Communication channels. The CEO was prepared to listen to the management team
and there is no indication that managers held back information.
 Ability to adapt. Managers were focused on their own roles; the role culture was
likely to act as a barrier to change.
 Learning organisation. Each function was unable to deal with unexpected crises in
any way other than to revert to the status quo.
The memos sent by each manager giving a reason for delaying proposed strategy
changes exemplify the role culture that MythicOil displays and could show that
there is widespread resistance to change: events are interpreted without hesitation as
an excuse to maintain the current situation.
Each of the events that triggered a memo from the functional managers can also
be related back to the process model (Table 8.4).
Table 8.4 Events by process stage

Event Process model Issue
component
Headhunted Internal analysis Company value chain should not depend on
one person
Cash flow Internal analysis Examine underlying profitability
Upgrade cost overruns Internal analysis Examine quality of investment appraisals
Filling station invasion Resource allocation Examine resource allocation criteria
Labour relations Implementation Role culture permeates whole organisation
By assessing the implications of each event in terms of its impact on the strategic
process, it is possible that the ‘insurmountable’ problems now facing the CEO
might be rectifiable, and that if the organisation’s strategic process is robust, then it
will be able to cope, as follows.
 The loss of the finance director can be managed, because he was only one link in
the value chain.
 The cash-flow problem is temporary and the underlying profitability of the old
platforms is a better indicator of performance.
 The upgrade cost overrun can be avoided in the future if investment appraisal
techniques are refined.
 The filling station invasion by the major oil company can be dealt with by
reallocating resources.
 The labour relations problem is more difficult to resolve, but may be sympto-
matic of the role culture that permeates MythicOil. There is room for
negotiation in the short run, however, and once key employees are brought on
side, the company may wish to try to change the prevailing work culture by rea-
ligning the incentive system, and encouraging innovation and adaptability.
The key is to understand the implications of feedback and incorporate them into the
strategic process.
8.6 The Augmented Process Model

The augmented strategic process model presented in Core SP Section 8.6 is set out
now, in Table 8.5, to identify some of the factors at each stage of the process model
that are particularly relevant to a company operating in the oil and gas industry.
Table 8.5 does not replace the strategy process model introduced in the Core SP
course, which is applicable to any industry or organisation; rather, the process model
has been used here to analyse different organisations within the oil and gas industry,
in conjunction with the model of the industry supply chain introduced in Module 1.
The outcome is a set of observations about the oil and gas industry, and identifica-
tion of a number of strategic factors that make it unique.
Table 8.5 Strategic process issues in the oil and gas industry
Who decides to do what Analysis and diagnosis Choice Implementation

Objectives Macro-environment Alternatives Structure
‘Oil and gas’ is not a business Energy demand External environment drives Structure must be appropriate to
definition Rig count strategy the area of supply chain
Many companies diversified Backstop price of oil Differentiation diminishes as Very large companies difficult to
without realising Substitutes and renewable product moves down supply organise efficiently
CSR and ethics is a sensitive energy chain
issue – ‘Big Oil’ Business cycle
NOCs set objectives in line with
government and national
expectations, not only share-
holders’
Strategists Industry environment Variations Resource allocation
Power culture common Oil price Acquisition of smaller companies Importance of culture and
Relevance of being an ‘oil man’ Derived demand constant management style
Expectations Joint ventures and partnerships
Overshooting and undershooting with volatile partners
Cobweb Unrelated diversification
common Evaluation and control
Characteristics at different parts
of the chain Vertical integration common Varying approaches produce
different levels of success
Internal analysis Feedback
Value chain rationale for a Dependent on CEO characteristics
vertically integrated business How is information used?
Strategic groups
8.7 Conclusion: Strategic Thinking in the Oil and Gas Industry

If the strategic process model is generic and applicable to any industry or organisa-
tion, and if it was covered in its entirety in the Core SP text, then what was the
reason for an industry-specific strategic planning course?
This course has provided a wealth of examples specific to the oil and gas indus-
try, which have served two purposes, as follows.
 To improve understanding of the strategy process model and how it can
be applied to diverse situations that at first seem difficult to explain
You should now be comfortable with the various models that make up the pro-
cess model and their application. The process was first used in Module 1 to
analyse the MythicOil company, and then to examine the role of two famous oil
and gas CEOs and their impact on their organisations in Module 2. Components
of the process were used in the subsequent modules to analyse other organisa-
tions such as Shell, ENI SpA and Centrica, and the industry and macro
environment more widely.
 To enable you to observe your own industry more objectively
The strategy process provides a structure for looking at strategic planning in a
rational manner, and the industry supply chain model provides a structure for
analysing the oil and gas industry in the same rational manner. By applying the
strategy process model to the industry supply chain model, a number of strategic
issues that are peculiar to the oil and gas industry have been identified, and areas
in which the strategic process is likely to be weak in the industry have been re-
vealed. Some so-called phenomena, such as the riskiness of the exploration
sector, low refining margins and the apparent inexplicability of the volatile oil
price, have been explained in terms of existing models.
It is often difficult for managers to take a step back and look at their own industry
in an objective manner, but such objective thinking about your own industry should
be the end result of this second course. The first strategic planning course contained
the tools for strategic thinking, and this one has presented the application of these
tools to the oil and gas industry. You should now be in a position to analyse events
in your industry in a rational and objective manner.
In Core SP Review Question 8.1, Wilson and Bates’s (2005) seven ‘myths that
could sink a small company’ were identified. Each of these was analysed by means
of concepts drawn from the augmented process model. These myths can be
reformulated as follows to reflect those typically encountered in the oil and gas
industry when the oil price is falling.
1. We can handle this because nobody knows the oil industry like an oil man
What are the optimal characteristics of a strategist in the industry? A brief glance
at the industry supply chain suggests that it is unlikely that the strategist will have
experience in all parts of it, thus demanding that we ask what is meant by an ‘oil
man’. In a volatile competitive environment, you have to watch out for people
who think they know what they actually do not. This can lead to major weak-
nesses in the analysis and control sections of the process model.
2. The company would not survive without me

This type of thinking reveals a power culture in which there is not sufficient delega-
tion of authority, particularly in large integrated companies. This is an issue of
managerial perceptions, whereby it is assumed that success in the past will carry over
into the future.
3. We are not affected by competition
This sentiment is usually justified on the basis of quality service provision,
unique technology and so on. The trouble is that most things can be imitated and
the incentive to imitate increases when times get tough. It is therefore essential
to understand competitive position and the basis on which the company competes.
For example, identifying whether it is because of a set of core competences, dominant
market share, first-mover advantage or whatever will reveal the types of competitive
pressure acting on the company.
4. Cutting overheads will ensure survival
Because they are conditioned by the volatile environment, oil and gas companies
tend to react to events as they occur, rather than try to ensure that they are al-
ways operating as efficiently as they can. The fact that overheads, however
defined, can be cut suggests that inadequate internal analysis has been carried out
in the past. A major problem is that if ‘overheads’ are taken to include ‘non-
essential’ activities such as marketing, management development and training,
there could be a significant impact on competitive advantage in the long term. This
impacts on generic choice, although it might not be obvious to those involved.
5. Borrowing money is too risky
This statement may or not be true, but it reflects a personal preference, rather
than an understanding of the current asset position. It is not the fact of borrow-
ing money compared with financing from retained earnings that is risky, but the
projects selected. It is often the case that borrowing is less risky than internal
financing, because the investment has to be subjected to external appraisal
whereby factors such as the company’s track record, current gearing and the plau-
sibility of forecasts are taken into account.
6. Quality matters, not price
This myth makes an assumption about the price elasticity of demand and the respon-
siveness of sales to perceived differences in quality. An understanding of product
positioning within the perceived price–differentiation matrix is central to an analysis of
competitive positioning. This is bound up with the position in the industry sup-
ply chain, in regard to which it has been demonstrated that, in general, the
importance of differentiation falls the nearer the final customer.
7. We have all the information we need; things cannot go on getting worse
This is a variation on the first myth, and relates to the problem of environmental
scanning and the use to which such information is put. A major problem is that
decision-makers often do not understand what information they need, because
they do not properly understand the dynamics of the industry. The cobweb model,
combined with overshooting and undershooting, reveals that things can (and do) keep
on getting worse than expected.
Learning Summary
This module has provided an examination of different aspects of strategy implemen-
tation in the oil and gas industry. The evolution of organisational structure has been
examined in the context of Royal Dutch Shell over a 100-year period. The factors
that can affect resource allocation decisions have been discussed and the types of
control system in use have also been examined. Some common strategy process
issues in the oil and gas industry have been provided in the form of a new augment-
ed process model. Examples of feedback systems and the way in which
organisations manage these have been provided. Finally, the rationale for providing
this course has been discussed and some common myths debunked.
References
Centrica (2008) Corporate Profile 2008, July.
Wilson, P., and Bates, S. (2005) The Essential Guide to Managing Small Business Growth, Chiches-
ter: John Wiley & Sons.
Appendix 1
Practice Final Examinations

Contents
Practice Final Examination 1 ........................................................................A1/2
Practice Final Examination 2 ........................................................................A1/7
Strategic Planning for the Oil and Gas Industry Edinburgh Business School A1/1
Appendix 1 / Practice Final Examinations
Practice Final Examination 1
Question 1
A year ago, AcmeOil, an exploration company with an oil products plant, acquired PastChemiCo. At the
time, the press release read: ‘CEO Jack Driver is convinced that this acquisition will add significant value to
AcmeOil by bringing the company closer to the final consumer.’ Now, the first year’s results are under
discussion.
CEO:
I think we made our move at the right time; there have been some big technical changes in explo-
ration in the past five years, which we’ve not been able to keep up with, and some of the majors
are increasing their investments in oil products. So it was essential that we expand into new areas.
The products market has been growing fast for the past five years, but I’m convinced we should
get a presence in the more stable chemicals market.
Finance Director:
I’ve become increasingly concerned about our performance. Our share price has fallen by 25%
over the past year and our ROE is also down. We must have paid too much for PastChemiCo,
although I thought $1.2 billion at the time was a fair price. But otherwise I feel we are financially
secure.
Production Director:
PastChemiCo is a well-run operation and has caused me no serious problems. But we might have
been better spending the money on our existing operations.
HR Director:
Overall, we have a pretty well-motivated workforce, and we had little difficulty integrating the
new personnel. Mind you, they don’t have much contact with our exploration and production
people: they do completely different things.
Project Management Director:
The integration process was fairly straightforward and I must say I’m surprised that things haven’t
turned out better financially.
CEO:
I think we did everything by the book and that we’re pretty efficient. But I feel we’re missing
something.
A1/2 Edinburgh Business School Strategic Planning for the Oil and Gas Industry
Acme Plc financial statements

Operating account at end year: Cost, revenue and gross profit ($000)
SALES REVENUE 1 008 501
COST OF GOODS SOLD 602 295
GROSS PROFIT 406 206
Operating account at end year: Overheads and operating surplus ($000)
Factory overheads 2 000
Corporate HQ 9 000
Corporate marketing 1 000
Hiring & redundancy cost 2 790
TOTAL OVERHEAD 14 790
OPERATING SURPLUS 391 416
Cash flow for year ($000)
OUTLAY INCOME
Material purchase 326 200
Loan interest 140 000 Interest on assets 300
Wage cost 135 300
Equipment cost 102 880
Product marketing 8 080
Product development 5 250
Total overhead 114 790 Sales revenue 1 008 501
Total outlay 740 956 Total income 1 008 801
NET CASH FLOW 267 845
Balance sheet at end year ($000)
FIXED ASSETS
Factory 150 000
Equipment 5 000 000
Corporate HQ 50 000
TOTAL FIXED ASSETS 5 200 000
CURRENT ASSETS
Raw materials 81 550
Finished goods 14 214
Cash 10 000
TOTAL CURRENT ASSETS 105 764
TOTAL ASSETS 5 305 764
OWNERS’ EQUITY 3 305 764
DEBT (long term)
Loan 2 000 000
TOTAL DEBT 2 000 000
TOTAL LIABILITIES 5 305 764
Report on products for year

EXPLOR PROD CHEM EXPLOR PROD CHEM
Market share 20 5 15 COMPOSITION OF SUPPLY
(%)
Output 117 000 80 500
Inventory (year beginning) 12 000 5 000
ORDERS 125 000 75 000 TOTAL SUPPLY 129 000 85 500
DISTRIBUTION OF SUPPLY
Working time (%) 100 90 120 Sales to orders 125 000 75 000
Labour attrition rate (%) 2 6 6 Inventory (year end) 4 000 10 500
Price ($/unit) 380 2 500 6 000
Competing price 380 2 500 6 000
($/unit)
Account at end year
Wage cost ($000) 112 500 19 800 30 000
Equipment cost 100 000 2 600 280
($000)
Material used ($000) 40 000 253 500 32 200
Product marketing 4 575 3 125 360
($000)
Product develop 13 725 SALES REVENUE 660 000 31 250 36 000
($000) ($000)
TOTAL COST 270 800 279 025 35 840 COGS ($000) 270 800 298 104 33 391
($000)
Unit cost ($/unit) 2 385 445 GROSS PROFIT 389 200 14 396 2 609
($000)
1 Analyse AcmeOil’s finances and assess whether it did actually ‘pay too much for
PastChemiCo’. Are there any other problems?
2 Is there a real benefit to becoming ‘closer to the final consumer’?
3 What do you think is the ‘something’ that the CEO feels is missing?
Question 2
Offshore Acquisition
Aberdeen-based Containental Offshore has been acquired by an investor group led by
London-based private equity firms Lansdowne Capital and Claver Capital.
The company provides high-specification containers and cargo-carrying units to the off-
shore oil and gas industry, and the acquisition, which valued Containental Offshore at in
excess of £10 million, provides a strong and secure financial base for it to further expand its
fleet of more than 2500 rental units.
The deal was backed by debt funding arranged by Royal Bank of Scotland (RBS).
Containental Offshore’s management team of David Nightingale and Peter Coy will remain
with the business, and are reinvesting as part of the transaction.
The move will also enable the company – based at Pitmedden Road Industrial Estate, in
Dyce – to develop into further overseas regions, while also extending its product offering into
related offshore oil and gas services and equipment.
The company – which currently employs 14 staff – also expects to increase its workforce
considerably over the next few years as it grows both organically and through further
acquisition.
Containental Offshore’s managing director, David Nightingale, said:
We are excited to have Lansdowne Capital and Claver Capital working with us on
the further development of the business. This sizeable investment by leading interna-
tional financial experts will allow us to accelerate our expansion and build on the
successes of recent years, in both our domestic and international markets.
We have invested significantly in our rental fleet, but we have also built a strong be-
spoke container design and manufacturing business that has exceeded all
expectations. We now export to oil service customers in locations as diverse as Aus-
tralia, Asia, Africa and the Americas.
This growth has been driven by the broadening acceptance of high-specification DNV
2.7-1 / EN 12079 industry-standard equipment by the upstream oil industry and an
ever-increasing variety of cargo being transported to offshore installations.
Mr Nightingale added that the acquisition provides the resources necessary to grow the
business substantially through a combination of capital investment, rolling out new services,
and further acquisitions both in the UK and overseas.
Containental Offshore represents Lansdowne Capital’s first investment in an oil services
company, but the firm has had excellent success in related sectors and believes that a number
of important trends support the potential for growth of logistics businesses in the oil services
sector.
Lansdowne Capital’s chairman, Alan Dargan, said: ‘We have previously supported a number
of successful investments in the packaging and distribution sectors, and identified in Con-
tainental Offshore an excellent opportunity to support experienced management to expand
their global reach and attain their full potential.’
RBS Structured Finance provided acquisition and working capital facilities in support of the
deal.
Stuart Roberts, Head of Structured Finance with RBS in Aberdeen, said:
This is a great deal for all parties involved. David and Peter both have significant oil
and gas industry experience, and stand to benefit not only from the injection of new
capital, but also from the ideas and experience that will be brought to the table by
these ambitious private equity sponsors.
1 Why was it necessary for the company to be bought by a private equity company in
order to expand?
2 How does Containental fit with the rest of Landsdowne’s portfolio?
3 What are the prospects for the success of this venture?
Question 3
Making things happen
The CEO of an integrated major has invested a great deal of time and effort in developing a
strategic process for the company, which he feels involves all managers in a constructive
fashion. But an internal survey conducted by an independent management consultant con-
cludes that most middle and senior managers still feel that they have little role to play in
strategic decisions, and that most of their time is spent ‘making things happen’.
When asked to explain this contradiction, the personnel director said that this was the way
things were in the oil industry: managers had little time for non-essential tasks. The strategists
disagreed, saying that this was a generic problem and applied to all industries.
1 Explain the strategist’s reasoning.
Question 1
AcmeLook is a medium-sized exploration business. Three years ago, it was in financial trouble and
appointed Jim Swish, a specialist in oil company financing, to turn the company round. Jim presented the
results of his third year compared with the year in which he took over and claimed that there was no
doubt that he had not only saved the company from short-term bankruptcy, but had also laid the founda-
tion for long-term success.
It was pointed out that he had taken over when the oil price had fallen to $65 per barrel and it was
now $105. Swish replied that the oil price only indirectly affected the exploration business: under his
leadership, contracts had increased by 60%. He had initiated an investment programme of $150 million and
had rid AcmeLook of underused resources and capacity. In the unlikely event that the oil price fell again,
claimed Swish, the new, efficient AcmeLook would be insulated against adverse market movements; he was
confident that AcmeLook would continue to attract business from existing and new customers. Ac-
meLook’s reputation had soared in the three years and it was now regarded as a real ‘go-getter’. In
addition, the stringent financial control system he had introduced would ensure that early action was taken
on the cost side to counteract any reductions in revenue. Swish also pointed out that he had trimmed
development expenditure on the FieldFinder seismic tool, which he felt was too speculative.
Swish presented the following data to illustrate his success.
Before After
Operating surplus −$15m $108m
Cash flow −$22m $63m
ROS 4% 32%
ROTA 0% 15%
Swish was annoyed by the reaction of Duncan Clyde, a board member, who claimed to know something
about strategic planning. Clyde claimed that it was actually highly likely that the oil price would fall again
before too long, that the impact on AcmeLook’s contracts would be severe and that the ‘superefficient’
company was just as much at risk as it had been three years ago. The additional contracts had been won
only by severely undercutting competitors. Clyde went further to claim that Jim Swish did not understand
the dynamics of the industry and was living in a fool’s paradise. Clyde pointed out that R&D in the gas
sector had been cut in the interests of financial efficiency and that there was a real danger of being
overtaken by less profitable companies who were still spending on R&D.
Swish responded that ‘figures cannot lie’ and walked out of the meeting.
AcmeLook Plc’s financial statements

Operating account at end year: Production cost and revenue ($000)
Before After
Before After SALES REVENUE 314 352 552 240
COST OF GOODS SOLD 303 648 418 122
GROSS PROFIT 10 704 134 118
Operating account at end year: Overheads and operating surplus ($000)
Before After Before After
Corporate 4 000 5 000
Other overheads 4 000 5 000
Hiring and redundancy cost 2 820 5 640
Development expenditure 15 000 10 000
TOTAL OVERHEAD 25 820 25 640
OPERATING SURPLUS −15 116 108 478
Cash flow for year ($000)
OUTLAY INCOME
Material purchase 4 748 6 022
Loan interest 7 000 45 000 Interest on assets 200 320
Wage cost 202 400 303 600
Equipment cost 80 000 96 000
Product development 8 000 6 000
Product marketing 9 000 7 000
Total overhead 25 820 25 640 Sales revenue 314 352 552 240
Total outlay 336 968 489 262 Total income 314 552 552 560
NET CASH FLOW −22 416 63 298
Balance sheet at end year ($000)
Before After
FIXED ASSETS
Buildings 5 000 8 000
Equipment 500 000 620 000
TOTAL FIXED ASSETS 505 000 700 000
CURRENT ASSETS
Raw materials 2 000 2 000
Finished goods
Cash 10 000 8 000
TOTAL CURRENT 12 000 10 000
TOTAL ASSETS 517 000 710 000
OWNERS’ EQUITY 417 000 210 000
DEBT
Long-term loan 100 000 500 000
TOTAL DEBT 100 000 500 000
TOTAL LIABILITIES 517 000 710 000
Report on exploration for year

Market share (%) 13.0 11.0
Account at end year

Wage cost ($000) 202 400 303 600 Labour force 4 700 5 500
Equipment cost ($000) 80 000 96 000 Working time (%) 100 110
Cost of material used ($000) 4 248 5 522 Labour attrition rate (%) 1.5 2.0
Product development ($000) 8 000 6 000 Approx. competing price 37 000 80 000
($/unit)
Product marketing ($000) 9 000 7 000 Price ($/unit) 37 000 65 000
TOTAL COST ($000) 303 648 418 122 Unit cost ($/unit) 35 740 49 214
Sales revenue ($000) 314 352 552 240
Cost of goods sold ($000) 303 648 418 122
GROSS PROFIT ($000) 10 704 134 118
Report on development of FieldFinder

Estimated: Before After
Launch date 3 years Uncertain
Forecast market share (%) 15.0 12.0
Spending in year ($000) 15 000 10 000
Total to date ($000) 30 000 60 000
1 What did Duncan Clyde mean when he claimed that Jim Swish did not understand the
dynamics of the industry?
2 Why is a ‘superefficient’ company still at high risk in the exploration sector?
3 Was AcmeLook really in a better financial and strategic position than before Jim Swish?
Assess this issue using strategic models.
Question 2
Expro Group: Repositioning the company

Expro was the company that produced the first UK oil in 1975; it has come a long way since.
By 2008, it employed more than 4000 people in 50 countries worldwide and held the domi-
nant world market share in surface well testing. After making its first acquisition in 1987 – of
Exal, a data acquisition and sampling company – the company grew both organically and by
means of acquisition throughout the 1990s and early 2000s. Expro was bought out by
management in 1992 and floated on the London Stock Exchange in 1995, with a market value
of £103 million. By early 2008, Expro had a capitalised value of £1.1 billion.
In 2002, Expro outlined a plan to seek acquisitions in order to be able to compete with its
UK oilfield services rival, John Wood Group. At the time, Expro was reporting its best results
so far, shaking off the economic instability and fluctuating oil and gas prices of the period. By
the end of the year, it was claiming to benefit from the political and economic uncertainty in
the oil sector, as more of the large oil companies used their services to drive down costs.
Uncertainty meant that the majors were not prepared to commit vast capital expenditure to
exploration and drilling projects. This was confirmed when Expro’s interim profits shot up
45% on the previous year.
At the end of 2002, Expro operated through three business arms: cased hole services, for
production optimisation; subsurface systems, for deep-water field development; and surface
and environmental services, providing well clean-up and production solutions. The most
profitable of these was the deep-water development, which was becoming more popular on
the back of the now-rising oil price.
Early in 2003, Baker-Hughes and Expro formed a joint venture called QuantX Wellbore
Instrumentation, designed for the high-growth in-well-monitoring market. The venture was to
take advantage of Expro’s expertise in well-monitoring systems and Baker Hughes’ well-
completion skills. The technology was expected to be most useful in deep-water development.
Profiting from economic uncertainty did not last. In March 2003, Expro’s share price
dropped by 40% on the back of news of an unexpected profits warning. Poor performance in
Asia and Africa was blamed, along with delays in the Gulf of Mexico. Profits from the compa-
ny’s US operations were vital to cover high tax bills elsewhere in the world. When final profits
were announced in June, they were 19% lower than in the previous year and shares fell
another 6%. However, the joint venture had made a strong contribution to profits for the
period.
In September that year, Expro Americas opened a large new headquarters in Houston,
Texas, including both office space and workshops, to cater for the Gulf of Mexico market.
CEO John Dawson then announced that the group stood to benefit from increased worldwide
energy demand, and stated that China, Russia and West Africa were the most promising areas
for future development. However, Expro shares fell again by 20% in November after a second
profit warning. Shareholders were confused, because there had been two positive statements
and two profit warnings from the company in 11 months. By this time, John Dawson had been
replaced by former chief operating officer (COO) Graeme Coutts, who said, ‘This business is
not broken. It simply needs to be realigned.’
Coutts established an entirely new management team and set out a new four-point strate-
gy, which involved establishing areas of critical mass, enhanced customer care, best-in-class
technology and strategic acquisitions.
Immediately, he reorganised the company into three geographical divisions: the US; Europe
and the Former Soviet Union; and Asia, Middle East and Africa. The company was having a
hard time with poor recovery rates in the Gulf of Mexico. He identified Africa, the former
Soviet Union and the Middle East as the areas with most potential. By mid-2004, Coutts
sought to reduce the company’s reliance on the Gulf of Mexico market, which was now
shrinking. Also at this time the dollar was weakening, causing further problems in this area.
Coutts confessed to having a strong interest in technology and, in 2004−05, made several
acquisitions of companies specialising in a range of technologies, including in-well wireless
communications and downhole robotics. By the end of 2004, Expro won the Best Completion
Solution award for its ‘CaTSTM’ technology at the World Oil Awards in Houston. The new
technology was now beginning to bring in new business and win contracts, including a $60
million Russian deal with ExxonMobil.
The company’s fortunes had initially been slow to recover, because oil majors were cau-
tious about higher oil prices initially and chose to return most of their cash to shareholders
through buybacks. By mid-2005, Expro had returned to profit and oil companies were planning
ahead on the assumption of higher oil prices lasting well into the future. Contributing to this
was the rapidly rising energy demand in Asia and the fact that many companies had failed to
replace their reserves in 2004.
By the end of 2005, Expro’s fortunes had recovered, and it reported that increased focus
on technology and expansion into areas such as Russia and West Africa had been the main
contributor to the turnaround. Improvements in the US market had also been a contributing
factor. The company’s share price had recovered to levels higher than in 2002 for the first
time. The company refers to 2003 onwards as ‘New Expro’ in order to differentiate it from
previous times.
1 How much of a difference did Graeme Coutts actually make and what did he mean by
realigning the company? Answer the question using the process model.
Question 3
The CEO of a large vertically integrated oil company had been called to account by the board
for losses that had increased during the past two years. Two board members could not agree
on what they though the problem was.
Board member 1, a non-executive director with a background in banking, said that the
problem was a result of the CEO’s lack of planning, and that he should have had a clearer
vision of where the company was going and stuck to it.
Board member 2, who had extensive experience in the oil services industry, disagreed,
saying that the CEO had been well aware of his approach and had chosen an emergent, rather
than planned, approach because of the turbulent nature of the markets in recent years. The
problem was that the emergent approach was quite appropriate for upstream, but down-
stream required the planning approach. Board member 2 also stated that the real issue was
the impact of upstream and downstream industry characteristics on the strategic process.
1 Is board member 2 right that these different approaches are required for upstream and
downstream?
Examination Answers
Question 1
1 AcmeOil paid $1.2 billion for PastChemiCo and the gross profit for the division was
£2.6 million, so the ROI is virtually zero. This suggests that PastChemiCo was a
worthless asset. The price may have been based on the expectation of factors that
do not emerge in the accounts directly or on expectation of future growth in gross
profit. The falling share price reflects the market view of the available information.
The problem is that the finance director has paid little attention to the details. The
precise answer depends on the view taken of the numbers.
There are some positive aspects to the corporate accounts. Both operating surplus
and net cash flow are positive, and ROE is 11.8%, which is higher than the 7% cost
of capital. But ROTA is 7.4%, which is barely higher than the cost of capital. Net
cash flow is 1% of total assets, so there is little prospect of paying off the debt in the
short run. AcmeOil is not exposed to interest rate risk, because interest payable is
only 50% of net cash flow. The gearing ratio on owners’ equity is 60%, which may
constrain future borrowing.
The divisional accounts, on which the corporate accounts are based, show that
almost all gross profit is the result of exploration and production. The low margins
on both products and chemicals raise the risk that a marginal worsening in price or
cost, or both, would lead to divisional losses.
A profile of the financial data might be drawn up to identify the strengths and
weaknesses of the current financial position.
Models can be applied to assess the competitive position and whether AcmeOil is
being managed consistently with these. The following might be noted:
 Price differentiation: an adverse shift in exploration.
 Product life cycles: marketing, price-setting and inventory management.
 BCG matrix: possibly entering chemicals as a dog.
 Expansion trajectory: moving away from resources and routines into unrelated
diversification.
 Value chain: no obvious linkages or architecture.
The SAP can be drawn up based on the interpretation of the data and conclusions
drawn on the competitive position.
2 A framework for tackling this issue is to:

 outline the complexity of the industry supply chain;
 derive implications for the company value chain; and
 identify some of the different competitive conditions that affect the existing and
acquired divisions.
3 The acquisition and the current situation are being addressed in terms of inputs,
without a great deal of analysis. The ‘something missing’ is an analysis of how the
internal factors fit together and the impact of external factors – in other words,
analysis of the augmented strategic process and the robustness of the AcmeOil
strategic process to the extent that it is revealed by the data and the strategic
discussion. For example, there is no input from economics, accounting, marketing
or strategy.
The types of analysis that may be suggested include:
 a full augmented process model;
 analysis of the acquisition in terms of strategic fit;
 an application of market models; and
 SWOT analysis.
However, while these last three analyses are useful, they demonstrate understanding
of the current situation, but not the deeper issue of why it happened or whether the
company is likely to make the same mistake again.
Question 2
1 There are several strategic variations available for financing expansion besides being
bought by a financial entity, including:
 bank loan;
 venture capital;
 flotation on the stock market;
 entering into partnership;
 strategic alliance; or
 acquisition by a competitor.
It is not clear whether the costs and benefits of these variations were investigated;
hence it is not clear why private equity was the option selected.
2 It appears to be unrelated diversification. Landsdowne’s core competence lies in

raising finance. It is claimed that the Landsdowne team will bring ‘ideas and
experience that will be brought to the table by these ambitious private equity
sponsors’. Given that this is an acknowledged unrelated diversification for
Landsdowne, it is not clear what these ‘ideas and experience’ might be.
3 The prospects depend on the robustness of the strategic process.

Who does what?
 Objectives. Containental Offshore’s stated objective is to develop into further
overseas regions, while also extending its product offering into related offshore
oil and gas services and equipment. Thus Containental intends to expand both
geographically and into related services.
Landsdowne wishes to diversify its portfolio by entering the unrelated oil ser-
vices sector using Containental Offshore as the vehicle for growth. It makes
sense for a financial entity to diversify its risk, but that does not mean it should
be involved in managing the risk directly.
It is not clear that these objectives are aligned. Containental visualises itself as a
service sector design and manufacturing business that can expand from that
secure base, while Landsdowne sees Containental as a financial asset.
 Strategists. The two incumbents are to remain in their jobs, with a financial stake
in Containental Offshore. This is one way of addressing principal–agent issues.
The Landsdowne team expects to benefit from the ‘ideas and experience that
will be brought to the table by these ambitious private equity sponsors’. Given
that this is an acknowledged unrelated diversification for Landsdowne, it is not
clear what these ‘ideas and experience’ might be. There is scope for conflict,
because of different levels of understanding and different objectives.
The incumbents have experience only of running a small business; there is no
guarantee that they will be able to cope with expansion into new markets by
investment and acquisition.
The combination of non-aligned objectives and strategists with different skill sets
could lead to a principal–agent problem.
Competitive environment
 Macro environment. Landsdowne made the acquisition at a time when the oil price
was historically high and there was a high level of demand for upstream services
because of the derived demand effect. Because of its lack of experience,
Landsdowne may not have been fully aware of the cyclical nature of the services
sector and, as a result, may have overestimated the potential for expansion.
 Industry environment. The analysis of competition at the different stages of the
industry supply chain demonstrated that there are significant competitive differ-
ences among stages, particularly progressing downstream. This means that
Containental Offshore will have to be careful about its definition of ‘related’.
Containental also intends to expand internationally and this introduces a whole
new range of variables. In particular, it is an open question whether its competi-
tive advantage can be transferred abroad.
It is necessary to establish Containental Offshore’s competitive position prior to
deciding on expansion and there is a danger of embarking on growth for its own
sake now that finance appears to be available.
 Internal factors. The acquisition would appear to have strengthened Containental
Offshore’s balance sheet and made it possible to raise more finance. But the
acquisition was actually financed using debt supplied by RBS; there could be a
danger of becoming part of a financial entity that in turn is exposed to unrelated
events in the financial sector, such as the credit crunch. The oil price was histori-
cally high at the time of the acquisition, and neither party may have been aware
of the cyclical nature of oil prices and derived demand for services; as a result,
Landsdowne may have paid too much for Containental, in the light of the fall in
the price of oil later in 2008, so may have difficulty generating the expected rate
of return.
It is not clear what benefits Landsdowne brings to the existing Containental
Offshore value chain; they could be in the support activities of management
systems, but there is no evidence that Containental has been hampered by the
quality of management in the past.
Containental Offshore’s core competence lies in the container design and manu-
facturing sector, where it focuses on the high-quality niche. It is not clear what
competences can be transferred to other ‘related’ activities. Certainly,
Landsdowne brings no relevant competences in the operational sense.
The expansion trajectory needs to be clarified: will expansion be routine-based
or resource-based? It seems unlikely that it will be routine-based, because Con-
tainental Offshore’s current business is highly specialised; otherwise, it is
possible that Containental will blunder into unrelated diversification without
realising it. A major problem is that the Landsdowne investors may be able to
recognise opportunities in the financial sense, but they may not relate to Con-
tainental’s competences.
 Competitive position. Containental Offshore has a strong position in its niche, but
there are no guarantees in other markets. The aspiration to expand into other
related activities is too vague to be operational.
There are doubts regarding the price paid, the competitive environment, the basis
on which Containental Offshore will compete in the future and the definition of its
competitive advantage.
Strategic choice
 Generic strategy. The rationale for the acquisition at the corporate level is expan-
sion – but it seems that the emphasis is on expansion into new activities, rather
than growth of the existing business.
 Strategy variations. One of the stated objectives is growth by acquisitions. At this
stage, issues of strategic fit have not been addressed, because it remains an aspi-
ration rather than an explicit course of action. It is not clear what criteria would
be used to determine the choice of acquisition.
 Choice. The choice process may present problems in the future for the principal–
agent problems discussed above.
The choice process was largely opportunistic, given that the other financing options
were not investigated.
Implementation
 Resources and structure. The impression is given that, once the financial resources
are available, the rest will fall into place. The incumbents have no experience of
integrating and running a multiproduct company with several divisions, which
would be the case after acquisitions.
 Resource allocation. It is not clear how closely Landsdowne will become involved in
the actual running of the company. The incumbents have no experience of re-
source allocation in a multiproduct company.
 Evaluation and control. It is likely that the company will end up under tight
financial control as the equity partners attempt to earn a high rate of return.
Containental Offshore was probably originally in the strategic planning sector,
given the focus on the niche and its ability to cope with the unexpected expan-
sion in foreign markets.
There are likely to be many barriers to achieving these somewhat vague aims.
Feedback
The company started small, at which size the incumbents were able to control the
business directly. If the expansion takes place, they will be faced with a different set
of problems, with which they have no experience of dealing. They will have to learn
fast if they are to be successful.
Overall strategic process
There are weaknesses in all parts of the process. On the basis of this analysis, it
seems unlikely that the venture will be successful in the next downturn of the
business cycle.
Question 3
1 Managers are involved in the overall strategic process, but they may not recognise
that; they often define themselves in relation to their task (exploration, oil refining),
rather than their managerial role. It is difficult to relate cause and effect – that is, the
relationship between strategy decision making and managers’ activities may be
obscure. In some instances, the strategic process may be seen as mechanistic and
rigid, and of little relevance to the managerial function. Managers are typically most
heavily involved in the implementation part of the strategic process; reasons for
perceiving that a minor role is played in other parts of the strategic process are as
follows.
Strategists and objectives
 The size of company (small, medium integrated or large diversified) has an
impact on the roles that managers perform.
 Managerial style may be dictatorial, leading to lack of communication.
 The strategist may adopt a reactive, rather than proactive, approach: time is
spent dealing with problems as they arise.
 The strategist may be a prospector rather than an analyser.
 The company culture may be task-orientated.
 There may be a lack of strategic overview and clear objectives: managers seem to
lack participation and corporate objectives are not disaggregated.
 There may be a conflict of objectives: strategic business units may pursue
different objectives; units and corporate managers may have different perspec-
tives.
Is the oil industry different?
Because of the volatility of the oil industry, some features may be accentuated: there
has been a history of ‘dictatorial’ style CEOs in the industry, there may be a tenden-
cy to adopt a reactive approach, and the perspectives of upstream and downstream
strategic business units are different.
Analysis and diagnoses
 There may be a lack of time to identify and assimilate relevant information.
 There may be a lack of tools: managers may not be well educated.
 It may be difficult to obtain information because of poor IT systems.

 Accounting, marketing and economic information may not be integrated.
 Interaction among functional specialists may not be facilitated.
Managers in every industry tend to think that their competitive situation is unique,
but it is a matter of degree; competitive conditions vary along the industry supply
chain, but typically managers are concerned only with their own sector, so in
practice there is no real difference.
Strategic choice
 Generic decisions may be made only occasionally.
 Strategic decisions are typically taken only rarely.
 The choice process may not be transparent, despite what the CEO and the
board think.
The complexities of decision making and the difficulties that managers have in
relating to it are common to all industries.
Implementation
 Divisional and matrix structures may conceal the individual manager’s strategic
role.
 Monitor and control is an important strategic function, but is not recognised as
such.
 Managerial focus is on financial control, instead of strategic control (within the
planning and control matrix).
 The stage of the product life cycle will have an effect, for example more in-
volvement is required for new product launches than for managing mature
products.
 Bureaucratic structure, in terms of size, organisation and promotion criteria, etc.,
may inhibit involvement.
 Principal–agent problems in a task-orientated organisation include that rewards
may be for doing rather than thinking.
 The incentive structure may not be aligned with company objectives.
Most stages of the industry supply chain are seen as ‘doing things’, for example
finding oil, getting it out of the ground, transporting it and so on. This preoccupa-
tion with implementation may contribute to the lack of association with the rest of
the strategic process.
Feedback
 This is a dynamic process: strategy and implementation are closely related in real
life.
 Communications channels are necessary to ensure that the company learns and
adapts to changing circumstances.
 The dynamic feedback process may give the impression that strategy making is
opportunistic.
The more vertically integrated companies are, the more difficult communication
becomes. Effective communication is a feature of companies rather than of specific
industries.
Overall
The role of the CEO is to ensure that the strategic process is robust. Because
managers have a specific job to do, it is not surprising that they do not feel involved
in strategy. The industry difference is one of degree. The danger is that if managers
think their situation is different, they will fail to recognise the contribution that
generic tools can make.
Question 1
1 The oil price is characterised by undershooting and overshooting. This means that it
is unwise to assume that it is highly unlikely that the oil price will fall again.
Activity in the exploration sector is determined by derived demand. This means that
changes in final demand have an amplified impact on exploration.
Thus Swish’s assumption that there would be a period of stability was open to
question. Swish gave no indication that he understood the fundamental instability of
the oil price and the exploration sector.
2 When the downturn comes, a company needs a financial ‘cushion’ to see it through,
and flexibility in hiring and firing. But if the structure of the company is predicated
on stability or growth, its apparent ‘efficiency’ is irrelevant. It is essential that
companies in this sector have contingency plans to deal with amplified business
swings.
3 As is often the case, argument about figures is confusing. There has been an
improvement in the measures quoted, but the important issue is whether they are
the relevant figures for assessing competitive advantage.
Profitability
Before: ROTA was 0%; the gearing ratio was 19% on total assets; net cash flow was
negative and the company clearly could not carry on like this indefinitely. It would
be necessary to increase short-term debt merely to stay in business.
After: ROTA had increased to 15%; the investment programme led to high gearing –
70% on equity; the interest burden was now 34% of gross profit.
Conclusion: Swish does not mention gearing or interest rate exposure. AcmeLook is
no longer in danger of going bankrupt. But it is now subject to interest rate risk and
will have difficulty raising further funds for expansion. The ROI in efficiency can be
approximated by taking the difference between cost of goods sold (COGS) and
what it would have been at the original unit cost, approximated by grossing up by
the sales revenue: (552 ÷ 314) × 304 = $534 million. This compares with the
additional interest payment of $38 million. From that perspective, the efficiency
investment certainly paid off.
Central overheads
Before: Hire and fire costs were 1% of the wage bill; corporate costs were 1% of
COGS; FieldFinder development was 5% of COGS.
After: Hire and fire costs had increased to 2% of the wage bill; corporate costs were
kept at 1% of COGS; FieldFinder development was reduced to 2% of COGS.
Conclusion: Overheads and corporate spending were kept under control, but R&D
was reduced.
Development
Before: $15 million was being spent per year on development of FieldFinder, with the
intention of a launch in three years.
After: R&D had been reduced to $10 million and FieldFinder’s launch delayed
indefinitely; it would be going to market with potentially lower market share and
higher unit cost.
Conclusion: There could be a loss of first-mover advantage, together with increased
risk resulting from a lengthening of timescales. Probably both breakeven and
payback are significantly increased (depending on assumptions made on sunk costs
and time to launch). Swish’s actions had not reduced the risks associated with
FieldFinder.
Marketing
Before: The company was charging a competitive price; marketing expenditure was
3% of sales; product development, 3% of sales; market share was 13%.
After: The company was charging 20% below competing price; marketing had
reduced to 1% of sales; product development had been cut to 1% of sales; market
share was 11%.
Conclusion: Swish did not refer to any market data. The cuts in spending can be
justified at the mature stage of the life cycle, but the market is currently growing.
Swish’s economies are not consistent with the stage in the product life cycle.
Resource allocation
Before: 100% working time
After: 110% working time
Conclusion: ‘Superefficiency’ is dependent on overcapacity working.
Improvement in sales
The market and prices increased significantly during the period, so sales would have
increased anyway. The market size has increased approximately from 8500 ÷ 0.13 =
65 000 to 1170 ÷ 0.11 = 77 000.
The actual increase in gross profit was $123 414 000 – but how much of this would
have happened anyway in a growing market? This depends on the assumptions
made, for example the calculation could be based on maintaining market share of
13% and charging the competing price.
Improvement in cash flow
This improvement was almost entirely the result of the increased revenue driven by
an increased market.
Product life cycle
The total market is growing. Swish has acted as though exploration is in the mature
stage of the cycle. This has led to a significant loss in competitive advantage, as will
be seen shortly.
Portfolio
Exploration was a developing star in BCG matrix terms three years ago. This
contributed to the negative cash flow, high marketing costs, competitive pricing, low
position on the learning curve, overtime working, excess capacity, etc. Exploration
has now lost market share and is in danger of becoming a question mark, and then a
dog, when the market matures.
The original intention would have been to launch FieldFinder as a star. But now its
breakeven and payback are indeterminate, and the chances are it will lose first-
mover advantage. It is unlikely to contribute to the development of a balanced
portfolio.
Price and differentiation
The position on the price–differentiation matrix may be eroded by the reduction in
development and marketing.
Competitive environment
The balance of the Five Forces depends on interpretation.
Bargaining power of buyers High – plenty of choice
Bargaining power of suppliers High – specialists
Threat of new entrants Low – structural barriers
Threat of substitutes High – depending on R&D
Rivalry High
This is a highly competitive market and it will therefore be difficult to recover any
losses in competitive advantage. Swish acted as if competition were less important
than internal efficiency.
Value chain
The new approach improved elements of the value chain. There has been an
improvement in the support activities: procurement has been improved; investment
has improved the technology within the company; HRM has been improved with
reduced overtime and labour turnover; and management systems have been
improved as far as quality control is concerned. But product development has been
cut back without a corresponding increase in marketing effort; no matter how
effective the underlying support activities are, the company cannot hope to maintain
its competitive advantage if it does not market its products effectively. The value-
generating potential of the chain has been eroded.
Planning and control
The appointment of the finance director as CEO has resulted in a shift from loose
strategic planning to tight financial control. This approach can cause problems in
the development of a star.
Competitive advantage
AcmeLook has lost competitive advantage on just about every criterion.
A SWOT analysis integrates the following.
Modern plant Develop exploration into cash cow
Low cost Increase expenditure on FieldFinder
Stable workforce
High on experience curve
Weaknesses Threats
Capacity constrained Exploration may be near maturity stage
High gearing Exploration losing differentiation
FieldFinder delayed indefinitely Increasing competition
History of haphazard management FieldFinder likely to be too late to market
Interest rate movements
Banker concern over gearing ratio
It can be concluded that the improved profitability and cash flow mask the fact that
the long-term potential has been compromised. AcmeLook has become more
efficient in terms of cost, but is financially exposed to simultaneous reduction in
price and orders. It is constrained in terms of finance and has heavy interest
commitments that it must meet. It has sacrificed long-term earnings from explora-
tion and FieldFinder in favour of better short-term cash flow. The tight financial
approach has been applied without recognising that it has resulted in a low cost
defender approach. There does not appear to be any recognition that the future of
the company lies in continued differentiation and the expansion of its portfolio into
related products in which its core competence could be further developed. There is
a significant danger that the haphazard application of management ideas will cause
AcmeLook to end up stuck in the middle.
Question 2
1 The following is an example of differences in the process before and after Graeme
Coutts took over.
Old Expro New Expro
Objectives Expand by acquisition to compete Expand by ‘strategic’ acquisitions – not
with John Wood Group necessarily related
Strategist Analyser Prospector
Macro P: uncertainty P: uncertainty
environment E: uncertainty E: uncertainty
Future in China, Russia, West Africa Future in Russia, Middle East, Africa
T: stay focused on three core areas Oil price starting to increase
T: acquire new technologies
Industry Oligopoly Expanded into new markets with new
environment technologies
Internal factors Financial: highly sensitive and confusing Financial: back to profit in 2005, but
Core competence: three defined areas partly owing to oil price
Core competence: hi-tech
Competitive Focus on competence, but hampered Focus on technology in unrelated areas,
position by weak financial position with financial strength dependent on oil
price
Generic Corporate: related expansion Corporate: related expansion
strategy Business: focused differentiation Business: technology-based differentiation
Strategy Joint venture with Baker-Hughes Acquisition

variations
Choice John Dawson mainly reactive Graeme Coutts carried on in COO role:
focus on technology
Resources and Three divisions
structure
Resource
allocation
Evaluation and Poor financial control and conflicting Control is not one in the four-point
control messages issued: loose planning sector strategy
Feedback Impression that John Dawson did not Close interest in technology, but may
understand what was going on have little understanding of what drives
profits
Question 3
1 Turbulent conditions, which are a common feature of the oil and gas industry, often
produce two points of view:
 that the pursuit of clear objectives will help a company to find a way through the
maze; or
 that the emphasis should be on developing a flexible organisation that can react
fast to changing conditions.
The planned approach
The extreme planned approach to strategy makes a number of questionable assump-
tions that might be different upstream and downstream.
 The future can be predicted accurately enough to make rational choices.
The upstream industry is characterised by derived demand, which makes it more
volatile than downstream. But volatility does not necessarily mean less predicta-
ble than the downstream industry, which responds to changing demand by final
consumers; this, in turn, depends on many imponderables, including the business
cycle, technological change, the emergence of substitutes, government regula-
tion, etc.
 Strategy formulation can be detached from day-to-day management.
Downstream activities are geared more towards mass production of homogeneous
products than upstream; hence it may be concluded that day-to-day management
is much more concerned with simply getting on with the job. But the fact that
products are more homogeneous does not mean that the market is not continu-
ally changing and competitive forces shifting.
 Short-term benefits can be traded off against long-term competitive
advantage. The volatile nature of the upstream industry may make it appear more
difficult to trade off the present against the future. But competitive changes
downstream are also unpredictable.
 Strategic choices can be implemented as planned. One of the most im-
portant factors determining how effectively strategy is implemented is the
change management process. It could be argued that change is more gradual
downstream and therefore more manageable, but it could also be argued that there
is much more experience of change in the volatile upstream environment.
 The CEO has the power to make strategic decisions. This depends much
more on the effectiveness of the CEO than on the stage in the industry supply
chain.
 External circumstances do not impact on a selected strategy. This is a
general fallacy that is much more apparent in the volatile upstream sector, but it is
actually no less important downstream – particularly if periods of stability lead to
complacency.
 Implementation comes after strategic choice. Because of the differences
between upstream and downstream, it might be concluded that the implementation
of downstream choices is more straightforward – but implementation is an inte-
gral part of the strategic process and the penalties for ignoring this at either stage
are likely to be severe.
There are therefore some differences in emphasis, but the chairman’s argument is
not convincing.
The emergent approach
It can be argued that the problem of bounded rationality is exacerbated by the
volatility of the upstream sector: change is more pronounced and appears to occur
more quickly; as a result, the flexibility associated with the emergent approach may
appear to be more relevant. This is, of course, open to dispute. It can equally be
argued that managers learn to cope with the volatile environment and hence the
extent to which it is less comprehensible is marginal.
It may be that the ‘satisficing’ process is curtailed in a volatile environment, but
again that is open to debate. It could be argued that it is simply an excuse for being
reactive.
Impact on the strategic process
 Objectives. Companies need to have a clear business definition. The emergent
approach could lead to lack of focus both upstream and downstream.
 Strategists. The planner could be classified as an analyser, while the emergent is
more likely to be a prospector. The planner could be regarded as a manager who
sees his or her role as implementing within a given framework, while the emer-
gent approach may be more entrepreneurial. It then becomes a matter of
whether an entrepreneurial approach is more appropriate upstream or down-
stream. That is an open question.
 Analysis. It is necessary for both types of CEO to understand the environment,
the competitive forces and the company’s internal operations. But these need to
be assessed in a dynamic fashion and the planner must avoid regarding analysis
as a once-and-for-all activity. The planner is likely to focus much more on in-
formation gathering and analysis, while the emergent approach is more likely to
take an impressionistic approach to data. It is not obvious that either approach
to information is more appropriate for upstream or downstream.
 Choice. Unless analysis has been carried out and objectives set, choice might as
well be random. The choice process needs to be more than a series of reactive
moves to changing conditions. It is essential to determine the appropriate gener-
ic approach at both corporate and business levels. At the same time, choices
need to be made in such a way as to ensure flexibility in the face of changing
economic conditions. The planner may be slow to react and miss opportunities
for first-mover advantage. Consideration needs to be given to contingency plan-
ning in case events turn out to be significantly different from initial predictions.
The planner must appreciate that competitors do not act passively in the face of
strategic moves. These arguments apply equally upstream and downstream.
 Implementation. The structure of the company and the techniques of resource
allocation can help to ensure flexibility. There are many instances of successful
profitable companies that have found that their value chains break down when
competitive conditions change. The planned and emergent approaches can be locat-
ed in different parts of the planning and control matrix, in which the planned
approach could be located in the tight financial sector and the emergent, in the
loose control sector; the precise location of the two is a matter of judgement.
From this perspective, the dangers of weak implementation are no different
upstream and downstream.
 Feedback. The planner would attribute much less importance to feedback than the
emergent approach. The danger for the planner is to focus exclusively on achiev-
ing the identified objectives without taking the dynamics of the market into
account. It could be argued that it is in the volatile upstream sector that feedback
is most important.
Overall strategic process
The planning and emergent approaches could result in quite different strategic
processes. But the extent to which either is more appropriate to upstream rather than
downstream is debatable. It is likely that the most appropriate course of action is a
reconciliation of the two extremes through the application of the strategy process.
Index
Abbot Group/Songa Drilling, breadth and focus 3/5
acquisition/merger 7/20–7/24 business definition 3/2–3/5, 3/6–3/7
accounting report, MythicOil company business ethics 3/24–3/26
1/8, 1/9 business principles 3/24–3/26
acquisitions/mergers corporate profiles 3/2–3/5
Abbot Group/Songa Drilling 7/20– creeping scope 3/6–3/7
7/24 evaluation and control 8/11–8/13
motivations 7/20–7/24 market positioning 3/4–3/5
outcomes 7/20–7/24 mission 3/9–3/13
reasons for poor performance 7/20– objectives from strategy 3/13–3/17
7/24 productive scope 3/4
strategic option 7/20–7/24 strategic priorities 3/10–3/13
Africa, PEST analysis 4/36–4/37, 4/37– target market 3/5
4/38 vision 3/7–3/8
alliances, strategic option 7/24–7/25 vision and strategy 8/11–8/13
Analyser, decision-maker type 2/3–2/5 CEOs
augmented process model, strategic Browne, John 2/7–2/14, 2/14–2/15
process implementation 8/15 decision-maker types 2/3–2/5
backstop price of oil 4/11–4/13 Human Resource Management
bareboat charter 5/46–5/47 (HRM) culture 2/5–2/7
BP, Browne, John (CEO) 2/7–2/14, Raymond, Lee 2/7–2/14, 2/14–2/15
2/14–2/15 strategists' characteristics 2/1–2/15
BP, corporate social responsibility (CSR) CEO's statement, MythicOil company
3/22–3/23 1/8, 1/9
breadth and focus, Centrica 3/5 CEO's summary, MythicOil company
British Gas 1/9, 1/10
objectives from strategy 3/13–3/17 change management, resource allocation
objectives, stretch principle 3/20– 8/9–8/10
3/21 change, achieving successful, MythicOil
SMART objectives 3/17–3/20 company 1/10
Browne, John, CEO, BP 2/7–2/14, charter types 5/46–5/47
2/14–2/15 China in 2012, SWOT analysis 7/2–7/4
business definition 3/1–3/7 cobweb model, oil prices 5/13–5/16
Centrica 3/2–3/5, 3/6–3/7 combining corporate strategies 7/9–7/12
creeping scope 3/6–3/7 ENI SpA 7/9–7/12, 7/14–7/15
over time 3/7 company finances, Shell plc, analysing
business definition, Shell plc 6/3–6/6 historical company accounts 6/6–
business ethics 3/24–3/26 6/11
business principles, Centrica 3/24–3/26 company mission 3/9–3/13
business strategy options 7/12–7/14 company vision 3/7–3/8, 8/11–8/13
cost leadership 7/12–7/13 competences, Shell plc, analysing
differentiation 7/13 historical company accounts 6/34–
focus 7/13–7/14 6/35
'stuck in the middle' 7/14 competitive advantage
business unit objectives 3/17–3/21 'Diamond Framework' 4/23–4/25
cash flow, MythicOil company 1/10 economy, (the) 4/22–4/25
Centrica of nations 4/23–4/25
Strategic Planning for the Oil and Gas Industry Edinburgh Business School I/1
Index
competitive advantage, economies of market analysis 5/40–5/44

scale 6/26–6/27 market dynamics 5/44
competitive profile OPEC 5/41
development 5/35 culture, Human Resource Management
distribution 5/66 (HRM) 2/5–2/7, 8/9–8/10
exploration 5/32 decision-maker types 2/3–2/5
gas marketing 5/63 strategic process 2/14–2/15
marketing and distribution 5/57 Defender, decision-maker type 2/3–2/5
production 5/38–5/39 defining the oil and gas industry 1/3–1/6
refining and petrochemicals 5/53 core business disciplines 1/3–1/6
storage 5/55–5/56 downstream sector 1/3–1/6
transmission and storage 5/65 strategic process model 1/3–1/6
transportation 5/48 supply chain model 1/3–1/6
consolidation, strategic option 7/27– upstream sector 1/3–1/6
7/28 demand 5/2–5/7
control and evaluation, strategic process derived demand model 5/3–5/7
implementation 8/11–8/13 firm's demand curve 5/2–5/3
core business disciplines, oil and gas oil price growth vs oilfield services
industry 1/3–1/6 market growth 5/5–5/7
corporate profiles, Centrica 3/2–3/5 primary demand vs derived demand
corporate social responsibility (CSR) 5/3–5/7
3/21–3/23 upstream sector 5/2–5/3
BP 3/22–3/23 demand and supply, price determination
externalities 3/21–3/22 5/10–5/15
ExxonMobil 3/22–3/23 demand-side links, oil/gas prices 5/7–
real world 3/22–3/23 5/10
corporate strategy options 7/6–7/12 demerger, strategic option 7/27–7/28
combining corporate strategies 7/9– development
7/12 competitive profile 5/35
expansion 7/6–7/7 five forces profile 5/34–5/35
retrenchment 7/7–7/8 market structure 5/33
stability 7/8–7/9 perceived price and differentiation
cost and revenue model 4/2–4/6 5/33
costs 4/3–4/5 price-differentiation matrix 5/33
electric submersible pump (ESP) 4/3– product life cycle 5/33–5/34
4/5 shale resources 5/33
profits 4/6 unconventional resources 5/33
revenue 4/2–4/3 upstream sector activity 5/21
cost leadership, business strategy 7/12– upstream sector market analysis 5/32–
7/13 5/35
costs development, economies of scale 6/26
cost and revenue model 4/3–4/5 'Diamond Framework', competitive
drivers 4/3–4/5 advantage 4/23–4/25
upstream sector 4/3–4/5 differentiation, business strategy 7/13
course outline 1/13–1/14 distribution
creeping scope competitive profile 5/66
business definition 3/6–3/7 downstream gas market analysis
Centrica 3/6–3/7 5/65–5/66
crude oil trading 5/22–5/23 downstream gas sector activity 5/26
expectations 5/42–5/43 five forces profile 5/66
five forces profile 5/42–5/43 market structure 5/65–5/66
I/2 Edinburgh Business School Strategic Planning for the Oil and Gas Industry
Index
diversification development 6/26

related/unrelated 7/15–7/17 exploration 6/25–6/26
strategic options 7/15–7/17 production 6/26
diversification, Shell plc, analysing refining 6/26
historical company accounts 6/28– Shell plc, analysing historical company
6/31 accounts 6/24–6/27
divestment, strategic option 7/27–7/28 storage 6/26
divisional performance, Shell plc, transportation 6/26
analysing historical company accounts economies of scope, Shell plc, analysing
6/11–6/17 historical company accounts 6/27–
divisional structure, organisational 6/28
structure 8/2–8/9 economy, (the) 4/21–4/30
downstream gas market analysis 5/61– competitive advantage 4/22–4/25
5/67 competitive advantage of nations
distribution 5/65–5/66 4/23–4/25
gas marketing 5/61–5/63 exchange rates 4/22–4/23
transmission and storage 5/63–5/65 inflation 4/22–4/23
downstream gas sector 5/26 leading indicators 4/25–4/30
distribution 5/26 oil prices 4/26
marketing 5/26 reasons for analysing 4/21–4/22
transmission and storage 5/26 electric submersible pump (ESP), cost
downstream oil market analysis 5/44– and revenue model 4/3–4/5
5/59 ENI SpA, combining corporate strategies
downstream sector cf. upstream sector 7/9–7/12, 7/14–7/15
5/44–5/45 environmental threat and opportunity
marketing and distribution 5/56–5/57 profile (ETOP) 4/38–4/39, 5/69–
refining and petrochemicals 5/49– 5/70
5/53 environmental threat and opportunity
storage 5/54–5/56 profile (ETOP), strategic advantage
strategic models and concerns 5/58– profile (SAP) 6/35
5/59 Europe, PEST analysis 4/36, 4/37–4/38
transportation 5/45–5/48 evaluation and control
downstream sector Centrica 8/11–8/13
cf. upstream sector 5/44–5/45 strategic process implementation
marketing and distribution 5/25 8/11–8/13
refining and petrochemicals 5/25 exchange rates, economy, (the) 4/22–
storage 5/25 4/23
supply chain 5/24–5/27 expansion
transport 5/24 corporate strategy 7/6–7/7
downstream sector, leading indicators international expansion 7/25–7/27
4/25–4/30 strategic option 7/25–7/27
downstream sector, oil and gas industry expectations, crude oil trading 5/42–
1/3–1/6 5/43
downstream sector, value chain analysis exploration
6/18–6/24 competitive profile 5/32
dynamic market analysis, oil prices 5/16– five forces profile 5/30–5/31
5/17 market structure 5/27–5/28
economic report, MythicOil company perceived price and differentiation
1/8, 1/9 5/28–5/29
economies of scale price-differentiation matrix 5/28–
competitive advantage 6/26–6/27 5/29
Index
product life cycle 5/29–5/30 gas trading 5/60–5/61

upstream sector activity 5/21 geographic area, PEST analysis 4/35–
upstream sector market analysis 5/27– 4/38
5/32 headhunting, MythicOil company 1/11
exploration, economies of scale 6/25– Hotelling's Rule, oil prices 4/11–4/13
6/26 how to use this course 1/2–1/3
externalities, corporate social Human Resource Management (HRM),
responsibility (CSR) 3/21–3/22 culture 2/5–2/7, 8/9–8/10
ExxonMobil, corporate social inflation, economy, (the) 4/22–4/23
responsibility (CSR) 3/22–3/23 international expansion, strategic option
ExxonMobil, Raymond, Lee (CEO) 2/7– 7/25–7/27
2/14, 2/14–2/15 inventory optimisation, storage 5/54
feedback, strategic process joint ventures, strategic option 7/24–
implementation 8/13–8/15 7/25
filling stations, MythicOil company 1/11 labour relations, MythicOil company
financial structure, Shell plc, analysing 1/11–1/12
historical company accounts 6/10– Latin America, PEST analysis 4/35–
6/11 4/36, 4/37–4/38
five forces profile leading indicators, scenarios 4/28–4/30
crude oil trading 5/42–5/43 liquefied natural gas (LNG)
development 5/34–5/35 natural gas processing 5/59–5/60
distribution 5/66 trading 5/23–5/24, 5/59–5/60
exploration 5/30–5/31 long-run marginal cost (LRMC) curve, oil
gas marketing 5/62–5/63 prices 4/9
marketing and distribution 5/57 macro-environment issues 4/1–4/40
production 5/37–5/38 cost and revenue model 4/2–4/6
refining and petrochemicals 5/52– economy, (the) 4/21–4/30
5/53 environmental threat and opportunity
storage 5/54–5/55 profile (ETOP) 4/38–4/39
transmission and storage 5/64–5/65 oil prices 4/7–4/13
transportation 5/48 peak oil 4/13–4/18
focus and breadth, Centrica 3/5 PEST analysis 4/30–4/38
focus, business strategy 7/13–7/14 renewable energy 4/19–4/21
functional structure, organisational management buyout, strategic option
structure 8/2–8/9 7/27–7/28
gas marketing management of change, resource
competitive profile 5/63 allocation 8/9–8/10
downstream gas market analysis management style, resource allocation
5/61–5/63 8/10
five forces profile 5/62–5/63 manpower report, MythicOil company
market structure 5/61–5/62 1/9, 1/10
perceived price and differentiation market analysis, crude oil trading 5/40–
5/62 5/44
product life cycle 5/62 market dynamics, crude oil trading 5/44
gas prices market structures
demand-side links to oil prices 5/7– development 5/33
5/10 distribution 5/65–5/66
supply-side links to oil prices 5/7– exploration 5/27–5/28
5/10 gas marketing 5/61–5/62
vs oil prices 5/7–5/10 marketing and distribution 5/56
gas processing, trading 5/23–5/24, 5/59 monopoly 5/18
Index
oil and gas industry 5/17–5/19 upgrade investment cost overruns

oligopolies 5/18–5/19 1/11
perfect competition 5/18 natural gas processing
production 5/36 gas processing 5/59
refining and petrochemicals 5/51– gas trading 5/60–5/61
5/52 liquefied natural gas (LNG) 5/59–
storage 5/54 5/60
transmission and storage 5/64 market analysis 5/59–5/61
transportation 5/47 trading 5/23–5/24, 5/59–5/61
marketing and distribution net present value (NPV), peak oil 4/18
competitive profile 5/57 network structure, organisational
downstream oil market analysis 5/56– structure 8/2–8/9
5/57 North America, PEST analysis 4/35,
downstream sector activity 5/25 4/37–4/38
five forces profile 5/57 North America, SWOT analysis 7/2–7/4
market structure 5/56 objectives 3/1–3/26
perceived price and differentiation business definition 3/1–3/7
5/56 business ethics 3/24–3/26
marketing report, MythicOil company business unit objectives 3/17–3/21
1/8, 1/9 company mission 3/9–3/13
marketing, downstream gas sector activity company vision 3/7–3/8
5/26 corporate social responsibility (CSR)
matrix structure, organisational structure 3/21–3/23
8/2–8/9 from strategy 3/13–3/17
Middle East and Asia-Pacific, PEST in practice 3/26
analysis 4/36, 4/37–4/38 SMART objectives 3/17–3/20
mission stretch principle 3/20–3/21
Centrica 3/9–3/13 oil prices 4/7–4/13, 5/7–5/17
company 3/9–3/13 backstop price 4/11–4/13
disaggregating 3/10–3/13 cobweb model 5/13–5/16
strategic priorities 3/10–3/13 demand and supply 5/10–5/15
monopoly, market structure 5/18 demand-side links to gas prices 5/7–
MythicOil company 1/7–1/13 5/10
accounting report 1/8, 1/9 dynamic market analysis 5/16–5/17
cash flow 1/10 history of oil prices 4/7–4/9
CEO's statement 1/8, 1/9 Hotelling's Rule 4/11–4/13
CEO's summary 1/9, 1/10 leading indicator of the state of the
change, achieving successful 1/10 industry 4/26
economic report 1/8, 1/9 long run 4/7–4/13
filling stations 1/11 long-run marginal cost (LRMC) curve
future 1/9–1/10 4/9
headhunting 1/11 oil price growth vs oilfield services
labour relations 1/11–1/12 market growth 5/5–5/7
manpower report 1/9, 1/10 OPEC 5/7–5/8, 5/10–5/11
marketing report 1/8, 1/9 overshooting 5/16–5/17
present 1/8–1/9 price determination, demand and
production report 1/8 supply 5/10–5/15
strategic issues 1/7–1/13 refining and petrochemicals 5/52–
strategic planning elements 1/12– 5/53
1/13 scenarios 4/10–4/11
strategy and crises 1/10–1/12 supply and demand 5/10–5/15
Index
supply chain 5/67–5/69 Russia and Central Asia 4/36, 4/37–

supply-side links to gas prices 5/7– 4/38
5/10 pipelines 5/45–5/46
undershooting 5/16–5/17 possible reserves, oil 4/14–4/16
vs gas prices 5/7–5/10 Power culture, Human Resource
oligopolies Management (HRM) 2/5–2/7, 8/9–
firm's demand curve 5/2–5/3 8/10
market structure 5/18–5/19 price-differentiation matrix
upstream sector 5/2–5/3 development 5/33
OPEC exploration 5/28–5/29
crude oil trading 5/41 production 5/36–5/37
oil prices 5/7–5/8, 5/10–5/11 probable reserves, oil 4/14–4/16
operating efficiency, Shell plc, analysing product life cycle
historical company accounts 6/11– development 5/33–5/34
6/17 exploration 5/29–5/30
operating segments, Shell plc 6/3–6/6 gas marketing 5/62
organisational structure 8/2–8/9 production 5/37
Royal Dutch Shell plc 8/2–8/9 refining and petrochemicals 5/49–
strategic process implementation 8/2– 5/50
8/9 production
value chain 8/2–8/9 competitive profile 5/38–5/39
outcome of this course 1/1–1/2 five forces profile 5/37–5/38
overshooting, oil prices 5/16–5/17 market structure 5/36
peak oil 4/13–4/18 perceived price and differentiation
impact 4/16–4/17 5/36–5/37
implications 4/17–4/18 price-differentiation matrix 5/36–
net present value (NPV) 4/18 5/37
predicting 4/14–4/16 product life cycle 5/37
reserves 4/14–4/16 upstream sector activity 5/21–5/22
perceived price and differentiation upstream sector market analysis 5/36–
development 5/33 5/39
exploration 5/28–5/29 production report, MythicOil company
gas marketing 5/62 1/8
marketing and distribution 5/56 production, economies of scale 6/26
production 5/36–5/37 productive scope, Centrica 3/4
transportation 5/46–5/47 profit ratios, Shell plc, analysing historical
perfect competition, market structure company accounts 6/10
5/18 profits, cost and revenue model 4/6
Personal culture, Human Resource Prospector, decision-maker type 2/3–2/5
Management (HRM) 2/5–2/7, 8/9– proved reserves, oil 4/14–4/16
8/10 Raymond, Lee, CEO, ExxonMobil 2/7–
PEST analysis 4/30–4/38 2/14, 2/14–2/15
Africa 4/36–4/37, 4/37–4/38 Reactor, decision-maker type 2/3–2/5
Europe 4/36, 4/37–4/38 refining and petrochemicals
geographic area 4/35–4/38 competitive profile 5/53
international oil company in 2015 downstream oil market analysis 5/49–
4/31–4/35 5/53
Latin America 4/35–4/36, 4/37–4/38 downstream sector activity 5/25
Middle East and Asia-Pacific 4/36, five forces profile 5/52–5/53
4/37–4/38 market structure 5/51–5/52
North America 4/35, 4/37–4/38
Index
oil prices vs refining margin 5/52– Chemicals division 6/17

5/53 company finances 6/6–6/11
product life cycle 5/49–5/50 competences 6/34–6/35
refining margin vs oil prices 5/52– diversification 6/28–6/31
5/53 divisional performance 6/11–6/17
shale resources 5/25 economies of scale 6/24–6/27
refining, economies of scale 6/26 economies of scope 6/27–6/28
renewable energy 4/19–4/21 exploration and production 6/13–
strategic reaction 4/19–4/21 6/14
substitutability 4/19–4/20 financial structure 6/10–6/11
reserves, oil 4/14–4/16 Gas and Power division 6/14–6/15
reserves-to-production (R/P) ratio 4/14– Oil products division 6/16–6/17
4/16 Oil sands division 6/15–6/16
resource allocation 8/9–8/10 operating efficiency 6/11–6/17
management of change 8/9–8/10 operating segments 6/3–6/6
management style 8/10 overall company finances 6/18
strategic process implementation 8/9– profit ratios 6/10
8/10 reasons for analysing 6/2–6/3
retrenchment, corporate strategy 7/7– revenues, costs and profit 6/6–6/11
7/8 scope and scale 6/24–6/34
revenue Shell in 2015 6/36–6/37
cost and revenue model 4/2–4/3 strategic advantage profile (SAP) 6/35
drivers 4/2–4/3 strategic architecture 6/34–6/35
revenues, costs and profit, Shell plc, strategy and business definition 6/3–
analysing historical company accounts 6/6
6/6–6/11 value chain 6/18–6/24
Role culture, Human Resource vertical integration 6/31–6/34
Management (HRM) 2/5–2/7, 8/9– SMART objectives 3/17–3/20
8/10 Songa Drilling/Abbot Group,
role of this course 1/1–1/2 acquisition/merger 7/20–7/24
Royal Dutch Shell plc, organisational speculation, storage 5/54
structure 8/2–8/9 spin-off/sale, strategic option 7/27–7/28
Russia and Central Asia, PEST analysis stability, corporate strategy 7/8–7/9
4/36, 4/37–4/38 storage
scenarios competitive profile 5/55–5/56
leading indicators 4/28–4/30 downstream oil market analysis 5/54–
oil prices 4/10–4/11 5/56
scope and scale 6/24–6/34 downstream sector activity 5/25
scope economies, Shell plc, analysing five forces profile 5/54–5/55
historical company accounts 6/27– inventory optimisation 5/54
6/28 market structure 5/54
scope, creeping 3/6–3/7 speculation 5/54
shale resources storage, economies of scale 6/26
development 5/33 strategic advantage profile (SAP)
refining and petrochemicals 5/25 environmental threat and opportunity
upstream sector activity 5/21 profile (ETOP) 6/35
upstream sector market analysis 5/39 Shell plc, analysing historical company
Shell plc, analysing historical company accounts 6/35
accounts 6/1–6/37 strategic architecture, Shell plc, analysing
aims of the analysis 6/2 historical company accounts 6/34–
business definition 6/3–6/6 6/35
Index
strategic issues supply and demand, price determination

MythicOil company 1/7–1/13 5/10–5/15
oil and gas industry 1/6–1/7 supply chain 5/19–5/27
strategic models and concerns, downstream sector 5/24–5/27
downstream oil market analysis 5/58– implications of analysis 5/67–5/69
5/59 oil prices 5/67–5/69
strategic options 7/1–7/29 overall 5/26–5/27
acquisition/merger 7/20–7/24 trading 5/22–5/24
alliances 7/24–7/25 upstream sector 5/20–5/22
consolidation 7/27–7/28 supply chain model, oil and gas industry
demerger 7/27–7/28 1/3–1/6, 5/19–5/20
directions 7/14–7/28 supply-side links, oil/gas prices 5/7–5/10
diversification 7/15–7/17 SWOT analysis 7/2–7/6
divestment 7/27–7/28 alignment 7/2–7/4
international expansion 7/25–7/27 ambiguity 7/5–7/6
joint ventures 7/24–7/25 China in 2012 7/2–7/4
management buyout 7/27–7/28 difficulties 7/5–7/6
merger/acquisition 7/20–7/24 imagination 7/5–7/6
methods 7/14–7/28 North America in 2008 7/2–7/4
spin-off/sale 7/27–7/28 outcomes 7/28–7/29
SWOT analysis 7/2–7/6, 7/28–7/29 purposes 7/5–7/6
vertical integration 7/17–7/19 snapshot 7/5–7/6
withdrawal 7/27–7/28 strategic options 7/28–7/29
strategic planning elements, MythicOil usefulness 7/28–7/29
company 1/12–1/13 SWOT analysis, peak oil impact 4/16–
strategic planning process 2/1–2/3 4/17
strategic priorities target market, Centrica 3/5
Centrica 3/10–3/13 Task culture, Human Resource
mission 3/10–3/13 Management (HRM) 2/5–2/7, 8/9–
strategic process implementation 8/1– 8/10
8/19 time charter 5/46–5/47
augmented process model 8/15 total recoverable oil 4/14–4/16
evaluation and control 8/11–8/13 trading
feedback 8/13–8/15 crude oil 5/22–5/23, 5/40–5/44
organisational structure 8/2–8/9 gas processing 5/23–5/24, 5/59
resource allocation 8/9–8/10 gas trading 5/60–5/61
strategic thinking 8/17–8/18 liquefied natural gas (LNG) 5/23–
strategic process model, oil and gas 5/24, 5/59–5/60
industry 1/3–1/6 natural gas processing 5/23–5/24,
strategic process, decision-maker types 5/59–5/61
2/14–2/15 supply chain 5/22–5/24
strategic thinking, strategic process transaction cost economics (TCE),
implementation 8/17–8/18 vertical integration 7/17–7/19
strategists' characteristics 2/1–2/15 transmission and storage
strategy and business definition, Shell plc competitive profile 5/65
6/3–6/6 downstream gas market analysis
strategy and crises, MythicOil company 5/63–5/65
1/10–1/12 downstream gas sector activity 5/26
strategy, objectives from 3/13–3/17 five forces profile 5/64–5/65
'stuck in the middle', business strategy market structure 5/64
7/14
Index
transport, downstream sector activity production 5/21–5/22

5/24 revenue 4/2–4/3
transportation supply chain 5/20–5/22
charter types 5/46–5/47 unconventional resources 5/21
competitive profile 5/48 upstream sector market analysis 5/27–
downstream oil market analysis 5/45– 5/40
5/48 development 5/32–5/35
five forces profile 5/48 exploration 5/27–5/32
market structure 5/47 production 5/36–5/39
perceived price and differentiation shale resources 5/39
5/46–5/47 unconventional resources 5/39
pipelines 5/45–5/46 upstream sector, oil and gas industry
very large crude carriers (VLCCs) 1/3–1/6
5/45–5/46 upstream sector, value chain analysis
transportation, economies of scale 6/26 6/18–6/24
unconventional resources value chain, organisational structure 8/2–
development 5/33 8/9
upstream sector activity 5/21 value chain, Shell plc, analysing historical
upstream sector market analysis 5/39 company accounts 6/18–6/24
undershooting, oil prices 5/16–5/17 vertical integration
upgrade investment cost overruns, strategic option 7/17–7/19
MythicOil company 1/11 transaction cost economics (TCE)
upstream sector 7/17–7/19
activities 5/20–5/22 vertical integration, Shell plc, analysing
cf. downstream sector 5/44–5/45 historical company accounts 6/31–
costs 4/3–4/5 6/34
development 5/21 very large crude carriers (VLCCs) 5/45–
exploration 5/21 5/46
firm's demand curve 5/2–5/3 vision and strategy, Centrica 8/11–8/13
leading indicators 4/25–4/30 vision, company 3/7–3/8, 8/11–8/13
oil and gas industry 4/2–4/3, 4/3–4/5 voyage charter 5/46–5/47
oligopolies 5/2–5/3 withdrawal, strategic option 7/27–7/28

H17picoursetext PDF

Uploaded by

Copyright:

Available Formats

You might also like

H17picoursetext PDF

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

H17picoursetext PDF

Uploaded by

Copyright:

Available Formats

Strategic

Professor Alex Scott

PI-A1 1/2017 (1052)

Edinburgh Business School

Tel + 44 (0) 131 451 3090

1.1 Introduction 1/1

2.1 Introduction 2/1

Module 3 Strategic Objectives in the Oil and Gas Industry 3/1

3.1 Introduction 3/1

Module 4 Macro-environment Issues in the Oil and Gas Industry 4/1

4.1 Introduction 4/1

4.7 PEST Analysis 4/30

Module 5 Competitive Environments in the Oil and Gas Industry 5/1

5.1 Introduction 5/1

Module 6 Strategic Analysis of Historical Company Accounts 6/1

6.1 Introduction 6/1

Module 7 Strategic Options in the Oil and Gas Industry 7/1

7.1 Introduction 7/1

7.6 From SWOT to Strategy 7/29

8.1 Introduction 8/1

Appendix 1 Practice Final Examinations A1/1

The Oil and Gas Industry: A Strategic

Strategists Objectives Who decides

The macro The industry Internal Competitive Analysis and

Generic strategy Strategy Strategy Choice

Resources and Resource Evaluation Implementation

Figure 1.1 The strategic planning process model

1.2 How to Use This Course

Core SP text that is of relevance at a particular time. (Those using electronic

1.3 The Context: Defining the Oil and Gas Industry

Crude oil trading Gas processing

Petrochemicals Storage Transmission

Marketing and Distribution

1.4 Strategic Issues in the Oil and Gas Industry

 What objectives do different companies have?

1.5 The MythicOil Company

presented is fictional but serves as a useful introduction to strategic thinking in the

1.5.1 How Well Are We Performing?

1.5.2 What Should We Be Doing in the Future?

Memo from Accounting Department to CEO: In view of the additional cash-flow

 Generic options. A corporate generic choice of expansion has been taken on

1.5.5 Elements of Strategic Planning

This is indicative of a need to embed some understanding of strategic planning in

1.6 Course Outline

Common approaches in the industry, such as vertical integration and acquisition,

Strategists and Their Characteristics

pendent variables. There is a rough chronological order to the strategic planning

Strategists Objectives Who decides

The macro The industry Internal Competitive Analysis and

Generic strategy Strategy Strategy Choice

Resources and Resource Evaluation

Figure 2.1 The strategic planning process model

 Who decides in which business areas the company operates?

2.2 Decision-Maker Types

 Analyser. The analyser is characterised by sophisticated internal information

Table 2.1 Decision-maker types I

Table 2.2 Decision-maker types II

In each case, the dominant characteristic leads to three recognisable responses