The Downstream Business does not compare with the Upstream Business on profitability leading to calls for de-merger of the two. However this can be avoided by improving profitibility of the Downstream business. It can be achieved by targeted investments on process standardisation, allocating elements of value-stream to right locations and implementing uniform IT platform.

Introduction

The current commodity boom is more a decade old. During this period there has been a sea change in the profitability of the Oil & Gas majors. In late nineties crude was trading at around $15 per barrel. Compare this with the price of around $100 per barrel for the last 12 months. The boom has brought the mismatch of profitability between the Downstream and Upstream business of the Oil majors into sharp focus. The Upstream part has out-performed the Downstream part by a wide margin.

The Oil majors have tried to tackle this in a variety of ways. Some of them are sound business approach such as (asset rationalisation) while others reflect strategic myopia (such as plans to hive off downstream business completely). This article makes a case for re-invigorating the Downstream business to make it a worthy business to keep.

Current Issues affecting the Downstream Business

Low profit margin compared to Upstream: The high crude price over the last decade has made the Upstream business i.e. exploration and production of crude (E&P) hugely profitable. Compared to this the Downstream business struggled to improve its profitability. As a result it has failed to attract capital expenditure vis-à-vis the Upstream Business. Moreover new, unconventional sources such as shale gas/ tar sands have captured investors and management attention and have further migrated capital expenditure to Upstream.

Peaking of Oil demand in developed countries: It is quite clear the demand for oil would not rise significantly in the developed markets. In fact, since the financial crisis of 2008 the oil demand has stagnated and has fallen slightly in many countries. Consumption is not going to rise dramatically in the coming decade. If Oil price remains at its current level, demand would continue to fall as consumers make changes to their lifestyle, make changes in their energy basket and adopt energy saving technologies – such as hybrid vehicles.

Mature portfolio of Downstream assets: Most of the assets in developed countries are mature. There has been little investment in new refining capacity in recent years. Also the refineries represent a variety of size – a result of varying investment policies over past decades. However the mature asset base is not restricted to refineries alone. The number of retail outlets has been falling for years and there have been few new retail outlets to fill their place.

The Oil & Gas majors have reacted to this situation by rationalising asset portfolio in developed markets. The process of asset consolidation - by pruning the portfolio of low-quality assets - would continue for some more time. At first sight this strategy seems self-evident. After all who would like to tie the major portion of their assets to slow growing markets when emerging markets are booming and have a strong demand for investments?

However starving the Downstream business of fresh investments might not be a good long-term strategy. In spite of all the boom in emerging markets the developed countries would still remain major markets in the coming decades. Also due to their long association with these markets the Oil & Gas majors enjoy big incumbency advantage. Asset pruning is one thing but full-scale withdrawal from the developed markets is an entirely different issue. Yet departure from certain European countries has happened on the ground the markets are no more of strategic value to the Oil majors.

The Downstream business is unlikely to match the Upstream in profitability. Yet it does not mean nothing can be done to improve the situation. By making strategic investments in the Downstream business Oil majors can improve its profitability and convince investors about the merit of keeping both Upstream and Downstream in the integrated company.

I have identified below three improvement areas in the Downstream business to increase its profitability. The areas are distinct to merit their separate mention but at the same time are interconnected.

Process re-engineering: The Downstream business of Oil majors can be broken down into some key business processes such as Order to Cash (OtC), Hydrocarbon Management, Product Distribution etc. A surprising feature is the sheer variety each of these processes has across the world. Even the variations within a single country can be astonishing. Historically the Oil majors have retained country specific business practices and processes instead of standardising them across the globe. Although global processes cannot be built on the principle of one-size-fits-all, the number of variations can be brought down dramatically by process re-engineering.

For example in one Oil major, twelve different OtC models have been standardised to 3 models and implemented across the world. Instances of such re-engineering not only helps to rationalise manpower and cost but also have other auxiliary benefits such as ease of management reporting, training new staff and implementing uniform Key Performance Indicators (KPI) across the globe.

Allocation of value-stream elements to right locations: This is closely linked to the previous point. It is not enough to streamline the value stream. The entire value stream needs to be broken down to meaningful elements and allocated to locations where it can be most efficiently performed. For example in OtC process the credit checks of commercial customers need not be done at individual countries. It can be handled by a small global hub that can virtually support the business sales managers in each country. That way, it is also easy to build and maintain excellence. The cost of training a disperse staff spread across the world is significantly reduced. Another example is preparing invoices. This activity can be outsourced or consolidated in a shared service centre located in a country where labour is relatively cheap. This will allow manpower rationalisation in countries where labour is expensive. It would also free employees from routine work to have more face-time with their customers.

This should not be a onetime exercise but be a continuous management endeavour. The labour cost and skills availability of countries changes with time. Management should look out for opportunities where they can relocate business elements to extract more value.

Simplified and uniform IT platforms: As mentioned before, the Oil majors has historically operated as a loose federation of national organisations. The fallout of this practice is each country deciding their own IT infrastructure and maintenance. There are instances of dozens of different ERP platforms within the same company. Not counting the hundreds of other IT applications that are installed for various processes.

Current ERP vendors have the capability of supplying platforms that can handle the variety of process requirements of a global business. Moreover latest versions of ERP software have much additional functionality for which earlier separate applications were required. Thus there are opportunities of simplifying the IT landscape of Downstream business in conjunction with the standardisation of business processes.

Conclusion

The three improvement areas are significantly interrelated and a well executed implementation programme can significantly improve the Downstream business profitability. The Upstream would remain a leader in profits for the Oil majors but the Downstream part would shake off its perception of a poor cousin and win its right to be accepted as a profitable business.



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Samiran Sarkar is senior Strategy & Transformation consultant at IBM Global Business Services with wide-ranging consulting experience in the Energy sector.