Managing Director & Senior Partner
Time to Reconsider Oil Supply and Marketing
For companies that are competing in an industry facing commoditization, the task is straightforward albeit sizable: determine the nature of competitive advantage in the industry and adapt the company’s strategy and business model to it. (See “Escaping the Doghouse: Winning in Commoditized Markets,” BCG article, April 2015.)
Oil companies and the oil industry are a case in point. The industry offers companies opportunities to create advantage through access to low-cost assets; simultaneously, players are highly exposed to price volatility and market imperfections. Some of the industry leaders, such as BP, Total, and Royal Dutch Shell, have responded to this environment by adopting an asset-backed trading model, one that marries production and arbitrage and allows these companies to capture both the structural and the dynamic advantages that the industry’s characteristics afford.
Recent events in the industry highlight the relevance of this approach. While today’s oil-price environment continues to pose a significant hardship for the upstream oil sector, it has been highly beneficial for oil trading. Indeed, recent conversations we have had with leaders of major trading operations indicate that 2015 could prove to be the most profitable year for oil trading since 2008.
Driving this tailwind for trading is relatively high oil-price volatility, which has led to an increase in temporary pricing imperfections across markets and, hence, greater opportunity for arbitrage. Oil companies that recognize and exploit these opportunities stand to reap a windfall. And, in the process, they will render themselves less vulnerable to potentially sharp swings in earnings caused by turbulence in other parts of the value chain.
In recent years, oil trading has suffered from a bad reputation in some circles, largely stemming from a number of related financial scandals, including the Enron debacle of the early years of the twenty-first century. Many executives still consider trading an unnecessary source of risk and volatility; some view it as, essentially, gambling. (It should be noted that few traders, in fact, are authorized to take sizable positions on the outright evolution of oil prices.)
We believe that this reputation significantly belies the nature of oil trading and understates its potential value. Properly executed, trading can provide a critical source of diversification and stability for integrated oil companies. This is because returns on trading are not positively correlated with returns on upstream or downstream operations. (See Exhibit 1.) Returns on trading are also not directly impacted by the level or direction of oil prices. Trading can thus play an important role in an integrated oil company’s overall portfolio, a role that is particularly valuable during times of market turbulence.
Oil trading can also be a material driver of a company’s absolute financial performance in its own right. Annual trading-related revenues can reach into the billions of dollars for the largest oil companies.1
In sum, oil trading can be a powerful source of competitive advantage. This is especially true in today’s oil-price environment.
The best traders use an agile business model that allows them to systematically identify and exploit pricing imperfections where they occur. The current market backdrop is rife with such imperfections, translating into significant arbitrage opportunities. These fall into three main categories: time, location, and quality.
The high degree of oil price volatility that has prevailed in the market since the summer of 2014 has increased both the number and the magnitude of market pricing imperfections, thereby increasing companies’ scope for engaging in all three types of arbitrage. It has also increased the size of the potential prize attached to successful execution.
High market volatility has also created an additional type of opportunity—one that is not pure arbitrage—that traders can capitalize on. Oil price gyrations have spawned strong demand for risk management instruments that offer downside protection. Demand has been particularly strong from companies that are highly vulnerable to further decreases in oil prices and for which maintaining a sustainable cash-flow profile is critical to their business. The demand has led to a general overpricing of these instruments, one that sophisticated traders can take advantage of, particularly now that investment banks, the traditional providers of such instruments, have withdrawn from the market, widening the opportunity for trading organizations.
A greater focus on trading can be extremely beneficial to a broad range of companies in today’s environment.
Among the businesses that would particularly benefit are complex refineries operating in Asia. These companies can process many types of crude oil and should be quick to take advantage of significant price differentials between sweet and sour and heavy and light grades. Few of these refineries are doing so, however. Instead, most maintain a highly conservative approach, with far greater emphasis on security of supply than on optimization of sourcing. We consider this stance suboptimal, given the oil market’s relatively high liquidity and the potential economic cost of this policy to these companies’ bottom lines. Indeed, our studies indicate that such conservative oil-supply policies can cost refiners’ margins as much as $1 to $2 per barrel.
Large oil-producing companies and countries, including those operating in the Middle East, could also benefit significantly by reconsidering the role that trading plays in their business. Many of these players have shunned or underemphasized trading, believing that it runs counter to their goal of becoming respected, reliable suppliers of crude.
We have a somewhat different view. In our opinion, being a reliable, predictable producer is largely a function of being transparent with regard to production and its evolution. An increased focus on trading is not inconsistent with this, nor does greater emphasis on trading preclude honoring politically driven volume regulation, such as OPEC targets. Trading could thus be highly advantageous to these businesses. Indeed, by placing greater emphasis on it, and increasing their focus on spot trading versus long-term contracts, these players could boost their returns significantly. We have determined, for example, that SOCAR, the State Oil Company of Azerbaijan Republic, increased its revenues by $1.70 per barrel by shifting its emphasis from marketing to trading.5
All companies, however, should consider the potential gains to be obtained by increasing their emphasis on trading, given the potential upside. Many European and U.S. oil majors are thinking along these lines and have already invested to increase the professionalism of their trading divisions. Some players in Asia are now in the process of doing so as well (China National Petroleum, for example, created a trading arm in recent years), as are some national oil companies (including those of Azerbaijan and Oman) in various regions.
Admittedly, the business model required for success in asset-backed trading is significantly different from the model necessary for success in exploration and production, refining, and marketing and is therefore not suited to all companies. But trading’s benefits can be material and, for many players, will more than compensate for the challenges of implementation. Not only can trading expand companies’ margins, it can stabilize portfolio returns and make a company more responsive to market opportunities. Oil companies that view trading solely as a source of supply for refineries could be leaving an important source of value creation idle.