National' becomes less of a definer for NOCs while 'international' is no longer only for the IOCs

Perhaps it is time to move on from differentiating NOCs and IOCs and start addressing them all simply as oil and gas companies?

Andy Brogan, Ernst & Young

National Oil Companies (NOCs) are leaving behind traditional concepts of nationality and state ownership, acquiring new skills and using their advantages to compete with International Oil Companies (IOCs) on a global playing field. However, NOCs are a varied group, motivated by a number of different political and social factors. These factors drive and shape their international ambitions. NOCs will face new challenges as they expand their presence in the global arena, and can take action now to meet those challenges and become International National Oil Companies (INOCs).

THE RISE OF THE INOC

Traditionally gatekeepers of national resources, NOCs were historically defined by their national identity. But the rise in oil prices over the last five years has enabled an increased number of NOCs to broaden their horizons and ambitions.

This expansion has occurred on a number of levels. Internationally, NOCs are accessing new countries and global financial markets. NOCs are also expanding vertically along the supply chain, as well as strategically, using their competitive advantages in new ways.

More than half of the world’s 100-plus NOCs now have overseas operations. The geographical spread, maturity and nature of transnational operations vary greatly from NOC to NOC. An analysis of a cross-section of the major NOCs reveals just how much variation there has been in internationalization to date, Fig. 1.

Fig. 1. The internationalization of NOCs.

Spending on upstream acquisitions by state-owned entities-NOCs and Sovereign Wealth Funds (SWFs)-outside of their home countries totaled $13 billion in 2007, on par with 2006, Fig. 2. These deals accounted for a third of total spending by state-owned companies in the year.

Fig. 2. NOC and SWF transactions outside home market.

The expansion is vertical too, with NOCs increasingly developing integrated operating models, both within their home markets and internationally. Such integration enables NOCs to secure diversified markets for their products and ensure some insulation from oil price volatility. Some NOCs are partnering with overseas companies in the construction of refineries capable of handling heavy oil. Others are forming strategic partnerships to secure access to LNG. CNOOC acquired upstream stakes in LNG projects in Australia and Indonesia in exchange for access to its LNG import terminals. Some, such as Gazprom, are securing positions in liberalized energy markets, providing a route of market access from their own upstream operations. Other NOCs, such as Petrobras and CNOOC, are investing in alternative energy, power generation and biofuels as a means of diversifying away from dependence on oil and gas.

Ownership models also have changed. Gazprom and Petrobras, for example, have reduced the level of government ownership-and to some extent state control-over their operations by listing on capital markets. Figure 3 compares the performance of leading NOCs’ and IOCs’ shares over the last five years. Shares in the major NOCs have outperformed the IOCs by a significant margin over the period, demonstrating the NOCs’ ability to deliver share price growth for private investors and indicating the value of potential future growth compared with that of IOCs. NOCs also have comparatively low finding and developing costs, which have allowed them to benefit fully from the increase in oil prices.

Fig. 3. Comparative share performance of NOCs and IOCs.

INOC COMPANIES

The five NOCs profiled here provide examples of the different levels of integration and internationalization that have been sought and acquired. They demonstrate the extent to which NOCs are already competing with, and acting like, IOCs.

Petronas. The Malaysian NOC has operations in 33 countries worldwide, including upstream ventures in 22 countries, with a focus on Africa. Downstream operations are spread across a dozen countries, including natural gas distribution and LNG assets in Europe and Asia. In 2007, Petronas’ international reserves accounted for nearly 25% of its total reserves. Production from international operations accounted for 34% of total group production, up from 27% in 2006.

Petronas is 100% state-owned but operates largely free from government control on a day-to-day basis. Four of its subsidiaries are partially listed on the Bursa Malaysia, but Petronas and the Malaysian government have no immediate plans for an Initial Public Offering (IPO) of the company. Petronas has been competing with IOCs in the global Mergers and Acquisitions (M&A) market. It was one of just three rival companies allowed to buy into Russian oil company Rosneft’s IPO in 2006. Petronas acquired the largest minority share, paying $1.1 billion for 10% of the shares on offer, thereby securing a strategically important position for potential involvement in Russia’s energy market. In 2007, the company secured a position in the UK gas infrastructure market via the £354 million acquisition of gas storage company Star Energy plc.

CNPC and PetroChina. China National Petroleum Corporation (CNPC) and its subsidiary PetroChina are examples of advancing Asian NOCs. CNPC owns upstream and downstream assets in 27 countries across Africa, the Middle East, North and South America and Asia. It also markets its oilfield services, construction and engineering skills in almost 50 countries worldwide. In 2005, CNPC defeated competing interests from India’s ONGC and Russia’s Lukoil, with a $4.18 billion acquisition of PetroKazakhstan, a Toronto-listed explorer with exploration and development rights in Kazakhstan, giving CNPC an important foothold in resource-rich Kazakhstan.

The evolution from traditional NOC to INOC is a gradual process. In November 2007, PetroChina floated A-shares on the Shanghai stock exchange, raising $8.9 billion to fund upstream and downstream projects both at home and overseas. The listing set a new domestic record, attracted record subscriptions and made PetroChina the world’s largest company by market value at that time.

Petrobras. The Brazilian NOC has operations in over 20 countries and has pledged to invest $15 billion in overseas activities between 2008 and 2012-13% of the company’s total planned capital investment. Of this, 70% will be focused on upstream activities.

Petrobras has honed its deepwater skills and has built a strategy around exploiting opportunities where these technologies and capabilities represent a competitive advantage.

Petrobras has pledged to invest $1.3 billion in renewable energies over 2008-2012, part of its commitment to integration, diversity and sustainability. In particular, Petrobras has global ambitions for its role in biofuels, through international marketing and distribution, and leadership of domestic production and technological development. The company is currently constructing three industrial biodiesel production plants in Brazil, each due to come online in 2008.

Gazprom is more focused and less widespread than some NOCs. With substantial domestic resources-Gazprom is the world’s largest gas company, both upstream and downstream-the company’s strategy is focused on diversification and securing markets for its gas. The company is keen to build routes to market by establishing a presence in Europe’s liberalized energy market and forging alliances in Asia.

Upstream, Gazprom has operations in Libya, Asia, India, Vietnam and Venezuela. Priority regions for future development include the Arctic regions of East and West Siberia and the shelf of the Arctic seas.

Gazprom’s diversification has also occurred through the acquisition of a controlling stake in OAO Sibneft, thereby doubling Gazprom’s oil reserves, and through the acquisition of stakes in power sector players such as OAO Mosenergo.

NOCS, IOCS INTERNATIONALIZE COMPETITION

NOCs have proven successful in leveraging their competitive advantages both to achieve strategic aims and to compete successfully for market share with traditional IOCs.

Leveraging political ties. PDVSA is using its political influence to forge an alliance, Petrocaribe, between Caribbean nations and Venezuela. The alliance plans to construct a refinery in Cuba, where fuel will be produced for distribution among the member countries. The Venezuelan government is actively encouraging energy cooperation between nations with sympathetic political leanings.

Venezuela has been strengthening its relations with Iran, including a $4 billion joint investment to develop Venezuela’s Orinoco oil belt. The deal is just one of a series of accords signed between the two nations.

Forging partnerships. Few NOCs have been successful in expanding into new markets without the assistance of a partner. The newfound oil wealth of many resource-holding countries is helping a greater number of NOCs to move beyond their home borders. Almost exclusively they are choosing to further their international ambitions through partnerships. The international reach of many IOCs is an advantage for many of the NOCs seeking to enhance their global presence. However, IOCs are facing competition from other companies that have experience and skills that are of interest to NOCs. In the last year, a number of chemical companies have been chosen or short-listed by NOCs as partners in new petrochemical plants.

Oilfield service companies have significant opportunities in countries where IOCs have been frozen out or where there has been a prolonged period of underinvestment in the oil and gas sector. Service companies have an advantage over IOCs in that they do not need ownership of reserves. NOCs are able to retain sovereignty over their hydrocarbon resources. This is a key consideration for a number of resource-rich nations.

Compared with IOCs, service companies have a different relationship with NOCs, which is based on mutual need. NOCs own the opportunities but the service companies are needed to help develop those opportunities. NOCs now need the service companies in the way they used to need the IOCs.

Several NOCs are looking to form partnerships with service companies to generate benefits that would not be available if they were just a buyer of products and services.

Leveraging domestic resource abundance. For every country seeking to increase foreign investment in its oil and gas sector, there is another that is closing the door. Unfortunately for the reserve chasers, it is usually the hydrocarbon-rich countries that are looking to restrict foreign access. Some NOCs are beginning to leverage their domestic resource strength to gain positions in new target markets.

Algeria and Qatar have indicated that if companies want access to their hydrocarbon sectors, then they need to reciprocate with offers of ownership in assets that provide access to markets or are complementary to existing activities. A number of NOCs see a competitive advantage over IOCs in their collective, shared experience of state ownership. Asset swaps may increasingly be used by NOCs to gain access to markets of choice where they currently have limited or no presence.

Value-add propositions. NOCs also are able to offer value-add packages to host countries that are beyond the remit of IOCs. CNPC’s acquisition of PetroKazakhstan was underscored by a commitment to local development in Kazakhstan, including investment in railways and power generation infrastructure. IOCs may think that by investing in non-hydrocarbon-related projects they are filling in the gaps in public services that are the responsibility of the government.

Greater appetite for risk. NOCs have demonstrated a greater willingness to invest in countries that face human rights and environmental challenges. These include countries that most IOCs have been less reluctant to engage with so far due to pressure from shareholders and special interest groups.

DRIVERS OF INTERNATIONALIZATION

NOCs are a diverse group, with distinct strategies, motivations and ambitions. But common goals drive the NOCs’ desire for international and vertical integration.

The reserve holders. Reserve-holding NOCs are able, financially and politically, to invest record profits from domestic production back into the national oil industry and into international projects. They are likely to have the political backing and operational and technical ability to secure partnerships with IOCs and other NOCs, and have the financial clout to compete in the global M&A market. In addition, a number of specific concerns may be driving their internationalization activities:

• Securing access to growth markets for their products
• Diversifying to prepare for domestic output decline
• Reducing exposure to oil price volatility
• Integrating along the supply chain to capture value.

Saudi Aramco has been progressively reinvesting its oil wealth into vertical integration. The Petro Rabigh refinery joint venture with Sumitomo Chemical of Japan is evidence of Saudi Arabia’s commitment to ensuring the sustainability of its oil industry. Saudi Aramco’s international expansion efforts have focused on the downstream arena, and over half of the company’s refinery capacity is held through international ventures.

The reserve seekers. Due to the necessity to secure supplies for their domestic market, reserve-seeking NOCs may have a greater appetite for risk exploration, or a greater propensity to invest in “riskier” locations than their peers. They are typically willing to invest across the value chain in order to diversify. Their overseas activities are therefore likely to be widespread and numerous. By having stakes in overseas equity oil, these NOCs can help reduce their respective countries’ vulnerability to supply interruptions or price increases by exporting countries.

India’s ONGC operates in about 15 countries, with 14 of its 29 upstream projects under subsidiary ONGC Videsh Ltd. India currently imports around 70% of its oil needs, and is expected to become the world’s fourth-largest consumer of energy by 2010. ONGC’s vision is thus firmly rooted in meeting the needs of its national stakeholders to provide secure oil supplies for the country. To meet burgeoning demand, the company has set itself an ambitious target of acquiring 20 million tonnes equity oil and gas per year from overseas.

Petronas is another example of an internationalizing reserve seeker, as are the Asian NOCs. And of course, IOCs also fit into this category, competing with each other and with NOCs for access to oil and gas reserves to secure supply for the long-term growth of their business.

The domestic developers. A third class of NOC sits behind the reserve holders and seekers in terms of internationalization. NOCs in this group may be emerging from years of underinvestment or corruption and are thus driven by a need to channel investment into the development of national resources and production capacity. Their short-term ambitions are national. They talk in regional, not global, terms, and international ambitions are not on their agenda. They may be refocusing on core markets and operational efficiency, but a legacy of underinvestment means they lack the technical skills or financial capital to develop their resources alone. They therefore require the assistance of IOCs or other NOCs to help reinvigorate their industry. Alternatively, their oil and gas sectors may remain closed to foreign inward investment if protection of national interests is the main priority.

Nigeria’s oil industry has suffered from years of underinvestment and alleged corruption. The country’s domestic refinery capacity has suffered from years of neglect and is insufficient to meet the domestic demand for refined products. Under new and invigorated management, the Nigerian National Petroleum Corporation (NNPC) has embarked on a restructuring program to arrest the decline. The company is committed to focusing on the development of downstream activities and natural gas, inviting IOCs and NOCs to partner on development projects.

CHALLENGES FACING INTERNATIONALIZING NOCS

As NOCs expand further into international markets, they must prepare for a new set of risks and challenges.

Competing stakeholders. A fundamental challenge for NOCs is the need to deliver against the competing priorities of their various stakeholders, government and private. A further challenge is an NOC’s dual role as state ambassador and a global oil company. For IOCs, broadly speaking, the main objective is common to all-to maximize shareholder value. The objectives of NOCs are diverse, fundamentally complicated by disparate and competing stakeholders.

For companies with partially privatized ownership structures, the demands of the host government are often set against the requirements of private stakeholders. The NOCs of the future must not only deliver economic and social benefit to their countries, but deliver profits, demonstrate growth potential and deliver financial returns to private shareholders.

Domestic politics. NOCs typically have a strong and clear mandate from the state. However, in some instances the NOC can be undermined by lack of political consensus on corporate direction. The NOC may consider that forming partnerships with IOCs is the best option for the development of its country’s oil reserves, but political opposition to foreign investment may prevent that from happening. International aspirations are likely to be of low priority if the mandate for the NOC is unclear and the domestic industry is in need of investment.

In Kuwait, plans to boost output from the country’s northern oil fields in collaboration with foreign partners have been under debate for numerous years. Political divisions on the merits of allowing foreign participation in the country’s oil sector have stymied various proposals for reform for almost a decade. Similarly, planned oil sector reform in Mexico has been delayed by the failure of the main political parties to reach consensus on proposals for reform. The need to increase domestic output is recognized, but there is some strong opposition to plans to increase private sector involvement.

Transparency, controls and reporting. Internationalization brings other challenges, particularly for partially privatized NOCs competing with IOCs on global capital markets.

Performing on a global stage invites the attention of a new global audience composed of shareholders, potential partners, competitors, future host governments and capital providers. This audience, to varying degrees, will demand a level of transparency, and a level of commitment to international financial, industry and regulatory standards of reporting and accountability.

Accounting standards. The international NOCs of the future may increasingly look to secure finance on global capital markets, as their investment needs to scale up to meet their global ambitions. The ability to demonstrate robust, independently audited financial accounts and reserves estimates, as well as operational excellence and efficiency, will increasingly become a competitive differentiator.

NOCs may also seek funding via global credit markets. The ability to demonstrate financial strength and transparency will be key to achieving investment-grade credit ratings and in turn, access to cheaper credit.

Corporate governance. Equally, NOCs will need to demonstrate robust corporate governance and a level of discernable operational independence from their host government if they are to secure the best contracts and earn the trust of future partners and host countries. Indonesia has made a concerted and public attempt to clarify and rationalize the functions of state oil company Pertamina ahead of a planned IPO in 2012. The company is being encouraged to operate more independently and on a commercial basis.

Operating in multiple jurisdictions. Working across borders creates financial and operational complexity, requiring robust internal controls and back-office systems. Internal systems and risk-management controls need to be scalable on a global level. IOCs and many NOCs are moving to standardize business systems across their countries of operation.

One IOC attributed the failings of its international expansion efforts to the attempt to micromanage its overseas operations from headquarters in the US. Many NOCs have centralized business models, which were devised to effectively manage domestic operations. However, a company is likely to be stretched by the complexity of managing operations in multiple jurisdictions within a business model that is very centralized. Establishing or retaining adequate oversight of international operations is a key challenge.

Investor relations and branding. Investor relations are a key mechanism for establishing trust between shareholders and the NOC. Being able to successfully demonstrate strategic focus and operational success, beyond and above the bottom line, also translates into a powerful marketing tool.

IOCs have some of the most recognizable and powerful brands globally. Much of their brand recognition is due to the IOCs’ interaction with customers through their retail sites. It will take time for NOCs to get their brand positioned, but it will become increasingly important due to their growing international prominence. Some NOCs have already begun to reposition themselves using their revamped websites to present their new external face.

Meeting with political resistance. Just as IOCs are facing the challenge of exclusion from certain countries, so NOCs can face political resistance to their international ambitions. In 2005, CNOOC was forced to withdraw its bid for US energy company Unocal following fierce opposition to the prospect of Chinese control from US lawyers and politicians who feared a potential threat to US energy security.

Likewise, Gazprom’s rumored attempt to acquire a controlling stake in the UK’s leading integrated energy player, Centrica, was met with reports that there could be strong political resistance from the British government. It is a challenge that is likely to get tougher as NOCs continue to seek access to overseas markets, while at the same time their home markets are becoming increasingly closed to foreign participation.

Acting sustainably and responsibly. NOCs have demonstrated a willingness to do business in countries that are effectively offlimits to IOCs on the grounds of shareholder opposition and political resistance. IOCs have generally publicly committed to international standards of corporate social responsibility and are under pressure to operate in a sustainable and responsible way. This has typically precluded most from operating in countries with poor human rights records or countries where violence to personnel is a real threat.

NOCs are likely to come under increased scrutiny from special interest groups as their international profile rises. NOCs will need to establish the extent to which corporate and social responsibility becomes, and is seen to become, a priority, and the extent to which a commitment to global best practice will shape investment and expansion strategies.

LEARNING THE LESSONS: WHAT CAN NOCS DO TO PREPARE?

The INOCs of the future need to prepare for the challenges ahead. They can learn from the experiences of their peers, both national and international. IOCs and other global organizations faced many of the same challenges that NOCs are beginning to face in establishing a global footprint.

Alignment with corporate strategy. A fundamental priority for NOCs will be to reconcile the objectives of their various stakeholders. They will need to establish clear goals and be open about the purpose and desired outcome of those goals. These may include securing new markets, floating their shares on the financial markets or bringing about efficiency and longevity in the domestic market.

Governments need to be clear about their NOCs’ function and the long-term goals for the countries energy industry:

• Does international expansion create economic value?
• Is internationalization a strategically or commercially driven decision?
• Is internationalization the best option for the national oil industry and the state?

The decision to float shares also necessitates significant preparation, requiring the establishment of clear objectives for the IPO, clarification of ownership structure, potential restructuring, preparedness for the burden of regulatory compliance and investor relations. There is also likely to be a requirement for significant investment in building the corporate image.

Build relationships based on mutual benefit. Contracts based on long-term mutual benefit have enabled NOCs and IOCs to secure positions in overseas markets. A key challenge for IOCs as they strive to gain access to markets of resource abundance is to build relationships with host governments, and the same applies to NOCs seeking to forge new relationships. Some NOCs have cited a natural advantage when working with other governments-a culturally shared background-but no two NOCs are the same. For some NOCs, partnerships are formed purely on a transactional basis: The best partner for the job gets the job. A track record of strong project management and technical proficiency is as important as, if not more important than, the benefit of shared experience.

Prepare for the risks. Securing competitive advantage by gaining positions in markets that are off limits to IOCs brings inherent risks. NOCs need to be prepared for these risks, not least in terms of availability of exit options should things go wrong. Likewise, NOCs can equally be victims of nationalistic moves and expropriation by host governments. In 2006, Petronas’ stake in Chad came under threat over alleged underpayment of taxes.

Doing the right deals. CNOOC learned an important lesson in its failed attempt to acquire Unocal. As with any deal, research and preparation are paramount. It is important to gain an understanding of the target market and be transparent about motives for the deal and how integration will be achieved. The concept of nationalistic protectionism is not just the preserve of NOCs and their governments but is increasingly also a reality in Western economies.

Stakeholder engagement. As they become more international, NOCs will come under greater scrutiny from a variety of stakeholders. When activities have been confined to the domestic market, NOCs have only had to communicate with one principal stakeholder, the state. In the international arena there are many more stakeholders with whom NOCs will need to engage. These include their customers, other governments, minority shareholders, regulatory bodies and financial institutions. How the corporate face of the NOC is portrayed to the external world will have some bearing on its ability to gain access to some markets.

Customers in many countries are distrustful of foreign corporations looking to acquire or build interests in key sectors, such as energy. Political resistance to the NOCs of some countries gaining access to strategically important national assets can feed through into consumers’ consciousness, whipping up of public opposition. Effective engagement with local stakeholders before, during and after any country entry is a prerequisite to winning and maintaining a license to operate. Securing political support prior to any new market entry will help sway public sentiment. Guarantees of local employment and contractor opportunities are also important gestures to help build trust.

If an NOC has a less well-perceived reputation in foreign markets, it may be wise to establish a “neutral,” non-country aligned brand or separate corporate entity for international acquisitions. Demonstrating some distance from the state, even where in practice it retains control of corporate direction, may encourage more interested parties to do business with an NOC.

NOC-THE NEW IOC?

The major NOCs either already have moved or are moving beyond the traditional NOC role to be major international players. The distinction between NOCs and IOCs is becoming less obvious. Both are evolving to address global challenges, and the two are increasingly together.

NOCs are present in every part of the supply chain from oilfield services and upstream developments through refining and retail distribution. Some NOCs are also showing greater interest in alternative energies, previously the almost exclusive domain of the IOCs. Not all NOCs have a presence at each stage of the value chain, but neither do all IOCs. Besides the integrated IOCs, there are independent explorers, pure play refiners, infrastructure owners and retail distributors. But NOCs are becoming increasingly integrated and international in scope.