PETROLEUM INDUSTRY SEGMENTS & VALUE CHAIN Petroleum Industry Structure

PETROLEUM INDUSTRY SEGMENTS & VALUE CHAIN PWI2017EEI 1 Petroleum Industry Structure Petroleum industry consists of a series of distinct segments—Upstream, Midstream & Downstream UPSTREAM Exploration, Development, & Production MIDSTREAM Transportation, Processing (Gas), Storage, Crude Trading DOWNSTREAM Refining, Distribution, & Marketing PWI2017EEI 2 1 Upstream Petroleum Industry E&P industry is an extractive capital intensive industry with a high level of risk factor. Low success rate High self-financing Large size of firms Vertical integration Reserves are the principal assets. Discovering new oil and gas reserves is the life blood of PWI2017EEI the industry 3 Upstream Petroleum Industry Total Costs: technical costs and fiscal costs Vary significantly form area to area in addition to the fact of High ratio between fixed and variable costs Low ratio between production costs and oil and gas prices Low supply-price elasticity Technical cost factor: Number of wells drilled before discovery; the depth of the wells; nature of the rock drilled; costs of capital investments PWI2017EEI 4 2 Upstream: Exploration, Development & Production Oil and gas are discovered during prospecting after a prospecting license is obtained Exploration takes place where resources are located Subsequent to commercial discoveries is development and production follows after infrastructures are installed Bidding process for leases varies from country to country Most upstream projects are based on some form of partnership to share risk. Profitability in this segment is affected mostly by costs and commonly price and costs varied widely worldwide PWI2017EEI 5 E&P Project Development There are six phases in an E&P project development The search for and development of oil and gas begin with obtaining the right to prospect from, mostly, the government The second phase is exploration, which is highly risky and expensive, to identify prospective areas of the concession Appraisal, development, and production phases follow exploration if the latter is commercially successful The finally phase is the abandonment stage when the field or project is decommissioned. PWI2017EEI 6 3 Upstream Project Life Cycle PWI2017EEI 7 Petroleum Industry Structure Industry structure is a determination of the environment within which the industry operates in terms of Entry conditions (barrier to entry) Concentration ratio Number of producers and consumers. It reflects market participants’ attempts to effect changes in market prices, demand, supply, investment or rents through different bargaining strategies. PWI2017EEI 8 4 Elements of Industry Structure Concentration Ratio—a measure of the size and distribution of producers of a particular commodity. Significance of concentration is to provide an insight to industry performance--HHI. Highly concentrated industry can negatively affect market performance in terms of efficient allocation of resources (HHI > 1800). For an industry with four firms and shares of 0.10, .25, 0.30 and 0.35, what is the HHI? Transactions that raise HHI by 100 may have anticompetitive implications PWI2017EEI 9 Elements of Industry Structure Product differentiation reflecting how buyers perceive a seller’s product as a close or perfect substitute. Markets with high degree of product differentiation are often characterized with a high degree of control over prices. Ignorance of buyers Timing and location of products Role of advertising or sale promotion Existence of perfect substitute implies high price elastiticity PWI2017EEI 10 5 Elements of Industry Structure Entry condition refers to the ease with which new producers may establish themselves in the industry. Entry barriers occur in several ways: Cost advantage Institutional restraints Scale economy barrier Specialized technology or intellectual property Regulation Advertisement PWI2017EEI 11 Petroleum Industry Conduct Vertical Integration is the extent to which a firm performs different successive stages in the production process, e.g. oil exploration, drilling, production, refining, processing, transportation, etc. Horizontal Integration: Cutting across related business ventures--outsourcing Mergers & Acquisitions Decoupling the value chain PWI2017EEI 12 6 Petroleum Industry Conduct Vertical Integration is the extent to which a firm performs different successive stages in the production process, Upstream--Oil and gas exploration and production, including well drilling, comprises the upstream. Midstream-- initial processing of crude oil at a field production site to remove gas, crude oil storage and the subsequent transportation of crude oil to a refinery Downstream-- include oil refining, storage of refined products and transportation of products to retails outlets, where they are sold. Horizontal Integration: Cutting across related business ventures--outsourcing Mergers & Acquisitions Decoupling the value chain PWI2017EEI 13 Elements Industry Conduct Major advantages of vertical integration Storage cost reduction Refinery design cost (producing own crude) Increased ability to bear a broad category transaction cost Guaranteed flow of information Logistic handling PWI2017EEI 14 7 Elements Industry Conduct Limitations of Vertical Integration Raises barriers to entry—economy of scale Management and organization diseconomies Creates opportunity for market imperfections An existing monopoly if vertically integrated increases market power Vertical integration does not lead to monopoly power unless it is already in existence. PWI2017EEI 15 Element Industry Conduct Joint Venture Activities Lease acquisitions Ownership of pipelines Ownership of and production from leases International joint venturing Why JVS are common in O&G: Capital intensive Risk concentration Access to technology Access to resources and complementary assets or reserves. Regulatory requirements Political sensitivity or energy security. PWI2017EEI 16 8 Joint Venture Types JVs typically employed within the oil and gas industry broadly fall into one of three categories: Full asset JV with specific set of existing asset(s) or to develop asset(s)--upstream JVs, pipelines, refineries and LNG projects. Upstream full asset JV is the most common type Full business JV combines the resources of entire businesses to create marketing, supply chain, production and scale synergies Usually occurs in downstream, chemicals and midstream businesses; as well as in oil field services companies within the upstream sector Marketing alliance JV has intent of jointly marketing product(s), e.g., motor fuels retailers and convenience stores joining forces PWI2017EEI 17 Joint Venture Activities May substantially weakened incentives for independent competitive actions Enable the sharing of unusually large risks Facilitate smaller firms and investors entry into industry they will not be able to enter individually Can promote efficiency in operations depending on the partners PWI2017EEI 18 9 Elements Industry Conduct Major advantages of vertical integration Storage cost reduction Refinery design cost (producing own crude) Increased ability to bear a broad category transaction cost Guaranteed flow of information Logistic handling PWI2017EEI 19 Elements Industry Conduct Limitations of Vertical Integration Raises barrier to entry Management and organization diseconomies Creates opportunity for market imperfections An existing monopoly if vertically integrated becomes more monopolistic Vertical integration does not lead to monopoly power unless it is already in existence. PWI2017EEI 20 10 Element Industry Conduct Joint Venture Activities This is a widely spread phenomenon all over the world Lease acquisition Ownership of pipelines Ownership of and production from leases International joint venturing PWI2017EEI 21 Joint Venture Activities May substantially weakened incentives for independent competitive actions Enable the sharing of unusually large risks Facilitate smaller firms and investors entry into industry they will not be able to enter individually Can promote efficiency in operations depending on the partners PWI2017EEI 22 11 Forms of Industry Structure Perfect competition Pure Monopoly Monopolistic Competition Oligopoly PWI2017EEI 23 Perfect Market Structure Perfect Competition is a valuable starting point for examining market behavior or conduct with respect to resource allocation Formal Assumptions of the Competitive Model: There are many small buyers and sellers The product is standardized or homogenous There is a free and easy entry and exit There is complete and perfect knowledge PWI2017EEI 24 12 Perfect Market Structure Competitive market performance: P = MC = MR for maximum profit AR=MR, every firm is a price taker Resources are allocated most efficiently and easily. Purely competitive markets hardly exist. Demand curve is horizontal for each firm (illustrate). PWI2017EEI 25 Pure Monopoly Structure Pure Monopoly A market with only one seller. Pure monopoly market hardly exists. It is another extreme form of market behavior. Features of a Monopoly Market Single seller in the market and demand is inelastic. No close substitutes are available. PWI2017EEI 26 13 Pure Monopoly Pricing Profit-maximizing price: MC = MR for maximum profit but price is higher than both Resources are allocated less efficiently. Monopoly output is less than competitive output and at a higher price. Unregulated pure monopoly is illegal in the U.S. Regulated monopoly does exist in some industries. Rule of thumb/mark-up over marginal cost: P = (MC * elasticity) /(elasticity-1) = MC / (1PWI2017EEI 27 1/elasticity) Monopolistic Market Structure Monopolistic competition Monopolistic competition involves a blending of monopoly and competition. Probably the most common form of market structure in a developed economy. Features of a Monopolistic Competition Has large number of small firms with relative ease to entry. Many firms selling similar but distinguishable products which are close substitutes. Can earn profit in the SR, but LR industry profit is28 PWI2017EEI zero 14 Oligopoly Market Structure Oligopoly: Oligopoly means a few sellers The classification is less precise and covers more ground than the other classifications Features of oligopoly Relatively small number of relatively large firms in the industry. Interdependence in pricing, products, advertisement, and many other decisions. Prominent models to explain behavior include: cartels, dominant firm behavior; price leadership or limiting pricing. PWI2017EEI 29 Economic Framework for Petroleum Resource Allocation: Dynamic Criteria The role and determinants of petroleum prices Economic framework for petroleum resource allocation Petroleum resource allocation criteria and analysis PWI2017EEI 30 15 The Role and Determinants of Oil Prices Global economic activity, trend in production cost of output, economic growth, inflation, and business cycle fluctuations in a developed economy. Degree of competition, especially the type and degree of market control by major producers: Competition vs. monopoly, monopolistic competition or oligopoly Changes in protective measures or market restrictions such as: Subsidies, tariffs, or price controls Fluctuations in exchange rates PWI2017EEI 31 The Role and Determinants of Crude Oil Prices Price is a signal that induces oil producers to produce oil and consumers to buy it. It establishes output and method of production. Oil prices are determined by The magnitude of supply and demand through factors such as intensity of oil use, extent of oil exploration, growth in productive capacity, and technology innovation. PWI2017EEI 32 16 The Role and Determinants of Oil Prices Own price elasticity: Measured as point elasticity or arc elasticity Point elasticity measures elasticity at given point on a function: % change in Qx / % change in Px Arc elasticity measures the average elasticity over a given range of a function: change in Qx / change in Px times (average Qx / average Px) Cross price elasticity: Measured as point elasticity or arc elasticity % change in Qx / % change in the price of Qy PWI2017EEI 33 The Role and Determinants of Oil Prices The difference in SR and LR elasticity puts a limit to how high prices can go for oil. Low value of elasticity can explain why disturbances in demand may cause substantial changes in price to move the market to equilibrium. PWI2017EEI 34 17 Reference Framework for Petroleum Resource Allocation Some underlying facts about petroleum resource allocation Oil and gas are finite resources --they are non renewable in a sense. The supply is of an unknown quantity. The cost of finding out about the magnitude of oil supply is substantial. PWI2017EEI 35 Dynamic & Efficient Allocation of Non Renewable Resource Static allocation criteria assume that consumption and production occur in one particular time period In the case of petroleum each period is not independent of the other. Today’s consumption reduces the resource base available tomorrow Production must be optimized over many period both from firms and society viewpoint PWI2017EEI 36 18 The Role of Interest Rate Interest rate holds the key to resource allocation over time It affects resource allocation through the introduction of the price for future resource consumption into current decisions The rate of interest also plays a role in affecting the output and profitability of firms over time PWI2017EEI 37 Long-run Profit Maximization Long run profits maximization involves generating a stream of profits over time π0 π1 π2 π3 ………. πn Interest rate provides a means to compare one dollar’s profit today with a profit of $1 in the future. PV= π0 + π1 / (1+r) + π2 / (1+r)2 + π3 (1+r)3 ……+ πn / (1+r)n PWI2017EEI 38 19 Maximizing Present Value with A Non Renewable Resource For a hot dog vendor, maximizing present value of future profits is simple: MR0=MC0, MR1=MC1, MRn = MCn In the case of non renewable resources, it is not that simple. Why not? Illustrate: Consider a monopolist with only 60 barrels of oil to sell at no significant production cost in periods 0 and 1. If he thinks the demand in period 0 is P0 = 5 - 0.05Q0 and demand in period 1 is P1 = 5 - 0.033Q1. How can PV of profit be maximized, assuming a discount rate of10%? PWI2017EEI 39 Maximizing Present Value with A Non Renewable Resource p p Assuming the monopolist sets MR0=MC0 , MR1=MC1 then Q0=50 and Q1=75. Is this possible? Why or why not? Suppose he sells 50 barrels in period 0 and 10 barrels in period 1: PV= π + π1 / (1+r) = PV50,10 = 125 + 42.45 = 167.45 Does this represent the optimal output combination to maximize revenue? Suppose the monopolist sells 49 and 11: PV49,11 = 124.95 + 46.37 = 171.32 0 PWI2017EEI 40 20 Maximizing Present Value: Opportunity Cost Concept Opportunity cost (OC) of shifting a barrel of oil to the future for this monopolist is 3.87= PV49,11 - PV50,10 The OC of not selling in period 0 is $0.05 and the OC of selling in the future is$4.31discounted as $3.92. So what can be done? In general ∆PV = OC0+OC1= ∆ π0 + ∆ π1 / (1+r) = (MR0-MCp0)∆Q0-[(MR 1-MCp1)∆Q1/]/(1+r) PWI2017EEI 41 Maximizing Present Value: Opportunity Cost Concept In general ∆PV = OC0+OC1= ∆ π0 + ∆ π1 / (1+r) = (MR0-MCp0)∆Q0-[(MR 1-MCp1)∆Q1/]/(1+r) As long as the discounted opportunity cost is higher in the future than now it makes sense to defer current production to the future. Note MRi in the above equation is defined as the change in total revenue at period i PWI2017EEI 42 21 User Costs Phenomena: Optimal Output Criteria User cost is the measure of the opportunity cost of producing a unit of non renewable resource, such as oil and gas today rather than later. It reflects the inherent scarcity value of the resource in each period. It is measured simply as: U0 = (MR0-MCp0) and U 1 = (MR 1-MCp1) PWI2017EEI 43 User Costs Phenomena: Optimal Output Criteria For production optimization, the user cost of producing today must equal the discounted user cost of producing a unit in the future. The producer is indifferent between shifting production from 1 period to the other in all periods. U0 = U1 /(1=r) = U2/(1+r)2= … = Un/(1+r)n PWI2017EEI 44 22 User Costs Phenomena: Monopoly Vs. Competitive For Monopoly, MR=MC=MCp+U to maximize profit Given: Pi = a -bQi, MRi = a-2bQi For Competitive model, MR=MC=MCp+U to maximize profit given: Pi = a -bQi, MRi = a-bQi U i = (MR i-MCpi) PWI2017EEI 45 User Costs Phenomena: Monopoly Vs. Competitive Show that competition leads to lower prices and higher output in the present and higher prices and lower output in the future. The market price under competition tend to rise faster than under monopoly. PWI2017EEI 46 23 The User Cost Phenomena: Shadow from the Future The important profit maximization condition is that the user cost of a resource, reflecting its value for uses in other periods, rises with interest rate. And efficient dynamic resource allocation requires that the market price P in any period i equal the marginal cost MC composed of the MCp and user cost U Pi = MCi = MCip + Ui The user cost phenomenon also plays the fundamental role of allocating resources over time. PWI2017EEI 47 Effects of Revisions in Future Demand Conditions Effect of future demand which assumes that the price is one dollar higher than currently anticipated on current decisions (illustrate) Assume competitive model with only 60 barrels of oil to sell at no significant production cost in periods 0 and 1. If he thinks the demand in period 0 is P0 = 5 - 0.05Q0 and demand in period 1 is now P*1 = 6 0.033Q*1 instead of P1 = 5 - 0.033Q1 PWI2017EEI 48 24 Effects of Revisions in Future Demand Conditions Show that current output is cut from 28.2 to 16.8 and future consumption will be 43.2 instead of 31.8. The user costs and current market prices become 4.16 now and 4.57 in the future. Show that at r=10 percent, 4.57 in the future = 4.16 today. PWI2017EEI 49 Future Expectation and Current Conditions (contd.) Future scarcities are reflected in current prices to reallocate production from the present to the future well b4 the future shortages occur. Consequently, future expectations about reserves, new discoveries and growth in demand have important implications on present prices. Illustrate by increasing total future production to 90 instead of 60 (graph) PWI2017EEI 50 25 Effect of rising production cost on the present market conditions Suppose production costs rise from 5 cents per bbl from the first barrel to 3 dollars for the 60th barrel. At the initial competitive output combination of 28.2 and 31.8, the MCp of the last barrel produce in period 0 is $1.40. U0 of the 28th barrel costing $1.40 is $2.19 (3.591.40) and U1 of the 28th barrel is $2.55 (3.95-1.40). The PV = 2.55/1.1=$2.32>2.18. 28th barrel is better produced in the future. PWI2017EEI 51 Effect of rising production cost on the present market conditions The optimal output occurs when U0 = U1 /(1+r) Rising production costs will reduce current production leaving more to the future. In an undistorted market, the lowest cost oil will be produced first. PWI2017EEI 52 26 Effects of changing the social interest rate As the rate of interest is reduced, the present value of future user costs increases relative to user costs in the current period Production becomes more favorable in the future compared to current production. Assumes interest rate declines from 10 percent to 5 percent, the new equilibrium output is obtained as 26.2 now and 33.8 in the future The market price are greater by 5 percent in the future than the market price now of $3.70 per barrel. PWI2017EEI 53 Important implications of changing the social discount rate on prices If there are no changes in inflation, increases in interest lead to lower prices of oil relative to other goods in the period they occur Oil prices will rise faster in a relative sense because U now rises at the higher interest rate Technology makes possible for prices to decrease in the period in which expectations about interest rates, reserves and demand are revised. PWI2017EEI 54 27 The effects of technical change Technology plays a major role in altering the natural resource base. Many resources are not economical at a given period because they do not yield a positive user cost i.e. MSC>MSB The economic reserves of a resource--reserves with a lower MCP in comparison to the price--are significantly less than physical reserves. Two factors affecting the relative size of these two categories are price and technical progress or technology. PWI2017EEI 55 How technology affects resource use over time and price Suppose there are 60 reservoirs in a field, each producing 1 barrel at 50 percent recovery rate now, but recovery rate can rise to 52 percent in the future and each reservoir contains 2 barrels. Reservoir exploited this period does not have access to new technology since it is an advancement in new completion technique. Why can’t producers wait for this new technology since it yields 1.04 barrels instead of 1 for producers? PWI2017EEI 56 28 How technology affects resource use over time and price Recall that optimal output always occur when U0 = U1 /(1+r) for MSB to equal MSC Advancement in new completion technique in the future means the undiscounted user cost in the future will increase by a g factor. Optimal output in the presence of technical change occur when U0 = [U1 (1+g)] /(1+r) for MSB to equal MSC PWI2017EEI 57 Noteworthy effects of technology on resource use and price over time As a result of technological progress we can expect: a transfer of current production to the future an increase in economic reserves, rather than have a fixed reserves, there will be growth in reserves as a result of new discoveries smaller rate of increase in prices because reserves are augmented enough to affect the future cost of extraction the rate of increase in marginal extraction cost will fall PWI2017EEI 58 29 The Simple Mathematics of Dynamic Efficiency Assumption: The demand curve for petroleum resource is linear and stable over time such that: P (t) = a - b q (t). The total benefits for extracting q(t) in year t is given by TBt = ∫q0 (a - b q (t)) dq If marginal cost of extraction is a constant c, then total cost of extraction TCt = cq (t) PWI2017EEI 59 The Simple Mathematics of Dynamic Efficiency If the total amount available resource S0 is less than would normally be demanded, then the dynamic efficient allocation must satisfy these conditions under perfect model: [a - b qt-c] / (1-r) t-1 = λ S0 - ∫1 ( qt)dq for t=1, …,T The implication is that user cost (P-MC) rises over time at the rate of interest For a monopoly user cost is MR -MC and it rises over time with the rate of interest as well. PWI2017EEI 60 30 Dynamic Resource Allocation: The Mathematics of a 2-Period Model The demand curve for petroleum resource is linear and stable over two periods such that: P (t) = 8 - 0.4q (t). S0 = 20, c = 2, and r = 0.10 Assuming a perfectly competitive market: [8 - .4 q1-2] / (1.1) 0 = λ (1) 1 [8 - .4 q2-2] / (1.1) = λ (2) q1 + q2 = 20 It can be readily verified that q1 = 10.238 q2 = 9.762 and λ = $1.905. PWI2017EEI 61 Extension of the 2-Period model for n-Period The case where the time of extraction is unlimited Solving the equations describing the optimality conditions becomes a non trivial matter, neither is it overtly difficult. One method is to develop a computer algorithm which converges on the correct answer. For example, assume a value for λ and solve for all q in condition 1 and check with condition 2. Adjust λ up or down depend on how close the solutions to U0. Repeat until you get close enough to U0. PWI2017EEI 62 31 Dynamic resource allocation in the presence of a backstop fuel Thus far we have assumed that there is no close substitute for oil in our analysis Assuming a special type of fuel available in relatively infinite abundance exists at a fixed price is a perfect substitute for oil at say $P. e.g. solar energy and nuclear fusion ( supply is horizontal with infinite elasticity) What effects will the existence of backstop fuel have on fuel prices and oil production? Is the price of oil going to be P in both periods? Why not? Will all the available oil be produced in the current period? PWI2017EEI 63 The concept and significance of backstop fuel in resource allocation Backstop fuel does not affect the tendency for oil Price to rise but the final price must stop at the backstop price Backstop fuel enables higher current production at a lower price than would occur otherwise Backstop fuel assures future generations of constant price once the price reaches the backstop. PWI2017EEI 64 32 Dynamic Resource Allocation: Some important conclusions If the amount of oil available at time 0 increases, the price at any future point in time is expected to decrease, the extraction period will increase because more oil is available, and more extracted. Raising the backstop price will pull the price path upward, thus less will be extracted at future date, but the extraction period will become shorter. PWI2017EEI 65 Dynamic Resource Allocation: Some concluding remarks The return on extracting one unit today and interests in capital market for returns equals the gain in delaying extraction in terms of rising price and lowering rise in extraction costs. If c is not constant and rises with time, then extraction stops when p < c. PWI2017EEI 66 33 Dynamic Resource Allocation: Some concluding remarks Some implications: Cheaper resources are extracted before the more expensive ones. Economic factors determine the size of recoverable reserves. Oil and gas wells may be abandoned long before they die physically. PWI2017EEI 67 34