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Short-termism at Royal Dutch Shell

UPDATED MONDAY 26 APRIL 2010

“In an obsessively cost conscious environment such as the one that rules in Shell at the moment all labour-intensive sectors are at risk –irrespective of their intrinsic value or their competence – or even the likely long-term demand for their products and services.”

Posting on Shell Blog by Wilt Staph on Apr 24th, 2010 at 12:14 pm

A couple of decades ago Shell had five refineries in the United Kingdom – when the sale of Stanlow is completed soon they will have none. Is this because refining is a sunset industry with no growth potential and no chance of earning returns? Not if you take note of reliable global demand forecasts it isn’t. The “US Joint Forces Command” – the top of the American armed forces pyramid – has recently said that globally a “severe energy crunch is inevitable without massive expansion of production and refining capacity”. Most other forecasters agree that the planet will need substantially more not less refining capability in the years ahead. So why has Shell retreated so dramatically from refining and what are the implications for the “new Shell” which will emerge from the radical reviews underway under Peter Voser?

Historically Shell has been pretty good at running refineries. Many of the advanced processing techniques that are commonplace in sophisticated refineries are Shell inventions or incorporate propriety Shell technologies. The challenge to extract the maximum amount of distillates and gasoline from crude oils of a variety of chemical complexity was one that Shell embraced many years ago and their success record is impressive. Even the heaviest and most unpromising crudes can be forced to deliver high spec white oils these days – it’s almost taken for granted that they will. Similarly Shell refineries are hugely more energy efficient than they used to be. The amount of energy used in processing crude is orders of magnitude less today than it was even ten years ago. Similarly although there are safety and environmental failures that Shell prefers not to talk about (ask the inhabitants of Durban South Africa for example) overall the refinery HSE record is a good one – perhaps the best amongst the oil majors.

So if refining is historically a core competence in Shell, if the demand for refinery capacity is on the increase not the reverse and if Shell’s general track record is a good one why are they running away from this sector at such a rate? The reason is that there is a fallacy in Shell as to what refineries actually are! They are seen as profit centres rather that the cost centres that they really are. The economics of a refinery are comparatively simple. Crude oil arrives, it is processed and then products cross the refinery fence. The cost of the crude oil is not the refiners concern and the value realised for the products is not their concern either. Crude is bought by the traders and products are sold by the traders and marketers. The refiner’s challenge is to process what the traders give them and supply what the marketers ask for as cheaply as possible. But in order to do this it requires a management imperative which sees that it is worthwhile being involved in this business at all. In the past vertical integration was seen to add value all the way along the supply chain – from wellhead to the motorist’s car if you like. This is no longer the case and every business has to deliver individual returns. The traders buy the right crude at the right prices and the marketers and traders sell the right products and achieve the maximum returns that they can. The poor refiner is squeezed in the middle and however well he runs his operation it will always be under scrutiny. This is particularly so as refineries are still quite labour intensive operations. Shell has around a thousand employees at Stanlow and there are hoards of contractors on top of that. In an obsessively cost conscious environment such as the one that rules in Shell at the moment all labour-intensive sectors are at risk –irrespective of their intrinsic value or their competence – or even the likely long-term demand for their products and services.

ARTICLE ENDS

definition of short-termism

Adoption of rapid results as a business aim. Short-termism involves maximizing profits in the near future, possibly by raising profits to the highest level and cutting costs by laying off staff. The pressures of maximizing shareholder value often lead to the adoption of a short-term approach, regardless of whether this is in the company’s long-term interests.

Posting by Jo Blow on Apr 25th, 2010 at 1:35 pm

Well written article Wilt. I thought perhaps that I would expand further in hopes of further helping folks understand where the modern refinery shakes out in the big picture.

The modern refinery as Wilt points out is caught somewhat in the middle of a complex situation. At times the refinery functions as a profit center, at others a cost center. This fluctuation is driven by the pace with which the spread between raw crude prices and finished product prices rise and fall, and is further influenced by the given refinery complexity and efficiency along with grade of crude oil it is able to refine. There are many more variables at play, but the above mentioned represent the largest and most important. I will illustrate in simple math below.

42 gallon barrel of oil @ 80$ a barrel = $1.90 per gallon of raw crude processed.

Assuming a refinery capability of 95% conversion to value product. this translates to roughly 40 gallons of product to be sold. Assuming that the average cost of all product streams to the consumer is around $2.75 per gallon for ease of illustration.

So as you see with these assumptions you basically have a spread of $30.00 a barrel processed. Now you have to take out your cost to process, the marketers cut on the finished product side, the retailers cut, any transportation costs etc. Under this assumption that leaves somewhere around a net gain of $8-$12 bucks in the refiners pocket depending on the variables mentioned above.

Now, without a refinery, there is no need to drill for nor produce oil! Oil in its virgin state has no value, the value is derived from the products that can be produced from the raw material. It is for this reason that a total exodus from downstream is short sighted. Shell should be focused on reducing costs, and maximizing yields to position itself to benefit from margin rich environments, and minimize loss during margin poor environments. This would be the appropriate long term approach in the downstream business.

Regards,
Jo Blow

Posting by Wilt Staph on Apr 26th, 2010 at 8:52 am

Thanks for this Jo Blow – some very helpful additions to my original post. I am an enthusiast for the hiving off of Shell’s global marketing business into a separate Shell-branded company. I’m a tad ambivalent about whether there would be merit in including the refineries in this or not. If not then maybe Shell could create a third company to run refineries? If others (independents) can do this profitably (they obviously can) then why not create a “Shell Refining Inc.” ?

2 Comments on “Short-termism at Royal Dutch Shell”

  1. #1 Wilt Staph
    on Apr 26th, 2010 at 08:52

    Thanks for this Jo Blow – some very helpful additions to my original post. I am an enthusiast for the hiving off of Shell’s global marketing business into a separate Shell-branded company. I’m a tad ambivalent about whether there would be merit in including the refineries in this or not. If not then maybe Shell could create a third company to run refineries? If others (independents) can do this profitably (they obviously can) then why not create a “Shell Refining Inc.” ?

  2. #2 Jo Blow
    on Apr 25th, 2010 at 13:35

    Well written article Wilt. I thought perhaps that I would expand further in hopes of further helping folks understand where the modern refinery shakes out in the big picture.

    The modern refinery as Wilt points out is caught somewhat in the middle of a complex situation. At times the refinery functions as a profit center, at others a cost center. This fluctuation is driven by the pace with which the spread between raw crude prices and finished product prices rise and fall, and is further influenced by the given refinery complexity and efficiency along with grade of crude oil it is able to refine. There are many more variables at play, but the above mentioned represent the largest and most important. I will illustrate in simple math below.

    42 gallon barrel of oil @ 80$ a barrel = $1.90 per gallon of raw crude processed.

    Assuming a refinery capability of 95% conversion to value product. this translates to roughly 40 gallons of product to be sold. Assuming that the average cost of all product streams to the consumer is around $2.75 per gallon for ease of illustration.

    So as you see with these assumptions you basically have a spread of $30.00 a barrel processed. Now you have to take out your cost to process, the marketers cut on the finished product side, the retailers cut, any transportation costs etc. Under this assumption that leaves somewhere around a net gain of $8-$12 bucks in the refiners pocket depending on the variables mentioned above.

    Now, without a refinery, there is no need to drill for nor produce oil! Oil in its virgin state has no value, the value is derived from the products that can be produced from the raw material. It is for this reason that a total exodus from downstream is short sighted. Shell should be focused on reducing costs, and maximizing yields to position itself to benefit from margin rich environments, and minimize loss during margin poor environments. This would be the appropriate long term approach in the downstream business.

    Regards,
    Jo Blow

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