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An era of volatility and opportunity: the outlook for CFOs in the energy industry

Speech given by Simon Henry, Chief Financial Officer, Royal Dutch Shell plc, at the FT CFO Global Energy Forum, London on September 28, 2011.
Simon Henry

Against a backdrop of strong macro-economic volatility, CFOs are preparing their businesses for leaner times, while sowing the seeds of future growth.  As part of this, they are also taking on a broader range of responsibilities and spending more time engaging with external stakeholders, such as policymakers. In this speech, Simon Henry, Royal Dutch Shell’s Chief Financial Officer, describes his role in delivering Shell’s corporate strategy, from expanding the influence of the finance function in delivering the company’s major projects to building partnerships with China’s national oil companies.    

An era of volatility and opportunity: the outlook for CFOs in the energy industry

Good morning, and it’s great to be back at the CFO Global Energy Forum.
 
Today, I’ve been asked to set out the challenges and opportunities facing CFOs in the energy industry, and to describe the direction of travel in Shell’s finance function. I’ve also been asked to share some thoughts on developing successful partnerships and joint ventures in the emerging markets. So I’ll take each of these points in turn.

Volatile outlook

So first the big picture.
 
Earlier this year, Shell published an update on our long-term energy scenarios. It cautioned that we have entered an era of prolonged macro-economic volatility - in sharp contrast to the strong growth and stability of the previous decade.
 
In recent days alone, we’ve seen a fresh warning from the US Federal Reserve about the state of the global economy, an escalation in the Eurozone debt crisis, and wild fluctuations in global stock markets: all symptoms of a lengthy and fragile recovery from the “The Great Recession”, as it’s already being described by economists.
 
High and volatile oil prices have also weighed heavily on the global recovery. Earlier in the year, they rose sharply on the back of strong demand growth in the emerging economies and fears about the availability of supplies amid the civil war in Libya.
 
But in recent weeks, the IEA has scaled back its oil demand growth projections, due to the weakness of the global economy.
 
At Shell, we expect this kind of volatility to remain a feature of the next decade and beyond, as surging demand for energy puts supplies under pressure. According to our scenarios planners, by 2050 underlying global energy demand will double and could even treble on its level in 2000 if emerging economies follow historical patterns of development.
 
To keep pace with this demand the world will need to invest heavily in all energy sources, from oil and gas to biofuels, wind and nuclear. According to the IEA, the world could need to invest as much as $33 trillion in the global energy infrastructure by 2035. Recent figures show investment of around $1.2 trillion per year, of which close to $500 billion is in oil and gas.
 
At the same time, the world will attempt to make the journey to a more sustainable energy system. More governments are introducing legislation to reduce the environmental stresses associated with energy production and consumption. For example, the Australian government is preparing to introduce a tax on carbon next year for the country’s heaviest emitters. Investment in renewable forms of energy is now estimated to have reached $200 billion of annual spend.
 
All the while, the industry is becoming more competitive, as the national oil companies grow more powerful. In just the past couple of years, we’ve seen NOCs make a growing number of acquisitions outside of their domestic borders – a sure sign of their increasing financial and technical capacity.
 
For international oil companies, that makes the task of forging long-term and productive partnerships with the NOCs tougher and more urgent. It also throws a spotlight on our powers of technological innovation, which are now critical to winning business opportunities with the NOCs.

Implications for CFOs

So what does all this mean for CFOs in the energy industry?
 
It means maintaining a sound balance sheet appropriate to an era of macro-economic volatility - while investing billions of dollars in finding and developing new energy sources.
 
And it means adapting our businesses to leaner times, while laying the foundations for future growth – in unfamiliar emerging markets and in new areas of business activity, such as renewable energy.  
 
But that’s not all. Even before the recession, many CFOs’ job descriptions had expanded rapidly from the days when their main focus was on the core tasks of accounting and capital raising. New areas of responsibility range from strategy development and IT to risk management and overseeing M&A deals.
 
But expectations among board members and investors have ratcheted up even further amid tougher business conditions. They want to be sure that growth plans and strategic decisions create lasting value.
 
And that’s to say nothing of the tax and regulatory environment.
 
With many governments running enormous deficits, corporate tax regimes are becoming even more unpredictable. And energy companies have again proved to be convenient targets, not least here in the UK. For CFOs, these short-term political pressures are severely out of step with the investment cycles for energy projects, which span decades.  
 
Within the accountancy profession, we face a relentless upheaval in standards, from mark-to-market accounting to the International Accounting Standards Board’s new rules on profit reporting.
 
But the regulatory fall-out from the financial crisis carries far more wide-ranging implications. In particular, the Dodd-Frank Act is poised to affect a swathe of areas from the trading and clearing of “over the counter” - or OTC - derivatives to revenue transparency. 
 
This is understandable, given the state of public confidence in the business sector. But for CFOs this wave of regulation will not just create thousands of hours of additional compliance work for our finance teams. It also obliges us to spend much more time engaging with policymakers to ensure that legislation produces real results, rather than unintended consequences.
 
This is no easy task: we must strike an appropriate balance between protecting our own narrow interests and acting in the public interest. All told, I now spend well over one-third of my time on external engagements of one sort or another.
 
So for CFOs the story of the coming years will be one of delivering on a broader range of fronts in a tougher economic and regulatory environment.

Raising near-term performance

But that also brings an opportunity. CFOs now have the chance to impose the influence of the finance function on all areas of business activity, and to play a bigger role in delivering corporate strategy.
 
So what are Shell’s strategic objectives?
 
Shell’s first goal is to raise our near-term performance.
 
From my point of view, that means preparing Shell and our finance function for leaner and more competitive times.
 
In 2009 and 2010, we managed a total of $4 billion in cost savings across the company. A sizeable chunk of that was attributable to our major company-wide re-organization in 2009. This sought to encourage faster ways of working, and strengthen accountability for our key business value drivers.
 
Some 7,000 employees left the company, and we reduced the number of senior leaders by one-fifth.
 
To promote capital efficiency, we are selling many of our more marginal or “non-core” assets. This ensures that we focus our financial and management resources on our most promising markets and projects. For example, we have sold a number of smaller refineries in Europe as we focus on larger, integrated sites in growth markets.
 
So far in 2011 we have managed $4.4 billion in divestments, with more to come. That follows 2009 and 2010 when we made divestments totalling some $10 billion. On average over the past five years, we divested between 3 and 4% of total capital employed per year.
 
Within the finance function, we’ve streamlined our operations.
 
Back in 2005, our operations were spread across more than 100 countries, all with their own processes and controls. Two-thirds of the finance department’s costs were generated by basic processes like reporting controls. And less than 10% of staff were located in dedicated operations centres.
 
So we adopted a plan to overhaul the function by the end of 2010. Our goals included a 40% reduction in costs – the equivalent of some $800 million – the shifting of half of our roles to operations centres by 2010. And the setting of clear targets for our business support activities.
 
At the end of 2010, we drew the plan to a close, having delivered on our major targets. Recent benchmarking puts us in ‘top quartile’ performance for efficiency and effectiveness metrics – but only just. Competitive standards continue to improve so we still have some work to do.
 
We are now pushing for continuous improvement throughout the company. And Shell’s executive committee has identified five core business processes that we want to sharpen.
 
One is our order-to-cash process. With Shell processing invoices running to several hundred billion dollars every year, a slicker process would not just achieve substantial cost savings. It would make it easier for our customers to do business with Shell, giving us – and them - a competitive advantage.

Growing our cash-flow from operations

All of which leads onto a second of Shell’s strategic objectives: growing our cash flow from operations by as much as 80% between 2009 and 2012, assuming an $80 per barrel oil price. That would be an increase from $24 billion to $43 billion. 
 
That brings our major projects into sharp focus. Between 2011 and 2014 we have some 20 projects scheduled to start production – or some 800,000 boe per day of new production. Over the same period, we expect to invest well over $100 billion.
 
To get a sense of the scale of some of our projects, you only have to look at Pearl, our giant new $18-19 billion project in Qatar, which converts natural gas into liquid transport fuels and other high value products.
 
A joint development with Qatar Petroleum, at one point more than 50,000 workers from 60 nations were at work on a construction site the size of Hyde Park and Kensington Gardens.
 
From my perspective as CFO, this level of capital expenditure calls for sound and flexible management of the balance sheet. After all, I’m talking about investing $25-30 billion a year in an era of fluctuating revenues and macro-economic volatility.
 
That’s why, for example, we set a target gearing range of 0-30%. And our gearing currently stands at 12%, down from 14% in the first quarter of the year.
 
But, of course, delivering our major projects on-time and on-budget requires more than a sound balance sheet.
 
That’s why another of my priorities has been ensuring that the finance function plays a bigger role in the delivery of our major projects.
 
After all, energy projects can be derailed by more than just technical problems. They can also be undermined by poor management of financial or political risks. Or by a lack of agreement about their main value drivers.
 
Frankly, back in 2004, the role played by Shell’s finance function in delivering our projects was too limited. Finance managers did not always have a seat at the project management table. Their teams had a narrow focus on project accounting and basic financial processes. And they were scattered across the world, without access to standard systems and processes.
 
So we began putting this right about six years ago, developing a cadre of mid-range and senior finance managers to work on our major projects. And we built a central repository of expertise and knowledge for them to draw on.
 
At the same time, we initiated a development programme for finance staff in our projects, drawing on a range of academic and industry expertise. Several hundred staff have since graduated and are now working on our projects. And the programme has been certified as part of a Masters programme by the University of Brisbane. 
 
Most recently, in 2009, we established a dedicated ‘Finance in Projects’ team, as an integral part of Shell’s new Projects and Technology business.
 
The business was set up to assume global responsibility for the delivery of our major projects. And to foster a culture of continuous improvement and technical excellence in project delivery.
 
For the finance function, this has brought several benefits. Most important, finance managers are now firmly embedded in project management teams.
 
They are also taking on a broader range of responsibilities beyond their core financial tasks, including risk management and performance reviews for senior project staff. In short, they now have a bigger say in the strategic direction of our major projects.
 
All of which makes it more likely that our projects are not just impressive feats of engineering, but also create maximum value for the business.
 
Our project delivery record has improved in recent years, with the majority of our major projects now being completed on-time and on-budget.
 
There’s no better example than Pearl GTL.
 
From a financial perspective, the project has presented particular challenges. One is that Shell is the operator of Pearl under a production sharing agreement with Qatar Petroleum. And under these agreements, operators must wait until production has started before they can recover their development and construction costs.
 
And it’s all too easy for those costs to be disallowed if detailed and accurate reports, accounts and requisitions aren’t available to back up every claim. For a project of Pearl’s size, built over a 5 year period, the disallowed costs could potentially run to several billion dollars.

But thanks to the professionalism of Pearl’s finance team, we’ve successfully recovered more than 99% of our costs so far.
 
So that’s one way in which Shell’s finance team is playing a leading role in boosting our cash flow from operations.

Building our long-term portfolio

All of which brings me to a third of Shell’s strategic objectives: building a competitive portfolio of projects for the longer-term.
 
Inevitably, the emerging markets play an increasingly prominent role in our plans.  
 
Although our strategy has explicitly targeted investment in OECD type economies such as North America, Europe and Australia, investment in emerging markets represents around one third of our total investment, almost $10 billion per year.
 
For IOCs like Shell, it will take more than the right portfolio calls to deliver value in these markets. Success also depends on our ability to forge new kinds of strategic partnerships with the national oil companies.
 
That means growing together as equal partners over the long term. And jointly developing our human capabilities across a wide range of fields.  
 
At Shell, we’ve been making strong progress in a number of countries: in Brazil, Qatar and Saudi Arabia, for example.
 
But I’ll focus on our partnerships with China’s NOCs. I’ve been fortunate to play a leading role in their development because I’m accountable for Shell’s business there.
 
In June we signed a strategic alliance agreement with the China National Petroleum Corporation, after several years of growing co-operation. Together, we will pursue mutually beneficial opportunities in China and across the world.
 
But history shows that developing these partnerships is far from straightforward. Even those grounded in relatively modest ambitions can be knocked off course by a lack of shared benefits or by an absence of mutual respect.  
 
So how have we given our partnerships in China firm roots?
 
The first critical step was to identify areas of mutual interest.
 
Chief among them is natural gas. To reduce its dependence on coal, the Chinese government is boosting the share of natural gas in the energy mix. As a result, China’s gas consumption could treble between 2008 and 2015, according to the IEA.
 
To meet this demand, China must draw on all sources of gas production and distribution.
 
This strategy has created opportunities for us. By next year, we expect natural gas to account for around half of our production. And we have been driving the technical advances that have underpinned the shale and tight gas production boom in North America.
 
China’s own tight and shale gas deposits are potentially enormous. On one recent estimate, its shale gas resources could be 50% bigger than those of the US.
 
In tapping them, Petrochina has been keen to draw on Shell’s expertise. An important milestone came in 2005, when we signed a production sharing agreement for Shell to become the operator of the Changbei tight gas field in Shaanxi Province, which supplies gas to Beijing and other cities in Eastern China.
 
We are now working together to appraise and develop shale gas and coal bed methane elsewhere in Shaanxi and in Sichuan.
 
A second important step has been the active engagement of the most senior leaders in Shell and CNPC.
 
This high level involvement helps to ensure that both companies pursue the same goals and priorities throughout their organisations. Every 3 or 4 months the senior leaders of Shell and CNPC meet to discuss progress. In formal terms, the meetings are opportunities to ensure our priorities are aligned and to set new goals.
 
But they have also proved important in fostering trust and enthusiasm for our partnership. We take the opportunity to mark important milestones and celebrate the meeting of targets. For example, in June, Shell’s board met in China for the first time to mark the signing of our co-operation agreement with CNPC.

Having built this mutual respect, we are now taking a third major step in our partnership: developing our shared capabilities across a wide range of fields.
 
For example, together, we’re deepening our understanding of the international energy markets beyond China. Last year Shell and Petrochina – CNPC’s listed arm – completed the joint purchase of Arrow Energy, an Australian gas company based in Queensland. The joint venture plans to convert coal seam gas to LNG, making this abundant gas source exportable to China and other Asian countries.
 
For both sides, it’s been an invaluable experience. After all, this was the first purchase of a public company in a western economy by a Chinese oil company. And, of course, Australia is an especially open economy.
 
One major benefit is that it enabled both sides to work as equal partners in preparing a multi-billion dollar acquisition. And each side came to appreciate the strengths the other brought to the deal.
 
Together, we’ve also satisfied Australia’s legal and regulatory requirements, for example, in obtaining shareholder approval. And in maintaining a clear separation of duties between the employees of Shell and Petrochina on one side and those working for Arrow on the other.
 
And we were delighted over the weekend to see a second deal to acquire Bow Energy in the same play accepted by the Board of the target company and recommended to shareholders.
 
Looking ahead, we will continue to explore and develop hydrocarbons in China and beyond. And meeting China’s gas needs will be a continuing priority.

Conclusion

Let me sum up. There’s no doubt that CFOs in our industry face a tougher time in this decade than the last. Not only is there a backdrop of stronger macro-economic volatility and regulatory uncertainty. We must also deliver on a broader range of fronts than our predecessors. 
 
But all this gives us the chance to make a bigger impact on the performance of our companies. I’ve described the steps taken by Shell’s finance function to create value in our major projects. And some of the ways in which my team and I are sowing the seeds of future growth in China.
 
So I look forward to hearing about some of your thoughts and experiences in meeting our shared challenges.


Thank you.