Preparing for Fundamental Shifts in Energy - BCG · We consider every assignment a ... Changes on...

Preparing for Fundamental Shifts in Energy

Strategies for a Changing Industry

BCG REPORT

Since its founding in 1963, The Boston Consulting Group has focused

on helping clients achieve competitive advantage. Our firm believes

that best practices or benchmarks are rarely enough to create lasting

value and that positive change requires new insight into economics,

markets, and organizational dynamics. We consider every assignment a

unique set of opportunities and constraints for which no standard solu-

tion will be adequate. BCG has 59 offices in 36 countries and serves

companies in all industries and markets. For further information,

please visit our Web site at www.bcg.com.

Preparing for Fundamental Shifts in Energy

Strategies for a Changing Industry

OCTOBER 2005

A Report from the Energy Practice of

www.bcg.com

2 BCG REPORT

© The Boston Consulting Group, Inc. 2005. All rights reserved.

For information or permission to reprint, please contact BCG at:E-mail: [email protected]: +1 617 973 1339, attention BCG/PermissionsMail: BCG/Permissions

The Boston Consulting Group, Inc.Exchange PlaceBoston, MA 02109USA

Preparing for Fundamental Shifts in Energy 3

Table of Contents

Note to the Reader 4

Preface 5

Integrating Value and Risk in Portfolio Strategy for Energy Companies 7Beyond Determinism 8

An Integrated View of Value and Risk 9

Create a Successful Strategy for Refining 13The United States and Europe: Balancing Supply and Demand 15

Asia: Strong Growth and Decreasing Capacity 15

Widening Price Spreads Reflect the Declining Quality of Crude Oil 16

Changes on the Horizon Mean Opportunity and Risk 17

Develop a Winning Global Strategy 19

Stake Out a Winning Position in the Global Gas Market 21Relative Power May Shift in the Atlantic and Pacific Basin Markets 22

The Oil Majors Could Be Threatened as Global LNG Buyers Go Directly to the NOCs for Their Supplies 24

New Energy Policies and Supply Lines Could Have a Geopolitical Impact 25

GTL Production May Put Natural Gas in the European Fuel Tank 25

Stake Out a Place in the Global Gas Market 27

Take Aim to Hit Cost Reduction Targets 29Rising Costs and Public Scrutiny Squeeze Customer Rates 30

Spreads in Operating Costs Demonstrate the Potential for Improvement 31

Targeted Actions Will Improve Cost and Service Levels 31

Target Change for Maximum Improvement 36

This publication is the first in a

series by the Energy practice of The

Boston Consulting Group that will

explore complex issues in the global

energy market. Upcoming publica-

tions will describe other aspects of

the market, such as risk manage-

ment for utilities, strategies for oil

retailing, and information technol-

ogy for energy companies.

The Energy practice helps compa-

nies navigate an increasingly com-

plex business environment. We

work with the full range of players

in the industry: international

energy companies, major oil compa-

nies and utilities, global power

developers and marketers, govern-

ment authorities, and regulatory

bodies. These players are shaping

the future of the industry and help-

ing to define the new rules of the

competitive game in many countries.

I would like to thank the members

of the Energy practice who con-

tributed to this report:

4 BCG REPORT

Note to the ReaderBalu Balagopal, Vice President

and Director, Houston

[email protected]

Marc Benayoun, Vice President

and Director, Paris

[email protected]

Michael J. Finger, Research Analyst,

Houston

[email protected]

Guy Gilliland, Manager, Dallas

[email protected]

Thad Hill, former Vice President

and Director, Dallas

Chris Phelps, Manager, Dallas

[email protected]

J. Puckett, Senior Vice President


[email protected]

Pattabi Seshadri, Vice President


[email protected]

Oliver Steen, Energy Practice Area

Manager, Houston

[email protected]

Brad VanTassel, Vice President

and Director, Houston

[email protected]

Chris Weber, Manager, Houston

[email protected]

I would also like to thank the edito-

rial and production team that

helped to prepare the report: Barry

Adler, Katherine Andrews, Gary

Callahan, Kim Friedman, Sharon

Slodki, and Lynne Smith.

Our practice hopes that you find

the report helpful, and we look for-

ward to discussing it with you.

Rick Peters

Senior Vice President and Director

Global Leader, Energy Practice

Houston

[email protected]

New trends in economics,

geopolitics, industry be-

havior, and technology are

causing fundamental shifts in the

energy landscape. For industry play-

ers, these shifts pose a significant

threat and opportunity at the same

time. Some players will be able to

take advantage of these shifts, but

many others will destroy value for

investors and other stakeholders.

These new competitive forces are

changing the balance of power

between sellers and buyers and

destabilizing established businesses.

Succeeding in this volatile environ-

ment demands fresh insight and cre-

ativity, as well as new capabilities and

new business skills. But change can

be risky when the stakes are high.

Despite the risk, energy companies

must continue to place their bets,

making enormous long-term invest-

ments and necessary short-term

commitments. They must take into

account how change is affecting

other players—for example, allow-

ing national oil companies to flex

their muscles. New technologies,

such as gas-to-liquids and carbon

sequestration, and new regulatory

requirements, affecting such things

as market capacity and carbon diox-

ide limits, are likely to alter tradi-

tional strategic alignments and

decision-making platforms. The

perspectives of external sharehold-

ers, with their shorter time horizons

and different information sources,

must also be taken into account

even as internal company perspec-

tives dictate many decisions.

Players across the value chain—

from those in upstream exploration

and production, to refinery opera-

tions and integrated gas, to power

generation and wholesale market-

ing, to wires and pipes, and ulti-

mately to customer retail—must

stake out their positions in the

energy industry arena. But this is

easier said than done.

In our view, energy company execu-

tives who focus on the new industry

realities and take steps to manage

risk will position their companies

for success, even with price uncer-

tainty, geopolitical change, and new

supply-and-demand structures.

In this report, we focus on four

areas that deserve the attention of

senior management in decision-

making positions: the importance of

an integrated value and risk portfo-

lio strategy, shifts in the oil refining

market, the increasingly complex

liquid natural gas (LNG) market,

and cost reduction imperatives for

utilities. The following is a short

summary of the four articles that

discuss these critical areas.

Integrating Value and Risk in

Portfolio Strategy for Energy

Companies. Risk and uncertainty

are inherent to any corporate port-

folio. To optimize value creation for

shareholders, energy companies

must acknowledge that value and

risk are intertwined. Portfolio

strategies that integrate value and

risk require sophisticated analysis

and tools, not just deterministic or

“single point” estimates.

Create a Successful Strategy for

Refining. Several factors have re-

cently come together to create

higher refining margins, and they

are likely to extend the profitability

cycle over the next few years.

Tempted by this favorable margin

environment, refiners may overin-

vest, resulting in a capacity over-

hang. Creating a successful global

strategy for refining is tricky be-

cause the issues and opportunities

differ by geographic region.

Stake Out a Winning Position in the

Global Gas Market. In the next few

years, global forces and shifts in

demand will affect gas markets to an

unprecedented degree. Oil majors,

national oil companies, and utilities

must stake out their places in this

increasingly global market, taking

into account new competitive and

geopolitical factors. This article

explores the opportunities and

threats that are emerging as a result

of these new forces.

Take Aim to Hit Cost Reduction

Targets. Rising costs and growing

public scrutiny are putting the

squeeze on customer rates for U.S.

utilities. To maximize gains in oper-

ating efficiency, utility executives

must target areas for improvement

based on a detailed analysis of

industry benchmarks and their

company’s specific needs.


Preface

New competitive forcesare changing

the balance of powerbetween sellers

and buyers.

6 BCG REPORT


Integrating Value and Risk in Portfolio Strategyfor Energy Companies

Balu BalagopalGuy Gilliland

8 BCG REPORT

Risk and uncertainty are

inherent to any corporateportfolio. Just as the potential

for value creation varies across a set ofbusinesses, so too does risk and itslikely impact. Good portfolio strategyrequires senior executives to assessnot only differences in potential valueamong assets and their strategic fitbut also the inevitable uncertaintiesand risks associated with that value.

The idea that there is a relationbetween risk and returns has been acornerstone of modern portfolio the-ory for more than 50 years. It has had aprofound impact on the way investorsand financial institutions manage valueand risk in a portfolio of financialassets. And yet, with relatively fewexceptions, the concept has not af-fected the way companies manage thereal assets of the corporate portfolio.

To be fair, energy companies do bet-ter than companies in many otherindustry sectors. Energy marketingand trading businesses, for example,have adapted many of the tools andmetrics from the financial world tointegrate value and risk management.While such adaptations have beenapplied mostly to liquid markets forenergy commodities, a few have alsoextended the approach to illiquidmarkets. And upstream energy busi-nesses, long used to dealing withuncertainty, have historically factoredin probabilities when assessing value.

Nevertheless, many energy companiescontinue to ignore uncertainty andrisk: they calculate single-point esti-mates of the likely value of each oftheir businesses, despite significantuncertainties associated with theunderlying value drivers and cashflows. Others treat risk more or lessintuitively: they develop a few scenar-ios (worst case, best case, and base

case) to bound the range of out-comes. Still others quantify bothdownside and upside uncertainty, butonly for a few assets or in the contextof just a few decisions. A few treat riskassessment largely as a functionalresponsibility—to be handled by thefinance department, perhaps—butonly after the portfolio strategy hasbeen set. It’s the rare company thatintegrates a rigorous assessment of

uncertainty and risk into the veryprocess of setting portfolio strategy.

Companies that fail to integrate valueand risk in portfolio strategy are miss-ing a big opportunity. Our experiencesuggests that many of the techniquesand metrics used to assess and man-age risk in financial assets can, withsome adaptation, be applied to realassets across a wide range of indus-tries. Doing so, however, requiresassessing the value of the corporateportfolio in a probabilistic, not adeterministic, fashion. It also requiresa well-defined, systematic process toidentify and quantify the mainsources of risk, as well as the interac-tions and offsets that determine thevariability of the portfolio as a whole.The result is a far more comprehen-sive and realistic approach—one thatcan fundamentally transform howsenior executives manage the corpo-rate portfolio.

Beyond Determinism

Many companies have a clear pictureof the main factors that drive value in

each of their businesses. The startingpoint for the integrated approach isto enrich that picture by developing adetailed understanding of the degreeto which each of those drivers and theresulting cash flows are uncertain,reflecting underlying risks.

Why is it that more companies do notconsistently do this? Often, man-agers’ initial response is that it isimpossible to reliably quantify theuncertainty affecting many key valuedrivers. They’re wrong. In recentyears, a number of organizations—incontexts as varied as military combat,Coast Guard search-and-rescue mis-sions, and oil exploration—havedeveloped creative approaches to esti-mating and quantifying uncertainty.These techniques can be applied toalmost any industry.

For example, expert opinion can pro-vide good estimates of, say, the rangesof prospective success rates for oiland gas exploration in a particulararea or the technical feasibility of var-ious new gas-to-liquids technologies.Projections from historical data canhelp estimate variables such as thecost of leases in the Gulf of Mexico orthe historical success rate for drillingcommercial wells in the North Sea.Group opinion can be a surprisinglyeffective way to calculate hard-to-esti-mate factors such as the potential dis-tribution range for exploratory re-serves in an offshore oil field, the costof pipeline infrastructure connectingproducing wells, or the likely compet-itive response to building a newpower plant or refinery.1 Finally, cer-

Integrating Value and Risk in Portfolio Strategy

for Energy Companies

1. Group opinion is often dismissed as inaccurate andunreliable. However, recent research suggests thatappropriately structured and analyzed group opinioncan yield better results than even expert opinion. SeeJames Surowiecki, The Wisdom of Crowds: Why the ManyAre Smarter Than the Few and How Collective WisdomShapes Business, Economies, Societies, and Nations(Doubleday, 2004).

Many companies ignoreuncertainty and risk,

and calculate single-pointestimates of likely value.

tain physical and logical limits willdetermine factors like the maximumproduction rate from a well-knowngeological reservoir or the maximumefficiency of a particular refineryprocess.

Given adequate care in targeting mul-tiple sources of data—and in aggre-gating those data through a variety ofcomplementary approaches (forexample, simple weighted averages,Bayesian inferences, and nonlinearregressions)—it is possible to arrive atreasonable bottom-up estimates forwhat are often highly uncertainparameters.

Once a company has quantified thedrivers of uncertainty affecting anasset or initiative, it is in a position toexpress the likely financial value cre-ated not as a single-point estimate butas a distribution of possible outcomes.Modern statistical techniques, such asMonte Carlo analysis, then make itpossible to calculate and express tra-ditional value metrics, such as netpresent value (NPV), as probabilisticdistributions. They also allow man-agers to quantify value and risk simul-taneously using metrics that expressthe risk-return tradeoffs faced byinvestors and the extent of the vari-ability associated with differentdesired or expected outcomes. Forexample, value at risk (VAR), a meas-ure of the likely distribution of valuein a business, is a good indicator ofdownside risk. Return on value at risk(ROVAR), which is the ratio of NPVto VAR, is a normalized measure ofthe value generated by a business rel-ative to the downside risk. And simplestandard deviations represent overallvariability—on the upside as well asthe downside.

But it’s not enough to estimate thevalue and risk for each stream of cashflow and then simply add themtogether. Often there are systemicconnections across the portfolio—forexample, ways in which the risks inone area correlate to or offset the risks

in another. Commodity prices are per-haps the simplest of these linkages: anoil and gas company with assets in var-ious parts of the world will have corre-lated risk and value creation acrossthis diverse set of assets. The correla-tions stem from the linked uncertaintyin the prices of various commoditiesaround the world. Any realistic portfo-lio assessment must factor in thesecorrelations. For example, a global

multicommodity player must factor incorrelations between various crudeprices around the world, betweenbasis spreads at various gas-liquidityhubs, between commodities such asgas and oil as well as crack and sparkspreads, and so on. Unless a companyunderstands these correlations, it cansignificantly misjudge the degree ofrisk in its portfolio.

These correlations can also be esti-mated and analyzed. The most rele-vant linkages will vary depending onthe specific business situation. Insome cases, reliable historical orempirical data will make the task ofestimating portfolio correlations eas-ier. But as with the case of estimatinguncertainty, the absence of readilyavailable data should not be a reasonto ignore critical correlative effectsand portfolio linkages. Many tech-niques exist to estimate them. Whensuch linkages are well understood,the resulting view of the valuecreation potential and risks of theentire portfolio is likely to be farmore realistic.

An Integrated View of Valueand Risk

An integrated approach to value andrisk can yield critical insights. For

example, one company discoveredto its surprise that a key operationalmetric it was using to inform itsearnings guidance for Wall Streetanalysts had only a 30 percent prob-ability of being achieved by the port-folio as a whole. When the companybecame aware of just how uncertainits estimates were, it revised itsapproach.

Another company discovered thatthe newest growth projects in itsportfolio had a much poorer risk-return profile than its other initia-tives. If the company continued to pursue those new projects, theresult would be an increase in theoverall portfolio’s value at risk from10 percent of enterprise value to 30percent. Although such an increaseis not right or wrong per se, the in-formation forced a reexaminationof the underlying strategy. Becausethe likely incremental value creationfrom the newer elements in the port-folio was not commensurate with theincremental risks, the companydecided to reshape its portfolioby delaying some of the longer-term,riskier investments and putting ahigher priority on investments with more attractive risk-returnprofiles.

The goal is to construct an inte-grated view of the entire portfolio interms of value and risk. This perspec-tive allows a company to comparediverse assets and businesses on aconsistent risk-reward basis and canbe a powerful tool for driving deci-sions about capital and otherresource allocation, growth initia-tives, new-product development, andmergers and acquisitions.

The risk-return profile of a majorenergy company, depicted in theexhibit “One Company’s IntegratedView of Value and Risk,” on page 10,illustrates the value of this integratedapproach. Each square representsone of the company’s existing busi-ness units; each dot represents a

An integrated view ofvalue and risk allowscompanies to compare

diverse assets and makebetter decisions.


future investment option. The solidtriangle A represents the risk-returnprofile of the existing portfolio; thethree clear triangles B, C, and D rep-resent alternative combinations ofexisting business units and futureinvestment options.2

As the exhibit suggests, the variousportfolio elements differ greatly, notonly in their expected returns butalso in the risks associated withachieving those returns. For exam-ple, the investment options labeled 1 and 2 provide fundamentally moreattractive risk-return tradeoffs thando options 3 and 4. Furthermore,

option 4 has substantially higher relative risk than 3 without offer-ing a commensurate increase inreturn potential. So options 3 and 4 will need to have other com-pelling rationales (related to thestrategic or diversification goals ofthe portfolio) in order to be cred-ible alternatives to 1 and 2. Similarobservations can be made about the individual businesses and their relative risk-return profiles.

At the portfolio level, the exhibitshows that the company’s existingportfolio, A, is at the conservativeend of the risk spectrum in relationto the alternative portfolios. Clearlythe company could increase itsreturns by taking on more risk. Forexample, portfolio option B has thepotential to boost average annualreturns significantly. But the added

risk of this portfolio is also substan-tial. Options C and D, by contrast,vastly increase the risk relative to A orB without bringing commensurateincreases in returns. Again, absentsome other compelling strategiclogic, a move to C or D would be dif-ficult to justify. However, in theabsence of such an integrated value-and-risk perspective, executives mightwell think C is the most attractiveoption (because it has the highestpotential return).

Of course, an integrated view of the portfolio, by itself, cannot tella senior management team every-thing about the choices it shouldmake. Executives also need toconsider the strategic fit amongassets, the appetite of the company’sinvestors for both risk and returns,and other factors relevant to the

10 BCG REPORT

2. Of course, another important dimension is theabsolute size of each investment option, business,and portfolio. For the purposes of this discussion,we have chosen not to include the size dimension inthe exhibit, but it is a critical input to any portfolioanalysis.

0

5

10

15

20

25

1.0 2.0 3.0 4.0 5.0 6.0

Returns1

(%)

Business unit Investment option Existing portfolio Portfolio option

2

3 4

B

C

D

A

1

Risk2

One Company’s Integrated View of Value and Risk

SOURCE: BCG analysis.1Ten-year average annual total-business return.2Expressed as a measure of normalized risk: the ratio of value at risk (VAR) to net present value (NPV).

specific situation. However, in ourexperience, the ability to array acomplex set of options on a consis-tent, quantified risk-return matrixserves as a powerful catalyst for theright senior-management debates:Do the large uncertainties and risksof pursuing certain growth initia-tives outweigh the attractiveness oftheir potential for value creation?Are initiatives that have compellingrisk-return tradeoffs getting ap-propriate priority over those thatdon’t? Given knowledge of the spe-cific drivers, what can be done toreduce uncertainty and mitigate therisk of otherwise attractive options?Is the risk tolerance of the com-pany’s board of directors and share-

holders consistent with theirdemands, targets, and recom-mended pathways for value creationand growth? What portfolio-shapingmoves are necessary to hit the “sweetspot” of value creation and risk forthe company?

* * *

The integrated approach to portfo-lio strategy creates a common lan-guage that allows senior executivesto make value-and-risk comparisonsacross diverse businesses a standardpart of portfolio management. Itallows them to confront and managekey tradeoffs across the portfolio,make better-informed decisions,


have a critical dialogue about risks,and take action to mitigate them.That is why integrating value andrisk is likely to become the next wavein modern corporate portfolio strat-egy—for companies in the energysector and beyond.

Balu BalagopalGuy Gilliland

Balu Balagopal is a vice president anddirector in the Houston office of TheBoston Consulting Group. Guy Gillilandis a manager in the firm’s Dallas office.

You may contact the authors by e-mail at:

[email protected]

[email protected]

12 BCG REPORT


Create a Successful

Strategy for Refining

Brad VanTasselOliver Steen

14 BCG REPORT

PROFIT MARGINS FOR REFINERIES

have exhibited great volatilityand high overall levels in recent

years in all three global refiningregions: the United States, Europe,and Asia. (See Exhibit 1.) Meanwhile,crude oil prices recently hit all-timehighs of $65 per barrel and more.Much has been made of this pricesurge because it clearly affects worldeconomic growth. However, this over-reported and overanalyzed increase isnot the only structural change drivingrefining margins.

Indeed, several factors have cometogether to generate the higher mar-gins and, in all likelihood, to extendthe profitability cycle over the nextfew years. Strong demand growth andincreasingly stringent product specifi-cations are driving up prices. At the

same time, high utilization and thedeclining quality of crude oil are caus-ing price spreads to widen betweenthe more desirable light grades ofcrude, which are low in metals andsulfur and which flow easily, and theless desirable heavy grades, which arehigher in metals and sulfur and mustbe heated to become fluid. The pricespread is also increasing between“sweet” crudes, which are low in mal-odorous sulfur compounds, and“sour” crudes, which contain high lev-els of such compounds. These grow-ing differentials are boosting the prof-itability of refiners that have thecapacity for upgrading to handle agreater quantity of heavy and sourproducts.

Although these factors have con-verged to create ideal conditions for

refining profitability, the delicate bal-ance in each region is demonstratedby the high volatility of refining mar-gins. Tempted by the high margins,refiners may overinvest, creating acapacity overhang.

Developing a successful global refin-ing strategy is tricky because theissues and opportunities differ byregion. Moreover, the industry hasdemonstrated a herd mentality foroverinvesting in times of high prof-itability. This investment behavior hasled to a boom-or-bust cycle that hasplagued the industry for the last 20years. Given the current high levels ofprofitability in refining, how shouldcompanies shape their strategy?While companies must take sometime to conduct a rigorous analysis ofeach region, once the analysis is com-

Create a Successful Strategy for Refining

Net cash margin ($/barrel)

–4

–2

0

2

4

6

8

10

Northwest Europe Singapore

January 1, 1995 January 1, 1997 January 1, 1999 January 1, 2001 January 1, 2003 January 1, 2005

U.S. Gulf Coast

EXHIBIT 1

Refinery Margins Are High—but Volatile

SOURCE: Oil Price Information Service.

plete, they must take rapid action togain a first-mover advantage andavoid overinvestment.

In this article, we analyze the forces atwork in the global industry and raisequestions about how refining compa-nies should position themselves tocompete successfully in this environ-ment. Refining is a multiregional busi-ness linked by cross-continent flows;thus, understanding the issues andopportunities by region is critical todeveloping successful global strategies.An analysis of each region establishesthe context for the strategy discussion.

The United States and Europe:Balancing Supply and Demand

As demand for oil products has con-tinued to increase, expansion of exist-ing capacity, or “debottlenecking,”has not kept pace in the UnitedStates. High capacity utilization andincreased imports of light crude oilare required in order to meetdemand. This tight supply-and-demand situation will worsen whenthe gasoline sulfur specifications that

will be implemented in 2006 decreasegasoline imports to the East Coast byan estimated 240,000 barrels per day.(See Exhibit 2.)

Europe is in a similar position when itcomes to capacity utilization and

changing specifications, but the con-straining product is diesel. At thesame time, refiners in the region aremaximizing distillate production andgenerating an excess supply of gaso-line. This imbalance is driving a sig-nificant increase in global trade flowsfor refined products and blend stocks.

Imports from Russia and CentralEurope are helping to fill the WesternEuropean diesel supply gap. Russianrefiners are increasingly shippingmiddle distillates to Western Europebecause of low demand in Russia,overcapacity in Russia’s refining sec-tor, and growing crude-oil produc-

tion. Crude oil exports from Russiahave increased by more than 60 per-cent over the past five years, from 3million barrels per day to 5 million.

In turn, Europe ships its excess gaso-line across the Atlantic to the UnitedStates, traditionally to New YorkHarbor but now to the entire EastCoast. These imports increased from100,000 barrels per day in 2000 to anaverage of more than 250,000 per dayin 2004. In fact, these imports haveerased the traditional 75-cent-per-barrel differential between New YorkHarbor and Houston.

The recent proliferation of U.S. gaso-line specifications makes it difficultfor importers to move large cargoesof finished products. Thus, shipmentsof unfinished blending componentshave also skyrocketed, driving ship-ping rates to record highs.

Asia: Strong Growth andDecreasing Capacity

The most dramatic change indemand and refining profitability has


Total East Coast imports:830,000 barrels per day

240,000

251,000

Finished gasoline imports:491,000 barrels per day

Unlikely to meet 2006 specifications

• Argentina• Brazil• Italy• Russia• Saudi Arabia

Capable of meeting specifications

• Northwest Europe

Components40%

Finished gasoline60%

EXHIBIT 2

U.S. Sulfur Specifications Could Cut East Coast Gasoline Imports by Nearly Half

SOURCE: BCG analysis.

NOTE: Import figures are for 2003 and are estimates.

Companies must gaina first-mover advantage

and avoidoverinvestment.

occurred in Asia as economies therehave recovered from the financial cri-sis of the late 1990s. The recovery hasresulted in strong demand for allrefined products, especially gasolinein China. Strong economic growthin China, a SARS-related declinein the use of public transportation,and an increase in the availability ofsmall, inexpensive cars have pro-duced double-digit growth in gasolinedemand.

Asia’s poor refining margins from1998 to 2002 caused the closing ofmany small and inefficient refineriesin the region. Japan, for example, hasshut down 300,000 barrels per day ofcapacity over the past few years. Theoil majors, especially ExxonMobil andShell, have rationalized capacity inthe region to decrease exposure tothe Asian market and to avoid majorcapital investments needed in orderto comply with new product speci-fications. This combination of strong demand growth and de-creasing capacity has transformedthe Asian refining industry from abusiness struggling to break even intoone that is enjoying record refiningmargins.

Widening Price SpreadsReflect the Declining Qualityof Crude Oil

Widening price differentials betweenlight and heavy and sweet and sourcrude have significantly increasedrefining margins worldwide, especiallyfor refineries with heavy upgradingcapacity such as that required for cok-ing. Over the past three years, growingdemand for light, sweet crude has out-paced supply, and heavy, sour crudehas made up the supply gap. (SeeExhibits 3 and 4.)

In North America, significant quanti-ties of the heavy Mexican andVenezuelan crude have come on themarket to meet the growing demand.To sell these heavy crudes, Pemex and

16 BCG REPORT

Sweet

Heavysour

Light/mediumsour

63%16%

19%

2%

High acid(sweet)

Quality of crude by type

Sulfur(%)

Sweet

Sour

0

0.5

1

1.5

2

2.5

3

3.5

API gravitya

1980

2000

1990

2010b

LightHeavy

Maya

Arab Heavy

Arab Medium

Venezuela Medium

West Texas Intermediate

Tapis GippslandCabinda

BonnieLight

Minas

AlaskaNorth Slope

Iran LightUrals

West Texas Sour

Arab Light

MarsDubai

Iran Heavy

Average globalcrude slate

20 25 30 35 40 45 50

Quality of proven oil reserves, 2005

EXHIBIT 3

Global Crude Oil Slate Is Becoming Heavier and Sourer

SOURCES: Simmons & Company International; Oil & Gas Journal; BCG analysis. aAPI gravity is a measure set by the American Petroleum Institute that is one of the main quality indicators for pricing crude

oil. The higher the API gravity, the lighter the crude.bQuality for 2010 is an estimate.

PDVSA, respectively Mexico’s andVenezuela’s state-owned national oilcompanies, structured supply agree-ments that encourage refiners toinvest in upgrading facilities. How-ever, high capacity utilization at NorthAmerican refineries has inevitablyresulted in an increased use of simpleconfigurations that produce largequantities of heavy, sour fuel oil. Once demands for refinery upgrad-ing, boiler fuel, and bunkering aremet, excess fuel oil will competeagainst coal in the Mediterra-nean and Eastern Europe, pushingdown the prices of fuel oil and heavycrude oil.

In Asia, the price spreads betweensweet and sour crude oil have alsowidened substantially in recent years.As the production of light, sweetcrude has declined, Australia and

China have become major importersof West African crude to meet gaso-line and diesel sulfur specifications.China is now satisfying more than 30percent of its demand with imports ofcrude from West Africa, pushing thedifferential between the light andsweet Tapis crude and the heavier,sourer Dubai crude from the tradi-tional level of $2 to $3 per barrel toapproximately $10.

Changes on the HorizonMean Opportunity and Risk

Although the refining industry isbooming right now, several factors onthe horizon could destabilize it,increase volatility, and create bothopportunity and risk for industry par-ticipants. Three important globaltrends are accelerating:

• more stringent fuel specifications

• degradation of crude oil quality

• high capacity utilization

These three trends work in favor ofthe refining industry, but if high mar-gins continue, the industry may over-invest. Each region has issues andopportunities that companies shouldconsider in order to shape strategy.

In the United States, the declining

quality of crude oil and stringent

new fuel specifications will likely

keep capacity utilization high. De-mand for refined products has con-tinued to grow over the last few years.In fact, demand is reaching levels notseen since the late 1970s. While indus-trywide debottlenecking has allowed“capacity creep” of 2 to 3 percent peryear, new capacity expansions needed


Tapis/Dubai Brent/Dubai West Texas Intermediate/West Texas Sour

0

2

4

6

8

10

1999 2000 2001 2002 2003 2004

$/barrel

EXHIBIT 4

Crude Oil Price Differentials Are Widening

SOURCE: Oil Price Information Service.

to meet growing demand will be slow,since it is difficult to obtain permits inmost parts of the country. The declin-ing quality of crude and the new fuelspecifications will likely keep utiliza-tion rates above 90 percent and thebalance of supply and demand tight.

The quality of crude continues to fallas the decline in West Texas produc-tion is replaced by heavier, sourer bar-rels from Mexico and Venezuela. Thischange, coupled with high utilization,is increasing worldwide production ofheavy, sour fuel oil and driving widerdifferentials between light and heavyand sweet and sour crude. Thesetrends appear likely to continue forthe next few years.

Fuel specifications will keep utiliza-tion high in several ways. First, stateand federal environmental regula-tions for reduced-sulfur gasoline anddiesel have required major invest-ments across the industry. Imple-mentation of these specifications in2006 will curtail gasoline imports, fur-ther tightening the balance betweensupply and demand. Gasoline cur-rently coming from Russia, theMediterranean, Saudi Arabia, andSouth America will not meet the newU.S. specifications. This gap hasimplications for Europe, too, becausemany of these exporters are also distil-late suppliers to northwest Europe.

Second, the gasoline supply may begreatly reduced by the potentialremoval of MTBE, a chemical com-pound that has been used to replacelead as an octane enhancer.California has already banned MTBE,and many states are evaluating itsremoval to avoid groundwater con-tamination. MTBE currently repre-sents 6 to 8 percent of the gasolinepool, and its removal will also make itharder for refiners to meet the newsulfur specifications.

Third, the continued proliferation ofstate-by-state gasoline specificationsmakes distribution more difficult for

pipelines because smaller batchesresult in scheduling problems and anincrease in the quantity of transmix.Importers also find it hard to shipmultiple grades of gasoline. As aresult, imports of gasoline compo-nents have grown substantially. Thecombination of these gasoline-relatedchanges will keep supply and demandtight and continue to put upwardpressure on refining margins.

The wild card for U.S. supply anddemand is automobile fuel efficiency.Will the government increase theCAFE (corporate average fuel econ-omy) standards—which set fuel con-sumption levels for new cars and lighttrucks? An increase in CAFE wouldreduce demand for high-pricedimported crude oil and ease thestrain on the domestic refining indus-try. U.S. fuel economy is only 21 milesper gallon, compared with Europe’s43 miles per gallon. Even modestincreases in fuel efficiency could havea major impact on the U.S. balance ofsupply and demand, although it takessix to seven years for the U.S. fleet toturn over and for efficiency gains toaffect demand significantly. There-fore, the outlook for U.S. demand iscontinued tightness.

In Europe, new supply sources,

changing fuel specifications, tax

incentives, and the declining quality

of crude may actually decrease

refinery utilization. Like the UnitedStates, Europe has been experiencinghigh refinery utilization, but theissues that influence the region aredifferent.

In terms of supply, several newsources of exports to Europe of crudeand refined products appear likely.Russia is increasing its production in

the Urals as well as expanding itspipeline and terminal capacity.Expansions of the Druzhba pipelineand of terminals at Primorsk andMurmansk will provide more crudeand refined products for Europe.

In addition, diesel supply may beaffected by gas-to-liquids (GTL)plants quickly being developed inQatar and other parts of the MiddleEast. These plants would export low-sulfur diesel to Europe, helpingresolve the product imbalance thereand decreasing the supply of excessgasoline currently being exported tothe United States. In Qatar alone, sixGTL projects are in various stages ofplanning and development. Althoughthere is substantial uncertainty aboutthe number and timing of theannounced projects, a new supply ofup to 500,000 barrels per day of dieselcould be headed to Europe and theUnited States if all six were built.

Additional supply may also come fromseveral Middle Eastern countries thatare rumored to be building largeexport refineries to supply Europe. Aswith the GTL projects, the number,size, and timing of these refineries areuncertain, but large additions tocapacity could diminish the profitabil-ity of European refineries.

In terms of changing fuel specifica-tions, Europe, like the United States,is implementing more stringent rulesfor sulfur in gasoline and diesel prod-ucts. These specifications, required bynew European Union legislation, willreduce refinery output and requiremajor investments to upgrade re-fineries.

Changes in European tax policycould make gasoline more attractivecompared with diesel and helpresolve the product imbalance in theregion. Politicians in Germany arecurrently considering a tax increaseon diesel sales that could start a move-ment across the EU to change fuelincentives.

18 BCG REPORT

The best strategy may beto make modest

capital investments and increase

trading capability.

The last issue, the quality of crude, ischanging in two ways that will nega-tively affect refiners. The decliningproduction of light, sweet North Seacrude is being offset by the produc-tion of heavier, sourer Russian crudeas well as ultralight crude fromAlgeria. The availability of the Algeriancrude, coupled with naphtha produc-tion from GTL plants, will ensure anabundant supply of petrochemicalfeedstock. But the increasing produc-tion of heavy, sour crude will make itharder for refiners to meet changinggasoline and diesel specifications.

In Asia, surging demand, new fuel

specifications, and the declining

quality of crude could lead to tight

supply—or overbuilding. Asian refin-ing margins have grown from nil to $6 to $8 per barrel in the last threeyears. This increase has been drivenby capacity rationalization and stronggrowth in gasoline demand in China.Continued growth, even at modestlevels, would keep Asian refiningtight; however, today’s high marginsmay encourage another overbuildingcycle. If China builds a refinery capa-ble of handling 400,000 to 500,000barrels per day, the region will be backto the low profitability of 1998 to 2002.

As in the other regions, most coun-tries in Asia are changing their fuelspecifications. Refiners can meet thenew specifications either by upgrad-ing their refineries or by reducingtheir output of these fuels.

Asia’s production of indigenous light,sweet crude is rapidly declining, andmany refineries in the region haveresorted to importing West Africancrudes to meet sulfur specificationsfor gasoline and diesel. These importsand the lack of capacity to processsour products have pushed theTapis/Dubai differential to about $10per barrel. Price spreads of this mag-nitude greatly increase the profitabil-ity of refineries with the capacity toprocess sour products and couldtempt Asian refiners to overbuild.

Develop a Winning GlobalStrategy

Given the attractiveness of today’senvironment and the structural issuesand uncertainties in each region, thetwo key strategic questions facing allrefiners involve investment in newcapacity: how much and where? Theoptimal strategy depends heavily, ofcourse, on the view of the future.Careful analysis of the trends using anevaluation of alternative scenariosmay be the best approach to strategydevelopment.

In each region—the United States,Europe, and Asia––industry condi-tions currently support new invest-ments. However, each region also hasuncertainties that could change theprofitability picture quickly. Likeother capital-intensive, cyclical busi-nesses, refining profitability follows aboom-and-bust cycle as overbuildingcreates excess capacity for many years. Clearly, first movers will have an advantage, and companies thattake bold action early will reap thebenefits.

Given the increase of heavy crude inthe Atlantic Basin, there may beanother round of deals with nationaloil companies that will reduce the riskof major coking investments.Although upgrading a refinery whileexpanding capacity and shifting yieldto produce more light crude productsis attractive, this approach will beexpensive and risky without making adeal with a national oil company for asupply of crude.

The U.S. environmental laws and per-mitting process will make it difficultto expand capacity in the lower 48states. Should new capacity or majorexpansion be planned for Caribbeanexport refineries? Europe is in a simi-lar situation, so should the oil majorscreate joint ventures in the MiddleEast to move products to the UnitedStates and northwest Europe?

Asia has several opportunities but alsomajor uncertainties. How long willthe price spread between sweet andsour crude last in Asia, and how muchcapacity will it take to move theTapis/Dubai spread back to tradi-tional levels? Will China overbuild toserve its booming gasoline and petro-chemical demand? If so, will this newcapacity send profitability tumbling inthe region?

The volatility described here will con-tinue, so the best strategy may be tomake modest capital investments andincrease trading capability to takeadvantage of cross-continent arbi-trage and infrastructure tightness.Using detailed market knowledge andindustry supply capability may be asuccessful, capital-light strategy.

To create a winning strategy for refin-ing, companies must understandglobal interdependencies, develop aclear perspective for each region, andseize a first-mover advantage.

Brad VanTasselOliver Steen

Brad VanTassel is a vice president anddirector, and Oliver Steen a practice areamanager, in the Houston office of TheBoston Consulting Group.


[email protected]

[email protected]


20 BCG REPORT


Stake Out a Winning Positionin the Global Gas Market

Marc BenayounThad Hill

Rick PetersChris Phelps

22 BCG REPORT

The last several years have

been a time of intense changein the global energy business.

Markets have been roiled by shifts inthe global economy, changes inregional supply and demand, geopo-litical uncertainty, and competitivedynamics. Players across all segmentsof the value chain—major oil compa-nies, utilities, gas suppliers, andnational oil companies (NOCs)—must consider these factors as theymake strategic business decisions.

The fast-growing economies of Chinaand India and the economic recover-ies in the industrialized world havedriven up oil demand. Production hasstruggled to keep up. Many of themajor producing regions, includingthe Middle East, Venezuela, and theformer Soviet Union, have been subject to political uncertainty. Theresult has been a steep increase in oil prices that threatens the global economy.

At the same time, demand for lique-fied natural gas (LNG) has beengrowing dramatically. An enormousnumber of new LNG projects andcontracts have been announcedaround the globe. Not surprisingly,global LNG prices have increased intandem with oil prices. In the UnitedStates, LNG price increases are theresult of a shift in the fundamentals:modest but continuing growth in con-sumption, declining North Americanproduction, and an increasinglystrained gas-delivery infrastructure.The U.S. and global price increasesand the relative decline in LNG tech-nology costs over the last decade havecaused the major oil companies andthe NOCs to focus on monetizingtheir gas reserves. Several of themajors have launched integrated gasbusiness units, and the NOCs haveawakened to the value of their gasresources.

In the midst of all this activity, thecompetitive dynamics of the LNGbusiness are evolving rapidly. Severalemerging trends in worldwide gasmarkets will set the stage for competi-tion, create new opportunities andthreats, and even affect global poli-tics. In this article, we explore four ofthese emerging trends:

• Relative power may shift in theAtlantic and Pacific Basin markets

• The oil majors could be threatenedas global LNG buyers go directly tothe NOCs for their supplies

• New energy policies and supplylines could have a geopoliticalimpact

• Gas-to-liquids (GTL) productionmay put natural gas in theEuropean fuel tank

Relative Power May Shift inthe Atlantic and Pacific BasinMarkets

All energy markets are regionalbecause they are defined by trans-portation constraints and regulatoryregimes. For LNG, there are two dis-tinct regional markets: the AtlanticBasin and the Pacific Basin. Each isevolving with its own supply-and-demand fundamentals, asset bottle-necks, pricing mechanisms, and play-ers. As companies consider theirability to compete in these markets,they must take these dynamics intoaccount.

In the recent past, access to regasifica-tion terminals was the major bottle-neck to exploiting the potential ofLNG. In the last decade, second-waveLNG pioneers British Gas and El Pasobuilt strategies based on control ofthose terminals. Such control allowedthese companies to capture attractive

margins because gas producersupstream had to pay “tolls” to gothrough the bottlenecks to reachtheir utility customers downstream.However, as market conditions havechanged, the asset bottlenecks haveshifted in both the Atlantic andPacific basins.

In the Atlantic Basin, upstream sup-

pliers have begun driving LNG proj-

ect terms, even though well-posi-

tioned downstream utility players

still have bargaining power. Thestrength in the Atlantic Basin hasshifted upstream and away from theintermediaries that controlled theregasification terminals. Many pro-ducers—especially the oil majors,with their strong balance sheets andaccess to gas reserves—have decidedto go directly to the U.S. Gulf Coastwith their LNG supplies. (See Exhibit1.) A number of reasons explain thisshift: the attractive long-term HenryHub price index, which sets the pricefor gas futures traded on the NewYork Mercantile Exchange; the trad-ing liquidity of the gas market; theability to locate a terminal on the U.S.Gulf Coast with relatively few local orregional objections; and the rapidgrowth in LNG demand driven by declining production rates in traditional North American produc-ing areas.

The advantage of landing gas in otherlocations with potentially more attrac-tive basis spreads, such as northernEurope or the East or West Coast ofthe United States, has been somewhateroded by difficulties in locating ter-minals, the need for offtake agree-ments to win approval for projects inwhich liquidity is less robust, andcredit issues with potential buyers.The Gulf Coast has become the desti-nation of choice, with the netbackprice to Henry Hub effectively actingas a price floor for all gas sold into the

Stake Out a Winning Position in the Global Gas Market

Atlantic Basin—and even for someMiddle Eastern LNG that could reachinto either the Atlantic or the PacificBasin. LNG will certainly go to desti-nations beyond the Gulf Coast—butLNG economics in the Gulf Coasthave become the yardstick by whichall other projects will be measured.Some market participants, however,may be willing to accept even lowerprices in order to stake out positionsin a strategic market (such asEurope).

Despite the shift in market power toupstream gas supply in the AtlanticBasin, downstream players still haveclout in areas where utilities havestrong credit ratings and significant“contestable” gas demand—in otherwords, demand that is not alreadyunder contract. These downstreamcompanies, which include some ofthe strong eastern and southern U.S.utilities and the European incumbentutilities, can take advantage of theirsizable demand and strong credit tomake themselves very attractive coun-terparties for LNG suppliers.

In the Pacific Basin, power residesfirmly with downstream utility buy-ers, but there is a possibility offuture shifts if demand exceedssupply. The Pacific Basin is unlike theAtlantic Basin in a number of respects.First, it has no market that is the equiv-alent of Henry Hub, which sets a pricefloor. Second, gas markets are illiquid(with the possible exception of partsof the West Coast of North America—although liquidity even there is lim-ited). The growth in LNG demand,although strong in a few developingmarkets such as China and India, isbroadly driven by economic growth,not by production decline, and the setof LNG buyers with significant con-testable demand is fairly concen-trated. Finally, in the near term atleast, there are more LNG projects indevelopment than there are gas con-tracts, which are required in order towin approval for those projects.


Announcements of regasification terminal capacity in the U.S. Atlantic Basin, 2000–2004 (by player)

Announcements of regasification terminal capacity in the U.S. Atlantic Basin, 2000–2004 (by region)

(%)

0

10

20

30

40

50

60

70

80

90

100

2000 2001 2002 2003 2004

(%)(%)

0

10

20

30

40

50

60

70

80

90

100

2000 2001 2002 2003 2004

Other playersOil majors

BahamasExpansion at existing terminals

Gulf CoastEast Coast

EXHIBIT 1

An Increasing Amount of U.S. Atlantic Basin RegasificationCapacity Is Owned by the Majors and Targeted at the Gulf

SOURCES: Petroleum Economist; press articles; BCG analysis.

Upstream competition for down-stream access has been vigorous.Some buyers, such as China andIndia, have won very attractive pricing(at least in publicly disclosed informa-tion) on LNG deals relative to tradi-tional pricing in the region. (SeeExhibit 2.) Suppliers in several LNGprojects have also relinquished a por-tion of their upstream equity stakes asa further incentive for downstreamutility buyers. Of course, the gas flow-ing into Asia comes from very differ-ent sources with different politicalrisks and different cost bases (forexample, Iran and Australia). And thebuyers have very different price sensi-tivities and levels of willingness to tol-erate those risks. These sensitivitiescontribute substantially to the premi-

ums and discounts observed in someof the more recent LNG pricing.

This balance of power may shift from the buyers to the suppliers inthe future, however, as projectedcontestable demand begins to growrelative to potential supply.According to some forecasts,demand will exceed the supply available from the LNG projectsthat are under construction orplanned through 2012. Althoughmore LNG projects are likely to bedeveloped, the gap could be suffi-cient to strengthen the suppliers’negotiating positions. As a result,recent trends in LNG pricing pres-sure could shift as the supply-and-demand dynamics tip back in favor of the upstream suppliers.

The Oil Majors Could BeThreatened as Global LNGBuyers Go Directly to theNOCs for Their Supplies

Although the oil majors are critical tomaking the global oil markets work,they may wind up playing a smallerrole in LNG markets. As the NOCsbecome more sophisticated, so toowill some of the largest wholesale gasbuyers. In the next wave of significantLNG projects—most likely after 2015,when current projects and resourcesare developed—wholesale buyerscould have opportunities to circum-vent the oil majors and work directlywith the owners of the resources.

Despite much industry discussionabout the development of LNG spotmarkets and the free flow of gas,LNG—unlike crude and most refinedproducts—will remain primarily a“base-load market,” in which particu-lar purchasers that require stable,continuous delivery strike long-termcontracts for delivered gas. The base-load market trend will continue forseveral reasons.

Gas is not fungible. Specificationsfor global gas pipelines and users dif-fer. For example, in the United Statesthe composition of pipeline-qualitynatural gas is defined by limits set byinterstate pipeline-transmission com-panies. In general, pipeline-qualitygas must have an energy content nolower than 970 British thermal units(BTU) per cubic foot and no higherthan 1,100 BTU per cubic foot. InJapan the maximum is about 1,200BTU. In addition, some destinationmarkets require specialized process-ing and fractionation into compo-nent elements. The need for dedi-cated capacity in these markets limitstransportation flexibility.

Huge amounts of capital arerequired. Companies must commitseveral billion dollars of capital for asingle LNG project. Projects requir-ing these levels of capital outlay will

24 BCG REPORT

Landed or negotiated landed LNG prices in the Pacific Basin, 2003

$ permillionBTU

0

1

2

3

4

5

6

2.792.70

4.735.00

South Korea Japan India China

EXHIBIT 2

The Pacific Basin Is Experiencing Extreme Price PressureThe Chinese Contract Is the New Benchmark

SOURCES: Press articles; BCG analysis.

not be sanctioned unless there isassured market access for the gas.There are few markets in the worldthat have the liquidity and depth totake large amounts of LNG that arenot under contract and to pay a com-petitive market price. While theremay be some spot cargoes and limitedtrading around LNG assets and mar-kets, few projects are likely to be sanc-tioned without contracts, except forthose with guaranteed U.S. Gulf Coastcapacity.

Downstream buyers need a secure

supply. Very few downstream buyersare likely to accept LNG as a fuelsource without long-term supply con-tracts, given the lack of gas market liq-uidity and the focus of most utilitieson a secure supply to ensure reliabil-ity for their customers.

Because of the persistence of thisbase-load market—as well as theincreasing commercial capability ofthe NOCs and the technical expertiseprovided by global engineering, pro-curement, and construction compa-nies—there is a strong likelihood thatlarger LNG buyers will begin talkingdirectly to the resource owners,bypassing the oil majors and otherintermediary players for these proj-ects. The implications for all threeparties—large LNG buyers, oilmajors, and NOCs—would obviouslybe considerable.

New Energy Policies andSupply Lines Could Have a Geopolitical Impact

One of the primary issues for Western

users of LNG—especially the United

States—is their increasing reliance on

nonindigenous resources. Although

U.S. rhetoric has emphasized the

importance of becoming more inde-

pendent in meeting energy needs as a

national security priority, the trend

has continued toward more and more

use of foreign oil and, increasingly,

gas. Dependence on foreign sources

for natural gas is even more politically

sensitive than for crude oil, given its

physical characteristics, the cost and

difficulty of storage, and the need for

a single source that is reliable over the

long term for any given project.

There is little doubt that a truly globalgas market will affect foreign policy,domestic energy priorities, and evenmilitary postures. A sharp reaction inenergy policy is likely in the case of asupply disruption due to domesticissues in supplier countries—and cer-tainly in the case of more extremepossibilities, such as an attack by ter-rorists.

Many foreign sources of gas are inpolitically unstable countries with lowcredit ratings. (See Exhibit 3, page26.) In addition, LNG must travel sig-nificant distances to reach the UnitedStates, and the resulting long supplylines are susceptible to human andweather disruptions. With theirincreasing reliance on foreign suppli-ers, the governments of the UnitedStates and other countries may haveto play an interventionist role eitherdirectly or through new policies.These interventions, in one way oranother, are likely to reverberate inthe halls of international diplomacy.

From a U.S. policy perspective, poten-tial responses to various scenarioscould include

• more drilling on federal lands, suchas Alaska’s Arctic National WildlifeRefuge

• stronger federal support for theAlaskan pipeline

• military support to defend U.S.LNG supply lines overseas in theevent of unrest in source countries

• programs to limit domestic con-sumption of natural gas in favor of“clean” technologies

• an active push for a different mix ofpower generation facilities—with afocus on clean coal and renewableenergy sources, and even a resur-gence of nuclear generation—along with continued pressure torealize even further efficiencyimprovements from existing gener-ation assets

GTL Production May PutNatural Gas in the EuropeanFuel Tank

Gas-to-liquids production is becom-ing another way to monetize naturalgas reserves. Unlike LNG, which isnatural gas that has been cooled tothe point where it condenses into aliquid, GTL involves a process thatconverts methane gas to other, morecomplex hydrocarbons and fuels. InQatar, Nigeria, and other marketswith significant gas reserves, a seriouscommercial and engineering efforthas begun through discussionsbetween NOCs and the internationaloil majors. In fact, more than $30 bil-lion of GTL project spending is tar-geted for Qatar, including the $7 bil-lion agreement between QatarPetroleum and ExxonMobil signed inJuly 2004 to develop the world’slargest fully integrated GTL project atRas Laffan.

The promise for GTL is potentiallyhuge. Its commercialization rests atthe intersection of the internationaloil companies’ aggressive movementinto gas, the interest of some NOCs infurthering their position in the inter-national gas market, and an emergingdemand for certain refined productsand fuels.

Although there is much growth indemand for these products in Asia, theplans there—particularly in China—call for the development of significantinternal refining capacity. Europe maybetter illustrate the opportunity forsome of this potential GTL capacity.


In Europe, a major part of the trans-port fuel market—and the fastestgrowing—is low-sulfur diesel. TheEuropean Union is in the process offurther tightening sulfur limits acrossall member countries. By 2008, all thenew EU countries in Eastern Europewill have to meet the same limits thatare beginning to be enforced in theWestern European countries. Meet-ing these limits will require significantupgrades or expansion of the refineryinfrastructure, much of which is sub-scale and may not even be upgrad-

able. Furthermore, it is far from cer-tain that the Eastern European coun-tries will be able to attract the capitalfor those investments.

At the same time, Western Europeanrefineries will also be challenged—not because of their inability to man-ufacture low-sulfur diesel but becauseof the changing economics of theavailable crude slates. Many of theserefineries are relatively simple andutilize primarily Brent crude ratherthan the cheaper but heavier Ural

crude. Given the expanding pricespread between Brent and Uralcrude, refiners face the decisioneither to overhaul refineries for theuse of heavier crude or to continuepaying for the more expensive lighter,sweeter crudes.

These dynamics make Europe a per-fect source of demand for GTL-pro-duced diesel. As many of the oilmajors seek to shift investments fromdownstream business to higher-return upstream business, a substan-

26 BCG REPORT

Credit rating

20

40

60

80

100

0 2,000 4,000 6,000 8,000 10,000 12,000

Norway

Trinidad andTobago

Malaysia

SaudiArabia

Australia

United ArabEmirates

Kuwait

Qatar

Venezuela

Algeria

RussianFederation

Egypt

Libya

Nigeria

Indonesia

Iraq

Turkmenistan

Uzbekistan

Iran

Kazakhstan

Gas reserves (100 trillion cubic feet)

Nautical miles to a U.S. regasification terminal

Most U.S. LNG supply sources are in higher-risk countries at significant shipping distances

EXHIBIT 3

Supply Risks Increase with Greater Reliance on Nonindigenous Gas Sources

SOURCES: BP Statistical Review of World Energy; Fairplay; Institutional Investor.

tive GTL production effort couldforestall at least a portion of the significant investment in theEuropean refinery infrastructure thatwill be required in the next severalyears. But there are some majorimpediments that any oil companyleading a GTL effort must confront:

The scale of the investment is large.

Some GTL projects run as high as $5 billion in capital for a 100,000-barrel-per-day capacity. This is fivetimes the cost of building a crude oilrefinery of similar capacity.

GTL technology is uncertain.

Although there are working small-scale models of several GTL technolo-gies, no significant large-scale GTLproduction facilities are operationalyet or even under construction.

The NOCs may take hard-line nego-

tiating stances. The NOCs in thepotential gas-producing countriesrecognize the importance, value, andviability of GTL, as well as the technol-ogy risks. Their increasing sophistica-tion will lead to difficult negotiatingpositions. In some circumstances, theNOCs have suggested investmentstructures in which the returns oftheir partners (the oil companies) arecapped at percentages in the teens—returns far lower than what would beexpected in similarly risky, more tradi-tional upstream investments.

Stake Out a Place in the Global Gas Market

Gas markets will be increasinglyaffected by shifts in the global energymarket and by competitive forces inadjacent commodity sectors and loca-tions, even as they continue to bedriven by local and regional dynam-ics. New opportunities and threats areemerging as a result of the intersec-tion of the forces explored in this arti-cle. Market participants across all sec-tors must reevaluate their positionsand sources of advantage.

The oil majors should compete

aggressively to stay relevant. Whilethe next great strategic issue for theoil majors is access and rights to gasresources, they must also continue todevelop their technical and commer-cial expertise and maintain their rela-tionships with both resource ownersand customers. An installed base ofcustomers, a deep set of relationships,and a good track record of fair andstraightforward commercial dealingswill go a long way toward maintainingthe oil majors’ relevance in the globalLNG trade.

The NOCs should build relation-

ships and commercial savvy. TheNOCs have an opportunity to expandtheir global position, prestige, andfinancial rewards. However, in manyplaces such an expansion will requirea significant change in culture, pro-fessionalism, and strategy. It is a tallorder to expect an NOC to convincelarge LNG buyers in developed coun-tries that it can develop, invest in, andoperate the different parts of an LNGsupply chain. But perhaps this sce-nario is one to aspire to, given theincreasing resource advantage thatmany NOCs will have vis-à-vis the oilmajors.

Utilities should begin looking

beyond the shore. LNG may repre-sent a growth opportunity for largegas-consuming utilities. To expandtheir current consumer-only role, util-ities must begin a systematic processof understanding LNG marketdynamics, technologies, and coststructure. They must also understandthe way the commercial marketworks. The potential rewards ofbroader participation in the LNGmarket are substantial for utility cus-tomers and shareholders. But so, too,are the associated risks, given gas mar-ket volatility, relationships amongcompeting fuel sources, and the sig-nificant capital expenditures, creditimplications, and long-term commit-ments required of LNG trade.Developing relationships with key

supply-chain players is the first step inthis process.

LNG suppliers and purchasers alike

should factor geopolitical risk into

management decision-making. Withtheir increasing reliance on sourcesof LNG from countries that are lessstable politically and economicallythan previous suppliers, LNG suppli-ers and buyers face a greater expo-sure to risks relating to the security ofthe supply stream than they did in thecase of crude oil. Participants in allaspects of LNG trade must take thoseincreased risks into account whenevaluating their positions. Height-ened regulatory or political interven-tion to guard against these new riskscould affect both the timing and costsof LNG projects.

Marc Benayoun Thad Hill

Rick PetersChris Phelps

Marc Benayoun is a vice president anddirector in the Paris office of The BostonConsulting Group. Thad Hill is a for-mer vice president and director of BCG.Rick Peters is a senior vice president anddirector in the firm’s Houston office.Chris Phelps is a manager in BCG’sDallas office.

You may contact the BCG authors by e-mail at:

[email protected]

[email protected]

[email protected]


28 BCG REPORT


Take Aim to Hit Cost Reduction Targets

Pattabi SeshadriJ. Puckett

Chris WeberMichael J. Finger

30 BCG REPORT

U.S . utilities are operating

under increasing pressurefrom customers, regulators,

and shareholders alike as concernsmount over the rising costs of fueland purchased power, environmentalregulations, and employee pensionsand health care. High-cost utilitiesare in a particular bind: if they don’tfix their operations, they could wellbecome acquisition targets for moreefficient operators in a post-PUHCA(Public Utility Holding CompanyAct) world. In the face of such pres-sure, utility executives must take deci-sive action to improve operationalefficiencies and preserve historicalreturns. But actions that lack specificobjectives can leave organizationsexhausted and fail to achieve thedesired results.

A diagnosis of the issues specific toeach utility—supported by targetedbenchmarking—can help executivespick the right course of action,whether it be delayering manage-ment, optimizing business processes,selectively eliminating the company’slow-value support activities, or out-sourcing business functions.Managing the impact of change alongthose dimensions can ensure long-term stability.

The benefits of this targetedapproach can be substantial: reducedoperating costs, more stable customerrates, and a more favorable regulatoryenvironment in the face of escalatingrate pressures.

Rising Costs and PublicScrutiny Squeeze Customer Rates

Customer rates—for all utilities andin all regions—are increasing fasterthan ever before. Factors outside thecontrol of utility management teamsaccount for much of the rising cost.

• Increasing and Volatile Fuel Prices.Gas and oil prices are significantlyhigher today than they were in the1990s and are projected to remainhigh. Coal prices, stable untilrecently, skyrocketed in 2004, par-ticularly for utilities in the EasternInterconnect, the power grid com-prising all the states east of theMississippi River. Prices for all threefuels rose by nearly 75 percentbetween 1999 and 2004, comparedwith a decline of nearly 10 percentbetween 1990 and 1999. In addi-tion, the prices of all three havebecome more volatile.

• Required Environmental Investments.Utilities nationwide are planningsignificant environmental capitaloutlays focused on regulatory com-pliance, not on improved plant per-formance. Estimates of these invest-ments range from $50 billion to $60 billion, of which only $10 bil-lion have been spent to date, withthe rest of the spending still tocome over the next three to fiveyears. These capital programs,unlike investment in new genera-tion, will not result in any savingsthat can be passed along to cus-tomers. To the contrary, they willproduce rate increases in the rangeof $3 to $4 per megawatt hour, or 4 to 5 percent for the average utilitycustomer. Of course, the rateincrease for customers of utilitieswith a high percentage of coal-firedgeneration in their supply mix willbe much greater.

• Rising Employee Expenses. Risingpension and health care costs are anational phenomenon affecting allindustries. Because of their agingand largely unionized work force,however, utilities have beenaffected more than other indus-tries. Overall, annual expenses foremployee pensions and benefits asa component of customer rates

have increased nearly 25 percentbetween 1999 and 2004, comparedwith a decrease of close to 15 per-cent between 1990 and 1999.

The overall impact of these changeson utilities’ cost structure—in aggre-gate and on the worst-performingutilities in terms of total rates—is con-siderable. Of the nation’s 100 largestutilities (in terms of customersserved), total customer rates for thebest-performing utilities increasednearly 10 percent between 1990 and2004. For the worst-performing utili-ties, however, they increased 35 per-cent in just the five-year period from1999 to 2004. As a result, many utili-ties have come under increased regu-latory and public scrutiny.

In several jurisdictions, for example,regulatory agencies have disallowedrate increases tied to significant por-tions of the higher costs of fuel, pur-chased power, and operations andmaintenance (O&M). Even whenrate proceedings have not resulted indisallowances, the level of scrutinyhas been burdensome—in most casescausing negative publicity and cus-tomer dissatisfaction.

Return on equity (ROE) has alsocome under greater scrutiny. Giventhat state utility commissions tend tofollow Treasury bond yields when set-ting allowed ROE, and that ten-yearbond yields are at historic lows, utili-ties with upcoming general rate-caseproceedings are facing challenges. Infact, utilities that underwent ratedecisions in the last 12 months typi-cally had their ROE reduced bybetween 30 and 100 basis points. Ifapplied broadly to the estimated $360 billion rate base of the 100largest U.S. utilities, that decreasecould translate into a reduction in netincome of between $500 million and$1.5 billion—an enormous potentialreduction in utility shareholder value.

Take Aim to Hit Cost Reduction Targets

The magnitude of these changesvaries from one utility to another anddepends on the status of deregulationand settlements, but all utility execu-tives will need to control costs moretightly on both O&M and capitalbudgets. To continue receiving favor-able regulatory treatment, manage-ment must be able to demonstrate tocustomers and regulators alike itsefforts to stabilize rates.

Spreads in Operating CostsDemonstrate the Potentialfor Improvement

Utility operating costs vary signifi-cantly from region to region—andeven within regions—depending onseveral factors, such as service areadensity, terrain, weather, and mix andage of infrastructure. Even with thesevariations, all utilities have somepotential to improve efficiency forboth power-generation and otheroperating costs (such as transmissionand distribution, customer service,

and general and administrativeitems).

For the 100 largest utilities, top-quar-tile performers are those with the low-est operating costs—less than $10 permegawatt hour, excluding power gen-eration. Utilities with median operat-ing costs can post savings of about 24percent if they can achieve top-quar-tile performance. Similarly, utilitieswith operating costs in the bottomquartile can reduce their costs byabout 20 percent if they can achievethe level of median performers. (SeeExhibit 1.)

Utilities also have an opportunity toimprove power generation costs. Forexample, setting aside variations inplant age, technology, configuration,and level of historical investment,coal-fired generators that move fromthe level of median performers to thetop quartile can capture a potentialsavings of 25 percent. Similarly, coal-fired generators that can move fromthe bottom quartile to the median

level can potentially cut costs by 30percent.

We estimate that the 100 largest utili-ties have the opportunity to improvetheir overall operating costs by asmuch as 15 percent, or about $4.5 bil-lion on a total annual cost base of $30 billion. Similarly, we estimate thatthe nation’s coal-fired generatorshave the potential to improve theirgeneration costs by as much as 15 per-cent, or $1.5 billion on a total annualcost base of $10 billion. These esti-mates do not include the potential forimprovement in more than $22 bil-lion of annual capital deployment bythe nation’s largest utilities.

Utility executives often cite concernsthat operational improvement willreduce reliability and customer satis-faction. In fact, there is little evidencethat lower-cost utilities have lower lev-els of reliability or customer satisfac-tion. To the contrary: low rates tendto be the primary driver of customersatisfaction.

Targeted Actions Will ImproveCost and Service Levels

Utilities must develop blueprints forimprovement and then produce tan-gible results. The framework illus-trated in Exhibit 2, on page 32,describes a proven workflow for creat-ing value, starting with benchmarkingand plan development, then movinginto implementation and changemanagement.

Use industry benchmarks to set tar-

gets. Many companies have fiercedebates about whether change isworth the pain that will accompanythe process. Benchmarking perfor-mance in relation to other utilitiesensures that such debates areinformed by facts. Although data onutilities are available in great quanti-ties, analyzing the data to ensure com-parability and to establish meaningfultargets is complex. Once benchmarks


0

5

10

15

20

25

1 98

Averagecost in$ permegawatthour

Performance rank

Bottom quartile = $15.9

Top quartile = $9.6 ~24%

~20%Median = $12.7

25 50 75 100

EXHIBIT 1

Operating Costs Vary Significantly Among the 100 LargestU.S. Utilities

SOURCE: Federal Energy Regulatory Commission Form 1 (2004).

NOTE: Costs are for customer service, transportation and distribution, and general and administrative items. Dollar amounts

are annual costs divided by annual retail sales (megawatt hours).

are developed, however, they can beused to establish a sound businesscase for change and to motivate man-agement to stay the course whenfaced with difficult decisions, such asreducing head count or eliminatingactivities.

Make commitments and create

action plans. Once targets are inplace, action plans must be developedthat “hard-wire” the targets into oper-ating plans for the business. Withoutthis step, management teams oftenback away from original valueestimates and spend much timedebating the targets. This process canmake use of four actions, each ofwhich must be targeted to the specificcircumstances.

Delayering Management. Reducing thenumber of management layers whilebroadening spans of control at eachlayer is a highly effective approach forimproving efficiency in companieswith more than five layers betweenthe CEO and frontline employees.During the market downturn of 2001through 2003, many companies

across all industries stabilized orreduced total head count to align itwith their revenue and growth expec-tations, but few were effective inreducing their management headcount. In some companies, manage-ment head count rose despite reduc-tions in total head count.

Delayering is especially difficult forutilities because of their complexcost and organizational structures.For example, middle managers tendto be tenured. In addition, utilitiestend to have many employees in so-called individual-contributor posi-tions. These positions are filled bypeople with unique skills who are notqualified for managerial jobs. Incompanies with low turnover, thenumber of people in such positionsoften builds up beyond the needs ofthe organization.

A structured process to reduce thetotal number of layers in an organiza-tion can result in a drop of 10 to 30percent in management head countand a flattening of the organizationby two to five layers, depending onthe starting point. Exhibit 3 shows theresults achieved by a utility using sucha disciplined approach. The resultingimprovements in organizationaleffectiveness can be substantial. Theyinclude a tighter alignment of thework force with activities of the high-est value, faster decision making,improved accountability, upgradedskills and capabilities, more reliableand rapid communication, and bettermorale.

Delayering is certainly not a new idea.However, it has been shelved formore complicated approachesbecause it is hard to let people gowhen one works directly with them. Arigorous three-step approach canhelp secure the desired results.

First, find out if the organization hasa problem by systematically mappingits layers. If more than a 10 percent

32 BCG REPORT

Top-downbenchmarks(peer group)

Useindustry

benchmarksto set targets

Functionalbenchmarks

(cross-industry)

Benchmarksfrom BCGexperience

Makecommitments

and createactionplans

Managechange for

impact

Delayeringmanagement

Outsourcingbusinessfunctions

Optimizingbusiness

processes

Eliminatinglow-valueactivities

Trackingresults

Culturalchange

management

Transparentcommunication

EXHIBIT 2

Using a Framework for Targeted Change


Action plansmust be developed that“hard-wire” the targetsinto operating plans

for the business.

reduction in management headcount is possible, a significant prob-lem exists.

Second, establish clear guiding prin-ciples and policies to support thedelayering process. Doing so typicallyrequires that senior managers agreeon such matters as the target numberof layers between the CEO and front-line employees, specific span-of-con-trol guidelines, a well-crafted commu-nications approach, and transparenttimelines. In many cases, the guidingprinciples could include supplemen-tary human-resources policies con-cerning the selection of employees tobe laid off and their severance plans.

Third, implement a cascading processto ensure that line managers own theresults. Top management will designthe new organizational layers andappoint new managers at the nextlayer. Managers in the new layer willown the organizational design andthe employee selection process foreach subsequent layer. This type ofcascading process—if executed in afast, fair, and disciplined manner—can improve line ownership of theresults and revitalize the employeebase by removing poor performersand bringing in fresh talent at theappropriate levels.

Optimizing Business Processes. Duringthe last decade, most utilities have ini-tiated at least one broad-reachingprocess-improvement program, a fewhave undertaken multiple efforts, andsome have pursued continuous-improvement programs. In the coreutility functions of generation, trans-mission, distribution, and customerinterface, those efforts have helpedcosts per megawatt hour to remainflat—and in some cases to decline. Yetthere is still significant opportunityfor improvement.

Our recent work has shown that thereis considerable value in challengingthe fundamental decision-makingprocess for a few high-priority O&M


Pre-restructuring

Layer(reportingstructure)

Level (pay levels)

7 6 5 4 3 2

0

1

2

3

4

5

6

7

1

Total 5,00020 61 105 27 224 638 3,925

145

1

9

62

328

802

2,631

1,022

Total

1

8

11

1

22

33

5

13

58

32

2

3

8

6

10

3

21

111

83

6

8

82

153

258

115

22

2

126

495

2,278

901

123

Post-restructuring

Layer(reportingstructure)

Level (pay levels)

7 6 5 4 3 2

0

1

2

3

4

5

6

7

1

Total 4,50014 54 70 57 321 512 3,472

0

1

7

55

289

937

3,211

0

Total

1

7

6 36

18

13

57 9

48

81

129

111

18

180

314

106

580

2,786

Restructuring resulted in the elimination of two layers,

a 10% reduction in total head count, and a

12.5% reduction in management head count.

EXHIBIT 3

A Utility Company Uses Delayering to Remake ItselfNumber of employees by pay level and reporting layer


and capital decisions. For example,most utilities allocate annual O&Mand capital dollars to generating facil-ities using a bottom-up and top-downprocess. As an illustration of thisapproach, each plant in a utility setshigh budgetary needs for very specificprojects. Corporate management thensets a top-down spending level andallocates an amount to each plant.Typically, this practice results in sub-optimal solutions based on “fair” allo-cations for the overall fleet of plants.

A more disciplined approach to capi-tal decision making could result incost and performance improvementsin the range of 20 to 30 percent of cur-rent O&M spending. Adopting thisapproach, management takes a fleetperspective, not a plant perspective;weighs tradeoffs across plants andprojects; assesses capital versus O&Mtradeoffs; and evaluates a broad rangeof spending and timing options tooptimize risks and returns. A similarapproach would help when manage-ment is prioritizing information tech-nology projects, planning mainte-nance for the transmission anddistribution network, and allocatingcapital for transmission and distribu-tion projects.

There is another way that companiescan take a fresh approach to capitaland operating decisions. By reorgan-izing and consolidating the field oper-ating entities (regions, districts, andhubs), managers can increase thebreadth and scope of coverage in anyparticular region. Operational effi-ciencies include reduced field over-head, crew dispatch improvementsfrom the pooling of resources, andstandardization of delivery modelsacross regions for material specs,designs, metrics, and deploymentapproaches.

This type of process change requiresthe attention of senior managementbecause it entails balancing the evolv-ing decision-making process and play-ers, injecting creative tension at the

appropriate levels of the organiza-tion, and selectively upgrading man-agement talent and capabilities in keypositions.

Eliminating Low-Value Activities.Although delayering is valuable forreducing the complexity and cost ofan organizational structure, it doesnot fully tackle one problem with autility’s overhead functions: the iner-tial effect of continuing to generate

internal products—such as reports,analyses, and support services—thathave lost their original value to thecorporation. When an organizationconducts low-value work, costsbecome absorbed in the overheadstructure in a way that is difficult todetect. Activity value analysis can helpcompanies identify low-value workand reduce costs or reallocateresources to more strategic efforts. Itis a multistep process.

First, managers in support functionscompile a list of services provided bytheir functions. Second, they estimatethe costs and the number of employ-ees involved in delivering each ser-vice. Third, they survey the businessesin order to understand the perceivedvalue of each service and to comparethat value with the cost incurred todeliver the service. All services arearrayed on the basis of this value-costcomparison. Finally, managers de-velop and implement recommenda-tions to eliminate, modify, or retainthe services.

Activity value analysis typically resultsin a reduction in overhead costs thatis 15 to 30 percent of baseline costs. Italso improves the alignment of sup-port functions with the key needs ofthe business units. In many situa-

tions, this process can be liberatingfor high-performance managers be-cause it tends to confirm their intu-ition about the value of differentactivities in their functions and be-cause it results in decisive action.

Outsourcing Business Functions. Inrecent years, outsourcing has gaineda significantly higher profile as busi-nesses look for additional ways toimprove productivity. In fact, out-sourcing contracts have expandedfrom one-off elements, such as appli-cations and data centers, to com-plete functions. Outsourcers havemade great strides toward develop-ing a compelling value propositionfor complete processes, such as keyelements of customer service,finance and accounting, and the sup-ply chain.

Despite the growth in outsourcing,utilities still lag other industries intheir level of participation. There areseveral reasons for this disparity,including the potential for height-ened regulatory and public scrutinyin local markets; a higher degree ofunionization in key processes, such ascustomer service and supply chainmanagement; and, until recently,lower levels of external cost pressures.Yet the recent increase in outsourcingactivity by many utilities has demon-strated the potential for substantialcost improvements.

We estimate that key utility processescan achieve cost improvements of 20to 30 percent from outsourcing. (SeeExhibit 4.) In addition, improve-ments in customer service levels canbe quite dramatic. In recent transac-tions, large outsourcers have commit-ted to step-change improvements inservice levels across metrics such ascall wait times and billing and collec-tion cycle times. For both small andlarge utilities, outsourcing can offeraccess to a bigger pool of capabilitiesand talent. It might also reducefuture capital investments by structur-ing the transactions so that the capital

34 BCG REPORT

More disciplined decisionmaking could improvecost and performanceby 20 to 30 percentof O&M spending.

cost of technology improvements andservice-level enhancements isincluded in the customer fee struc-ture. This restructuring of costs hasthe potential to release significantcapital for core investments in trans-mission and distribution, generation,and environmental requirements.

In a recent survey of utilities that hadadopted outsourcing, managers saidthey achieved only one-half to two-thirds of the cost improvements theyhad expected. Several common pit-falls prevent utilities from realizingthe benefits of outsourcing. Theyinclude

• failing to systematically evaluate abroad range of options, includingimprovements to internal processes

• focusing on cost improvementsand placing less emphasis on otherbenefits, such as access to capabili-ties and improvements to servicelevels

• applying cookie-cutter transactionstructures and not aligning themwith the utility-specific regulatoryenvironment, the evolving ratestructure, and settlements

• concentrating on the front end ofthe transaction, without developinga comprehensive approach to man-aging the full outsourcing life cycle

We recommend a life cycle approachto evaluating and completing out-sourcing transactions. A major ele-ment of this approach is a broadassessment of options, including spe-cific alternatives for assets and peo-ple, participation models, and theincremental economics of in-house,near-shore, and offshore models.Regulatory options, the impact ofsequencing and timing alternativeson ROE, and the benefits from ser-vice-level enhancements—particu-larly in jurisdictions with incentivesand penalties—should also beassessed. A life cycle approach also

includes change management consid-erations specific to utilities, such asthe alignment of the governancemodel with service company struc-tures of holding companies.

Manage change for impact. This is acritical step toward realizing the tar-geted value identified by the actionplans described above. Most—if notall—operational improvement initia-tives require tracking progress care-fully against the baseline and the tar-get, and transparent communicationof the process and results. However,one more step is typically required toengage employees and deliver results:cultural change. Cultural change canhave many aspects, such as settinghigh aspirations, managing conse-quences if targets are not met, manag-ing behavioral change in leadershipteams, improving the effectiveness ofcross-functional teams, nurturing andtraining future leaders, and integrat-ing divisive cultures (in merger andacquisition situations).

Broad BCG experience and surveysrelated to organizational change indi-cate that engaged employees usuallyprovide 10 to 30 percent “discre-tionary effort”—effort that is overand above what is required of them. Ahigh level of engagement ultimatelyreflects on the financial performanceof the company.

Engaging employees for results typi-cally requires two broad sets of levers:those relating to performance disci-plines and those that function as per-sonal motivators. Performance disci-plines include such elements aswell-defined organizations andaccountabilities, individual perfor-mance goals tangibly linked to overallcorporate goals, and pay-for-perfor-mance arrangements. Personal moti-vators include developing and com-municating a compelling vision forchange, encouraging new leadershipbehaviors, and balancing financialrewards with intrinsic job satisfaction.Both sets of levers are needed in


<5

>30

20–30

<20

>85–8

Potentialsavings (%)

Share of utility cost (%)

Accountingservices

Human resources

Customer service(call centers)

Credit and collections Operations and maintenance1

Administrative functions2

Other processes, suchas meter reading

Billing services

Information technology

EXHIBIT 4

Some Key Utility Functions Can Reap Significant Savingsfrom Outsourcing

SOURCE: BCG analysis.1Includes facilities maintenance, fleet maintenance, and security.2Includes mailroom, document-reproduction, legal, record-management, and investor-relations administration.

order to manage cultural change—and to capture lasting value fromoperational improvement programs.

Target Change for MaximumImprovement

Utility executives must take decisive,well-planned actions that target spe-cific areas for improvement, with spe-cific approaches to change, if they areto raise operational efficiency andpreserve historical returns. The oper-ating spreads between the highest-and lowest-performing utilities pointto the potential for improvement.

Our experience indicates that adetailed diagnosis of the issuesspecific to each utility and eachfunction within the utility is an impor-tant first step. Once these issues areunderstood and targets are set, execu-tives need to choose the rightapproach toward change. Broad cam-paigns—or programs that fail to

address the underlying areas thatneed improvement—run the risk ofleaving organizations exhausted.Managing change for the company’scontinued stability—and for its reju-venation, by engaging employees forresults—is an often-neglected but crit-ical final step.

Pattabi SeshadriJ. Puckett

Chris WeberMichael J. Finger

Pattabi Seshadri is a vice president anddirector, and J. Puckett a senior vicepresident and director, in the Dallasoffice of The Boston Consulting Group.Chris Weber is a manager and MichaelJ. Finger a research analyst in the firm’sHouston office.


[email protected]

[email protected]

[email protected]

[email protected]

36 BCG REPORT

For a complete list of BCG publications and information about how to

obtain copies, please visit our Web site at www.bcg.com.

To receive future publications in electronic form about this topic or

others, please visit our subscription Web site at www.bcg.com/subscribe.

Amsterdam

Athens

Atlanta

Auckland

Bangkok

Barcelona

Beijing

Berlin

Boston

Brussels

Budapest

Buenos Aires

Chicago

Cologne

Copenhagen

Dallas

Düsseldorf

Frankfurt

Hamburg

Helsinki

Hong Kong

Houston

Jakarta

Kuala Lumpur

Lisbon

London

Los Angeles

Madrid

Melbourne

Mexico City

Miami

Milan

Monterrey

Moscow

Mumbai

Munich

Nagoya

New Delhi

New York

Oslo

Paris

Prague

Rome

San Francisco

Santiago

São Paulo

Seoul

Shanghai

Singapore

Stockholm

Stuttgart

Sydney

Taipei

Tokyo

Toronto

Vienna

Warsaw

Washington

Zürich

www.bcg.com

BCG

Date post:	17-Jun-2018
Category:	Documents
Upload:	doanhanh
View:	212 times
Download:	0 times

Preparing for Fundamental Shifts in Energy - BCG · We consider every assignment a ... Changes on...

Documents