Energy Value Chains. What is a Value Chain?

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1 Energy s Overview of Fundamentals Center for Energy Economics, UT-Austin. No reproduction, distribution or attribution without permission. 1 What is a? The process of linking specific functions from input through output to delivery, enhancing the economic value of the final product Related concepts supply chain business system, industry system The challenge building value chains around dynamic commodity markets that require fixed infrastructure for physical delivery and liquidity for price risk management Center for Energy Economics, UT-Austin. No reproduction, distribution or attribution without permission. 2 reserved. 1

2 Generic Support Activities Firm Infrastructure Human Resource Management Technology Development Procurement Margin Inbound Outbound Logistics Operations Logistics Marketing & Sales Service Margin Primary Activities Source: Porter, 1985 Center for Energy Economics, UT-Austin. No reproduction, distribution or attribution without permission. 3 How Thinking Has Changed, I Traditional : Starts with core competencies Assets/Core Competencies Inputs, Raw Materials Products/ Service Offering Channels The Customer Customer Priorities Channels Offering Inputs, Raw Materials Assets/Core Competencies Modern : Starts with the customer Source: Porter, 1985 Center for Energy Economics, UT-Austin. No reproduction, distribution or attribution without permission. 4 reserved. 2

3 How Thinking Has Changed, II Source: McKinsey & Company Center for Energy Economics, UT-Austin. No reproduction, distribution or attribution without permission. 5 Energy Issues Center for Energy Economics, UT-Austin. No reproduction, distribution or attribution without permission. 6 reserved. 3

4 Human Resource Management Source: McKinsey & Company Center for Energy Economics, UT-Austin. No reproduction, distribution or attribution without permission. 7 Derivation of Basis Risk Production Transportation Distribution End Use Basis Differential between cash/spot and nearest futures price as a result of time, product forms, quality, location Basis risk : Uncertainty as to whether differential will widen or narrow Center for Energy Economics, UT-Austin. No reproduction, distribution or attribution without permission. 8 reserved. 4

5 Balancing the Market Mean reversion is a reality if marketclearing participants exist DEMAND SUPPLY LOW Prices HIGH Center for Energy Economics, UT-Austin. No reproduction, distribution or attribution without permission. 9 Mean Reversion: Oil Price Example 91:02-03:12 86:02-03:12 82:01-03: Price Frequency Center for Energy Economics, UT-Austin. No reproduction, distribution or attribution without permission. 10 reserved. 5

6 Price Volatility and Risk Trade Offs with Competition: Open Access Example Commodity price risk flows E&P Pipelines LDCs End Users Power Capacity price risk flows Risk accepting entities Center for Energy Economics, UT-Austin. No reproduction, distribution or attribution without permission. 11 Mechanisms to Manage Price Risk Trading in futures contracts Long-term contracts Fixed-price contracts Storage for physicals hedging Ability to use alternate fuels; efficiency; conservation Allow residential customers to choose budget payment plans; energy service contracts for commercial and industrial customers Develop mechanisms for capacity risk Center for Energy Economics, UT-Austin. No reproduction, distribution or attribution without permission. 12 reserved. 6

7 Global Oil Market Illustration Physical Market Specific Market Term Market Spot Deals Forward Deals Tenders Bilateral Tenders Bilateral Futures Swaps & Other OTC Formal Options Source: Oil in Asia by Paul Horsnell, 1997, Oxford Institute for Energy Studies Center for Energy Economics, UT-Austin. No reproduction, distribution or attribution without permission. 13 From: ESAI Center for Energy Economics, UT-Austin. No reproduction, distribution or attribution without permission. 14 reserved. 7

8 Industry Organization: Vertical Integration? Source: McKinsey & Company Willingness to pay Windfall Center for Energy Economics, UT-Austin. No reproduction, distribution or attribution without permission. 15 Energy Value Add Comparison with Other Industries Source: McKinsey & Company Center for Energy Economics, UT-Austin. No reproduction, distribution or attribution without permission. 16 reserved. 8

9 Derivation of Market Power Production Transportation Distribution End Use Monopoly producer Barriers to entry, exit Technical economies of scale(?) Natural monopoly systems Barriers to entry, access Monopsony buyer Barriers to entry, exit Center for Energy Economics, UT-Austin. No reproduction, distribution or attribution without permission. 17 Energy and Example SD Issues Production Transport Distribution Conversion End Use Access for private investment Rights of way and lands ownership Environmental impacts Transparency Allocation of economic rents and revenue management Local content Community relations and community benefits Access for private investment Environmental impacts Transparency Allocation of economic rents and revenue management Consumer interface Access to service, reliability, quality of service Subsidy and system loss issues and pricing for core customers Center for Energy Economics, UT-Austin. No reproduction, distribution or attribution without permission. 18 reserved. 9

10 US Example Center for Energy Economics, UT-Austin. No reproduction, distribution or attribution without permission. 19 The Major Energy s Processing (if needed) Gas Separation (if needed), Gathering Oil and Gas Field Production Crude Transport Oil Refining (product markets) Pipeline Transportation (imports/exports) Regasification Liquefaction (LNG) Liquids (LPG) Transportation Natural Gas Liquids Extraction Product Transport Alternative generation technologies can be used. Local Distribution Domestic production can be liquefied and stored; LNG can be regasified for seasonal use; or used in transport. LNG Tanker Shipment (imports/exports) Marketing and Distribution (if applicable) Oil/condensate stream Methane stream Liquids (LPG) stream (propane, butanes, etc.) Power stream Electric Power Generation (utilities, IPP, industrial) Industrial (Direct Use) Commercial Residential Direct Use (e.g., vehicle transport)* Upstream Midstream Downstream Electric Power Transmission Electric Power Distribution Compressed natural gas (CNG; methane) and LPG are also used for vehicle transport; alternative fuels can be used. Center for Energy Economics, UT-Austin. No reproduction, distribution or attribution without permission. 20 reserved. 10

11 A U.S. Illustration of Energy Pricing, Data (U.S. EIA, Annual Energy Review) Transport+Treatment $2.26 IN RAC (16 mmb/d) Domestic $17.82 Import $17.23 Composite $17.46 MARGIN (BL) Motor Gasoline $9.53 Jet Fuel $5.12 No. 2 Distillate $5.04 Residual FO ($3.44) Composite $7.89 OUT (BL) (17 mmb/d) Motor Gasoline $32.80 (8 mmb/d) Jet Fuel $22.59 No. 2 Distillate $24.15 Residual FO $15.79 ON HIGHWAY (BL) Motor Gasoline $47.04 CRUDE OIL VALUE CHAIN 6 mmb/d U.S. Avg. DFPP $15.56/bl Transportation (pipeline, tanker, truck, rail) Refining (to petroleum products: gasolines, jet fuels, diesel, fuel oils, etc.) Petrochemicals (feedstocks for intermediate products) Wholesale and retail marketing Wholesale marketing End users: individuals, businesses, governments, institutions Conversion to final products (fertilizers, plastics, etc.) Oil and gas field production 24 tcf Wellhead $2.07/mcf Gathering, processing NATURAL GAS VALUE CHAIN Marketed production 20 tcf Dry Gas 19 tcf Net Imports 4 tcf LNG Field-to-liquefaction 10-20% (Percentages reflect approx. share of total LNG value chain cost; $/MMBtu amounts assume 2,500-mile voyage) $1.04 (to City Gate) Natural gas pipeline transportation Natural gas liquids transportation (pipeline, truck, tanker) Liquefaction (liquefied natural gas or LNG) 25-35% $1.00/MMBtu City Gate $3.11 Natural gas distribution Wholesale and retail marketing and distribution Propane* sold to resellers: $0.78/gallon (refinery) Propane sold to end-users: $1.27/gallon LNG tanker shipment to markets 15-25% $0.40/MMBtu End users: Residential $6.60 Commercial $5.26 Industrial $3.04 Electric Utilities $2.56 Industrial $3.04 (Fuel and feedstock for industrial processes, including petrochemicals) Conversion back to gas phase for pipeline, distribution, end use 5-15% $0.40/MMBtu Direct use (electric power generation) 25-35% DFPP = domestic first purchase price (wellhead); RAC = refiner acquisition cost Center for Energy Economics, UT-Austin. No reproduction, distribution or attribution without permission. 21 $0.97 * About 2mmb/d of propane produced at refineries, about 538,000 b/d at gas plants; about 1 mmb/d LPG sold for end use. $3.49 Energy Investment Center for Energy Economics, UT-Austin. No reproduction, distribution or attribution without permission. 22 reserved. 11

12 $16 Trillion Energy Investment Required Across the Energy s, Source: IEA World Energy Investment Outlook 2003 Center for Energy Economics, UT-Austin. No reproduction, distribution or attribution without permission. 23 Investment Requirements in the Oil Sector ($ billion) Exploration & Development Unconventional Oil Refining Tankers Pipelines TOTAL $ $ $ $1,045 $1,135 Source: World Energy Investment Outlook, International Energy Agency, $ Center for Energy Economics, UT-Austin. No reproduction, distribution or attribution without permission. 24 reserved. 12

13 Investments Required in Natural Gas Sector E&P LNG Power Generation Pipelines Transmission Local Distribution (Gas & Power) WORLD TOTAL $1.73 $0.25 $4.20 $0.71 $1.60 $4.29 $12.78 Source: IEA Global Investment Outlook, 2003 Center for Energy Economics, UT-Austin. No reproduction, distribution or attribution without permission. 25 Comparative Risks and Returns: Electricity Lags Oil & Gas per cent Oil and gas upstream Electricity Gas downstream OECD Non-OECD Source: IEA Global Investment Survey 2003 Center for Energy Economics, UT-Austin. No reproduction, distribution or attribution without permission. 26 reserved. 13

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