Analysis: Energy Industry Faces Higher Levels of Working Capital

The degree of working capital tied up by the oil and gas industry has grown substantially over the past six years, according to Ernst & Young's report, Cash in the Barrel: Benchmarking and analysis of working capital management in the oil and gas industry.

Ernst & Young reports that working capital among oil and gas companies in terms of cash-to-cash (C2C) grew from 24.9 to 32.0 days, an increase of 7.1 days or 29 percent between 2003 and 2009. While the expansion of the industry-wide C2C cycle was driven by 20 of the 34 companies surveyed, the difference between the best performers and laggard performers is considerable.

Working capital, the measure of a company's current assets after subtracting its liabilities, can negatively impact a company's cash flow when it increases. "There is a growing awareness throughout the industry of just how much value is being left on the table as a result of too little focus on working capital management," Ernst & Young said. However, issues such as price volatility and, in particular, any interval of relatively higher oil and gas prices tend to draw attention away from sound working capital management.

Ernst & Young noted that a key factor in the deterioration of the industry's C2C performance is inventory levels, which grew substantially from 2003 to 2009. While the meaning behind such a decline may not be immediately apparent, in general, this reflects the impact of much stronger oil prices on the value and composition of total inventories, as well as higher levels of physical stocks.

"Moreover, the apparent paradox of holding more physical inventories when oil prices are high can be explained today by the current combination of low interest rates and significant price volatility," Ernst & Young said. "Low interest rates reduce the cost of storage. Meanwhile, volatility creates a significant price differential between spot and forward prices. As such, firms can afford to hold on to crude for longer intervals, delivering stock into more lucrative forward markets."

Ernst & Young notes that wide variations exist in working capital management performance in the oil and gas industry, often due to variations in business models, customers, levels of vertical integration, nature of supply contracts and production and distribution infrastructure.

However, the size of disparities in performance indicates that there are fundamental differences in the degree of management focus on cash and process effectiveness. "Huge opportunities for improvement exist within areas such as inventory management, demand forecasting, supply chain planning, billing, collection, commercial terms, contractor management and sourcing," Ernst & Young said.

Ernst & Young found that exploration and production (E&P) firms carry the lowest level of working capital across the industry, seven days, reflecting a combination of low inventory and high payables levels. By comparison, refining and marketing and integrated firms show significantly longer C2C cycles of 32 days and 30 days respectively.

Oilfield service companies carry much higher working capital levels, 97 days, than other segments of the industry. "This reflects the complex, sometimes long-cycle nature of the segment's operating model, with certain long-term contracts carrying significant down payment and progress billing terms."

Overall C2C performance was also positively impacted, to a small degree, by changes in the industry sales mix, and as more companies focus on E&P and dispose of refining, marketing and chemical interests, their relative capital working performance should begin to improve. "However, companies should be careful not to use such passive gains as an excuse to put off more substantive steps to improve working capital management."

Working Capital Challenge

The working capital challenge comers at a time when the industry is experiencing a number of issues exerting significant pressure on cash-flow, financing and operations at a time when the industry is still being called upon to produce more product to satisfy demand surges for energy and oil-based products coming from emerging markets.

Upstream and downstream oil and gas industry costs nearly doubled between 2003 and mid-2008, according to Ernst & Young. Though capital costs eventually fell between 15 percent and 20 percent in 2009, the absolute levels still represented a long-term increase.
A combination of rising investment in exploration and new refining capacity, up 90 percent amid higher oil prices and strong demand, and tightness in the service sector, have driven up costs in the energy industry.

"Such trends are exacerbated by a prolonged period of underinvestment across the whole industry through the 1990s. Moreover, as actions to regulate the carbon molecule accelerate, and as discovery and recovery require ever greater technological and operational sophistication, costs can only move higher," Ernst & Young said.

Ernst & Young noted that the industry tends to underemphasize working capital performance, with the focus being on operational metrics such as throughput, day rates and pricing, and not on inventory, payables or similar metrics. For example, local managers are making the decisions about what sorts of items to hold in inventory. Often they are not evaluated on working capital, so there's no incentive to manage a leaner inventory.

"In many cases, parts are purchased and then never used or even returned or sold. Similarly, there is little collaboration between upstream field sites-even when these operations are relatively nearby. There are no attempts to standardize parts, consolidate inventories, or collaborate on procurement," Ernst & Young noted.


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