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A new role for NOCs

To cope with an era of lower oil prices, state-owned firms must put value above volume and focus less on production, more on their commercial position

National oil companies (NOCs) are under tremendous pressure to transform. These companies were originally set up to maximise the realisation of their country's hydrocarbon resources and fund their government's budgets through taxes and dividends. Many NOCs have also been called on to be major employers and contribute to social-welfare programs. Changing circumstances have required all NOCs, including net importers, to refocus on capital allocation and costs.

Now, due to the steep decline in oil prices by more than 60% from their peak, NOCs are struggling to remain profitable and continue fulfilling their commitment to their governments. As a result, governments that depend on oil and gas for revenue—particularly in the Middle East—have had to cut back spending on economic investment incentives and social-welfare programs.

To manage volatility, governments have taken steps toward reducing or removing fuel subsidies to lessen the financial burden on themselves or their NOC. Meanwhile, NOCs have made adjustments by reducing capital expenditure, taking on higher debt, selling assets, spinning off subsidiaries or pursuing an IPO of a parent company to try to continue meeting their commitments. Some NOCs have also frozen or cut employee salaries and, in a few cases, have laid off workers. But these ad hoc measures aren't sufficient.

The role of the NOC needs to be reexamined and the structure of the NOC needs to evolve in order to deliver competitive returns in a lower-for-longer oil-price future. This means transitioning from production-focused to commercial NOCs; from a volume to value mindset. This transformation is easier said than done, especially given the complex and multifaceted relationship between NOCs and government.

The first step for any NOC on the path to transformation should be to understand where the state stands in terms of economic development and what role the NOC needs—or is expected—to play in future. Consider a country that produces crude oil but imports finished products as it lacks refining capacity. Many countries are tempted to reduce their import dependence and instruct the NOC to set up new refining plants or upgrade their older or underperforming plants. An investment in setting up or upgrading a new refinery involves an investment of billions of dollars and access to technology from world leaders in refining. With parts of the world awash with excess refining capacity, it may not make much sense for the NOC to invest significant sums to build or upgrade a new refinery. The NOC might be better served by focusing its capital on investing in streamlining its downstream retail network or optimising its mid-stream network, which could add more value and, at the same time, create new employment opportunities. For this to happen, the NOC would need to engage actively with the energy or economy ministries to showcase the cost benefit analysis of alternate options.

This example highlights the delicate balance needed between an NOC's commitment to the state (its main shareholder) and meeting the expectations of all stakeholders. Striking this balance is critical to the successful transformation of NOCs. In some cases, this may mean the renegotiation of elements of their contract with the state.

Adding value

To do this, NOCs must clearly outline their purpose—how it intends to create value for a broad set of stakeholders. The business case for purpose is simple: it improves corporate performance. An EY survey found that 58% of firms prioritising business purpose were growing at 10%+ per year. What's more, 84% of executives said they felt business transformation would be more successful if integrated with purpose—aligning all people to a single purpose ensures stakeholders work towards a common goal. Identifying a new purpose is especially important for NOCs needing to balance national and commercial objectives.

To become commercial in this way, NOCs should consider eight critical factors. They must take into account the total value of their contribution. This is a combination of two critical elements of value creation: shared value and externalities. Shared value refers to value creation for all stakeholders—customers, suppliers, local communities and employees. An externality, when positive, refers to value creation for society at large. This often revolves around the consumption or production of a good that benefits a third party. For instance, an NOC may purchase goods and services from a domestic supplier rather than importing them, or invest in local training.

The coming years will be defining for NOCs as they carve out a new model that maximises both their potential enterprise value and the contribution they make to their country. Those that follow a new purpose to transform themselves will achieve greater long-term success.

ANDY BROGAN is EY's Global Oil & Gas Transactions Leader

This article is part of an in-depth series on NOCs. Next article: How to thrive in the transition

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