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Oil and Gas: Linking Up the Dots

Oil & Gas	1629 VIEWS
Oil & Gas
1629 VIEWS

Thursday, January 14, 2021 /05:20 AM / By Proshare Research/ Header Image Credit: EcoGraphics

Oil & Gas and Financial Markets

Nigeria's O&G sector has been a key driver of domestic economic growth in the last four decades bringing huge foreign revenues but lacking complementary growth in infrastructural and socio-economic development. The sector contributes less than 10% to gross domestic product (GDP) in contrast to its agriculture sector counterpart which contributes 24%.

The alignment between the oil & gas sector and the financial services sector mirrors an interesting misalignment between the financial services sector and agriculture. While a large slice of loans and advances of deposit money banks (DMBs) flowing to the oil & gas and power sectors, the agriculture sector has had to rely on special lending arrangements supported by the Central Bank of Nigeria (CBN) and its affiliate institutions.

The oil & gas sector has been a poster child for growth in Nigeria but its weak linkages with the rest of the economy have created a bizarre situation where the growth of the sector has increased the size of the wallets of sector participants but has not led to the required multiple benefits to the larger society which wants to see a rise in living standards. Nigeria's oil sector expansion has merely supported an accretion of funds to the Federal Allocation Account (FAAC), which mainly goes into funding rising and bloated recurrent expenditure of the government.

Nevertheless, local banks still favour the oil & gas (upstream) sector as a linchpin of domestic economic growth and allocate about a fifth of their loan book to the sector. Another 7% of bank loans go to the mid and downstream segments of the sector bringing total sectoral lending to 26.27% as of Q2 2020. Trailing the oil & gas sector banks in 2020 have equally batted a favourable eye towards the manufacturing sector despite a downturn in activities as a result of a COVID-19-inspired fall in demand and disruption to local and foreign supply chains. Roughly 16% of total bank credit went to the sector in Q2 2020 (see chart 6 below).

Chart 6: Choosing the Right Credit Jar; Nigerian Banks Still Favour Oil

Proshare Nigeria Pvt. Ltd.

Source: National Bureau of Statistics (NBS), Proshare Research

The agricultural sector was able to muster a comparatively modest 4.8% of total banking sector credit at the end of the second quarter of the year, suggesting that banks have not been overly impressed with the suggestions given by the federal government to increase sectoral credit exposure. The total credit to the agricultural sector was about N903.7m in Q2 2020 as against credit to the oil & gas sector of N3.6trn in Q2 2020 (see chart 7 below).

Chart 7: Nigerian Bank Credit Q2 2020; A Look at The Sectoral Slices

Proshare Nigeria Pvt. Ltd.

Source: National Bureau of Statistics (NBS), Proshare Research

The reluctance of banks to lend to the agricultural sector in comparison to the oil & gas sector is understandable. The oil & gas sector, especially the down and midstream segments of the sector do not throw up stellar returns (the same is increasingly true of the upstream sector as costs grow steeper and revenues turn flat), but they offer some notion (perhaps false) of stability and predictability. Conversely, the agricultural sector is pepper-sprayed with problems ranging from adverse seasonal weather conditions to poor storage facilities, high transportation costs, lack of standardized contracts (leading to highly variable incomes), and low farmgate margins.

The relative exposure of banks to the two sectors also reflects in the relative proportions of non-performing loans that banks carry on their books reflecting the weight of sectoral lending. As of Q2 2020, the banking sector had a total non-performing loan exposure to the oil & gas sector of N268.79bn. This was followed by general commerce at N171.55bn and then construction at N167.86bn. The fourth was general loans at N132.90bn and the fifth was manufacturing at N117.26bn. The non-performing loans of the agricultural sector were eight at N51.35bn (see chart 8 below).

Chart 8: Nigerian Bank Credit Q2 2020; When Nigerian Bank Loans Go Bad

Source: National Bureau of Statistics (NBS), Proshare Research

The total non-performing loans in the banking sector were N1.21trn in Q2 2020 with the oil & gas sector representing 22.17% and the agriculture sector representing 4.24% of bad domestic credit. General commerce represented the second-largest slice of the non-performing loan pie at 14.15% with the construction industry cutting in with a delinquent loan status of 13.85% (see chart 9 below).

Chart 9: Nigerian Domestic Credit; The Bad Boys of Non-performing Loans (%)

Proshare Nigeria Pvt. Ltd.

Source: National Bureau of Statistics (NBS), Proshare Research

Of Banks, Bankers, and Oil & Gas

Banks and bankers have not been able to shrug off the long-term romance with the oil and gas sector that has spanned over five decades. The average banking officer sees it as a stellar breakthrough to bring an oil loan into the bank's current asset ledger. The excitement presumes that oil company revenues are large and stable and would add sizeable value to the bank's profit and loss (P&L) account. Unfortunately, this is usually fiction rather than fact.

The global O&G sector in the last few years has been under intense pressure to remain both stable and profitable. The rising costs of production and falling revenues have squeezed operating margins thereby challenging the sustainability of the sector. The pressure under which O&Gs operate is mirrored in the proportion of non-performing loans (NPLs) associated with the sector on bank loan books (see table 1 below).

Table 1: O&G and Banks: The Tangled Relationship

To wriggle out of the reshaped realities of the business, downstream oil & gas businesses would have to adopt a three-phased approach to leaning into the future according to analysts at a global research company, McKinsey Consulting.

The McKinsey analysts argued that downstream oil firms will have to embark on the following phased and overlapping measures:

Illustration 4: O&G Restrategizing: Thinking Across Three Horizons

Phase 1: Readjust

In this phase, downstream companies would be required to preserve cash until a stronger indication of industry depression ends. The analysts admonished that companies in the segment should "They should exercise the full set of cash management levers, including reducing inventory positions, lengthening suppliers' payment terms, reducing receivables terms, deferring capital expenditures, and halting equity disbursements".

A few companies have already embarked on these measures, but this is just a start to ensuring that businesses respond appropriately to the imperatives of a shift in industry dynamics as they pull a few more levers.

Phase 2: Reimagine

The second phase of actions required to realign the downstream oil & gas business with changing supply and demand algorithms would include the following:

Rightsize general and administrative costs (G&As)- This would see companies taking a hacksaw to areas where it can reduce general and personnel costs. One way of assessing whether corporate costs are fit-for-purpose is to take a set of industry metrics and evaluate corporate performance to the industry average. For example, a company could look at its G&A expenses-to-revenue ratio and line it up against the industry average (median and not mean) to decide how much adjustments must be made to reduce the size of recurrent spending. As part of this effort, companies could outsource the payroll management function. To remain fiscally sustainable companies may need to cut their G&As by as much as 20 to 30%.

Launch improvements through operations- Companies in the downstream industry will have to get their hands dirty by reviewing their operations and chipping away at activities and/or processes that can be cut without adversely affecting revenues. The companies would also have to deliberately wrestle with cost heads and thump down on their expenditures. Mr. Tunji Oyebanji, managing director/CEO of 11 Plc. at a recent webinar on the future of the O&G industry in Nigeria emphasized the importance of process recalibration and market-friendly domestic pricing models. He specifically called for a review of all regulatory hindrances to efficient local operations of the downstream oil sector. 2If we are going to see operational sustainability in the local Nigerian oil market, then the forces of demand and supply must be allowed to determine the price of premium motor spirit (PMS) and other sundry products, marketers should be permitted to sell white products at differential prices based on their cost structures and efficiencies; also, the Nigerian National Petroleum Corporation (NNPC) prices should be commercially-anchored to promote fair competition", he noted.

Globally downstream participants, particularly oil refiners, stand to pump additional margins of between US$1.00 and US$1.50 if they can cap the pressure of rising industry costs. A few ways of doing this would include, but would not be limited to the following:

Repair and maintenance- the cost of repairs of equipment need to be scaled down with improvement in machine use and the measuring of the contribution of each machine to operating costs, profitability, environmental sustainability, and the corporate digital footprint.
Operational decision-making- organizations may be required to change their decision- making procedures and criteria. As operating conditions alter, companies will have to face the mirror and ask the hard questions about how ugly present practices and guidelines are in the presence of new cost-to-performance trade-offs. For example, companies may need to decide how often spares are switched and when new thresholds for vibration or process conditions have been attained.
Staffing- Corporations will have to come clean with themselves on how much staffing is optimal. A fall in demand and a thinning of operating margins will require some reconsideration of optimal staff strength. Consideration will also have to be given to what type of staff would be required for the organization's future transformation. With digitization and machine learning becoming an increasingly important factor in efficiency and cost containment within the industry corporations must begin re-skill, re-educate, and re-tool the workforce. An indication of how a staff cost optimization springboard could work is gleaned from how an operating plant reduced its project-engineering-labor cost by 25% by changing the way it allocated technical support. Such initiatives and cost-savings could be replicated in other operational areas.
Product quality levels- Improving product value chains will be critical to sustainable businesses and companies in the downstream oil & gas sector will need to craft a path towards improved product quality and delivery platforms. The corporations will need to reduce the number of times products randomly exceed minimum threshold quality benchmarks. If companies can improve demand-forecasts, they can improve product portfolios to align with demand expectations meaning that the cost of holding product inventories could be reduced sizably.
Planning operations- In times of volatility, especially in O&G markets, precision becomes a crucial consideration in operational sustainability. Businesses in the oil and gas sector must craft models that establish predictable links between raw materials and operational outcomes. Proper modeling reduces energy consumption and frees capital by guaranteeing better production planning.

Phase 3: Reform

The third horizon of O&G executives in a volatile business environment has to be reform. To assume that the old ways of doing business would achieve the expected new results would be naive. The shifts in global oil and gas demands and the evolution of energy use and technology would require the O&G sector to rethink and reform its business because not doing so would be like swimming happily while the tide is high only to realize that one has no pants on when the tide runs out, many businesses will suffer this fate as they remain oblivious of the technological Tsunami flooding their doorsteps.