Energy Value Chains. What is a Value Chain?

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Energy Value Chains

Overview of Fundamentals

What is a “Value Chain?”

• 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

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Generic Value Chain

Firm Infrastructure

Human Resource Management Technology Development

Procurement

Inbound

Logistics Operations

Outbound Logistics

Marketing

& Sales Service

Mar

gin

ar M gin

Primary Activities

Support Activities

Source: Porter, 1985

How Thinking Has Changed, I

Assets/Core Competencies

Inputs, Raw Materials

Products/

Service Offering

Channels The Customer

Customer

Priorities Channels Offering Inputs, Raw Materials

Assets/Core Competencies Traditional Value Chain: Starts with core competencies

Modern Value Chain: Starts with the customer

Source: Porter, 1985

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Thinking How Changed, II Has

Source: McKinsey &

Company

Energy Value Chain Issues

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Human Resource Management

Source: McKinsey

& Company

Derivation of Basis Risk

“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

Production Transportation Distribution End Use

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Balancing the Market

LOW Prices HIGH SUPPLY DEMAND

Mean reversion is a reality if market- clearing participants exist

Mean Reversion: Oil Price Example

6 10 14 18 22 26 30 34 38 42 46 0 10 20 30 40 50 60 70 80

Fr eq ue nc y

Price

91:02-03:12

86:02-03:12

82:01-03:12

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Price Volatility and Risk Trade Offs with Competition: Open Access Example

E&P Pipelines LDCs End Users Power Commodity price risk flows

Capacity price risk flows

Risk accepting entities

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

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Global Oil Market Illustration

Physical Market

Bilateral Tenders

Term Market

Forward Deals Specific Market

Spot Deals

Tenders Bilateral

Futures

Swaps & Other OTC Formal Options

Source: Oil in Asia by Paul Horsnell, 1997, Oxford Institute for Energy Studies

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Industry Organization:

Vertical Integration?

Source: McKinsey &

Company

Willingness to pay

“Windfall”

Energy Value Add Comparison with

Other Industries

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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

Energy Value Chain 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

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US Value Chain Example

Oil and Gas Field Production Processing (if needed)

Pipeline Transportation (imports/exports)

Local Distribution

Liquefaction (LNG)

LNG Tanker Shipment (imports/exports) Regasification

Liquids (LPG) Transportation

Marketing and Distribution (if

applicable) Gas Separation

(if needed), Gathering

Residential Commercial Industrial (Direct Use) Electric Power

Generation (utilities, IPP,

industrial)

Electric Power Transmission

Electric Power Distribution

Direct Use (e.g., vehicle

transport)*

Oil Refining

(product Natural Gas Liquids Extraction

Liquids (LPG) stream Liquids (LPG) stream (propane, butanes, etc.) (propane, butanes, etc.) Methane stream Methane stream

Compressed natural gas (CNG; methane) and LPG are also used for vehicle transport;

alternative fuels can be used.

Oil/condensate stream Oil/condensate stream

Upstream

Downstream Midstream

The Major Energy Value Chains

Alternative generation technologies can be used.

Domestic production can be liquefied and stored;

LNG can be regasified for seasonal use; or used in transport.

Crude Transport

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Oil and gas field production

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.)

Gathering, processing

Natural gas pipeline transportation

Natural gas distribution

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)

Liquefaction (liquefied natural gas or LNG) 25-35%

$1.00/MMBtu

LNG tanker shipment to markets 15-25%

$0.40/MMBtu

Conversion back to gas phase for pipeline, distribution, end use 5-15%

$0.40/MMBtu

Direct use (electric power generation) 25-35%

CRUDE OIL VALUE CHAIN

NATURAL GAS VALUE CHAIN

Natural gas liquids transportation (pipeline, truck, tanker)

Wholesale and retail marketing and distribution Propane* sold to resellers:

$0.78/gallon (refinery) Propane sold to end-users:

$1.27/gallon 6 mmb/d

U.S. Avg.

DFPP

$15.56/bl

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

Transport+Treatment

$2.26

24 tcf Wellhead

$2.07/mcf

City Gate $3.11

$3.49

$1.04 (to City Gate)

$0.97

LNG Field-to-liquefaction 10-20%

(Percentages reflect approx.

share of total LNG value chain cost; $/MMBtu amounts assume 2,500-mile voyage) 1999 Data (U.S. EIA, Annual Energy Review)

* 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.

Marketed production 20 tcf Dry Gas 19 tcf Net Imports 4 tcf

A U.S. Illustration of Energy Value Chain Pricing, 1999

DFPP = domestic first purchase price (wellhead); RAC = refiner acquisition cost

Energy Value Chain Investment

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$16 Trillion Energy Investment Required Across the Energy Value Chains, 2001-2030

Source: IEA World Energy Investment Outlook 2003

Source: World Energy Investment Outlook, International Energy Agency, 2003.

$1,135

$1,045

$917 TOTAL

23 23

20 Pipelines

76 79

37 Tankers

147 143

122 Refining

96 60

49 Unconventional Oil

$793

$740

$689 Exploration &

Development

2021–2030 2011–2020

2001–2010

Investment Requirements in the Oil Sector ($ billion)

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Investments Required in Natural Gas Sector

$12.78 WORLD TOTAL

$4.29 Local Distribution (Gas & Power)

$1.60 Transmission

$0.71 Pipelines

$4.20 Power Generation

$0.25 LNG

$1.73 E&P

Source: IEA Global Investment Outlook, 2003

Comparative Risks and Returns:

Electricity Lags Oil & Gas

0 2 4 6 8 10 12 14 16

Oil and gas upstream Electricity Gas downstream

per cent

OECD Non-OECD

Energy Value Chains. What is a Value Chain?

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