Why the Oil and Gas Industry Is Vertically Integrated - Assignment Example

Why the Oil and Gas Industry Is Vertically Integrated Introduction Under management and microeconomics, vertical integration describes a model of management control, where the companies and distributors within the supply chain are united through a common player. Normally, each player in the supply chain acts at a different level of production or service provision, which combine to meet the common needs of the consumers. The distinction of vertical integration is that the model brings large segments of the supply chain, not only under the control of a universal ownership, but also under a single jurisdiction. An example here is the case of Ford River Rouge – during the 1920s, which engaged in the production of its own steel, as opposed to buying it from their previous suppliers. Vertical integration is one of the management styles, which can be used to circumvent the hold-up problem. The resultant monopoly created through vertical integration is referred as a vertical monopoly. The concept was introduced by Andrew Carnegie, a steel tycoon of the 19th century, towards fostering financial growth and efficiency in business. This paper is an explicative account of how the oil and gas industry is vertically integrated, with special regard to the oil and gas industry of the GCC, and discussing the advantages and the disadvantages of the model (Chu 12; Bento 29; Martin 145). Discussion According to Pusenkova (20), the oil and gas industry has been frequented by the talk of the need to heighten oil processing, so as to shift from the exportation of raw oil to the trading of processed oil, which fetches higher added value. In this regard, there is the case of national Oil companies (NOC), which has shifted from mere extraction of oil and gas, to engage in the processing of oil products, and the more developed level of engaging in oil chemistry. All NOCs began with the geological prospection of oil mining, then moved upwards through vertical integration – mounting oil processing plants and oil distribution models locally and internationally. These moves are affected to realize the reduction of transaction costs, as well aid these companies control the supply chain – from the oil well to the consumption point. The moves also aid in eliminating the effects of abrupt oil price fluctuations, due to the stability in the costs of production (Pusencova 21). An example of a NOC center, which has successfully applied vertical integration, is Saudi Arabia’s Aramco, which has effectively used the model to impose changes in oil and gas production. From the case, the company is projecting a rise in extraction levels to 15 million barrels each day, by 2025, from the 10 million daily barrels produced in a day, in 2006. The company, further forecasts holding a reserve production capacity of 1.5 - 2 million barrels a day by the same year. However, towards the realization of these, the company invested USD 50 billion towards the expansion of the production infrastructure and models. During the 1980s, production leaders set out to extend their national productivity and independence through diversification and increased control over their customer base. This was realized through establishing control over refining plants, where they sought to posses 50% of the total oil extracted. By 2008, Aramco had command over five operational refineries within the country, all of capacity range between 1.4 million a day and entered into 2 partnership ventures with Shell and ExxonMobil – both of which produce 500,000 barrels of oil on a daily basis. In the same year, the company held rights in different foreign refineries at South East Asia, Greece and the US – producing a total of 1.65 million daily. The company also entered into a deal with Sumitomo Chemicals, for an integrated production of oil-refining and petro-chemical production. Other chemical deals secured by the company include that with Dow Chemicals, to produce plastic and chemical products (Pusencova 1; Bozon 47). A second case is that of the KPC company of Kuwait, which has fully developed its sales model, acquiring oil refining centers at Denmark and Holland, qualifying it as the first state-run company from a third world country, trading oil products in foreign markets under its petrol stations and brand name. In 1995, the company’s subsidiary, Petrochemical Industries Company (PIC) signed an agreement for a partnership venture with Union Carbide. In 1997, the two built a petro-chemical company for the production of ethyl-glycol and polyethylene for exportation to Europe, the Middle East, and Asia. The new deals helped Kuwait reduce dependence on oil revenues and further developed petro-chemical technology, finance, management and marketing – as well as a source of jobs. In 2003, Dow Chemicals and PIC engaged in the setup of Olefins II complex to produce derivatives and ethylene, which resumed operations in 2008 (Pusencova 1). The third case is that of the UAE, which diversified their business from being a raw material appendage party to developed nations. In 1998, ADNOC entered into a joint venture with Borealis – towards the creation of the polymer producing company, Borouge. In 2001, the company built a major petro-chemical plant in the Middle East – which produces 450,000 tons of polythene a year. These countries, mainly due to their natural gas endowment, they are acquiring advanced technologies – thus shifting from purely raw material trading. In this case, liquefied natural gas is traded to export markets, thus the acquisition of liquefying technology – which further fostered their economic development. Other countries like Indonesia diversified into the production of gas in 1971, after uncovering its Arun gas field. In 1977, the Pertamina Company developed the first gas liquefying factory – thus started shipping its produce to Japan (Pusencova 1). The factors that are leading to the emergence of vertical integration at GCC countries include the recognition that they lose a lot of revenues, from the trading of raw oil and gas resources. That was the case with Saudi Arabia’s Aramco, after realizing that they were losing from exporting raw oil and gas products. Another factor was the setup of the legal framework – which placed the Gulf region as a broker between international and regional utilities. This was the case, after the creation of the GCC interconnection authority, geared at enhancing cooperation between the countries and the establishment of a universal market for the region. The region is recognized as a gateway towards realizing Pan-Arab and regional power implements, towards promoting environmental, economic and social developments with other centers like the Middle East and North Africa. Taking this principal role calls for centralized development of the region’s economy, which can be realized through diversification of the models of production. Further, the diversification will act as the launching pad for other developments like railway and water infrastructure –which pushes the region deeper into vertical integration – both at the national, regional, and the international level (Al-Asaad et al. 33-34). Conclusion The benefits of vertical integration upon GCC countries include a reduction in the transportation costs involved in non-diversified production, especially in the cases where production is carried out at closer geographic proximity. From vertical integration, they will also benefit from improved supply chain coordination, and an increased level of opportunities – due to the higher level of control over production inputs. The countries and the respective companies will capture downstream and upstream profit margins, thus realize an increase in revenues. The integration, further acts as facilitation towards investing in highly specialized production models and assets, which downstream or upstream players may not be able to invest in. vertical integration acts as a model of increasing entry barriers to potential competition – thus securing the current investors within the member countries. The model will also foster the expansion of core competencies in the areas of increased production channels – thus increased national dependence. The advantages resulting from vertical integration include capacity balancing problems – for example, the countries, and the respective companies, may be obligated to further development of upstream capacity, towards ensuring that downstream specializations receive adequate supply under all demand variations. The companies and their respective companies may face the problems of higher production costs, due to the low efficiencies developed from lack of supplier competition. The new competencies developed may compromise the existing competency-bases, due to the resultant shift in concentration onto the new specialization areas (Oba & Chan-Olmstead 99-118). Works Cited Al-Asaad, Hassan et al. “GCC Power Grid: Transforming the GCC Power Sector into a Major Energy Trading Market” paper presented at Cigre Conference, Abu Dhabi, UAE (2006): 33-34. Bento, John. “Supply-Chain Logistics Reduce Costs.” Journal of Petroleum Technology, August, 2003: 29. Bozon, Ivo. “Uncertainty and Volatility in Today’s Energy System: Stability, Security, and Sustainability through Mutual Interdependence.” Journal of Petroleum Technology, March, 2006: 47. Chu, Edward. “Managing Supply Chains: Lessons from Simulation Studies.” California Journal of Operations Management 2. 1 (2004): 12. Martin, Perry. “Vertical Integration: Determinants and Effects." in Handbook of Industrial Organization, North Holland, 1988: 145. Oba, Goro, & Chan-Olmstead Sylvia. "Self-Dealing or Market Transaction? An Exploratory Study of Vertical Integration in the U.S. Television Syndication Market." Journal of Media Economics 19. 2 (2006): 99-118. Pusencova, Nina. “Strategies of National Oil Companies: On the way to Vertical Integration.” Nezavisimaya Gazeta, 2008. Web. May 18 2012. Read More