Download national oil companies` vertical integration strategy for oil supply

NATIONAL OIL COMPANIES’ VERTICAL INTEGRATION STRATEGY
FOR OIL SUPPLY SECURITY IN CHINA AND INDIA
Draga Claudia MARIN, CGEMP Leda Université Paris-Dauphine, +33 6 38 54 16 35, [email protected]
Overview
China and India, two countries of the BRIC 1 (Brazil, Russia, India and China) are significant actors on the energy
markets. They have specific characteristic and play a growing role. Thanks to its economic growth, China became a
net importer in 1993. Its R/P ratio2 is very low (11.4) compared to the one of the world (52.9) (BP Statistical Review
of World Energy June 2013). India is a net oil importer, even if the country is the 24 thworld oil producer. The proved
reserves (22nd place in 2012) cannot cover the consumption (India was the fourth oil consumer in 2012). BRIC
countries are among the ten first consumers of oil, and China was the second most important consumer of oil in
2012. BRIC countries have decided that the oil sector should remain under the State's control, by the mean of
National Oil Companies (NOC). NOCs own 80 % of world oil reserves 3; they count among the main actors in the
offer-demand game. This is the reason why there are a lot of debates concerning the politics of their companies, their
objectives and priorities.
The internationalization of supply flows has emphasized the importance of supply security. Supply security is used
when we talk about energy security. A sure supply is a regular and continuous flow of energy with an affordable
price, starting from the primary energy production and until the final consumer. Supply security concerns the access
to primary resources, production, processing, transport and distribution.
In our analysis, we consider China and India as the two consumer countries from the BRICs. The strategy of their
NOCs to enhance oil supply security depends on their countries profile of consumer. China and India’s NOCs want
to increase their vertical integration degree, so they develop in downstream markets in order to enhance supply
security. Van der Linde (2000) emphasizes that the desire to ensure supply and demand security has sustained the
vertical integration and the internalization of oil companies since the beginning of the modern oil industry.
Williamson (1971, 1975, 1989, 2002) argues that vertical integration can reduce transaction costs. If a transaction is
too costly on the market, the company can reduce the costs if this transaction is internalized. Williamson’s work
(1975) has been used by Teece (1976) for oil industry. He studies a refinery’s integration in oil production and
analyses the advantages in terms of supply security. His results show that in the oil market, where there the number
of actors who negotiate is restrained, they might have opportunistic behaviors.
In this paper, we analyze the impact of vertical integration (upstream and downstream) of main NOCs from China
and India on the supply security of their country. The first part of this article makes a short presentation of
PetroChina, China Petroleum & Chemical Corporation – for China, and Oil and Natural Gas Corporation Ltd for
India. Then, we present theoretic aspects of vertical integration, including advantages and disadvantages. It is
traditionally considered that this strategy is well represented by the oil industry, because the production levels are
distinguished. The construction of the econometrical model used to show the influence of vertical integration of
NOCs on oil supply security in China and India is presented. The final part of this analysis shows the results and
conclusions based on empirical evidence.
There are a certain number of studies that were made concerning vertical integration, but NOC literature is limited.
This is the reason why the World Bank started in 2008 a study concerning NOCs and value creation. A restrain
number of papers talk about the NOCs role in supply security, like Downs (2004) or the analysis of James A. Baker
III Institute for Public Policy of Rice University (2007). Despite their growing role on the energy market, there are
few quantitative studies about the National Oil Companies because of limited dates on them. This paper brings an
empirical evidence of their vertical integration impact on supply security through a pooled linear regression model,
by measuring different aspects of their strategy.
Methods
In this paper, we use econometric techniques in order to show the influence of NOCs’ vertical integration on supply
security for China and India. Oil supply sources diversity is one of the most appropriate solutions to ensure supply
security. Based on Stirling's (1994) work, the Shannon index can be used to measure it. We employ Arkel, Boots
and Jansen’s report (2004) in order to create several indicators for oil supply security measurement:
The acronym « BRIC » has been introduced for the first time by the economist Jim O’Neill from Goldman Sachs in 2001, in a study
published in the Global Economics Papers, with the title « Building Better Global Economic BRICs ».
2
The R/P ratio (Reserves / Production) is obtained by the division of energy reserves remaining at the end of the year by the production
of that year. The result is the period of time for which these reserves will be sufficient if the production level remains the same.
3
La Documentation Française, January 2011, ttp://www.ladocumentationfrancaise.fr/dossiers/petrole/economie-petrole.shtml.
1

the diversity index. For each country, we consider two supply sources : imports and domestic production of
crude oil ;
 the diversity of oil supply regions ;
 the resources depletion index, which is based on the R/P ratio for each supply region.
We create an index for oil supply security, as the average of these three indicators. Vertical integration is measured
by using two of the traditional dimensions of Harrigan (1986) : the degree and the ownership form in the
downstream. We use a pooled linear regression model to show the relationship between oil supply security, which is
the dependent variable, and vertical integration. The degree and ownership form will be considered as predictors.
We consider that the coefficients showing the effect of independent variable on the dependent one are constant in
time and for all NOCs, we use a fixed effects model. The regression is done on a period of 10 years (2003-2012).
The youngest company, Sinopec Corp (China Petroleum & Chemical Corporation), has been created in 2000.
Results
Results show that 89 % of oil supply security’s variance is explained by the degree of vertical integration and
ownership form in downstream (adjusted
is 88.9%). The two dimensions of vertical integration that we’ve
considered are statistically significant to describe the dependent variable. The relationships are positive, so an
increase of the independent variables values means a higher oil supply security. A NOC that will increase the
vertical integration degree or her participation in subsidiaries or joint-ventures will improve her country’s oil supply
security. Also, the ownership form is the most important in the model, as it has the highest t-value, and it can be
used by the company to control uncertainities. Joint ventures in the downstream will give access to new markets and
can help NOCs to win host countries’ trust.
Conclusions
Vertical integration has three main advantages: economies in oil refining costs, transaction costs reduction and less
risk. Even if upstream is the main focus of NOCs from China’s and India’s investments abroad, building refineries
and pipelines can contribute to the reinforcement of their relationships with the host countries. National oil
companies which failed to vertically integrate have difficulties. For example, the national oil company of Nigeria
has problems to supply petroleum products, even if it owns important oil reserves. The country has made significant
investments in refining, but the four refineries of Nigerian National Petroleum Company (NNPC) can't cover all the
demand and the country needs to import4.
This study is an evidence of the impact of NOCs’ role for their country in their politics to ensure energy security.
The indicators used to calculate the supply security index take into account different aspects based on diversity of
supply. This paper shows empirically that NOCs fulfill non-commercial objectives as requested by their States. It
brings more information about these companies behavior, based on concrete cases of two countries who count
among the main energy actors.
The econometric model that we propose in this study to analyze the relationship between oil supply security and
vertical integration can be developed by introducing some other variables, like oil transportation by pipeline, tanker,
truck. We would then have nine types of supply sources, for each type of transportation. Also, a more detailed
analysis of vertical integration can be made, by using the concept of breath of activities that Harrigan proposes in
her works. But this would imply to have access to on companies’ subsidiaries activities in each business segment.
References
Van Arkel, W.G. and M.G. Boots, J.C Jansen. Designing indicators of long-term energy supply security. Energy
Research Centre of the Netherlands ECN, 2004.
Downs, Erica. « The Chinese energy security debate. » The China Quarterly 177 (2004) : 21-41.
Harrigan, Kathryn. « Matching vertical integration strategies to competitive conditions. » Strategic Management
Journal 7, n°6 (1986) : 535-555.
Mitchell, Edward J. Vertical integration in the oil industry. Washington, D.C. : American Enterprise Institute for
Public Policy Research, 1976.
Striling, Andrew. « Diversity and ignorance in electricity supply investment. Adressing the solution rather than the
problem. » Energy Policy 22, n° 3 (1994) : 195-216.
Van der Linde, Coby. The State and the International Oil Market. Competition and the changing ownership of cude
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Williamson, Olivier E. Markets and Hierarchies – Analysis and Antitrust Implications : A Study in the Economics of
Internal Organization. New York : The Free Press, 1975.
4
Pusenkova, Nina Nikolayevna. « Strategies of National Oil Companies. On the Way to Vertical Integration.» Nezavisimaya gazeta
(16th of January 2008). http://en.ng.ru/energy/2008-01-16/5_oilcomp.html.