Hodge: Oil industry must update financial model
Royal Dutch/Shell Group Finance Director Stephen Hodge Monday cautioned that many of the oil industry's longstanding financial policies need updating to adjust to a business environment being transformed by technology, sector maturity, and the digital economy. Left unmodernized, he said, the financial management orthodoxy that concentrated on "size for its own sake, return on capital, and cost cutting, [would prove] unreliable guides to long term growth in shareholder value."
LONDON, Feb. 19�Royal Dutch/Shell Group Finance Director Stephen Hodge Monday cautioned that many of the oil industry's longstanding financial policies need updating to adjust to a business environment being transformed by technology, sector maturity, and the digital economy.
Left unmodernized, he said, the financial management orthodoxy that concentrated on "size for its own sake, return on capital, and cost cutting, [would prove] unreliable guides to long term growth in shareholder value."
Speaking at an Institute of Petroleum meeting, he said, "There is a sort of standard model for financial management in the oil industry. Like any other standard model it is a practical one�it does work, because it contains a lot of truth. But I would like to suggest that it is less that the whole truth, and may now be quite flawed."
Hodge said the ongoing reliance by the oil industry on certain outdated financial conventions is leaving companies exposed to uncharted market forces as the sector enters a period that will confirm "volatility is not going to go away."
Financial practices marked by notions of "biggest is best," a "paramount desire for return on capital at all times," and "stay strong," he said, are being complicated by realities including "an unfriendly basic environment, notwithstanding (the high oil prices) we are enjoying today," a need to "totally rethink" the industry model for financial and "back office" support for the business, and more "sophisticated" financial markets.
"It is a matter of observation that the oil industry is out of scale to banks, which, in any event, are less inclined to lend their balance sheet," he said. "This has caused us all to turn to the capital markets which are undeniably huge, but cannot be relied on totally�witness the lack of liquidity towards Jan. 1, 2000."
Hodge acknowledges that the standard financial management model should not be discarded, however, as many of its hallmarks�operational merit, capital discipline, and "continuous strategic cost reduction"�are still valid.
"It is just that in the world of customer power and technology innovation we are moving to, it will not be enough to do well what we have always done," he stressed.
Large-scale oil companies, he notes, are better able to "ride out the violent swings in credit availability and liquidity," but because of high absolute levels of spare financial capacity, not "absolute size."
"In the 21st century, we need to move on and to change the game, using technology and financial innovation to drive costs down and service levels up in our mature businesses, and, to the extent we can, reposition our companies in the higher margin, faster growing, and less capital intensive sectors of the energy business."
Normalization�adjusting results to "constant" conditions�will be key to the financial metrics of the new economy, where the physical capital base is growing more slower that the business and "measures of quality are ambiguous and unreliable" as a yardstick of a company's long term performance, Hodge believes.
"Take total shareholder return�up to March last year the dotcoms showed truly stellar TSRs. But was this evidence of true quality?" he asked. "More seriously, premium return on average capital earnings through investment standstill or cost cutting to the point of anorexia is not a sign of quality.
"Conservative financial policies are still essential for us but going forward the emphasis should not be on size and wealth, but on strength and resilience," he added. "In some areas this will mean we must turn nearly 180�."