Integrated Oil & Gas Sector Report

EXCERPT ONLY THIS IS NOT A FULL REPORT

KEY ISSUES FOR STRATEGIC INVESTORS: Integrated Oil & Gas Securing Access to New Sector Report Reserves Major oil and gas reserves are located in emerging markets, often in politically November 2006 volatile regions or conflict zones. There are associated environmental and social Report prepared by: Christian Meade, Analyst, [email protected]; Doug issues particularly regarding human Morrow, Senior Analyst, [email protected]; Dana Sasarean, Analyst, rights, transparency and the [email protected]; Susan Viets, Director, Research, environment. Failure to manage these [email protected]. For more information on this report or other Innovest reports, issues with upfront risk analysis can please contact Peter Wilkes, Managing Director, [email protected]. result in sunk investments that are either unrecoverable or fail to generate growth Developed Countries Emerging Market Countries

400 at anticipated rates. Similar issues exist in developed countries for growth

350 through the expansion of reserves in 300 ecologically sensitive regions like the Arctic, and growth through non- 250 conventional oil, such as oil sands 200 operations, where the environmental impact is high. Return (%) 150

100 Climate Change Strategies Companies are increasingly operating in 50 a carbon-constrained world owing to 0 tightening regulatory regimes. Exposure AAA AA A BBB BB B CCC to emissions and associated costs varies Rating depending on volume of emissions and

the geographic base for operations and Innovest Rating vs. Three Year Total Returns as of September 2006. Innovest sales. For proactive companies energy- believes that as these companies in emerging markets increasingly compete in efficiency and cogeneration lower international markets for access to capital that over the long term they will be at a operating costs; a focus on natural gas disadvantage in comparison with sector leaders, unless they substantially improve as well as renewable fuels and energy their sustainability performance. See page 14 for further explanation. reduces the environmental footprint… No part of this report may be reproduced in any manner without the written permission of Innovest Strategic Value Advisors, Inc. The information herein has been obtained from sources which we believe to be reliable, but we do not guarantee its accuracy or completeness. All opinions expressed herein are subject to change without Go to page 6 for the full list of notice. Innovest Strategic Value Advisors, Inc., its affiliated companies, or their respective shareholders, directors, officers and/or employees, may have a position in the securities discussed herein. The securities mentioned in this Key Issues for Strategic Investors document may not be eligible for sale in some states or countries, nor suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates. © 2006 Innovest Strategic Value Advisors, Inc. All rights reserved.

New York Toronto San Francisco Tokyo Mr. Peter Wilkes Ms. Susan McGeachie Mr. Pierre Trevet Mr. Hiromichi Soma Managing Director Director Managing Director Director +1 212 421 2000 ext. 216 +1 905 707 0876 ext. 217 +1 415 332 3506 +81 3 5976 8337 [email protected] [email protected] [email protected] [email protected]

Paris London Sydney Innovest Uncovering Hidden Value Perrine Dutronc Mr. Andy White Mr. Bill Hartnett for Strategic Investors Managing Director Managing Director Managing Director +33 (0)1 44 54 04 89 +44 (0) 20 7073 0469 +61 2 9940 2688 [email protected] [email protected] [email protected] www.innovestgroup.com

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Table of Contents

Chapters

1 Executive Summary...... 6 Securing Access to New Reserves...... 6 Climate Change Strategies ...... 6 Growth Market in Clean Energy...... 6 Managing Environmental Impacts...... 7 Managing Social Impact at the Community Level...... 7 Best and Worst Performers ...... 8 Top Rated Companies ...... 10 Bottom Rated Companies...... 10 Leaders and Laggards...... 10 Sector Leaders...... 10 Sector Laggards...... 10

2 Ratings and Financials...... 11 Company Ratings and Rankings...... 11 Investment valuation and financial ratios...... 12

3 Core Industry Trends: Environmental, Social and Governance (ESG) Trends Impacting Company Growth ...... 17 3.1 Global Energy Demand and Supply ...... 18 3.2 Climate Change and the Regulatory Environment: Companies are Operating in a Carbon- Constrained World...... 21 3.3 Growth Opportunities for Integrated Oil and Gas Companies...... 29 3.4 Growth Beyond Fossil Fuels: Renewables...... 33 Biofuels are a Growth Market ...... 38 Regulatory Support for Biofuels ...... 38 Public, Industry and Investor Interest in Biofuels ...... 39 Integrated Oil and Gas Companies Step Up Involvement in Biofuels Market...... 39 The Downside of Biofuels ...... 39 Synfuels ...... 39

4 Key Intangible Value Drivers, Current/Best Practice and Company Performance...... 40 Strategic Governance ...... 41 I) Strategy ...... 42 Value Drivers ...... 42 Current/ Best Practice and Company Performance...... 43 Value Drivers ...... 45 Current Practice and Company Performance ...... 45 II) Strategic Adaptability/Responsiveness and Capability ...... 47 Value Drivers ...... 48 Current/Best Practice and Company Performance...... 48 2

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Value Drivers ...... 49 Current Practice and Company Performance ...... 50 III) Traditional Governance...... 52 Value Drivers ...... 52 Current/Best Practice and Company Performance...... 52 Products and Services – Strategic Profit Opportunities...... 55 I) Intellectual Capital ...... 57 Value Drivers ...... 57 Current Practice and Company Performance ...... 57 II) Product Safety...... 58 Value Drivers ...... 58 Current Practice and Company Performance ...... 59 Human Capital ...... 60 I) Labor Relations ...... 61 Value Drivers ...... 61 Current/Best Practices and Company Performance ...... 62 II) Workplace Practices...... 63 Value Drivers ...... 63 Current Practice and Company Performance ...... 64 III) Health & Safety ...... 66 Value Drivers ...... 66 Best/Current Practice and Company Performance...... 67 Value Drivers ...... 68 Current Practice and Company Performance ...... 69 Environmental Performance...... 70 I) Environmental Strategy and Management...... 73 Value Drivers ...... 73 Current Practice and Company Performance ...... 74 II) Environmental Risk Factors and Eco-efficiency...... 77 General Risks and Value Drivers...... 77 Current Practices and Company Performance ...... 80 Climate Change ...... 81 Environmental Management Performance ...... 85 Biodiversity and habitat protection ...... 91 Stakeholder Capital...... 93 I) Stakeholder Relations ...... 95 Value Drivers ...... 95 Current Practice and Company Performance ...... 95 II) Local Communities...... 97 Value Drivers ...... 97 Current Practice and Company Performance ...... 98 III) Supply Chain ...... 100 Value Drivers ...... 100 Current Practice and Company Performance ...... 101 Emerging Market Operations ...... 102 Value Drivers ...... 102 Current Practice and Company Performance ...... 103

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5 Appendix 1 – Financials...... 106

6 Appendix 2 – Profiles ...... 109

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Figures

Figure 1 – IVA Best and Worst Performers...... 8 Figure 2 – Innovest Ratings for 28 Companies in the Integrated Oil and Gas Sector ...... 11 Figure 3 – IVA Ratings vs. Street Concensus...... 13 Figure 4 –IVA Ratings vs. 36 month Total Investment Return ...... 15 Figure 5 – World Primary Energy Demand ...... 18 Figure 6 – Oil and Gas Reserves in OECD and Non-OECD Countries...... 20 Figure 7 – The Kyoto Protocol Signatory Countries throughout the World ...... 21 Figure 8 – Industry GHG Emissions 2001–2005...... 22 Figure 9 – Economic Regions (% of World GDP) Committed to Greenhouse Gas Emissions Reductions Under the Kyoto Protocol ...... 23 Figure 10 – GHG Emissions in the Integrated Oil and Gas Sector ...... 25 Figure 11 – Sample Historical and Projected Emissions: Statoil versus Petrobras ...... 26 Figure 12 – Sample Emissions Intensity: Statoil versus Petrobras...... 26 Figure 13 – Average Number of Countries and Territories Where Companies Operate ...... 30 Figure 14 – Integrated Oil and Gas Proven Reserves ...... 34 Figure 15 – Clean Energy Projected Growth 2005 - 2015 ...... 36 Figure 16 – Actual, Estimated and Projected Oil Prices (Yearly Averages)...... 37 Figure 17 – Innovest Ratings for Strategic Governance ...... 41 Figure 18 – Innovest Ratings for Strategy Scores ...... 47 Figure 19 – Strategic Capability Scores...... 52 Figure 20 – Traditional Governance Scores ...... 55 Figure 21 – Strategic Profit Oportunities Scores...... 56 Figure 22 – Intellectual Capital Scores ...... 58 Figure 23 – Product Safety Scores ...... 60 Figure 24 – Human Capital Scores ...... 61 Figure 25 – Workplace Practices Scores ...... 66 Figure 26 – Business activities and HIV/AIDS risk...... 69 Figure 27 – Environmental Management Scores...... 77 Figure 28 – Structure of Revenue by Business Area ...... 81 Figure 29 – Integrated Oil & Gas Activities and Associated Direct Environmental Impacts...... 86 Figure 30 – Environmental Performance Scores ...... 93 Figure 31 – Stakeholder Capital Scores ...... 94 Figure 32 – Stakeholder Relations and Regulatory Concerns Scores...... 97 Figure 33 – Local Communities Scores ...... 100 Figure 34 – Supply Chain Scores ...... 102 Figure 35 – Emerging Market Operations Scores...... 105

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1 Executive Summary

In this, our fifth report on the integrated oil and gas sector, we focus on the impact of intangible value drivers (strategic governance, human capital, environmental management, and stakeholder capital) on growth and profitability for 28 companies in the global integrated oil and gas sector. Our top picks in the sector include Royal Dutch Shell, XXX, and XXX, although the latter company remains on watch. Laggards include PetroChina, XXX and XXX.

We also highlight key issues for strategic investors. These include:

Securing Access to New Reserves Major oil and gas reserves are located in emerging markets, often in politically volatile regions or conflict zones. There are associated environmental and social issues particularly regarding human rights, transparency and the environment. Failure to manage these issues with upfront risk analysis can result in sunk investments that are either unrecoverable or fail to generate growth at anticipated rates. Similar issues exist in developed countries for growth through the expansion of reserves in ecologically sensitive regions like the Arctic, and growth through non-conventional oil, such as oil sands operations, where the environmental impact is high.

Climate Change Strategies Companies are increasingly operating in a carbon-constrained world owing to tightening regulatory regimes. Exposure to emissions and associated costs varies depending on volume of emissions and the geographic base for operations and sales. For proactive companies energy-efficiency and cogeneration lower operating costs; a focus on natural gas as well as renewable fuels and energy reduces the environmental footprint on the consumer side, enabling these companies to capitalize on new clean energy markets. Extreme weather events such as hurricanes pose downside risk particularly for Gulf of Mexico operations.

Growth Market in Clean Energy There is strong upside potential in the clean energy market, which is growing rapidly and is projected to more than quadruple in size to USD 167 billion by 2015. The regulatory framework in many European countries and other parts of the world is accelerating clean energy growth. Opportunities for integrated oil and gas companies exist, in natural gas based products, cleaner burning fuels as well as in biofuels, wind and solar power.

Managing Environmental Impacts Variable costs place downward pressure on profitability margins and include expenditures to meet compliance with local, regional, and international

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restrictions on air emissions, water discharges, and waste generation. Companies that are better able to respond to increasing regulatory pressures and improve energy and resource efficiency are likely to be in a superior cost position relative to less sophisticated counterparts. Such companies will also have fewer environmentally-related complaints and less litigation filed against them by local communities and other stakeholders concerned by health hazards.

Managing Social Impact at the Community Level Stakeholder relations, particularly community relations, are becoming increasingly important given the number of human rights issues and community protests associated with oil and gas projects around the world. A firm’s ‘license to operate’ is ultimately dependent on approval from local communities and competitive advantage accrues to companies seen as bringing tangible benefits to local development.

In this report we also examine company growth strategies in the context of sustainability. Conventional growth strategies continue to focus on increasing company oil and gas reserves. As noted above, these reserves are increasingly located in volatile emerging markets. Companies with sophisticated environmental, social and emerging markets strategies in place are at an advantage in securing access to these resources; those failing to implement upfront risk assessment strategies can face financial risks from unrecoverable sunk investments or poor growth.

Growth through non-conventional oil production is environmentally controversial, with associated waste, water use and emissions issues, as is the case for oil sands production. The same is true for companies exploring in ecologically fragile regions such as the Arctic. With banks signing on in increasing numbers to the Equator Principles, project finance for many operations and particularly for those in emerging markets, is increasingly contingent on companies being able to demonstrate strong policy and performance on social and environmental issues. Companies focusing on R&D, such as carbon capture and sequestration, to mitigate environmental impacts and those with sophisticated stakeholder relations strategies in place face fewer risks of project delay or disruption.

More than 140 specific environmental, social and governance metrics lie at the core of our research model. Specific examples include an assessment of policy and performance for: senior management commitment to sustainability, success in attracting skilled employees in a tight labor market, health and safety, eco- efficiency measures, emissions reduction (reduced flaring, cogeneration etc.), renewable energy and renewable fuels, fines, litigation, local community relations and supply chain issues. Each of the 28 companies in our competitive set is rated, in a best in sector analysis, for its policies and performance on each of our metrics.

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BEST AND WORST PERFORMERS

Below we summarize the top three and bottom three company performers, both overall and for each of the four “pillars” of Innovest’s Intangible Value Assessment: Strategic Governance, Human Capital, Environment and Stakeholder Capital.

COMPANY NAMES EXCLUDED FROM THIS

EXCERPT BUT INCLUDED IN FULL REPORT

Figure 1 – IVA Best and Worst Performers

This table continues on the following page.

OVERALL IVA COMBO RATING

Highest IVA Score Key Risks and Advantages: The integrated oil and gas sector is faced with a distinct set of Lowest IVA Score XXX sustainability risks and opportunities, mainly focused on environmental, social and emerging XXX XXX markets issues connected to access to new reserves, the increasing demand for clean energy, XXX XXX regulatory (carbon) constraints associated with climate change, product development and XXX renewables, environmental mangement and safety, attracting employees in a climate of labor shortages, product safety and development, health and safety, stakeholder relations and local community interactions. Environmental issues are quantitative, qualitative and diverse in assessment with eco-efficiency practices, environmental management systems, accounting and reporting methods, environmental opportunities and risk amongst others incorporated into Innovest’s analysis. STRATEGIC GOVERNANCE STRATEGY

Highest IVA Score Key Risks and Advantages: With proper governance mechanisms in place, integrated oil and Lowest IVA Score XXX gas companies are better placed to implement an effective sustainability strategy. Advantages XXX XXX associated with a good sustainability strategy and strong performance include greater operational XXX XXX efficiency, reduced risk of accidents, an improved public image that can result in increased XXX market share, greater ease in meeting tightening regulatory requirements, and in some cases, improved access to project finance, particularly for emerging market operations. One of the key factors that we look for in our assessment is senior management commitment to sustainability. Companies that have not developed effective governance mechanisms remain open to a variety of risks including negative media campaigns, problems recruiting talented people, fines, and project delay. Further, sustainability issues tend to crop up quickly and unexpectedly; inadequate governance implies that companies will be unable to respond effectively, thus magnifying these risks.

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HUMAN CAPITAL

Highest IVA Score Key Risks and Advantages: Company spending on education, training and development, Lowest IVA Score XXX recruitment and retention, and health and safety are seen as key investments in human capital. XXX XXX A competitive differentiator, human capital management is an increasingly important indicator of XXX XXX corporate sophistication and a firm’s ability to generate value from its workforce. In addition XXX access to skilled employees is crucial to long term profitability in the integrated oil and gas sector. With exploration and production increasingly focusing on remote regions in emerging markets and harsh regions like the Arctic, some companies face additional complications of having to recruit individuals suited to operating in these conditions. ENVIRONMENT

Highest IVA Score Key Risks and Advantages: The successful management of environmental issues is one of Lowest IVA Score XXX the key drivers of intangible value in the integrated oil and gas sector. This is a high impact, XXX XXX extractive industry; the consumption of fossil fuels also has global environmental implications. XXX XXX Environmental concerns are at the top of the priorities list for numerous oil and gas XXX stakeholders, including local communities, policy-makers and NGOs. In addition to this environmental performance has a direct impact on company profitability. The quality of a company’s environmental management can impact access to capital and operating costs (due to efficiency measures), access to resources, speed of project approval, operating fines, product pricing, health and safety risk and overall reputation. Integrated oil and gas companies have direct environmental impacts from the normal course of operations (emissions, waste generation, discharges etc.) and from unscheduled and accidental occurences (spills, uncontrolled emissions, technological failure, human error, etc.). There are also indirect environmental impact issues associated with final products and services consumption (energy, gasoline, diesel, natural gas use etc.) In our analysis we believe that numerous factors including: setting targets, tracking and reporting emissions; energy efficiency measures; investment in renewable energy and renewable fuels; carbon capture and storage; a shift in fossil fuel product mix to natural gas; cogeneration; reduced flaring; and low overall decommissioning and environmental liabilities contribute significantly to a company’s value. STAKEHOLDER CAPITAL

Highest IVA Score Key Risks and Advantages: Investment in stakeholder capital is becoming an increasingly Lowest IVA Score XXX important factor for integrated oil and gas companies particularly in connection with their search XXX XXX for new reserves and their focus on non-conventional oil (NCO). Strong stakeholder relations, XXX XXX especially with local communities, can lead to strategic benefits for a company, including XXX increased access to resources, capital and project finance. Failure to address stakeholder issues can adversely impact on a company's license to operate and negatively impact a firm's overall reputation. Our research clearly shows an increase in the number of incidents where a local community has strongly opposed oil and gas drilling operations or LNG facilities denying or revoking a company’s social license to operate. Local community efforts have been successful in delaying approval and financing processes and disrupting production. In emerging markets infrastructure security and workers’ safety are also liabilities, with associated human rights implications, especially when companies hire private security forces to guard their facilities and personnel.

Source: Innovest’s Rating Model and Databases, 2006

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LEADERS AND LAGGARDS

Sector Leaders Sector leaders have a clear understanding of the value added from strong management of environmental, social and governance (ESG) issues, including a focus on climate change strategy and renewables, as well as brand reputation benefit. In the integrated oil and gas sector, it is not necessarily the larger companies with greater resources who are always the sustainability leaders.

Sector Laggards Sector laggards tend to be located in emerging markets where the regulatory environment is less stringent than in developed markets and where sustainability is only an emerging concept. These firms are competing for capital in the international arena and are at a disadvantage in comparison with sector leaders owing to their poor performance regarding the implementation of strong environmental, social and governance (ESG) strategies and policies, especially as they court investors in markets where extra-financial risks are increasingly on the radar.

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2 Ratings and Financials

REDACTED CHART

COMPANY RATINGS AND RANKINGS

Figure 2 – Innovest Ratings for 28 Companies in the Integrated Oil and Gas Sector

Overall Overall Social Env. Strategic Human Environ- Stake- Rating Rank Rating Rating Gover- Capital ment holder nance Capital Amerada Hess Corp. BG Group PLC BP PLC Chevron Corp. Conocophillips ENI Exxon Mobil Corp. Husky Energy Inc Imperial Oil Lukoil OAO Marathon Oil Corp. Murphy Oil Corp. Norsk Hydro AS Occidental Petroleum Corp. OMV AG Origin Energy Limited Petro-Canada PetroChina Company Petroleo Brasileiro Sa - Petrobras Petroleos (Cepsa) Repsol YPF Royal Dutch Shell Plc AAA 1 AAA AAA 7.7 7.3 7.9 9 Shell Canada Limited SNP Petrom Statoil Suncor Energy Inc Surgutneftegas Oao Total SA

Source: Innovest’s Rating Model and Databases, 2006

Innovest’s rating methodology was used to assess the relative performance of 28 companies within the integrated oil and industry on over 140 different aspects of: 11

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Intangible Value Assessment

Jun-06 RATING OUTLOOK: Steady excel in the sustainability area. The com- As a global player in the integrated oil and pany continues to improve sophistication Royal Dutch Shell Plc gas sector, RDS faces a wide range of sus- on its management of sustainability issues worldwide. Country: Netherlands tainability risks, ranging from working on environmentally sensitive sites in emerging Ticker Symbol: RDSB-LN Governance Improvements: RDS has markets to addressing community concerns governance structures in and accountability Industrial Sector: Integrated Oil & Gas in OECD countries. The company faced of top management place that should im- Combined IVA AAA major issues in connection with reserves prove transparency teams. This approach is Rating: overbooking but has implemented policies improving its reputation among regulators Sub-Factors: and restructuring to address this, although and industry organizations. litigation risk remains. Of particular con- Strategic Strong Investment in Renewables: cern for the international community is the Governance: 7.7 Shell has strongly invested not only in status of human rights in this industry. Human Capital: 7.3 technology development but also in the Although Shell faces continued problems in commercialization of renewable energy Environment: 7.9 Nigeria, it is one of the companies at the systems, becoming a sector leader in the Stakeholder Capital: 9.0 forefront with suitable policies and systems area. Through the commercialization of to manage these issues. RDS has imple- Analyst: Dana Sasarean such technology, the company has gained a 905-707-0876 mented suitable initiatives to reduce its competitive advantage. [email protected] exposure to sustainability risks and is in the

process of improving the sophistication of Intangible value comprises a growing STRATEGIC PROFIT OPPORTUNITIES percentage of companies’ market capi- its management system to enhance trans- talization. Innovest’s IVATM ratings ana- parency and accountability. Leading firms are engaged in research to lyze relative corporate performance on develop alternative energy technologies intangible value drivers related to the AREAS OF POTENTIAL RISK and bring them to market. Activities include research to commercialize and de- strength and sustainability of companies’ Environmental Fines: Recent environ- competitive advantage. By assessing dif- velop natural gas-based systems, clean mental fines and clean-up costs demon- ferentials typically not identified by tradi- vehicle fuels including fuel cells, develop- tional securities analysis, IVATM ratings strate that Shell still faces environmental ment of wind, solar and other renewable uncover hidden risks and value potential liabilities that may potentially tarnish its energy technologies, and partnerships to for investors. Ratings range from AAA reputation among regulatory bodies and operationalize small-scale clean distributed (best) to CCC (worst). Scores on sub- communities. This is important considering generation technologies. In our view, such factors range from 10 (best) to 0 (worst). that the company does not report environ- activities will create significant environmental costs in various other countries mental and social benefits over the long since their legislation is not strong enough term, in addition to attractive investment PERFORMANCE / to consider them a regulatory violation. ALPHA INTENSITY MATRIX opportunities for investors. Stakeholder Engagement: Despite the Going forward, RDS is one of the best 10 fact that Shell is strongly investing in im- positioned companies in the sector to capi- 9 proving relations with communities, current talize on these emerging opportunities. The 8 stakeholder engagement mechanisms have company says that its long term strategy is 7 still not proven sufficient to overcome past to establish a leading position in the new 6 issues and non-compliance claims. energy (‘alternative energy’) sector – a 5 Litigation Risk: RDS faces litigation in sector, which RDS says is expected to 4 connection with the overstatement of re- make up between a quarter and a third of 3

Performance of Company of Performance serve bookings and could face the prospect the energy mix by 2050. Shell has been 2 of more cases in the future. experimenting with renewable energy tech- 1 Security Risk: Due to the nature of its nologies for more than 20 years. In 1997, it 0 business, as a global player, Shell will con- made a commitment to invest US$500 012345678910 million over five years to significantly Alpha Intensity of Sub-Factor tinue to face security risks in various loca- tions in emerging markets. Despite the fact increase the renewable business area. For Strategic Governance Environment this purpose, Shell created another core Human Capital Stakeholder Capital that the company has been implementing business called "Shell Renewables”. Shell suitable systems and standards to reduce Renewables has so far focused on forestry, This matrix situates the four key intangi- negative impacts of its security-related ble value drivers along 2 dimensions: decisions, this issue will still be a challenge making and marketing photovoltaic (PV) 1. How well or poorly the company per- that needs to be resolved with the participa- panels that produce electricity from the sun forms on each of the 4 key factors. tion of local governments, organizations power, and using wood for energy (bio- 2. How much impact that particular factor and communities. mass). In 1999, Shell Renewables began has on financial performance in that in- investing in wind energy. Later in 1999 dustry sector; its “alpha intensity”. AREAS OF COMPETITIVE ADVANTAGE these initiatives were extended when Shell Hydrogen was established to pursue and Sustainable Governance Practices: develop business opportunities related to Shell has implemented proactive programs hydrogen and fuel cells on a global basis. and leading edge policies and standards to RDS does, however, state that renewables Copyright© 1998-2006. All rights reserved. Innovest Strategic Value Advisors, Inc.