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1.

0 Introduction

Five forces framework is a tool to understand the dynamics of doing business in an

industry sector. In this article, the five forces framework is applied to understand the

dynamics of the oil industry. The external environment which influences the business of

a company consists of macroeconomic forces as well as industry dynamics. The article

uses Shell as an example to illustrate that the profitability of a company is significantly

dependent on the underlying industry dynamics. Shell is a global group of energy and

petrochemicals companies with around 93000 employees in more than 90 countries and

territories.

2.0 Five forces framework

For an organization to be successful in any industry, it is necessary to understand the

competitive structure of that industry. Organizations use various methods to carry out

industry analysis and one of the most influential and popular method is using Porters

Five Forces. It is an important framework that was developed my Micheal Porter in

1979. This framework is used to determine target markets, frame market entry strategies

and also to determine competition. The five forces are

The bargaining power of the suppliers An organization requires a number of inputs

such as raw materials, service suppliers, components and expertise. The capital that is

spent on these inputs go a long way in determining the profitability of the

organization. Hence, it is important to determine the bargaining power of the suppliers

and how they are able to have an influence to ensure that the transactions are in their

favor. If they have a strong power, then the organizations may have to pay a higher
price for their product or service. Vice versa, the organizations can get a favorable

deal.

The bargaining power of the customers - The bargaining power of the buyers has a

key role to play in the how the profits of an organization take shape. The bargaining

power of the buyers increases when there are more products in the industry, when the

number of buyers is less, buyers are aware of the market rates and trends and when

customers have an alternative option

The threat of entry of new competitors A market which has become successful will

attract new entrants and hence, the competition gets tougher. Some instances when the

threat of new entrants increases is when licenses and regulations are simpler, when

customers do not have much brand loyalty, when the investment required to set up a

company is low

The threat of substitute products or services If there are substitutes available in the

market, then customers can easily opt for substitutes when they want to. Substitutes

may not always be direct competitors. Threat of substitution is higher when products

do not offer unique benefits, when it is easier for customers to switch and when brand

loyalty is low.

The intensity of competitive rivalry If the intensity of the competition is high, then

organizations are forced to enhance their product/services or reduce the costs where as

if the intensity is low, then companies can earn more profit. The intensity is high when

there are a higher number of competitors in the market.


3.0 Shell

Shell is a leading energy company of the world and operates as an oil and gas

company. It operates as a global group of companies whose parent company is Royal

Dutch Shell plc which is incorporated in England and Wales. The headquarters of the

company are in Hague. The value chain of Royal Dutch shell extends from extraction

of crude oil and natural gas to marketing and trading of cleaner fuels. Thus it operates

in both downstream and upstream segment of oil and gas industry segment. The

upstream segment consists of exploring of oil and gas fields which requires technical

expertise and project management. The downstream activities require significant

economies of scale.

The scale of Royal Dutch shell is enormous (as will be for any company that exists in

the entire value chain of oil and energy sector). The company operates 30 refineries,

9000 kilometers of pipelines, 2500 storage tanks, 250 distribution facilities, 43,000

service stations and supplies approximately 11,000 tones of bitumen fuel products to

industry. It employs approximately 93,000 employees.


Apart from scale and scope of operations, Shell operates in 90 countries and

territories. Shell partners with different companies in different nations and continents.

The ownership and management of partner companies tend to vary significantly.

Sometimes the management structure of many joint ventures can be significantly

complicated. For instance Shell partners with Saudi Armaco in a venture called

Motiva. Motiva is a joint venture for refining in marketing in the United States of

America. Motivas sister company is Shell Oil Products which is owned by Royal

Dutch Shell plc. Royal Dutch Shell plc is the second largest integrated oil company in

the world after Exxon Mobil.

The large scale and scope of Shell means that it can have a significant role in

influencing the dynamics of the industry sector. For example a company like Shell

will directly influence the rivalry among existing competitors. We would also see how

the five forces influence the strategic evolution of a large company, which is expected

to be immune to local political and social environment prevailing in a particular part

of the world.

4.0 Quantitative and Qualitative data

The energy industry and the oil and gas segments get significant coverage from

prestigious business papers and periodicals like the economist, Wall Street Journal

and Financial times. There are lot of analysis done about the sector by consulting

firms like McKinsey, BCG, Bain, EnY, PwC and others. Some of the reports and

white papers published by such consulting firms are available on the internet and are

used to understand the dynamics of the industry structure, by using the five forces

framework. The research papers published on various topics and issues relevant to the

oil and energy industry are another important source of analysis. These papers are

published in industry specific journals but were researched using the internet search
engines. Some more relevant papers may have been missed out due to restricted

access to select prestigious journals.

The information about the company is available in the annual reports of Shell and the

company website. The management discussion and analysis section of the annual

report is a useful section of annual report which can help in understanding the past

strategy and vision of the company management. But corporate managers are in a

principal agent relationship with the shareholders of the company and the views

expressed by them are likely to be prone to certain errors and biases. A more neutral

perspective on the strategy of Shell is available in the reports published by financial

analysts. A decent amount of analyst coverage can be gathered from the internet

search engines without paying any subscription fee.

5.0 Research Methodology

To apply the five forces framework in the oil and gas sector, scholarly articles which

mention some of the fundamental elements in the Porter five forces framework were

researched. For example there are journals and periodicals which have explored the

effects of economies of scale in the oil and energy sector. There are other articles

which mention how scale leads to an entry barrier in the industry. The preference was

given to academic and scholarly articles but some amount of information on the sector

has been gathered from prestigious financial papers and magazines like the

Economist, Financial Times and Wall Street Journal.

The overall approach was to identify the more fundamental elements in each of the

five forces and to research them individually. For example to understand the threat of

new completion in the oil and energy industry scholarly articles and business

journalism was researched pertaining to topics like role of patents and rights in the oil
and energy industry, switching costs for consumer of oil and gas industrial products,

role of brand equity in retailing and marketing of finished energy products, capital

requirements in the drilling and exploration industry segment (upstream) and capital

requirements in the refining and distribution segment (downstream). The threat of

new competition can be further explored by understanding the access of a new player

to distribution channels, the loyalty of retail and industrial consumers to a certain

brand or product and the industry profitability which will make the industry

potentially attractive or unattractive for a new entrant.

The past strategy of Shell (as understood from the analyst coverage and management

discussion and analysis in the annual report) is evaluated in the light of the five

underlying forces as we have understood them. Some comments are made about what

the future of Shell can be, using the past and the industry dynamics (as understood

from the five forces framework) as a guidance.

6.0 Research findings

6.1 Power of Suppliers

The suppliers to a company like Shell would consist of suppliers of rigs, pipelines and

other such instruments and service companies for operations like drilling. Although,

the suppliers for a company like Shell, can be large companies in themselves, the

threat of bargaining power of suppliers is perceived to be low in energy industry for a

company which is present in both upstream segment and downstream segment. Since

Shell is one of the largest Oil and Gas Company in the world, it is unlikely that any

suppliers would have any significant bargaining power with Shell. The global

presence of Shell, the financial strength of its balance sheet and its range of expertise

in upstream and downstream segment makes the threat of the bargaining power of

suppliers insignificant. Supplier concentration ratio is lower in the oil and energy
industry as compared to the firm concentration ratio (oil and gas sector consists of few

large companies).

The annual reports of Royal Dutch Shell Oil Company, often mention the network of

suppliers as an asset rather than a threat in the management, discussion and analysis

section.

6.2 Threat of New Entrants


The capital investment in oil and gas industry is large, but capital requirements are

only one entry barrier. Other entry barriers like patents, rights, legal status often vary

a lot from region to region. The sunk cost of starting an oil and energy industrial units

are high, which is another entry barrier. Customers often do not have a lot of loyalty

towards particular energy products, thus a new cash rich company can threaten the old

established companies. Access to distribution (pipelines, waterways) can also be a

barrier to entry which varies globally. The importance of scale and scope in the oil

industry can be gauged from the fact that mergers and acquisitions tend to go up in the

industry during a downturn as many relatively small business become unprofitable

and large companies feel they can lower their operations cost by acquiring small

companies (Rhodes, 1999).

The significant technological expertise needed in the oil and energy industry is

another entry barrier. Leading oil companies are able to negotiate favorable joint

venture contracts, as their partners value the expertise and project management skills

of large companies.

The need for scale and scope which is evident from the five forces dynamic also

reflects in the organization structure of Shell and other oil companies. Most

companies in this industry tend to have a strong central staff with decentralized

central operations (Roeber, 1994).


6.3 Threat of substitute products or services

Alternative fuels are typically mentioned as possible substitutes for oil and energy

fuel products. Alternative fuels consist of solar power, wind and hydroelectricity and

nuclear power. Shell has been aligning its strategy with evolution of alternative fuels

to become a more diversified energy firm (Dean, 2007). The project management

expertise of Shell is harder to substitute.

Another threat of substitute for a company like Shell is from the product of other

leading oil companies. Retail customers switch easily to the company that offers the

best prices for its product. The relationships with industrial consumers are not so

easily dissolved.

For some energy companies, natural gas can be a threat as a substitute product for

automotives instead of crude oil (Hekkert, 2003). Since Shell is a diversified oil

company with large percentage of revenues from both oil and gas industrial segments,

the threat of substitute products is not very relevant.

6.4 Power of buyers

The buyers of oil and gas energy products do not differentiate between products of

different leading companies and are essentially buying commodities. They demand

better prices or contract from the oil companies. Thus the leading oil companies have

rather limited pricing power since there are only few large companies capable of

providing energy fuels to the customers, but the products they offer are not

differentiated (Leonard and Young, 2002).

6.5 Rivalry among existing competitors

The competitive rivalry depends (among other things) on exit barriers. The exit

barriers are particularly high in oil and gas industry as the sunk cost of investment is

very high. An oil refinery that is not operating does not have any other capability that
can be utilized for creating shareholder value. The cyclical nature of the industry often

results in an excess of capacity in the industry.

In the industry rising oil and gas prices do not always translate to high profits

(Economist, 2007). For example the oil prices shot up to $110 a barrel in 2007, but

during the quarter in which the price spike happened, most oil companies reported a

loss (Financial Times, 2007). The profits of oil companies are also affected by

exchange rate fluctuations. A large company like Shell can manage the exchange rate

fluctuations better.

In the long run oil and gas industry has been very profitable. The stock prices of Shell

recovered within a year after a serious accounting scandal in 2004, when Shell was

made to reevaluate its proven reserves (Financial Times, 2005). Sustainable high

prices of oil may boost the value of companies like Shell as it did in the 1970s

(Economist, 2005).

The threat to future profitability of oil and energy companies (including Shell) can

come from depletion of existing reserves, high cost of resources and poor access to

new and economical reserves (Dean, 2007)

7.0 Conclusion

The management discussion and analysis in the last few annual reports of Shell,

suggest that company is keen in developing technology, brand management,

partnership skills and project management expertise. The reasons for the same are

evident from the industry dynamic that emerges from the five forces analysis. The

threat of suppliers is low and entry barriers are high in the industry. Yet the

competition from existing players is high and consumers easily switch to more value

for money products. There is also a threat from alternative fuels, and the world would
gradually move in that direction. Thus Shell is wise in positioning itself as an energy

company which can manage large projects with expertise.

An examination of annual reports also suggests that Shell is investing significantly in

its alternative resources strategy by mergers, acquisitions and joint ventures with

alternative energy players. Thus Shell is combating the threat of substitute products

and increasing power of buyers by leveraging upon its strength of project

management and global scale and presence.

Thus Shell is moving towards becoming an even more diverse energy company thus

reducing the threat of substitute products. It remains to be seen if it able to develop a

significant brand equity in renewable or alternative energy. If it succeeds in doing so,

Shell would mitigate the increasing power of buyers as well. Some of the mergers or

acquisitions have not worked as Shell may have envisioned them and shell has backed

out of quite few of them (Shell International, 2010; Financial Times, 2008).

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