ORLEN ORLEN Group 2017
Integrated Report

Outlook 2018+

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Time of Change for Business

Watching and analysing changes in the business landscape is one of the basic duties of any respectable company’s strategy team. Oil companies are obviously focused on the oil market, which can be looked at from many perspectives. Until recently, we concentrated mainly on oil price developments, while changes in the supply and demand were seen primarily as factors driving the prices. In 2010 it was still believed that oil reserves would run out one day, the question was only when exactly that would happen. The shale revolution in the US and new discoveries of oil deposits across the globe proved the theory wrong. Today, the general conviction is that thanks to revolutionary changes in oil exploration and production technologies, the recoverable oil reserves will be sufficient to meet demand at acceptable prices for a few decades. What today gives headaches to oil companies’ executives and strategists is uncertainty about the demand for crude oil, the key resource used to produce fuel for means of transport. In this area, there have been a number of developments.

The electrical revolution

A central feature of publications and scenarios envisaging or built around the vision of shrinking oil demand is negative demand drivers. Electric mobility is to the fore, obviously, but looming in the background is a much more powerful force − the progressing digital revolution, which has been hailed as the fourth industrial revolution. Its impacts reach far beyond traditional industry and are strongly influenced by demographic and social changes.

In one of its reports, The Boston Consulting Group presents the following nine pillars of technological advancement that will transform industrial production: big data and analytics, augmented reality, additive manufacturing (3D printing), the cloud, cybersecurity, autonomous robots, simulation, horizontal and vertical system integration and the industrial Internet of Things. Importantly, all the technologies overlap and will logically interact, and in the long run the interactions will probably not be controlled by humans any more but by artificial intelligence.

What all the technologies have in common is their ‘digitality’. Since anything digital is also electric, the fourth industrial revolution is an electrical revolution as well, with far-reaching implications for the energy and transport sectors. In view of all that, looking for and observing the first signs of changes, and assessing where they might lead, is more important than ever, especially that the pace of changes has been accelerating, with final consumers playing an increasingly important role in the process. The revolution is also having an impact on the demand side of the market, determining which primary energy sources we choose and how we use energy.

A good example here is Google, whose data centres consume five terawatt-hours of electricity per year (as much as one million people living in San Francisco), with more than 80% of the energy coming from renewable sources. Predictability and stability of energy prices, which are offered by renewable sources, greatly help to run businesses where electricity is the largest cost item. The use of renewables is driven by business rationale − the cost of energy is easy to predict and, consisting mainly of depreciation charges, does not fluctuate with economic cycles. Production of electricity from renewable sources does not require fuel, whose prices move in response to supply and demand changes.

A closer look at these trends and underlying factors leads to the conclusion that something big and inevitable is going on. Digitalisation, i.e. technology, is the basis of it, but its driving force are people who reject the status quo and invent new services and products. All this can happen because of the power of the Internet and the disappearance of communication barriers.

Extending the strategy horizon

The rate of technological changes varies and depends on the life cycle of equipment. In the energy sector, where the life cycle lasts decades, they are slower than in the services sector, but they are also all-pervasive, because so are the Internet and social networks of our customers, competitors and suppliers. The risk is that slow changes are not that easy to spot, but once they are visible to the naked eye, it may be too late or too painful to adapt accordingly.

An illustrative example is the use of innovative hydraulic fracturing technologies to extract oil from unconventional fields. Because large oil companies failed to see the potential of hydraulic fracturing for more than a decade, oil prices slumped deeply and persistently, forcing many oil-exporting countries to make hard economic and social changes.

In order to see the potential effects of new technologies in the energy sector, both on the production and consumption side, the time horizon of the analysis needs to be expanded to at least three or four decades. Only then can the scale of the upcoming changes in transport and energy mix be visible. In the shorter term, the forecast share of electric cars in the global vehicle fleet is not particularly impressive.

In an interview for the university website Knowledge@Wharton, Professor Kevin Werbach of the University of Pennsylvania said: ‘There’s something big going on, and it’s a bigger trend than most people realize. There are three trends, and each in and of themselves is significant. One is what we often call the sharing economy — it’s really more the on-demand economy. It’s not just about sharing resources, but services like Uber and Airbnb, which give on-demand access to resources. The second piece is the Internet of Things — all kinds of devices, billions of devices getting networked. And the third is big data and analytics — the ability to understand and manipulate trends coming out of all those devices. What those three things together mean is that all of the world, potentially, is networked. It’s not just that you go somewhere to a computer or you go to your phone to get access to information. It’s that potentially everything is a generator of data, and all that data can be integrated and analysed and processed and manipulated. What that means is the kinds of trends and the kinds of developments that we saw online are now happening offline. They’re happening to things and physical objects in the world, as well.”

We are among those who realise how powerful the trends are, even if they start quite inconspicuously. It is our duty not only to take this knowledge into account in our work on strategy and in future decision-making processes, but also to share our observations and predictions as to the impact of those trends on our business with wide audiences.

Challenges to business

  • Despite the great uncertainty as to the future of the energy sector, one thing is sure: continuation scenarios are going into oblivion. There is no escape from changes – lagging behind may lead to measurable business losses.
  • The future belongs to those who spearhead the change. Today we already can see how powerful social media are. Those who ignore them lose customers, lose elections, and land on the outskirts of history. Equally powerful are digital platforms used to provide services – ignore them and you will lose to your rivals.
  • Industry and the energy sector are in for inevitable digitisation and, therefore, their business models must be adapted accordingly to meet customers’ needs. Those who fail to embark on adjustment measures put themselves in a losing position.
  • Consumers’ side will rule also in the energy sector, thanks to innovative technologies, developed and scaled up by industry. Safe automatic coordination, synchronisation and billing of electricity supply and consumption, all made possible by the blockchain technology, enhance the competitiveness of distributed electricity generation.
  • It is high time that we start setting new development paths in some areas. In the era of revolutionary changes, when continuity is out of question, the future is becoming extremely uncertain. The uncertainty is about how – rather that if – the world is going to change. No one can say for sure what the world will look like in 30 years. However, we must not stick to the belief that since we do not know what it will be like, we’d better not do anything and wait until things clarify.
  • Waiting for a change is not a good strategy to follow – you will only lag behind, weaken your competitive position, be marginalised, moved to the periphery or even excluded from the business community. A better solution is to use the changes as a driving force and – where possible – to influence them through innovative ventures.

Upcoming developments are a real challenge to the traditional industry and the energy sector as they are rather slow in the beginning and appear to be of a niche nature. Research into these processes at the business level shows that many of the world's giants, such as Boeing or General Electric, are changing their business models to capture the opportunities and avoid the threats posed by the fourth industrial revolution. Digitised companies are taking it all and growing rapidly, widening the gap between their efficiency and earnings and those of businesses that still operate in the analogue world.

It is important that any search for new solutions and related new business models takes into account the perspective of three groups of entities:

  • Individual consumers and their needs How to identify and satisfy those needs? How does the on-demand economy change consumer behaviour? To what extent will consumers' preferences affect the demand for energy and energy carriers?
  • Flexible businesses that make and deliver personalised products and services Do businesses, by offering new solutions, give consumers the opportunity to customise their products and services, or do the consumers and their behaviour, discovered through big data and analytics, play the leading part? How does business deal with digitisation? How do the new business models based on digital platforms and integrating with real business affect competition? In the past, a company from country A competed with a company from country B; today ‘digital companies’ compete with ‘analogue companies’.
  • Market moderators. How to regulate markets so as not to throw the baby out with the bathwater? How to accelerate the transformation of business models? What challenges does digitisation pose to regulators with respect to security anf protection of consumers against unfair competition?

Risk factor: differences in the capacity to adapt between the financial and oil sectors

Both the oil industry, which makes fuels, and transport, which relies on the oil industry’s products, are characterised by a considerable inertia: changes take a lot of time. In the opinion of the sectors’ major players, global demand is not going to decline in a time horizon of several decades, but there is a consensus that its growth will decelerate. They believe that we are more likely to see demand to plateau rather than to peak: demand reduction caused by the development of electromobility and improvement of the energy efficiency of internal combustion engines will be offset by growing transport needs as global population grows (over the next three decades global population is expected to increase by three billion people, which corresponds to today’s China and India taken together) and global GDP goes up. Upstream sector operators are of the opinion that oil reserves are sufficient to satisfy future demand at a reasonable price in the long term. This, however, will require exploration for and launch of production from new fields (YTF, or yet-to-find fields). The need for new fields is obvious as the existing ones are being depleted at the rate of approximately 2.5–3.0m barrels per day – such volumes must be produced today to keep demand levels unchanged.

Although today the oil sector appears to believe that demand is set to plateau, such belief is not shared by the financial sector, which provides funding for upstream projects. The reason is that the financial sector is inherently very flexible and accustomed to changes taking place rapidly when triggered by innovation, as is the case in the IT industry. The seed of uncertainty was planted in 2015, when the price of oil fell and it was clear that it would not rebound soon. It was at that time that predictions of the end (of growth) of the demand for oil and the prospects of prices stabilising at a low level appeared. The financial sector began to show signs of worry since oil prices serve as the basis for valuation of oil companies and many financial assets. We did not have to wait long to see the effects of this situation. At the end of 2015, the Financial Stability Board, an international body that monitors and makes recommendations about the global financial system, set up the Task Force on Climate-related Financial Disclosures (TCFD) led by Michael R. Bloomberg as its chairman. In June 2017, the TCFD issued recommendations on disclosing exposure to climate-related risks, which are actually becoming reporting standards for companies with revenues in excess of USD 1 billion. In December 2017, 230 organisations, including 150 financial institutions with total assets worth more than USD 80 trillion, many large energy companies, governments of European countries, and the London Stock Exchange, accepted those recommendations. According to the TCFD, the energy sector is exposed to climate risk due to changes in demand for fossil fuels, production and application technologies, emission reductions, and water availability.

Therefore, the TCFD recommendations are not supportive of investing in exploration for and production of new oil reserves, which creates the risk of a mismatch between future supply of crude and the fast growing and very inert demand for the commodity. Oil companies that have adopted the recommendations report on exposure of their current strategies to CO2 emission allowance price increases (to EUR 60 per tonne) and what mitigation measures they are taking. On the one hand, such measures involve considerable investments in new technologies to modernise existing assets, and in technologies creating new assets that do not generate emissions, often outside the companies’ traditional business areas. On the other hand, considerable time is needed before any results of these adjustments become visible in real economy.

For companies from the financial sector, the situation is quite different. Their exposures to climate risk stem from portfolios of financial assets invested in the real economy (including loans and credit facilities provided to oil companies and investments in their shares or bonds). Their risk exposure reduction process consists in adjusting their portfolios by eliminating the most risky assets and refraining from providing financing to companies and projects exposed to climate risk.

The difference in the possible pace of adjustment between the flexible financial sector and the inert oil sector requires coordination of their joint activities in the long-term horizon, including identification of appropriate metrics and methods of measurement, as well as evaluation criteria. Without such coordination, we will face growing risk of underinvestment in the hydrocarbon production sector in the period of rapid growth of demand, entailing the risk of uncontrolled oil price rallies and then slumps in the market.

Progress in adjusting recommendations and regulations to the adaptive capacity of the oil and transport sectors could be achieved through cooperation between the Financial Stability Board, the watchdog of the global financial system stability (security), and the International Energy Agency, which is responsible for overseeing the energy security of its member states.

Conclusions for the business

Digitisation is not happening in the virtual world but is creating and moving real world objects. You press a button on your smartphone thinking, ‘let a car appear’, and you see a man driving a real car to pick you up. Despite the virtual nature of the relationship with a customer, its effects are real. Digital technologies provide us with tools to reinvent our relationships with customers, build rapport with partners and suppliers, improve efficiency in production and logistics and build new growth areas.

Technology is just a tool. In order to use it effectively, we need to rethink the logic of change and how it will affect the way we do business. We are watching market trends: changing business models, pervasive digitisation, automation, and marketing personalisation. For an integrated energy market player like PKN ORLEN, a number of opportunities open up across all areas of activity, from retail, through production, to administration. The impact of these changes is so great that we have no choice but to become actively involved.

The new business models of the fourth industrial revolution are not just a development option for a traditional enterprise, which can be used or not. They are an imperative for change whose direction we already know: digitisation, automation and robotisation aimed at improving efficiency and the ability to sense and quickly respond to shifting customer needs. What can be automated, will be automated, to enhance quality and reliability. Studies already show (McKinsey) that competition is taking place between industries, not countries. Companies that go digital are able to offer higher quality products at lower prices, and by winning over customers and top talent from competitors, they strengthen their advantages even further. Companies that fail to digitise will lose out to those who entered the process early refusing to wait for what others will do.

What cannot be automated? Design, creativity, innovation. Benefits accrue to those who have invented a business and are at the centre of the value network. Those who occupy the peripheries, supplying materials, spare parts and components, may and will be replaced with cheaper suppliers. This holds true for companies as well as entire economies relying on cheap labour as the cornerstone of their development models.

It is the role of the government to ensure that value chain centres originate and remain at home. Regulators need to be active and dynamically align regulations to the requirements of new business models. A number of standards have been established: infant industry protection, the good practice of US regulators to allow a business scale-up where no threat to consumer interests has been identified, and subsequently to adjust existing regulations in consultation with business so that the adopted solutions are safe and beneficial.

A business success in the new reality is predicated on transparent regulations that favour innovative business models. Such regulations should be developed through dialogue with business and consumers as the prime movers of change. Industrial policy-makers need to closely monitor areas where technological innovations and new business models are emerging in order to understand their needs and implications and to make the necessary regulatory adjustments. Such a broad-based approach to regulation is a prerequisite for economic and social success.

However, simply initiating change early, which is a precondition for success, is not a guarantee of a successful business transformation. The success largely depends on the company itself – its strategy, organisational culture and competencies, as well as its ability to interpret trends, smoothly carry out the corporate transformation and adjust its product mix to ever changing customer needs. It is also crucial that management has the determination to pro-actively address change. This determination needs to go hand in hand with reasonable investment decisions, in line with the principle of ‘show me your capex, and I’ll tell what your strategy is’.

Finally, the most important thing of all. Introducing innovations and the related new business models will undoubtedly entail risks. However, Polish industry has begun to realise that it needs to change because the pressure from other players – including those outside the sector – is immense. If we do not innovate and change, someone else will eat our lunch. The examples of Uber, AirBnB, Spotify, and digital giants like Google and Amazon, demonstrate that new confident players are born every day, having huge potential to reframe industry for a digital future. We should do our best to join them.

Author of Outlook 2018+:
Adam Czyżewski
Chief Economist, PKN ORLEN



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