If one owns-or contemplates owning-an oil-related stock, one needs to know what these companies are doing to address the highly competitive landscape of the new economy, to ask, "What is your Internet strategy?" Simply put, the technology is too important to be ignored any longer, from the perspectives of creating new business opportunities, competitive positioning within existing businesses and overall cost. The oil business is intensely competitive-even cut-throat. Producers compete for razor-thin margins and treat new information and technology as proprietary. The industry is also mature, overcapitalized and highly sensitive to volatile commodity prices. The "organic" market growth rate of the oil business is probably limited to 1% to 3% per year, which is the projected annual growth rate of global petroleum-related demand. So, on the surface, the oil business does not appear to have a lot going for it. And now it is facing potentially one of the most disruptive macro events we have seen in a long time-the advent of the Internet. By virtue of its ubiquitous nature, the Internet could rapidly destroy traditional sources of competitive advantage and create new ones. Therefore, those companies that have traditionally been thought of as market leaders could be found on the sidelines of the new economy, unless they innovate. E-commerce, and ultimately broader related e-business applications (workflow process value-added services in addition to the transaction platform of e-commerce), have the potential to be the next leg of major cost savings for the major oil companies. Full application of e-commerce/e-business will shave an incremental 5% to 15% of costs out of the system. These cost savings could improve earnings by 3% to 10% on a run-rate basis, with early adopters potentially generating even a better earnings uplift. Companies that embrace the technology and lead rather than follow will be rewarded with incremental market share, which could further fuel earnings power going forward. Chevron has already experienced this in its core gasoline retailing area in the United States. (For more on this, see "Cyber Sales, Real Cash," Oil and Gas Investor, September 1999.) Adopting e-commerce will be especially critical to the major oils in light of our assertion that BP Amoco's acquisition of Arco will be the last megamerger for a long time in the oil patch. We do not believe major oil companies should bank on mergers and acquisitions to bail themselves out going forward, as international regulatory bodies such as the European Commission, and especially the U.S. Federal Trade Commission, have become highly sensitive to further consolidation in this sector. E-oil markets and opportunities The oil and gas trade is one of the largest businesses in the world, accounting for roughly $2.5 trillion in gross trade revenues and roughly $430 billion in annual procurement costs worldwide. Although oil represents roughly two-thirds of this mix, natural gas has experienced a faster growth rate because of technological, environmental and supply-security reasons. According to Richard Spears & Associates, the com- bined value of oil services markets was roughly $8 billion at the peak in 1998. According to Greg Mitchell of PricewaterhouseCoopers, it takes about 150 different systems in a single company to carry out a drilling proposal process, from seismic to wireline logging. Clearly there is vast potential for cost savings and improved workflow management and reduced paperwork. The Internet has the potential to introduce a new class of intermediaries into the oil business: online trading hubs. The Internet will not eliminate the middlemen, but it will enable a new class of middlemen that would notionally add value more effectively than traditional middlemen. One of the key added values that intermediaries provide comes from helping a large number of buyers and suppliers reduce the cost of doing business with each other by reducing the number of relationships they need to develop and manage. Trading hubs create huge value by leveraging information delivery and live community-building capabilities to become vital middlemen in the new economy. Using the concept of Information, Transaction and Fulfillment (ITF), these hubs can create significant added value and establish high-ROI business models by becoming the best intermediaries of information and transaction flow in their respective markets. Distinguishing between the opportunity and hype surrounding trading hubs is not easy. According to AMR research director Bob Parker, "There are currently 600 funded trading exchanges. This probably will expand to almost 2,000 before it begins to contract." By our most recent count, there are more than 40 online procurement and trading exchanges in hydrocarbon-land (both upstream and downstream), and more seem to be cropping up every day. Is there room for so many? AMR Research believes there is room for one dominant player, and up to two contenders, which suggests that ultimately most of these exchanges likely will be acquired or fail. Although we believe it is too early to determine the ultimate victors in the race for the B2B ecommerce space, the rapid pace of "Internet time" should favor those companies that have already begun to develop Internet-based strategies and/or have begun the process of implementing them. The combination of relatively low barriers to entry in creating the basic building blocks of trading hubs, along with the tremendous power of owning Internet market and mind share, should create huge first-mover advantages. While the characteristics of each B2B market are unique-some have supplier power, others buyer power, yet others distributor power-the following fundamental critical success factors should remain constant. We think these will separate the winners from the losers across the spectrum. Strong management team. Some things never change. The ability to create, manage and maintain trading hubs should require strong, experienced management teams that can combine technological savvy with real-life understanding of customer problem solving. In our view, managements will need to successfully develop viable business plans, build Web-based trading capabilities, manage the formation of strategic alliances and ensure solid customer service in all aspects of the trading hub. Customer service. Technology is the great enabler, but trading hubs are about providing customers with solutions. We believe it is critical for trading hubs to create strong customer service organizations that can ensure that digital value added gets translated into the real world. We believe both buyers and suppliers must benefit from the services of a trading hub. Industry and domain expertise. The ability to understand the inner workings of an industry, what drives it, where value is added and who the major players are, likely will be essential for market leaders. This expertise likely will be essential in establishing a trading hub's credentials, in determining what type of information industry participants want, and in how to improve the efficiency of the market. Execution and implementation. Successful trading hubs likely will not only facilitate transactions and aggregate and organize information, but likely will ensure that transactions processed through the hub will meet the needs of both suppliers and buyers. Fast creation of critical mass by lowering adoption barriers. The network effect suggests that trading hubs in each specific market should act quickly to become the de facto industry standard, which can create a huge competitive barrier to entry. In our opinion, trading hubs should work quickly to identify and eliminate the adoption barriers that exist in the industry. Moreover, the oil industry has some peculiarities that we believe reshuffle the priorities among the basic criteria and add others, including fulfillment, back-office integration and market knowledge. What to do? Traditional distributors will need to reinvent core competencies or lose share. While the role of the traditional distributor as a physical fulfillment intermediary likely will not disappear in the new economy, the value-added proposition of distributors is likely to change rapidly. As we mentioned earlier, traditional distributors have performed all three components of "ITF" intermediation. The Internet should reduce the value-added that traditional distributors have provided in the information and transaction areas, but not in the fulfillment area. Clearly, the Internet's greatest effect should be on information and transaction intermediation. Distributors that have built their value proposition primarily on superior information and transaction intermediation likely will have the most to lose. Prior excellence attributable to a great catalog or a superior sales force likely will be undercut in the new economy by the Internet's profound potential to change information delivery. The Internet will level the playing field substantially in this regard. Trading hubs should therefore be in a position to displace traditional distributors as the premiere information intermediaries between buyers and sellers, thus lowering the value-added proposition of many traditional distributors. We believe marketing-centric distributors will need to either restructure to compete as New Economy information intermediaries or refocus on physical supply-chain intermediation. Fulfillment intermediation, or operating inventory warehouses where production goods arrive in large quantities from large manufacturing runs and are eventually reaggregated and rerouted to final end users, should remain a vital component to the supply-chain process. Since the Internet should have a decidedly less important effect on the physical supply chain than on pure information delivery and transaction facilitation, distributors whose key added value is in physical fulfillment should continue to serve as part of the supply chain. Distributors that cannot adapt their information and transaction capabilities to compete with trading hubs likely will migrate toward becoming fulfillment houses, or disappear. Winning the bricks-to-clicks game What kinds of distributors will be able to leverage their fixed, physical asset bases to win in the new economy? Distributors that serve essential product categories with a high assortment complexity and low individual item value (low-value cubes), such as maintenance, repair and operations (MRO) and office supply, have the best chance of maintaining a strong value proposition. In these areas, distributors' added value of aggregating multiple line-item orders that are made from different manufacturers and reorganizing them in streamlined packages for customer consumption should not go away. However, the added value of helping find information on a wide variety of items may be superceded by a trading hub. One distributor's catalog likely will be no match for an aggregation of catalogs from multiple competitors. While some distributors may sneer at the early versions of catalog aggregation and the inconsistencies created by searching or scanning for products across multiple vendors, it should only be a matter of time before these technologies improve. One of the best strategies for distributors, particularly in categories such as office and MRO supplies where their physical distribution assets should retain some value, will be to aggressively partner with hubs and create as many online relationships as possible. Successful strategies may involve sharing transaction fees or sales commissions with online hubs, while aggressively moving to reduce sales and marketing expenses and becoming the low-cost fulfillment player in the industry. We think successful companies will leverage the bricks and partner for clicks. An example of an oilfield-related company that is attempting to play the bricks-to-clicks game is Smith International, through its Wilson subsidiary. Smith International positioned itself in the e-world when it acquired Wilson in April 1998. The acquisition was a sign that management recognized the oncoming trend well before its peers and industry observers, and seized the opportunity to create out of Wilson-a recognized leader in oilfield distribution for 79 years-a leading supply chain management company. Two years of technology investment, which to date has focused on the back end, has transformed the company from bricks and mortar to a clicks-and-mortar enterprise, with the ability to provide not only a new interface with its customers, but the ability to deliver customized solutions, improved transaction flows (including lower costs) and seamless execution throughout the entire supply chain. The biggest piece Value-added services are the biggest piece of the procurement pie, but the toughest to access. Between 70% and 80% of annual procurement spending in the oil business is related to some sort of value-added services, which are usually bundled together with equipment. It is hard to unbundle the services from the equipment, as there is much customized specification required. In the upstream segment, the supplier market is highly concentrated (on average, the top three or four players in each market collectively account for more than 80% of the market). There is little standardization among most products (exceptions being low-end roller cone drill bits and oil country tubular goods). So, any e-business solution would need to intensely focus not just on the purchasers (oil companies), but also the equipment and services providers, and to provide a compelling value proposition that addresses the cost and efficiency concerns of both parties. At this stage, there are very few solutions on the market, and on the surface it looks as if the bulk of the upstream market could be inclined to supplement traditional EDI (electronic data interchange) with a more flexible extranet system. While the cost and inflexibility of EDI kept many oil services companies from adopting the system, the extranet would allow for all of the efficiencies of B2B (such as reduction of paperwork flows) without the introduction of an intermediary. The best approach to this more challenging e-business opportunity is through what we call value-added services, examples of which include workflow process simplification and Web-based reservoir management tools. Given that it takes about 150 different systems in a single company to carry out the drilling proposal process, greater workflow efficiency is critical. Web-based reservoir management systems-unlike traditional systems, which require enormous and often duplicative IT build-outs by operators-simply provide broadband access to data stored and managed by a third party. Strategic services and contracts should account for the bulk of potential procurement-related savings. However, these savings may be among the most complex to implement, given the lack of standardization among most services contracts and oilfield products (especially in the upstream sectors). Relatively few companies to date have attempted to tackle this market. Among them are eNersection and WellBid in the upstream sector (offering workflow management solutions) and Downstream Energy and Petrolsoft in the downstream sector (providing information/knowledge management solutions). FlashFind's database/knowledge management software products and services are applicable to the upstream, downstream and potentially other non-energy-related sectors. (For more on energy e-players, see Online E&P Marketplace, a supplement to Oil and Gas Investor, May 2000.) Our conclusion On the surface, the oil industry appears to be fertile ground for e-commerce: roughly 90% of all transactions in the oil industry are conducted with businesses rather than consumers; its vertical integration means it is highly intermediated; its "command and control" bureaucracy is almost legendary; it is overcapitalized, which is a polite way of describing capital inefficiency; and its end-market buyers are highly fragmented. Despite such rich opportunity, however, the industry has lagged other old-economy sectors (most notably the auto industry) in its acceptance of Internet-based technologies. In our view, the industry must make significant structural changes before the benefits of e-commerce-let alone other e-business applications-can be fully realized. There is the potential for some entities to win big as "e-nablers" for oil. Some names should be familiar, whereas others likely will come seemingly out of nowhere. Many start-ups likely will attempt to go public in the near future, although we believe only a few will survive as independent entities longer-term. In our view, those that have the best shot of succeeding will have a focus on their customers, both buyers and suppliers; buy- and sell-side liquidity; a service that adds value to existing business practices; a service that cannot be easily commoditized; superior execution; and exceptionally broad and deep content. While there is no public e-oil pure-play today, we believe several companies are well positioned to compete in the new economy. Chevron, Royal Dutch/Shell, BP Amoco and Texaco have emerged as the leaders amongst the major oils, while Schlumberger, Smith International, National Oilwell, Paradigm Geophysical and Cooper Cameron have been the earliest movers in the oil services sector. Many among the growing list of private pure-plays are equity investments of, primary suppliers to or wholly owned subsidiaries of these well-positioned public companies. M Tyler Dann and Michael LaMotte are energy-sector analysts for Banc of America Securities LLC; Dann covers domestic and international oils and LaMotte covers oil services. Bob Austrian is the firm's B2B strategist. Associate analysts David Carlisle and Trevor Hamilton contributed to this report. Key Issues for Service Companies Oil company adoption rate. The Internet is such a great equalizer that fast-moving oil services companies may actually be in a position to assist operators, and thereby be the catalyst for change. Such an outcome would require not only progressive-thinking management (to break from the "we'll wait until we're told what to do" mentality), but superior execution of the Internet strategy as well. Providing visible value, and getting paid for it. Although direct transactions may not be the largest market opportunity for oil services companies, they may be the easiest illustration of the dilemma of getting paid. According to SAP, "The common rule of thumb when dealing with e-commerce is that it will save a company between 3.5% and 5% of the value of every transaction." The Aberdeen Group has estimated the cost savings to be between 5% and 10%. Assuming these estimate ranges are correct, and given that most of the revenue models-particularly those of the exchanges-extract a transaction fee of 2% to 20% depending on the transaction size, where is the benefit? The economics must make sense for all parties. Pace of infrastructure and IT spending. Many operators are still looking at ways to cut overhead, not spend more on it; this is particularly true for independents and national oil companies. Recently merged major oil companies are still struggling with multiple systems, and even many of those that have not been involved in consolidation are struggling with multiple systems across different operating divisions. For well-capitalized oil service companies, spending on knowledge warehousing, data mining, enterprise software applications and high-bandwidth communications capabilities now could create the necessary value-added edge operators seek when these capabilities finally begin to get broader attention. Other value-added capabilities include technical-to-business (T2B) software applications that improve the asset management process by allowing for economic analysis of reservoir data. Programs such as these can both encourage adaptation rates and provide clear economic incentive to customers. Finding the talent. The oil industry in general has not only had difficulty attracting investor capital, but also in hiring the talent to execute Internet strategies. Not only are Silicon Valley firms paying more, the memory of 1998-99's massive layoffs within the industry is still fresh in the minds of potential employees. AN E-COMMERCE SAMPLER Several major oil and oil-service companies have begun investing in e-commerce by developing a variety of business-to-consumer and business-to-business sites of their own, or by forming joint ventures with peers and with nonenergy companies. Here are a few examples. Chevron Corp. • Co-founded (with Texaco, Caltex and Ariba) Petrocosm.com, an interactive market for products and services. It is a global, neutral Internet marketplace owned by buyers and suppliers across the energy industry. It also offers electronic payments, logistics, integration to ERP systems and online community forums. Norman C. Chambers, a former senior vice president of Halliburton Co., is CEO. • Co-founded (with Oracle and a Wal-Mart subsidiary) RetailersMarketXchange, for convenience-store merchandise. • Developing a third exchange, Upstreaminfo, related to upstream properties and data. • Formed Chevron Technology Ventures in 1999 to take advantage of the company's proximity to Silicon Valley, and to invest in venture capital funds and tech start-ups. BP Amoco • Moved 15% of its annual procurement budget of $20 billion onto the Internet as of year-end 1999. Made an equity investment in Chemconnect.com. Has also used freemarkets.com to conduct a reverse auction for at least one purchase of petrochemicals. • Co-founded Oceanconnect.com, an independent site for buying and selling marine fuel and other products and services by ship owners. Investors also include Shell, Chevron and Texaco. Initial rollout is set for second-quarter 2000, with a rapid global roll-out after that. • Co-founded the IntercontinentalExchange (intercontinentalexchange.com), a petroleum and metals online trading joint venture. Other founders: Deutsche Bank AG, Goldman Sachs Group, Morgan Stanley Dean Witter, Royal Dutch/Shell, SG Investment Banking and TotalFina Elf. • Invested in some ventures not directly related to the oil business: OneSwoop (oneswoop.com), a European-based portal for customized Internet car buying at discounted prices. • Invested in GreenMountainPower.com, which sells solar and wind energy. Royal Dutch/Shell • Participating in seven business-to-business sites to date, including MarketSite, a joint venture with Commerce One for procurement; and IntercontinentalExchange. • Says it will route a large portion of its annual procurement budget of $39 billion (including equity companies) through MarketSite. (The site should go live in the second quarter with Shell, and 13 other companies.) • Co-founding partner in Oceanconnect.com. • Invested $6 million to develop a crude oil and refined products marketplace through HoustonStreet.com's site, through the shared-services arm of its U.S. downstream joint venture, Equiva. The unit launched its proprietary "Speedway" trading floor application in February 2000. • Formed, through Coral Energy, its wholly owned gas and power arm, Coralconnect.com, to enter the U.S. online gas and electricity trading business. The site offers transaction capability, content and the ability to personally aggregate and manage data online. • Relaunched a consumer site, ShellGeostar.com, an interactive portal offering travel planning services to 16 European countries, in English, German, Dutch, Danish, Swedish and French. Texaco • Joined OceanConnect and two related crude and refined products trading platforms (HoustonStreet and TradeCapture). Also made a major investment in a procurement exchange (Petrocosm). TradeCapture.com is an Internet-based commodity marketplace that opened for trading in February. It provides trading for multiple commodities and locations in the physical and financial markets and allows for anonymous bids and negotiations. Cooper Cameron • Recently won PC Magazine's award for "Best Site" in the oil services industry, for its site launched in 1996. Knowledge management, interoperability and provision of value-added services distinguish it from its peers, many of which only post raw data, such as press releases and SEC filings. • Upgraded CooperCameron.com several times to take advantage of the benefits of e-commerce. Latest upgrade: the 1997 implementation of "Transact," an extranet that facilitates e-procurement for existing customers. Unlike many third-party, or neutral, sites, this is geared more towards problem solving and less toward mass distribution of products. With traditional products (valves, pipe, etc.), point-and-click may be sufficient. But for complex products where the wrong choice can be costly, more interaction is required. "Transact" provides mass informational databases and technical salespeople to assist in decision-making. A customer can input data indicating, "I think I need A," but "Transact" may reply, based on that data, "You actually need B and C, and you already have C in your inventory." Schlumberger Oilfield Services • Launched IndigoPool.com, a Web-based exchange for producing properties worldwide, in February. Buyers can examine seismic, wireline, production and other reservoir data, and perform valuation analyses as well as see descriptions of the properties for sale. Sellers and brokers can market their properties online to a worldwide audience, with secure access to commercial and proprietary data sets, scaleable property marketing services and virtual interpretation centers. Users will have access to evaluation tools, consulting services and industry-related news. • Launched on March 1, "Realtime" has replaced the company's first web site, pulling all its e-efforts together. It is now an interactive, customizable portal through which users can get real-time access to literally anything related to their business, from newswire stories to price quotes on products and services. In our view, it is the "My Yahoo" of the oil patch. Smith International/Wilson • Transformed Wilson, a once sleepy oilfield distribution company, into a real "bricks-to-clicks" entity with 200 physical locations in North America, through acquisitions and key IT investments. Wilsononline.com is expected to go live in third-quarter 2000. Services offered include: Wil-Powr Integrated Supply System, which allows customers to choose products from a variety of different suppliers, place one order, receive one shipment and pay one invoice; and WilTrac Inventory Management System, which via the Web provides a streamlined way to manage inventories and capitalize on stranded assets. It also offers warehouse management services, project management services, disposition of surplus materials, and customized supply-chain solutions.