Energy Technology Expert

THE CASE AGAINST OIL DEREGULATION – Marcial Ocampo’s comment #4

[Editor: This is Marcial Ocampo's response to Mar Tecson's comment #3. Reader is also advised to contribute his views and comments to enrich further this discussion.  Cheers.  Marcial]

From: Ocampo Marcial <mars_ocampo@yahoo.com>

Subject: Re: PER LITER MARGIN is Gateway to PERCENT RETURN on CAPITAL… Re: DEREGULATION AFFECTS MARGIN ONLY… Re: THE TEST OF DEREGULATION IS ON PER LITER MARGIN… Fw: Re: For CEBU C… THE CASE AGAINST OIL DEREGULATION/Let’s oil ourselves

Hi Mar,

I fully agree with you that in the end, the measure of profitability is the % return on capital which is the ratio of sales volume x margin / capital used in providing the product to the market.

Let’s take the case of a sari-sari store.  He buys goods and adds 10% gross margin.  If he is able to sell his product within a week, his annual return is 10% x 52 weeks/year = 520% per year assuming he reinvest all his capital and earnings and does not withdraw capital or earnings for his upkeep.

In the case of an oil company, if each delivery of product measured as DPLC (FOB + FRT + INS + DUTIES + SPECIFIC TAX + VAT + DEMURRAGE + BOE FEE + OCEAN LOSS) the oil company applies a 3% gross margin, and the oil major has an inventory turnover of 1 month, then his annual gross return is 36% per annum, which he has to budget to pay for his loans, salaries, expenses and capital expansion projects.

After adding the gross margin to the DPLC, the oil company adds the biofuels, allots depot maintenance costs, pays transshipment (barges, ships), hauling fees, dealer’s margin/refiller’s margin and VAT on this additional items to arrive at the pump price.

In a sense, the gross margin per liter x sales volume is a rough estimate of the net income of the oil company.

I do project finance models for oil expansion studies and my models works like this:

1) gross revenue = sales volume x gross margin per liter

2) Less expenses = maintenance + admin + regulatory + etc

3) Less depreciation, amortization and interest on loans

4) Equals income before tax

5) Less corporate income tax = income after tax

6) Add back depreciation and amortization and other non-cash items

7) Less principal repayment plus incomes with final tax less expenses not tax deductible

8) Equals net cash flow

9) Compare net cash flow with total project cost ==> get the discounted cash flow internal rate of return of the total investment (DCF ROI)

10) Compare net cash flow with the equity portion of project cost ==> get the discounted cash flow rate of return of equity investment (DCF ROE or commonly known as IRR)

11) Calculate cumulative cash flow and payback period.

The calculated DCF ROE or known as the IRR is compared with the hurdle rate of the investing company.  If it is lower than say 12% or 15% p.a., then the project is not feasible and not providing sufficient returns or incentives to proceed with the project.  At the very least, the project must be able to recoup its weighted average cost of capital (WACC) which is

WACC = % equity x 15% p.a. minimum hurdle rate + % debt x 10% p.a. loan interest rate

= 30% x 15% + 70% x 10% = 11.5% p.a.

The project should be able to recover at least its WACC otherwise it would be destroying capital and the project in the long term is not sustainable.

That is why the main driver of the financial model is the % gross margin applied on the DPLC.  It is varied in the model so that the resulting gross revenue could sustain the cost of operation, pay off debt, provide returns to shareholders, make provisions for replacing capital equipment thru depreciation ==> and yield a DCF-ROE at least equal to the 15% p.a. minimum hurdle rate for making a feasible investment.

Mar, I guess you have to move from simple accounting (margin per liter) to financial management in order to fully understand the above principles I just shared with you.

The above financial analysis is the cornerstone of all major investments in oil, electricity and energy industry as well as in major infrastructure like telecommunications.

The use of large capital requires such sophisticated financial analysis.

I could apply this technique to each major and minor oil industry player and determine the level of % margin for each product line or for the entire oil production that will allow such company to have a DCF-ROE at least equal to 15% p.a. hurdle rate for making sound investments.

This is something beyond our control, Mar, and we have to live with it.  Investment decisions are based on the above principles, not on the simplistic return on capital which is calculated from gross margin per liter x sales volume / capital.  You need more sophisticated financial tools in order to make an investment decision, which, unfortunately, is the norm in large businesses such as oil refining, oil marketing, power generation and telecommunications and other industries.

In fact in my own lending investor company, I applied the same principle when I prepared my business model – I determined the level of interest margin (lending rate less my cost of borrowing) that would be needed to have a gross revenue (receivables x interest margin per month) to arrive at my monthly income needed to meet all my operating costs (salaries, rent, utilities, supplies, taxes and permits, marketing expenses) in order to have a DCF-ROE at least equal to 15% p.a.

Perhaps let us sit down so I could illustrate to you a financial model made when it invested in oil distribution and marketing activities throughout the country.  This is the level of analysis needed in making an investment decision to bring secure supplies to the country.

Regards,

Marcial

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[Editor:  I've added this short email to save on space.  Thanks. Marcial]

Hi Mar,

At last our discussion is moving forward.

If I may suggest, using a constant margin per liter, should be adjusted regularly depending on the current price of oil, in the same way the the customs duty on imported crude oil is varied from 0%, 1%, 2% and 3% according to the price of crude.

In doing so, under varying regimes of DPLC, a set of margin per liter, will be able to address the need for sufficient return and could also be related at the same time with % return on capital (net income / capital).

This is where my financial model is useful as we could simulate various DPLC regimes based on varying MOPS or CRUDE prices.  We could vary % gross margin on DPLC and see how % return on capital varies and the resulting absolute margin per liter.

Thanks,

Marcial