To what extent has the acquisition of Essar Oil by Rosneft helped them attain profitability?

Economy is one of the most important factors that governs the development of nation and also the world. Despite a lot of government sectors, the economy of the countries across the globe is maintained by the well-established companies, industries and business houses. Being an inquirer and an innovating thinker, I always aspired to go beyond the lines to understand the fundamentals of growth and development and Business Management provides me the tool to analyze the factors affecting the growth and development.

Being an IB student, I have been taught to knock every door of an event that creates a curiosity in my mind. Thus, to understand the real – life in a more evasive way, I regularly read newspapers and follow news articles in several online platforms. Recently, I came across a news-article which was on the Indian Business giant – ‘The Essar Oil’. After reading the article, I found that in the year of 2017, the company was undertaken by a Russian oil refining unit – ‘Rosneft’. With further research, it came into my observation that Rosneft is one of the largest oil refining industries in the world and the largest oil refining unit in Russia. This event has raised a few questions in my mind. Why does an eminent oil manufacturing giant – ‘Rosneft’ undertaken or collaborated with an Indian Company – ‘The Essar Oil’? How will it be beneficial for a fully established industry to take over a company in a developing country like India?

With more research, I found that the acquisition of Essar Oil by Rosneft was a futuristic deal as Rosneft has made huge profit from that. This has implanted another question in my mind – “How does Rosneft analyzed that the acquisition of a company in a developing country like India be profitable?”

To find the answers of these above-mentioned question, I read a few business journals and articles. However, I couldn’t get the answer of my inquisitions with the study that I have done. This has landed to choose research question of this extended essay.

Rosneft is one of the leading companies in oil sector in Russia. It’s business and operation involve around oil production, oil sales, other byproducts of oil and gases (fuel), projects on development of offshore fields, exploration and appraisal of hydrocarbon fields, in Russia and also across the globe. Few of the prime objectives of Rosneft are the reserves replacement at the level of no less than 100%, beginning of new projects followed by efficient growth in Brownfields, establishment of production hubs at offshore, building a world class working environment by providing current and updated infrastructure, optimal refining configuration and increase the profit %.

The code of conduct and objectives of operation of Rosneft oil company are mentioned below:

LEADERSHIP: The company encourages leadership for all its activities and builds its future on original approaches and latest technologies in an ecofriendly manner.

EFFECTIVENESS: The company undertakes and achieves targets based on discipline, professionalism and teamwork, ensuring the company’s and every employee’s interest balance.

INTEGRITY: The company takes responsibility for everything it does and says to its clients, partners, colleagues and many more.

SAFETY: Our highest priority is to preserve life and health and ensure the safety of work and the environment.

Rosneft Oil Company has joined the initiative of the world’s leading oil and gas companies and signed “The Guidelines for Methane Emission Reduction in Natural Gas Supply Chain”. The signed Guidelines are focused on enhancing the efficiency in decrementing the emission of methane at every stages of the supply chain of gas industry, upgrading rules and policies on emission of methane, and many more.

Rosneft – 2022 strategy was developed and approved by Rosneft’s Board of Directors at the end of 2017. The strategy takes into account UN Sustainable Development Goals and the priorities of Russia’s development, and sets 3 key priorities: increasing business profitability and returns from core assets, focus on the key projects implementation, and rapid replication of the new technologies to ensure a step change for the Company addressing technological opportunities.

Rosneft is ahead of the majority of global oil and gas companies with respect to reporting transparency, according to Bloomberg and Refinitv ratings. The Company will continue to combat anthropological effect on the environment, which is a key priority for Rosneft.

Essar Oil is an Indian multinational company mainly dealing in the domain of construction and oil refinery and petroleum products. It was established in 1969 in Mumbai and mainly focused its operation in construction works, precisely building ports and many more. Later on, the company extended its working operations to petroleum refining and products. In the year 2017, after acquisition of Essar Oil, India by the Russian business magnet – ‘Rosneft Oil Company’, the joint company was renamed as Naraya Energy and still continues its operation in India.

Gross Profit Margin Ratio: The ratio indicates an improvement required inventory management. A declining value of the ratio with respect to time signifies that that the selling prices are not rising with respect to the COGS (cost of goods sold).

Gross Profit Margin Ratio = \(\frac{Gross\ Profit}{Sales}\)

Sample Calculation for the parameters for 2016:

Purchases = Cost of purchased oil, gas, petroleum products, goods for retail and refining cost + General and administrative expenses+Transportation cost = 614 + 129 + 575 = 1318 billion RUB

Cost of Goods Sold = Opening Inventory + Purchases-Closing Inventory = 219 + 1318 - 283 = 1254 billion RUB

Gross Profit = Revenue - Cost of Goods Sold = 4988 - 1254 = 3734 billion RUB

Gross Profit Margin Ratio = \(\frac{Gross\ Profit}{Sales}=\frac{3734}{4887}\) ≈ 0.76

Evaluation of Gross Profit Margin Ratio:

Analysis of Graph 1:

A significant decrease in the Profitability ratio has been observed for the year 2019 which is equal to 0.733. In the last two years, an increase in the profitability ratio has been observed which indicates that currently the profit of the company is increasing. As there is no definite trend observed in the exploration, thus, it cannot be said that the profitability of 2021 will increase or decrease.

In the year 2017, Essar Oil in India was taken over by Rosneft. As a result, the market has been increased for Rosneft in 2017. As a result, the revenue of has been significantly increased in 2018 with respect to the previous years. With an increase in Revenue of the company, the Gross Profit has been increased and consequently, the Gross Profit Margin Ratio has been increased.

Despite of a significant increase in revenue in the year of 2019 with respect to 2018, there is a significant decrease in the Profitability Ratio. It can be explained in terms of Cost of Goods Sold. With an increase in market after acquisition of Essar Oil by Rosneft, the market demands and production of the company has increased. To meet the production demands in India due to acquisition of Essar Oil as well as neighbouring countries of India, the cost in purchasing the raw materials as well as the transportation expenses has increased. As a result, the Cost of Goods Sold has been increased and consequently the gross profit has decreased. Despite an increase in revenue, as the Cost of Goods Sold has increased at a higher rate with respect to the Revenue in the year 2019, the Gross Profit has decreased. Secondly, with an increase in Sales after acquisition of Essar Oil by Rosneft, the Profitability Ratio has decreased. In 2018, the Profitability Ratio was maximum despite of a significant increase in Sales with respect to 2017 because the Cost of Goods Sold was not at the peak just after acquisition of Essar Oil by Rosneft. This could be because of developing a trust in market by the new company – Rosneft. As a result, there was a significant value of Gross Profit. In a contrary, the Sales was also increased in 2019 with a significant increase in Cost of Goods Sold due to increase in market demand after acquisition of Essar Oil by Rosneft. As by the end of one year of acquisition, Rosneft has gained trust amongst the clients of Essar Oil, and thus the market demand has increased. As the result, the numerator of the Profitability Ratio (Gross Profit) has decreased and the denominator of the Profitability Ratio (Sales) has increased. Consequently, the Profitability Ratio has been decreased and obtained to be minimum out of the years that are considered in the above exploration.

In the latest year (2020), there is an increase in the profitability ratio of the company with respect to the previous year (2019). From Figure – 1, it is clearly observed that the cost of purchase of raw materials is minimum out of the last five years in the year 2020. This is due to lack of demands of goods and products due to the COVID – 19 pandemics across the globe. As the cost of purchase of raw materials has decreased and consequently, the Cost of Goods Sold has decreased. Despite of a decrease in revenue in 2020 due to lack of market demands, the ratio of gross profit to sales has increased with respect to the previous year because of strategically cutting down the expenses in terms Cost of Goods Sold. As a result, the profitability ratio has increased.

Evaluating the tool?

Leverage ratio is a measure to determine the amount of capital that is in the form of debt. This ratio provides details about which type of financing to be used so as to focus on long-term solvency position of the company.

Leverage ratio is the ratio of total debt of the company to the total shareholder’s fund in the company. This ratio represents the contribution of capital which is in debt per unit shareholder’s fund.

Leverage Ratio = \(\frac{Total\ Debt}{Shareholder's\ fund}\)

Sample Calculation for 2016:

Total debt = Total current liabilities - Total non current liabilities = 2773 + 4531 = 7304 (billion RUB)

Leverage Ratio = \(\frac{7304}{3309}\) ≈ 2.207

Interpreting the patterns in leverage ratio to deduce if the deal of Rosneft with Essar Oil was profitable or not:

Small value of leverage ratio signifies that the liabilities and hence, debt of the company is less. Thus, an ideal value of Leverage Ratio is considered to be 0.5 as indicated by the black line in the graph. However, the values of leverage ratio obtained in both the years 2017 and 2018 is significantly more than 0.5. The leverage ratio for the year 2017 and 2018 are 2.223 and 2.094 respectively. This signifies that the company was running in high debt before acquisition of Essar Oil in 2017. In order to increase the revenue earned by the company to get rid of very high liabilities, Rosneft Oil company might have collaborated with Essar Oil to increase its market demand and hence, revenue of the company. Despite of such a massive step in the growth of business, a significant reduction of leverage ratio was not observed in 2018. However, the slight decrease in leverage ratio could be explained by the fact that due to increase in the market demands, the revenue of the company has increased. For example, the revenue of Rosneft Oil has increased from 6011 billion RUBs in 2017 to 8238 billion RUBs in 2018. This, in turn, has attracted funding organizations like Trafigura, UCP to invest to invest in the shares to earn some profit. As the shareholder’s equity of the company has increased, the leverage ratio has decreased.

In the first and second quarters of the financial year 2018, the share of Rosneft Oil Company was not decreased as they have been able to meet the market demands. As a result, Rosneft Oil Company was slowly acquiring the Indian oil market. This has attracted more individuals in investing in the shares of the company. Hence, the share has been increased by approximately 400 billion RUBs which has resulted building trust and assurance amongst the shareholders. Hence, the leverage ratio has decreased to 1.726 in 2019.

In the year 2020, due to COVID – 19 pandemics, the market share has fallen exponentially. After the decline of market share of each and every company has decreased and as a result, people didn’t invest in stocks and shares. As a result, shareholder’s equity of every company including Rosneft has decreased. Consequently, the leverage ratio has increased to 2.096.

Thus, the pattern in the leverage ratio clearly indicates that the deal with Essar Oil was profitable for Rosneft.

Evaluating the use of Leverage Ratio as a tool to measure profitability:

Leverage Ratio (Debt – Equity ratio) is considered as a reliable tool to assess the financial health of a company only when the company has a fixed financial cost. The annual report of Rosneft clearly indicates the massive changes in the financial liabilities over a span of five years. For example, the revenue of Rosneft Oil in 2016 was 4988 billion RUBs to 5757 billion RUBs in 2020 after declining from a very high revenue in 2019 equal to 8676 billion RUBs. This limits the accuracy of interpretation need from analyzing the leverage ratio in the section above.

It is very similar to the discussion of Leverage Ratio. In order to increase the revenue of the company, Essar Oil was undertaken by the Rosneft Oil Company in 2017 with a strategy of increase in market demand of the company and revenue. After acquisition of Essar Oil in 2018, the market has enlarged for Rosneft Oil and as a result, its revenue has increased from 6014 billion RUB in 2017 to 8238 billion RUB in 2018. With continuous development in business in the sector of oil, the share of Rosneft in 2018 has increased. However, due to the COVID – 19 pandemics, upon fall of stock market, the price of share has decreased and hence, the revenue has decreased.

The Ansoff Matrix is a tool used to plan strategies for growth of any company or business. It shows four different strategies which might lead to the growth of company with the risk factors associated with each strategy.

From the above figure, it is clear that, the first growth strategy, i.e., Market Penetration or increasing the sale of existing commodities has minimum risk and fourth growth strategy, i.e., Diversification or introduction of a new product in a new market has maximum risk. Product Development, i.e., introduction of new product in the existing market, and Market Development, i.e., introduction of the existing product of the company in a completely new market place has moderate risk factor.

Acquisition of Essar Oil by Rosneft is a type of Market Development. The reasons behind choosing Market Development strategy by Rosneft are shown as follows:

Justification behind acquisition of Essar Oil by Rosneft as a Market Development Strategy:

Rosneft is one of the largest oil refining and petroleum products companies in Europe and the largest in Russia. It has expanded its operation in different countries in Europe. In 2017, they have introduced major manufacturing units in Germany which has increased their production significantly. Rosneft has 13 major refineries units in Russia. The total design capacity of the Company's main oil refineries in Russia is 118.4 million tons of oil per year. Rosneft's share in refining in Russia is more than 35%. In Germany, the Company holds stakes (24% to 54%) in three highly efficient refineries. Refining volumes at German refineries in 2018 amounted to 11.5 million tons.

Rosneft operates its business across a wide range of products. As Rosneft’s operation involves refining of oil and petroleum product, its products and services are limited. However, Rosneft’s operation involves oil refining, production of petroleum products, sale of crude oil, petroleum gas production, and many more. Unlike textile industry, which involves creativity in the product, Rosneft, being an industry related to petroleum commodities and services, does not have such a window to expand their business by introducing new products.

India is a developing country and need of fuel in developing country is always at the peak. India will provide huge market demands which will enhance the business of Rosneft. It has established business in Europe. However, India is an Asian country. It is a gateway to the neighboring Asian countries as well. It will allow the company to meet new market. New market will allow Rosneft to increase its revenue. India is a land of efficient workers. Due to high population density, workers are available at very cheap rate which is beneficial for the growth of the Rosneft Oil Company.

The above discussion justifies the decision of Rosneft to undertake Essar Oil as a Marketing Development strategy instead of focusing on other alternatives – Market Penetration, Product Development, and Diversification.

Force Field Analysis is a tool which is used prior to implement any strategy to analyze the pros and cons of any change that is about to be implemented in the business structure. In the analysis, the factors which are supporting the change are marked in order (or by points) and the factors which are against the change are marked in order (or by points). In the end, net point is calculated by subtracting the total point against the change from the total points supporting the change. A positive value of the previously mentioned calculation indicates that the change will be beneficial for the company and the business; however, a negative value of the calculation signifies that the change will not be beneficial rather it will incur loss to the company.

The objective of this section is to consider the factors that drives or opposes the acquisition of Essar oil by Rosneft in the year of 2017, score each of the factors out of 5 and then find the total score in favor of the change as well as against the change to identify if this deal was profitable for Rosneft or not.