When Dave O'Reilly became chairman and chief executive officer of Chevron Corp. in January, the oil and gas business was in the throes of significant change. Several of the San Francisco multinational oil company's competitors were becoming megamajors. Others were experimenting with joint ventures to increase shareholder returns. Chevron had explored, then abandoned, merging with Texaco Inc. Clearly, it would not pursue "business as usual." During his career, O'Reilly repeatedly has challenged the idea of doing business as usual. He believes in breaking down institutional barriers and creating an environment where everyone's opinion is welcome. When he became manager of Chevron's El Segundo, California, refinery in 1986, supervisors routinely wore neckties. Employees even had a phrase for moving into management: "putting on the tie." O'Reilly did away with the practice almost immediately so communication with line workers would improve. He also is the first Chevron CEO to have been born outside the United States. Growing up in Dublin, Ireland, helped make him open-minded. "Spending my first 21 years in a country of 3 million, where news was made by other people in other places, instilled in me a respect for countries' dependence on each other," he says. "It also gave me respect for people's dependence on each other, regardless of their origin or rank." He joined Chevron in 1968 as a process engineer after graduating with a bachelor's degree in chemical engineering from University College in Dublin. But O'Reilly's affability is matched with real management ability. When he became president of Chevron Products Co. in 1994, profits in the company's refining and marketing division were scraping bottom due to low margins and operational problems. O'Reilly refocused the company on keeping operations free of incidents and meeting customers' needs. Aided by a strengthening market, earnings soared from $75 million in 1995 to $633 million in 1998. Much of the improvement came from O'Reilly's practice of establishing specific goals and working hard to reach them-all with an open mind. Investor Although it explored merging with Texaco last year, Chevron has resisted pressure to turn itself into a megamajor. How does it plan to improve returns to shareholders from all of its operations while continuing to grow? O'Reilly The premise that we resisted a merger is somewhat misleading, since we obviously tried to do one last year. It didn't work out for reasons that have been widely reported. We are focusing now on internal means of growth. We have four main priorities, driven by a fifth. First is operational excellence. We have a major asset base that needs to be operated efficiently, safely and reliably, with high utilization. We need to continue improving that performance throughout our organization. I expect to see continued improvement to the bottom line. Second is cost reduction. We have done a lot of the obvious things during the past decade. Now, we must embark on new ways of using technology to reduce costs in everything from procurement to our own back-office functions. Leveraging the Internet, both internally and externally, is just one example of future opportunities to become more efficient and effective. Third is capital stewardship. Our annual capital budget is more than $5 billion. With a $25-billion asset base, we reinvest in the entire company every five years. So it's absolutely critical that we make good, quality decisions and execute them properly, all the way through design, engineering, startup and operations. Fourth is profitable growth, by getting the balance right between investment and returns. We have organic growth within our businesses. Upstream, there are opportunities from some acquisitions that we have made. We bought Rutherford Moran Oil Corp. last year when the market was pretty rocky and the values were good. We acquired Petrolera Argentina San Jorge about the same time. In fact, six years ago, we didn't have a Latin American business. Today, about 15% of our earnings come from Latin America. We then need to focus on our organizational capability in these four key areas. That's really what makes it happen-the melding of people and skills. Investor Has Chevron established targets for return on capital employed in each of its divisions? O'Reilly Yes, we have. On a macro level, we have set the bar at 12%, minimum. We think that setting it there reinforces capital discipline. Upstream, we intend to be above 12%. Obviously, some of the more mature areas will be considerably higher. The newer segments that are growing, and in which we are investing, will not. Downstream, it's more realistic to expect returns that are close to the cost of capital-in the 10% to 12% range. And in our chemical business, with our new joint venture with Phillips Petroleum, we have set our sights on a 15% return over the cycle. Investor The oil industry has taken some knocks because its returns have not been competitive with other businesses. Why invest in oils? O'Reilly There seemed to be a disconnect between oil equities and prices in February. Everyone was saying that we were part of the old economy and dead. I kept saying that in this new economy, energy is absolutely essential. We can't succeed as a nation or a global organization without energy, no matter where you are on the development curve. The new economy still needs energy. The Internet and computers consume 14% of the electricity generated in the United States. A decade ago, they consumed only 4%. So the concept that there's a whole new economy out there, and that somehow energy doesn't matter, is flawed. Energy will be even more important in the new economic era, particularly during the next decade. The energy business has experienced a period of under-investment because of declining returns. The companies that have not exercised good discipline or executed well, have disappeared or are struggling. That should provide a good opportunity for high-quality companies that have a good track record and have met their commitments. Investor In the latest Fortune 500, Chevron was the highest among oil companies in average annual profit growth over 10 years. What are other areas where the company intends to lead? O'Reilly I don't want to burst the balloon, but the 1989 base that Fortune used was extraordinarily low because of an environmental writeoff. Even if you backed that out, our earnings per share growth during the last 10 years has been higher than our North American-based competitors for two or three reasons. First, we focused on rationalizing our portfolio. We got out of businesses that had low profit potential, such as agricultural chemicals, fertilizer and hard rock minerals in the early 1990s. We rationalized our upstream significantly from 4,000 fields in North America to less than 300 in a decade, focusing on major asset areas where we felt we had a competitive advantage. We also shifted our portfolio from low-return, mature properties to younger assets that are much earlier on the maturity curve. That trend is continuing. We've tackled our cost structure significantly during the 1990s and reduced our operating costs per barrel from about $7 to a little over $5 per barrel. That's an enormous reduction. All of this has helped catapult us to the high end of the earnings growth per share stakes. It's absolutely essential that we maintain that position. We have set a goal, using 1999 flat prices, to continue earnings per share growth, in the next three years alone, at 15% per year. That may seem high, but the reality is we came off a relatively low year in 1999. Obviously, we will do better than that if current high price levels persist. Investor As you review your exploration and production priorities, what balances do you seek? O'Reilly I think the best way to deal with that question is to talk about capturing new opportunities. We don't try to over-define our portfolio. But there is an inexorable trend toward more upstream investment outside the United States. That's where the opportunities are. So we must look there for growth. We have been very successful as an early entrant in the Caspian Sea. We've been a long-time player in West Africa and continue to grow there. In addition to Nigeria and Angola and the Congos, we've added participation in the Chad-Cameroon Project as well as new exploration in Equatorial Guinea. Six years ago, we didn't have a business in Latin America. Today, we're producing in a range of 200,000 barrels per day, most of that as operator and producer. We've added four deepwater blocks to our portfolio in Brazil during the last six months. The message here is that we see about 65% to 70% of our capital and focus going into the upstream business. The majority of that will be outside the United States. Investor Which upstream projects do you expect to have the greatest impact on increasing the value of Chevron's shares in the near term? O'Reilly I expect it will be Tengiz for two reasons. When we originally got into it seven years ago and it was producing about 60,000 barrels per day, people said it was a big risk in the Caspian. Seven years later, we're projected to produce 260,000 barrels per day, having just completed a three-year expansion project. We're successfully getting the oil to the market. We have a major new pipeline that will be completed from Tengiz all the way to Novorossiysk in the Black Sea in mid-2001. That will allow us to reduce transportation costs and increase the oil's value by using a Western-style quality bank whereby we will be receiving the value of Tengiz crude, rather than a Urals blend. Investor Tengiz and the Caspian Basin are an example of a part of the world that only recently opened to outside oil and gas investment. How can multinational oil companies play a part and still keep returns to shareholders high? O'Reilly Shareholders want good returns, but they also want to see evidence of good profit growth. With the opening of nations that were closed to investment, we would be remiss not to evaluate and take on the opportunities. We have done that in the last decade in Kazakhstan, in Venezuela to some extent and now in Brazil. The important point is to maintain the correct balance between growth and returns. By setting the bar at 12% to insure that we have investment discipline, I think our shareholders will value our portfolio's long-term growth prospects. Investor You have said that Chevron would not consider a joint venture for domestic refining and marketing because it is a leader in its markets. How will the segment continue to lead its peers? O'Reilly We have done a lot of rationalizing in our U.S. downstream portfolio. A little more than a decade ago, we had 2 million barrels per day of refining capacity in the United States. Starting in the late 1980s, we reduced capacity to about 1 million barrels per day by shutting down plants and selling refineries that were not a good strategic fit. We also rationalized our market to focus on the West and the Sun Belt. We have critical mass in those markets-a 15% to 20% share of the gasoline market in most of them. West of the Rockies, it's 20%. We want to continue improving our cost structure; to exercise capital discipline, particularly in refining, which can be a big capital consumer if not managed carefully; and to enhance our profitability through selected growth opportunities, particularly in marketing. Investor Chevron is represented in diversified services with its investment in Dynegy Corp. What's your vision for this part of the business in the next 10 or 15 years? O'Reilly We invested in Dynegy four years ago. It was relatively modest by our company's standards. Dynegy today is a $10-billion-market-cap enterprise. Its stock price is about $75 per share, and our equity in it is about 30%. So we've converted our investment into about a $3-billion reward. And that business is still early in its cycle. We are now the sole major industrial shareholder in Dynegy. Investor All of this suggests that the oil and gas business has changed-a new management model is needed, other than the old upstream-downstream-chemicals division. How has this influenced the assignment of responsibilities? O'Reilly This is where the benefits of integration really come to bear in our business. I believe that the value to an integrated company isn't so much in the physical assets, but in the integration of its intellectual capital. Our management processes today tend to look a lot more along the value chain than strictly up and down functional expertise. There's more horizontal integration than there was a decade ago. If you go to Tengiz, for instance, you notice first that it's a very big oil field. There's also something very much like a refinery there. All of that oil has to be treated, the gas has to be separated and the hydrogen sulfide taken out of the gas. That requires big processing plants that are operated by people from our refineries. The first person you see may be someone that comes from our refinery at Richmond, El Segundo or Pascagoula. They bring skills-intellectual capital-to that part of the value chain. We need to get Tengiz oil to the market. The people involved in building and preparing to operate that pipeline, bring a set of skills from our pipeline company. We're going to load the oil into tankers using an offshore single-point mooring system. Our shipping company people bring expertise to this effort. Investor How do you expect Chevron to look 10 years from now? O'Reilly Looking forward 10 or 15 years, we will be more international. We will have added new businesses to our portfolio because our history suggests that we will. We also will be in parts of the world that we're not in today. We will have taken technology to the next step. We're looking at how we use it to enhance all aspects of our business. Our e-commerce businesses will be more mature. But we will have realized lots of benefits, many of which we can't predict today. E-PLUCK E-commerce has been part of Chevron Corp.'s business operations for several years. The company has been transferring many of its own purchases to online transactions, saving considerable dollars in the process. Its goals also include transforming itself into a network-enabled company as a foundation to improve its core businesses, according to Donald L. Paul, Chevron's vice president, technology and environmental affairs. But it also sees external e-business opportunities across its operations, he says. The question was how to transform Chevron so that it didn't operate at some disadvantage, but rather, become what Paul calls "a new species, a combination of the DNA of the old economy and the new economy using the Internet." As important as improving capital efficiency was a companywide desire to enhance interactions with partners, vendors, consumers, communities and governments, making the Internet the best vehicle available. "We want to operate all significant relationships and transactions in the context of a networked world," Paul says. "We want to be in the forefront of 'surfing the wave.'" This cultural change began at Chevron about three years ago. Upstream, the company tested its e-business theories following its acquisition of Rutherford Moran Corp.'s Thai gas assets last year. Since Chevron had only downstream assets in the country, it had to quickly gear up for drilling and production in the Gulf of Thailand, Paul explains. It designed the new business in Thailand from the ground up to be conducted over the Internet. Secure Web access for its contractors and partners, as well as the Thai government, now allows for real-time collaboration, project management and information sharing between Bangkok, San Francisco and Houston. "It really has transformed the way we do things," Paul says. 'We don't need to send as many employees over to Thailand, yet we are just as closely involved." In the U.S., Chevron developed an internal network for its oil products jobbers, dealers and company-operated stations not just as a pricing and supply backup, but also for training, marketing and merchandise programs. "When we saw its strengths and potential, we recognized that we would need to take it further," says Dave O'Reilly, the San Francisco-based multinational oil's chairman. "That led us to form RetailersMarketXchange earlier this year. It's an e-business geared at aggregating suppliers, branded marketers and convenience store operators. It's designed to be a transaction community that enables them to be more efficient and effective." Another Chevron e-business, Silicon Valley Oil Co., grew from an internal network for lubricant jobbers to become an online fuels and lubricants marketplace for commercial and industrial customers. The company also is involved in PetroCosm Corp., a Houston-based industry procurement online marketplace whose other partners include Texaco Inc., e-business technology provider Ariba Inc., KPMG Consulting LLC (which helped build PetroCosm's technical architecture and marketplace), and Crosspoint Venture Partners, a business-to-business venture capital provider. "At the first level, we use e-commerce to drive performance improvement in our own businesses. At a second level, where we see that it makes good business sense, we're forming and holding equity in companies that take the concept to a broader market, where we hope to generate good returns. That's the icing on the cake," O'Reilly observes. Chevron also is using external venture-capital investments to gain access to emerging e-commerce technologies and business opportunities. Through divisions like Chevron Technology Ventures LLC and Chevron eBusiness Development Co., it has taken stakes in Harmony Software, a business performance management technology developer; Illumina, a biotech company; and Outerlink, which develops vehicle tracking systems. "Most of this has nothing to do with the oil and gas industry per se. But it definitely could," Paul says. "We're very fortunate because we're based in the Bay Area, close to Silicon Valley," O'Reilly says. " People who have an idea that they'd like to try or that they think might be relevant to our business, don't have to travel far. Everyone in California knows who Chevron is and what we do. So we get the first look at lots of ideas before other companies find out about them. I see much more opportunity here. This has not run its course. The whole e-commerce business is in its early stages."