Big Questions For Big Oil

Aug 30, 2007 (From The Wall Street Journal Europe via Dow Jones Newswires)

As summer draws rapidly to its conclusion, eyes are already turning to the colder months ahead and, inevitably, to the price of oil. In recent weeks, Goldman Sachs analysts have suggested that oil could reach $100 before the end of 2007. A record number of options to buy oil at $100 a barrel have been sold. Some mainstream commentators are even raising the specter of $200 a barrel by mid-2008 if the risk premium -- which industry estimates average at around $34 -- increases in response to Iranian retaliation against further sanctions or growing unrest in Nigeria.

In such circumstances, one would expect such commentators to be bullish about the prospect for independent oil companies (IOCs) such as Exxon Mobil, Royal Dutch Shell and BP. Rising oil prices have pushed these companies' profits sky-high over the past five years. Yet a growing number of industry voices suggest that the era of the vertically integrated supermajor may be over, and that IOCs have been unable to adapt to the new global business environment.

Second-quarter results in late July saw Shell, BP, ConocoPhillips and Exxon Mobil all report declining output. Jeroen van der Veer, the chief executive of Shell -- the only firm to post an overall rise in net income on the back of record refining revenues -- said the company was "rejuvenating" itself through production from unconventional projects such as Canadian tar sands and LNG projects in Qatar. Such marginal activities are now having an effect on the balance sheet as returns from traditional operations -- namely, sub-surface crude oil and gas production -- begin to disappoint.

IOCs are facing both structural and cyclical challenges. Depressed oil prices throughout the mid- to late 1990s caused a period of low investment in new exploration by IOCs and nationalized oil companies (NOCs) alike, which has left many firms reliant on a relatively smaller number of "superfields" that are beginning to dry up. As the oil price has steadily risen, several governments -- most notably in Russia and Venezuela -- have responded by expropriating foreign-owned oil and gas fields for their own state-run firms, usually under the guise of environmental transgressions or tax irregularities.

ConocoPhillips lost a $4.5 billion investment recently when Hugo Chavez turned control of their assets over to PDVSA, the Venezuelan state oil company. BP and Shell have both lost majority control of significant hydrocarbon reserves in Russia over the last 12 months. Rosprirodnadzor, the Russian Environmental Conservation Agency, recently announced that it was conducting investigations into a further 19 foreign oil and gas firms. These losses, combined with continued instability in less-politicized markets like Nigeria, have weakened confidence in IOCs' ability to consistently replace their proven reserves -- the sine qua non of long-term profitability.

As this trend emerged, many within the industry argued that IOCs' superior technical ability, particularly in deep-sea and arctic exploration and production, would force NOCs to offer them access to reserves that would otherwise lie dormant. Total's recent deal with Gazprom over the huge Shtokman gas field -- the first between a Russian NOC and an IOC since 2003 -- heralded precisely this new model.

However, Gazprom's monopoly position allowed it to negotiate, aided by a phone call between Presidents Vladimir Putin and Nicolas Sarkozy, a deal that effectively relegated Total to the role of an oil services provider like Schlumberger or Halliburton. These firms are contracted to provide technical assistance to the actual asset owner, usually an oil major. Total received a 25% stake in the special purpose vehicle that owns the infrastructure of the Shtokman operation, and will take 25% of the profits under the terms of their production-sharing agreement. But in order to put the commensurate 25% of Shtokman's gas onto their assets and liabilities sheet, the French company had to pay Gazprom $800 million. Under a traditional product-sharing agreement, that share of the reserves would have come at no additional cost. In return, Gazprom has gained access to cutting-edge deep-water extraction and gas liquefaction technology.

Total, which was competing against Statoil and Chevron for the contract, had little choice but to accept these punitive terms since IOCs' business models are predicated on developing access to new reserves. Yet paying for the privilege diverts cash away from R&D, an area in which IOCs need to invest heavily if they are to compete with oil services providers. Throughout the postwar period, IOCs have pioneered advances in exploratory and extractive technologies. But their recent underinvestment within a highly cyclical industry means the services providers, funded by huge contracts from newly cash-flush NOCs, are now set to lead the research field. Recent figures suggest that while Exxon Mobil plans to spend $650 million on R&D in 2007, Schlumberger will spend $720 million, further squeezing IOCs' future technological advantage.

So what is the future for IOCs? A further round of mergers is unlikely because of stringent Western competition rules, as BP and Shell once concluded. Ironically, the paradox of the high oil price is that all the major IOCs are beginning to divest their non-core assets, such as refineries and consumer-distribution infrastructure, even as their profits in oil and gas production should be rising.

With NOCs undertaking ever-more challenging exploration -- Pemex, the Mexican state oil company, recently leased three semisubmersible drilling rigs which can operate in 5,000 feet of water -- competition between oil services providers and IOCs to provide technical support will intensify. Such competition is likely to radically reshape the oil industry over the next two decades. Total's deal over Shtokman may represent the beginning of the end of the supermajor.

Mr. Kumaria is a senior adviser to the Center for Energy Studies at Cambridge University.

Copyright (c) 2007 Dow Jones & Company, Inc.

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