Oil Cos' Bet on Swift Price Rebound Has Its Risks

LONDON (Dow Jones Newswires), Feb. 18, 2009

Major oil companies are trying not to repeat the mistakes of the last price slump in the late 1990s, when cutting back on investment left them ill-prepared to meet growing demand in later years. This time they promise to maintain investment through the current price dip, but the risk is growing that a prolonged slump could stymie their plans.

If the years ahead follow the pattern of the last major recession in the early the 1980s, where global oil demand shrank during the downturn and remained well below production capacity for years, even as the recovery accelerated, prices may stay low for much longer than current expectations. Steady as she goes may be their mantra for 2009, but oil chiefs may be on course for some tough choices in 2010.

The world's biggest oil companies -- ExxonMobil Corp., Royal Dutch Shell PLC, BP PLC and Chevron Corp., Eni SpA and Total SA  -- have all said they will more or less match 2008 investment in 2009, to the tune of around $125 billion. Their confidence is based on long-term trends showing steadily expanding energy consumption matched against scarcer and costlier oil reserves.

"The future is not canceled," said BP Chief Executive Tony Hayward. The world's population will grow in size and wealth and, "with this growth and improvement in living standards comes increasing demand for energy," which the International Energy Agency forecasts will be 40% higher by 2030, he said.

The world economy will recover in a few years and energy demand growth will resume, Hayward said. "It's important that the Organization of the Petroleum Exporting Countries and non-OPEC invest through the downturn," to ensure there's enough supply in the future, he said.

As the economic outlook darkens, especially for emerging economies that drove much of the recent growth in oil demand, some industry experts say hopes of a quick rebound may be overly optimistic.

The generally cautious International Energy Agency expects world oil consumption to fall by 1 million barrels a day to 84.7 million barrels a day in 2009, the biggest annual fall in 27 years. Some analyst predict an even sharper drop.

China Unlikely To Be Growth Engine

Most of the predicted decline comes from developed economies already in recession, but many export-driven Asian economies also hit the wall in the fourth quarter of 2008, posting double digit drops in industrial output and significant quarterly GDP contractions.

The IEA said demand in China, the engine of the previous oil boom, would rise by a paltry 0.7% in 2009.

That forecast assumes China's economy, which depends on exports to developed countries for more than a third of its GDP, clocks growth of 6.7% next year.

But China's economy barely grew at all from the third to the fourth quarter of 2008, and by some analysts' estimates it may even have contracted slightly.

To maintain strong growth while its export markets are deep in recession, China needs to transform its economic model, boosting domestic demand to make up for lackluster exports. There is, however, no precedent for a centrally managed economy like China fostering such a consumer boom, said Francisco Blanch, commodity strategist at Merrill Lynch.

Even if China and its fellow emerging giants can meet these optimistic growth forecasts, it may not be enough to offset the slump in the developed world. Oil demand in the developing world kept growing through the recession of the early 1980s, but the contraction in demand in the developed world was too big and long lasting for emerging markets to support the oil price.

"The current market looks much like it did in the 1980s," said a report from analysts at Bernstein Research. Following an oil price shock and deep recession, global oil demand shrank from 1980 to 1984. "The market believed that demand destruction was temporary. As a result, consensus expectations were flawed because they overestimated when demand would bounce back," the analysts said.

By 1986, the world's economy had been growing again for several years, but oil production capacity still exceeded demand by over 8 million barrels a day. Despite the resumption of economic growth, spare capacity remained high, keeping prices at $20-30 a barrel for much of the next 15 years.

We are barely six months past the last peak in the oil price, but OPEC already has 8 million barrels a day of spare oil production capacity after big output cuts, said the group's Secretary General Abdullah Al-Badri. The group is very concerned about the impact the economic downturn will have on the medium- and long-term oil demand, he said.

OPEC's spare capacity looks likely to grow. Thanks to investment in the boom years, the world's productive capacity should grow faster between 2009 and 2012 than it did from 2003 to 2008, said a report from U.S.-based consultancy Cambridge Energy Research Associates.

Companies May Face Massive Cash Outflows

If companies do not reduce their upstream investment at all during the current economic downturn, CERA said spare capacity could reach 10 million barrels a day by 2013. "This would be an unprecedented margin and would tend to undermine the oil price," the consultancy said.

Were the price of oil to average Tuesday's closing price of $35 a barrel for the next couple of years, most of the major oil companies would see massive cash outflows, said Bernstein.

BP and Shell would see the greatest cash outflows of $12.9 billion and $15.1 billion respectively in 2009, and even greater amounts in 2010. Only Total and ExxonMobil would be weakly cash positive, Bernstein said.

"(This) would require serious decisions over the balance of cash-flow, capex and dividends," said Collins Stewart analyst Gordon Gray.

Companies' first option in a price trough lasting several years would be to raise their debt level. "Total, ExxonMobil and Chevron would not require additional debt, but could simply spend their existing cash balances on dividends and stay in the black (in 2009)," said Bernstein. "BP and Shell would need large increases in debt to stay out of trouble," as would most other companies if prices are still low in 2010, said Bernstein.

Next on the list would be investment cuts, but the majors are unlikely to repeat this on the scale seen in the late 1990s because of the detrimental affect it had on production and reserves last time, Griffiths said. "The most extreme version of this was Royal Dutch Shell which by 2004 had to confess to a significant reserves downgrade," he said.

"Amongst the majors the key investment controversy surrounds the ability to pay dividends through a low oil price period," said Bernstein. So far the majors have promised a stable or growing dividend in the years ahead in what Royal Dutch Shell Chief Executive Jeroen van der Veer described as a "signal of confidence in our future profitability."

However, price-to-earnings multiples for Shell and others, "clearly suggest that the market does not believe the majors' earnings are sustainable," Griffiths said.

For the moment, at least, oil chiefs still have faith in immutable long-term energy demand growth.

"This powerful trend will not be stopped by the turmoil we are now experiencing," said BP's Hayward.

"If we stop (investment), it will be very difficult to restart (production growth) when there is a restart of the economy," said Total Chief Executive Christophe de Margerie.

"Nobody knows how long (the downturn) will last," said Shell's van der Veer. But he is certain that if oil companies cut back now the next commodity cycle will be even more violent than the last.

Copyright (c) 2009 Dow Jones & Company, Inc.

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