Is the International Tide Changing for Oil and Gas?

Abstract: Oil and gas industry forecasts traditionally alternate between those who believe in short supply and those who think the world is a couple of barrels away from overproduction. It may be time to consider an alternative.

Analysis: Sometimes literature serves as a proxy for real life.

This is true even in oil and gas. Over the years, oil and gas forecasting has fallen into two camps. There are those who followed the short supply thesis, or variations like the Hubbert Curve theory. This is the idea that global oil production peaks in the first decade of the 21st century. Supplies tighten while rising demand creates price spikes. The world adjusts, sometimes violently, to the Malthusian realities of a declining resource.

There is a corollary to the short supply thesis popularized during the 1990s by Matthew Simmons, CEO of Simmons and Company International, a Houston investment banking firm.

Mr. Simmons argued that world energy demand would outstrip the oil and gas industry's ability to supply hydrocarbons without a massive investment in infrastructure. The Simmons theory electrified the oil and gas industry during the late 1990s and gave hope to an industry that had been suffering the effects of overcapacity since 1982.

Clearly, a substantial portion of the oil and gas industry, particularly the oil services side, finds comfort in the Simmons thesis.

On the other side of the forecast ledger is the theory that there is too much supply in the world, and that the oil industry perches precariously on a precipice just a few barrels away from overproduction and collapse. The most cynical of the international analysts argue that the only thing that saves the industry from a repeat of the $10-per-barrel oil regime in 1999 is the tenuous restraint of the OPEC cartel.

Clearly, a glance at announced additions to global production between now and 2010 can create anxiety, with everyone, including Algeria, Canada, Iran, Mexico, and Russia talking up double-digit percentage production increases.

It may now be time to consider a third forecast scenario. This has less to do with ultimate global supply--or demand--and deals more with the economic and geopolitical milieu in which the oil and gas industry operates.

Maybe the best literary proxy for this concept is a tale by Edgar Alan Poe. The story, "A Descent into the Maelstrom," begins with an aging, broken, white-haired man escorting a visitor to the top of a precipice overlooking a fiord on the northern Norwegian coast. The narrator encourages his guest to look out over the sea as the tide changes and massive tidal currents begin rippling the waters below.

The narrator informs his subject that he was not always a white-haired, worn old man. In fact, it was a single incident that whitened his hair overnight and challenged his emotional foundations.

That event was a disastrous incident off the Norwegian coast at Lofoten where huge tidal currents create massive eddies in 20-knot flows. The narrator is a former fisherman of the nutrient-rich cold currents who one day finds himself aboard a fishing boat which is caught in a whirlpool and begins its descent down the sides to certain destruction. In the end, just before the boat founders, the narrator leaps overboard with a barrel in an Archimedian gamble for survival.

Then the tidal currents change, and the swirling waters come back to normalcy. While the narrator survives, his brother, who stayed with the boat, does not.

Imagine now that the narrator is a proxy for the oil and gas industry, looking back on a watershed event that altered the appearance and nature of the industry itself.

This alternative theory holds that the world is headed to an extended period of general economic and political uncertainty--rippling tidal waters--that more closely resemble international historic norms. The broad sweep of history has not been a lot of fun for most of mankind.

This emerging international environment is in contrast to the last couple of decades when the oil and gas industry navigated a 20-year period of relative calm in the foreign environment, both in terms of conflict and business conditions. Such interludes are rare. The period can be described as Pax Americana. This global world order straddled the end of the Cold War, the dominant world order after World War II, and a decade or so where the concepts of globalization, market liberalization, and open trade were a major international economic force, backed by institutions such as the World Bank and International Monetary Fund.

Whole countries in Latin America, Africa, and Asia were remade under the policy guidance and financial stimulus of these world institutions. For more than a decade, the global economy grew. Though there were occasional flare-ups overseas, such as the Gulf War, dissolution in the Balkans, or currency crises in Asia, it proved to be a beneficial time on balance for international commerce.

This period also proved favorable for the transition during which major oil companies divested themselves of marginal properties in North America beginning in the early 1990s and expanded into the international arena or exotic offshore locations where the financial returns were better.

As the majors divested North American properties, independents with lean management structures rushed in to take their place. Through a combination of technology, mergers, acquisitions, and the drillbit, several of these independents eventually evolved into very large North American companies.

This trend appears to be peaking with two results for oil and gas. For one, the majors now find themselves having to look even farther afield. It is this reality that drove mega-mergers among the majors over the last three years and more recently encouraged BP to invest $6.5 billion in the Russian oil industry. It also encouraged the expenditure of funds in the offshore region of Africa, Southeast Asia, or Latin America.

The second trend is that the super-independents now find themselves in the same situation the majors did a decade ago. They have reached critical mass and the economics in North America (lack of quality prospects) no longer make sense. So they, too, must follow the majors overseas for the returns that can match their size.

Two things made it easy for the majors to make their transition. The first was a connection to low-cost sustained oil production in areas like the Permian Basin, which provided the cash flow from long-lasting reserves to underwrite riskier ventures overseas.

The second was an international business climate characterized by growing commercial liberalization.

Independents are not likely to have the same advantages the majors enjoyed as they make their transition in this new world milieu. For one, the portfolio for independent exploration and production (E&P) firms consists largely of North American gas properties. Everyone understands the depletion curve. To finance their ventures overseas, the independents cannot live on their natural gas reserves. Instead, they will need to divest gas properties to underwrite expansion.

The second challenge is the international order. Opposition to economic liberalization is growing in areas like Latin America, while geopolitical instability is returning to historic norms, which is basically one precarious step above general chaos.

This third alternative theory holds that the international environment will be more unpredictable and troubling over the next decade than it was in the last. Indeed, the most recent decade-long period of relative calm has been an anomaly. The swirling tidal waters of this new international geopolitical and economic milieu will be more representative of the normal situation in human affairs--"A Descent into the Maelstrom."

It is enough to turn a CEO's hair gray. Overnight.

Associate Editor: Robin Beckwith