17 June 2008: Understanding the position of oil companies reveals a lot about the different issues that are in play as oil prices have risen over the past months. This exercise also provides insight into the thought process of oil-producing states.
First, however, take a step back and think about how energy markets used to operate. In the early 20th century, oil companies like Standard, from the U.S., and Royal Dutch/Shell, based out of London, would go to countries where oil could be found, acquire a concession and pay the host government a portion of the proceeds. This payment often paled in comparison to the huge profits that the companies enjoyed; it could even be smaller than the tax revenue that the U.S. and Great Britain gathered from the oil companies.
This status quo began to shift as host countries demanded larger and larger payments. Fueled by longstanding rivalries, the likes of Iran and Saudi Arabia looked to one-up the other in search of greater control over the black gold—and greater payments. For a long time, the companies and governments agreed to a modus vivendi, splitting profits 50-50. But soon this distribution was not enough as ownership, and then outright nationalization, became the order of the day. Generally, as host governments took the upper hand, so did prices. With the oil embargo in 1973 and the second oil crisis following the Iranian revolution in 1979, the price of oil shot up as the scarcity of alternative suppliers became evident. By the 1990s, independent oil companies were increasingly limited in where they could operate. They became guests in an invitation-only part.
The lack of alternatives remains the case today. There have been very few new fields that have come online because these multinationals are restricted in their most promising foreign operations. For example, Russia put pressure on Shell until it was forced to pull out of the Sakhalin project in 2006. Seeing that old tricks still work, the Kremlin is repeating the act with its joint venture with BP. Exxon/Mobil and others had their Venezuelan assets seized as part of a nationalization drive by President Hugo Chavez. Other promising locations such as Iraq and Nigeria are off limits because of violence and internal strife.
As BP Chairman Tony Hayward wrote in the Financial Times: “Access to resources for international oil companies such as BP remains very restricted. Resource nationalism is on the rise. That is important because it is the oil majors that have some of the best technology for bringing difficult resources on-stream”
The second problem is that the fields that are available are returning less and less. Aging fields mean that more money must be put into them to extract the small amount of oil. This is driving up the cost of exploration as never before; just in the past six months, costs have climbed 12%. Companies are forced to turn to less efficient alternatives like Canadian tar sands or Arctic drilling, which are also more expensive and difficult to establish and maintain. As the head of PFC Energy noted last year, “There are no easy barrels left.”
That is not to say that these oil companies are hard up. Their revenues are astronomical. Exxon has enjoyed record profits as energy prices have risen (though, sometimes even these returns are not enough for investors it seems.) But why? All evidence points that since they cannot get access to as much oil, their profits should take a hit. But oil companies are now working within the paradigm that has been present to (and created by) them, a framework where they cannot get into other countries to extract petroleum, but have a commitment to their shareholders.
The idiosyncrasies of the oil market means that oil producers—both companies and countries—can actually enjoy greater revenue by decreasing production. As has been reported, Exxon is not planning on increasing its oil production in the near future, yet its share price continues to rise. As the article quite rightly points out, “What if Steve Jobs said Apple wasn't going to sell any more iPhones than it did in 2007? What if Howard Schultz said Starbucks' latte production would stagnate, at least until the next U.S. president embarked on his reelection campaign? Shares of both companies would plummet.”
However, it is important to remember that cellular phones and lattes are not like oil: People can (if forced to) forego their morning coffee; they can use a Blackberry instead of an iPhone. The inelasticity of oil—due to the lack of viable substitutes—means that as supply tightens, prices jump.
And it looks like oil-exporting countries have reached the same conclusion.
OPEC saw its output fall by 350,000 barrels a day last year, despite record prices. Other countries like Russia have allowed their energy infrastructure to age, curtailing their own output capacity. Even Saudi Arabia, known as the world’s central banker for oil because of its ability to easily increase supply when needed, actually cut its production by 400,000 barrels a day, or 4.1%, in 2007. While there are signs that Riyadh is finally answering the West’s pleas for more oil, there is not the same urgency that there once was. This is because a weakening U.S. economy has become less of a concern because there is no concomitant softening of demand; oil that was intended for the U.S. can simply be sent to the emerging economies of India and China.
So are supply concerns increasing energy prices—and consequently revenues? Or are there other forces at work, including the weak dollar and speculators?
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