EconoMonitor

Policies of Scale: Efficient Global Policy

The Death of the Independent Oil Company is on the Horizon

Last week I described how national oil companies (NOCs) are dominating the global oil and gas market, controlling as much as 90% of oil and gas reserves. This did not used to be the case: in the 1970s, it was the “Seven Sisters,” a group of seven independent oil companies (IOCs), who controlled 85% of global reserves. IOCs, which are also defined as “integrated oil companies,” remain important but have been relegated to secondary forces in the global energy market. Last week’s NOC-focused piece explained that this shift in the balance of oil production is likely to have detrimental impacts for America and global economies. This piece explains why the IOCs have lost so much ground to NOCs and makes the argument that their role will continue to recede, paving the way for effective NOC domination of the market.

Interestingly enough, as much as today’s NOCs represent an extension of the government-dominated oil sector (that is a plural “government”) that effectively distorts the market by coordinating production, the Seven Sisters was the result of a decision by three men, a Dane, an American, and a Brit, to coordinate their private oil business decisions and practices. For several decades, the seven IOCs were able to control, more or less, the governments of the oil producing countries in which they did business, sometimes directly by working to install certain leaders. Over time, however, smart native forces realized they could take over production and, therefore, control of their energy resources. As demand for oil grew in the (now) developed world (and created today’s modern economies which rely on the substance for locomotion), the consuming countries were forced into acquiescing to the nationalization of petroleum. The results are the incredible figures cited in the first paragraph.

Fast-forwarding to today, NOCs have significant advantages in the energy sector. They are able to raise equity and debt in global capital markets like IOCs, but because they are backed by the governments of the countries in which they predominantly operate, they are safer investment destinations than IOCs. PetroChina (China), Rosneft (Russia), and Petrobras (Brazil), three of the largest NOCs, were able to raise more than 27 billion USD collectively in the first half of 2012, compared to about 10 billion USD collectively among the supermajors. The debt they raise often comes at more favorable rates, as well. The six largest publicly traded NOCs have price-earning ratios of around ten compared to supermajor ratios closer to seven. In 2012 three of the five supermajors’ ratios declined while the strongest, Exxon, increasingly relies on expensive heavy, unconventional, and deep water oil for around 50% of its production — compared just to 17% a decade ago.

Further, parent governments actively protect the interests of their NOCs against IOCs by limiting or restricting foreign companies’ access to reserves, while market-friendly countries like the United States do little to protect IOCs against NOC encroachment (more on this below). The number of countries doing this has increased fivefold over the last 40 years. And when allowed to operate, IOCs face more regulations when coordinating operations or merging. For example, two Ecuadorian NOCs recently merged, allowing them to reduce operating costs, increase production, and improve efficiency and profitability. It is almost impossible to imagine IOCs merging or partnering with such ease in any area of operation. And along these lines, parent governments are able, incentive and finances contingent, to support NOCs through troubling periods. Russia’s recent decision to implement significant tax incentives for shale gas production, for example, lines up perfectly with Rosneft’s rising costs across existing conventional oil fields as the company looks to expand into the shale play.

IOCs were once, and not that long ago, the bastion of investment in research and development. Not only did this put them on the cutting edge of their industry, but it made them critical to countries looking for expertise in efficiency and technology. Since 2005, however, a sample set of just five of the largest NOCs have increased their R&D budgets at twice the rate of the supermajors. As of two years ago this group of NOCs was out-investing the supermajors by almost 1 billion USD.

One potential reason for the decline in IOC R&D spending is that a reasonable return on investment for such expenditure may be unachievable. Conventional oil discoveries peaked in the 1960s and 90% of known conventional oil reserves are currently in production. Of the forty biggest discoveries between 2006 and 2011, twenty-eight are in countries with NOCs. The reserve replacement ratio (RRR), which measures the reserves an operator has to replace current production, is looking far more favorable for the NOCs (78 years for the top ten) than the IOCs (13 years for the top ten). Taken together, the supermajors now inject just one-quarter of total capital spending on exploration and production: Exxon was recently overtaken by PetroChina as the leader in this area. The oil wells are drying up, literally and metaphorically, for the IOCs and existing opportunities to put R&D to use are shrinking.

As the IOCs flounder, NOCs are expanding beyond their home nations. The Chinese NOCs have been particularly active in shale gas, currently holding around 20% of the world’s shale gas reserves. Sinopec, a Chinese NOC, has acquired over 22 billion USD in oil and gas assets since 2010. Thailand’s NOC, PTT, recently outbid Shell for Cove Energy’s East African holdings. Here at home, 20% of investments in shale between 2008 and 2012 involved joint ventures with (needless to say foreign) NOCs. The two largest oil and gas deals in 2012 involved NOCs from China and Russia entering into joint ventures in Canada and Russia. Encouraging this trend are stubbornly persistent low gas prices that generate insufficient revenues for IOCs to continue producing on their own; capital expenses have increased by 127% since 2000, while operating expenses have risen by 89% over the same period. Meanwhile, the average IOC operating profit margin fell from 15% in 2006 to under 12% last year.

The ability of NOCs themselves to source financial, human, and technical resources, services once provided almost exclusively by IOCs and independent companies, has blossomed. Where opportunities exist, oilfield service companies (OSCs) have risen to fill niche needs for NOCs at prices more competitive and contracts more flexible than IOCs can often provide. This has led to the creation of NOSCs, nationally owned oilfield service companies, a rising force in the industry.

As a result, IOCs are fighting to demonstrate their relevance, and could eventually be restricted to the one domain where NOCs remain reluctant to lead: the most challenging, complex, and expensive frontiers where the terrain is most difficult (like the Arctic,) and where the most cutting edge technology is required (such as unconventional oil and gas.) These are the last remaining areas where IOCs are able to acquire and control reserves, and because of the costs and conditions involved are often the most risky and least profitable plays.

Some of the best opportunities IOCs have at the moment are in Canada, the US, and potentially Mexico (more on this below). New production in the Canadian sands requires a price of $81 per barrel, while onshore US oil demands a per barrel price of $70 and Gulf of Mexico oil a price of $63. Meanwhile, in the Middle East, where some of the biggest NOCs have almost free reign, the required per barrel price is just $23. The cost of producing barrels from inhospitable countries or challenging frontiers is now estimated to be around $100 per barrel, not much below the going market per barrel rate and therefore not an answer for the IOCs’ troubles.

There is one potential bright spot for IOCs: Mexico. The government recently unveiled a bill to change the country’s constitution, which has imbedded in it a protected government monopoly of the country’s oil that has persisted for 75 years. The new bill would undo part of that monopoly by allowing Mexico’s NOC, Petroleos Mexicanos, to partner with private companies for oil and gas production. Mexico is home to the world’s 18th largest proven reserves, and has relied on OSCs to do everything from exploration to drilling. The arrangement has led to a plummeting in production.

The overhaul is not a complete sector liberalization, however. It falls short of allowing IOCs the right to outright ownership of fields, and it does not allow IOCs to own shares of the oil. Instead, cash equivalents of oil found and produced will be paid to the IOCs, a model similar to those in Ecuador, Iran, Iraq and Malaysia. Many details remain undecided, including what the tax and fee structure will look like for IOCs. How these questions are answered will determine the extent of IOC interest in Mexico’s oil. Given the IOCs’ end-to-end expertise — still not fully achieved by many NOCs — they would likely be the big players should they chose to participate. Nevertheless, while Mexico would be the biggest play on the market, at the end of the day it likely represents the last of its kind for IOCs starved of such a large conventional production source.

There is an underlying question that could make all these facts and factors less important, however, and that is whether there are even going to be opportunities in the oil business for IOCs in the coming decades. While the IOCs have been encouraged to believe their own (some would say) idealistic projections of massive demand growth by certain IEA, EIA, and other projections, there is a body of work suggesting that even the IOC, IEA, and EIA baseline projections could be overstating the case.

To begin with, all the projections acknowledge that the growth will occur in the NOC-dominated developing world where IOCs have increasingly limited access to, or are already locked out of, future production opportunities, limiting their opportunities to supply burgeoning markets. Further, these countries are from the beginning introducing some of the most fuel efficient vehicle fleets in the world, including some powered by alternative fuels. Natural gas is on the rise in the developing world’s transportation sector as the developed world is slowly drifting away from oil-fueled transportation systems as well. In the US, one-fifth of buses now run on natural gas, as do 40% of garbage trucks. Caterpillar and GE are both developing natural gas-powered railway trains while TOTE, a shipping company, has placed the first order for container ships that run on liquefied natural gas (LNG). Further, the multiplying motivations for developing a transportation system that can increasingly run on natural gas means working to liquefy and export the same natural gas may become economically unattractive. Such a shift in transportation could significantly reduce the developed and developing worlds’ need for oil, stunting those large demand projections.

According to analysis by Citi, demand in 2020 will be 3.8 million barrels per day lower than it would be without the kind of efficiency gains expected in automotive fleets. If natural gas takes off as an input for electricity in the Middle East as it well could, it would put as much as 3 million additional barrels per day of NOC-produced oil into the global market. Taking all these factors into account, Citi and others project demand to be far lower than the supermajors estimate. If the supermajors cannot acquire profitable areas of production and demand comes in under expectations, their futures look very dim.

None of this is news to the supermajors, and they have responded in part by accepting more risk. However, not all the moves have paid off. Shell’s decision to invest heavily in the Arctic has faced many technical challenges that have caused long delays in production. BP’s decision to switch partners in Russia in the hope that it would lead to new reserves could prove costly, as it forced them to give up the steady income stream the former partnership ensured. The NOC and multi IOC liquefied natural gas partnership in Nigeria appears to be falling apart as BG, Chevron, and Shell have all now pulled out over production issues that held back progress. And Exxon’s new investments in Central Asia and its joint venture with Rosneft are uncharacteristically risky for the company.

The supermajors are also trying to invest heavily in natural gas, and at this stage the resource accounts for 40-50% of production for most of them. However, most entered the shale game at the peak of the investment cycle and, as natural gas prices have remained low, have now written off good chunks of the value of their acquisitions. As a result of this and of poor outlooks in the oil sector, the market has not been impressed as investor enthusiasm for the supermajors has flat lined.

The numbers do not generate much hope in this area. Royal Dutch Shell, the most valuable company on the London Stock Exchange, announced earlier this month that their oil production fell by 1.3% from a year earlier, while profit fell 57% in large part because of a write-down on the value of their US land leases. They also announced the abandonment of plans to boost production by 1 million barrels per day by 2018 from their current daily rate of 3 million barrels, perhaps a decision related to a 20% increase in production costs as production from oil sands and shale have come on-line. Exxon also announced its profits plummeted by 57% to their lowest level in three years while production fell by 1.9%. Tellingly, the last time Exxon’s earnings fell this low in one quarter, oil was at $79 per barrel; this time around it was $94. BP, which is on the hook for as much as 90 billion USD in fines and compensation from the Deepwater Horizon incident, reported a production decline of 1.5% and forecasted a further drop for the following quarter. And just last week, the company opted out of a US government auction for Gulf leases, likely because it felt its suspension from new government contracts is not about to end anytime soon.

The kind of influence NOCs will have remains to play out because the nature of how an NOC succeeds internationally depends on the countries in which they aim to operate. But given the nature of what NOCs represent – arms of governments – their expansion is likely to enlarge, and complicate, their parent governments’ foreign relations. Therefore, from a political perspective, they raise the opportunity for conflict.

For global economies, they reduce the size of the private sector, and where NOCs are not traded publicly, they eliminate a source of investment earnings. They add to government revenues, and therefore can enlarge the public sector depending on how the government decides to use any profits it may be earning; one could easily picture a new type of resource curse that is funded by foreign oil procured by domestic NOCs. Conversely, a government could choose to invest profits in any  number of quality destinations that improve prosperity (the Norway model comes to mind).

Further, relying on NOCs from downstream to upstream means greater challenges for the parent government. A current example can be found in China, whose refiners, part of the country’s NOCs, have had a terrible two years. Until recently, the trouble stemmed from the gasoline prices held artificially low by the central government. Now, however, a slowing economy is driving increasingly weak demand growth and bringing  sales down. At the same time, the Chinese government has taken aim at bringing prices closer to global norms, further depressing demand. Additionally, Sinopec, one NOC with a refining operation, is publicly traded, and has seen investor interest decline. However, relying on NOCs means a government can shift money internally, supporting a losing refinery business in order to keep its end-to-end supply chain together. Whether China and others can succeed in keeping its energy strategy alive and healthy remains to be seen, but will depend in part on their long-term ability to manage inherently contradictory forces.

If the prospects of the IOCs are as poor as I have suggested, and they do not find ways of remaining relevant or reinventing themselves, we are looking at a point – probably not far in the future – where OPEC will continue to have a large influence over the oil market while countries with NOCs, including importers like China who “forward deploy” their NOCs to secure foreign production for domestic use, will create a new type of influence in energy markets at the expensive of the IOCs.

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