Why big oil should kill it­self

Financial Mirror (Cyprus) - - FRONT PAGE -

Now that oil prices have set­tled into a long-term range of $30-50 per bar­rel, en­ergy users every­where are en­joy­ing an an­nual in­come boost worth more than $2 tril­lion. The net re­sult will al­most cer­tainly ac­cel­er­ate global growth, be­cause the ben­e­fi­cia­ries of this enor­mous in­come re­dis­tri­bu­tion are mostly lower- and mid­dle-in­come house­holds that spend all they earn.

Of course, there will be some big losers – mainly gov­ern­ments in oil-pro­duc­ing coun­tries, which will run down re­serves and bor­row in fi­nan­cial mar­kets for as long as pos­si­ble, rather than cut pub­lic spend­ing. That, af­ter all, is politi­cians’ pre­ferred ap­proach, es­pe­cially when they are fight­ing wars, de­fy­ing geopo­lit­i­cal pres­sures, or con­fronting pop­u­lar re­volts.

But not all pro­duc­ers will lose equally. One group really is cut­ting back sharply: Western oil com­pa­nies, which have an­nounced in­vest­ment re­duc­tions worth about $200 bil­lion this year. That has con­trib­uted to the weak­ness of stock mar­kets world­wide; yet, para­dox­i­cally, oil com­pa­nies’ share­hold­ers could end up ben­e­fit­ing hand­somely from the new era of cheap oil.

Just one con­di­tion must be met. The man­age­ments of lead­ing en­ergy com­pa­nies must face eco­nomic re­al­ity and aban­don their waste­ful ob­ses­sion with find­ing new oil. The 75 big­gest oil com­pa­nies are still in­vest­ing more than $650 bil­lion an­nu­ally to find and ex­tract fos­sil fu­els in ever more chal­leng­ing en­vi­ron­ments. This has been one of the great­est mis­al­lo­ca­tions of cap­i­tal in history – eco­nom­i­cally fea­si­ble only be­cause of ar­ti­fi­cial monopoly prices.

But the monopoly has fallen on hard times. As­sum­ing that a com­bi­na­tion of shale de­vel­op­ment, en­vi­ron­men­tal pres­sure, and ad­vances in clean en­ergy keep the OPEC car­tel paral­ysed, oil will now trade like any other com­mod­ity in a nor­mal com­pet­i­tive mar­ket, as it did from 1986 to 2005. As in­vestors ap­pre­ci­ate this new re­al­ity, they will fo­cus on a ba­sic prin­ci­ple of eco­nomics: “mar­ginal cost pric­ing.”

In a nor­mal com­pet­i­tive mar­ket, prices will be set by the cost of pro­duc­ing an ex­tra bar­rel from the cheap­est oil­fields with spare ca­pac­ity. This means that all the re­serves in Saudi Ara­bia, Iran, Iraq, Rus­sia, and Cen­tral Asia would have to be fully de­vel­oped and ex­hausted be­fore any­one even both­ered ex­plor­ing un­der the Arc­tic ice cap or deep in the Gulf of Mex­ico or hun­dreds of miles off the Brazil­ian coast.

Of course, the real world never as sim­ple as an eco­nomics text­book. Geopo­lit­i­cal ten­sions, trans­port costs, and in­fra­struc­ture bot­tle­necks mean that oil­con­sum­ing coun­tries are will­ing to pay a pre­mium for en­ergy se­cu­rity, in­clud­ing the ac­cu­mu­la­tion of strate­gic sup­plies on their own ter­ri­tory.

Nonethe­less, with OPEC on the ropes, the broad prin­ci­ple ap­plies: ExxonMo­bil, Shell, and BP can no longer hope to com­pete with Saudi, Ira­nian, or Rus­sian com­pa­nies, which now have ex­clu­sive ac­cess to re­serves that can be ex­tracted with noth­ing more so­phis­ti­cated than nine­teenth-cen­tury “nod­ding don­keys.” Iran, for ex­am­ple, claims to pro­duce oil for only $1 a bar­rel. Its read­ily ac­ces­si­ble re­serves – sec­ond only in the Mid­dle East to Saudi Ara­bia’s –will be rapidly de­vel­oped once in­ter­na­tional eco­nomic sanc­tions are lifted.

For Western oil com­pa­nies, the ra­tio­nal strat­egy will be to stop oil ex­plo­ration and seek prof­its by pro­vid­ing equip­ment, ge­o­log­i­cal knowhow, and new tech­nolo­gies such as hy­draulic frac­tur­ing (“frack­ing”) to oil-pro­duc­ing coun­tries. But their ul­ti­mate goal should be to sell their ex­ist­ing oil re­serves as quickly as pos­si­ble and dis­trib­ute the re­sult­ing tsunami of cash to their share­hold­ers un­til all of their low-cost oil­fields run dry.

That is pre­cisely the strat­egy of self­liq­ui­da­tion that tobacco com­pa­nies used, to the ben­e­fit of their share­hold­ers. If oil man­age­ments refuse to put them­selves out of busi­ness in the same way, ac­tivist share­hold­ers or cor­po­rate raiders could do it

is for them. If a con­sor­tium of pri­vate-eq­uity in­vestors raised the $118 bil­lion needed to buy BP at its cur­rent share price, it could im­me­di­ately start to liq­ui­date 10.5 bil­lion bar­rels of proven re­serves worth over $360 bil­lion, even at to­day’s “de­pressed” price of $36 a bar­rel.

There are two rea­sons why this has not hap­pened – yet. Oil com­pany man­age­ments still be­lieve, with quasi-re­li­gious fer­vour, in per­pet­u­ally ris­ing de­mand and prices. So they pre­fer to waste money seek­ing new re­serves in­stead of max­imis­ing share­hold­ers’ cash pay­outs. And they con­temp­tu­ously dis­miss the only other plau­si­ble strat­egy: an in­vest­ment shift from oil ex­plo­ration to new en­ergy tech­nolo­gies that will even­tu­ally re­place fos­sil fu­els.

Redi­rect­ing just half the $50 bil­lion that oil com­pa­nies are likely to spend this year on ex­plor­ing for new re­serves would more than dou­ble the $10 bil­lion for clean-en­ergy re­search an­nounced this month by 20 gov­ern­ments at the Paris cli­mate-change con­fer­ence. The fi­nan­cial re­turns from such in­vest­ment would al­most cer­tainly be far higher than from oil ex­plo­ration. Yet, as one BP di­rec­tor replied when I asked why his com­pany con­tin­ued to risk deep-wa­ter drilling, in­stead of in­vest­ing in al­ter­na­tive en­ergy: “We are a drilling busi­ness, and that is our ex­per­tise. Why should we spend our time and money com­pet­ing in new tech­nol­ogy with Gen­eral Elec­tric or Toshiba?”

As long as OPEC’s out­put re­stric­tions and ex­pan­sion of cheap Mid­dle East­ern oil­fields shel­tered Western oil com­pa­nies from mar­ginal-cost pric­ing, such com­pla­cency was un­der­stand­able. But the Saudis and other OPEC gov­ern­ments now seem to recog­nise that out­put re­stric­tions merely cede mar­ket share to Amer­i­can frack­ers and other higher-cost pro­duc­ers, while en­vi­ron­men­tal pres­sures and ad­vances in clean en­ergy trans­form much of their oil into a worth­less “stranded as­set” that can never be used or sold.

Mark Car­ney, Gov­er­nor of the Bank of Eng­land, has warned that the stranded-as­set prob­lem could threaten global fi­nan­cial sta­bil­ity if the “car­bon bud­gets” im­plied by global and re­gional cli­mate deals ren­der worth­less fos­sil-fuel re­serves that oil com­pa­nies’ bal­ance sheets cur­rently value at tril­lions of dol­lars.

This en­vi­ron­men­tal pres­sure is now in­ter­act­ing with tech­no­log­i­cal progress, re­duc­ing prices for so­lar en­ergy to nearpar­ity with fos­sil fu­els.

As tech­nol­ogy con­tin­ues to im­prove and en­vi­ron­men­tal re­stric­tions tighten, it seems in­evitable that much of the world’s proven oil re­serves will be left where they are, like most of the world’s coal. Sheikh Zaki Ya­mani, the long­time Saudi oil min­is­ter, knew this back in the 1980s. “The Stone Age did not end,” he warned his com­pa­tri­ots, “be­cause the cave­men ran out of stone.”

OPEC seems fi­nally to have ab­sorbed this mes­sage and re­al­ized that the Oil Age is end­ing. Western oil com­pa­nies need to wake up to the same re­al­ity, stop ex­plor­ing, and ei­ther in­no­vate or liq­ui­date.

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