BHP puts up a fight to win oil market war

AMID the back-and-forth about just what Saudi Arabia is doing in the oil market comes a message from BHP Billiton: “Whatever it is, it’s working.”

As David Fickling wrote earlier, the firm was struggling to dig out from the commodities crash. One glaring blemish was its US onshore oil and gas business, where it spent about $20 billion (R266bn) to buy its way into the fracking game – and written off more than half of that amount.

So much for the past five years. What was more interesting for the oil market today was what Peter Beaven, BHP’s finance chief, said in response to a question about spending plans: “I wanted to point out that I think this is one of the strengths of having this petroleum business inside of a broader business, in fact, a shale business inside of a broader business. We have a very, very strong business particularly in the Black Hawk field in Texas’s Eagle Ford shale basin. Those returns are available well north of 15percent today at today’s prices given the strength of our position. But on the other hand, we’re able to – because we think that oil prices will increase, it’s better for us to keep those barrels in the ground and produce them in due course for higher prices and higher returns to shareholders.”

Finite resource Consciously or not, BHP was following Hotelling’s Theory here. This is the economic principle that states producers of a finite resource will only sell it today if the price, plus an appropriate discount rate, exceeds what they think it can fetch in the future. It treats barrels of oil like a share of a company or any other asset.

What is fascinating about this is that it is the exact opposite of what Saudi Arabia appears to be doing these days – and thereby vindicates that country’s approach. Saudi Arabia has not just been ratcheting up production. It is also planning to float Saudi Aramco as part of an ambitious plan to diversify its economy away from overwhelming reliance on pumping crude. These are not the actions of an oil producer convinced that prices can only head up from here.

Part of the reason for this is the shale boom itself. Spencer Dale, BP’s chief economist, laid out the reasoning in a speech last year: “In its simplest form, Hotelling does not allow for the possibility of new discoveries of oil or for uncertainty as to how much can

be extracted from a particular reservoir. The total stock of recoverable oil resources is assumed to be known and the main focus is on the optimal pace at which these resources should be exhausted. But in practice, estimates of recoverable oil resources are increasing all the time, as new discoveries are made and technology and understanding improves.”

If oil is not, in practical terms, finite then the old wisdom of keeping barrels off the market gets upended.

In maximising production, Saudi Arabia’s actions help make weaker prices a reality in the here and now. And this, in turn, makes BHP wait. That is how a competitive oil market operates. As Andrew Mackenzie, BHP’s chief executive, put it: “In shale we have to be responsive to market conditions and produce when we think the prices are high and likely to remain so in order to maximise its longer-term value.”

If that sounds like an admission of defeat in the face of Saudi Arabia’s onslaught of supply, though, I doubt Riyadh would entirely see it that way.

BHP’s experience shows that shale is not a miracle source of supply where everyone’s costs only go down and production up. Equally, though, it is a huge source of reserves that, unlike conventional fields in, say, the deep ocean, can respond reasonably quickly to rising prices – and thereby potentially cap them. In other words, BHP’s shale plans show Saudi Arabia is winning the battle, but the war is still very much on. – Bloomberg