Thursday, April 29, 2004

Does Size Matter for Oil Companies?
This question has vexed the industry for years, though the equity markets have clearly cast their vote in the affirmative. Most of the mega-mergers in the industry were greeted favorably by the markets, particularly ExxonMobil and BP-Amoco-Arco-Castrol (now just BP, Beyond Petroleum). But the recent problems at Shell have focused attention on some of the challenges brought about by operating at this scale, as highlighted in this provocative article in the Financial Times.

One of the biggest concerns is over the ability of the so-called Supermajors to replace their oil reserves economically, to underpin production and revenue growth into the future. Every year, these enterprises need to replace the enormous quantities of oil they produce, amounting to 1.5 billion equivalent barrels of oil and natural gas for Exxon alone. But in principle these mammoth companies have at least as many resources as their pre-merger predecessors, in terms of the capital budgets and technical staffs required to find this oil. So on the surface, size should be neutral in this calculation. However, I think size plays a negative role in two important ways.

First and most directly, much of the initial financial benefit of these mergers has come through staff reductions. (Full disclosure: I left Texaco immediately after its merger with Chevron.) Although these reductions are intended to come from overlapping headquarters and support staffs, some technical staff invariably leave for personal reasons including undesirable relocation, diminished promotion opportunities, and lucrative separation packages.

As a result, these mergers invariably trim vital capabilities, along with the intended overlaps. In a shrinking industry, separated workers often find employment in other industries, leaving fewer highly-skilled technical personnel to chase the next oil discoveries. While some of this attrition may be offset by new graduates and improved technology, including information technology, I'm skeptical that you can really replace the value of a 20 or 30 year veteran geoscientist or petroleum engineer this way.

The second problem is a direct result of the size of the merged companies' asset portfolios. These are so large that the threshold of what is material to them changes. If they can only work on x new opportunities a year, then they must be the largest x opportunities. But as the FT article reminds us, there is growing evidence that the largest opportunities have already been found, and in many cases sit within the inaccessible portfolios of state oil companies such as Saudi Aramco.

So would an Exxon be content to chase 1000 smaller opportunities, rather than the 100 larger ones they are structured for and financially biased towards? Not if they want to keep their finding and development costs in the top quartile, an important indicator to market analysts. It is much harder to hold these metrics down if the denominators shrink.

Even though I've chosen to illustrate these issues in the case of a merged Supermajor, I believe they also apply to Shell, which chose not to grow via merger. Instead, they have had to take many of the same steps through internal reorganization that others achieved through their mergers, in order to remain competitive.

Where does all this lead? Probably not to oil shortages, but at least to some significant challenges for the industry in the years ahead. At a time when the global demand for petroleum is advancing steadily, the most successful incumbents in the industry, driven by the financial expectations of the equity markets and by technical factors, have compromised their ability to expand their oil production to keep pace with demand. At the same time, social, political and demographic pressures on national oil companies will make it harder for them to finance and execute the further development of their own vast reserves, without capital and assistance from the international industry.

The solution to this conundrum is breathtakingly simple: allowing the major oil companies to access the reserves of the national oil companies. The trick will be to find a way to do this that does not threaten the proud independence of the latter, while still proving sufficiently lucrative for the former. The whole history of the industry since 1972 is against it, but there are promising signs in places like Venezuela and Libya. I think we'll hear a lot more about this in the future.

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