Wednesday, October 27, 2004

Plowing It Back
With the international oil majors in the midst of releasing earnings that should set new records, based on sustained high oil prices, those who follow the industry are increasingly asking how much of this cash windfall will be reinvested to find and develop new oilfields. Share buybacks and healthy dividends are fine and good if the only goal is elevating stock prices, but the current market tightness poses a challenge that the industry must either meet or else run the risk of damaging the market's future potential and stimulating the rise of alternatives.

Another recent Financial Times editorial, though, points out that OPEC has been even more remiss in reinvestment than the majors have, for reasons that make perfect sense to the producing countries, if not to the global economy. Much of this comes down to metrics.

The indicators by which you evaluate your success have a lot to do with shaping your future direction, and for the last decade most of the private oil sector has focused on reducing expense , lowering finding and development costs, and improving upstream margins. Those are excellent metrics from a shareholder perspective, since they reward companies for developing only the most profitable projects, but not for a global economy that needs expanding reserves and production to meet future demand.

Similarly, for the OPEC countries the metric that matters most is the remittance from their national oil companies to their national treasuries, or, in some cases, to the pockets of corrupt officials. Investing in extra capacity has not been seen as a good way to maximize this metric, in a market that yields higher prices--and thus higher OPEC revenues--when supplies are tight.

Today's producers, driven by these two sets of metrics, could never have created the industry we see. Rather, we are living off the largesse of a previous era, when the industry's performance metrics supported growth in capacity and infrastructure, even if that didn't always maximize short-term profitability. The vintage of the key producing oilfields around the world (when they were discovered and first developed) reflects this, and has become the prime evidence for those suggesting a geologically driven peak in production is near.

Could it be that the relative age of these big discoveries reflects a recent marketplace of diminished rewards for the behavior that found those fields in the first place, rather than signifying a diminished universe of opportunities? Perhaps the key component of a peak in production--or at least a supply crunch--lies not in the earth's crust, but in the incentives driving corporate executives and national oil company chiefs.

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