The Future of Oil Companies
A couple of weeks ago I wrote about some of the changes taking place in the international oil industry, describing them as a of realignment of ecological niches. (See postings of Nov. 17 & 18.) Yesterday's Financial Times included a truly insightful article that probed these issues in much greater detail, using the opening of new exploration and production opportunities in Libya as a case in point. Anyone interested in the oil industry, whether as an investor, supplier, or employee, should give some thought to the issues the authors raise. The outcome will determine the nature and profitability of the major oil companies for the next ten to twenty years.

If you look at the oil business in purely economic terms, there are three principal sources of value associated with petroleum. (The analysis is similar, but slightly different for natural gas.) First, there is the value created by finding oil, taking it from the earth and bringing it to market. This corresponds to the "upstream" portion of the industry. The second portion covers the "midstream" and "downstream", in which the oil is transported, refined, and the resulting products sold. Finally, there's the value created through the use of the products, including transportation and the petrochemicals.

Despite massive investments in refineries and highly visible service station networks, most of the economic value of the international oil majors, for most of their history, has come from the Upstream, through their ability to capture part of the economic "rent" on oil production. What makes the issues raised in the FT article so challenging is that they threaten to dry up the companies' access not only to new oil and gas reserves, but more fundamentally to the gusher of above-average returns--the "rent"--derived from them.

To understand how this works, compare an oil field in the North Sea to one in Kuwait. In the former case, the company producing the oil paid for an exploration concession, invested in finding and developing the oil, and now enjoys the full value of the production stream, less operating costs, taxes and royalties. In Kuwait, on the other hand, the state oil company may hire one of the majors or service companies to perform work on a field, but only pays them a fee for the work. The state oil company keeps essentially 100% of the uplift between the cost of production and the market price. The worst-case scenario for the majors is a world in which all the future production opportunities look like Kuwait, and none look like the North Sea.

While that may be an unlikely outcome, the threat of the cost of production sharing contracts and concessions being bid up by new competitors to levels that leave little room for upstream profitability by the majors is not. Nor is it hard to imagine more and more of these deals being done preferentially between state oil companies, leaving little role for the majors.

None of this is new. Some companies have seen these possibilities for at least a decade. What is not apparent, however, is the kind of transformed oil company value proposition that would be required to carve out an advantaged and highly profitable niche in such a world. To find that, as the article suggests, the companies must have a very clear idea of what they bring to the table, and with today's global markets for capital, it can't just be money.

What can the likes of ExxonMobil, BP, Shell, ChevronTexaco and their smaller brethren offer that a Sinopec or Petrobras--or an alliance between a hedge fund and a service provider--can't compete with? The answer to that question will end up being the majors' dominant business model for the next couple of decades, unless they want to treat their upstream businesses as depleting cash cows from which to fund other activities.