A Very Incomplete Story

I've watched CBS's "60 Minutes" periodically since I was a teenager. Over the decades they've aired fascinating character studies and uncovered dirt in high and low places. But there's one style of reporting that I'd be surprised if they haven't patented by now, because it's so effective at getting viewers riled at their chosen targets. You know the setup: innocent victims wronged by a Bad Company, camera angles and backdrops carefully chosen to reinforce the reactions they seek to evoke, and the reasonable-sounding correspondent getting evasive-seeming answers from some corporate official. They're very good at this, and I confess I have no more immunity to such manipulation than most viewers, except in the case of the lead segment of last Sunday's program, which I finally caught up with on TiVo. I got mad all right, but this time at "60 Minutes", because the story in question, concerning a lawsuit against Chevron for alleged environmental damage in Ecuador, is one that I know well enough to spot just how skewed the coverage was. In its eagerness to pillory Big Oil, the segment's bias let the real culprit, the national oil company of Ecuador, off the hook.

I want to be very clear about my inherent conflict of interest here, which also provides the basis for my knowledge about the facts of this case. For more than 20 years I was employed by Texaco, Inc., a subsidiary of which was the partner of the Ecuadoran state oil company, Petroecuador, in the Oriente oil fields of Ecuador from 1964 to 1992. I am also a shareholder of Chevron Corporation, which acquired Texaco in 2001--thus inheriting a lawsuit that had already been dismissed by courts in multiple US jurisdictions. I never traveled to Ecuador or worked in the divisions of the company that were directly involved with the producing operations there, but I had colleagues that did. So although I have no first-hand knowledge concerning the evidence put forward by either the plaintiffs or the defendants, I picked up enough information around the water cooler to have a good sense for what was missing from Mr. Pelley's reporting of this story.

The first questions that anyone digging into this story should have been asking concern the history and structure of the agreement governing the oil producing consortium in Ecuador. It started as a 50/50 arrangement between Texaco and a unit of Gulf Oil, one of the other "seven sisters". During the global wave of resource nationalism of the early 1970s, the state oil company of Ecuador acquired first a 25% share of the Consortium and then Gulf's entire remaining share, giving them 62.5% of the operation. (I am sure there were many times that my former employer wished that the government had simply nationalized the whole thing, back then.) This means that while Texaco collected 37.5% of the profits from the Oriente fields, Petroecuador and the government that owned it received not only the bulk of the profits, but also 100% of the royalties and taxes paid throughout the term of the concession. Even in those days, that amounted to many billions of dollars by the time Texaco's interest terminated in 1992, two years after Petroecuador became the operator, not just the majority owner of the field. The company's estimate is that Ecuador received nearly $25 billion over the life of the contract. That's consistent with production of roughly 200,000 barrels per day in that period, at an average price somewhere around $20/barrel. Out of that, Texaco earned about $0.5 billion in total, a figure that wouldn't surprise anyone familiar with oil concession contracts of that era. That equates to less than a penny per gallon of oil produced.

Now, if Texaco were responsible for all the damage alleged in Ecuador, it might not matter so much that it only earned a fraction of what it is being sued for in an Ecuadoran court. However, the allocation of revenue is extremely relevant to attempting to understand who would have benefited from cutting the corners that the plaintiffs claim were cut in the operations there. Cui bono? The answer is glaringly simple, and not just for the period after Texaco ceased acting as operator: Petroecuador--which by all rights should have been sitting in Mr. Pelley's hotseat last Sunday. Petroecuador, a company with a less than sterling reputation for operational excellence, even now. The reason they are not there is that Ecuador refused to waive its sovereign immunity in the case, and thus could not be sued even though it controlled the ongoing operation of the field since 1990, has been the main beneficiary of the region's oil wealth, and bears all responsibility for the poor state of the sanitary and healthcare infrastructure that contributed greatly to whatever ills the indigenous people have experienced. The logic of suing Texaco was inescapable: sue the party you can reach, whatever their share of the responsibility, and go for the deep pockets.

If you've read this far and still have an open mind about the case, then you might be interested in looking at Chevron's side of the story. My purpose here is not to make their case or to suggest that Texaco operated the Ecuadoran fields in the 1960s, '70s and '80s to the standards that prevail today, decades later. But I do feel the need to point out that there is another side to this story that you didn't see last Sunday, and it is not remotely the black and white tale of a big corporation behaving badly that "60 Minutes" portrayed. I am disappointed that CBS allowed itself to be used to paint such a one-sided picture, sullying the reputation of a company I knew inside and out, and of the tens of thousands of fine, responsible people who worked there--not a gang of environmental criminals. I know "60 Minutes" can do better.

Petro Profits

This energy crisis has given rise to a new American ritual: every quarter, after ExxonMobil's earnings are announced, the media breaks them down into dollars per hour, minute and second, and then cues to reaction shots of consumers expressing outrage that any company should benefit so much from their pain at the gas pump. Although I'm not suggesting we should all feel warm and cozy about oil company profits, we might be better served to focus our fulminating on the dog that doesn't bark. If the largest US oil company produces only 3% of the world's oil and still made nearly $12 billion last quarter, what did the national oil companies that own most of the world's oil make, and who paid for that?

Considering the average price of oil in the 2nd quarter, no one should be surprised that Exxon had stellar results, in spite of earning 54% less on refining and marketing and a third less on chemicals than they did last year at the same time. Allocated over the 26 billion gallons of petroleum products they sold around the world in the quarter, these profits equate to an average of 45¢ per gallon, with 87% coming from finding and producing the oil that went into making those products. It's not unreasonable for consumers paying roughly $4 per gallon to grouse about that, though it does say something about our current national mood that the media chooses to highlight that reaction, rather than someone seeing the results enjoyed by Exxon's shareholders and wanting a piece of the action, no matter how small. But whatever the US oil companies, including Chevron, ConocoPhillips, Marathon, and numerous others make, at least most of their profits get recycled into the US economy, in the form of new investments and the savings and spending of the millions of us who collect their dividends, directly or indirectly. The same can't be said for the profits of Saudi Aramco, the National Iranian Oil Co. (NIOC), Kuwait Petroleum Co., PdVSA, Rosneft, and so on.

Consider NIOC, the second-largest producer among national oil companies, at 4.15 million barrels per day, about 60% of which is exported. Iran is a relatively low-cost producer, though probably not as low as Saudi Arabia. If their total costs per barrel averaged more than $15 per barrel, I'd be surprised. So at an average price for Iranian Heavy for 2Q08 of $113.85/bbl., that works out to a quarterly gross profit just on exports in the neighborhood of $22 billion, excluding NIOC's earnings from domestic sales, refining and its substantial production of natural gas. Those might add another $10 billion to the total. Lop off a billion or so for overhead, and NIOC is probably reporting to its sole shareholder second-quarter results north of $30 billion. That'll buy a few centrifuges.

So go ahead and grumble about big US oil companies making record profits, while we pay near-record prices at the pump. But don't forget that we import 12 million barrels per day of oil and petroleum products, for which each and every quarter we must send roughly $135 billion outside the country, at current prices. Mr. Pickens is right to bemoan this enormous and unsustainable transfer of wealth. In that context, a smart national energy policy would not bog down in trying to choose among expanded drilling, conservation, and renewable energy, as though these were mutually exclusive options; it would pursue all of them, vigorously, and without vilifying companies for wanting to produce more energy here in the US.

Global Energy Overview

I’m back in Connecticut this week, attending the annual Pacesetters Energy Conference of John S. Herold, Inc., which sponsors this blog. The conference brings together the oil & gas and investment communities, focusing on the major trends in the energy industry and their financial consequences. This year it is taking place against a backdrop of relevant events nearby, as the UN meets in New York and the President convenes an international conference on climate change in D.C. The UN session includes the visit of Iran’s President Ahmadinejad, the walking personification of political risk. It’s going to be an interesting week.

The opening panel of the conference provided some interesting statistics on the publicly-traded energy companies that Herold tracks. The industry spent $400 billion in “upstream” capital investments last year, apparently constituting the seventh consecutive increase and exceeding the total cash flow of the sector for the first time since the 1990s—when that cash flow was much lower. But because of limited access to resources around the world—a theme I’ve touched on many times—aggregate oil reserves have increased only modestly, and much of that has come from the Canadian oil sands. And the combination of weaker natural gas prices and rising costs are putting pressure on the industry’s profit margins—not something you expect to hear with oil at $80/barrel.

These are serious issues, to be sure, but in his videotaped message at the start of the conference Ron Mobed, the President and COO of IHS Energy, which recently acquired Herold, mentioned the “environmental and climate change concerns that are currently the biggest drivers of change in operating practices in the industry today.” Given the magnitude of the other challenges, such as political risk and access to resources, I thought this statement was remarkable.

Thursday morning I will be moderating a panel discussion on alternative energy, with participation from a major oil company, an ethanol technology startup, a large consultancy, a coal processor, and the US Department of Agriculture. Alternative energy is going to play an increasingly important role in connecting the energy industry to climate change. Not only is it a principal avenue for reducing emissions, both globally and for the industry’s own operations, but it could prove essential for making the product slate of energy companies compatible with a world of constrained carbon emissions and effectively constrained hydrocarbon production.

My postings for the remainder of the week will include some of the key insights from the conference, along with my comments on any noteworthy developments from NY and DC.

Short Memories

One of my ongoing themes here is that, despite high energy prices that now rival those of the last energy crisis, we are not experiencing the second coming of the 1970s. Unfortunately, we do seem fated to revisit every bad energy idea from that period, and today we have two on display. First, a columnist in the Washington Post proposes establishing a national oil company (NOC) to promote expanded supply, new refineries, and "hyper-competitive" pricing. Then later this morning the Joint Economic Committee of the Congress is holding a hearing on whether to pursue breaking up the largest US oil companies. At this rate, I'd better make room in my closet for the paisley shirts and leisure suits that must surely be on their way.

In his column Steven Pearlstein anticipates all sorts of oil industry opposition to the idea of a chartered national oil company set up to compete with them, and given all sorts of breaks on refinery siting and permitting and production from federal lands. Never mind that if the existing oil companies had been given those breaks when energy prices were low, we might not be in the present pickle. While I'm sure Mr. Pearlstein's plan would provoke the expected response from energy companies and trade associations, the biggest complaints ought to come from taxpayers and watchdog groups. This approach was tried all over the developed world in the 1970s, and with very few exceptions, it was given up as a bad idea. The successful NOCs are all in big net-producing countries, not net consumers. The history of Petro-Canada, founded in 1975 and 80% privatized in the early 1990s, illustrates this cycle. Mr. Pearlstein probably isn't serious, of course. His contrasting portrayal of a hypothetical NOC seems mainly intended to shame the publicly-traded oil firms for being profitable and rewarding their shareholders. But in today's climate, I wouldn't be surprised to see some legislator take up this mock cause.

Turning to today's Congressional hearing, it has become an article of faith in some quarters that the country's energy woes are the result of the industry consolidation that took place in the late nineties and early oughts. Smaller, more aggressive competitors would have apparently increased oil production and expanded their refineries at a faster pace, so that while global oil prices might now be high, at least refining margins would be lower, with consumers paying more like $2.40/gallon, instead of $3.22. But while you're unlikely to find an industry insider less enamored of merger mania than I am, this scenario flies in the face of the economic facts that drove those mergers in the first place.

From 1997-2001 I worked in Texaco's Corporate Planning & Economics Department. During that period, we experienced the disdain of investors for "old economy" industrial firms that needed capital to compete with the growing power of the NOCs in producing countries, which held more than 80% of the world's oil reserves. We just weren't New Economy enough. Then, to add insult to injury, the price of oil collapsed from the $20s to single digits, before recovering. The mergers triggered by these events weren't focused on market domination and pricing power: they were about ensuring the survival of an industry that had just come through a near-death experience.

One of the other concerns that occupied much of my time in that period was refineries. Simply put, they were dogs. Not only were US refineries consistently earning less than the cost of capital, but they were a constant drain on capital, because of wave after wave of environmental investments in reformulated gasoline and ever-lower sulfur diesel fuel, for which consumers didn't want to pay an extra penny. All that management wanted to do was to find ways to reduce our exposure to this awful sector, and that's exactly what we and the other majors did, through joint ventures and outright sales. Is it any wonder that, on the back end of such a cycle--when demand growth has outstripped domestic capacity and our reliance on gasoline imports from Europe and elsewhere has grown steadily--refining margins are finally enjoying a bonanza? If oil companies invested as much in new refining capacity as their critics would like--even if new greenfield facilities could get permits--the result would likely be another protracted cyclical bust. In the face of a 35 billion gallon/year alternative fuels mandate, that may just happen anyway.

I persist in my hope that enough of us actually learned something from the experience of the 1970s and the energy price cycles that followed that first energy crisis. If we want to ensure that the US has access to the oil and gas it will need during a lengthy transition away from fossil fuels, then what we need is not a national oil company, and certainly not a gaggle of smaller oil companies. Instead, we need a strong, dynamic energy sector, led by companies big enough to deal with the NOCs as equals and to take expensive risks on the frontiers of technology, whether in ultra-deepwater drilling or cellulosic ethanol. The times demand something much better than merely recycling the ill-considered notions of the past.