One supermajor too many?

It is difficult to talk about the oil price these days without somebody or other popping up with a conspiracy theory involving the Saudis deliberately not cutting back on production in order to simultaneously cripple Russia, damage Iran, and hobble the fledgling US shale oil industry. Streetwise Professor does an admirable job of explaining why this is bollocks, that the price drop is from the demand side, and the Saudis cutting production would cause them to lose revenue (which is a pretty explanation of why they aren’t).

Putting aside all the conspiracy theories, what amuses me is the supposition amongst many people in the oil industry that $50 per barrel oil is a disaster and OPEC (meaning, the Saudis) should intervene to drive the price back up.  Take this for example:

Leading oil companies Eni and Total were also critical of Opec policy, arguing that investment would dry up and markets will in the long run face serious shortages. Prices could then soar past $200 per barrel, Eni’s head Claudio Descalzi warned.

Total chief executive Patrick Pouyane said that partly because of natural declines averaging 5% per year, more than half the existing global oil production would disappear in another 15 years. The amounts of investment then needed would be “enormous”.

If the CEO of both Apple and Samsung came out saying that technological progress would grind to a halt unless the price of smartphone handsets doubled, you’d laugh and rightly so.  Now here is a chart of the oil price since 2000:

We last saw $50 per barrel oil in late 2004, before which it had been consistently lower than that.  I was working in the industry in late 2004 and I don’t recall there being mass panic among the oil companies about not being able to cope.  So what’s different this time?

The chart tells the story.  Having enjoyed an oil price sustained around $100 for the past 10 or so years – a temporary blip in 2008 nothwithstanding – oil companies have gotten fat, bloated, and inefficient.  Indeed, the whole industry has.  Salaries have soared along with equipment hire rates, while the headcount in operating companies – both nationalised and private – has ballooned.  Like a Hollywood starlet who has gotten used to the allowance an ageing, wealthy husband bestows on her, the oil industry has forgotten what it was like to live in a house in the woods outside Pageland, South Carolina.  And as a starlet berates the husband through the divorce proceedings whilst hoping for a bumper settlement, certain oil companies are directing their ire at the Saudis.

Now I have no love for the Saudis, far from it.  I worked there for a time, and couldn’t stand them.  But in this instance they are absolutely right to ignore the pleas from CEOs who have allowed their own costs to run out of control and lack either the brains or the balls to reduce them.  The way they are sounding off, it’s as if they have a God-given right to $100 per barrel oil.  Who are they to say that this is the correct market rate, and if the participants in the market are saying something different then the supply should be artificially constrained until their revenues return?  Seriously, that the CEOs of private, western oil companies should be advocating this smacks of desperation.

But they are desperate.  The high oil price has ushered in, and reinforced, a culture of incompetence, favouritism, indecision, inefficiency, and cowardice across the whole global industry as any fallout from these practices could be masked by throwing a billion or two at it.  How much has Eni’s mismanagement of the Kashagan project cost the consortium?  And now the CEO wants guaranteed, artificially-inflated revenues?  I bet he fucking does.

Faced with a much lower oil price that is likely here to stay, oil industry heads are now being forced to make the decisions they have avoided making for about a decade.  But in all likelihood, they no longer have the expertise to make them.  Most middle-managers in an oil company wouldn’t have the faintest idea how to even identify major costs, let alone take bold actions to reduce them.  Their idea of contractor management is to slag them off behind their backs in the corridors of power and hope enough mud sticks when the change order comes through that nothing awkward comes up in their annual appraisal.  Barely a few percent would know how to negotiate a contract to ensure value for money, and most couldn’t make the connection between manhours spent and costs to company if their lives depended on it.

Whatever individuals used to make do with $50 oil in 2004, and even less before that, have most likely retired or turned useless.  Ten years is a long time in industry, and skills are quickly lost. While the oil companies and contractors took care to retain their technical expertise having learned the hard way from the last serious downturn, they have done little to ensure their management, cost base, and commercial skills are prepared for the next one.  In short, they’re in the shit.

Total’s CEO Patrick Pouyanne was in the FT this week telling investors that expenditure would be cut, the dividend maintained, but no jobs would be lost.  I do hope his strategy consists of more than bawling at the Saudis to help drive the oil price higher, because that’s a tough circle to square.

Personally, I think the oil industry has changed fundamentally in the past decade in a way which few of the western majors realise.  As evidenced by their strategy of production growth over profitability – a strategy suddenly shelved when they belatedly realised they wouldn’t meet their targets – oil companies are insistent that massive, multi-billion dollar projects in technically challenging locations using cutting-edge technology is where their future lies.  Me, I’m not so sure, for two reasons.

Firstly, the chances of stumbling across a giant oilfield – think Tengiz or Santos/Campos – are getting smaller and smaller with every passing year that billions of dollars of exploration fails to turn one up.  To base the entire strategy of a company on finding one is to plumb the depths of stupidity, but that appears to be what’s happening in some places.  I was in a meeting the other day, trying in vain to persuade a middle manager that the wishy-washy style of management he prefers will need to become a lot more decisive if he wishes his company to survive in the new era of low oil prices.  “Don’t worry,” he assured me “one major find and all this talk of cost cutting will be forgotten.”

Secondly, and more seriously, even supposing there are dozens of elephants and big cats lying out there waiting to be found, the era of western oil companies enjoying unfettered access to giant deposits from which they can rake the lion’s share of the profits is long gone.  Nowadays, even the governments of tinpot banana republics are smart enough to ensure they are the ones who will reap the greatest rewards (while the palefaces shoulder the risk and provide the CAPEX), and the partners in any project are often small independents.  The latter simply don’t have billions to throw at mismanaged projects while the former – as I argued here – are going to be increasingly less receptive to cash-calls on mega-projects whose budgets have been blown, especially when they are cash-strapped as most of them currently now are.  There’s no way any government is going to allow a western oil company to continue living the high life while its own coffers dwindle, and so holding out for exploratory success to pull themselves out of their cashflow is also unrealistic.

Slowly but surely, the global oil industry is shifting from giant projects being operated by western majors who own the majority stake to smaller projects being operated by the majors on behalf of a national oil company.  Thus far, the majors have been able to stay in contention by virtue of their bringing capital, technology, and project management expertise to the party – all of which national oil companies and small independents lack.

Or do they?  Let’s take capital.  Time was, national oil companies in bongo-bongo land needed a western major on board in order to give western creditors the assurances they needed that they’d see their money again.  But with the Chinese willing to invest, often via their own national oil companies, this requirement is slowly being relaxed.  September 2014 saw a significant event in this regard:

Kenya’s first effort to raise capital from European and American investors is being seen as a success after it attracted strong demand.

The country sought to raise $1.5bn through the Eurobond, but eventually raised $2bn after it attracted bids four times its initial target.

US investors bought about two thirds of the bonds, with British investors taking a quarter.

And ne’er an oil company in sight.  If Kenya can raise $2bn on its own without breaking sweat, so can others.  Oil companies would do well to take note.

What about technology?  The majors will still be required on vastly complex developments involving floating LNG, subsea separation, deep water, heavy oils, etc. or those which require the full integration of platforms, pipelines, and onshore installations particularly in difficult areas like the Arctic.  But on smaller, less complex projects requiring proven technology freely available on the open market, it is less certain that the involvement of a major is necessary.  As I said, I am not convinced the future of the oil industry lies solely with giant, complex mega-projects in very challenging locations.  These projects will still exist, but their share of production in relation to smaller, conventional developments remains to be seen.

One of the most active areas in the world right now is Kurdistan in northern Iraq, which has seen dozens of small to medium-sized independent operators piling in with development plans which would cause anyone working in a supermajor to go pale and take the rest of the week off.  Using off-the-shelf modular process units, some of these fields are up and producing in a matter of months; a supermajor would still be bogged down in petty bickering over which entity should be in charge of the in-country travel policy.  Sure, these fields are not producing much, in the region of 20k-50k barrels per day: but in an era of supposed “profitability over production” does this matter?  Equally interesting is the Petrobras approach to their field development (large-scale corruption allegations notwithstanding).  They have elected to use off-the-shelf equipment as far as possible, standardised across all their assets in order to benefit from economies of scale in purchasing and ease of operations.  The downside is a less than optimal design which will result in inefficiencies, but they reckon these will be eclipsed by the savings made elsewhere, and they are probably right.  Western oil companies delight in having a bespoke, fully-optimised design for every piece of equipment which costs three times as much to have fabricated and nobody knows how to maintain it when it arrives.  And that’s assuming, perhaps optimisically, that the design specification is correct in the first place.  So there are two models in two currently booming, frontier regions of oil and gas development that are somewhat out of sync with the majors’ insistence that multi-billion dollar, hi-tech projects are the way to go.

Finally, there is the issue of project management.  Traditionally a western major was brought on board to ensure the project would be delivered on time, on budget, and to spec.  Whatever reputation these companies may once have had in this area has fast been diminished by gargantuan fuckups such as Kashagan and Angola LNG, and the inescapable fact that most major projects run hopelessly over budget, arrive late, and often don’t work properly.  Now it could be argued, quite successfully, that despite their faults western majors run projects far more effectively than the national oil companies with whom they’re partnered, but at what cost?  I have already written about how institutionalised managerial cowardice costs oil companies billions, but that only tells half the story.  Western majors are vastly expensive due to an enormous payroll, armies of adminstrators, sprawling bureaucracies, towering HQs in prime locations, generous final-salary pension schemes, and an expectation on the part of most expatriated employees that the oil company should pay for the private schooling of their offspring even when based in western Europe.  When you combine the two together, the cost of placing a single brick on top of another runs into the tens of millions if carried out by a major oil company.  They are simply no longer able to carry out small or even medium-sized projects because their structural costs are just so damned high.  This is why the CEOs of Total and Eni are warning that “investment” will dry up if the oil price remains low: they cannot afford to invest in anything unless their colossal overheads are covered.

Even supposing they are more cost effective than a national oil company, does this mean their position is safe?  Not at all.  For a national oil company might reach the conclusion that $5bn spent for the benefit of even corrupt locals might be better than $2bn spent on keeping the employees of western expats in their continued life of relative luxury.  This certainly seems to be the stance taken by the many governments with their imposition of local content legislation.

What has changed is that international private oil companies are rapidly becoming seen as a contributing partner who is expected to add value, and particularly add value for money, in the development of a project.  In this respect, they are becoming more and more like the conractors and service providers who are expected to demonstrate their cost-effectiveness in advance and shoulder the risk of underperformance as a matter of course.  As the national oil companies tighten their grip, the private oil companies are going to come under increasing pressure to demonstrate their added value to win involvement in a development: no longer is handing over an envelope stuffed full of hard currency going to cut it.  With countries being able to raise their own financing and smaller, cheaper, faster projects becoming the norm, the lumbering giants which have dominated the industry for a century might find their opportunities drying up in the coming years as sleeker, more efficient companies provide the right mix of technology, delivery, and cost.

Such a move would be somewhat of a volte-face from the mega-mergers of the late 1990s which appeared to confirm leviathans exploiting vast economies of scale were the future of the industry. Even now, there is much talk about mergers and acquisitions being one result of the low oil price, and it is indeed likely: Repsol has already snapped up Talisman and it is surely only a matter of time before Tullow is bought out.

But death by acquisition is not the only possibility.  In the 1960s nobody could have dreamed that General Motors would ever be facing bankrupcy.  In the 1970s, ICI was seemingly invincible.  Corporate history is littered with examples of companies that rose to the top, dominated for decades, and then slowly disintegrated as their costs outweighed dwindling revenues and their employees, management, and political backers remained unwilling or unable to take the necessary steps to adapt to the changing landscape.  Ford was not driven to near-bankrupcy because nobody wanted cars any more: the Japanese simply started doing it better.  The spectacular fall of Nokia was not caused by a lack of demand for phone handsets, but by its failing to understand that smartphones were the future.

In my opinion, the oil and gas landscape has changed dramatically in the last decade, and not to the benefit of large, private, western oil companies.  It is also my opinion that there is one too many supermajor in an increasingly crowded field.  Only unlike in previous downturns, a mega-merger will not solve the issue any more than the merger of Chrysler and Daimler helped either one of them: the problem is not one of size, but form and function.

So the actions and announcements of the major oil companies are worth paying attention for the duration of this downturn, because this will reveal the extent to which each one has grasped the problem.  Thus far, few seem to realise it even exists.

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3 Responses to One supermajor too many?

  1. dearieme says:

    “They are simply no longer able to carry out small or even medium-sized projects because their structural costs are just so damned high.” That sounds like Big Pharma, and its inability to compete with outsiders when its products go off-patent. It’s preposterous: if you’ve been making something for 15 or more years you should logically have a huge advantage over an outsider, not least because much of your CAPEX was EX’d years before. It’s an admission of lousy management.

  2. dearieme says:

    And then, there are disadvantages to the customers if the outsiders misbehave.

    http://pipeline.corante.com/archives/2015/01/26/indias_gvk_accused_of_systematic_fraud.php#comments

  3. Jake Barnes says:

    Welcome!

    Yes, I expect Big Pharma are not the only ones in a similar situation as well.