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Arctic Leaf

By health check or economic necessity: A tale of two oil industries and their response to illness

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By John Hofmeister and Marshall Kaplan

shutterstock_118647259A bad cold starts with a tickle in the throat and a languid day. It grows to painful swallows, stuffed sinuses and likely a fever. Does the patient treat the symptoms? Does he or she transform to avoid illness in the future?

Few oil company players will admit to it yet, but the future threatens a very bad cold for the current industry, or worse. Very few feel it coming because current business plans are robust and the workload is on overload. When they are recognized, the threats to the current business model are going to take more than treating the symptoms; there are transformative requirements to avoid getting permanently sick, including, for many, a difficult transition to alternative fuels. The industry’s investors are not likely to remain committed to oil. Neither are the politicians, the Wall Street analysts and the public who, for different reasons, some economic and some with concerns for the environment, are already shaky with respect to the future of oil. Unenthused investors actions, however, will speak much louder than concerned words.

Everyone agrees that conventional oil has peaked. Unconventional oil may be abundant, but it’s expensive. It’s so expensive that industry valuation is already being impacted by worried investors who don’t like companies borrowing cash to pay dividends. Shale formation decline rates demand evermore drilling. Drilling costs increase as more wells per amount of production are completed, raising per barrel costs. Sweet spots are finite as the majors have learned the hard way. They bought into many plays too late. The Middle East is, well, the Middle East. Don’t look for reduced tension in the near future. Do look for OPEC nations to increasingly shift oil for export into oil for local consumption — a residual of the Arab Spring. Business as usual is history. Brazilian, East African, Russian and Arctic production opportunities abound, except that the degrees of difficulty are unclear and uncertain, but are sure to be costly. The high costs and regulatory uncertainties of oil limit global growth and nourish alternative fuel prospects. Oil investors don’t like sore throats emerging from hard to swallow realities. They will want to create a new reality to protect their financial wellbeing.

The costs of carbon have yet to be added onto oil and we know they’re coming. There’s debate over the form of payment, not the reality. Take a look not only at the number of governments backing carbon constraints coming out of this year’s climate meeting at the UN, but, more importantly, count the companies! Count the crowd recently claiming the high ground from Central Park to Midtown in New York and other cities around the world. The oil industry’s low favorability gives it limited public influence. While special-interest money may run out the clock on near-term legislation in the next Congress, for the industry, it not a long term solution. Civil society and political trends are inevitably contrary to the industry’s status quo interests. The rhetoric alone will tax the bronchial capacity of oil and gas leaders; investors will cease shaking hands with infected stocks.

Cash is to oil what gasoline is to the internal combustion engine. Higher upstream costs and more expensive fuels reduce consumer demand and, inevitably, cash flow. Downstream cash can’t make up the difference for higher upstream capital (cash) outlays when consumers drive less or take advantage of increasing availability of lower-cost alternative fuels, despite the BTU and/or mileage disadvantages of alcohol fuels versus oil products.

Finally, when divestment trends start to impact the industry, perhaps initially not directly through actual shifting of resources, but because of the growing perceptions of the risk of stranded assets, opportunity costing equations will begin to hit hard. The value associated with increasing capital costs for oil development will be muted. With ever higher costs, more difficult unconventional production, more challenging resource basins and tighter regulatory scrutiny, along with environmental constraints, existing assets may never get produced. The probable reserve that never makes it to proven becomes ever less valuable with time, perhaps even worthless. Investors don’t like that. Oil price to support such production is unsustainable; the price rises until it crashes; production cannot recover from the collapse because sustainable alternative fuels will have taken increasing market share. To remain competitive, oil may not be able to climb above the $55 – 75 range. This prospect will cause full blown pneumonia for oil companies. Most still do not see it coming. For OPEC countries who are under inconsistent pressures — first to increase exports for needed revenues at home to fund services for an often restive population; second, to reduce exports to provide energy and gasoline products to larger population numbers, it could present real challenges affecting political stability.

Some companies that sense it coming will not wait for the cold symptoms to lodge in their respiratory systems. They will get out in front with natural gas, using an entirely different cost/price structure to displace high cost oil by producing natural gas for fuels, including ethanol, methanol, CNG and LNG. They’ll also embrace biofuels as a sustainable and carbon-reducing alternative to oil products only. In both cases, their cash flows and capital outlays will fund reasonable and rational alternative investments in downstream and midstream infrastructure to produce, distribute and sell alternative fuels, extending their business models and capabilities rather than risking everything on their past model. They’ll choose investor and their own health and economic necessity as the basis of a new business model transforming the mobility industry with fuels competition.

A handful of smart companies will astutely come to grips with their industry’s endemic inability to change their historic focus on oil as their base business. They’ll see diversity as an opportunity to run the race with competitive fuels, and they’ll recognize that oil and gasoline will only be able to sustain their monopoly status at the pump for a relatively short period of time. They will trade one form of steel in the ground for another, bringing the competencies of size, scale and execution to an ever-growing, oil-displacing, alternative fuels industry. In the process, they will simultaneously reduce the size of the oil upstream capital, cash, environmental and stranded asset problems that alienated investors, and, at times, the public, particularly related to emissions and other pollutants.

With a proper health check, after scanning the industry’s economic and environmental horizons, they acknowledge the inevitability of the changing critical role of investors. Their own financial health and economic necessity will redefine the role of oil and change the competitive landscape.

 

John Hofmeister, Former President Shell Oil Company (retired), Founder and CEO Citizens for Affordable Energy, Author of Why We Hate the Oil Companies: Straight Talk from an Energy Insider (Palgrave Macmillan 2010)

Marshall Kaplan, Advisor Fuel Freedom and Merage Foundations, Senior Official in Kennedy and Carter Administrations, Author

Arctic Leaf

Life is becoming tough for oil companies and oil nations

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Wow. Over the last few days, the nation has seen the possibilities inherent in a transportation-related energy and environmental policy. No, Washington has not become more functional. It’s still a mess! Happily, Congress is out! (They weren’t doing much.) While they’re still being paid, we can at least turn down the thermostat in both the Senate and House Chambers. No new holidays have been created, and no new articles are being put in the Quarterly that cater to requests from constituents. Leaving town is consistent with one part of the Hippocratic Oath that guides doctors and at least vacations for congressman and women … do no harm!

The light in the energy-policy tunnel, or the canary in the policy mineshaft, results from the seeming collapse of the oil market. The price of Brent crude oil has fallen more than 20 percent since June, and on Friday it rose a little to $86.16 a barrel. The four-month drop in oil prices, caused mostly by an oil glut, falling demand and speculation related to both, likely will continue the recent trend toward lower gas prices at the pump, at least for the next few months. The U.S. average is now near $3.16 a gallon, reflecting a drop of about 15 percent since early summer.

The unseen hand of the marketplace — in this case, the actually relatively transparent hand of the marketplace — may provide a substitute for Congressional inaction concerning the presently complicated and sometimes weak policies that ostensibly protect sensitive global and U.S. land and water from harm. At $82 a barrel, oil producers and their investor colleagues have little incentive to invest heavily in tight shale oil. It just costs too much to get to and take out of the ground (or water). If the negative “opportunity costing” concerning decisions about future exploration and rig development become tougher, folks concerned with the environmental well-being of the Arctic Circle and the Monterrey Shale, etc. may end up smiling. They will see less drilling, fewer rigs, less GHG emissions and less non-GHG pollutants!

Apart from environmental benefits, falling oil prices will cause not-so-friendly and even sometimes-friendly Middle East nations to make difficult choices. They are reflected in the current dialogue within OPEC. Should OPEC and its member states sanction the production of more oil and contribute to the global surplus or lessen oil production targets to secure higher prices?

Both decisions, once made, have high risks. Raising prices by lowering production could lead to less market share and ultimately less revenue. Keeping prices low (and lower if the surplus continues to grow and demand continues to fall) could also mean less revenue and an earlier arrival of the time when production costs are near to, or exceed, returns for hard-to-get-at oil. Some Middle Eastern nations may not have a choice. Easy-to-drill oil is becoming increasingly hard to find, even in the once-productive oil-rich desert, and production costs are increasing, as they are around the world. It will be difficult to keep prices low. Yet if countries raise prices, they lose market share. Perhaps another compelling fact of life that Middle Eastern nations must look at is the increase in domestic needs brought about by the Arab Spring and the yearning for a better life among their citizens. Indeed, in this context, both lower prices and higher prices may limit their competitive abilities and result in declining revenue for national budgets. It will present them with a conundrum. Translated into political realities, countries in the Middle East may have less to spend on social welfare programs, exacerbating tension that already exists in the Middle East.

Low prices for oil, resulting from market variables, could well also provide another important international impact: Russia, already hit by sanctions, faces increased budget constraints because of the fall in oil prices. According to The Wall Street Journal, “Economists say falling oil prices could kill off Russia’s flagging economic growth, forecast at no more than 0.5% this year.” Apparently, some Russian economists see $90 as their economic tipping point.

Short-term projections of U.S. oil production suggest a continued (but more modest) decline of oil imports and dependency. But will U.S. oil surpluses and lower costs transfer into oil independence? No! The oil industry is pushing hard for, and is likely to secure, an increased capacity to expand crude oil exports from the federal government. However, trafficking in oil is, and will remain, a two-way street. Price, as well as profits, will be the determining variable. Imports now contribute about one-third of the oil used in the country. The number will hover around 30 percent at least for the near future.

Who knows? We might wake up one morning to find out from public television that we are selling oil to the oil-needy Chinese, while still buying it from countries in the Middle East and maybe even Russia.

There is another possible scenario (we cannot say probable yet) at least to consider in thinking about oil’s future. Because of the likelihood of increasing economic tension between objectives related to drilling for hard-to-get-at oil and its cost, we may go to sleep one night in the not-too-distant future, after hearing again on public television (of course) that oil companies are moving in a big way into the replacement fuel business and lessening their focus on oil. Assets will be sold and bought, followed by media attention suggesting that a major structural shift is occurring in the oil industry. Let’s anticipate what oil CEOs might say: “It’s tough to make the balance sheets work. Drilling for tight oil, really most of the oil left, is just too damn expensive in light of the uncertainty of prices and demand. While still only a small percentage of the overall fuel market, replacement fuels, including natural gas-based ethanol and renewable fuels, seem to be catching on. Detroit, our earlier partner in crime (not literally, of course) in restricting consumer choices to gasoline, hasn’t helped either, recently. It is producing more and more flex-fuel vehicles. Besides continuing to make money, we would like to get off the most disliked industry lists in America.”

Stranger things have happened!