Shifting Sands - The future of the oil industry

Changing times

The next decade could see a restructuring and shake-out of the global oil industry on a massive scale.

Oil companies must find fresh crude reserves to replace declining output from existing fields; the supply chain is at full stretch, with a chronic shortage of people and an ageing workforce; prices are high and demand continues to rise.

Crucially, there is growing acknowledgement across the sector that reserves are being used faster than they are found. Output from producing fields is shrinking at 8–10%per annum. New reserves are constantly being discovered, but their control often rests firmly in the hands of increasingly powerful non-western national oil companies (NOCs).

George W. Bush has highlighted the seriousness of the issue. In his State of the Union address in January 2006, the US President said: “Keeping America competitive requires affordable energy. And here we have a serious problem: America is addicted to oil, which is often imported from unstable parts of the world.”



This addiction is driving up prices. Oil prices have held close to the $70 mark for many months, while analysts and international oil companies (IOCs) have been repeatedly
obliged to revise their 2006 average barrel price forecasts upwards. In August 2006, OPEC predicted oil would stay above $70 until at least the end of the year.

At the Oil & Money Conference in London in November 2004, BP’s chief executive Lord Browne said $40 per barrel was unsustainable and the real value was $25-$27. Fast-forward 18 months and he is predicting a medium-term price of $40. At the World Economic Forum in Davos in 2006, Bill Browder, founder of hedge fund Hermitage Capital, outlineda worst case scenario that could see the oil price rise to $262 a barrel. Yet Jeroen van der Veer, CEO of Royal Dutch Shell, said: “There is no reason for pessimism.”

Over the past three years, oil prices have moved up in decile bands, hitting resistance at $40, $50, $60 and $70 per barrel before breaking through and establishing what appears to be a new norm.

On the one hand, there is a simple explanation. “It comes down to the basic economics of supply and demand,” says Graeme Sword, 3i Head of Oil, Gas and Power. “China and India are the regions people talk about, but demand is rising across the whole of the developing world and there is no slow down in the developed world. Demand is marching on, so the question is whether supply can keep up.”

That is a difficult question. Saudi Aramco, the world’s largest NOC, for example, says there is demand for much of its heavy, sour crude but because of a refining capacity constraint there is a bottleneck restricting downstream supply.

The International Energy Agency in Paris is saying the capacity shortage is being addressed and there will be an extra 11 million barrels per day (bpd) on stream by 2011.

But Matt Simmons, Chairman of Simmons & Company, the specialist energy investment bank is sceptical. “The odds of that happening are zero,” he says. “Even if you started today, you couldn’t build the production and refining capacity necessary to meet those requirements.”

Security of supply has also climbed up the political agenda. China, for example, is building a 60-day reserve, such is its reliance on imported oil. Predictions that Chinese demand for oil would not  be sustained at $70 a barrel have proved false, with demand in May 2006 increasing by a massive 13%. China’s equally thirsty neighbour India is also actively expanding its reserves.

Nationalisation of resources is being seen. In May 2006, the Bolivian Government took control of the country’s oil and gas reserves and facilities. This has led to a change in terms of access for foreign companies. Others, including Russia and Venezuela, are redefining licence terms to protect their domestic interests.

“There is undoubtedly a political risk premium in the oil price,” explains Sword. “The places where the oil is going to come from in the future – Nigeria, Iraq, Iran, Russia, Venezuela – have a high degree of geopolitical risk.”

Some argue that speculation is fuelling the fire. OPEC believes it contributes $15 per barrel to the price. Others point to the doubling of the number of contracts struck on the New York Mercantile Exchange (NYMEX) over the past two years.

Matt Simmons, however, points to simple economics: “We are out of productive capacity at the wellhead, at the drilling rig and at the refinery. We are losing supply and demand is still growing.”

Whatever the causes behind oil price rises, there is clear evidence that oil prices are having an impact on company behaviour.



Raising the bar

There has been a resurgence of M&A activity, such as the double takeover by Anadarko of Kerr-McGee and Western Gas in June 2006. The $16.4bn Kerr-McGee deal represented a 40% premium to the share price, while the $4.7bn Western Gas deal marked a near 50% premium. At $18 a barrel for proven reserves, the deal set a benchmark and the question now is whether it will be surpassed.

Growing competition coupled with a shortage of available assets and rising prices mean this is an environment where having a sector-focused team and a strong network are essential for an investor to add value. “Long gone are the days whenproduction could be acquired cheaply to generate early cash flow and form the core of a new independent E&P company,”says Sword.

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