Energy ... Oil
Impact of low prices

BUSINESS & FINANCE ... Why Big Oil Should Kill Itself

Burgess COMMENTARY

Peter Burgess

BUSINESS & FINANCE ... Why Big Oil Should Kill Itself

LONDON – Now that oil prices have settled into a long-term range of $30-50 per barrel (as described here a year ago), energy users everywhere are enjoying an annual income boost worth more than $2 trillion. The net result will almost certainly accelerate global growth, because the beneficiaries of this enormous income redistribution are mostly lower- and middle-income households that spend all they earn.

Of course, there will be some big losers – mainly governments in oil-producing countries, which will run down reserves and borrow in financial markets for as long as possible, rather than cut public spending. That, after all, is politicians’ preferred approach, especially when they are fighting wars, defying geopolitical pressures, or confronting popular revolts.

But not all producers will lose equally. One group really is cutting back sharply: Western oil companies, which have announced investment reductions worth about $200 billion this year. That has contributed to the weakness of stock markets worldwide; yet, paradoxically, oil companies’ shareholders could end up benefiting handsomely from the new era of cheap oil.

Just one condition must be met. The managements of leading energy companies must face economic reality and abandon their wasteful obsession with finding new oil. The 75 biggest oil companies are still investing more than $650 billion annually to find and extract fossil fuels in ever more challenging environments. This has been one of the greatest misallocations of capital in history – economically feasible only because of artificial monopoly prices.

But the monopoly has fallen on hard times. Assuming that a combination of shale development, environmental pressure, and advances in clean energy keep the OPEC cartel paralyzed, oil will now trade like any other commodity in a normal competitive market, as it did from 1986 to 2005. As investors appreciate this new reality, they will focus on a basic principle of economics: “marginal cost pricing.”

In a normal competitive market, prices will be set by the cost of producing an extra barrel from the cheapest oilfields with spare capacity. This means that all the reserves in Saudi Arabia, Iran, Iraq, Russia, and Central Asia would have to be fully developed and exhausted before anyone even bothered exploring under the Arctic ice cap or deep in the Gulf of Mexico or hundreds of miles off the Brazilian coast.

Of course, the real world is never as simple as an economics textbook. Geopolitical tensions, transport costs, and infrastructure bottlenecks mean that oil-consuming countries are willing to pay a premium for energy security, including the accumulation of strategic supplies on their own territory.

Nonetheless, with OPEC on the ropes, the broad principle applies: ExxonMobil, Shell, and BP can no longer hope to compete with Saudi, Iranian, or Russian companies, which now have exclusive access to reserves that can be extracted with nothing more sophisticated than nineteenth-century “nodding donkeys.” Iran, for example, claims to produce oil for only $1 a barrel. Its readily accessible reserves – second only in the Middle East to Saudi Arabia’s –will be rapidly developed once international economic sanctions are lifted.

For Western oil companies,the rational strategy will be to stop oil exploration and seek profits by providing equipment, geological knowhow, and new technologies such as hydraulic fracturing (“fracking”) to oil-producing countries. But their ultimate goal should be to sell their existing oil reserves as quickly as possible and distribute the resulting tsunami of cash to their shareholders until all of their low-cost oilfields run dry.

That is precisely the strategy of self-liquidation that tobacco companies used, to the benefit of their shareholders. If oil managements refuse to put themselves out of business in the same way, activist shareholders or corporate raiders could do it for them. If a consortium of private-equity investors raised the $118 billion needed to buy BP at its current share price, it could immediately start to liquidate 10.5 billion barrels of proven reserves worth over $360 billion, even at today’s “depressed” price of $36 a barrel.

There are two reasons why this has not happened – yet. Oil company managements still believe, with quasi-religious fervor, in perpetually rising demand and prices. So they prefer to waste money seeking new reserves instead of maximizing shareholders’ cash payouts. And they contemptuously dismiss the only other plausible strategy: an investment shift from oil exploration to new energy technologies that will eventually replace fossil fuels.

Redirecting just half the $50 billion that oil companies are likely to spend this year on exploring for new reserves would more than double the $10 billion for clean-energy research announced this month by 20 governments at the Paris climate-change conference. The financial returns from such investment would almost certainly be far higher than from oil exploration. Yet, as one BP director replied when I asked why his company continued to risk deep-water drilling, instead of investing in alternative energy: “We are a drilling business, and that is our expertise. Why should we spend our time and money competing in new technology with General Electric or Toshiba?”

As long as OPEC’s output restrictions and expansion of cheap Middle Eastern oilfields sheltered Western oil companies from marginal-cost pricing, such complacency was understandable. But the Saudis and other OPEC governments now seem to recognize that output restrictions merely cede market share to American frackers and other higher-cost producers, while environmental pressures and advances in clean energy transform much of their oil into a worthless “stranded asset” that can never be used or sold.

Mark Carney, Governor of the Bank of England, has warned that the stranded-asset problem could threaten global financial stability if the “carbon budgets” implied by global and regional climate deals render worthless fossil-fuel reserves that oil companies’ balance sheets currently value at trillions of dollars. This environmental pressure is now interacting with technological progress, reducing prices for solar energy to near-parity with fossil fuels.

As technology continues to improve and environmental restrictions tighten, it seems inevitable that much of the world’s proven oil reserves will be left where they are, like most of the world’s coal. Sheikh Zaki Yamani, the longtime Saudi oil minister, knew this back in the 1980s. “The Stone Age did not end,” he warned his compatriots, “because the cavemen ran out of stone.” OPEC seems finally to have absorbed this message and realized that the Oil Age is ending. Western oil companies need to wake up to the same reality, stop exploring, and either innovate or liquidate.

© 1995 – 2016 Project Syndicate

image: https://www.project-syndicate.org/default/library/62bca2721fc39eba194b7cb72ff9ad09.square.png Photo of Anatole Kaletsky ANATOLE KALETSKY Anatole Kaletsky is Chief Economist and Co-Chairman of Gavekal Dragonomics. A former columnist at the Times of London, the International New York Times and the Financial Times, he is the author of Capitalism 4.0, The Birth of a New Economy, which anticipated many of the post-crisis transformations o… READ MORE

Comment Kevin Furr JAN 3, 2016 'as one BP director replied when I asked why his company continued to risk deep-water drilling, instead of investing in alternative energy' BP's objection was 100% valid and it shows poor judgment to be dismissive of it. An oil driller DOESN'T have the slightest expertise in making better solar panels or batteries or ... whatever. You're talking about an abruptly different set of technologies and an abruptly different culture to achieve progress. You can say they're in the vague 'energy business' all you want, it changes nothing. Expecting BP or Exxon to create the next alternate energy is like expecting US Steel to have created Google or Facebook. No different. Leaving aside the billions that governments are doing to waste with politically-driven decisions here, if oil cos tried to dump 10s of billions into tech alt energy tech research, they literally would not be able to find things to invest in. You can't just create an infinite number of labs, PhD's and resources out of thin air on demand to do anything productive. You expect BP to buy out Tesla? If an oil company tried such a thing the culture clash would simply ruin the investment and there'd be nothing to come of it. Eventually when the economics makes sense we'll HAVE our alt energy ... and it'll be from other companies and not the giant oil suppliers. Future energy won't come from BP any more than Windows and iPhones came from Univac. Read less Comment Commented

Jason Houdek JAN 4, 2016 Those who think oil companies couldn't invest their massive exploration budgets in clean energy development because it is isn't their core expertise would do well to remember that the Shell Oil Company started life as an antique dealer. Reply Comment Commented

Stock Soup JAN 3, 2016 You might want to republish this fine article in 15 years, you are way to early, Mr K. Global demand is at an all time high, and this with global growth anemic. http://www.indexmundi.com/energy.aspx Reply Comment Commented

Douglas Leyendecker JAN 3, 2016 Kodak didn't invent the digital camera. Columbia Records did not invent the song download. Digital Equipment did not invent the personal computer. And AT&T didn't invent the cell phone. You can't teach an old dog new tricks. You can't change a tiger's stripes. Large legacy infrastructures, whether public or private, thrive on incremental change because they are so well established in their market. Step change on the other hand can't come from legacy giants because it threatens their existence. Although an interesting theoretical exercise it is implausible to expect big oil companies to sell their assets and join the race to alternative energy technological breakthroughs. The odds are such a breakthrough, like so many, will not come from the legacy energy industry. And not to worry, we have so much oil in the world that airplane and trucking companies will have ample fuel for a very long time...and much cheaper fuel if economic alternatives do develop. In the meantime we have rushed so fast to force change away from hydrocarbons that we are denying...that's right, a new set of deniers...we are denying developing nation citizens of their economic potential. And to get all those developing nations to sign that climate change accord WITH NO TEETH we have resorted to $100B a year bribes. 'Hey you guys, we'll give you $100B a year if you sign this.' Foreign Corrupt Practices Act is of course only for the private sector. Do as I say, don't do as I do. Seems pretty hypocritical. Read less Reply Comment Commented

Oserver Observer JAN 3, 2016 Anyone care to give me a date when the airline industry will not be reliant on petrochemicals for the fuel to power the jets? Thought not! Petrochemicals, for transport, are going to be required for many years yet. Comment Commented

thomas braum JAN 3, 2016 I agree that air and sea transportation will take quite a while to move away from oil unless there are some significant breakthroughs. However, change does not happen all at once and there is no way to know when or exactly how that change will occur. Fossil fuels are not going away quickly, but there will be a major shift in how the world produces energy. Reply

image: https://www.project-syndicate.org/default/library/3c1fad2db40b086018e04efe5d1fcc81.square.jpg Portrait of Christopher T. Mahoney Comment Commented

Christopher T. Mahoney JAN 1, 2016 A big part of the problem is that GAAP allows the oil companies to capitalize their exploration activities. If capex were treated as opex, they would all be losing money. Reply Comment Commented

Stan Paul DEC 30, 2015 I think you are exaggerating how easily OPEC can deploy these reserves. Reply Comment Commented

Jose Mellado DEC 29, 2015 we venezuelans are having hard time now! Reply Comment Commented

Tore Folk DEC 28, 2015 What everyone seem to fail mentioning is that the low oil prices is caused by Isis dumping oil on the market at that the prices will probably change as soon as this connection is severed. The other thing I would like to mention is that, the way it is now, stopping oil use all together will make us rely on technology that still is not at the advance we need. The fact that certain extremely popular electric cars has made a bigger impact on the environment before leaving the factory floor than a modern petrol car after 20 years of use. Lastly I would like to mention that in the case of a global catastrophe like super volcanoes or meteors hitting our planet, fossil fuels will be the only hope of keeping us alive through a 'nuclear winter '. That this should be pumped up and saved in deposits for the future. This means that both the supporters and opponents has to let go of their dogmatic thinking and start thinking in a long term exceeding 500 years into the future. Read less Comment Commented

Jose Mellado DEC 29, 2015 How much oil Is ISIS selling? Comment Commented

John Ranta DEC 29, 2015 @Tore, two questions for you. One is why you think the minuscule amount of oil ISIS sells per day (maybe 50,000 bbls) can have any impact on a world market that consumes 85,000,000 bbls/day? ISIS oil black marketeering is a drop in the bucket, and has no impact on world prices for oil. Two is your claim that production of an electric car has the same environmental impact as 20 years of internal combustion vehicle production and use. That claim fails a basic logic test. Producing an electric vehicle and an internal combustion vehicle require more or less the same processes and amounts of materials. And running an electric vehicle has a lower annual environmental impact than does an internal combustion engine vehicle. Your numbers don't add up. Read less Reply Comment Commented

peter fairley DEC 28, 2015 A contrary view could easily be made with an equally inspired vision about increasing DEMAND for oil. Affordable battery powered cars are not a sure thing in the next 5 years even for wealthy nations. Vehicles like this are even less affordable in developing nations. Affordable clean technology that is NOW available, such as natural gas powered cars are slow to be adopted even in USA. Asia has been choking on bad air for many years without switching to natural gas vehicles. Read less Reply Comment Commented

Talal Serhan DEC 28, 2015 What realy threatens oil is advancement in solar technology, but i don not believe it will end like coal. In comparison, the sun as a source of energy is weak. It can neither drive ships nor lift airoplanes. World population is very likely to continue rising. Oil will continue as a major source of energy, and be very profitable, especially, for OPEC countrues. Reply Comment Commented

Doug Robbins DEC 28, 2015 BP's reserves are not worth $360 billion. The latest BP annual report is found here: http://www.bp.com/content/dam/bp/pdf/investors/bp-annual-report-and-form-20f-2014.pdf The most important part of an oil company annual report is the Standardized Measures of Discounted Cash Flows relating to Proved Reserves, found on page 192 of the BP report. This calculation, performed by company engineers, represents the value of all of the proved reserves, after allowing for development costs (not all of the proved reserves are developed), operating expense, and transportation to market. The timing of investments and production streams is also applied in the calculation. According to an SEC rule-change in 2008, the price assumed for the product is the average first-of-month price for each month in 2014, which is about $97 per barrel. The discounted cash-flow analysis shows the value of BPs proved reserves was $127 billion, at $97/bbl. We can expect that value to drop sharply when the 2015 report is issued in the spring, using the 2015 price of $54.43/bbl. Most of the market value in BP is currently in the refining and marketing business, with some speculative value for a possible rise in prices. Total company reserves are given on page 179. Proved DEVELOPED reserves are 9.7 billion barrels equivalent, and proved UNDEVELOPED reserves are 7.8 billion barrels equivalent. Separate figures for proved oil and gas, developed and undeveloped, are given on pages 177 and 178. Read less Reply Comment Commented

Craig Campbell DEC 28, 2015 Albeit this is economic point. I think the author is forgetting what happens to the burden of relying on foreign oil during times of crisis. With ISIS, Russia, Turkey and the middle east playing with fire I for one am no keen on letting whatever we have left up for grabs. As long as their is turmoil in the world and until there's a clear path to an alternative I say lets let the oil companies keep spending money... Reply Comment Commented

Steve Hurst DEC 27, 2015 Cowboys dont make good Indians and Indians dont make good Cowboys 'Yet, as one BP director replied when I asked why his company continued to risk deep-water drilling, instead of investing in alternative energy: “We are a drilling business, and that is our expertise. Why should we spend our time and money competing in new technology with General Electric or Toshiba?”..' Can I remind you that BPs technology to contain the Deep Water spill at one point involved trying to bung the hole with old rubber tyres. Oil companies do not have many transferable skills Read less Reply Comment Commented

Stan Kormak DEC 25, 2015 It is not surprising that oil companies do not venture to other businesses. They tried it during the 70's crises, with Exxon getting into office products. This did not pan out and Mr. Kaletsky ought to remember this episode. He is correct about the futility of spending the enormous amounts of money in searching for new oil, but rather than give his own prescription on what oil companies should do, he would have served his readers better by noting that what an industry such as oil ( in a world that uses oil at more than double or triple the rate that new oil is found) does is to buy reserves my merging, with consolidation of the industry. This is what is likely to happen, because this is how business works. Read less Reply Comment Commented

jagjeet sinha DEC 24, 2015 Mark Carney and Sheikh Yamani both brilliance exemplified. The ultimate solution to The Planet's energy needs perhaps The Sun. That shines most brilliantly in Saudi Arabia as well as Africa. Africa indeed can become The Solar Superpower. The Stone Age did not end because the cavemen ran out of stone. The Solar System will not end because The Sun runs out. Human efforts in harnessing the ultimate source is indeed Big Oil 's final weapon. Reply Comment Commented

Michael Public DEC 23, 2015 The real issue is their borrowing are secured against ground reserves. Heading for another toxic debt and too big to fail situation. Reply Comment Commented

Avraam Dectis DEC 23, 2015 . If there were a battery breakthrough tomorrow that gave cars a 500 mile range, recharged in 10 minutes and did it all economically, what would oil stocks be worth? Oil stocks would be worth nothing because nobody would want an internal combustion vehicle. People do not yet realize how quickly the market could change. It is just a matter of time until those breakthroughs happen. . Read less Comment Commented

portocala mechanica DEC 24, 2015 Sorry, from what pocket will you get the energy to charge the wonder battery? The mine coals did not close because there was no more coal but because it become available a more efficient energy source, (not more clean!!!) Did you ever try to lift off an one hundred passengers plane on solar panels? I think that only plants in this word develops with solar energy, the animals use to eat each others. Read less Comment Commented

Michael Public DEC 23, 2015 No. Most people don't drive 500 miles a day. Most people don't need a car to charge in 10 minutes. What most people need is electric cars to cost close to the price of regular cars.