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The oil price since November 1997 has been steadily falling and is reaching lows unprecedented since the first oil shock of 1973. Today, many oil companies believe prices will remain low for several years if not longer. If true, such low prices will force changes in behavior with implications for private companies, national oil companies and oil markets generally.
For private companies a low price world will generate even greater pressure for cost cutting. Initially this will involve short-term cuts in capital expenditure. There is already plenty of anecdotal evidence to suggest this is well underway with the majors cutting by some 10% and smaller upstream companies with no downstream hedge cutting by around 25%.
However, in oil, investment is essential simply to stand still. Hence once the initial reduction in capital expenditure has taken place, the focus will switch to long- term cost reductions which will add shareholder value. In the aftermath of the last great price collapse of 1986 this meant reducing project costs. New technologies such as 3-D and 4-D seismic, horizontal drilling, sub- sea completion and offshore loading were employed to slash offshore production costs. At the same time projects were changed to introduce incentives for subcontractors to share risk and reduce costs. In areas such as the North Sea this translated into industry-wide programs to investigate costs cutting such as "Cost Reduction Initiative for the New Era" (CRINE).
Obviously such project cost cutting will continue. For example, recently the UK Government announced the setting up of a DTI working party chaired by the Energy Minister, John Battle, effectively to revive the work of CRINE including revisiting the fiscal system. However, having already achieved spectacular savings, the scope for further dramatic cost reductions are limited. At best, all that can be hoped for is that these new technologies are disseminated more quickly to other areas of the world where the companies are operating. To survive with today's current price levels (which could go even lower) other sources of cost cutting must emerge and this has been given as the logic for the recent mergers. There are a number of conventional arguments why large company mergers can assist in cost cutting:
- Overheads can be spread over ever larger throughput. Most obviously head office costs can be significantly reduced if two sets of operations are combined. This is reinforced in today's world of high technology information flows.
- A wider portfolio of assets can reduce the costs of managing risks and the costs of using capital markets.
Neither argument is very convincing and academic research shows the majority of mergers fail to add value. Head office economies are limited since many have already made deep inroads into head office costs in response to the 1986 price collapse. New methods of project financing are reducing the advantages of size in capital markets. Today there is a battery of methods from alliances to derivatives which can be used to manage risk equally as effectively as the diversified portfolios of the majors. The argument that size alone reduces costs is unconvincing. The major companies were huge before merger mania struck. How much bigger did Exxon need to be to gain such advantages?
There are alternative explanations for the mergers which have greater plausibility. One is the obvious point that the industry has always suffered from a very strong herd instinct. Once BP and Amoco merged, shareholders expected others to follow. Another explanation relates to the opportunities for fundamental restructuring. A larger portfolio of assets gives greater scope for dropping lesser performing assets, thereby increasing shareholder value. In any corporation there will be a performance ranking for assets although badly performing assets were removed from the portfolio after 1986. Putting together two sets of assets each with descending attractiveness allows for divestiture at the lower end of the performing scale. This process is reinforced because synergy may take two lesser performing assets and create a high flier. Once the mergers are completed and the assessments done, the new larger companies will almost certainly begin to sell selected assets.
The tendency for asset sales will be reinforced by regulatory requirements driven by concerns over competition. The BP-Amoco merger attracted relatively little hostile comment over the competitive implications. This was in part because there were relatively few serious problems. The more recent mergers are unlikely to slip through the system so easily. For example, in relation to the European downstream, Mobil's existing BP alliance will lead to serious concerns out of Brussels if the Exxon merger goes ahead. Almost certainly in Europe and the US the merger activity will force divestiture of certain downstream assets implying even more assets coming to market. In addition, in some countries, host governments may be concerned about the merger implications for their upstream operations and they may also demand renegotiation. This in turn would add further to the tendency to sell assets. The overall result is that a lot of assets previously owned by the larger companies will be coming to market for sale.
For the national oil companies of the major producing countries, the challenges posed by a low oil price world are even greater than for the private oil companies. Effectively since 1986, oil producing governments have been using their national oil companies as tax collectors for the nation. Hence they have been given minimal resources to generate as much revenue as possible. This has then been siphoned off into the Finance Ministry to pay the nation's bills. However, the bureaucrats within the national oil companies have been able to limit the cash outflow by classic rent seeking behavior. Most frequently this has involved investing abroad to strengthen the information asymmetries which exists between the Ministries and the companies. The result has been many investments of doubtful commercial validity and sharply rising production costs at a time when costs for the private companies have been falling.
An obvious solution for the producing governments, already underway before the current price crisis, is to allow foreign companies access to develop the reserves. The logic is that the private sector companies will generate greater revenues more quickly and at lower costs. This process of de facto privatization will undermine and diminish the national oil company and will force it to behave as if in a competitive environment – a process of enforced corporatization. This undermining of the national oil companies will be reinforced by a growing lack of investment funds. Since the second oil shock, many national oil companies have grown by purchasing assets sold off by the major companies as the basis of a downstream strategy. However, greater attention to commercial criteria plus a shortage of capital funds as Finance Ministries scrabble for every last dollar will mean the national oil companies are unlikely to benefit from the assets sell-off described above. Hence, for the national oil companies, a low oil price world will put them under very strong scrutiny from their own governments plus strong competition within their own national boundaries from foreign companies.
This analysis creates a simple conundrum. A low price world will force extensive asset sales by the big companies as they restructure their portfolios to maximize synergy and provide some contribution to cash flow. However, these assets will be offered into a market where low prices might be expected to reduce buyers' willingness and ability to bid. Several solutions to this conundrum suggest themselves which have considerable implications for the future structure of the industry and the market. One answer may lay in an influx of new players into the industry. The 1990s have seen the rise of newcomers to various stages of the oil industry. These so-called petropreneurs such as Apache, Chesapeake Energy, Enron, Koch, Tejas Gas and Tosco have significantly outperformed the major oil companies in the US. Such companies have the flexibility and the drive to improve asset performance and may well be tempted to join the auction.
Another possible answer lies in the potential for cost saving for merged private companies in terms of geographic strategy. In a low price world, access to low cost reserves becomes imperative. Access to such reserves for reasons described above will be available. Governments with such reserves – largely in the Gulf – will be able to pick and choose their partners and will tend to go for the larger well known names. This was a key reason given for the BP-Amoco merger. At the same time, the national oil companies, in an effort to defend themselves from foreign investment in their upstream, may well seek some form of access or alliance involving the majors' assets abroad as a quid pro quo. This effectively resurrects the ideas of Zaki Yamani, the Oil Minister of Saudi Arabia, who introduced his concept of "participation" in the late 1960s. The concept was that the producer governments would take an equity share in the upstream companies operating in their countries – at the time wholly owned by the majors – together with equity in the majors' downstream assets abroad. The purpose of this "catholic marriage" was for the governments and majors to gang-up on the independent oil companies who were seen as responsible for the weakening of oil prices which dogged the 1960s.
If this pattern of events comes to pass, the market implications would be significant. If new petropreneurs do absorb some of the individual assets, this could create within the industry a very strong competitive fringe forcing the majors into even greater efforts to cut costs. The petropreneurs, already emerging onto the international stage, have proved capable of gaining competitive advantage by identifying niche markets where skills become more important than size. The result would be a strengthening of competition within the international oil industry. This competitive trend would be greatly reinforced by the opening up of low cost reserves described above. Raising capacity and production from such reserves would restore to the industry a normal supply curve where the low cost reserves are produced first and the high cost reserves last. Since the early 1970s, industry supply has been distorted by low cost reserves acting as the marginal suppliers to the market. The restoration of a normal supply curve would usher in an era of intense competition in crude oil markets. This would keep oil prices low for some considerable time, providing producer governments could survive the consequent economic deprivation. Eventually however, such competition would restore a dominant position for the Gulf producers in global supply as high cost areas such as the Caspian are pushed out of business. The resulting market power would be likely to encourage a revival of cartel power and generate an oil price shock, although such a process would take at least a decade if not longer. |
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