Financial Times: Cash-rich oil groups are betting high

By Thomas Catan
On the face of it, oil companies have never had it so good.
Last month, ExxonMobil posted the largest annual profit in US corporate history. BP, Shell, Total and others also smashed their own earnings records. Industry bosses are having a hard time figuring out what to do with their unprecedented cash gushers.
An enviable problem, perhaps. But those staggering profits mask a deeper sense of malaise in the oil and gas industry.
Not long ago, the so-called “Seven Sisters” dominated the production, refining and distribution of oil and divided the world among them. Today, their descendants are masters of an ever-shrinking universe, excluded from the best energy prospects in the world.
Oil companies now offer few services that host governments cannot buy elsewhere and, as a result, are struggling to replace their reserves – a key indicator of future growth. “Almost 75 per cent of the world’s reserves are closed off to them now,” says Philip Verleger, an energy economist. “It’s staggering how little access they have.”
Under such circumstances, the best thing oil companies have found to do with their cash is hand it back to investors. In the past two years, they have returned an estimated $120bn (£69bn) through dividends and share buybacks, prompting accusations that they are failing to invest in new production.
But arguably, the real problem with oil companies is the opposite: they have been throwing cash at projects that until recently many would have regarded as wholly impractical.
Without access to Middle East oil, companies are being forced to extract from ever more forbidding environments, in the deepest waters and the coldest climates. They are committing tens of billions of dollars to develop “unconventional” sources such as oil sands in Canada, a process that is logistically difficult, expensive and immensely wasteful.
This frenzy of activity has spurred rampant cost inflation. The price of everything from labour to drilling rigs has soared. The result is that capital spending by the big oil companies has virtually doubled since 1999, according to a recent report by McKinsey, the consultancy, to reach nearly $200bn a year.
Some companies are also buying reserves through expensive corporate acquisitions that amount to giant bets that energy prices will stay high.
While the oil price remains at between $60 and $70 a barrel, none of this should matter. But if history is a guide, it will not.
Analysts at Foresight Research in New York recently read the annual reports of 16 of the largest oil companies from 1979 and 1980, the last time experts declared that prices had moved permanently higher. They made for sobering reading.
“The oil companies were horrible in their forecasts,” says Bernard Picchi, head of Foresight’s energy team. “In the early 1980s, everyone was predicting that oil and gas prices would remain high and of course they didn’t.”
Ah, say optimists: this time things are different. The oil price may have gone through boom and bust many times but the rise of China and India means that demand will not fall again. Add to that the fact that many of the easily accessible oilfields have been exhausted and suddenly today’s price begins to look like a floor, not a ceiling.
Many who lived through the 1979–81 boom and the subsequent bust have different ideas. Prices may not hit $10 again any time soon, they say, but there is no structural reason why they should be as high as they are. And they would not have to fall very far for many oil companies to find themselves in serious trouble.
At least one of the largest international oil companies routinely runs financial health checks on smaller competitors to determine how vulnerable they are to a fall in the oil price. When oil hits $45 a barrel (recently seen as a high price) they are planning to sweep up overstretched oil companies with assets all over the globe.
To be in that position, however, oil companies will have to remain disciplined with their own spending. The so-called “supermajors” are just about holding the line but, as the longest oil boom in 40 years continues, capital discipline is becoming harder to sustain.
Increased investment, moreover, will eventually undercut the oil price that gave rise to it. Much of the new capacity may come on-stream when high prices have already affected oil use. A slowdown in the US, China or India would further depress demand.
“It may take time but the iron law of supply and demand never fails,” says Mr Picchi.
But if prices are set to fall, then when? Samuel Bodman, US energy secretary, last year declared the era of cheap energy to be over, echoing a pronouncement by his predecessor during the 1979–81 boom. If such statements are anything to go by, the cycle may already be getting ready for another turn.
“During all oil price booms, it becomes possible to imagine that the industry’s economics have changed forever,” McKinsey notes. “But history shows that the point when industry observers start to say that things are really different this time around usually marks the top of the cycle. By then, the seeds of the crash to come have germinated.”

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