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Newsweek International: Big Big Problem

EXTRACT: As Shell CEO Jeroen van der Veer recently told NEWSWEEK, it’s important for oil executives to “stand with their hat in their hand” in front of developing-world politicians if they want to get even a small slice of the pie these days. He would know. Shell’s Sakhalin gas project in Siberia is emblematic of how big Western oil companies must push into ever more difficult areas to find reserves, taking on greater financial and political risks. Shell recently announced that its Sakhalin project would run some $10 billion over budget due to labor and materials costs as well as the difficult local terrain. That infuriated Russian politicians, who would have to wait longer to get their share of the profit if costs escalate. The result is that the government has revoked Shell’s environmental permit to operate in Sakhalin, which could halt operations, and has threatened to do the same to other companies in the area, including Exxon. “As big and as rich as they are, the independent oil companies are not rule makers, but rule takers,” says West.

THE ARTICLE:

Despite billions in profits, the majors are full of gloom, warning of steadily rising costs and lower prices.

By Rana Faroohar

Oct. 9, 2006 issue – Under the 11-year leadership of Lord John Browne, BP cultivated a reputation as a different kind of oil company, kinder and gentler on everything from the environment to the issue of women in its work force. Browne has often topped lists of “most-admired CEOs.” But in recent months BP has suffered a deadly refinery explosion in Texas City, an oil spill in Alaska, and accusations that the company’s trading arm manipulated energy markets.

Key investors have asked whether there is a systemic problem at the company. U.S. congressmen have lambasted BP executives over safety standards. The U.S. Justice Department and other agencies are investigating; BP has appointed an ex-judge to review claims of whistle-blowers, some of whom allege a cover-up, which the company flatly denies. As Lord Browne told NEWSWEEK this summer, “We’re moving from a situation of business as usual to a situation of business as unusual.”

That transition doesn’t end with BP. While the world’s third largest oil company (after ExxonMobil and Shell) is undoubtedly in the hottest water, John Browne is by no means the only oil chief worried about the future. From the outside, the oil industry may look like a bunch of fat cats enjoying record prices, profits and CEO salaries. But what many executives dwell on are costs—which are rising as fast or faster than profits—and past experience, which tells them not to enjoy high prices because they are likely not to last.

Most see the recent price dip below $60 a barrel as only the first sign of a slide that will take prices below $40, even $30, as new supplies come on line. Indeed, the oil industry was so focused on containing costs for so many years before the recent runup in prices, many analysts say it was only a matter of time before a giant like BP found itself accused of cutting corners on safety and maintenance.

Implausible as it may seem for oil CEOs to plead hard times, the truth is that Big Oil is not much richer in absolute terms than it was before the price spike. For the past six years, returns have been flat—according to Goldman Sachs, the average integrated Western oil company will earn a 19 percent return on capital employed, up only about 2 percent since 2000. In the supremely capital-intensive oil industry, return on capital is a key measure, because it reflects not just how much profit a company made, but the cost of making it.

The bottom line: value creation at oil companies is stagnating. Companies are making more than ever before, but they’re also spending unprecedented amounts to generate those profits. The problem is a perfect storm of factors: two decades of underinvestment, rising oil nationalism, the maturing of old reserves and more and more risky exploration projects. All of which has conspired to limit Western majors’ access to easy oil, and to send costs spiraling out of control (graphic). “People just look at oil company revenues and think things must be great,” says Jeffrey Currie, Goldman Sachs’s head of commodity research. “What they don’t see are all the tremendous challenges in today’s operating environment, and the slew of difficulties going forward.”

The markets are much more aware of these difficulties than the general public, which is one big reason why oil share prices have not risen with recent profits. The average price-to-earnings ratio for the Big Oil companies on the S&P 500 now stands at 9.8—about half their historic average, says senior S&P analyst Howard Silverblatt. That’s much lower than the average for all big-company stocks, which lag their historic P/E average by about 20 percent. And it’s nothing for Big Oil execs to smile about, even if their average pay is now well above $20 million. “There is no doubt that the view from the CEO’s office these days is less than buoyant,” says Daniel Yergin, the head of Cambridge Energy Research Associates (CERA) and author of The Prize, a Pulitzer-winning history of the oil business. “CEOs are concerned about more-restricted access to new resources, the rise of resource nationalism, the shortage of people and certainly by how rapidly costs are rising. This is a long-term industry, and there are big, unanswered questions about how different the energy supply system will look in 10 to 15 years.”

It’s already clear that the record prices that have made these companies the richest in history over the past few years won’t necessarily last. For some time, Browne and his peers have been making mid- to long-term investment decisions on the assumption that oil would ultimately fall to $35 per barrel. As early as this summer, Browne told NEWSWEEK he believes that $25 per barrel could well be the longer-term price, a number that many industry experts agree with. “People tend to forget that it has been only two years since the price of oil has been above $40 a barrel, and only one year since it’s been above $50,” says Browne. “That’s important context.”

While banks like Goldman Sachs expect the price to creep back up toward $75 as the winter heating season kicks in, the recent drop is an important reminder that oil is a volatile business full of peaks and troughs. In fact, the trough of the past two decades, when average prices were around $20 per barrel, and twice dropped as low as $10 a barrel, is responsible not only for some of BP’s problems, but those of the industry at large.

Oversupply and to a lesser extent lower demand after the Asian financial crisis of the late 1990s kept prices low until about 2002. During that time, there was massive consolidation within the industry. Wages plunged, and in the United States, for example, employment was slashed from more than 1 million to under 500,000. Some 400 Western oil companies went out of business. Those that didn’t go under survived by slashing costs and capacity. The result is nothing less than a missing generation in the oil business. “Young people ten years ago just didn’t want to go into mining or minerals engineering,” notes Leonardo Maugeri, group senior VP for strategy at the Italian oil major ENI. “It was considered a losing game.”

BP and Shell were known as perhaps the most aggressive cost-slashers of that era. Others, to a greater or lesser extent, followed their lead. The big question now is whether BP went too far, risking safety in operations for the sake of profit (among other things, whistle-blowers have accused the company of skimping on maintenance in Alaska and using outdated equipment in Texas City). “The culture at BP in the ’90s was very different than at Exxon or Chevron,” says one high-level oil veteran who asked to remain anonymous so he could speak more freely. “Their problems now aren’t just about bad luck.” But for every industry insider who says that BP played it too close to the wire, it’s easy to find another who is less than certain. The bottom line according to experts like Yergin is that it will take another several months of testing and reports to determine exactly what did or didn’t happen in places like Prudhoe Bay and Texas City.

Still, one fact is crystal clear—the market rewarded the most aggressive cost-cutters. “BP’s stock was not in favor in the early 1990s,” notes ING oil analyst Jason Kenney. “But by the late 1990s, it was a darling.” That was exactly when market dynamics began to turn. By 2000, after more than 15 years of underinvestment, the industry had virtually tapped out its spare capacity—that is, the amount of oil that could quickly and easily be pumped out of the ground. “That’s when everyone finally began spending again,” notes Goldman’s Currie.

They couldn’t spend fast enough. The lack of everything from oil rigs (massive machines that need to be ordered months or even years in advance) to engineers collided with growing demand from fast-growing developing countries like China and India, and costs began to spiral. CERA estimates that since 2000 overall offshore costs have risen by 68 percent, and costs for certain types of machinery and equipment have risen even faster (chart).

A number of big industry projects have been stalled or run billions over budget because of a lack of human resources—BP’s Baku-Ceyhan pipeline will cost at least $1 billion more than expected because of soaring bills from contractors and materials suppliers; Shell’s Canadian oil sands project is facing capital costs 50 percent higher than expected last year. Everything from steel tubing to special corrosion-resistant metals has gotten exponentially more expensive. Browne has said that the maximum daily fee BP pays to lease rigs capable of drilling in “ultradeep” water (more than 1,500 meters) has risen from $200,000 to $500,000 since 2004. What’s more, he predicts, these costs are unlikely to go down: “There’s very rarely depreciation in the industry, so what you see is an additional inbuilt cost that will likely be with us forever.”

The spiraling costs are compounded by another megatrend within the industry—oil nationalism. As prices began to rise a few years ago, countries such as Mexico, Russia, Venezuela and others began taking back control of their wells, and cutting the access of Western majors to new drilling areas. The result is that only about 25 percent of known reserves in the world are open to the Western majors today, down from 85 percent in the 1960s according to Washington, D.C.-based energy-consulting firm PFC Energy. “While every other industry in the world has been globalizing, oil has headed the other way. In energy, the world is not flat,” says Robin West, head of PFC and former assistant secretary of the Interior under Ronald Reagan.

When they do let outsiders in, states are taking more of the profits from projects, around 90 cents of every dollar of oil revenue, up from 70 or 80 cents in the past. As Shell CEO Jeroen van der Veer recently told NEWSWEEK, it’s important for oil executives to “stand with their hat in their hand” in front of developing-world politicians if they want to get even a small slice of the pie these days.

He would know. Shell’s Sakhalin gas project in Siberia is emblematic of how big Western oil companies must push into ever more difficult areas to find reserves, taking on greater financial and political risks. Shell recently announced that its Sakhalin project would run some $10 billion over budget due to labor and materials costs as well as the difficult local terrain. That infuriated Russian politicians, who would have to wait longer to get their share of the profit if costs escalate. The result is that the government has revoked Shell’s environmental permit to operate in Sakhalin, which could halt operations, and has threatened to do the same to other companies in the area, including Exxon. “As big and as rich as they are, the independent oil companies are not rule makers, but rule takers,” says West.

That’s one important reason why Big Oil is hardly celebrating its record profits. ExxonMobil’s current ad campaign is plaintively defensive, arguing for example that the real beneficiaries have been governments—because Exxon Mobil may have made more than $30 billion last year, but paid $99 billion in taxes. Even before BP’s stateside crises, European and U.S. politicians alike were lobbying for windfall taxes for Big Oil. In the wake of Chevron’s recent Gulf of Mexico find, Washington is pushing to renegotiate more favorable terms for royalty-sharing there.

There is a strong argument to be made that Big Oil is destined to get a lot smaller. Some analysts say the oil giants will increasingly act as consultants to the state companies, offering technology and know-how in exchange for a dwindling share of access. Energy economist Philip Verleger say that the typical Western major will shrink, becoming more like Mercedes than GM. There is already some evidence that this shift is underway, as players like Norway’s Statoil and Valero of the United States have posted better returns than some majors recently. The reason: they are less integrated, meaning they don’t do everything from exploration to retail sales. By focusing on fewer aspects of the oil business, they have a less complex balance of costs and risks to manage.

Whatever happens, the terrain will undoubtedly get more difficult—and more expensive. Most industry insiders expect more companies to face problems like the ones seen by BP. After two decades of underinvestment, people and equipment are being pushed to their limits—a recipe for problems. Safety and infrastructure spending will have to increase, particularly as companies push into rougher terrain and deeper water. Companies like Shell are spending small fortunes to develop new super-strong alloys to be used in such projects. The recent equipment failures on BP’s crucial Thunder Horse platform show just how tricky the new frontiers of oil will be.

Browne won’t see how this all plays out. He’ll step down as CEO in 2008, coincidentally BP’s centennial year. But by the looks of things, the next 100 years in the oil patch will be even trickier than the first.

© 2006 Newsweek, Inc.

URL: http://msnbc.msn.com/id/15081349/site/newsweek/ 

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