Independent On Sunday: If you’re in a hole, merge. But is it too late for BP and Shell?

 

With reserves running dry in non-Opec countries, rumours of a marriage could finally come true. Even a combined group, though, might struggle in its quest for more black gold. David Strahan reports

Published: 15 July 2007

BP and Shell are finally set to merge. That’s if you believe the tittle-tattle in the Square Mile.

Of course rumours that the energy giants might unite are hardly new and have been the stuff of bankers’ fevered imaginations for years. But there is now an increasingly compelling case for the two to integrate.

At 4.5 million barrels per day, the oil output of a combined Shell-BP would dwarf that of American behemoth ExxonMobil and even major oil-producing countries such as Iran. Some analysts make a positive case for such a merger on the basis of massive economies of scale, claiming it could save $5bn (£2.5bn). But if and when it happens, the real motivation will be far darker: desperation.

Both companies have suffered a variety of troubles in recent years – Shell in Nigeria, BP in the US, both in Russia – but their fundamental problem is identical: the inability to replenish the oil they produce with fresh reserves. This matters because the replacement ratio is one of the most important factors affecting an oil company’s stock market valuation, and a rough-and-ready guide to how long it can survive. Shell’s difficulties here are well known – in the five years to 2005 its reserve-replacement ratio was just 67 per cent – but BP is also struggling. Although its own ratio is still positive, it has fallen every year since 2002, and without the contribution of the fabulously risky Russian joint venture, TNK-BP, the figure last year would have been just 34 per cent.

Shell and BP’s troubles are neither unusual nor surprising, but they are exacerbated by these groups being some of the biggest fish in a shrinking pond. The fact is they are substantially excluded from Opec countries, which control 75 per cent of the world’s proven reserves. And their plight is worsening as resource nationalism takes hold from Russia – where Gazprom has just wrested control of both Shell’s Sakhalin II project and BP’s Kovykta field – to Venezuela, where international oil interests have simply been expropriated.

So the supermajors – ExxonMobil, Chevron, Shell, BP and Total – are largely restricted to operating in non-Opec countries where oil production is generally already in decline. Speaking in London recently, ExxonMobil chief executive Rex Tillerson admitted that continued growth of non-Opec production was now “very challenging” and unlikely to continue past 2010. And last week the International Energy Agency (IEA) predicted a global oil supply “crunch” within five years, driven in part by the crawling pace of non-Opec growth.

In these circumstances, the outlook for the world’s biggest oil companies looks dismal. In a recent interview with Le Monde, the IEA’s chief economist, Fatih Birol, said: “The supermajors will be in difficulty. They will no longer have access to new production capacity. They must redefine their strategies, or otherwise, if they remain concentrated on oil, they will have to be satisfied with niche markets.”

The respected Houston-based consultant Henry Groppe puts it even more bluntly: “The major, publicly traded oil companies are in long-term liquidation.”

Shell recently announced the start of a major drilling programme in the Beaufort Sea north of Alaska in the Arctic Ocean. The move raises the stakes in its strategy, post reserves scandal, of trying to explore its way out of trouble. But recent history suggests this plan is likely to fail. In the past decade it has been the companies “drilling for oil on Wall Street” – replacing reserves simply by taking over other companies – that have managed to increase their oil production; those that have relied solely on exploration have got into trouble.

Consolidation was always likely to be the more effective strategy since global annual oil discovery has been falling for 40 years. It was precisely Shell’s failure to find a partner in the late 1990s – when Exxon merged with Mobil, BP took over Amoco and Arco, and Total snapped up Fina and Elf – that led to the pressures that produced the reserves scandal of 2004, when Shell admitted it had overstated the proven oil and gas on its books by billions of barrels.

The company cannot have failed to learn the lesson; it admits to having conducted “scenario planning” with BP.

The problem with growing by acquisition is that it is addictive, and BP needs another fix. The initial impact of the TNK-BP deal is evidently wearing off – the group has admitted that in 2007 its oil and gas production will fall for the second year running. It claims output will pick up marginally by 2009, but according to brokers Dresdner Kleinwort, even that would mean average growth for 2005 to 2009 of just 1.4 per cent – against BP’s previous target of 4 per cent.

So it looks as if BP and Shell are made for each other, and if and when it happens, the deal will be lauded for busting all stock market records. But it should also be seen for its real significance: a warning light for the imminent peak of non-Opec oil production.

Of course the situation could be transformed, temporarily, if peace were to break out in Iraq and its parliament passed the hydrocarbon law granting access to international oil companies. In his interview with Le Monde, Mr Birol made it clear that Iraq is the only country on the planet with the potential capacity to save the world from the IEA’s predicted supply crunch: “If by 2015 Iraqi production does not increase exponentially, we have a very big problem – even if Saudi Arabia fulfils its promises. The figures are very simple; there’s no need to be an expert.”

This, of course, explains much recent history, but given the chaos and butchery of post-invasion Iraq, the country’s full oil potential is likely to remain untapped for the foreseeable future.

The IEA insists its predicted crunch is driven by factors above ground, such as the conflict in Iraq and does not amount to “peak oil” – the geologically determined onset of terminal decline in worldwide production. But that distinction may come to feel academic. As Mr Birol put it: “The oil industry will be facing a very serious test by 2015… the gap between supply and demand will widen significantly.”

At which point mega-mergers between the likes of BP and Shell will be exposed as powerless to combat the global energy crisis, whatever its cause.

David Strahan is the author of ‘The Last Oil Shock: a survival guide to the imminent extinction of petroleum man’ (John Murray, £12.99)

http://news.independent.co.uk/business/analysis_and_features/article2770906.ece

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