The surge in oil prices in 2005 suggests that the financial markets made a major miscalculation about the long-term supply and demand balance for oil. The conventional thinking on the current elevated level of oil prices is that it is temporary, and that the only thing that distinguishes this oil price spike from previous ones is that this one is demand-led. The previous sudden jumps in oil prices in the 1970s, 1980s and then at the start of the Gulf War in 1990 were all driven by problems on the supply side.
The argument goes that, although Iraq’s production has not recovered as quickly as some analysts had hoped and Russia’s production has failed to grow as much as many had expected, the current increase in oil prices has not been a response to an interruption to oil supplies. The main reason for the surge in prices is that China and the USA are buying more oil.
However, as oil prices have failed to come back down, even though oil producers have tried to increase production, dissenters have begun to argue against the consensus that the current oil price spike is the only the result of higher than anticipated demand.
These dissenters claim, instead, that the big oil producing countries in OPEC and elsewhere, notably Russia, may not have the oil reserves they claim to have.
OPEC oil companies are invariably state-owned and secretive. The Saudi oil company, Saudi Aramco, has guarded information about its reserves and production very tightly. What is known is that OPEC’s record production of 31.7 million barrels per day was in 1977, a figure not reached again until November 2003.
Since then, OPEC’s production has not dropped below this level. At the end of 2003, the region claimed to have reserves of 726 billion barrels. But last year, an experienced observer of the Middle Eastern oil industry suggested that oil reserves in the Middle East may have been overstated by 300 billion barrels.
The uncertainty over reserve levels is not confined to the Middle East. No one knows how much oil OPEC’s only Latin American member, Venezuela, the biggest oil producer in South America, is pumping. The government implies that Venezuela’s production is around 2.8 million barrels per day, but independent analysts and commentators say that this figure is inflated by production from joint ventures with foreign oil companies. They say the state oil company, PDVSA, is producing only about 2.2 million barrels per day, well below the 2.8 million barrels it was producing before the recent oil industry strike, which ended in March 2003.
According to BP’s authoritative Statistical Review of World Energy, the world’s oil reserves were 1147 billion barrels at the end of 2003.
MERGERS AND ACQUISITIONS
All this uncertainty, coupled with growing concern among foreign oil companies about investing in Russia – largely because of the well-publicised, government-supported financial raids on leading Russian oil companies – means that oil companies have started to eye each other as potential sources of oil, as the only reserve figures oil analysts can be sure about are those published by the stock market-quoted oil companies.
These figures are now highly reliable: the scandal over Shell’s inflation of its reserves that cost the Shell chief executive Sir Philip Watts his job in 2004 has made certain of that. Senior executives at other oil companies do not want to be caught out as Watts was.
If the world’s stock markets can misjudge the outlook for the world oil market, they are quite capable of undervaluing oil companies’ reserves of oil and gas. This is what happened in the 1970s and 1980s when the world had to adjust to increasing OPEC prices and the cheapest oil was on Wall Street – the US stock market was valuing oil companies’ reserves at a fraction of the market price.
What is happening now is that the stock market is assuming that the current $60 a barrel crude oil price is exceptional, and that the price will fall back to a more ‘normal’ $25 a barrel pretty soon. If the oil price does not fall back, oil companies’ published reserves will look extremely cheap to predators.
The collapse in the oil price in 1998 (to below $10 a barrel) prompted a shakeout in the industry, as companies with strong balance sheets snapped up those whose bets on higher oil prices had come unstuck. In 1995, the biggest five US energy companies controlled 8% of world oil production. A decade later they controlled 14%.
The takeover winners immediately tried to get some of their money back by cutting back on exploration. Oil companies have been slow to restore these cuts, fearing further oil gluts. Exploration drilling peaked in 1998 with a total of 725 wells drilled, but in 2003 the West’s oil industry drilled just 554 wells.
There has already been some merger and acquisition activity in the oil industry. Perhaps the most notable example is the competition between the Chinese National Offshore Oil Corporation (CNOOC) and Chevron for a California-based oil company, Unocal. CNOOC shocked Chevron and the US political establishment with its $18.5bn cash offer at the end of June for Unocal. The Chinese bid forced Chevron to increase its stock and cash offer. The Chevron deal looks likely to go through, as US lawmakers are erecting a series of barriers that make approval of the CNOOC bid increasingly improbable.
One attraction of buying oil and gas companies rather than exploring for oil is that the international oil industry has a pretty poor record of finding new oil reserves. A study by energy consultancy Wood Mackenzie found that, despite the steady annual increases in demand for oil over the past decade, the West’s big oil companies have largely failed to improve the annual exploration yield of new reserves.
The Wood Mackenzie report ‘Global Oil and Gas Risks and Rewards’ shows that typical annual returns from oil exploration average between three billion and five billion barrels and have not risen since the early 1990s. The only exception came in 2000 when Kashagan, a ten billion barrel oilfield, was discovered in the Caspian Sea.
Big oil companies certainly have the cash for takeovers. The surge in the oil price has improved oil companies’ cash flow. In 2004, when oil averaged $41 a barrel, the top ten global oil companies made more than $100bn in net profits. With crude breaching the $60 mark in June, and apparently being happy there, simple arithmetic suggests that companies’ cash flows are likely to increase by 50% this year. One of the beauties of the oil business is that higher prices and production flow straight through to the bottom line.
BP, one of the world’s biggest (and now best-run) oil companies, is certainly well placed to buy. At the end of July 2005, its first-half replacement cost profits (the standard industry measure) were up by 29% on the first half of 2004 at $10.5bn. BP’s last big takeover was the US company Arco, in 2000. Currently, the company is returning money to shareholders through buybacks: $4bn in the first half of this year and $6bn in the second half.
The company’s chief executive, Lord Browne, said that the company was expecting oil prices to average $40 a barrel over the next four years, provided the world economy did not slow down dramatically. Browne was bearish about the oil price further down the line: he said that a combination of substitution, conservation and increased supply could bring prices down to between $20 and $35 a barrel. Such bearishness may be a misplaced, however. The CNOOC offer for Unocal shows that China, whose demand for all sorts of commodities is rising dramatically, is prepared to use its huge cash reserves ($700bn) to secure supplies.
The CNOOC bid for Unocal may be a sign that non-western oil companies are interested in buying Western technology and know-how. This has happened before: Venezuela’s state-oil company, PDVSA, owns Citgo, the biggest refiner and petrol station operator in the eastern USA. Kuwait also dabbled in buying downstream assets in Europe in the 1980s. Now the oil producing companies may buy other oil producers.
The CNOOC intervention in the Unocal deal did not come as a complete surprise to analysts. At the time of the original Chevron offer, they had noted that CNOOC and Italy’s state-owned ENI were eyeing Unocal. Nor is it a surprise that CNOOC, with its access to cheap money from the state-owned Chinese banking system, initially outbid Chevron. Both Chevron and CNOOC are offering what analysts say is a full price for Unocal (about $65 a share).
It is unlikely that another big oil company will step into that fight. But other similar-sized oil companies with decent production and prospects are vulnerable.