The future of oil: It’s change or be changed for the largest corporates

PRESSURES are building on the world’s largest quoted oil firms. Environmental disasters and the economic downturn have taken their toll, but more profound trends are undermining traditional business models in the industry. And it won’t be enough to tinker around the edges. The response must be as radical as that that followed the oil company nationalisations of the 1960s and 1970s.

The situation is significant. Oil and gas companies form about 10 per cent of global stock market capitalisation, and are well-represented in pensions. They particularly contribute to dividend income, so their prospects matter to us all. But while there are signs that some oil companies realise that the world has changed, there is little sign of radical restructuring.

Investors should be asking for clear explanations about responses to three key trends. Firstly, how will quoted oil companies secure investment opportunities from increasingly state-controlled producers. Secondly, how will they employ technology to access challenging reserves in the face of innovative competition. And thirdly, how will they respond to the trend towards efficient motor vehicles in key markets.

One recent announcement was welcome. Last year, BP sold its stake in the Anglo-Russian venture TNK-BP to the Russian state oil company Rosneft. The $27bn (£16.7bn) deal left BP the second largest shareholder in Rosneft after the Russian government. Varying from the sophisticated to the embryonic, about 86 per cent of known reserves lie under state control, so oil companies must follow BP’s lead if they are to gain access.

Saudi Arabia and Kuwait remain closed to external investment, but about 55 per cent of known reserves, though state-controlled, are open to some foreign investment. The problem is that the terms offered to oil majors have become increasingly unattractive over the last decade. In the case of Iraq, they were so unappealing that licenses were not taken up or were returned. Nevertheless, for the oil majors to grow, access to these new projects is crucial, and more pragmatism is required. When Venezuela recently changed its license terms substantially, Exxon left the country. But with Venezuelan President Hugo Chavez expected to open a new licensing round for the Orinoco basin, oil companies will need to temper their misgivings.

The majors must also address concerns that 30 years of outsourcing to oil service companies has left them badly-placed to meet the technical challenges of the next wave of projects. These are predominantly unconventional or very difficult – ultra-deepwater, shale oil, or in areas of environmental sensitivity.

Innovation has mostly come from smaller independents, like the shale gas technology developed by Mitchell Energy. And many of the most important developments of the last 30 years have arisen in oil service companies – including horizontal drilling, 3D seismic imaging and fracking. Schlumberger, an oil management firm, spends about $1bn each year on research – as much as Exxon. The majors, meanwhile, have outsourced to cut costs.

Total’s chief executive recently admitted that its exploration success has been poor, and that it must rebuild its capacity or be disadvantaged. For major oil companies in general, outsourcing has gone further than appropriate – especially when technical superiority is likely to become more and more vital.

There is finally a problem downstream – with the users of oil and gas. About 50 per cent of oil goes to transport. But more efficient vehicles and emission controls are reducing demand growth in Asia, and will turn it negative in the OECD countries, where quoted companies have the bulk of their downstream assets. There have been some disposals, but a more significant response is needed. This is especially true in Europe, where 12 to 16 per cent overcapacity hampers the profitability of even the best assets. Just as petrol stations fit better with supermarkets, refining may be a better fit for national oil companies, or regional companies that address specific needs.

Company structures suitable for the last era will not serve for the next. We may see some companies becoming large-scale upstream specialists, able to participate in huge projects. Others may become avowed fuel conglomerates, with advantaged downstream assets. There is no right answer, but maintaining the status quo is surely wrong. The major quoted oil companies must change or be changed.

Beth Mitchell is co-author of a recent Chatham House report: What next for the oil and gas industry?

City A.M.'s Opinion pages are a place for thought-provoking opinions and views. These are not necessarily shared by City A.M.

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