In Oil Producers' Brave New World, a Key Word Is 'Partnerships'Published: May 02, 2007 in Knowledge@Wharton
In Venezuela, President Hugo Chavez is threatening to snatch control of several major projects from American and European firms. In Russia, the government recently strong-armed Royal Dutch Shell into relinquishing control of a large field called Sakhalin II. In developed countries, home to the six so-called "supermajor" oil producers, politicians have debated imposing windfall profits taxes.
Across the oil-producing world, governments are responding to higher petroleum prices by imposing new taxes on oil companies and forcing the renegotiation of contracts giving foreign firms access to critical reserves.
According to speakers at the 2007 Wharton Economic Summit, such developments augur a new age for the oil business. The time is over when major oil companies can dictate the terms of development deals to host countries. About four-fifths of the world's reserves are already controlled by state-owned firms, and political strongmen like Chavez and Russia's Vladimir Putin seem intent on tightening their hold on their countries' oil wealth. Russia has the world's largest oil reserves, after Saudi Arabia.
"The ability of major oil companies to exert their muscle has diminished," said David Fleischer, a principal with Chickasaw Capital Management in Memphis, Tenn. "They still bring a lot of technology and expertise, but that's less important in today's world. Countries like Venezuela don't care as much as they should about maximizing their revenues. They care about control of their resources."
Finding New Deals
Yet the situation isn't as dire as the headlines can make it seem, said Mohammad Azam Ali, chief executive of Dubai-based Orient & Gulf DMCC. Oftentimes, politicians' threats are just posturing intended to appeal to local people, and not genuine declarations of intent. "The governments, most of them anyway, are aware of what they need the companies for. There are many examples of major U.S. oil companies doing very well in the Middle East despite problems between the U.S. government and various Middle Eastern governments."
Consider Oman, a sultanate on the Arabian Peninsula, he said. It recently entered into a long-term contract with Los Angeles-based Occidental Petroleum to develop a billion-barrel field. Occidental approached Oman and committed to investing more than $1 billion and drill more than 1,000 wells -- far more than Oman could have managed alone. The government of Abu Dhabi, the largest of the United Arab Emirates, helped to broker the deal and ended up taking a 15% stake. By inviting Abu Dhabi in, Occidental found a way to more closely align its interests and Oman's. "If Oman decides that it wants to retrade the deal with Occidental, it will also have to do it with one of its neighbors," Azam Ali pointed out.
Marathon Oil also intends to have its projects work for both itself and its host, said Janet Clark, the Houston, Tex., firm's chief financial officer. In today's world, oil producers must embrace state-owned oil companies as partners, not try to squeeze them out of projects, she said.
Marathon is making a virtue of necessity, Clark admitted. "We're not Exxon or Chevron, and we can't push people around." Marathon last year reported revenues of $65 billion, compared with $378 billion for Exxon Mobil. But Marathon's executives also believe that fair dealing creates good will that can yield unexpected dividends later. Libya's government, for example, recently invited Marathon back into the country two decades after it had left the country because of economic sanctions imposed by the U.S. government. "In 1986, we had to walk away from 300 million barrels in reserves," Clark said. "Because we had a good relationship, they held that for us."
Marathon's development of a liquefied natural gas plant in Equatorial Guinea typifies its efforts to cooperate with local governments, Clark noted. Marathon has committed to training local people and employing them in skilled jobs. It has also undertaken an anti-malarial campaign in the region where it operates. The African country, for its part, has been investing in the plant to secure a 25% stake.
Of course, not every deal works out so well. True partnerships require two willing participants. And governments like Chavez's and Putin's have shown themselves to be more interested in expropriation than cooperation. When confronted with these sorts of tactics, some experts have urged oil producers to exhaust every legal remedy. Courts could interpret a failure to do so as a voluntary relinquishment of ownership rights, these people say.
Fleischer counseled humility over legal machismo. "The humble approach -- letting [state oil companies] own the reserves and you bringing the capability and technology -- makes more sense," he said. That way, no potential partner is alienated. And sooner or later, most oil-producing nations will have to call for the big firms' help. "Many of these OPEC countries are already spending all the resources they are getting from $60 oil and not reinvesting" in their production infrastructure, he noted. "And there are countries in the world -- Iraq is a prime example -- that just have no local talent. So they need the technology and capabilities that the major companies can bring."
A recent Marathon experience ratifies Fleischer's advice. The company recently won a bid against one of the supermajor firms for the right to own and operate a section of a big field. "I don't think the government in question thought our technical program was superior," Clark said. "That other company had taken an approach in prior negotiations that made it unwelcome as a partner."
A wild card in these sorts of strategy discussions is the growing role of China's state-owned oil producers, which are expanding aggressively. Though not as technologically advanced or experienced as Western firms, they have the financial backing of their government and might appeal politically to America-bashers like Chavez. "We can't compete in the same way the Chinese national oil companies can, because we don't have a government that's going to go into Angola and build a railroad or hospitals," Clark said. "If anything, we have a government that beats up on some of these countries because they don't have the kind of evolved democracy that we have here."
The High Profits -- and Costs -- of Oil
Underpinning much of the current debate about the oil industry is public outrage at the high profits that oil companies are earning, thanks to the recent rapid rise in prices. In the last three years, the price of a barrel of oil has doubled, hovering lately at about $60. In developing countries like Nigeria and Venezuela, high prices have created resentment and the perception, real or imagined, that resources are siphoned off while few dollars are ending up in local pockets.
A worldwide oil shortage compounds the problems, explained Wharton management professor Witold Henisz. Developed countries continue to consume oil, while demand surges in China and India. "Spare capacity globally is getting down below one million barrels a day," he noted.
Clark, for her part, took issue with the popular perception that oil wells gush greenbacks. The business looks lucrative now, but oil prices zigzag routinely and therefore profits do, too. "My second year as CFO was in 1998, when the price of oil hit $10. I was focused on how we could ... meet payroll." From 1972 through 2004, the industry's average return on invested capital fell short of that of U.S. manufacturers, she added. And even during the last two years, as prices have soared, the industry's average profit margin didn't beat the average of all U.S. companies by that much -- 9.5% vs. 8.2%. "If you look over an extended period, the oil industry hasn't generated excess profits."
Part of the reason, besides volatile prices, is that oil exploration and extraction costs a lot. Those costs have lately risen because oil companies have exhausted most of the easy-to-reach reserves. "We are going to deeper and deeper water and deeper [oil] reservoirs," Clark said. "We're drilling 25,000 feet below the earth's surface."
Offshore drilling, in particular, has seen surging costs, Clark added. Three years ago, a company would have paid about $170,000 a day to operate a deep-water drilling platform. A comparable well now costs about $500,000 a day. "These days, $50 million wells are pretty routine for deepwater drilling. And if you have problems, you will have a $150 million or $175 million well."
Fleischer agreed with her analysis: "I was around in the 1980s, when the price of oil went to $10, and all I saw for 15 years was companies going out of business."
Given the volatility of the oil business and the unpredictability of foreign governments, a member of the audience asked whether major oil companies should undertake coal gasification or oil shale exploration. In coal gasification, coal is pulverized and transformed into a gas fuel, while oil shale is a form of rock containing a material called kerogen that can be distilled into oil and gas. The United States has abundant supplies of coal and oil shale.
Clark pointed out that the volatility of oil prices undermines attempts to pursue alternative fuel sources. A project that looks prudent when oil is $60 a barrel might look profligate at $30. In addition, coal produces even greater pollution than oil. "If you are someone who worries about energy security, you want us to be mining all the coal we can. But if you are worried about the environment, coal is much more carbon intensive than either oil or natural gas. Before you ever see gasified coal become a significant energy source, they are going to have to solve the carbon sequestration problem."