Here’s why oil companies should be a lot more profitable than they are

December 5, 2014

Shaybah oilfield complex is seen at night in the Rub' al-Khali desert, Saudi Arabia

The 40 percent plunge in oil prices since July, when Brent crude peaked at $115 a barrel, is almost certainly good news for the world economy; but it is surely a crippling blow for oil producers. Oil prices below $70 certainly spell trouble for U.S. and Canadian shale and tar-sand producers and also for oil-exporting countries such as Venezuela, Nigeria, Mexico and Russia that depend on inflated oil revenues to finance government spending or pay foreign debts. On the other hand, the implications of lower oil prices for the biggest U.S. and European oil companies are more ambiguous and could even be positive.

In fact, the shareholders of oil majors such as Exxon, Chevron, Shell, BP and Total could be among the biggest beneficiaries of the price slump, if it forces their corporate managements to abandon some of the bad habits they acquired in the 40-year oil boom when OPEC first established itself as an effective cartel in January, 1974. If this period of cartelized monopoly pricing is now ending, as Saudi Arabia has strongly hinted in the past few weeks, then it is time to re-focus on some basic principles of resource economics that Big Oil managements have ignored for decades, to their shareholders’ enormous cost.

The most important of these principles is “diminishing returns”: The more oil that corporate geologists discover, the lower the returns their shareholders can hope to achieve, because new reserves will almost invariably be more expensive to develop than the ones discovered earlier that were, almost by definition, more accessible. This inherent flaw in the oil companies’ business model was disguised for the past 40 years by the fact that oil prices rose even faster than the costs of exploration and production. But this is where a second economic principle now starts to bite.

Unless a market is totally dominated by monopoly power, prices will be set by the most efficient supplier’s marginal costs of production – in layman’s terms, by the cost of producing an extra barrel from oil reserves that have already been discovered and developed. In a fully competitive market, the enormous sums of money invested in exploring for new oil fields could not be recovered until all lower-cost reserves ran dry and there would be no point in exploring for anywhere outside the Middle Eastern and central Asian oilfields where the oil is easiest to pump.

That is, of course, an over-simplification. In the real world of geopolitical conflicts and transport and infrastructure bottlenecks, consumers want energy security and will pay premium prices for supplies from their own oil-fields or from those that belong to trusted allies. Nevertheless, the broad principle applies: The vast sums spent on exploring and developing new reserves with production costs much higher than in Middle East oilfields will never be recovered if the oil market becomes even vaguely competitive.

Considering that Western companies spend about $450 billion annually on exploration and development according to the Ernst & Young oil reserves study, this could be one of the worst capital misallocations in history. The fact is that Western producers can never match the costs of oil pumped by Saudi Aramco, or even Rosneft or other state-owned companies with exclusive access to the world’s most accessible reserves. While Exxon or BP must spend billions drilling through Arctic ice-caps or exploring 5 miles under the Gulf of Mexico, the Saudis can pump oil from their deserts with machines not much more expensive than old-fashioned “nodding donkeys.”

In a competitive market the rational strategy for Western oil companies would be stop all exploration, while continuing to provide technology, geology and other profitable oilfield services to the nationalised owners of readily-accessible reserves. The vast amounts of cash generated by selling oil from existing low-cost reserves already developed could then be distributed to shareholders until these low-cost oilfields ran dry. This strategy of self-liquidation could be described euphemistically as “running the business for cash” in the same way as tobacco companies or closed insurance funds.

There are two reasons why this hasn’t happened thus far. Firstly, OPEC has sheltered Western oil companies from diminishing returns and marginal-cost pricing by keeping prices artificially high through output restraint and limited expansion of cheap Middle Eastern oilfields (strictures reinforced by wars and sanctions in Iraq and Iran). Secondly, oil company managements have believed with quasi-religious fervour in perpetually rising oil demand. Therefore finding new reserves seemed more important than maximising cash distributions to shareholders.

The second assumption could soon be overturned, as suggested by rumours of a takeover bid for BP. If private equity investors could raise the $160 billion needed to buy BP, they could liquidate for cash a company whose proven reserves of 10.05 billion barrels would be worth $350 billion even after another 50 percent price decline.

But what of the first condition? The Saudis would surely want to stabilize prices at some point by limiting production, but the target prices may now be considerably lower than previously assumed. The Saudis seem to have realised that by ceding market share to other producers they risk allowing much of their oil to become a worthless “stranded asset” that can never be sold or burnt. With the global atmosphere approaching its carbon limits and technological progress gradually reducing the price of non-fossil fuels, the Bank of England warned this week that some of the world’s oil reserves could become “stranded assets,” with no market value despite the huge sums sunk into the ground by oil companies, their shareholders and banks.

The Saudis are well aware of this risk. Back in the 1970s, Sheikh Zaki Yamani, the wily Saudi oil minister used to warn his compatriots not to rely forever on selling oil: “The stone age didn’t end because the cave-men ran out of stones.” Maybe the end of the “oil age” is now approaching, and the Saudis have understood this better than Western oil-men.

PHOTO: Shaybah oilfield complex is seen at night in the Rub’ al-Khali desert, Saudi Arabia, November 14, 2007. REUTERS/ Ali Jarekji

11 comments

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The oil industry has a history of cartels being formed to control price. It started with Rockerfella. Opec was not the first and may not be the last. The big producers have the profit motive to want to form cartels. Unless you believe in the honesty of politicians who need money to get elected and known and wisdom of the average voter and new reporter, expect that to happen sometime.

The fact that the US and Europe did not respond to the formation of Opec with sanctions of military force means, their leaders were in bed with the Oil industry.

Posted by SamuelReich | Report as abusive

As soon as you see the term “Tar sands” used to describe “Oil sands”, you know you are reading a green biased article = zero credibility. As in Waist of time.

Posted by Marpy | Report as abusive

“As soon as you see the term “Tar sands” used to describe “Oil sands”, you know you are reading a green biased article”

how so? the raw stuff being extracted from those deposits is bitumen. the word ‘tar’ is much more descriptive of bitumen than ‘oil’.

Posted by schwankmoe | Report as abusive

I think this is somewhat of a false argument and while I understand it’s an attempt to try and press for something more meaningful and long term as a solution, it misses the point and thus can be made to look like falseness by those of an opposed disposition. The low price is an artificially generated thing to alter the energy investment slants that have been going on for a while. Wind, solar, biofuels and electric vehicles are poised to make significant advances in the next 10 years, even while they grow at record paces now. The oil producers are very afraid of major breakthroughs and reductions in cost for alternative technologies, and if oil prices were to stay high those investments would be more strongly supported from a simple economic standpoint (although there are many broader social benefits, americans only care about money, and while their are many economic arguments such as money not spent on foreign oils stay in the US and helps our broader economy that’s too complex a concept for the typical American, and of course it is an irrelevant fact for the typical financial investor since they don’t really care about the USA anyway and money is their god). So, this latest decline in oil price is intended to stall investments including the alternative oil production techniques, but it actually targets all alternative energy. The intent is to stall the inevitable. However, this price cannot be sustained for long. Most of the OPEC nations are like a frivolous consumer in that they spend to their full capability and then cannot scale back when times are harder, because they are a compulsive and irrational consumer. Most of the OPEC nations can only take this low price for a short time or they will suffer major economic strains, since they have not built any sustainable alternative to their singular commodity wealth system. So, don’t use the low temporary price as the argument, you can still say that prices will rise drastically in the near future and will price in alternatives, alternatives that should be greener alternatives if we have a choice, because for some true americans, the broader social good is important too. Besides, if we are to make a change it should be away from a global commodity that will continue to become more scarce and higher priced. This is not speculation, a commodity that is increasing scarce and more costly to produce will always drag on an economy if it is widely used, and it will always go up in price.

Posted by brotherkenny4 | Report as abusive

Interesting point of view. I’m not sure I see a “stranded asset” scenario at present, with global oil demand forecast to continue to grow for the forseeable future. But there certainly is a case today where oil demand is lagging behind supply world wide, and it does indicate that some ‘high cost’ oil should be left in the ‘ground’ for now. Simply a case of ROI.

Whether an oil company should decide to “self liquidate” is an altogether other question; one which I’m sure ‘greens’ would love to see them answer in the affirmative. But I would suggest that the oil business is not going away any time in the next 100 years, so this is really a ‘marginal cost of production’ decision.
Western nations will reduce their demand for oil as they move ever so slowly to renewable energy coupled with efficiency gains. But the developing world – China, India, Asia and Africa – have significant pent up demand for energy, and as they grow and develop a middle class, they will consume ever increasing amounts of oil and LNG – this will become the future demand driver.

Saudi is protecting it’s relevance by continuing to pump. Saudi is also engaged in a geo-political cold war with Iran in the ME, and ‘cheap oil’ hurts Iran – hurts them badly.. So Saudi will continue to pump.
The US is engaged in a new ‘cold war’ with Russia, and ‘cheap oil’ hurts Russia – hurts them badly – much more than sanctions over Ukraine ever will. So the US will continue to pump.

Posted by willich6 | Report as abusive

“The 40 percent plunge in oil prices since July, when Brent crude peaked at $115 a barrel, is almost certainly good news for the world economy; but it is surely a crippling blow for oil producers.”

Poor oil producers. I feel like crying for them.

Posted by AlkalineState | Report as abusive

Hey Marpy you ignoramus,
I am old enough to remember when the oil industry began using the propaganda term “oil-Sands” when in the past everyone, including the oil industry players, called it what it is: Tar Sands.

Bitumen is not oil, never has been, never will be. It is you that is the idealogue, no thte author.

Just keeping you honest.

Posted by Benny27 | Report as abusive

A real economically viable breakthrough in the alternate sources of energy (or a combination of them) will soon be the next “big thing” in human history, after microcomputers and the Internet. So the oil is slated to become very expensive one day… as most precious antiques do.

Posted by UauS | Report as abusive

The author has it backwards. The price is set by the marginal producer who, by definition, is the high cost producer. The Saudi’s, Russians, etc. are inframarginal producers – they can produce at a cost lower than the marginal price. So, the price should fall to the marginal cost of the high cost producers, at the intersection of the supply and demand curves. This price is about $65 -75 boe.

Let’s not take innumerate English majors seriously. If they understood Math and Economics, they would be employed elsewhere.

Posted by bigbirddog | Report as abusive

Aramco only wanted Eighty USD per Barrel.Brent sweet crude went off the charts@136.29 per Barrel July 3,2008….Pump prices today are the same as when oil was 27 USD per Barrel….Saudi Ministers are Hedging a bluff to increase output to 32 million Barrels per day to Demonstrate that they are within control of the OPEC Cartel and they recognize the negative effect of public perception.They ask only for larger containers to store their money….and the Beltways response of reducing oil output now means that you should call 202-456-1414 1600 Penn. ave. ask for Ernesto in the Kitchen He knows about oil……

Posted by DJSanDiego | Report as abusive

How is it possible humans will ever be able to get away from oil? It is not even imaginable unless your a day dreamer. To much of human civilization relies on oil. Maybe we will find another viable fuel source, we sure wont for chemicals , paints, plastics, rubber and so many more. We all would like to think we have other choices and truth be we have nothing yet.

Posted by shades74 | Report as abusive