Governments Provide the Real Competition to ExxonMobil, Total, Shell, BP and Others

Relevance:  It was announced in January that the Kazakh government is seeking to double its stake in the Eni-led Kashagan oil project. Another day passes and another IOC (International Oil Company) feels the heat of a host government/NOC (National Oil Company) presence. Historically, IOCs have brought capital and technology to the oil and gas party. These seem no longer relevant in today’s oil and gas industry. NOCs have plenty of capital, and much of the technology resides with engineering contractors and service companies (who, in partnership with NOCs, are just as well placed as IOCs to invest in R&D to develop new technologies). NOCs are clawing back resources in their home countries and are scouring the planet in search of new resources. In the natural resource industries, one clear competitive advantage is access to the resources, and here the NOCs are building an unassailable lead. The longer the period of high oil prices lasts, the stronger NOCs get, and less dependent on IOCs they become. What is to be the response of IOCs?

Analysis:  Historic Perspective: The traditional view of the oil and gas business is that NOCs act as the resource protectors for their home country’s reserves, contracting with IOCs to help exploit such resources. IOCs, on the other hand, bring capital and technology, along with an implicit expectation that they will exploit resources in an efficient manner. A crucial part of the IOC business model has been the ability to “book the reserves” that they find and develop. We still see the traditional NOC resource protector approach in countries such as Mexico and Iran and, until very recently, Libya. In many countries energy has historically been subordinate to broad policies of economic liberalization, national development, independence, foreign policy and security.

Industry observers know that the IOC-NOC/government relationship is cyclical. NOCs have the upper hand now, but IOCs had dominance in the mid 1980s and at the end of the 1990s.

The New Situation: Oil and gas has become central to government policy in many countries. Perhaps nowhere is this better illustrated than in Russia, which is pursuing a policy of renationalization, with key oil and gas figures very prominent on the political scene. Another example is China, where government policy for security of supplies has seen the Chinese NOCs doing very large deals in West Africa and South America (among other places). NOCs are now much more aggressive, moving on from their traditional resource protector role, seeking to establish themselves as operators in their own right, and becoming national champions by expanding their interests abroad. They bring a new dynamic to the oil industry, and see the world very differently from their IOC counterparts. At the same time, NOCs and governments are placing a lower value on the IOC offer, as clearly demonstrated by Russia’s (and in particular Gazprom’s efforts to scale down IOC involvement

IOCs, on the other hand, seem to be caught on the back foot. The list of IOC challenges is long and includes: rising costs of investments; falling reserves bookings; decline in production growth; environmental concerns and an aging work force. They are increasingly having to access technically and politically more challenging projects, and these are proving difficult, as evidenced by the increasing list of project delays (Chevron-Tahiti, BP-Thunderhorse, ENI-Kashagan, Shell-Sakhalin, the list goes on) and cost overruns. At the same time they are handing back money to shareholders in record amounts (ConocoPhillips being the latest, recently announcing a $15b share buy back program) – a sure fire indication that they are short on opportunity, even in today’s high oil price environment.

Reasons for the Change: NOCs are now flush with money after several years of high oil prices. IOCs have under invested in technology for many years, and increasingly, much of the technology and know how now resides with industry service companies and engineering contractors (who, ironically, became stronger when the IOCs began outsourcing in the late 1980s). This technology is now accessible to NOCs without the involvement of IOCs.

Governments are now focusing on security of supply issues and the tremendous growth seen in countries such as China, India and others has been accompanied by an increase in demand for petroleum products. Government policy has now shifted to access to hydrocarbons at the well head, and NOCs are seen as the vehicle for implementing such policies.

Many countries (e.g. Qatar, Saudi Arabia, Indonesia) that remain net oil and gas exporters are now moving down the value chain, investing in downstream projects that require feedstock. Outside involvement through IOCs is often seen as less desirable in this scenario.

Other countries are building up their NOCs to become national champions, Statoil and Norway is the best long term example of this.

Conclusion: IOCs are now competing for access to resources with governments (through their proxies, the NOCs).

NOC Competitive Advantages: In the new world NOCs are financially stronger, and are no longer restricting themselves to being their country’s resource protector. In many critical aspects of the oil and gas business they enjoy seemingly unassailable competitive advantages over their IOC counter parts. These include:

  1. They often have a much lower cost of capital than IOCs.
  2. They do not need to trouble themselves with maximizing shareholder value or the profit motive.
  3. They are happy dealing with pariah states that will be off limits to IOCs.
  4. They can easily call upon bilateral trade agreements to strengthen their negotiating hand abroad.
  5. As mentioned above, NOCs are often supported by very strong government policy.

IOC Competitive Advantages: Traditionally, IOC supremacy has always been facilitated by extended periods of low oil prices, when NOCs simply need the capital. The concern for IOCs now is that the oil price has been high for so long, and may continue to be so for some time yet, that their negotiating hand has become irreversibly damaged. IOCs must now turn to their other competitive advantages:

  1. Access to downstream markets.
  2. Exploiting synergies across the value chain.
  3. Potential for reciprocity, i.e. access to western markets for NOCs, in return for IOC access to resources.
  4. Speed and flexibility to act in a wide range of technically and politically challenging operating environments.

How Should the IOCs Respond? Now is the correct time to consider the IOC response. Future IOC participation is likely to continue to involve capital investment and risk sharing, but the terms may be very different. New business models will need to be evaluated. In particular, booking reserves is a time honored approach that will be hard for IOCs (and even harder for Wall St.) to let go of. But there is no reason why an equivalent risk/reward contract could not be entered into without booked reserves. Here are a few options and permutations for the IOC response:

  1. A return to the traditional model. Bring technology back “in house”. Invest heavily in technology R&D in the belief that a technology breakthrough(s) will be found. Seek out partners that clearly need investment (e.g. Nigeria) or that find IOC technology attractive (e.g. Libya).
  2. Industry Consolidation. Even the mighty ExxonMobil only produces about 3% of the world’s oil. Consolidation amongst the majors (and a BP-Shell tie up has been in the news recently) would allow huge cost saving synergies; great high grading of assets; a balance sheet strong enough to take a larger share in very big projects; the financial strength to go head to head with the NOCs; and a lower cost of capital.
  3. Project Manager. Add value through the coordination of all aspects of an investment (engineering, operations, commercial, finance etc). This is a skill that is in short supply within the industry, and clearly IOCs have an edge here over the service companies. The IOCs may or may not put capital at risk or book reserves. At the extreme IOCs would become service companies themselves.
  4. Super Contractor. Become the ultimate contractor to NOCs/governments, bringing together the efforts of all subcontractors and service companies. In this case IOCs may not invest, and would not be able to book reserves. Such a move would facilitate immediate access to conservative oil provinces such as Mexico.
  5.  Focus on one part of the value chain. This approach would appeal to Jim Collins, the respected business researcher and author. He says that great companies focus on one thing, and do it better than anyone else. So for example, in this model, BP, the great explorer, and ExxonMobil, the great developer would focus on these areas as the source of their competitive advantage. This advantage may be appealing enough to NOCs to allow access.
  6. Deal Making. Similar to points 3. and 5. above, IOCs have great expertise in putting together and financing complex commercial structures for investments. LNG projects are a good example of the IOCs expertise in deal making, and their skills in accessing downstream markets.
  7. Focus on Downstream. Clearly, IOCs have a competitive advantage in their access to the markets of the large consuming nations. Historically, downstream has not enjoyed the returns available in the upstream, but it is much lower risk. A disproportionate amount of rent accrues to the upstream through the actions of OPEC (so called “monopoly rent”), but this could be altered through government policy of the consuming nations.
  8. Focus on Mature Assets. The IOC’s niche has traditionally been large, capital intensive, high risk projects in technically demanding environments. A refocus towards mature areas along with an increased investment (per point 1. above) in technology to increase recovery factors would give upside in assets already owned by the IOCs.
  9. Lastly, IOCs could use profits from oil and gas exploitation to invest in other forms of energy.

IOC Home Government Response: In the long run the “do nothing” approach is not an option. As hydrocarbon resources become ever more concentrated in NOC’s hands, IOCs run the risk of increasingly becoming political pawns as the geopolitics plays out. Also, there is a real threat to energy security of the consuming nations due to the increased market power of producers and the reduced level of flexibility in the system to supply oil. With this in mind, we must also consider the role of home governments (particularly the U.S. and E.U.).

One can imagine a scenario where Western governments drop their free market philosophy to insist on IOC participation in return for access to their markets (in a neat reversal to the traditional resource holder’s insistence on NOC participation to protect its hydrocarbons). Consuming nations could give power to this initiative by forming a buyer group that directly mirrors OPEC and that would extract rent from the oil and gas value chain at OPEC’s expense.

There is always the possibility that the U.S. and E.U. encourage NOCs and their governments to open up their resources to market competition as part of a broader free market philosophy. Most economists would agree that this would lead to the most efficient extraction of hydrocarbons, and would also free up scarce funds in developing countries for much more important projects (such as schools and hospitals).

In selected countries, the E.U. and U.S. could threaten the withdrawal of military protection, and access to technology, management expertise, finance and markets, culminating in full sanctions against states that do not allow for a free market approach to access to their resources.

The U.S. could also open up access to drilling lands currently off limits to IOCs. For example, only 15% of the U.S. shelf waters are currently available for exploration.

Further approaches available to the U.S. and E.U. that would not directly benefit IOCs include:

  • Pursuing a Middle East peace settlement. This is the one issue that unites most of OPEC and has spurred oil embargoes in the past.
  • Pursue an interventionist energy policy through the use of subsidies and other economic measures, for example in the areas of energy conservation and investment in other forms of energy.

4 January 2008

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