IOC’s – An Endangered Species?

RelevanceThe traditional IOC competitive advantages of capital and technology are 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). In the natural resource industries, one clear competitive advantage is access to the resources, and here the NOCs have 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?

AnalysisThe traditional view is that IOCs bring capital and technology to the oil industry party. However, that view does not seem as relevant in today’s world as it once did. NOCs are now flush with money after several years of high oil prices, and increasingly, much of the technology and know how resides with industry service companies and engineering contractors (who, ironically, became stronger when the IOCs began outsourcing in the late 1980s). 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.

In the new world NOCs are financially stronger, and are no longer restricting themselves to being their country’s resource protector, playing the role of state vehicle for signing contracts with the IOCs. NOCs are now much more aggressive, 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. They often enjoy a much lower cost of capital than IOCs, and do not always need to trouble themselves with maximizing shareholder value or the profit motive. They are happy dealing with pariah states, and can easily call upon bilateral trade agreements to strengthen their negotiating hand abroad. Often, they are supported by very strong government policy, such as China in its quest to address its security of supply issue.

IOCs, on the other hand, seem to be caught on the back foot. They are increasingly having to access technically and politically more challenging projects, and these are proving difficult, as evidenced by the increasing list of projects delays (Chevron-Tahiti, BP-Thunderhorse, ENI-Kashagan, Shell-Sakhalin, the list goes on). At the same time they are handing back money to shareholders in record amounts (ConocoPhillips is the latest, announcing this week a $15b share buy back program) – a sure fire indication that they are short on opportunity, even in today’s high oil price environment.

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. But IOC dominance is always 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, and that their historic competitive advantage has disappeared.

So, 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. Here are a few options and permutations:

  1. The traditional model. Carry on as now, 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 back 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; and the financial strength to go head to head with the NOCs.
  3. Project Manager. Add value through the coordination of all aspects of an investment (engineering, operations, commercial, finance). This is a skill that is in short supply within the industry, and clearly IOCs have an edge here.
  4. Super Contractor. Become the ultimate contractor to NOCs/governments, bringing together the efforts or all subcontractors and service companies. In this case IOCs may not invest, and would not be able to book reserves. Booking reserves is a time honored approach that will be hard for IOCs (and even harder for Wall St.) to let go of. But, if investing, there is no reason why an equivalent risk/reward contract could not be entered into without booked 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.
  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.

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. 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).

Another possible scenario is that NOCs encourage increased IOC participation as a method of increasing supplies quickly in the face of steep oil price increases (which would encourage energy substitution and conservation in consuming nations).

And, of course, there is always the possibility that NOCs and their governments may open up their resources to market competition. Many 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). But the trend seems to be in the opposite direction, as Venezuela is showing.

The IOC response to the NOC challenge is the most important issue facing IOC leaders today.

12 July 2007

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