Why Isn't Big Oil Drilling More?
It's easy to understand why many Americans are angry with Big Oil. Crude oil that peaked at $42 a barrel and $2-a-gallon gasoline have given the oil companies a Mississippi River of cash flow. And even though crude has dropped 11% in recent days, the forces that have stoked prices, including booming energy demand from China and fears of attacks on oil personnel and facilities in Saudi Arabia and Iraq aren't going away anytime soon.
You would expect oil companies to be pumping more oil from existing wells, drilling new wells in current fields, and boosting exploration budgets. After all, a basic rule of economics is that higher prices bring forth more supply. More output by the supermajors would loosen OPEC's grip on world markets and lower prices. Yet this year, worldwide exploration and production (E&P) spending will grow only 9%, up from the 4% first planned, according to Lehman Brothers Inc. (LEH ). That's a relatively weak response to a 2004 surge that sent oil prices up 30% over the 2000-03 average. Ten years ago, a similar runup would have boosted E&P budgets by over 20%, says Lehman analyst James D. Crandell.
Why isn't Big Oil doing more? The companies say it takes years to find and develop "elephant" fields that will produce meaningful amounts of oil. They also say they couldn't possibly have predicted the spike in prices this year; moreover, oil could fall again to $15 a barrel or so. All true. But there seems to be another factor as well: an extreme aversion to risk on the part of oil company executives and their shareholders. When oil prices plunged in the late '90s, decimating profits, risk aversion drove oil companies into megamergers aimed at cutting costs. Now, even as prices have risen considerably and look likely to stay high, oil companies remain cautious about investing. Moreover, by cutting the number of rivals, mergers have made it easier for them to get away with that reluctance to spend.
Whether mergers are mainly an effect of Big Oil's conservatism or an enabler, they're under more scrutiny now that oil prices are sky-high. The merger wave of 1998-2001 united Exxon with Mobil, Chevron with Texaco, BP with Amoco and Arco, Conoco with Phillips, and France's Total with PetroFina and Elf. Jon Meade Huntsman, founder of chemicals maker Huntsman LLC in Salt Lake City, recalls warning people that mergers would lead to high oil prices. He says costly oil is damaging the chemical, airline, and trucking industries while enriching a handful of giant companies. Says Huntsman: "We've got a monopoly that's in effect more dangerous than during the Rockefeller era" of a century ago.
That oil companies have played it safe on investment is hard to dispute. While prices have been super-high for only a short while, the challenge of rising oil demand from China and elsewhere has been obvious for years. Oil has been over $20 a barrel almost continuously since mid-1999. That should have been ample incentive for companies to open new fields, since new projects are designed to be profitable with prices as low as the mid-teens. Nevertheless, drilling has lagged. To meet growing demand, oil companies need to develop new fields faster than they deplete old ones -- a process known as "reserve replacement." Yet the three-year-average ratio of reserve replacement for five supermajors fell from 134% in 1999 to 113% last year, according to Norwalk (Conn.) researcher John S. Herold Inc. And experience shows that some of those new barrels will turn out to be unrecoverable.
`DRILLING ON WALL STREET'
Oil execs argue that bigger means stronger. "Consolidation has given companies the financial strength and technological capabilities to take on bigger risks," says John Browne, CEO of BP, the former British Petroleum. Trouble is, there's little evidence that they're doing so. Far from raising money to pursue opportunities, oil companies are paying down debt, buying back shares, and hoarding cash. Exxon Mobil Corp., for instance, earned record profits in 2003 and ended the year with nearly $11 billion in cash. It then piled on an additional $5 billion in cash in the first three months of 2004.
The conservatism of the supermajors is possible only because all of them behave pretty much the same. Mergers, by reducing the number of companies, helped stamp out diversity of opinion. No major has broken ranks by trying to snag a big share of the available deals. If one did, others might have to follow suit -- or be shut out of opportunities and eventually run out of oil. Rather than developing new fields, oil giants have preferred to buy rivals -- "drilling for oil on Wall Street." While that makes financial sense, it's no substitute for new oil.
If megamergers are part of the problem, why did the government O.K. them? In part because standard antitrust doctrine doesn't address the problems they pose. Trustbusters at the Federal Trade Commission focused on "downstream" problems, forcing the merging companies to spin off refineries and gas stations where they overlapped. But except for Arco's Alaska fields, they left their "upstream" operations of oil E&P intact on the grounds that the companies were too small to affect the world price of oil. Says former FTC Chairman Robert Pitofsky, who signed off on several mergers: "Exxon and Mobil accounted worldwide for 4% of reserves. No one has brought a successful antitrust case where the combined share was 4%.... It wasn't a close call."
But the oil industry is more complicated than the government understood. Contrary to antitrust theory, the big oil companies have strong institutional incentives to hold back somewhat on development of new oil wells, even if that limits their profit potential. Their risk-averse shareholders reward them for consistent results and big dividends. "CEOs are listening to what institutional shareholders want," says Lehman's Crandell. "Production growth is a secondary goal, if it's a goal at all."
Mergers may have also hurt competition in refining and marketing. When capacity is tight, like now, refiners can hike prices and boost profits by taking part of their capacity offline, says Severin Borenstein, director of the University of California Energy Institute in Berkeley. Although there's no proof they've done so, the risk is greater with fewer players in the market. With joint ventures dominating downstream operations such as refining and storage, the competition's inventories are no secret, critics charge. "You don't need a smoky back room. All you have to do is go to a computer," says Jamie Court, president of the nonprofit Foundation for Taxpayer & Consumer Rights.
Even the closure of a single refinery can cause trouble. When Shell Oil Co. (RD ) said that it planned to shut rather than sell a refinery in Bakersfield, Calif., critics charged it with trying to boost prices by reducing supply. Under pressure, Shell agreed to put the refinery up for sale. It says it has received 22 inquiries -- but still plans to shut it down by Sept. 30 "based on economic viability" if there's no deal.
To be sure, there's more to high prices than the behavior of Big Oil. Other factors include the big jump in oil demand, the weak dollar, and fears of terrorism. Regardless of the cause, though, the best solution is genuine competition. And it may emerge from surprising sources -- like China. For instance, Sinopec, China's largest oil producer, recently won a share of the rights to explore for natural gas in Saudi Arabia's Empty Quarter. An influx of companies vying to increase energy production may displease Big Oil, but it would be great for consumers.
By Peter Coy in New York, with Stephanie Anderson Forest in Dallas, Christopher Palmeri in Los Angeles, Lorraine Woellert in Washington, and Stanley Reed in London