Big Oil, Bigger Costs

These are curious times for international oil majors. Crude prices have fallen more than 10 percent from their mid-summer peak, and there are analysts that project futures will continue to slide as the global economic slowdown dampens the demand for oil. Nevertheless, oil majors have returned more than $120 bn to shareholder and are experiencing record profits. Such performance has relegated industry executives to pariah status at the recent Democratic and Republican National Conventions, where delegates are outraged at high fuel prices.

Oil majors must be somewhat troubled by their fat-cat caricatures. This attitude reflects a fundamental misunderstanding of the industry's structural woes. While no one should lose sleep over the financial solvency of its executives, the oil and gas industry has suffered from eroding profit margins. As oil and gas prices rose, many industry analysts declared that surging demand (fueled by developing nations like China and India) was one of the "new fundamentals" driving the bull market. According to the Cambridge Energy Research Associates (CERA), rising costs provide a serious challenge to industry growth.

The factors threatening profits are twofold: increased government involvement in the market and a weak dollar. For many years, the energy industry benefited from soft fiscal terms that provided rich incentives for exploration. Now as international majors are restricted from the Middle East and face increasingly hostile policies from Russia and Venezuela, oil companies are wary of the competition from state owned corporations in Asia. In 2006 CNOOC, China's biggest offshore producer secured a $2.7 bn contract in Nigeria. More recently, Russia's Gazprom has been in negotiations with Nigerian officials to explore in the Gulf of Guinea. 

Structural problems in the US market have also weakened the dollar, which is used as the reporting currency for the oil and gas industry. As a result, all final construction costs have seen a significant rise on account of recent exchange rate movements. The Upstream Capital Cost Index (UCCI) serves as an industry-specific measure of inflation, much like the general Consumer Price Index (CPI). This figure has doubled since 2005, a function of increasing input costs. The price of iron ore, primarily used to make steel, has shot up nearly 60% in 2008. The endogenous reality of high oil prices means that major internationals are paying more to transport their resources to importers. Installation vessels, which manage drilling platforms, have seen a 2% rise in costs over the past 6 months alone. Finally, the largest increase in the UCCI has been attributed to more expensive deep water equipment needed to maintain sub-sea umbilicals (up 12% in the last 6 months).

These rising costs have all bolstered the remarkable rise in organic capital spending (expenditures that do not include acquisitions), and have discouraged new investments in oil reserves. Perhaps politicians, in the US and abroad, should focus less on the knee-jerk populism surrounding energy prices and invest their efforts in alternative and renewable sources. In the 1970's structural variables in the oil market favored a green revolution, but the politically contrived shortage eased and hydrocarbons were once again cheap and plentiful. Today, an oil spike coincides with improving technological alternatives and real discussions of peak oil. If rich nations encourage investment in green energy, the end of the fossil fuel era may well be in sight. Rather than rail against big oil, statesman should work to coöperate with the profit incentives of major internationals. What has been fodder for political victories will not support a real transformation in the future of energy.