The State of the Oil Industry

Hillary wants the oil company's profits. But are all things what they seem. The oil sector is nowhere near as healthy as it appears, and even if it was, Hillanomix would likely put the stake into it.





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Of all the candidates on economic issues, Hillary Clinton concerns me the most. Every statement that she has made on the economy is that she will interfere in the markets and that her economic intelligence is incredibly shallow. One of her many pronouncements was that she wanted to "take the profits" of oil companies to fund some of her "green" programs." It would be hard to imagine something that would play more havoc with the energy sector. And as Carl Mortished writes in the Times, the oil industry is not as healthy as it would appear:

Bloated with profits and rolling in cash, but it isn't nearly enough. Oil companies confound our senses with big numbers - BP earned $17 billion (£8.6 billion) last year, a meagre performance compared with Shell's $28 billion, revealed last week. The European twins are hopelessly outclassed by ExxonMobil. The American ended the year with $40 billion tucked under its belt.

Don't be fooled; this pumped-up industry is impoverished, both in performance and opportunity. Beset from all sides, by inflation, weak operations and lack of opportunity, the oil majors have reverted to Plan A - cut the costs and raise the dividend.

The alternative to upsetting the staff would be to cut the payout and dismay the shareholders. For an oil company, yield is sacred, a Rubicon that must never be crossed.

It's just not good enough, says Tony Hayward about BP's numbers. The chief is in cheese-paring mode, demanding a 15-20 per cent reduction in overheads. Over at Shell, the mood is equally grim, with the entire IT staff to be removed from the payroll and ructions in Nigeria as the joint venture that houses Shell's embattled Niger Delta operation is put through the wringer.

Oil companies go through periodic shake-ups - it is in the nature of these beasts to add fat in the good times - but this is more than the scraping of a layer of surplus marzipan. The industry is suffering from a cost explosion that is eroding its ability to deliver satisfactory returns from exceptional oil prices.

Spending just keeps going up. Since 2003, Shell's capital budgets have doubled to more than $24 billion, but output of oil and gas has declined every year and the company gave warning last week that 2008 would be another year of falling production.

The massive investments are needed if Shell is to replace its output of 3.8 million barrels per day and at the same time fill the yawning gap that remains after the reserves scandal of 2004. Shell was coy about this year's reserve numbers, preferring to copy ExxonMobil and maintain radio silence until March. However, its hint that it had discovered one billion barrels of “resources”, to be distinguished from more rigorous “reserves”, is not comforting. In the space of a year, Shell pumps about 1.2 billion barrels, an indication of the huge challenge faced by these companies.

So, Shell and BP must spend, but are they really investing heavily? Or is it just that every barrel is costing a lot more? The evidence suggests the latter. Both companies cite near-double-digit rises in capital costs. Building things costs more, the cost of steel, cement and labour is on a never-ending escalator. Both companies are raising their capital budgets by around 10 per cent, in line with inflation, but industry statistics suggest that Shell and BP's 8-10 per cent inflationary adjustment is somewhat flattering.

IHS/CERA, the American consultancy, publishes an index of oil and gas industry inflation. The index shows that costs have almost doubled in less than three years. It's not unreasonable to assume that the oil majors get better terms than most operators, but they are also among the biggest consumers. You can only come to the conclusion that spending by the big battleships is not going up and is probably in decline in real terms.

That is troubling news for anxious energy consumers, but it is not entirely surprising. Over the past couple of years, BP and Shell have learnt that big, expensive projects go wrong in spectacular ways. Errors in management and design have cost BP many billions of dollars, from the Thunder Horse project to the Texas City fire. After several years of rampant spending that produced indifferent results, oil companies are looking for greater certainties, more discipline and better returns. The foot is easing off the accelerator.

It is ironic that $100 oil has not done much to boost BP's free cash flow, which fell $4 billion last year, in part due to the extra costs of clearing up the Texas City mess. As a result, BP had barely enough cash to cover $18 billion of investments and pay the ordinary dividend. Still, the British oil company has decided to boost the final dividend by 30 per cent, raising the annual payout from $7.8 billion in 2006 to $8.6 billion in 2007. . . .

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