The dawn of a disturbing new reality

By Carola Hoyos
Published: November 3 2008 02:00

In the past month, the world has witnessed one of the largest financial and economic upheavals in a generation. The fallout may have been most immediately felt on Wall Street, but the effect on energy, and perhaps even the environment, will also be profound.
Christophe de Margerie, chief executive of Total, the French oil company, who usually argues for governments to get out of the way of those trying to bring enough energy to the market to satisfy demand, this week said recent events meant lawmakers needed to consider extending a helping hand to environmentally friendly energy sources and technologies made uneconomical by falling oil prices.
Executives say environmental initiatives such as carbon capture and storage must not be abandoned and oilfields need to be developed in an as environmentally friendly way as possible. But Chevron has already warned that Australia's cap and trade initiative could make the development of the Gorgon gas field uneconomical.
Royal Dutch Shell has dropped its proposed investment in plans to build the world's biggest offshore wind farm, the London Array, to concentrate on less risky US onshore wind power.
On the government side, the trend could be similar, as environmentalists worry that the billions being spent on bailing out banks may not leave much for the environment. Indeed, amid the fiercely contested US presidential election, the credit crunch has firmly overtaken energy security as issue number one, at least in terms of rhetoric.
But Mr De Margerie's main message centred on security of supply, rather than the environment. He and other executives contend that the drop in oil prices will make it more difficult to develop enough energy to meet the future demand of countries, such as China and India, and could prolong the downturn.
The Opec oil cartel made that same point in its communiqué last week, in the hope of justifying its decision to cut production by as much as 1.8m barrels a day. "Oil prices have witnessed a dramatic collapse - unprecedented in speed and magnitude - with these falling to levels which may put at jeopardy many existing oil projects and lead to the cancellation or delay of others, possibly resulting in a medium-term supply shortage."
Projects in high-cost areas, such as Canada's oil sands and in the deep waters of west Africa, are already being delayed, while the development of giant fields such as Russia's Shtokman gasfield have become more tenuous, as Gazprom, the monopoly, struggles under the credit squeeze.
In fact, the International Energy Agency, the developed countries' watchdog, does not see Russia, the world's second largest oil exporter, being able to increase its production at all in a draft of the Paris-based agency's latest forecast to 2030.
Many of Russia's biggest oil fields are ageing and declining, and tax cuts meant to give companies incentives to develop new fields and help boost the production of old onesare too little, too late, executives and analysts say.
But the problem is far from limited to Russia.
In fact, the IEA believes the single most important factor in deciding how hard the energy industry will have to work to meet demand is the rate at which ageing oil fields are declining.
Preliminary results of a study of the world's largest oilfields, due to be published by the IEA next month, indicate that the scale of the challenge is great.
The world will need to invest $360bn a year in boosting oil production to meet demand, initial data in an early draft of the report obtained by the FT, states. Much of that money will need to be spent in countries where oil reserves are controlled by national oil companies that are either too badly managed or technically incapable of making the necesary investments.
Worldwide, oilfields are declining at an annual natural rate of 9.1 per cent and, even with investment to boost production, are still declining at 6.4 per cent, the IEA's draft report states.
Making the kinds of investments to arrest decline is more difficult when prices are low. Oil companies often choose to shut down a field, rather than pour more money in for little gain. It is a reality that could be felt in the North Sea, where years of high oil prices have prompted a flotilla of niche companies to sail in to save small oilfields.
In fact, many of those small oil companies are now struggling as their share prices have dropped and, in some cases, the credit crunch has eaten into their ability to fund production programmes.
This new reality is one of the other leading forces that have emerged to change the industry, as credit has become tight and oil prices have fallen.
Ian Taylor, head of Vitol, the energy trader, says he believes the industry stands at the edge of a wave of consolidation. "This is the best opportunity for 15-20 years. Many companies are trading at below the value of their assets," he says.
Indeed, on the day he was speaking, BG announced a deal to acquire Queensland Gas for A$5.6bn ($3.8bn). The bid was at an 80 per cent premium to the previous QGC share price, but still valued the Australian company's gas reserves at less than half the implied value paid by ConocoPhillips of the US for similar assets over the summer.
The pickings are richest for the biggest companies by market capitalisation. Their shares have for years traded at relatively low earning multiples despite record revenues, as their inability to grow by finding new fields or taking over large companies has let them down.
These companies are now sitting on unspent cash ($40bn in the case of ExxonMobil, the largest of the group) and very low debt.
As Tony Hayward, chief executive of BP, put it: "We think the current turmoil may create opportunities for us and we will look at those very closely."
Total is said to be eyeing Nexen, a Canadian oil company, whose shares have fallen more than 50 per cent in the past six months, meaning it is no longer too expensive to buy.
Executives from other big oil companies, meanwhile, say they are looking at US players, such as Anadarko.
BG, whose liquefied natural gas portfolio had for years made it attractive to the majors, but which was too big and expensive to be bought, is now again on radar screens, executives say.
Maurice Berns of the Boston Consulting Group, says: "In previous downturns, what have we seen the successful companies do? They consolidate and build competitive strength to come out in a better position when the dust has settled."
But the future will not lie in the hands of those companies. Instead, it will be the investment decisions of national oil companies, many of which are in Opec countries, that will decide whether there is enough oil to see the world out of economic turmoil. And it will be up to governments to ensure the environment is considered in times of economic sickness, as well as in times of economic health.
So far, the signs that either will be able to act in the world's best interest are growing weaker - with the fall in the oil price and the onset of recession - rather than stronger.
Copyright The Financial Times Limited 2008