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Markets: The Problem With Big Oil
New York: October 16, 2006
By John R. Stephenson

"They can't do that. The oil doesn't belong to them, it belongs to us!"

--Hugo Chavez, President of Venezuela

"Exxon Mobil regrets to announce it will commit no new capital to Russia or Venezuela"

--Lee Raymond, Former CEO of Exxon Mobil, 2005


How high can oil go? For the last several years, the debate in the business press has been about the price of oil and whether it was more likely to hit $20 a barrel or to skyrocket to $100 or more. Lately, with oil prices dropping 25 percent from their recent highs, a resounding chorus of "I told you so" can be heard from Wall Street analysts. That's because most of Wall Street and the industry itself is bearish on oil prices.

Over the last fifty years, OPEC (The Organization of the Petroleum Exporting Countries) has been the price setter for global oil. Sitting atop of more than three-quarters of the world's proven reserves, it was up to them to set the price for the world's most valuable commodity. Only by pumping out too much oil could OPEC create a problem for itself by creating a glut of crude oil on the world markets and by sending oil prices tumbling down.

In order to maintain control of the price, an elaborate system of quotas was created so that each member country could produce up to a certain specified amount. That amount was predetermined by what level of oil production from OPEC would balance the oil markets and therefore maximize profits. The quotas themselves were based on the total reserves that a specific member country had in relation to whole — in other words, the size of the slice of the overall OPEC pie.

By linking economic incentives to production volumes (quotas), the temptation for OPEC members to inflate their stated oil reserves (and hence be able to pump more liquid gold) was just too great to ignore. And cheat they did.

But that was then. In 1986, OPEC had spare capacity of more than 15 million barrels a day of production. So what if a member country or two produced a little too much crude? Today, the chickens are coming home to roost. For starters, a lot of the easy oil has been found. What's left is the heavier, thicker and less valuable oil. But that's not all. China and India have burst on the scene as major consumers of oil claiming the number two and number six slots respectively in terms of global crude oil consumption.

So what's this have to do with Big Oil? Plenty. Big Oil are those large behemoth oil companies such as Exxon Mobil, Shell and BP who explore the globe for the world's oil fix. During the 1980's and 1990's, Big Oil signed production-sharing agreements with plenty of unsavory characters to explore and produce oil in far-flung regions of the world. Back then, with oil at $10 dollars or less a barrel, the prospect of $100 oil seemed ludicrous. At that time, dictators and despots were eager to get the jobs and capital that Big Oil could bring to a region. They were willing to do just about anything to attract Big Oil.

So, lots of agreements to explore and produce oil were signed in Russia, Venezuela, Nigeria and elsewhere with Big Oil getting pretty much what it wanted. Of course, something was given up which was a greatly increased share of the production if oil prices were to reach "ludicrous levels" such as $40/barrel. But that was then.

That was also before these despots and dictators realized what a bad deal they had signed earlier. They needed the capital, jobs and know-how. With oil prices screaming, this band of thugs no longer seemed to need the Big Oil companies.

In Russia, Putin the ex-head of the KGB, decides to toss Mikhail Khodorkovsky (world's 4 th richest man) in jail and take control of his company (Yukos). Not soon after, control of his company was transferred to another ex KGB agent who later ran it, took it public (IPO) and the new company (TKN) was doing business with BP. In no time, oil had rallied to $50 a barrel and while some 33 percent of BP's revenues were coming from this joint venture, Putin decides to rewrite the deal, taking away the oil leases and transferring them to other companies.

In Venezuela, Ecuador, Bolivia and Nigeria the situation is much the same. To find more oil, Big Oil has had to go further and further away. The search for oil had led these oil companies into regions of the world where the rule of law just doesn't exist. Already, Venezuela's Hugo Chavez is talking about turning off the oil tap to the U.S. With 65% of the country's oil exports destined for the U.S., this is a big deal.

The newly-elected government of Ecuador looted Occidental's oil production and the Government of Bolivia looted the nation's gas reserves from Petrobras and Total. Meanwhile, trouble has been brewing for some time now in Nigeria as local rebels continue to harass Shell and Exxon Mobil and their large offshore operations.

The problem for Big Oil is increasingly a problem of political risk. The reserves that they state on their balance sheets are not risked for where they reside. If a government can so easily nationalize or expropriate the oil reserves of a large oil company, is a barrel of oil in the ground in Russia really the same as a barrel of oil in Texas?

Not only that, but if the price of crude oil stays elevated, then the proportion of oil that the Big Oil companies are likely to get from these far-flung regions drops because even if the leases aren't expropriated, the existing production sharing agreements call for a declining production profile for Big Oil when the commodity price rises. Another way of saying this is that they may be able to book reserves (assets) of 50 billion barrels if oil is $25 a barrel or less but at $60 a barrel their reserves could drop to 30 billion barrels or less.

Perhaps this can explain the behavior of Big Oil executives who like to tell us all "don't worry, be happy." Maybe if you tell enough people, for long enough that there is lots of oil left in the world and that the "true" price is $25/barrel, then they will actually start to believe you. It might be one smart way to keep the SEC (The Securities and Exchange Commission) from looking carefully at your accounting. No need to restate your reserves if the world things the price of crude is going to drop anyway.

So is Exxon Mobil (XOM - NYSE) really worth what it is worth? If part of the value of the company like Exxon is the value of its inventory, or oil reserves, what happens to the overall value of the company if those reserves were restated to show the effects of declining production profiles (shorter RLI) and political risk. Perhaps Exxon Mobil wouldn't have a reserve life index (Proven reserves divided by current annual production) of 17 years. What if it had only nine years of production left? Would investors really see this as the second most valuable company in the world?

Probably not! That's why investors and oil companies have been flocking to the oil sands of Alberta, Canada. While the cost of production may be high, the risks of expropriation are almost non-existent.

Investors looking to profit in what will likely be another leg upward in oil prices should consider investing in companies that explore and produce for oil in politically secure parts of the world.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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