Dec. 1, 2000
In a 100% supplier-consumer contract world, there are few economic cycles and low price excursions.

The e-energy race

In a 100% supplier-consumer contract world, there are few economic cycles and low price excursions. In the opposite spot price world, producers hedge product prices to survive during low-demand, low-price periods with minimal impact.

Alas - the oil and gas industry is doomed to operate somewhere between the two, producing strong margins during peak price periods and scrambling to prevent a collapse during trough price periods. But, there is a third world - long-term property/prospect portfolio optimization - that could provide insulation from damaging price excursions.

The traditional high-grading of drilling and development prospects to balance risks is only the first step in portfolio optimization; meeting long-term growth targets while coping with short-term volatility is the much tougher second phase. Without the latter, producers have little choice but to resort to unseemly cost vigilance and low-ball oil price thresholds for development projects. Because the number of variables in this sort of optimization are so numerous and the relationships so complex, software has great difficulty producing reliable outcomes from present working models.

Having recognized the deficit, a small number of entrepreneurial groups and software consultants are working to create the needed modeling tools. Addressed in these complex packages are such disparate factors as capitalization of technology and intellectual resources, benchmarking internal and external efficiencies, and hedging market and time-sensitive variables over long periods. The software's ultimate goal is to raise internal rates of return to steady 15-20% levels, from the current 6-9% results.

A financial ally

Current US and UK administrative leaders are inclined to point fingers at business for domestic economic problems. First, it was the US administration blaming petroleum producers for price gouging, overlooking the fact that private producers have only 20% of the global oil market. Then, it was the UK's Prime Minister raising the specter of a windfall profits tax to discipline an uncooperative petroleum industry. He earlier threatened to jail truckers and other fuel consumers for protesting outrageously high taxes on fuels.

Energy supply is a complex business, and both administrations are treating it as an easily manipulated entity. Fortunately, this sort of scapegoating is beginning to fall flat, as it should have when first voiced by an ill-advised former US President 20 years ago.

Commodity brokers and equity analysts are pointing fingers just where the blame belongs: (1) Lack of access to new offshore areas in the US and maturing plays offshore the UK; (2) Restrictions on refining that have diminished refinery capacity in the US and Europe; (3) Limited shipping capacity; (4) Very high shipping costs in the face of growing demand.

Wall Street investors have carefully pointed out that these "gouging" oil producers, as a group, have average margins and equity growth far below most other industries. But these growth failures are less a criticism of petroleum business management than a result of an industry constrained from revitalizing itself.

To begin with, commodity price cycles prevented oil producers from generating enough funds to drill or buy reserves to replace production for long periods. So, many producers went to the market with commercial paper or equity offerings. Next, facing relatively high capital costs because of low equity performance, they earnestly began efforts to restructure.

First, there was disgorging of non-core businesses, then various cost-cutting remedies, then personnel cutbacks, and then mergers and acquisitions. Finally, desperate majors collapsed E&P spending. This last measure worked, aided by rising oil demand and a suddenly capacity-constrained OPEC.

Will the political sniping on the industry continue? Probably, because politicians aren't often asked to back up accusations. Now, however, the petroleum industry has an ally in its defense - the financial community, which also must rely on facts, science, and logic to guide decision-making.

CORRECTION: The October lead story in Offshore contained a list mistakenly reported as US Gulf of Mexico deepwater discoveries. Inadvertently included in the list were seismically defined (and named) prospects that had not been drilled and tested by press time. Offshore apologizes for the error and cautions readers to use the list as a prospect list only. A corrected list and evaluation will be published shortly.