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Business Week: Open Season On Big Oil: An angry public wants quick relief from high prices. Here's why none is in sight: “Even promising projects are becoming harder to pull off -- a reality underlined this summer when Royal Dutch/Shell estimated that its Sakhalin II gas project in Russia would wind up costing $20 billion, double earlier forecasts.”: Monday 19 Sept 2005

 

John Browne, the chief executive of BP PLC (BP), the largest producer of oil and gas in the U.S., is already spending $14.5 billion this year on exploration and production and other capital projects, and he would like to do even more. "Could we expand our investment upstream?" he says in an interview in his office overlooking London's St. James's Square. "The answer is we have plenty of opportunities to do that. But we can't find the rigs, the service contracting, all the things we need to get it done."

 

For instance, Browne wants to rapidly expand BP's Rocky Mountain gas project in Wamsutter, Wyo. But BP can't find enough drilling rigs for hire, so it's having new ones built. That, however, will take about a year. Browne and other top oil executives are in an awkward position: They're feeling beleaguered even as they head toward record profits this year -- some $118 billion for the 10 of the largest companies, according to A.G. Edwards & Sons Inc. (AGE ). Even while the companies' costs are soaring as they scramble to secure more oil and gas, politicians from Senator Hillary Clinton (D-N.Y.) to French Finance Minister Thierry Breton are taking aim at them in response to consumers' growing fury over skyrocketing prices at the pump. France's Breton threatened a windfall-profit tax if oil companies don't immediately cut prices of refined products whenever the price of crude goes down. In Washington, pols -- mostly Democrats no longer in power -- are proposing excess-profit taxes and higher subsidies for renewable fuels. House Democratic Leader Nancy Pelosi also wants to give the Federal Trade Commission authority to prosecute oil companies for price gouging. "The fact that oil companies are enjoying record profits when consumers are paying record high prices does not sit well with people," says Tyson Slocum, research director of the pro-consumer group Public Citizen.

 

What can Big Oil do to defuse the anger? The best possible course of action is to pump more oil, refine more gasoline, and bring prices down to levels that won't spook investors and markets. But the best solution is not the likeliest: There's no way the oil majors can flood the markets, for the simple reason that it takes years to find the oil, build the refineries, and construct the pipelines that will turn a shortage into a surplus. The spending is now surging. But no quick relief is in sight, as new players like China drive up demand and a dearth of refineries globally sends gasoline prices skyrocketing.

 

How did this happen? A mix of missteps -- and a series of events beyond even the control of the oil giants. In some respects the oil companies have made their own bed. In the late 1990s, as prices sank to a low of close to $10 per barrel, they played to Wall Street, slashing veteran exploration and production staffers and gobbling each other up through acquisitions, often instead of drilling for new oil.

 

All this has led to a lean industry that has delivered strong financial results, but roller-coaster pricing for consumers. It is the penny-pinching of the past that has led to a shrunken drilling and refinery sector. Skilled workers are no longer around to make the steel that goes into building new rigs, man them, and more.

 

"The industry has not been an attractive place for people to work," says Browne. With demand surging, this dearth of equipment and talent has led to a doubling of day rates for drilling rigs in the past 18 months -- to $200,000 for sizable offshore rigs and as much as $400,000 for jumbos. Managing the industry for quarterly results has been less than ideal for an oil-thirsty world.

 

Meanwhile, the majors failed to anticipate the surge in global demand that has overtaken the industry. For much of the recent past, demand grew only 1.5% a year -- until 2004, when it jumped almost 4%. Even early last year demand forecasts from energy watchers were pessimistic. With predictions way off, the industry didn't prepare for the explosion in consumption. "The reason why these problems are hitting us now is that we have exhausted the spare capacity that kept us going for 20 years," says Jeffrey R. Currie, a Goldman, Sachs & Co. (GS ) analyst in London. "We need to tap new capital for greenfield projects in more hostile political and geological environments."

 

Executives need to make multibillion investment decisions without knowing whether oil prices are going to keep rising or plunge to the $20 range that prevailed through the 1990s and inched up gradually until 2004. Now companies are slowly increasing their pricing assumptions. Browne says BP figures prices will remain around $40 per barrel for the next five years. But the industry's leaders, who rose up the ranks in the relatively lean times of the '90s, are still being conservative -- some think obstinately so. No oil executive will cut a deal for five years out assuming that today's spot price of $65 will prevail.

 

A SAUDI GLUT?

 

Despite the risks, oil companies have boosted exploration substantially. Norwalk (Conn.)-based consultants John S. Herold Inc. report that 200 oil companies have roughly doubled exploration spending to a combined $180 billion for this year. "They're certainly spending a lot more. Whether or not they are spending enough, that's up for some debate," says research director Nicholas Cacchione.

 

But while they explore more for oil, the oil is harder to find. Companies are being forced to replace their depleted sources of oil and gas in the West with new supplies in politically and geologically more challenging areas, from Russia to the deep water off West Africa. "The companies are making more money, but they have more risks," says J. Robinson West, chairman of Washington-based consultants PFC Energy.

 

Adding to the tension, the rate at which reserves are replaced is falling, and the production of four of the top five companies -- ExxonMobil (XOM ), Total (TOT ), Chevron (CVX ), and Royal Dutch/Shell Group (RD ) -- declined in the first half of 2005 vs. a year earlier, according to PFC Energy. The major oil companies have lost clout to host governments such as Saudi Arabia and Iran and their national oil companies, which now control 78% of global reserves.

 

Another uncertainty is the size of reserves in Persian Gulf countries such as Saudi Arabia. While much has been made about the prospect of the Saudis running out of oil, Currie says the more nightmarish scenario for the oil industry is that the Saudis, who have hired some 70 international drilling rigs for a 2.5 million barrel-per-day expansion -- a boost the size of a key producer like Kuwait -- will turn out to have plenty of crude, eventually driving prices down.

 

Even promising projects are becoming harder to pull off -- a reality underlined this summer when Royal Dutch/Shell estimated that its Sakhalin II gas project in Russia would wind up costing $20 billion, double earlier forecasts. "The projects are in a variety of political environments," says Peter J. Robertson, vice-chairman of Chevron. "And they are technically more complex."

 

As a result, companies aren't getting as big a return on the money they do spend. The cost of finding new reserves has soared from $4.94 a barrel in 2000 to $8.61 today as prices for everything from rigs to steel pipe have jumped. For each dollar of price above $25 a barrel, Russia now takes 89 cents in taxes, up from 68 cents per dollar per barrel in 2003. Companies say these levies deter costly, risky investments.

 

BIG PLANS IN TEXAS

 

For similar reasons, oil companies are also leery of investing in refining. No new refineries have been built in the U.S. since 1976, because of a combination of regulatory hurdles and local opposition. And the majors still see refining as a poor business, although profits on refining are now very lucrative at $20 per barrel, vs. under $5 per barrel as recently as the fourth quarter of 2004. That's why Arizona Clean Fuels, a startup that is looking to build a new $3 billion refinery in remote Yuma, Ariz., still hasn't lined up financing after 10 years of making plans and seeking permits. "The fundamental problem has always been economics," says CEO Glenn McGinnis.

 

That may be starting to change. Motiva Enterprises LLC, a joint venture between Royal Dutch Shell Group and Saudi Aramco, Saudi Arabia's state-owned oil company, is considering long-term capacity additions at its three Gulf Coast refineries, according to spokesperson Stan Mays. This development could be huge, says Edward Murphy, group director for refining and marketing at the American Petroleum Institute, an industry trade group. "I think we're past the point of asking 'What do we need to do to see more expansion?' The incentives are there right now."

 

That's encouraging. But such projects take years to come to fruition -- one reason the current tight situation in the markets is likely to be with us for some time, and why frustration and anger with Big Oil will be a constant theme in politics around the world.

 

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