Emerging Dominance of Sovereign Oil Producers Presents Challenges To The West

It requires more than an understanding of geology and the mathematical models of M. King Hubbert to fully appreciate the complex situation that has led to the approaching inability of the world's oil producers to adequately meet the growing demand for crude oil. Significant political and economic considerations have also played an important role in getting us to this point, and these factors might actually turn out to be more important than the fundamental geological constraints will be in determining the future price of oil, the health of the world's economies and which conflicts (political, economic and military) arise in the coming decade.

Several decades ago, the vast majority of the world's oil production was performed by commercial oil companies under negotiated "concessions" that were granted by the sovereign government of the country in which the oil reserves are located. The concession for oil exploration and production in Saudi Arabia, for example, was granted to Standard Oil of California (later Chevron) by King Abd al-'Aziz in the 1930s, and was later shared by Texaco, Exxon and Mobil operating together under the name Aramco. During that period of time, the important decisions as to infrastructure investment, production and capacity were made by the oil companies, not the Saudis. Similar arrangements existed during that time in other major oil producing countries such as Iran, Iraq and Venezuela. Since nearly all of the commercial oil companies were either American or European, this effectively gave control of capacity and production decisions to the Western industrialized countries that were the main importers of crude oil.

The picture changed considerably in the mid-1970s, when several major oil exporting nations, including Saudi Arabia and Iran, "nationalized" their oil industries by revoking the concessions that were previously held by commercial oil companies and assumed control of the oil-producing infrastructure. The right to produce oil in those countries was henceforth limited to "national" or "sovereign" oil companies that are controlled by the sovereign government of the country. Saudi Aramco might have retained its name, but it now answers to Saudi Arabia's ruling family instead of Wall Street and corporate America. The countries that nationalized their oil industries in the 1970s also formed the core of OPEC, a cartel created for the purpose of maintaining the price of oil at well above its cost of extraction by limiting supply.

With the development of the North Sea and Alaskan North Slope oil fields, the threat of market share loss prevented OPEC from effectively exercising pricing control for a period of time from the early 1980s to the late 1990s. By the turn of the century, however, oil production from those fields and in other non-OPEC oil-producing regions had peaked and was beginning to decline, leaving an increasing proportion of the world's oil production and proven oil reserves under the control of OPEC and its collection of sovereign oil producers. At this time, over 80% of the world's proven oil reserves are under the control of national oil companies. In terms of daily production, the four largest producers in the world are the national oil companies of Saudi Arabia, Iran, Mexico and Venezuela, with Exxon Mobil in fifth place.  For reasons that I will address to presently, the implications of this are significant.

Commercial oil companies such as Exxon Mobil, British Petroleum, Royal Dutch Shell and ChevronTexaco together make up a significant part of the total stock market capitalization in the industrialized West. In an economic system that requires growth, they are already handicapped to some extent because reserve depletion is something that is inherent to their industry. In order for an oil company to remain viable, it must continuously replace reserves that are depleted by production. This is difficult in an environment where there are few remaining oil reserves to be located. The last significant discovery of major oil fields was over 30 years ago. In recent years, the world has been averaging four barrels of production for every barrel of new proved reserves that have been located and confirmed. To make matters worse for the commercial oil companies, most of the recent discoveries that have been made in recent years are located within countries that have nationalized their oil industries. The major oil companies are essentially fighting for table scraps (look closely at their share of the world's proved reserves in the pie chart provided above), and their future prospects for growth are dim unless they find a way to "become involved" in countries such as Saudi Arabia, Iran, Iraq, and Venezuela, courtesy of the US military or otherwise.  Consulting firm Accenture seems to have figured this out; its recent recommendations to clients in the oil industry urges increased involvement with national oil companies:

However by the next decade, we will be in a very different oil world, where the focus will have shifted more toward the Middle East. Excellence in technology and portfolio management will not be enough. Indeed without access to reserves, they will be useless. Balancing these short term goals, with a longer term vision around relationship building and new ways of working with national oil companies (probably using technology and management skills as the communicator) will be the primary way Western oil companies can manage their upstream objectives most effectively to 2010 and beyond.

There are however far bigger questions at stake than the financial health of the major commercial oil companies. National oil companies tend to make decisions for different reasons and with different results than commercial oil companies, and an understanding of those differences is essential in understanding how the Peak Oil situation is going to unravel in the coming decade.

For example, national oil companies are generally less "vertically integrated" than their commercial counterparts, i.e. they tend to focus strictly on the production of oil, rather than by adding value downstream such as by refining, chemical manufacturing or reselling petroleum products. On the other hand, large commercial oil companies such as Exxon Mobil, British Petroleum, Royal Dutch Shell and ChevronTexaco make much of their profits by operating refineries and chemical plants, through the wholesaling and retailing of refined products, and even in the consumer credit market. Because of their downstream operations, the large commercial oil companies can often make substantial profits even when the market price of crude oil is relatively low. Their profits do tend to rise somewhat along with the price of oil, but their strategies for increasing profits and shareholder value tend to be based more upon maximizing the volume of oil that they produce, refine and sell than than it does the price of crude oil.

A national oil company on the other hand will achieve its ideal optimization of profit and resource conservation by keeping the price of crude oil as high as possible. A national oil company and the government that controls it knows that it is going to profit only from the resources that are located within its own territory; it will not be able to move on to other countries and exploit new oil finds after its own resources are depleted like commercial oil companies are used to doing. It will maximize the total amount of profit that will be obtained from its oil reserves only by maximizing the price at which oil is sold, and it would like its resources to last for as long as possible. 

For similar reasons, commercial oil companies tend to produce a given oil-bearing resource at a greater extraction rate than would a national oil company.  This allows greater initial oil production (and higher profits) but ultimately results in a more rapid depletion of the resource. The inverse of the rate at which an oil field or oil province is being depleted by production is known as the Reserve to Production Ratio or R/P. The North Sea Brent oilfield, for example, has been produced at a rate that has caused 9.6% annual depletion or a R/P Ratio of about 10. This chart depicts the R/P Ratio for the world's major oil-producing countries; a high number may be indicative of a more conservative approach to resource extraction (although it is also a function of the sheer size of the proved reserves of some of the more well-endowed countries).  It is clear from the chart that Western countries such as the U.S., the U.K. and Norway are literally siphoning from the bottom of their respective barrels at their present extraction rates.  It could also be inferred that production in countries such as Saudi Arabia, Iran, Iraq, Kuwait, the United Arab Emirates and Venezuela might be significantly higher if commercial rather than sovereign oil companies were in control of production in those countries.

The present difference in expectations between the United States and Saudi Arabia regarding the degree to which Saudi Arabia can increase production by the year 2025 is a good example of the differing attitudes between national oil companies, commercial oil companies and major oil consumers like the United States. The United States EIA projects Saudi production to reach 22.5 Mb/d by the year 2025, while the Saudis have tentatively offered to increase production to about 12.5 Mb/d by 2009 and have allowed that it might be possible to raise production to about 15 Mb/d (although they are not guaranteeing it). Abdallah S. Jum'ah, the President and Chief Executive Officer of Saudi Aramco made it clear in an April 2004 speech that his company believed that oil fields are best shepherded by limiting the depletion or extraction rate:

Our third principle, which again sets us apart from common industry practice, is gradual depletion. As I noted earlier, we produce our reservoirs at much lower depletion rates than most other producers.

Commentators such as energy investment banker Matthew Simmons have hypothesized that undue pressure from the United States is leading Saudi Arabia to overproduce its oil fields, which could possibly damage them.

Clearly it is an emerging cornerstone of US policy to urge major oil exporting nations such as Saudi Arabia, Russia and Venezuela to invest heavily in oil production infrastructure and to produce as much oil as possible as soon as possible. As part of this policy, and in an effort to secure new sources for the reserve-starved U.S. oil companies, I would not be surprised if the United States starts to place heavy pressure on these countries (perhaps even by means of "regime change," except in the case of nuclear-armed Russia) to privatize their national oil companies, or at the very least to permit commercial oil companies to set up production operations. Given the recent published rumor that the Saudis have wired their own oil production facilities with explosives, the United States might already be placing even more pressure on the Saudi regime than has been publicly reported. The U.S. "war on terror" may in the end be nothing more than a cipher for the use of the U.S. military against recalcitrant oil producing countries.

One hallmark of commercial oil companies is that they tend to make decisions as to capacity, production and business relationships based on the goal of maximizing shareholder value. In contrast, decision-making in national oil companies is often driven by political considerations. This is significant, because most of the world's remaining oil reserves are located in regions that are generally unfriendly to the United States and that also have nationalized oil industries that are under the political control of the state. Venezuelan leader Hugo Chavez has already threatened to stop oil shipments to the United States for political reasons that are unrelated to economics. The theocratic Iranian regime would almost certainly be willing to do the same in the event that relations with the United States continue to worsen. Even Saudi Arabia has attempted to use its oil leverage with the United States to help secure a fair peace agreement for Palestine. Although Russia has not nationalized its oil industry, the recent seizure of the Yukos oil company by the Russian government is strong evidence that it intends to exert a strong measure of sovereign control. Political considerations will therefore most likely play an important role in determining Russian oil policy as well.

In the event that global oil supply continues to fall relative to demand, it is possible that political alliances may increasingly replace the free market in determining how the available supply of crude oil will be allocated among oil importing countries. I think it is quite likely that such considerations were an important reason that the United States effected the recent "regime change" in Iraq. It is likely that this factor will loom important in its future plans for countries such as Iran and Venezuela as well. Iran has adapted to U.S. economic sanctions by developing relationships with other oil importing countries such as Japan and China. Venezuela has been warming to China as well.  Iraq had close ties to France and Russia.  The U.S. would certainly prefer to have governments in place in those countries that are more open to relationships with the United States.

Being locally controlled and answerable to the concerns of the local elite, national oil companies also tend to be more sensitive than commercial oil companies to environmental concerns and other "social costs" of oil production, such as working conditions and the economic effects that are wrought on the community by oil exploration and production. Ignoring for the time being the morality of such considerations, satisfying such concerns is an added expense that directly adds to the cost of oil production and inflates the price of oil.

Commercial oil companies are much more likely than national oil companies to participate in the commodity futures and derivatives markets, which helps both producers and consumers manage future risk. As more and more production becomes concentrated in countries that have nationalized their oil industries, pricing volatility may increase as well, and the ability of consumers to hedge against price increases may be diminished.

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