Changing Oil Industry Dynamics

Today's Wall Street Journal carried an article in the 'breakingviews' column about ExxonMobil's inability to replace its oil reserves at historically high rates. According to the piece, the replacement rate, per Exxon's calculation, was 101% in 2007. Its 5-year average rate of replacement has allegedly fallen, according to Oppenheimer, from 121% to 112%.


The source of this trend, of course, has been the recent, increasing nationalization of oil reserve ownership and control. Where non-state-owned oil companies such as Exxon, Chevron, BP, and others used to bid on and purchase the right to develop and own oil from fields, in exchange for royalties paid to the country in which the oil resided, China, India and Russia have begun to effectively remove their oil reserves from the world's markets.


With each passing year, it seems that the amount of tradeable, shippable oil is becoming a smaller proportion of the oil pumped globally.


What does this portend for ExxonMobil, Rex Tillerson, and the private, non-state, publicly-held oil companies?


I thought about this while running errands this morning, and came to some tentative conclusions. After discussing them with my business partner over a working lunch, I feel they have been sustained.


Here's what I think the near-term and long-term reprecussions of the nationalized oil policies may be.


First, recall the 1974 Arab oil embargo. By withholding supply from the market, the near term effect was to hamper and, in some cases, cripple American automotive energy usage. But the longer term result was the halving of the amount of oil required to produce a dollar of US GDP two decades hence. Parenthetically, the price of oil eventually fell, too, to just $30/bbl only a few years ago.


As I wrote here a few months ago, Julian Simon noted years ago that the constant-dollar price of most commodities remains fairly stable over time, due to the process by which a rise in price causes new supplies to appear. Or substitutes to be developed, causing demand for the commodity to ebb, and, again, prices to fall.

Back to the present, what would the probably results be, near- and longer-term?

First, I think that oil firms such as ExxonMobil will have a tough time in the near-term. As I wrote here, in December of last year, if you need a commodity that you don't own, and the owners of the bulk of the commodity use it for their own purposes, you have a problem. I wrote,

"As I told my daughter, I think cars of the future will use other fuel sources than petroleum, because of the long term consequences of the world's major oil supplier electing to consume its own commodity for rather uneconomic purposes.

And, by the way, when the Saudis burn oil to make electricity, they are doing the equivalent of a Dutch tulip 'investor' buying a bulb in order to destroy it, and make his own worth that much more. The more oil the Saudis foolishly waste, the more valuable their remaining below-ground reserves.

In a world like this, American innovators have historically stepped in with creative solutions. In fact, this situation is virtually identical to our invention of synthetic rubber (the Buna process) before WWII, when the Japanese seized the Southeast Asian natural rubber plantations.

More than any other single driver of a change in how we fuel US autos, trains, planes and ships, this looming demand increase by the Saudis for their own commodity will, I think, cause a radical change in fuel technologies in this country over the next twenty years.

Rather than governmental standards, I told my daughter, you can usually count on some creative, hungry American inventor to develop a technological solution to the problem of ever more scarce and expensive gasoline to power our cars.

Imagine, a decade from now, Dupont, GM and ExxonMobil collaborating to power, build and fuel new technology cars. Or perhaps not Dupont, but some venture-capital funded new fuel technology startup. With the assurance of the production of the fuel, GM will build vehicles using it, and ExxonMobil will use its existing fuel distribution system, if relevant, to provide the new fuel's ubiquitous availability."

The larger global impact would almost certainly be similar, as in 1974. When oil becomes less available because China, India and Russia effectively bought nationalized reserves at implied high prices- north of $70/bbl- you might expect global oil markets to begin to disappear. Alternatives would be sought.

For example, in the US, if automotive energy needs were able to be supplied by improved batteries, then our former need for petroleum-refined gasoline for vehicles could be transitioned to coal-based electrical power to (re)charge those batteries.

In time, it's even possible that world production of various downstream products using non-petroleum energy sources could undercut the more costly products made using high-priced petroleum.

In the longer term, I think it's quite possible that the value of the petroleum reserves bought at such high prices by countries such as China and India would become a burden. Demand for the scarce commodity would fall, as alternative fuel sources were developed and commercialized. Eventually, the oil-owning nations might want to return to some market-oriented system, only to find that the new clearing price for their commodity was much lower than that at which they took the supplies private.

In effect, if a substantial proportion of world oil supplies are removed from the market, for internal consumption, the remainder of the world will have no choice to, where possible, behave similarly, and, then, where there are shortfalls, develop alternative energy sources.

Over time, then, total demand for the energy commodity would fall, and its implied price would, as well. Any country having built inventories of oil at high prices would have to absorb the loss in some fashion, if only in the national balance sheet value of oil reserves.

Like any other commodity supply disruption, that of oil may cause pain for industry players and consumers in the short term. ExxonMobil may become more of a refiner and distributor of what petroleum products are available to it for the foreseeable future. However, where market forces are allowed to function, substitutes will arise, demand for oil will wane, and it's effective market price will eventually fall.

I think Julian Simon's theory would still obtain in this scenario. Whether the ExxonMobils of the world could hold out that long is another matter.