The Politics and Economics of International Energy (Spring 2009- E657)

1. The Politics and Economics of International Energy (Spring 2009- E657) Lecture 5 The Oil Companies: National and International Prof. Giacomo Luciani

2. What are Oil Companies? • Companies are the main protagonists in the international oil and gas industry • Companies are living organisms that take time to develop and grow, acquire a specific know-how and develop their own culture • Companies are different – main cleavage between IOCs and NOCs, but certainly not the only important distinction

3. The Oil Industry • The system of companies constitutes the organisation of the industry • Key issues: vertical integration and horizontal concentration • The industry has gone through several waves of integration/dis-integration, and concentration/fragmentation

4. Vertical integration • Vertical integration is a consequence of the presence of a “strategic segment” • If markets do not work properly companies controlling the strategic segment have an opportunity and incentive to integrate upstream/downstream in the value chain • Doubts about the benefits of vertical integration

5. Horizontal concentration • Historically, oil and gas have been abundant, conditions for “excessive” competition have existed • Large up front investment encourages high capacity utilisation even in negative market conditions • Periodic waves of financial difficulty lead to disappearance of companies through mergers and acquisitions

6. Beginnings in the USA • Law of capture: low barriers to entry. • Booms and busts: the rigidity of oil supply and demand in the short term • Rockefeller and the strategic importance of pipelines and refining • The Standard Oil Trust • Spindletop and the Texas Railroad Commission

7. Outside the USA • More limited demand, competition from town gas • Developments in Russia and the Far East • Initial developments in the Ottoman Empire • Initial interest in Persia

8. The coming of Gulf Oil • D’arcy and Churchill: the birth of Anglo-Persian as a political object • The negotiations for IPC • The Red Line Agreement • The Great Depression and the Achnacarry agreement • Result: slow down the development of Gulf oil

9. Further Developments in the Gulf • Kuwait and British-American relations • Bahrain and Saudi Arabia: the US and the formation of ARAMCO • The golden age of the Seven Sisters • The Iranian crisis and the formation of the Iranian consortium • Newcomers: Libya, independents, NOCs

10. Equity participation in the main producing companies before 1972

11. Companies change names Anglo-Persian Anglo-Iranian British Petroleum BP

12. Middle East Oil is Under-exploited • This has been the case from the beginning, and a cause of considerable conflict • The international oil industry has consistently had to deal with the threat of oversupply and price collapse • Reserve additions do not come in small increments and supply is rigid in the short term

13. Oil Companies Control • Vertical integration • Joint Production companies based on agreements aiming at maintaining production under control • Contract typology: concession • Very large concession territory • Blatant asymmetry of information

14. Vertical integration - up to 1970’s • Companies were present in all stages: • exploration • production • shipping • refining • retail distribution • Balanced presence in all stages was key to profitability • An oil market existed, but was neither transparent nor efficient

16. Conflict and evolution • Tax assessment • Relinquishment • Posted price • Nationalization • Smaller concessions and multiple operators • OPEC

17. OPEC - a cartel by chance • OPEC was created in 1960, but had little impact for a decade or more because of conflict over production targets. • In 1969-73 some countries lost interest in increasing production and imposed unilateral limitations. • Prices exploded.

18. Nationalisations • Early nationalisations: Russia and Mexico • Mossadegh nationalises APOC • Qaddafi nationalises BP, Hunt • Kuwait, Algeria, Qatar, Iraq: 100% nationalisations • Abu Dhabi, Libya: IOCs remain • Saudi Arabia: negotiated takeover

19. Historical Production of 4 Main Gulf Producers

20. Evolution of contractual relations • Concession: • Company pays royalty and taxes but is in full control of production and marketing • Production sharing agreement: • IOC carries all investment costs; if a commercial find is declared, production is divided: “cost oil” to IOC, “profit oil” shared bet. IOC and NOC • Service contract: • IOC develops field and gets a fee • Iranian contracts: • IOC develops field then transfers “operatorship” and gets predetermined volumes of oil

21. Concession vs PSA • A concession is more likely to lead to conflict because of issues of tax assessment or management of production. • A PSA is more easily enforceable but it is very difficult to write a PSA that will be “fair” at any level of oil price. • Both can be combined with NOC participation

22. The PSA is versatile • A PSA is a very versatile contract – it can mean anything, depending on the numbers. • Key issues are: • How much of early production will be considered as cost oil? • What is the split of profit oil? Is it a function of volumes produced and/or oil price?

23. Access to World Proven Oil Reserves end-2005 Source: IEA

24. Fiscal tightening • Production sharing contracts which used to be based on simple sliding scales of production at varying thresholds have now in the main been superseded by rate of return based contracts. Such contracts are awarded to the company which offers the lowest rate of return on the concession. • This has the merit of effectively capping the reward to the IOC when oil prices are very high and maximising the rent to the host government. The extent to which IOCs are prepared to push down rates of return was highlighted in the recent bidding round in Libya where many companies bid a percentage rate of return of just 7 per cent on a number of blocks, very close to their weighted average cost of capital. • Therefore, even in the event of exploration success, it is very unlikely that these companies will add shareholder value from the concessions they were awarded.

25. Following 1973… • Following 1973, the International Oil Industry was forcibly dis-integrated: the 7/8 sisters lost most of their reserves. • Some disappeared fast; other attempted to recreate a vertical equilibrium by divesting downstream and looking for new reserves. • Hence came the investment boom in non-Opec countries – but not all were “open”.

26. Consequences of disintegration • Notwithstanding moves to recreate vertical integration, the industry continues to be disintegrated. • NOCs have divergent attitudes towards downstream integration (PDVSA and KOC vs. Aramco) • The IOCs concentrate their investment in the upstream. • A lot of crude is exchanged at arm’s length

27. Oil Market Development • Disintegration encouraged oil market development – and vice versa • Oil market development changed the concept of security and eroded the rationale for NOCs of the importing countries • Privatisation, profit maximisation, shareholders value

28. Pressure from financial analysts • The financial market has become increasingly demanding • Companies have made imprudent promises • The M&A logic • The opportunistic behavior of shareholders and managers – preference for the short term

29. Recent Mergers • BP acquired Sohio, Amoco, Arco, Castrol, Veba Oil, TNK • Exxon acquired Mobil • Chevron acquired Gulf, Texaco, Unocal • Total acquired Elf and Fina • Phillips acquired Tosco, merged with Conoco • Shell acquired Enterprise • Eni acquired Lasmo • Repsol acquired YPF

30. Degree of Established International Portfolio

31. Vertical Integration in Doubt • The development of crude and other markets raises doubts on the benefits of vertical integration • Companies have tended to get out of less profitable/more volatile segments: transport, refining, petrochemicals • Investment has been heavily concentrated on the upstream

32. Capital Rotation 1990 to 2001

33. Persistence of vertical integration • Nevertheless vertical integration has persisted • Pure upstream companies have not fared very well • Independent refiners have also succumbed • Pure retailers are rare • Service companies have multiplied

34. BP - a case study • BP is the company that has found the most oil • It has also suffered most from nationalisations: Iran, Nigeria, Libya, Kuwait… • Discovered Prudhoe Bay in 1968 • Discovered Forties in 1970 • …just in time to compensate for nationalisations…

35. BP and Sohio • BP initially acquired a minority interest in Sohio when it decided to associate the latter to the development of Prudhoe Bay • Eventually, BP’s interest grew to be a majority in the company • Bought out the minority interest in 1987 • Enter KIO

36. Privatisation problems • The British government sold its 31.5% remaining participation in BP in October 1987 • The sale was a flop because of negative stock market conditions – KIO bought • The MMC found that KIO’s holding could operate against the public interest; a cap of 9.9% was imposed on KIO’s holding • BP bought back KIO’s excess shares incurring in a major financial burden.

39. BP Amoco

41. 2002 production mboed 1600 1200 800 400 0 TNK Lukoil Yukos Sibneft Tatneft Sidanco NewCo Surgutneftegaz Russian industry position

45. BP and TNK-BP Plan Strategic Alliance with Gazprom as TNK-BP Sells its Stake in Kovykta Gas Field • Under the terms of the agreement signed by all parties, TNK-BP agreed to sell Gazprom its 62.89 per cent stake in Rusia Petroleum, the company which holds the licence for the Kovykta gas field in East Siberia. It will also sell its 50 per cent interest in East Siberian Gas Company (ESGCo), the company constructing the regional gasification project. • TNK-BP said a longer-term 'call' option for TNK-BP to buy a 25 per cent plus one share stake in Kovykta at an independently verified market price, had also been agreed with Gazprom. This option could be exercised once a significant joint investment or asset swap has been agreed under the terms of today's memorandum of understanding. (June 22, 2007)

47. The new protagonists • The companies of the producing countries – mostly state owned, some privately owned – are the new protagonists of the international oil industry. • How many will evolve into major international oil companies?

48. The ambiguous IOC/NOC relations • IOCs and NOCs are rivals • However, they also live in a symbiotic equilibrium • Can this dichotomy be progressively overcome? • What forms of partnership?

49. The merits of going with IOCs