An Olympic Business Model for Oil - July 16, 2012
Business model for the oil industry circa 2000 to 2011: prospect; drill a successful well; tie the production into the nearest pipeline; get paid the prevailing price. Then be assured the customer, a nebulous buyer somewhere at the end of the long pipe, will always buy more. Notwithstanding fleeting economic downturns, take comfort that the price paid for tomorrow’s barrel is going to be higher than the one sold yesterday.
This charmed commercial process for oil, one where customers keep buying more product at progressively higher prices, has run its course. Legitimizing this longstanding paradigm was a cocktail of fundamentals that was dominated by rapidly growing global oil consumption paired with resource scarcity, always sprinkled with a copious serving of geopolitical antagonism. Many of these factors are now gone, weakening or are independently insufficient to sustain upward price momentum. The new reality of weaker demand growth and new productive capacity doesn’t obviate investing in oil companies, but it means that constant market expansion and price appreciation should no longer form the central thesis.
Last week’s news threads highlighted the remnants of the old model. Oil prices regained some strength on news that China – the protagonist that drove consumption growth over the past decade – may shore up its decelerating economy with a stimulus package that includes easier credit. Also contributing to the bullish tone were market fears on how Iran –the 6th largest producer of oil – might retaliate under progressively more restrictive economic sanctions. By the end of the week a barrel of North Sea Brent was up $4 from the prior week’s close, fetching over $100 again.
Neither steroidal shots of capital into the Chinese economy nor the antagonism coming out of Iran are collectively sufficient to catalyze unrestrained price momentum. Today’s fundamentals are not nearly as collectively bullish as those prevalent last decade. Back then Western and emerging economies were expanding synchronously and aggressively; peak oil production was real in the absence of today’s new extractive technologies; inventories were declining; OPEC spare capacity was diminishing; and rogue producers like Venezuela were adding a layer of antagonism on top of the geopolitics of oil in the Middle East (which included real military action in Iraq). All these drivers have been dialed down significantly over the past two years.
Although there is less anxiety today about balancing supply side barrels with demand, the world is still demanding close to 90 million barrels a day, or just over 1,000 barrels a second. When you watch the upcoming London Olympics, visualize the competition size swimming pool at the Aquatics Centre full of oil, and think about it draining every 15 seconds; that’s how fast we are using this vital commodity.
For now, the oil world is moving to a new era where the “swimming pool” isn’t growing as quickly and refilling it is less of a challenge. From a business perspective that means that each new barrel of oil must now compete for market share instead of being always guaranteed a top-dollar buyer. This shift is already prevalent in North America where supply and demand dynamics are changing the fastest.
So here is the business model for the oil industry circa 2012 and beyond: prospect with a compass that seeks the highest value customers; drill a successful well with vigorous cost discipline; ensure the social license to produce and transport is constantly renewed; compete like an Olympian for market share and to get paid the best price possible. Understand the end customer’s needs and never assume they will always buy more. Operate with a mindset that the price paid for tomorrow’s barrel won’t always be higher than the one sold yesterday.
Ironically, investing in oil with this mindset will create more value than just waiting for the price to rise.