Petroleum Review Editorial May 2006
Split BP in two – quite a kite
At intervals, people both inside and outside the oil and gas industry ‘fly kites’ about the desirable shape and structure of the industry. The latest in this vein is a research paper from JP Morgan Cazenove, the investment banker (15 March 2006).
The fact that JP Morgan Cazenove provides investment banking services and acts as a financial advisor to BP suggests this is a well-informed ‘kite’ – even if the researcher, Fred Lucas, signs off with: ‘The views expressed in this research accurately reflect my personal views about the security or securities and the issue(s) which are the subject of my research.’
Lucas starts off by questioning the validity of upstream/downstream integration – the vertically integrated oil company model – posing the question as to whether such a structure would be used if an ideal oil company was being created? His key question is probably ‘Why is the oil industry, in many respects, one of the few remaining industries that still endorses a somewhat sterile, conglomerate asset structure that is essentially left unchallenged by corporate investors?’
He then goes on to suggest that BP ‘might dare’ and ‘could afford to be different’, noting that BP’s exit from bulk chemicals (Innovene – sold to INEOS for around £5bn in December 2005) can be seen as the first step in dis-integrating the company.
The claim is that by splitting BP into separately quoted upstream and downstream companies, ‘this restructuring could address the 15% to 20% equity value gap that we [JP Morgan Cazenove] believe BP suffers and that, we understand, is a growing concern for its top management’. Going on to assert that ‘investors would welcome the choice between two very large plays – one upstream, one downstream’.
Much of the subsequent justification is very much from the large investor point of view and can reasonably be described as self-serving. However, with the move over recent decades to the large-scale use of executive share options as a means of aligning investor and management interests, we are forced back to the fundamental question – ‘What is a major corporation for?’
Corporate public relations departments pour out torrents of fine words about aligning stakeholder interests, listing shareholders, employees, local and national administrations, communities local and national, as well as customers, clients and suppliers as just some of the many stakeholders whose interests need to be aligned. The City and financial community seem primarily concerned with shareholder interests, usually in the short term. Governments at intervals claim the national interest. Managements can be forgiven some confusion as to which interest to follow and in what order of priorities.
The research note points out that the largest European pure upstream play is the relatively small Cairn Energy (market capital $5.8bn), while the largest downstream play Neste Oil (market capital $8.3bn) is only slightly larger, seeking to imply there is space for new entrants. What was not pointed out, however, was that recent moves have been in the integration direction. Enterprise Oil – a large, pure upstream play – was integrated into Shell, the latest of a long list of upstream plays integrated into integrated companies, including Premier, Monument etc. On the pure downstream side, the refiner Valero has proved very successful, but Phillips merged with Tosco prior to the merger with Conoco. History tells us that pure exploration plays either stay small or are taken over by integrated companies. Downstream companies are a rarity and, apart from pure marketing plays are often taken over.
Now, neither self-interest nor contrary precedents mean that the suggestion that BP should be split should not be examined carefully. However, a number of questions do need to be answered.
- Does BP’s (or any other integrated company’s) size inhibit its effectiveness or reduce its ability to invest profitably?
- Does integration actually inhibit stockbrokers’ analysis and lead to underevaluation of the stocks?
- If dis-integration is desirable, is upstream/downstream the right split?
- If dis-integration would lead to a greater financial valuation in the short-term, does this justify the move?
- Or perhaps most relevant in an industry with a basic six-year investment payback horizon, over what time period should profits/valuations be maximised?
The Cazenove research briefing is a valuable ‘kite’ and one that deserves to stimulate a profound debate about the viability of corporate structures in the oil and gas industry. It is likely that an upstream/downstream split is just one of a variety of ways an oil corporation can be dis-integrated. Re-evaluation may even prove that the integrated model still provides the best structure for the industry. This, in turn, might lead the financial community to revalue the sector.
Rising oil prices
At the time of writing, oil prices had breached their post-Katrina high to reach $72/b. this is a level only exceeded, in real terms, at the price peak caused by the Iranian revolution in 1980/1981. Before that, you have to go back to the Pennsylvania oil boom and the 1862/1863 price spike for prices as high as today’s in real terms.
There are a whole range of causes for the current record prices. The stand-off between the US and Iran is the most public and the most dramatic. However, there are a number of other factors underpinning current high prices. some 25% of Nigerian production is shut-in as a result of the political unrest in the delta region. How soon this can be reversed is quite unpredictable, with further unrest a distinct possibility.
Meanwhile, the Chad government has fought off an insurrection, presumably one aiming to capture the oil revenues, but is threatening an oil supply cut-off in its dispute with the World Bank. President Chavez in Venezuela has renationalised oil fields owned by Eni and Repsol YPF in a move which appears to be finding imitations in other Latin American countries, including Bolivia and Ecuador.
Opec has also more or less publicly confirmed that it has no spare capacity to put on the market, while rapid inflation in oil field supplies, shortages of oilfield equipment (notably rigs) and major shortages of skilled manpower all threaten to slow down future developments.
As if all this was not enough to underpin current high prices, operations in the Gulf of Mexico are still struggling to rebuild capacity lost in last year’s hurricanes. With the next hurricane season now less than six weeks away, production has rebuilt to a little over 1.2mn b/d. In 2004, it was 1.43mn b/d. The International Energy Agency (IEA) currently anticipates it could average 1.3mn b/d in 2006.
The only thing that could undermine current high prices would be a collapse in demand or a surge in production. Both look unlikely, although there is some evidence for a slowing in demand over recent months.
Megaprojects update
Last month’s issue included a tabulation of megaprojects. However, shortly after publication, Opec posted further details of new projects on its website. These represent a significant additional capacity assuming they come onstream more or less on time. (The revised figures are published in the May issue of Petroleum Review.)
Capacity erosion is a straight line extrapolation from the 2005 actual of 1.261mn b/d, or approximately 1.5% of production, to 2.5% of production in 2011. This is a very conservative estimate and may prove too low. The Net figure is simply new capacity minus capacity erosionThe Net Net figure is calculated assuming projects are delayed on average by 73 days (20%) and that sustainable peak flows are 90% of quoted peak flows. As can be seen, available capacity to meet demand rises to 2007 and declines thereafter.
Chris Skrebowski
The opinions expressed here are entirely those of Chris Skrebowski, Editor of Petroleum Review, and do not necessarily reflect the view of the EI.
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