A Year of Boiling Frogs

For our first PFC Energy Quarterly of 2008, I asked several PFC Energy experts to write about the trends they see for 2008 in the context of the main events of the past year. In the articles that follow you will find their contributions on topics from global geopolitics to upstream, refining, gas and financial markets. But first, a few words from me on 2007 – a Year of Boiling Frogs.

Many of you know the story – actually, a scientific myth – that if you place a frog in tepid water and slowly bring it to the boil, the frog will sit there until death. The implication is that if change is slow enough we may not notice it… until too late, or almost too late. In 2007, the energy industry saw several signs of boiling frogs, but indications, too, that some of the smartest frogs may be thinking about jumping.

Probably the most obvious boiling frog concerns International Oil Companies (IOCs). There has long been concern over the ability of IOCs to sustain long-term value creation. The growing power and independence of National Oil Companies (NOCs) has made it increasingly difficult for IOCs to gain access to material oil and gas reserves, and their historical value propositions have been eroded as NOCs and service companies become larger and more sophisticated. Many IOCs have confirmed the lack of investment opportunities by their stock repurchases. The financial markets reflect these trends by pricing most IOCs in the 8-12 P/E range, compared with the 20s for some service companies (e.g. Schlumberger) and niche players (e.g. BG), and by accelerating market capitalizations of publicly traded NOCs (e.g. Petrobras) relative to IOCs.

In this context, the event that stands out in 2007 is BP’s entry into Canadian oil sands, one of the few sources of material reserves not controlled by NOCs. Coming from the company that differentiated itself through environmentally-focused marketing and had one of the least CO2-intensive portfolios among the IOCs, this move speaks volumes. Perhaps, in 2008, an IOC will make a strategic move that surprises us all – although its boardroom, or shareholder meeting, will probably need to reach boiling point first.

A frog that moved in 2007 is technology and R&D. Having allowed huge technology migration to service companies over the last 15 years, almost all IOCs raised their R&D budgets, and service companies followed suit. Shell’s 2007 R&D spending was over $1 billion and Schlumberger’s over $700 million. Oil and gas companies’ R&D spending remains woefully small relative to their size, and they will need to jump higher to differentiate themselves in the future through superior technology and project execution.

The capacity limits of the service industry, particularly EPC contractors, have been a growing concern. In 2007, the lack of experienced contractor capacity emerged as a common factor behind project delivery delays, cost overruns and deferred Final Investment Decisions. This boiling frog will get worse rather than better due to another emerging issue …

While all eyes have been on Asian energy demand, particularly in China, the changes within major producing countries have largely gone unnoticed. Many Middle East Gulf States need huge increases in infrastructure to serve fast-growing populations that enjoy state-subsidized energy prices. Today, Iran is the third largest gas market in the world after the US and Russia and, if trends continue, the Gulf States will be a bigger gas market than Europe in less than 10 years. These trends could have serious consequences. First, the greenfield refineries and petrochemical plants planned for the Middle East could stretch contractor capacity and pose another ‘access’ threat to IOCs: how to secure enough crude to feed their refinery systems. Secondly, OPEC countries may invest in downstream value-added and economic diversification at the expense of future oil development projects.

For some time, PFC Energy has expressed the (previously) contrarian view that the world is not running out of oil reserves, but out of oil production capacity – our base case forecasts have been unable to project production above 100 million barrels per day, falling short of long-term demand projections from such respected sources as the IEA and EIA. Others are beginning to share our view. This is a frog that will continue to boil with serious long-term consequences.

Which brings us to my last boiling frog – climate change. Despite the huge risks associated with rapidly increasing greenhouse gas emissions and the growing concerns of society, industry and governments, it seems unlikely there will be major preventative actions in 2008. The EU will likely continue to act as thought leader, but globally coordinated action is unlikely without the US, which will be diverted by the presidential election, and without agreement on a fair approach for China and India. We can look forward to a series of uncoordinated political and regulatory decisions that do not appreciably lower risks for future generations nor remove the uncertainties facing energy companies with long planning horizons.

We are living in a time of unprecedented uncertainty and change. We must learn to detect signals of major changes before they happen, and take prudent and responsible action. PFC Energy is committed to navigating the complex world of energy by creating clarity and understanding based on facts and fundamentals. To all of you reading this, to your companies and families, I wish you every success in 2008, a year of increasing risks and, of course, opportunities.

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Lew Watts is the President and CEO of PFC Energy. For further information on this article contact Enews_lwatts@pfcenergy.com.