topic 4: the international oil...

Topic 4: The International Oil Industry

() Global Energy Issues, Industries and Markets 1 / 51

Introduction

To understand oil industry, focus lecture on its history

General themes of relevance today:

Cartels/monopoly power

Importance of oil in economy/geopolitics

Resource nationalism, state ownership

Pricing and markets

Future of oil: new sources and new technology


Additional Readings

Course outline has several conventional academic readings on thistopic

But oil is a topic on which many popular writers have written:

Daniel Yergin has written two excellent popular books: The Prize andThe Quest

The Prize about history of oil industry, The Quest about modernenergy industry

Private Empire: ExxonMobil and American Power by Steve Collanother recent popular book

If you like audio material, there is even a podcast History of OIl(http://historyofoil.typepad.com/)


Characteristics of the Oil Industry

Remember from initial overview lecture:

Oil has been predominant fuel of the 20th century

In 21st century oil’s share is falling, but it is still large

BP forecast: in 2035 oil, gas and coal roughly equal share of energyproduced from fossil fuels

And fossil fuels forecast to account for 80% of energy production(unless major change in policy due to global warming)

Oil is mostly used for transportation (energy dense)


Characteristics of the Oil Industry

Some similarities with electricity industry:

Several stages in industry: exploration, extraction, refining,distributing and retailing

Companies often vertically integrated

Monopoly/cartel concerns

Some differences to electricity:

Oil is storable

Oil is relatively easy to transport (pipelines, or in tanks whethertruck/trains/ships)

International trade common (no need for anything like electricity grid)


Characteristics of Oil

In this lecture, I will simply refer to “oil” as a fuel and ignore many(interesting) subtleties

But let me briefly note the following:

Oil comes out of the ground as crude oil of varying compositions(sweet/sour, light/heavy, etc.)

Crude oil is used to produce many types of fuel (gasoline, fuel oil,aviation fuel, diesel, kerosene, etc.)

Also used to produce things unrelated to energy (e.g. plastics)

In terms of producing CO2 emissions oil is cleaner than coal, butdirtier than natural gas


Who Makes Money from Oil?

Oil industry is a complicated mix of ownership structures

Private companies (oil majors dominate, but many smaller oilcompanies esp. in exploration and production)

Countries with oil try to make money through:

State ownership (but of what? Entire value chain or only production?)

Royalties and taxes, auctioning of exploration rights/concessions

Note: remember fuel subsidies discussion of previous lecture


Who Makes Money from Oil?

Forced joint ventures between international oil company and stateowned company

Joint ventures between international oil company and (privatelyowned) national champion

Note: international oil companies considered more effi cient, access tolatest technology, etc.

National oil companies in some cases politicized and ineffi cient

Recent news: Mexico is changing constitution to allow some role forinternational oil companies

OECD governments make money from oil through taxation(politically controversial)


Early Days, 1859-1879

Oil used for various purposes in small ways for thousands of years

But big commercial use began when oil discovered in Pennsylvania

Used largely for lighting (kerosene) and gasoline largely a wasteproduct (pre-car era)

Chaotic oil rush led to over-supply, price collapse, bankruptcies, pricevolatility, etc.

Also wastefulness (excessive drilling led to low recovery rates)

This era largely in USA


Rockefeller and the Standard Oil Monopoly, 1870-1911

John D. Rockefeller decried “wasteful competition”

Through expansion, buying out of competitors, predatory practicesdriving competitors out of business, etc. sought to control oil industry

Soon Standard Oil company directly or indirectly controlled much ofoil

This allowed it to control prices and quantities (near monopoly)

Interesting to note that Standard Oil achieved control of refining anddistribution, not actual production of oil

Share of world oil refining 80-90% (and up to 95% control in the US)

Refining and distribution more liable to monopoly (increasing returnsto scale)

Producing of oil more competitive (always new oil wells opening up)

Economic concepts: monopoly/cartel, vertical versus horizontalintegration, predatory pricing



Prices much less volatile and Rockefeller richest man in the world(maybe richest man in history)

Gradual breaking of Standard Oil’s grip through:

International discoveries Baku (then in Russia) and Dutch East Indies(now Indonesia)

New world companies such as Royal Dutch Company and ShellCompany (later merged to form Royal Dutch Shell)

Big US discoveries in Texas led to new American competitors (esp.Gulf Oil Company and Texas Fuel Company, later Texaco).

Gulf merged with Standard Oil of California in 1985 and renamedChevron

Texaco also later merged with Chevron

Increasing competition undermined Standard Oil monopoly



But big blow to Standard Oil monopoly was political/legal

Anti-trust/restraint of trade laws passed in USA (era of“trustbusting”president and “muckraking” journalism)

In 1911 Standard Oil found in violation of anti-trust laws and forcedto break into smaller companies

In 1911 Standard Oil controlled 70% of refined production, but only14% of crude oil supply

Standard Oil of New Jersey (later Exxon, now ExxonMobil)

Standard Oil of New York (later Mobil, now ExxonMobil)

Standard Oil of California (later Chevron)

Standard Oil of Indiana (later merged with BP)

Standard Oil of Ohio (now the American arm of BP)

plus some more smaller ones


Internationalization of the Oil Industry 1911-1928

Big expansion in use of oil (beginning to displace coal)

Expansion of automobile, use of oil for navies, etc.

Great international expansion in production (finds in Mexico,Venezuela, Iran, etc.)

Geopolitics of oil

E.g. 1901 William Knox D’Arcy negotiated an oil concession withShah of Persia

Exclusive rights for 60 years in most of Iran.

Shah received financial payment, shares in Anglo-Persion OilCompany and 16% of future profits.

Big oil finds in 1908

Geopolitical point 1: such deals led to many fights between oilcompanies and governments wanting to re-negotiate



Geopolitical point 2: Increasing importance of oil for military andeconomic reasons

Coal versus oil for navies in Britain

Oil = faster ships, coal = secure supply (Britain had little oil)

UK government bought 51% stake in Anglo-Persian

Many company decisions made for security of supply reasons ratherthan economic effi ciency

Anglo-Persian eventually evolved into BP



Important development: cartels, anti-competitive arrangements

Over-production led to drop in oil prices

Achnacarry Agreement among major oil companies

Markets divided by geography (not US) and in each markets sharesallocated to each oil company

Thus, in each market a company could only produce more if entiremarket grew

Uniform selling price (American Gulf Coast price plus transportationcost)

Economic theory: cartelization, avoiding price wars, undercutting, etc.

Did not work well (too many agents outside the agreement), butsimilar attempts will recur in later history


The Seven Sisters and Rising Resource Nationalism:1928-1960

Seven Sisters = Standard Oil of New Jersey, New York, California,Texas Oil Company, Royal Dutch-Shell, Anglo-Persian and Gulf.

Seven Sisters dominated all parts of the industry (exploration,production, refining, distribution)

Various attempts at collusive behaviour (Red Line agreement) andgovernment intervention (quotas, etc.) in response to price volatility

Large new finds in US (Texas, Oklahoma, etc.), wildcatters, hot oil,etc.

Texas Railway Commission (state energy regulator) had huge impacton world oil prices (some say it set world oil price).


The Seven Sisters and Rising Resource Nationalism:1928-1960

Rising resource nationalism:

Shah of Iran cancelled oil concession of Anglo-Persian in 1932

Re-negotiated better terms

Mexico nationalized oil industry (new company = PEMEX) in 1938

Venezuelan government cut better deal in 1943 (50-50 split of profitsplus lump sum royalty)

Other countries also cut “50-50 deals”

Profits equally shared between oil company and state


But profits calculated based on “posted prices”

In production: big story was the emergence of Middle East (esp. Iraq,Saudia Arabia a bit later) as big oil producers, also Soviet Union

Supply increased, market prices dropped.

Market prices less than posted prices

Hurt international oil companies (since money paid to governmentscalculated using posted prices)

International oil companies cut posted prices (less money going togovernments)

Producing governments unhappy, which set the stage for OPEC


The OPEC Era

Organization of Petroleum Exporting Countries

OPEC started in 1960 (Iran, Iraq, Kuwait, Saudi Arabia, Venezuela)

Major oil producing countries

Eventually grew to 14 countries, but now back down to 12 (Indonesiaand Gabon left)

Large (but varying) influence on the price of oil

Economic theory: cartel

Remember: perfect competition leads to economically effi cientoutcome with no excess profits

Monopoly: can achieve higher profits by reducing output, forcing priceup (until MR=MC)

If cartel can get together to act as a monopoly, can increase profit


The OPEC Era

But agreement can be diffi cultMust reduce output, agree on quotasIf all cartel members exceed quota, price falls and profits fallBut if one member exceeds quota while others maintain, cheater canbenefitSince monopoly equilibrium has P>MC, small increases in output willearn P but only cost MCEach cartel member has incentive to cheatHigh prices for oil can hurt global economy (reduce demand for oil)High prices for oil can encourage consumers to improve energyeffi ciency (reduce demand for oil)Cartel needs to balance short term benefits with longer term costs ofhigh oil priceSummary of issues in history of OPEC: need for agreement, stoppingcheaters and balancing short versus long term profits


The Early years of OPEC, 1960-1973

OPEC arose at time of rising resource nationalism

Aspirations of non-western countries to control own resources

Early OPEC focussed on:

Nationalization of oil concessions

Controlling production

Change in tax systems

OPEC was disunited and achievements were modest

Note: OPEC’s share of world oil output 28% in 1960, rising to 41% in1970


The Early years of OPEC, 1960-1973

OPEC countries had to sell oil to international oil companies or getmoney from 50-50 deals

Mostly oil companies still produced the oil

Based on “posted prices” (heavily influenced by Seven Sisters)

Posted prices set too low?

Various negotiations to increase prices

Quotas started in 1965 but abandoned in 1967


Oil Price Shocks, 1973-1981

Following Arab-Israeli war, Arab countries imposed oil embargoagainst USA, the Netherlands, Portugal and South Africa25% cut in productionBig increase in prices —“first oil price shock”Prices increase fourfold, many economies go into recession (theme: oilhas big impact on macroeconomy)Nationalization proceeded.E.g. Saudi government acquired 25% stake in Aramco in 1973, then60% in 1974, with 100% by 1980 (renamed Saudi Aramco)But international oil companies still needed for exploration,development, transport and marketing of oilOil price shock (partly) caused recession in OECDEnergy effi ciency/alternative energy sources/renewables on policyagendaEnd of era of cheap oil, end of posted price system, OPEC startsoffi cial price mechanism


Oil Price Shocks, 1973-1981

Second oil price shock in 1979-1981 (Iranian revolution + Iran-Iraqwar)

OPEC diffi culty maintaining its offi cial price

Market price diverged from OPEC offi cial price

Eventually much OPEC oil sold in spot markets at higher prices

Prices more than doubled

Increasing pressure in oil consuming countries


Return of Cheap Oil, 1981-2000

Oil price shocks led to reduction in demand, increase of non-OPECsupply

Result: falling oil prices

Energy diversification (decline in importance of oil)

In 1970s OPEC produced 40-50% of oil

Early 1980’s dramatic drop to 20%-30%

Some details:

Production quotas introduced in 1982, but disagreements in 1983

Saudi Arabia emerged as swing producer to try and keep stable prices

But then price war as OPEC tries to regain market share

Third oil shock as prices plunged by 1986 to less than $10 per barrel


Return of Cheap Oil, 1981-2000

Throughout 1980s OPEC used quotas to try and keep reasonable oilprice

Kept prices from collapsing, but still low

But significant cheating on quotas

Emergence of non-OPEC players (we will discuss North Sea Oilshortly)

FSU = former Soviet Union

Within OPEC, Saudi Arabia has most influence on price

Saudi Arabia = biggest producer plus has excess capacity(expand/contract output to push prices down/up)


The New Era of Volatility? 2001-present

Oil prices dropped with financial crisis/recession late 2008 causeddemand to drop

Apart from this, oil prices have (in general) been high over 2001-2014period

Mostly demand-driven, emergence of non-OECD countries (esp.China) as industrial powers

Despite various shocks (wars in Kuwait, Iraq and Libya), general trendto gradually increasing oil prices

However, in autumn 2014 the price fell (roughly halved)

Demand is down (slightly slowing Chinese economy, slightly less usefor transport)

Supply has been hit by shocks in Syria/Iraq/Libya but US productionstrong


The New Era of Volatility? 2001-present

Lower oil prices are having big negative impact in some countries (e.g.Russia, Venezuela, Canada)

But positive impact elswhere (e.g. European consumers benefittingfrom lower petrol prices)

Big effects on oil industry

Many companies cancelling expansion products

US tight oil projects more flexible, but projects in Canadian Oil Sandshard to change

Oil sands plans made in era of $100 cannot easily be adjusted

IEA’s July Monthly Oil Report says:

“As US tight oil output flattens and then starts to fall back, Canadianoil sands emerge as the engine of North American supply.”

What will future bring now that sanctions on Iran may be lifted?


Case Study Topic: The Pricing of Oil

In my history of the international oil markets, I have mentionedpricing a bit

In a general sense, price is determined by demand and supply

But the details of price determination offer fascinating history

Good place to start:

Fattouh, B. (2011) “An Anatomy of the Crude Oil Pricing System”Oxford Institute for Energy Studies Working Paper 40

Financial Times article:http://ftalphaville.ft.com/2013/04/24/1469422/the-decline-of-the-oil-spot-market/

Later lecture will discuss financial markets for energy in more detail

But I briefly mention a few points here


The Pricing of Oil

A theme of recent decades is: increasingly oil just traded ascommodity

Before 1980 much oil contract traded (e.g. long term contractnegotiated directly between buyer and seller)

But now market trading common (or formula pricing which use pricestaken from markets)

Spot markets: oil sold for cash and delivered immediately

Future markets: promise to purchase at a specific date in future atprice agreed now

Oil commonly traded in spot and futures markets

Advantages of markets: price discovery and transparency


The Pricing of Oil: ICE and Brent Crude Futures

But oil is not a homogeneous good (different densities, sulfur content,etc.)

Various pricing benchmarks and exchanges, here give one example

ICE = IntercontinentalExchange trades oil price futures (and manyother things)

One contract equals 1,000 barrels of oil

But what "barrel of oil"? Brent Crude

Brent Crude is classification of sweet light crude oil comprising BrentBlend, Forties Blend, Oseberg and Ekofisk crudes

Financial Times, 5 July, 2012: Crude jumps to one month high onNorwegian lock-out.....The country’s production of high quality, lowsulphur crude oil is particularly important for the Brent market as it ispart of the Brent benchmark.


The Pricing of Oil

Formula pricing also popularLinks price of long-term contract to spot price prevailing at time oilchanges handsI will mention Saudi formula pricing later onBut formula pricing uses a spot price (taken from one of the markets)This is a very superficial over-view of oil pricing, if interest in moredetail do a case study on itThe Economist, May 5, 2012 headline:Riddles, mysteries and enigmas: Amid international concern about theintegrity of the global oil markets, we report on the Kremlin’sfavourite oil traderArticle worries about manipulation of Urals crude price by Gunvor(Russian oil trading firm)Concerns about manipulation of benchmarks possible case study forthis course


Increasing Role of State Oil Companies

Biggest oil companies by reserves?National oil companies of Saudi Arabia, Iran, Qatar, Iraq, Venezuela,Abu Dhabi, Kuwait, Nigeria, Libya, AlgeriaBiggest oil companies by production?Almost the same list, but Russian and Mexican state oil companiesenterRussia has several state-owned oil companies and partly state owned(state owns majority of shares in Gazprom and Rosneft)Seven Sisters not on either list, decreasing role of international oilcompaniesOf publicly-traded companies PetroChina recently surpassedExxonMobil (in production terms) to be biggest in worldIncrease of joint ventures (state company + international oilcompany)Table on next page lists top oil+gas companies (not including fullystate owned) by various financial metrics


Top 15 Oil-Gas Companies (not including state co.)Company State/Geograph Region Assets Revenues Profits

1. Exon-Mobil Texas/Americas $302,510 mil $341,578 mil $30,460 mil

2. Chevron California/Americas $184,769 mil $189,607 mil $19,024 mil

3.Gazprom OAO Russian Federation/EMEA $330,261 mil $118,401 mil $32,443 mil

4. PetroChina Co Ltd China/Asia-Pacific $254,914 mil $220,177 mil $21,034 mil

5. Total/EMEA Total/SA $206,640 mil $189,153 mil $14,234 mil

6.Royal Dutch Shell Plc UK/EMEA $322,560 mil $368,056 mil $20,127 mil

7.Conco-Philips Texas/Americas $156,314 mil $175,752 mil $113,58 mil

8. China Petroleum& Chem China/Asia-Pacific $153,143 mil $281,981 mil $10,788 mil

9.Rosneft Oil Company Russian Fed/EMEA $93,829 mil $61,942 mil $10,400 mil

10. Lukoil Russian Fed/EMEA $84,017 mil $104,956 mil $9,006 mil

11.Statoil ASA Norway/EMEA $119,203 mil $89,523 mil $6,473 mil

12. Petrobras-Petroleo Brasilier Brazi/Americas $328,193 mil $125,937 mil $20,779 mil

13. E.ON AG Germany/EMEA $219,815 mil $125,833 mil $9,007 mil

14.Repsol YPF SA Spain/EMEA $97,241 mil $74,779 mil $6,319 mil

15.CNOOC Ltd Hong Kong/Asia-Pacific $50,464 mil $27,280 mil $8,175 mil

Source: Platts Energy 2012


Oil in the Future

Two big issues hang over future of oil: Decarbonization and futuresupply

Both will affect quantity of oil used and its price

Will world bring in policies (carbon tax, carbon trading, etc.) toreduce CO2 emissions?

If yes, then this will reduce oil’s role

Oil is cleaner than coal, but dirtier than natural gas

Fossil fuels: oil produces roughly 50% more CO2 emissions thannatural gas in electricity generation (coal produces even more)

But oil is still best for transport

Decarbonization will be discussed in detail in a later lecture

It is probable (but uncertain) that climate change will cause pressureto reduce role of oil in energy mix


Future Supply of Oil

Peak oil debate, will we run out of oil?

An interesting topic for a case study?

Estimates of reserves are unreliable, but...

Most projections suggest no shortage, at least in medium term

Next slides are BP’s and OPEC’s future projections


Future of Oil: Existing Fields

Most of today’s oil come from fields that have been producing fordecades.

More than 95 percent of the crude oil produced today was discoveredbefore the year 2000.

About 75 percent was discovered before 1980.

Many large fields can hold decades of supply.

E.g. Ghawar field in Saudi Arabia began production in 1951 and stillis producing nearly 5 million barrels a day.


Future of Oil: New Finds

Brazil (Petrobras, pre-salt fields) and Caspian basin are importantgrowth areas (but Petrobras is a company with troubles)

Sub-saharan Africa: Nigeria and Angola already big oil producers, butrecent newspaper articles:

FT, 5 July, 2012: Tullow Oil said a big oil discovery made in Kenyaearlier this year was even larger than initially thought.

BBC, 21 February, 2012 New oil finds off Liberia and Sierra Leone

Arctic (Russia, US, etc.) potentially huge amounts of oil and gas (seeEconomist, June 12, 2012, case study?)


Future of Oil: Technological Improvements andNon-conventional Sources

Previous slide shows increasing importance of non-conventionalsources

Advances in technology means more oil

Improvements in deepwater production

But risk of environmental damage due to oil spills

Extraction of oil from sands (Canada in particular)

But costly and environmental consequences

Improvements in extraction technology (get more out of existingfields)

Sophisticated technology, will national oil companies need technicalskills of international oil companies?

tight oil


Future of Oil: Tight Oil

Next week lecture on natural gas and talk more about shale then

Shale gas revolution? Big issue (possible case study)

Large expansion in USA in oil production

Note: confusing terminology

Most common: tight oil = shale oil = crude oil occurring naturally inshale (these are the important ones)

Oil shale = something different = type of rock which contains adifferent hydrocarbon (but can be turned into crude oil at some cost)


Future of Oil: Tight Oil

Lots of shale around world (US and Canada is where mostdevelopment has been)

Bakken shale, Eagle Ford Shale big US shale plays

Potential huge, but unclear how much oil can be recovered (3%recovery rates used in most calculations)

Tight oil extracted using hydraulic fracturing (“fracking”)

Expensive to extract ($30-$80 per barrel) so needs high world oil priceto be viable

Environmental concerns about hydraulic fracturing

Summary: at least in next few decades, won’t run out of oil, butworries about whether it should be extracted and at what cost

This is a possible case study.


Case Study Topic: Policy Relevance for Future

Chapter 5 (written by Paul Stevens) on “Oil Markets and the Future”in The New Energy Paradigm (edited by Dieter Helm) written before2007

Provides a list of “Issues in the Oil Market which are Likely toPrompt Demands for a Policy Response”

This is possible case study you can do for this course.

Are all of his concerns still relevant almost 10 years on?

Did he miss any important issues?


Case Study Topic: Reducing Consumption of Oil fromTransportation

Starting point: C. Knittel (2012). “Reducing Petroleum Consumptionfrom Transportation,” Journal of Economic Perspectives, 26, 93-118.

In this lecture, have focussed on oil supply and markets

Little said about consumers of oil (largely for transport)

If interested, do a case study on this

Issues relating to: energy effi ciency, taxation of petrol, regulation (fueleffi ciency standards for cars), technology (hybrid/electric cars) andalternatives (biofuels)


Case Study Topic: Canada’s Oil Sands

Costs and benefits of Canada’s development of its oil sandsNote: environmental costs are largeAlso could discuss transportation issues (building of pipelines)Note: Shell has a carbon capture and storage project in oil sands, willit be commerically viable?Reading to get you started:The Economist, January 20, 2011, “Muck and brass”IAE publications, including World Energy Outlook andhttp://www.iea.org/papers/security/canada_2010.pdf have somematerialCanadian Energy Research Institute’s website (http://www.ceri.ca/)has interesting materialRoyal Society of Canada (2010), Environmental and Health Impactsof Canada’s Oil Sands Industry (available on the Royal Society ofCanada’s website)


Case Study Topic: The Oil and Gas Industry in Nigeria

Nigeria is increasingly a big player in oil and gas markets

Facing many interesting challenges (technical, economic and political)

Discussion of these could form the basis for an interesting case studies

Reading to get you started:

Finanical Times, Special Report: Nigeria: Oil and Gas 2012,http://www.ft.com/nigeria-oil-gas-2012

Financial Times, Special Report on Oil Futures:http://www.ft.com/indepth/oil-futures covers manycountries/companies


Case Study Topic: The Movement of Oil Within andBetween Countries

I have said little in this lecture about the mechanics of trade in oil

Oil tankers, pipelines, etc.

Pipeline: ensure open access at common price?

In lecture on natural gas will discuss pipelines (similar issues arise)

But a potential case study could focus on the details of theinternational oil trade

Chapter 14 of Dahl (2004)

OPEC World Energy Outlook (2011), section on “It’s in the Pipeline”

Keystone pipeline? (The Economist has recent articles)


Summary

Discussed history of oil industry to show economic issues which arise

Issues:

Industry structure

Cartels/monopoly power/OPEC

Impact of oil in world economy (and world politics)

Rising resource nationalism, state ownership

Pricing and markets

Future of oil: Tight oil, oil sands, etc.


topic 4: the international oil...

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