Here's why oil companies should be a lot more profitable than they are

(Reuters) - The 40 percent plunge in oil prices since July, when Brent crude peaked at $115 a barrel, is almost certainly good news for the world economy; but it is surely a crippling blow for oil producers. Oil prices below $70 certainly spell trouble for U.S. and Canadian shale and tar-sand producers and also for oil-exporting countries such as Venezuela, Nigeria, Mexico and Russia that depend on inflated oil revenues to finance government spending or pay foreign debts. On the other hand, the implications of lower oil prices for the biggest U.S. and European oil companies are more ambiguous and could even be positive.

Gas prices are shown at a Chevron gas station in Encinitas, California October 10, 2014. REUTERS/Mike Blake

In fact, the shareholders of oil majors such as Exxon, Chevron, Shell, BP and Total could be among the biggest beneficiaries of the price slump, if it forces their corporate managements to abandon some of the bad habits they acquired in the 40-year oil boom when OPEC first established itself as an effective cartel in January, 1974. If this period of cartelized monopoly pricing is now ending, as Saudi Arabia has strongly hinted in the past few weeks, then it is time to re-focus on some basic principles of resource economics that Big Oil managements have ignored for decades, to their shareholders’ enormous cost.

The most important of these principles is “diminishing returns”: The more oil that corporate geologists discover, the lower the returns their shareholders can hope to achieve, because new reserves will almost invariably be more expensive to develop than the ones discovered earlier that were, almost by definition, more accessible. This inherent flaw in the oil companies’ business model was disguised for the past 40 years by the fact that oil prices rose even faster than the costs of exploration and production. But this is where a second economic principle now starts to bite.

Unless a market is totally dominated by monopoly power, prices will be set by the most efficient supplier’s marginal costs of production – in layman’s terms, by the cost of producing an extra barrel from oil reserves that have already been discovered and developed. In a fully competitive market, the enormous sums of money invested in exploring for new oil fields could not be recovered until all lower-cost reserves ran dry and there would be no point in exploring for anywhere outside the Middle Eastern and central Asian oilfields where the oil is easiest to pump.

That is, of course, an over-simplification. In the real world of geopolitical conflicts and transport and infrastructure bottlenecks, consumers want energy security and will pay premium prices for supplies from their own oil-fields or from those that belong to trusted allies. Nevertheless, the broad principle applies: The vast sums spent on exploring and developing new reserves with production costs much higher than in Middle East oilfields will never be recovered if the oil market becomes even vaguely competitive.

Considering that Western companies spend about $450 billion annually on exploration and development according to the Ernst & Young oil reserves study, this could be one of the worst capital misallocations in history. The fact is that Western producers can never match the costs of oil pumped by Saudi Aramco, or even Rosneft or other state-owned companies with exclusive access to the world’s most accessible reserves. While Exxon or BP must spend billions drilling through Arctic ice-caps or exploring 5 miles under the Gulf of Mexico, the Saudis can pump oil from their deserts with machines not much more expensive than old-fashioned “nodding donkeys.”

In a competitive market the rational strategy for Western oil companies would be stop all exploration, while continuing to provide technology, geology and other profitable oilfield services to the nationalized owners of readily-accessible reserves. The vast amounts of cash generated by selling oil from existing low-cost reserves already developed could then be distributed to shareholders until these low-cost oilfields ran dry. This strategy of self-liquidation could be described euphemistically as “running the business for cash” in the same way as tobacco companies or closed insurance funds.

There are two reasons why this hasn’t happened thus far. Firstly, OPEC has sheltered Western oil companies from diminishing returns and marginal-cost pricing by keeping prices artificially high through output restraint and limited expansion of cheap Middle Eastern oilfields (strictures reinforced by wars and sanctions in Iraq and Iran). Secondly, oil company managements have believed with quasi-religious fervor in perpetually rising oil demand. Therefore finding new reserves seemed more important than maximizing cash distributions to shareholders.

The second assumption could soon be overturned, as suggested by rumors of a takeover bid for BP. If private equity investors could raise the $160 billion needed to buy BP, they could liquidate for cash a company whose proven reserves of 10.05 billion barrels would be worth $350 billion even after another 50 percent price decline.

But what of the first condition? The Saudis would surely want to stabilize prices at some point by limiting production, but the target prices may now be considerably lower than previously assumed. The Saudis seem to have realized that by ceding market share to other producers they risk allowing much of their oil to become a worthless “stranded asset” that can never be sold or burnt. With the global atmosphere approaching its carbon limits and technological progress gradually reducing the price of non-fossil fuels, the Bank of England warned this week that some of the world’s oil reserves could become “stranded assets,” with no market value despite the huge sums sunk into the ground by oil companies, their shareholders and banks.

The Saudis are well aware of this risk. Back in the 1970s, Sheikh Zaki Yamani, the wily Saudi oil minister used to warn his compatriots not to rely forever on selling oil: “The stone age didn’t end because the cave-men ran out of stones.” Maybe the end of the “oil age” is now approaching, and the Saudis have understood this better than Western oil-men.

Anatole Kaletsky