Wednesday, September 21, 2005

Why We Have an Oil Crisis, Or; Wait 'Til Chuck Schumer Gets a Load of This

Chuck Schumer is, in my opinion, a blow-hard, a media hound and a showboat…pretty much your basic U.S. Senator.

But he does mix it up pretty good whenever he finds a cause that gets him publicity—which is more or less every morning—and here in San Francisco, at the BankAmerica conference, I came across a cause that’s tailor-made for Chuck: it is timely, easy to grasp and begs for righteous indignation.

I call it “Why We Have an Oil Crisis.”

The British Petroleum investor relations person presented yesterday at the BankAmerica conference, and during the breakout session she defended the fact that BP uses a $20 per barrel oil price to “test” its spending projects—i.e. to decide whether to go ahead with drilling for oil.

When reminded that oil currently sells for about three-times that figure, the BP investor relations person vigorously defended this $20 “test” price, noting that BP sees oil trading in a $20 to $35 a barrel range over the long haul.

Since it takes five to seven years to bring a big project on stream, “it is reckless to be investing (based) on (today’s) oil price.”

That is true enough, I suppose…but when asked if $20 a barrel was not a little on the low side of recklessness, she noted that at the $20 per barrel “test” price, BP has enough exploration and production projects “to grow production 5% per year.”

And since world oil production is growing “at half” that rate—i.e. around 2.5%—then “we are doing more than our fair share.”

Now, this is where the numbers get easy to follow, even for a U.S. Senator.

How much of its cash flow is BP actually spending to explore for and produce oil this year, you might wonder?

“$9.5 to $10 billion,” according to the investor relations person.

And how much of its cash flow is BP “returning to shareholders” in the form of dividends and share repurchase, you might wonder?

$17 billion.

Therefore, British So-Called Petroleum is giving back to its shareholders 70% more of the cash flow it makes thanks to $65 oil prices than it is spending to find new sources of oil supply.

Perhaps they should change the company's name to “British Dividends & Share Repurchases.”

Of course, as this blog has noted previously, BP is not alone when it comes to capital allocation weighted to shareholders at the expense of a resource we are rapidly exhausting: ExxonMobil likewise spends more on dividends and share repurchases than on wildcatting, as they used to call it.

Which is why—along with a ridiculously low gasoline tax that Chuck and his colleagues don’t have the guts to increase—we have an oil crisis, Senator.

Go get ‘em.

Jeff Matthews
I Am Not Making This Up

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations.


Anonymous said...

Jeff, are you suggesting that companies shouldn't return a good proportion of their cash flow to shareholders? You must work for Cisco Systems or some other idiot technology shop where the employees get rich at the expense of shareholders. -Nelson Yu

RichL said...

Sounds like BP and the others actually want their share repurchase decisions to be profitable. It is intelligent management to believe that you are in business to make money, and not steel, or semis, or cars.

whydibuy said...

Lets see; generous div's to owners, stock buybacks, adequate reinvestment in the future along with a prudently conservative pricing model so they don't get swept up in a mania. WHOOHOOO !!!! The ideal mgt if I ever heard it. Putting the shareholders first. What a bizzare concept. I'm In !!!

Its_strange said...

Talk about blowhards . How about Kudlow , the guy whos show you were on the other night. His " energy policy" was the Iraq war and he said it many times on CNBC . Hasn't said much about Iraq oil lately .

Its_strange said...

" They get paid for this, part 1 " That was 10/30 and part 2 got side tracked cause of the hurricane. Something else deterring part 2 ?

Neil said...


Everyone else has said it well but for the benefit of repetition it sounds like BP is acting in the interests of its shareholders with its conservative CAPEX policy and great dividends. If you want to invest in production growth go somewhere else. I really hope you're playing devils advocate here!

tahoe kid said...

I prefer the BP model of prudent financial management and ample exploration capex. $10 billion is still one heck of a lot of money. How many companies have that much in revenue? It sure beats the Enron model of reckless spending of money they didn't even have. As for reckless behavior, how about Congress for not developing a national energy policy? And when was the last time we saw a member of Congress riding around in a Prius? In California where the Legislature gets car allowances, many opt to lease SUV's while they impose legislation promoting more effecient cars. I think they like the cushy ride.

dthorn said...


WOW when was the last time you had an agreeable readership? I think I actually agree with the question you are positing, however: why is there under-investment in oil exploration?

I don't think the question should be directed exclusively at the oil majors, though. Capital should flow to any opportunity, and by any measure you would think energy would be a hot sector to invest in. Why aren't the recipients of those dividends putting that money to work exploring for oil? Energy is one of the most basic businesses - capital in, energy out. Sure there have been a lot of technological advances, but few (if any?)are proprietary.

One of the few companies investing on spec. right now (that I know of) is Seadrill, a norwegian firm run by Jon Fredrikson of FRO fame. They have now ordered 3 Deap sea drilling rigs for ~500m each; all without contracts! (07-08 delivery) Oh, and did I mention he is Norways richest man? Must be lucky...

(Also am I crazy or is Solar energy close to being a significant viable energy source? take a look at this private (unfortunately) company. they have contracts to build 2 1000MW facilities of solar power, and they are not using photovoltaic panels?

erikpupo said...

I think what Jeff is wondering is why is BP using a model of 20 bucks a barrel to determine exploration capital allocation? At 65 bucks a barrel the potential for profit on each barrel is astronomical.

One theory I have heard is that the problem is also avaiability; most oil reserves not already located and drilled right now are in high-cost locations that would require massive capital investment to exhume.

Furthermore, why does BP beleive that over the long haul, oil will tick down to the 20-35 range? They seem to make this argument to say there is no reason to devote more to their exploration budget. What exactly makes them believe that oil will fall 30 dollars back to that range, not even accounting for the fact that oil is a finite resource. Its hard to see how it drops unless demand drops, which would imply a change in American lifestyle (since we consume a large chunk of the world's oil) I would not expect China to change their lifestyle (they are 2nd).

dthorn said...

One other question I would raise is how much of the price of oil is inflationary? If supply & demand dynamics are not the cause for $65 oil (OECD inventories are above 5yr averages) and energy costs turn out to be an inflationary bubble maybe those oil patch ceos are behaving more rationally than the bond traders. Who, I might add obviously don't read your blog.

gvtucker said...

We do not have a oil problem, we have a refinery problem.

Private equity is taking care of the shortfall of investment that normally went to traditional E&P companies. There is still no private equity going into refinery construction, though it is being talked about right now.

AllenCap said...

Maybe it's phsychological. How many times can you do the boom-and-bust thing and not get a little scarred about re-investing capital?

Bamass said...

Yes, it's annoying that the oil companies are sitting on their hands when they by rights ought to be going full tilt after new supply. But you have to remember that they did just that about 30 years ago and when prices subsequently fell the oil industry became as much of a basket case as the airline industry is today.

The problem from the perspective of the Schumers of the world is, while the oil companies hoarding money is bad, using that money to drill for more oil is no less unacceptable to their environmental lobby. So basically Schumer is stuck in a position of complaining about things being wrong but simultaneously being unable to offer any answers.

I do rather wish you'd have expanded on that last paragraph suggestion of a tax hike -- it seems far from obvious how that would help, given that prices seem to be going up nearly as quickly (ex-tax) in the high-tax countries of Europe.

bpl1000 said...
This comment has been removed by a blog administrator.
bpl1000 said...

I couldn't agree with you more about Chuck Schumer.

bubbles said...

That's one reason I'm still very bullish on energy, the fact the majors are using such a conservative number and like others have already mentioned these managers are rewarding shareholders. I think “bamass” hit it on the head, they remember the last bust. I believe Jeff's point about “along with a ridiculously low gasoline tax”, is it has increased demand or kept demand strong and that by raising the gas tax it would ration supply by driving demand lower or reduce consumption; by increasing energy efficiency through technological advances and by using alternative energy resources, like solar as dthorn mentioned. Also compared to some other industrialized countries our gas tax is relatively low. I want to be clear, I’m a Libertarian who believes in the Austrian School of Economics, so I’m no fan of taxes, but remember what Ross Perot’s solution to our deficit was?

OpinionsarelikeAH said...

Could it be that BP is making certain internal assumptions in future oil pricing? For instance, perhaps BP believes that consumer fatigue and awareness of a potential oil crisis and costly gasoline prices will lead to changes in behavior? For instance, sales of SUVs and trucks are already falling off the cliff according to August sales data. And, many manufacturers are rolling out additional models of hybrid vehicles due to customer demand. And, perhaps they see better global stability in oil producing countries. And, just maybe BP predicts a slowdown in the global economy, not necessarily brought on by energy costs - although that could be the first trigger - such that oil consumption (e.g., the supply/demand equation) improves in a waning economy. So, while a paradigm shift in consumer behavior and these other possible scenarios will take time, perhaps they are looking into their crystal ball to price oil $20-$35 per barrel?

Question for Jeff: To what extent do you think speculative oil investing has artificially ballooned the price of oil beyond the normal effect of traditional supply and demand issues? Mind you, I have not studied historical oil prices and the intra-day trading activity thereof. But, I ask because clearly, now more than ever, institutional investing in oil futures, etc. seems to be greater and causes one to wonder if that has something to do with $4 intraday spikes in price-per-barrel prices anytime some news comes out about oil supplies being disrupted.

Chris Fischer said...


There difference is, we consume almost 25% of the entire world's oil production. Having such a low tax encourages waste (see: Hummer H2, Soccer Mom with V8 SUV,) not to mention the foreign dependance on oil and all the negative things that brings with it.

Imagine an America without the huge dependance on foreign oil - trade deficit would be a fraction of what it is today, a less conflicted foreign policy, cleaner air, less highway deaths, etc.

But I agree, now isn't that time the tax should be implemented - that was a few years ago when gas was $1/gallon, when most of America developed the habits that are hurting us now.

Sam S. Park said...

BP’s strategy makes sense only if their “$20 test” story proves true. It seems more like oil majors’ excuse to limit refining and thus keep the current oil levels. Why spend on questionable capex if it would only increase oil supply (and lower prices), when they can go with the flow among peers - contain and control the oil supply and benefit from high oil prices.

On the other hand, maybe BP’s strategy is valid, and it seriously thinks that oil prices will come down to its benchmark levels. I suppose that if this $20 – 35 range is realistic, then BP’s management may be doing the right thing by allocating that capital to shareholders. If there really isn’t a viable investment opportunity, mine as well pass the cash flow to shareholders and keep them happy.

The real question is… where are crude prices really headed?

BelowTheCrowd said...

Hmmm, my business school education seemed to leave me the impression that a "good" management would always act to benefit the shareholders in the long run. There are some cases where returning capital directly is the best thing you can do with it because the opportunities in the company's core and related competencies just won't bear the investment of all the capital available. Microsoft recently (and I think correctly) made that determination.

There are other cases where paying a fat dividend is just a cop out for "we can't be bothered to seek out other profitable opportunities to deploy the capital, so here, take it back and figure it out yourselves."

Now, there's nothing wrong with a company like BP deciding that they're just going to sit on their reserves, run them down over time and use the proceeds to pay the shareholders. But if that's the case, I sure hope management is compensated accordingly -- as glorified administrators, not risk-takers. I strongly suspect that's not the case.

Aaron Koral said...

I think erikpupo hit it on the head with his comment, "...most oil reserves not already located and drilled right now are in high-cost locations that would require massive capital investment to exhume."

Maybe BP is thinking that the required return necessary to make a capital budgeting project like oil exploration in tar sands located up in Canada worthwhile mandates a huge capital investment.

I assume that if management at BP thinks the cost of capital, for both equity and debt, is too high, while the potential cash flow returns from the project is too low, they then pass on capital budgeting for E & P and return their current excess cash flow back to shareholders via share re-purchases and dividend increases.

I think almost everyone on the board, however, would agree that BP's management is acting quite prudently with the shareholder's money.

I only wish more companies acted as wisely for their shareholders as BP does IMHO.

Sam S. Park said...

Someone once passed down some wisdom about commodities to me. He summarized the message of Stanford professor, Thomas Sowell:

1. There is in actual fact almost inexhaustible supply of commodity X.
2. Increased demand causes temporary dearth of supply.
3. Then people, especially pundits paid to sell papers, holler that the supply of X is running out.
4. Greater demand stimulates investment, advancing technology in procuring X
5. Ever greater quantities of X are thus procured.
6. Price of X falls as supply outstrips demand, and then stabilizes.

Professor Sowell has recently written how politics and media can fool us about “crisis.” The two part article can be obtained from the following links:

Part 1
Part 2

However, this time it appears that BP plans to skip step 4 (when $65 oil is not worth their time and efforts) - as Jeff pointed out how BP does not plan to invest in technologies to drill more oil. Is BP anticipating that other world producers will be the ones to drill more and bring prices back to stable levels? There seems to be some complex issues going on... you can almost smell it.

MD said...


There's plenty of oil left in the world, it is just going to be in smaller basins, more expensive to develop, and of lower quality. We're not running out anytime soon, but it will be much harder to grow supply inline with demand.

Increased capital investment should bolster supply over the next few years, but the sad fact is that the oil industry hasn't found a huge megabasin since Prudhoe Bay some thirty years ago. Deepwater drilling was supposed to bail us out, but the size of those discoveries are continually getting smaller.

The theory about Hubbert's Peak is getting a lot more press, and oil executives who subscribe to this belief are feeling more comfortable talking about it.

I personally think market forces will solve our energy problems by forcing prices to a level where the development of alternative energy sources becomes economic.

Sam S. Park said...


You're right. There are plenty of oil, but getting it is the problem. We have ANWR among others, but the tree-hugging environmentalists make it extremely difficult for Congress to allow drilling in certain potential areas... costs will continue to rise. Granted so, we will find, develop and use alternative sources for energy. We're already seeing this happen... just give it some time.

Its_strange said...

While most were watching the huricanne news Saudi Arabia warned Iraq was heading towards disintergration and that could cause the whole region to erupt . Now thats something think about.

RichL said...

There are some firms with a pure speculative exploration model. McMoran Exploration (MMR on the NY), which is run by Jim Bob Moffett, is doing deep drilling in shallow water GOM and a LNG project on their existing Main Pass platform. All new ideas, which may or may not work, by a guy with a success record in doing nonconventional projects and not constrained by bureaucratic structure.

gvtucker said...

Moffett's various companies have consistently underperformed their peers over three and half decades, no matter whether you're talking about mining and minerals or oil & gas. He has, however, done well for both himself as well as for his investment bankers.

MMR is no exception. The stock is down about 4% year-to-date, while the sector is up year-to-date about 50%.

Geoffrey Styles said...

The tone of the comments to your post makes it clear why companies like BP and Exxon must return more money to shareholders than they use to drill: any management of a publicly-traded company that didn't do this would be ousted by the next annual meeting.

And you can't say they're wrong, with 80% of the oil in the world in the hands of OPEC and others like Mexico that won't let foreign companies explore and develop it.

Given the importance of metrics such as return on capital employed, and total return to shareholder, the major oil companies have serious disincentives to adding more incremental production than their market share justifies.

I'm sympathetic to all this, but when you step back from it, it's crystal clear that today's management could never have built the companies they run, nor the industry we see. That's all the legacy of a bunch of less sophisticated folks who thought the name of the game was to sell more than your competitor, keep your customers happy, and grow the whole market.

Jeff Matthews said...

We have a winner!

I think Geoffrey with a "G" nailed the issue down quite precisely: today's major oil companies are run by finance guys, at the pleasure of Wall Street analysts and shareholders.

And we all know--think Enron, Worldcom, for starters--what happens to businesses run with the short-term interests of Wall Street in mind.

Nicely put.

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