Massive and on-going advances in our lives (↑ life expectancy, ↓ hunger, ↑innovation, ↑work efficiency, etc.) can be directly correlated to the widespread commercial use of fossil fuels as they began to power the Industrial Revolution in the early 1800s. Few informed individuals would deny that the energy provided by fossil fuels is still necessary to maintain and continue improving our standard of living in developed countries, as well as providing the energy necessary to bring those same improvements to developing countries. The fossil fuel extraction industry continues to reliably produce their life-enhancing product, and yet it is among the most vilified industries on the planet today.
This apparent contradiction is even more remarkable when you consider the historical frame: an industry whose product has literally changed our world for the better in so many ways was born, has matured and then fallen to widespread public contempt in less than 200 years. How can this be the case?
A complete examination of this question would fill volumes, and is beyond the scope of this opinion piece. Two of the main perceptions (or theories) that drive this apparent contradiction are summarized below. Most of the evils that the public attributes to the oil and gas industry are variants of these issues on some level. Keep in mind as you consider the following commentary that life is full of compromises, and this industry has to balance more than its share.
Theory One: Oil and gas extraction companies do not care about the environment.
Oil and gas extraction is a messy proposition, and if you are someone who believes that the environment should not be impacted by mankind’s activities regardless of the benefits derived from doing so, then you will not appreciate this industry. As in any industry, there are good actors and bad (companies and individuals) – and there are frequently decisions that must be made in an operational context within a very short time frame that may have substantial consequences for individuals and the environment. This is the nature of extracting a commodity product that requires applied technology and heavy machinery, often in harsh and/or remote locations.
Can safety and environmental risks be eliminated during the oil & gas extraction process? The answer is “Yes, but not with 100% certainty. And by the way, how expensive would you like your energy to be?” It has been my personal experience that addressing personnel safety and environmental risks are constant considerations as oil companies pursue the business of natural resource extraction. Oil and gas are commodity products and it is impossible to differentiate a molecule produced by Company A from a molecule produced by Company B when they are producing from the same reservoir. Therefore, if Company A choses to spend more money mitigating environmental risks beyond the regulatory requirements of the geographies in which they operate, they are essentially choosing to accept lower margins than their competitors as the price for both molecules will be the same on the open market. Generally speaking, companies with lower margins are punished by investors and have reduced access to capital, which can easily become a death spiral. This leads us to another of the perceived transgressions of the oil and gas industry.
“Theory Two: Oil and gas extraction companies engage in predatory pricing as evidenced by the enormous profits these companies make.”
This theory was more in vogue at the beginning of 2014 than it is now, given the plummeting prices of oil in the last six months. The current oil pricing environment must be extremely confounding to those who hold this view, but I am sure they will create scenarios that allow them to continue believing in the alleged collective malfeasance of the industry. For example: “Why are oil companies cutting the price of their product? Perhaps to drive the renewable energy companies out of business.” Let’s examine some of the factors that drive this thinking.
Oil and natural gas prices are set by open market mechanisms: oil and gas companies sell futures or spot contracts on public exchanges, and the price the buyer is willing to pay establishes the price of the commodity. It is the investors on these exchanges that set the prices, and these prices are not always a direct reflection of the supply/demand curve. For example,. in the last six months there has been a roughly 2% increase in crude production / supply, while at the same time there has been greater than 50% reduction in price. You would also expect profit margins to be very high for an industry that allegedly routinely colludes on pricing. However that is not the case. A quick glance at current actual and forecasted 2015 margins for S&P 500 sectors as reported by Yardeni Research, Inc. in their S&P 500 Sectors and Industries Profit Margins report (page 14), shows that energy sector profit margins are decidedly pedestrian in the best of times, and are forecast to plunge by almost a quarter starting in mid-year 2015 to around 6% by the end of 2015.
How can this be the case when top line profits for oil and gas extraction companies are (or have been) so high? Most people fail to do enough research to understand that massive investments are required to generate these profits. If one stops at the ‘top line’ revenue numbers, the full context will not be understood. Commensurate investments in operations are required to generate income through the sales of production from current wells (depleting reserves), in addition to continually drilling more wells (replacing reserves) so production can continue.
My conclusion in response to the theory that oil and gas companies are manipulating prices to drive up margins, is either that the theory is wrong or the industry is not very good at it. The old saw “it takes (huge amounts of) money to make (huge amounts of) money” is never more true than when applied to this industry.
About Bart Stafford
Bart Stafford leads the Wipro oil & gas upstream solution group focused on Production Optimization & Integrated Operations. He previously led SAIC’s global digital oilfield solution until Wipro’s acquisition of SAIC’s oil & gas practice in 2011.
As a part of his responsibilities at SAIC and Wipro, he has worked directly with the Digital Oilfield/Integrated Operations programs at Chevron, ZADCO, Shell, PTTEP and Qatar Petroleum. He has also worked with joint industry/academic initiatives focused on providing an educational foundation for college graduates who wish to pursue careers in this domain.
Prior to joining SAIC, he was vice president of product marketing and sales for upstream oil & gas software companies OpenSpirit and Petris Technologies.
Mr. Stafford started his professional career with Mobil Oil and later moved to Burlington Resources. Bart holds a degree in business data processing from Stephen F. Austin State University and a management certificate in energy from Rice University. Bart is a member of the SPE where he is a frequent speaker and conference committee participant.