Big changes are in store for Big Oil

The track record of Petróleos de Venezuela (PDVSA), the Venezuelan national oil company, is a striking example. For President Hugo Chávez, PDVSA is a cash cow for social programs, and developing new production is apparently a low priority. Since 1998, just before Chávez took power, PDVSA's output has fallen by 46 percent. Iran, which has largely excluded foreign companies, has seen capacity fall from 7 million barrels per day before 1979 to below 4 million barrels. These collective shortfalls have driven OPEC'S capacity from more than 38 million barrels a day in 1979 to 32 million, according to Edward L. Morse, a senior analyst at Hetco, an energy trading company in New York. And since many OPEC producers won't divulge vital data, it's impossible to figure out what OPEC's true reserves are.

Personnel shortage
Given these ever-tighter restrictions, the oil majors are milking the acreage they hold in politically stable zones for all that it's worth. They include the North Sea, the Gulf of Mexico, and the North Slope of Alaska. Discovered in the 1960s and '70s, they are being depleted. As these fields dwindle, their scarcity value as safe zones is shooting up: BP recently sold fields in the Gulf of Mexico to Apache Corp. for $22 a barrel. Two years ago the price might have been around $7 per barrel.

With the older fields fading, the industry is turning to nonconventional sources like liquefied natural gas and tar sands. "The easy energy is already tackled," says Malcolm Brinded, Shell's executive director for exploration and production. "The industry is going to have to do more and more challenging projects." Shell should know: Its Sakhalin II oil and gas project has reported a cost overrun of $10 billion.

New strides in technology were supposed to lower the cost of finding these fresh reserves, but the complexity of new ventures adds to the expense. Morgan Stanley figures the costs of finding and developing a barrel have tripled since 1999, to over $10. Donald L. Paul, Chevron's chief technology officer, notes that offshore wells now often have to drill 10,000 feet or more to find oil: 600 was once the limit. "Wells are $50 million and up," says Paul. A decade ago, they cost $10 million.

Companies also say it's not easy finding the personnel needed to man these projects, especially in the West. In Russia, China, and elsewhere, it's a different story. Russia's Gubkin Institute of Oil & Gas has an enrollment of 8,000 students and adds 1,500 each year — more than the total native British and U.S. students studying petroleum science, says Joseph A. Stanislaw, senior adviser to Deloitte & Touche's energy practice. The scarcity of people and equipment is delaying projects, putting further pressure on costs and prices. Rigs are being channeled to development projects, which provide quicker profits, rather than pure exploration, possibly diminishing future prospects.

How will the majors respond to these challenges? Seasoned fields like the North Sea are enormously profitable. But as the majors switch to far more expensive fields, returns will drop. The big companies of course have huge resources. ExxonMobil, for example, has $33 billion in cash, and it has made some promising deals recently. And the majors have a head start if the industry shifts to alternative fuels. But the oil companies are still finding it easier to return billions to shareholders than find sensible new investments. Last year the six majors spent $71 billion on capital investment, but $74 billion on share repurchases and dividends.

In the long run, the big oil companies that can't find a way to invest profitably in their industry could find themselves vulnerable. "Companies can't go on returning cash to shareholders. Otherwise they might as well give the assets to someone else," says Mark Bentley, head of global energy investment banking at HSBC. Bentley says hedge funds and investors are closely scrutinizing oil company performance. Consumers take note: Big Oil has a future. But despite that gusher of profits, it's not an easy one.

By Stanley Reed, with Christopher Palmeri in Los Angeles, Peter Coy and Rose Brady in New York, and Mark Morrison in Austin, Tex.

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