Getting acquainted with the oil industry

Bugbear

Guyanese have read and heard about oil discoveries and production that have taken place in various parts of the world.  They have also heard about the behaviour of the markets and only know too well about the impact of oil prices on their competitive abilities, consumption and living standards.  For many Guyanese, oil has been a bugbear for nearly 44 years and its easy availability has been a thing on their minds for just as long. There have been articles in the newspapers about fuel shortages and fuel smuggling.  Fuel and lubricants account for nearly one-third of the import bill of the country and a sizable chunk of the revenues generated from the export of other products.  With the discovery of oil in the territorial waters of Guyana, the country is likely to start producing oil and natural gas some time in the future.  People will have to start shifting their attention to production and exports, if they have not done so already.  Making that shift in focus meaningful would require Guyanese to have a better understanding of the oil industry and the things that they should contemplate and look forward to as the industry evolves.

Analysts tend to discuss different characteristics of the oil industry, including who the most influential participants are.  In doing so, they look at proven reserves; they look at crude oil production and talk about light-sweet crude and heavy-sour crude; they look at refining capacity; they also look at exports and revenues.  Oil is so central to the economic and social activities of every country that changes in the industry are often analyzed in a geo-political context. Discussions tend to focus on the behaviour and reactions of countries and companies. The discussion about countries seeks to show which countries are highly influential in the oil industry and whose behaviour could have an adverse impact on the availability of supplies, prices and the condition of the global economy.  Discussions about companies also look to see who leads the industry and who controls market share and increases enterprise value and shareholder value.  New discoveries of oil spark interest around the world.  This article will discuss the major participants in the oil industry and how the industry is structured for the purpose of understanding the power among the major players and to appreciate some behaviours as the industry expands.  Limitations of space necessitate presenting the article in two parts.

Classification

Before discussing countries and companies and their influence on market share and market value, the article will describe how the oil industry is classified. Those who dwell in the oil industry and are familiar with its competitive nature tend to divide the industry structure into two parts, namely the upstream and downstream operations. Some analysts add a third element, namely midstream operations. For convenience, many analysts often link discussion of midstream operations with the downstream operations.  For those of us who know very little about the industry, this classification serves as a useful way to learn and understand it. The classification looks simple enough to enable one to appreciate what each stream consists of and the implications that they have for a country like Guyana.  Each grouping has its own set of related supply-chain activities.

Dreams

The desire of becoming an oil producer and exporter all starts in the upstream area.  It is where dreams take place and hopes are dashed.  Generally speaking, the upstream area consists of acquiring access to property to engage in exploration activities.  In cases where exploration produces positive results, then the activities in the upstream area would broaden to include efforts at evaluating and developing the reservoir and eventually producing oil and gas from the reservoir.  So far, acquisition of the property and exploration of the property have led to the discovery of oil in Guyana in at least two locations.  Evalua-tion of one of those locations has been completed while evaluation of the other is ongoing.  Given the events that have been taking place after the announcement of the oil find, development and eventual production from the known reservoirs were likely to occur.  Hope is still alive.

In reading about the industry, one of the things that becomes apparent is that initiating upstream activities is very capital intensive and risky.  The capital outlays can be substantial and sometimes exploratory activities turn up water.  As a consequence, a major strategy in the upstream area is the sharing of exploration costs.  This type of collaboration was evident in the exploration activities in Guyana where Esso Exploration and Production Guyana Limited, an Exxon affiliate, was joined by Hess Corporation and China National Offshore Oil Com-pany (CNOOC) in exploring for oil in the Stabroek Block in Guyana’s territorial waters.  Esso, with a 45 per cent interest, carried the largest share of the investment.  Hess had a 30 per cent interest while CNOOC had a 25 per cent interest.  However, industry analysts have pointed out that while the cost of bringing an oil field into production was high, the variable cost of producing oil was relatively low.  Consequently, the general tendency was for producers to move on to development and production in the upstream area once fixed costs had been sunk and the reserves proved viable.

Assurance

Notwithstanding the assurance and the favourable prospects for oil production, it is not a foregone conclusion that the full range of upstream activities might occur in Guyana and in the anticipated timeframe.  Even as it is now, many upstream support operations are being staged out of Trinidad & Tobago. Guyana does not have the infrastructure or enough expertise to support oil exploration and development.  As one gets closer to production, it is hoped that more upstream activities will take place in Guyana. The uncertainty about production emerges from the nature of the commodity and the conditions imposed on those who assert the discovery of oil and natural gas and the desire to exploit those natural resources.  Exxon has held back on developing several oilfields in Australia, the USA, Kazakhstan, the Netherlands, Nigeria and Qatar for more than five years.  The reason is linked to constraints on the capacity of infrastructure, the pace of government funding, as well as the time required to complete development for some of the projects.

Consumable assets

Oil and gas are consumable assets whose economic relevance is well-known to households and industry. Their accounting relevance, the thing that matters to investors, however, is dictated, among other things, by both market and non-market conditions. Money is spent on many activities during exploration for oil, but in the end, it is the proved reserves that matter.  The importance of proved reserves to the size and performance of a company cannot be overemphasized. Proved oil and gas reserves refer to quantities of crude oil, natural gas, and natural gas liquids which geological and engineering data suggest could be recovered in future years from known reservoirs.

Knowing that the oil and gas are there is not enough.  In order for what exists in the reservoir to have meaning, it must be matched with economic and operating conditions facing the company at the time that the discovery was being evaluated.  The price of oil at the time that the estimate is being made and the cost that the company thinks it will incur to recover the oil and gas help to determine how much proved reserves a company has.  Technology matters also in assessing proven reserves. Exxon utilizes proprietary seismic processing software, proprietary reservoir modelling and simulation software, and commercially available data analysis packages to arrive at proven reserves.  Reserves can change not only by increasing or depleting oil supplies, but also as a result of improved technology and price changes that are linked to contractual arrangements.

General economic conditions

It should not be surprising that ExxonMobil identified general economic conditions and price as two major risk factors in decisions about upstream operations in its 2015 annual report that was submitted to the SEC. ExxonMobil indicated that “[a]ny material decline in oil or natural gas prices could have a material adverse effect on certain of the Company’s operations, especially in the Upstream segment…” The issue of proved reserves among countries might not be a settled matter and could lead to major disagreements among experts, industry analysts and regulatory authorities. According to some oil industry analysts, there is inconsistency in the way proven reserves are measured by countries. Some countries include undiscovered reserves in their estimates of proved reserves while others rely on information from existing fields.  ExxonMobil does not have that luxury.  As a US company whose shares are publicly traded on the New York Stock Exchange, Exxon must follow SEC definitions about proven reserves.

Midstream activities

Midstream operations connect upstream operations with downstream operations and include the processing, storing, transporting and marketing of oil, natural gas and natural gas liquids.  It is essentially about the shipping and storing of oil before refinery.  The oil discoveries in Guyana have occurred some 120 miles offshore.  Because of its location, the produced crude does not lend itself to pipeline transportation.  Special tankers would have to play the role of transporting the crude to refinery.  It is not known if Guyana will have a refinery when the crude is ready for shipment.

(To be continued)