Incentivizing Distraction

In an economic environment dominated by fear incentives are needed to spur action. Creating the right incentives is critical to spurring the right actions.

Most everyone is happy that oil and gas are relatively cheap right now. Following the gyrations of oil prices and the oil market is exhausting; trying to predict them with any accuracy is nearly impossible, even for the experts and industry insiders. Now that the price appears to have stabilized at a modest level, the tendency is to exhale and relax and return to "normal." However, if you're an oil company, you never relax from the siege mentality.

Oh to be a benighted oil company, struggling against restrictive government policies and burdensome taxation. If only lawmakers would come to their senses! Why, Big Oil is heroically undertaking extraordinary financial risks to deliver fuel to thirsty consumers, and doing so in the face of pointless restrictions, crippling regulation and unfair taxation! If something isn't done, they darkly warn, exploration will atrophy, production will shrink, and the oil supply will become scarce and costly. There's really lots of oil in the US if only we could be allowed to drill it. It's an old story. Antipathy to Big Oil goes back at least to the trust-busting era, through the OPEC Oil Embargo and to the present day.

The industry is not the source of all the country’s energy problems nor is it solely to blame for the rising cost of energy.... But the companies have only themselves to thank for the low esteem in which the public presently holds them.

That was written in 1976, as Congress debated breaking up the vertical integration of the oil companies. That never happened, but Big Oil has since done little to build the public's trust, nor have they helped their image by clumsy greenwashing.

The American Petroleum Institute (API), the Grand Oil Party and others have been in high dudgeon over what they perceive as an insufficient emphasis on domestic oil exploration. Their voluble irritation has increased since the November election, and has been little mollified by signs that the Obama Administration will not return to a complete offshore drilling ban. Industry groups such as the API have long fought to preserve and expand their special-interest tax treatment, even arguing against the payment of loophole-avoided taxes because it would reduce the incentive for them "to search for new energy supplies."

To hear the flacks tell it, Big Oil is only barely making it with their marginal incentives (e.g. depletion allowances and expensing intangible drilling costs); any restrictions or reductions in their favorable tax treatment could have dramatically negative consequences. API head Jack Gerard frets that such things as a windfall profits tax will leave the industry no incentive to invest in new supply:

It creates a double disincentive. It takes [away] the potential for us to invest in the future, and it also tells us that now we have to look overseas because we have to go look at more competitive opportunities than we have here in the U.S.

That's right, give us what we want or we'll leave. However, the API may have failed to brief their members on these extraordinary risks, because Big Oil is keeping the pedal down on investment in new production. Exxon, the most profitable company in history is unequivocal:

“We intend to continue to invest at these record levels at least over the next five years,” Ken Cohen, Irving-based Exxon Mobil's vice president of public affairs, told reporters recently. The company's $26.1 billion in capital spending last year was 25 percent more than in 2007.

Chevron says nothing different:

Dave O'Reilly, Chevron's chairman and chief executive, told analysts that the San Ramon, Calif.-based company also will maintain spending levels of nearly $23 billion, focused on completing projects that have long been in the works.

Further:

Exxon Mobil and Chevron both said that while they'll keep spending on projects they had in their queues, they intend to chase every cost savings they can, including pushing oil field services providers to bring their prices in line with the fall in commodities. “Through these investments we continued to demonstrate our long-term focus throughout the business cycle,” Exxon Mobil Chairman and Chief Executive Rex Tillerson said in a statement.

And why not? Exxon has continued to set records for its quarterly earnings and the last quarter of 2008 earned $7.8B, a huge sum, but actually quite a drop from its usually lofty results. They've got the money to invest: Exxon has some $31.4B and Chevron some $9.4B in cash. It's not as if they need more taxpayer handouts to produce oil and gas; they seem to be doing very well already and there is no sign that they are poised to throw some kind of hissy fit and stop over the level of "incentives:"

Analysts largely view Exxon Mobil and Chevron as the strongest among the world's largest publicly traded oil companies, each with healthy cash on hand, low debt, a steady stream of project startups and the ability to acquire assets, including distressed companies, amid the recession.

Another area of continued investment and historically high returns their fat coffers allow is lobbying:

API began spending tens of millions of dollar a year in advertising not long after Hurricane Katrina struck in 2005 to deflect calls for a windfall-profits tax on oil companies and proposals to end billions of dollars in tax breaks for oil producers. Mr. Obama advocated a windfall-profits tax, saying he would like to subsidize renewable-energy sources with the extra revenue collected.

Mr. Gerard said he planned to continue spending significant amounts on issue advertising, but declined not give a specific number. "I think we'll play offense where we can. We'll play defense where we have to," he said.

With oil prices low right now there is worry that Big Oil has insufficient incentives to drill and produce; but apparently this is a misplaced concern since their actual investment continues apace. The reasons are not hard to discern.

Oil futures are trading much higher than today's spot price around $35 per barrel. Much higher. There are several reasons, including steadily reduced production from existing fields, oil exporters hoarding supply as they await higher prices, and a growing realization that Peak Oil is upon us:

Goldman Sachs oil analyst Jeffrey Currie issued a report yesterday predicting a, “swift and violent rise” in oil prices in the second half of 2009. Currie told a conference in London that, “Thirty dollar oil reflects the same imbalances that got us to $147 oil. The problems haven’t gone away. We still believe the day of reckoning is to come.” What problems? There are still major infrastructure bottlenecks in the global oil network. Currie says that despite the big fall off in demand, “This is not 1982-1983 all over again. The supply picture’s radically different…the demand picture’s radically different. The key difference is that today there are no large-scale next generation projects that are going to save the world. Commodity demand is exponentially higher than it was.”

There is also a lot of oil arbitrage,

...where supply is stockpiled offshore, and thus withheld from refiners, allowing existing gasoline inventories to be worked down. Then in six to twelve months time, when crude prices have moved higher, you simply park your ship at the terminal and cash in on the difference between what you paid six months ago (today) and the new market price. It is normal for the oil futures to be in cotango, where spot prices are lower than futures prices. What’s less normal is the amount of oil being stockpiled offshore. “Frontline Ltd., the world’s biggest owner of supertankers, said Jan. 14 about 80 million barrels of crude oil are being stored in tankers, the most in 20 years.”

API's Gerard says flatly that demand for oil will remain robust notwithstanding any push to reduce consumption. International Energy Agency (IEA) Executive Director Nobuo Tanaka foresees a "crunch" in oil supply with recovering demand as early as 2010 unless investments are made now. The IEA suggests that while demand destruction may already have caused oil demand to have peaked, much more oil would be needed even in a scenario of no growth in oil demand--as much as 45 million barrels per day of new oil production by 2030. The cotango says clearly that oil is going to get much more expensive again, and the amount of oil sitting in storage represents the speculators' confidence that buying now and paying for storage will yield nice profits against the locked-in future price. In this environment is it any wonder that Big Oil continues to both produce and aggressively invest in new capacity?

Contrast this with the grim mood in the orders-of-magnitude smaller renewable energy industry. Investment capital has dried up and companies have nothing close to the kind of cash on hand or profitable cash flows of Big Oil. At last week's Offshore Wind Financing Conference in San Diego the only deals getting done were for projects in the final stages with permits in hand, supply chain commitments, and signed power purchase agreements. Anything in any earlier stage cannot get funded in this investment climate.

IEA's Tanaka also noted the urgent need to invest in renewables:

Unfortunately we are seeing a deceleration occurring in the switch to renewables... While the economic slowdown itself serves to reduce CO2 emissions, if we don't invest now we will have serious problems in the future.

How much investment is needed? Jack Gerard:

"Oil and gas is the backbone of the American economy. It has been for many years; it will continue to be for many more years," said Mr. Gerard, who has been at API for just a few weeks. "We could quadruple what we're talking about in the area of alternatives and renewables that were doing today, and what would that give us? About 3 percent of our energy production."

Gerard is right. 3% just isn't very much. Finding massive new oil fields to sustain even current consumption is highly unlikely; the future belongs to renewables. Clearly investment in renewable sources will be needed on a much more massive scale than is even now being discussed. Government needs to play at least as strong role there as it has done throughout the history of the creation and nurture of the oil industry.

The bold and smart move is to take advantage of today's temporarily cheap oil to build the future energy economy as quickly as possible. Incentives are urgently needed, not by Big Oil, which already has all they need, but by renewable energy, which is critical to our future but lacks the broad infrastructure that allows rapid monetizing of its capital investment.