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By Rana Foroohar
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Under the 12-year leadership of Lord John Browne, BP cultivated a reputation as a different kind of oil company, kinder and gentler on issues from women in its work force to the environment. Browne often topped lists of "most admired CEOs." With his erudite and sophisticated style, he has stood in sharp contrast to many freewheeling U.S. oil executives.
But reputations are fragile. In recent months BP has suffered a refinery explosion that killed 15 people in Texas City, Texas; a spill in Prudhoe Bay that was the largest ever on Alaska's north slope, and accusations that the company's trading arm manipulated energy markets.
Key investors have asked whether there is a systemic problem at the company. U.S.-based BP executives have been lambasted about safety standards in congressional hearings. The U.S. Justice Department and other agencies are investigating issues of safety and market manipulation. Lord Browne himself may have to testify. Already, BP has rejiggered U.S. top management and appointed an ex-judge to review claims of whistle-blowers, some of whom have accused BP of intimidation and ignoring safety warnings in Alaska. (The company denies these accusations.) As Lord Browne told NEWSWEEK this summer, "We're moving from a situation of business as usual to a situation of business as unusual."
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It's a change that won't stop with BP. While the world's second largest oil company after ExxonMobil is undoubtedly in the hottest water, Browne is by no means the only oil chief who is worried about the future. From the outside, the oil industry may look like a bunch of fat cats enjoying record prices, profits and CEO salaries. What many CEOs dwell on are costs--which are rising as fast or faster than profits--and past experience, which tell them not to enjoy high prices because they are not likely to last. Most see the recent dip below $60 as only the first step in a fall that is likely to take prices below $40, even $30, as new supply from places like deep water and tar sands comes online. "People tend to forget that it has been only two years since the price of oil has been above $40 a barrel, and only one year since it's been above $50," says Browne. "I think that's important context."
Implausible as it may seem for oil CEOs to plead hard times, the truth is that Big Oil is not much richer in absolute terms than it was before the price spike. For the last six years, returns have been flat--according to Goldman Sachs, the average Western oil company will earn a 19 percent return on capital invested, up only about 2 percent since 2000. In the supremely capital-intensive oil industry, return on capital is a key measure, because it reflects not just how much profit a company made, but the cost of making it.
The bottom line: oil companies are stagnating. The problem is a perfect storm of two decades of underinvestment, rising oil nationalism, the maturing of old reserves and the rise of riskier exploration projects, which have conspired to limit Western majors' access to easy oil, and to send costs spiraling out of control (graphic). "People just look at oil-company revenues and think things must be great," says Jeffrey Currie, Goldman Sachs's head of commodity research. "What they don't see are all the tremendous challenges in today's operating environment, and the slew of difficulties going forward." Indeed, there are analysts who argue that, in a cost-cutting environment, it was only a matter of time before something like Prudhoe Bay happened.
The markets are much more aware of these difficulties than the public, which is one big reason that oil-share prices have not risen with recent profits. The average price-to-earnings ratio for the Big Oil companies on the S&P 500 (ExxonMobil, Chevron and Conoco) now stands at 9.8, or about half their historic average, says senior S&P analyst Howard Silverblatt. That's nothing for Big Oil CEOs to smile about, even if their average pay is now well above $20 million. "There is no doubt that the view from the CEO's office these days is less than buoyant," says Daniel Yergin, head of Cambridge Energy Research Associates.
In fact, the trough of the last two decades, when average prices were around $20 per barrel, is behind Big Oil's big problems. Oversupply and, to a lesser extent, lower demand after the Asian financial crisis of the late 1990s kept prices low until about 2002. During that time, there was massive consolidation within the industry. Wages plunged, and in the United States, oil-industry employment went from more than 1 million to fewer than 500,000. Some 400 Western oil companies went out of business. Those that didn't go under survived by slashing costs and capacity. The result is nothing less than a missing generation in the oil business. "Young people 10 years ago just didn't want to go into mining or minerals engineering," notes Leonardo Maugeri, group senior VP for strategy at the Italian oil major ENI. "It was considered a losing game."
BP was perhaps the most aggressive cost-slasher of that era. Browne was the strategic leader in the industry during the 1990s--he felt strongly that there was too much cost within the industry, and strove to make BP more competitive by tightening the reins across all operations, upstream and downstream. Others, to a greater or lesser extent, followed his lead. The big question now is whether BP went too far, risking safety in operations for the sake of profit (among other things, whistle-blowers have accused the company of skimping on Prudhoe Bay maintenance and using outdated equipment in Texas City; BP denies these accusations). "The culture at BP in the '90s was very different than at Exxon or Chevron. Their problems now aren't just about bad luck," says one high-level oil veteran who declined to be named so that he could speak more freely. Browne has denied such criticisms, saying there was no culture of "reckless risk" at the company. BP insists the recent incidents are unrelated to one another.
Still, many analysts say it was perhaps only a matter of time before all the fat-cutting began to affect operations. Today the cost problem is entirely different: it is not about fat, but about years of anemic spending that has left the supply of everything from oil-rig hardware to oilfield engineers way short of rising demand. That pushes up prices. CERA estimates, for example, that overall costs for offshore drilling have risen 68 percent since 2001, far faster than inflation. And Browne says that the maximum daily fee BP pays to lease rigs capable of drilling in "ultradeep" water (more than 1,500 meters) has risen from $200,000 to $500,000 since 2004. What's more, he predicts, these costs are unlikely to go down: "There's very rarely depreciation in the industry, so what you see is an additional inbuilt cost that will likely be with us forever."
The spiraling costs are compounded by another megatrend within the industry--oil nationalism. As prices began to rise a few years ago, countries like Mexico, Russia, Venezuela and others began taking back control of their wells, and cutting the access of Western majors to new drilling areas. The result is that only about 25 percent of known reserves in the world are open to the Western majors today, down from 85 percent in the 1960s, according to Washington, D.C.-based PFC Energy consulting. "While every other industry in the world has been globalizing, oil has headed the other way. In energy, the world is not flat," says Robin West, head of PFC and former assistant secretary of the Interior under Ronald Reagan.
When they do let outsiders in, states are taking more of the profits from projects, around 90 cents of every dollar of oil revenues, up from 70 or 80 cents in the past. As Shell CEO Jeroen van der Veer recently told NEWSWEEK, it's important for oil executives to "stand with their hat in their hand" in front of developing-world politicians if they want to get even a small slice of the pie these days.
That's one important reason that Big Oil is hardly celebrating its record profits. Everyone wants a piece of the windfall. ExxonMobil's current ad campaign is plaintively defensive, arguing, for example, that the real beneficiaries have been governments--because ExxonMobil may have made $36 billion last year, but paid $99 billion in taxes. Even before BP's stateside crises, European and U.S. politicians alike were lobbying for windfall taxes for Big Oil. Washington is now pushing to renegotiate more-favorable terms for royalty sharing in the Gulf of Mexico.
Whatever happens, the terrain will undoubtedly get more difficult--and more expensive. Goldman's Currie, Houston-based oil engineer Les Loushin and others say that they won't be surprised if more companies face problems like the ones seen recently by BP. After two decades of underinvestment, people and infrastructure are now being pushed to their limits. Loushin expects that safety and infrastructure spending will have to increase exponentially, as wells at the end of their lives (like those that failed in Prudhoe Bay) are by nature more problematic, as are unconventional projects like deepwater drilling. Companies like Shell are already spending a small fortune developing new superstrong alloys to be used on such projects. BP, for its part, has pledged an additional $1 billion to bolster its U.S. infrastructure over the next four years. Given the scope of its current judicial problems and its ongoing operational overhaul, it is likely that number will grow. Many experts believe the BP troubles will inspire tougher oversight of the oil industry at large. Though Browne is on the hot seat now, he won't be there to see how things end. Having provided the template for the modern Western oil company--doing the first big megamergers of the 1990s, signing the first major deal in Russia, speaking out about alternatives and cost cutting (perhaps infamously) his way to success--Browne will leave the future of oil to others. This summer, under pressure from his board, as well as shareholders eager for new blood, he agreed to step down as CEO of BP in 2008, coincidentally the company's centennial year. By the looks of things, the next hundred years of the oil business will be a lot tougher than the first.
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