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Trouble Comes to the Oil Patch

In the oil patch, the mood has gone from boom to gloom in record time.

Less than a year ago, pundits were predicting $200-a-barrel oil, endless growth in Chinese energy demand, and a world running out of crude. But at CERAWeek, the big energy conference put on by data and advisory outfit IHS (IHS), running Feb. 9-13 in Houston, the talk has now focused on industry consolidation, how to beat down supplier costs, and just how low the price of oil might go.

"It has become painfully clear that our understanding of market forces remains imprecise at best," Ali Ibrahim Al-Naimi, Saudi Arabia's Minister of Petroleum & Mineral Resources, told conference attendees on the night of Feb. 10. "Groupthink dominated financial markets. What many forgot, ignored, or wished away is that markets are cyclical and recessions inevitable." Al-Naimi said that with a big new field coming on line, his country would soon have some 4.5 million barrels per day of spare oil production capacity, well above the 1 million to 2 million barrels per day the country typically maintains.

In July of last year, crude peaked at $147 a barrel. On Feb. 11 it was trading below $36. Investment bank Morgan Stanley (MS) recently predicted it could fall to $25 in the second quarter of this year.

The Cracks Are Showing

"The economic outlook has changed dramatically," Tony Hayward, CEO of oil giant BP (BP) said. "The impact on our industry has been sudden and severe."

The cracks are beginning to show in Houston, America's energy capital. The city seems to shine right now, with gleaming new parks, shopping centers, and sports facilities. All over town, cranes are still erecting luxury condo towers, giving the city the feel of a Dubai on the Bayou. Look more closely, though, and there are For Lease signs in the windows of furniture stores. A gray-haired man and his wife ask for gas money in the parking lot of a fancy Italian restaurant. And a swanky downtown boutique hotel with an empty bar practically pleads for customers with a $4 happy-hour menu.

The world, it turns out, really is flat, or at least not "decoupled" as some pundits once suggested. Zhou Jiping, the head of China National Petroleum, that nation's largest energy producer, said oil demand in his country has shrunk dramatically in the past year. "The heart of every Chinese feels the same vibration as the rest of the world," he said.

How all this gloom affects oil-company spending is a $300 billion question. Research firm John S. Herold expects capital spending on the part of the world's oil companies to fall 13% this year from last year's $300 billion. Many of the higher-cost fields that attracted capital in recent years may not be profitable at today's prices.

The Price Equals the Cost

Peter Mellbye, senior vice-president at Norwegian oil company Statoil Hydro (STO), displayed a slide showing the cost to produce a barrel of oil all over the world, from $20 in Saudi Arabia to more than $100 for the viscous goo found in Venezuelan lake beds. In a startling display of oil-company candor, Mellbye also showed Statoil's costs across all its projects. The average was $40 a barrel, about where the price is today.

Many of the major oil company execs at the conference tried to put on a brave face. Jeroen van der Veer, CEO of Royal Dutch Shell (RDSa), said his company's $32 billion-a-year in capital expenditures would drop "only a little" this year. Asked how he would justify that level of investment to shareholders, he said: "You have to explain long-term how compelling energy investments are. This is a better investment than paying out cash in dividends today."

BP's Hayward concurred that investments today make more economic sense because the cost of new leases and equipment are no longer being bid up, as they were over the past five years. Hayward said that new investments will be needed down the road, when the world economy rebounds. "The future is not canceled," he said.

But the severe price deflation hasn't yet hit all parts of the oil patch. Ali Moshiri, president of Africa and Latin America for Chevron (CVX), said the companies that supply the drill bits, rigs, and other oilfield supplies would have to bring their prices down further.

Shaving Expenses

"Oil prices have come back to 2005 levels but the cost of goods and services is twice as much," he said. "If we don't manage that, projects will be delayed, and suppliers will be hurting even more." Moshiri said an oil-production vessel that cost Chevron $500 million to build four years ago now costs $1.2 billion. To drill and test an exploratory well in deep water can cost $350 million. "We can't run our business that way," he said.

Other companies spoke of specific ways they were lowering costs. David Latin, vice-president for technology at BP, said his company was using fiber-optic lines and wireless connections to transmit data in real time from unmanned, offshore wells. By measuring the pressure, temperature, and oil flows remotely, the company could tweak the levels of chemicals, water, and gases used to flush out the hydrocarbons. The company has also improved its safety record because it no longer has to send workers out in helicopters to get data from the platforms. BP has cut its chemical costs by 15% as a result, its labor costs by 25%, and boosted production from old fields by 2% in the process.

At ConocoPhillips (COP), manager Stein Wolden is designing new work areas with input from psychologists and architects to get formerly disparate teams to work together. He said travel budgets have been cut, but video conferencing usage is up 30% since the economic crisis began last year. Shell, meanwhile, has developed new drilling vessels that are half the size of the old ones. They cost less and burn 50% less fuel.

Some things haven't changed. Oil execs still plead for more help from Washington, more access to off-limits regions, less regulation, and environmental programs that don't cost them too much. This year some of their requests may be answered. On Feb. 9, Representative Edward Markey (D-Mass.), the new head of the House Commerce and Energy subcommittee on energy and the environment, indicated oil producers may be allowed to drill in some new areas.

Reconsidering Steep Terms

"I think we can find areas of the Outer Continental Shelf that are acceptable for drilling, but we need to protect our most sensitive areas," he told conference attendees.

Several oil executives suggested that countries that charged much steeper terms for access to their oil in recent years may have to reconsider such terms as income from their oil lands has dwindled along with crude prices.

Colombia is showing how that might work. The former economic basket case cut its taxes sharply in the past three years and allowed foreign oil companies to invest without having to be partnered with national oil company Ecopetrol (EC). Chevron alone has invested $500 million in Colombia. The result of such efforts is a 30% increase in oil production over the past two years, to an estimated 650,000 barrels per day in 2009. Some two-thirds of that will be exported to countries such as the U.S.

"The overall government take in Colombia is less," said the country's Minister of Mines & Energy, Hernán Martínez Torres. "Right now, Colombia is one of the most competitive countries in the world."

And what of the world's biggest economic growth engine? China National's Zhou said the Chinese economy would start to rebound in the second half of this year, thanks in part to a $1 trillion government spending program. Oil prices, he predicted, would bounce back to $60 a barrel by 2010. He quoted optimistically from a 1,000-year-old Chinese poem: "Where the hills and streams end. There seems no road beyond…another village appears."

And, perhaps, another oil well.

Palmeri is a senior correspondent in BusinessWeek's Los Angeles bureau.

Palmeri is a reporter for Bloomberg News and Bloomberg Businessweek in Los Angeles.

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