Ev Ehrlich's Everyday Economics

ConocoPhillips

First, I’ve got a new post on Huffington Post – I know Arianna will be sending me a check when the transactions closes – and you can read it here.

Now, let’s start with this article about what’s going on at ConocoPhillips.  No, wait, let’s stop there for a second – don’t you love the company names you get after mergers?   You know, combinations of the names of the participants that get slammed together like those run-on German nouns -- like  OLTimeWarner, or PriceWaterhouseCoopers.  It’s like the kids in my neighborhood who have hyphenated names.  Many of the kids with these portmanteau-like monikers were in the Bethesda-Chevy Chase Baseball league in which I spent six years coaching; they’d come to the plate with their names strewn over their shoulders from labrum to labrum, and I don’t mean guys with legit scapula bridges, like Doug Mientkiewicz or Jason Isringhausen, or Jared Saltamacchia.  I’m talking about Michael Horowitz-Murphy, or Brian Reynolds-Benedetti, guys whose unis were more autobiography than athletic  garment.  I used to wonder, as I’m sure many of you did, what would happen if these guys one day had children with a hyphenated-named partner , which world leave them with the choices of, 1) a four-component name, like Horowitz-Murphy-Reynolds-Benedetti, 2) dispensing with one of their original  names, and thereby defeating the whole purpose of the enterprise (at least I see it), or 3) an acronym! -- the aforementioned Horowitz, et. al. progeny could be renamed  Homurebe, for example.

Well, whatever.
OK, back to ConocoPhillips, and the good news is that they’re not going to merge with ExxonMobil.  In fact, they’re going to break themselves up – not into Conoco and Phillips, the component parts that constitute the merged entity, but into one company that explores for and produces oil, and another than refines it into products and distributes and sells it.

Over ten years ago, I was the speaker at a conclave of energy industry executives, investors, and other interested parties hosted by a leading private equity firm which I will not embarrass by naming.  I did a great job, in that virtually nothing I said would happen in the oil market happened, particularly when I provided to them this astonishing prediction – that the rationales for the vertically-integrated oil “majors” – the Seven Sisters, Exxon, Mobil, BP, Shell, Chevron, Texaco, and Gulf -- had disappeared, and we would soon see dis-integration of the integrated majors into separate companies focused on exploration, refining, and maybe marketing.

I wish I could somehow convey to you the sea of confused expressions that greeted me.  But there was a general consensus that my thinking made as much sense as if I had said “Alligator riboflavin besmirched Herkimer unicycle.”  Yet now, a decade later, thanks to vision of ConocoPhillips CEO Jim Mulva, it’s   coming true.

Why is this happening now?  At one level, the more interesting question is why hasn’t it happened already?  The different activities involved in an integrated oil company involve dramatically different skills.  Exploration is about geology, accumulated experience, and now, the use of technology.  Computers can now go way beyond the old, analog techniques of seismic refraction to map underground geological structure and find the sedimentary traps in which hydrocarbons accumulate.   They make the information needed for exploration cheaper, deeper, and more accurate.  (But, seismic refraction has left behind a legacy for us – the underground vibrations that provided the data from this technique led to better reel-to-reel, magnetic tape recording, which in turn improved studio music recording – the ability of the Beatles to work in four-track and make records such as Rubber Soul, Revolver¸and Sgt. Pepper was
an off-shoot of the search for oil by way of Ampex.  In fact, it’s not really conjectural that the need for better analogue recording devices for oil exploration ultimately led to the recording equipment that allowed Flatt and Scruggs to record The Ballad of Jed Clampett.  I’m told that the amazing Bela Fleck plays
banjo on the version used in the subsequent, eponymous movie, but whoever made a lousy movie out of a magnificent gem like the original Beverly   Hillbillies can rot in hell, Fleck or no Fleck.)

And exploration has nothing, and progressively less than nothing, to do with refining.  Aside from its basis in chemical engineering, refining is evermore an exercise in regulatory compliance – the most successful refiners are those who best manage he regulatory challenges of effluents, lead, flare gasses, and so on.  And then there’s marketing, which requires the logistical ability to move product to where it’s needed and to establish brand differentiation once it gets there.

How did these things all come together under the same aegis?  The answer derives from a central fact of the oil industry that is quickly becoming a fiction – oil was cheap, and its supply was concentrated in the Middle East.  Middle East oil still dominates the world market, but not as it once did, and the cost of lifting it is no longer the determinant of the world price – if it was, we’d be back in the days of $3 barrels.  At that time, “exploration and production”
meant being an Aramco partner and gradually exploring for an planning extensions of the major Middle Eastern oilfields.

Refining in this world was an annoying inconvenience on the way to market.  But by controlling refining capacity, the majors had the ability to control and plan the flow of oil from its extraction to its final destination – no need for buffer stocks at refineries, no need for co-ordination with independent refineries, no need to worry about seasonal changes in product mix – gasoline in summer, distillate in winter, and so on.  Oil majors controlled all of these stages much the same way that automobile producers made all their own parts – because that was the cheapest an easiest way to orchestrate all the moving pieces.

The initial OPEC shocks of 1973-74 changed the management philosophy of the Middle East fields, but not the lay of the land.  By asserting their control over their own resources, the Saudi, Kuwaiti, and other Middle Eastern royal families substituted their (lower) rate of time preference for the (higher) preferences of the western oil companies – oil in the ground meant more to them than to the companies.  The Western companies were happy to lift and sell all the Middle Eastern oil they could.  But the royals saw extraction as a portfolio decision – why lift oil that might command a better price tomorrow, and why produce more revenue than the nation’s development effort could productively use?  The resulting higher price of oil certainly gave added impetus to expanding Prudhoe Bay and Mexico’s Gulf fields, but the integrated majors still had access to the ace of trump.

Now, several decades later, Middle Eastern oil is locally controlled and its rents accrue to locals.  And the industry now depends on complements to Middle Eastern oil, and those complements are increasingly found in remote locations and deep water.  Exploration activity is more productive thanks to remarkable technology, but it takes more activity to find oil, and the oil that is found is characteristically in smaller concentrations.  Moreover, as  deepwater Horizon  -- a rig that must have gotten its name for precisely these reasons, that it was positioned at the horizon of deepwater exploration
and production – no sin of hubris there – demonstrated, production is now far more complex than running the Saudi tap.  Being good at both E&P and refining is like being good at painting and roller skating, or math and yoga – if you are, it’s almost an accident.

So the value chain has changed.  Cheap and easy oil production meant that marketing was the throttle – you produced and refined so you could control the
flow to market.  But now, the gating item is exploration; with oil seemingly perched near $100 for the foreseeable future, finding it is the trick.  And if
you know how, refining it and selling it will follow.

And ConocoPhillips is coming to terms with this new set of realities.  Moreover, since exploration and production  is a higher risk venture than refining – I mean, ultimately, who the hell knows where you’re going to find a big pool of oil in the ground? – it commands a higher return.   Refining is less risky, even if just as technical, and therefore more of a commoditized activity.  And marketing is now the tail of the dog – does anyone doubt there will be fewer gallons of gasoline sold in the developed world ten years from now?  The growth is in the rapidly growing economies of Asia and elsewhere, where it’s a more
competitive environment.

Moreover, every company that goes this route makes it easier for all the others, because each dis-integration creates a larger independent refining sector, which makes it easier for other integrated majors to imagine taking the plunge.  The press reports of Conoco’s mitosis were quickly followed by the news that BP might soon follow suit.  And from a risk management perspective, following Deepwater Horizon, they’d be wise to do so – their job is to focus
their risk management, not to spread it over a diverse set of activities.  BP showed the world that being a production company is harder than it looks – one hopes they’ve learned that lesson themselves.

In the end, all of this activity is a symptom of the post-industrial era, in which scale is less important that specialization.  In information technology, in
pharmaceuticals, in automobiles, and a host of other industries, the idea that scale – and in particular, vertical integration -- is the secret to competitive
success is being disproved.  The press of competition forces firms to decide where their bets will be places.  Information networks allow firms to disintegrate
and use zero-cost information to coordinate activities once orchestrated by internal pyramids.

ConocoPhillips’ decision reflects these changes.  And before the story ends, all of integrated oil majors will be faced with the same circumstances, and will travel the same route.  They will all break themselves up by stages.  Refining will turn into a low-margin engineering service, and exploration a high-risk, high-reward enterprise where innovators will rule over the well-capitalized giants.  It might take some time to get there, but time is only Nature’s way of making sure that everything doesn’t happen at once.