The NYTimes today carries a Reuters Breakingviews column arguing for a break up of the vertically integrated oil majors. The author trots out a number of questionable arguments in favor of a break up. He then voices a counterargument that is directly relevant to the themes of this blog:
“Executives argue that lumping refiners and explorers together offers a natural hedge. In theory, when falling crude prices hurt production, the refining business gets relief from lower input costs.”
Some might claim this is just a straw man, but I hear this thinking often enough that I think it is worth pushing back against it.
First, in its simplest form, this argument just has to be wrong. At a first approximation, combining production with refining in no way hedges production. The oil producer is a natural long. The refiner is neither long nor short. The refiner both buys crude oil and sells refined oil products. It captures the margin between the two. Adding up the exposure of a producer with the exposure of a refiner yields a company that still has the exposure of a producer. There is no natural hedge there.
What I mean by ‘at a first approximation’ is that we assume that the price of crude and the prices of refined products all move together, one-for-one. Of course, this assumption doesn’t hold. When crude prices move, margins on refining often move, too. But the relationship is complicated, and in no way can it be described as a natural hedge. At best, it is like any two distinct operations within a broadly defined industry which have exhibited some negative correlations in the past so that profits from the two divisions seem to hedge one another. Whether the correlation is really there and reliable in the future is a very difficult question to resolve.
Second, the imagination that the majors, as upstream producers, are primarily natural longs is off the mark. Of course, each of the majors owns some reserves, and, in this regard, appears to be a long. But even in their upstream operations, the majors are largely a pass through in terms of the natural resource. Just as their refiners buy crude and sell refined products, capturing a margin on the processing, so too do their E&P businesses buy access to reserves underground, develop them and lift the barrels, selling the above-ground barrel. Over the long haul, they are neither long nor short, except for the window of time over which they execute on a given resource. The real assets of the majors are (i) their IP, (ii) their human capital, and (iii) their organization. This is where they have real exposure.
Interestingly, even the majors’ exposure on their reserves is less of an exposure than at first meets the eye. Many of these reserves are a product of production sharing contracts, oftentimes with a host country’s national oil company or other state entity on the other end of the contract. The contracts are written so that the major’s share of the output is a function of the crude oil price. When the price rises, their share declines, so that their final exposure is much less than 1 for every barrel of reserves recorded on their books. Readers can find a study to this effect by Kretzschmar, Misund and Hatherly in the journal Energy Policy. The working paper version is available for free here. Readers can also look at some of the press releases by the majors and related press coverage whenever adjustments to their reserves are made due to large oil price changes. For example, see this quote from Kazakhstan Oil & Gas Weekly, 3:06 AM, 15 February 2010:
2009 reserve bookings were impacted by the higher-prices through Chevron’s Production Sharing Contracts (PSCs) which generally move inversely to oil prices. In 2009 Chevron saw PSC-related reserve debookings in Indonesia and Azerbaijan, as well as a 184 million barrel price-related PSC debooking by an equity affiliate in Kazakhstan.
Its the host country that is exposed to oil prices. The majors are really just hired hands, albeit with a bit more bargaining power than the expression suggests.