Current Gasoline and Diesel Market Conditions

Crude oil prices continue to advance. For six consecutive trading sessions, crude oil futures on the New York Mercantile Exchange set new records, settling at $125.96 per barrel on May 9. After a slight pause, the crude oil futures price hit an all-time record high of $126.98 in intraday trading on May 13, before falling to a settlement price of $124.22 on May 14. The weekly gasoline price survey published on May 12 by the Energy Information Administration (“EIA”) showed a new national average record for regular gasoline of $3.72 per gallon, up 11 cpg over the previous week and up a total of 62 cpg in the last year. Prices in every region of the country were up, with the Midwest experiencing the largest leap (16 cpg). Diesel prices also peaked at $4.33 per gallon, up 18 cpg over the prior week and 156 cpg over the past year.

Not all of the recent oil industry records have been highs. As reported by the EIA, the average refining, distribution, and retailing margin on gasoline fell in March to 15.9 percent – the lowest percentage recorded since 2000. The actual dollar margin of 51.6 cpg is down by 30.7 cpg from March 2007 and is less than half of the record margins set in May 2007. Stocks of independent refining companies that do not produce crude oil have tumbled. As of May 12, the stock prices of Valero (the largest independent), Tesoro (the second largest independent), and Western Refining (primarily a Southwestern refiner that acquired competitor Giant Industries last year at the peak of the market for refinery assets) had dropped by, respectively, 40 percent, 63 percent, and 87 percent from their 52-week highs.

In the last few years, gasoline prices have tended to peak in mid-May to early June, and they are now nearing the EIA’s forecasted peak. Although the peak may be near, however, realism also suggests that the current situation is outside the range of statistical experience upon which most forecasting models have been calibrated.

The Rise of Independent Crude Oil Producers

When the House Select Committee on Energy Independence and Global Warming wanted to examine the current state of play in oil and gas last month, it called a hearing and summoned as witnesses ExxonMobil, Royal Dutch Shell, BP, Chevron, and ConocoPhillips. These five, plus the French firm Total, are often referred to as “supermajors” – integrated firms that explore for, drill, produce, and ship crude oil and refine, distribute, and retail gasoline and other petroleum products.

Although these companies are among the largest private firms in the industry, the popular conception of them as the only important firms in the industry has never been wholly accurate. In fact, of the 10 largest U.S.-based petroleum companies in the Oil and Gas Journal 200, only four companies are what most people would consider household-name majors. The other six are independent oil and gas production companies, such as Anadarko Petroleum and Devon Energy.

The position of the majors in the world oil market also is somewhat less overwhelming than is commonly thought. The integrated, privately-owned majors control no more than five percent of the world’s oil production. Most crude reserves and production around the world are in the hands of state-owned companies. Among privately owned firms, Russia’s Lukoil has the largest position in ownership of global crude oil reserves, although it is outranked by 11 state-owned companies. ExxonMobil, the largest U.S. oil company and the second largest investor-owned company in the world, is the 14th largest oil company in terms of crude oil reserves.

The more limited role of the household-name majors has resulted from a lengthy evolution since the oil crisis of the early 1970s. The majors historically operated by acquiring rights to petroleum reserves, performing geological analyses to identify the most promising locations, having the wells drilled, producing oil from the wells, refining the oil in their own refineries, and selling it through their own branded stations. Although some of their revenues still derive from handling the product all the way from the oil well to the gasoline pump, the majors lost control of the bulk of the world’s crude oil reserves decades ago to the governments of the nations where the reserves are located.

Losing control of crude oil reserves did not immediately reduce the important role that the majors played over extraction of those reserves. For decades, the national oil companies of foreign countries lacked the capital and technology to discover and exploit reserves situated within their territories. During the 1990s, however, national oil companies began to exercise greater control over their indigenous resources and renegotiated their contracts with the majors into production sharing agreements. Under these contracts, the majors (or smaller, partially integrated oil companies) struck deals to provide the national oil companies with technology, knowhow, and capital in return for a share of any petroleum produced. The national oil companies were free to sell the balance on the world market to the highest bidder.

Moreover, the switch of reserve ownership to the national oil companies created opportunities for other firms, notably oil drilling service companies. These companies had provided drilling and related services to integrated oil companies for much of the history of the industry. The largest such firms – Schlumberger, Halliburton, and Baker Hughes – all were started in the early decades of the 20th Century. These “Big Three” of the service sector, as well as dozens of smaller firms, traditionally have provided well-drilling products and services up to the point of a completed well. The oil company, however, typically did the pre-drilling exploration and handled arrangements once the oil flowed.

Starting in the mid-1980s, the oil field service companies started diversifying their operations. Schlumberger added a geophysical exploration company in 1985, and in 1995 formed an integrated project management group to provide a wide range of services. For example, in 1997, the firm won a contract from the Mexican oil company PEMEX to redevelop the Burgos Basin by providing a wide range of services from geological analysis, to building roads and tank farms, to post-production reservoir management, as well as providing its traditional service by drilling 31 wells. In 1998, Baker Hughes, a major competitor of Schlumberger, responded by merging with Western Atlas, an exploration services firm, so that it could provide integrated development services from exploration through crude production management, as well as traditional drilling.

In some respects, the business model may be as important as the expertise. Service firms traditionally have worked for a fee, while the major oil companies often sought an equity interest. International service companies have acquired local oil service companies in their host countries and upgraded them. Such local connections may have helped some of the firms weather changes in the industry. Schlumberger, which bought a number of Russian service firms, won large contracts from the Russian state oil companies at the same time that the Government of Russia forced Royal Dutch Shell and BP to turn major reserves over to Gazprom and other government-affiliated oil interests.

Under the production sharing arrangements commonly employed today, the operators – including the majors – have relatively little leverage in dealing with the sovereign nations within whose borders they operate. Even a relatively small nation such as Venezuela was able to force most of the producers operating under such agreements to renegotiate on terms far more favorable to Venezuela, or to abandon their projects entirely. Two of the largest majors that chose to resist, ExxonMobil and ConocoPhillips, have had limited success in obtaining redress through the international legal system, and Venezuela threatened to disrupt U.S. oil supplies in retaliation for ExxonMobil’s winning court orders that froze some of Venezuela’s foreign financial assets.

Nevertheless, do not expect the major oil companies to fade away in the near future. Still among the world’s largest private enterprises, they have enjoyed record-setting profits and plan to remain active in exploration and development in many parts of the world. Moreover, mergers between majors and independents remain a real possibility that will call for close antitrust scrutiny. Still, recent developments – such as host governments’ reassertion of direct management of their oil resources – may lead the majors to behave more as service contractors and downstream processors than as firms with equity positions in crude oil resources.