Oil and Gas Industry - Case Study Example

EXECUTIVE SUMMARY The oil industry is a high risk industry with lot of critical factors that will determine the success of companies that engage in exploration and production of the commodity. This paper analysis the oil industry by studying the critical factors and also by using analysis tools like PEST analysis and Porter’s five forces. Heavy investment and possibly long gestation periods between exploration and production are the main risk factors and companies should have the resources to tide this over. The industry also has an oligopolic nature and results in low level of power for the consumers. Prices and tend to increase over the years except when a major recession (like the present one) happens. Introduction: No other commodity in the history of the modern world has evoked so much greed, violence, or passion as oil or petroleum. With the discovery of refined oil as a source of energy began the quest to explore and find a secure supply by nations ever hungry for the product to fuel a rapidly developing economy. In spite of rapid development in discovering and development of alternate sources of energy, oil still remains the most practical means to power the diverse energy needs in the world even today. This paper is a review of the oil industry with focus on the exploration and production areas of the industry. In the process, it will evaluate the critical factors that are important to be successful in this field. In order to gain a deeper understanding, critical factors like PEST analysis and Porter’s five forces model are also taken into account. Oil in its raw form has been in use (used mainly for cooking, heating, and lighting lanterns) in ancient Mesopotamia and the Middle East. (Maugeri 2006, p.3). Source was mostly from reservoirs near to the surface from which oil seeps out into the open. Petroleum which is another name for oil is derived from the Greek words ‘petra’ and ‘oleum’ which means earth and oil respectively. (Jagerson and Hansen 2006, p.132). Deep oil exploration began (using crude methods) about 150 years ago in the United States. (Oil Drilling: History. 2008). Since then sophisticated drilling and exploration techniques have been developed over the years. It was during the early years of the 20th century that corporations were formed to commercially exploit oil reserves using more sophisticated technology. These corporations had near total control over the prices and production of oil in the world. The situation began to change once these economies began to realize the importance of the assets that they owned and many of these corporations were nationalized starting from the 1940s and extending to the 1970s and even beyond. It was also during this time that the most influential body with regard to availability (production) of oil was formed which is the Organization of Petroleum Exporting Counties (OPEC). The organization came into existence in1960. (When was OPEC Formed. 2009). The commercial importance of oil: This brief overview is necessary because of the need, (or greed) and the resulting profits that can be got by having access and control to an oil source. The transportation industry (comprising of automobiles, aircraft, and water transport) is one area that is the most dependent on refined oil products. This includes military, personal, and commercial use. The polymer industry that produces most of the ‘plastic’ products seen today is dependent on oil almost totally. Oil-based products are also used for heating and cooking in homes. The fertilizer industry also needs refined oil products to manufacture many of its products. Machinery lubricants and asphalt used in road construction are also dependent on oil products. (What are the Uses of Crude Oil. 2009). Apart from nuclear, wind, solar, and water power, oil is also seen as a major source for producing electricity. It is also estimated that a commercially feasible replacement for oil-based energy sources is not expected until 2030. Only a 4% fall from the present 37% share to 33% is expected. (International Energy Outlook 2008: Highlights. 2008). Critical success factors: The oil industry is a high-risk, high-investment area of business and has several components that are critical to commercial success. Exploration and production costs: Apart from factors like refining costs, distribution costs, storage/transportation costs, and retailing costs (not a part of this paper), the major components critical to success are exploration costs and production costs. Of the above two costs, the most risky investment lies in exploration for oil due to the fact that companies can spend large amounts and ultimately find that the area is unsuitable for commercial exploitation. Costs may start at 5 m USD and may even cross 20m USD in some cases. (Oil and Gas Production: Modern Exploration. 2008). But if the find has commercial possibilities, profits can be enormous, and the costs of exploration can easily be absorbed. Influence of OPEC: The OPEC has a lot of influence on control of production of oil. This can be seen from the fact that the organization holds a major share of detected oil reserves in the world. (See Figure 1 in appendix) In spite of this huge share, this organization, except during the 1970s, has not yet had a strong say in controlling the operations and profits of oil companies. (Goldthau and Witte 2008). But oil, by being a non-renewable source of energy, OPEC can play a larger role in the industry in the future. But at present, the influence of this organization remains unclear. Demand for oil: The demand for this commodity to satisfy the ever increasing energy needs of the world has generally been steadily increasing with slight falls due to economic recessions during certain periods. The energy estimates (in British thermal units) showing the share of different sources of energy till the year 2030 is given. (See figure 2 in appendix) This rise in demand will be critical for the success of companies engaged in exploration and production. Price of oil has also been steadily increasing bringing huge profits for oil companies. It peaked to an all time high of nearly 160 USD/barrel. But the current global recession has now brought it down to less than 40 USD/barrel. Alternate sources of energy: It can be seen from the chart given above that oil is far ahead in comparison with other forms of energy. At present, the threat from such sources is negligible unless a practical alternative source that is commercially viable with enough of supply is made available. Non-conventional oil: This type of oil can challenge the traditional oil industry in a large way if the cost of exploitation is brought down. (Olah, Goeppert and Prakash 2006, p.55). PEST analysis: PEST analysis is a useful tool to understand the external environment of an industry and is often used to get a wide view of the market. (Pest Analysis. 2009). Politics plays a large part in the availability of oil which in turn can affect the profitability and success of oil companies. This is especially true since the commodity is highly concentrated in certain areas of the world. (How do Politics Affect the Oil Company: Assets and Politics in the Oil Company). For example, events like invasion of Kuwait by Iraq, oil sanctions on Iraq, other conflicts in the Middle East, all can have a potential effect on the production and supply of oil which can affect the success and profitability of oil companies. The demand for the product which is directly connected to development and health of the economy will be a crucial factor. The huge rise in price until the end of 2008 had resulted from a booming economy, especially of those in India, China, and the countries of the erstwhile Soviet Union. The current US and world economic slowdown has also resulted in falling levels of profitability for oil companies. The price chart (inflation adjusted) will show that prices are directly affected by the health of the world economy in general. (See figure 3) The relationship between social factors and the oil industry is relative to the health of the economy. Technical factors can have a strong influence in this area. Sophisticated methods of detection of oil, finding more efficient way of extraction and production, finding new oil reserves, availability of energy alternatives, and commercial exploitation of non-conventional oil are the technical factors that can affect the oil industry. Porter’s five forces: This highly popular method of industry analysis was developed by Michael Porter of the Harvard Business School and the forces are common to all organizations. (Gilad 2008, p.28). The five forces are shown in figure 4 in the appendix. Supplier power: By its inherent nature due to concentration of reserves in certain parts of the world, the oil industry can be said to be an oligopoly. (Lycos Retriever. 2009). Moreover, the merger of large companies has created mega corporations that have made the market more of an oligopoly. According to the Washington Post business correspondent Steven Pearlstein, these oil companies act together with OPEC in controlling the production of oil thereby creating artificial hikes in prices. (Pearlstein 2005). In such a market the supplier power is very high. Buyer power: In cases where supplier power is high, buyers have little option to control things. There are too many buyers wooing too little suppliers, and hence there is very little buyer power. Threat of substitution: This threat is low to moderate since alternative sources of energy only have a small share in the world market. But things may change in the future as more efficient and less expensive technology for alternate sources evolves. Competitive rivalry: This too appears to be moderate or low since oil companies form cartels and have agreement with the OPEC in restricting production. Only when other countries that are not members of the OPEC start supplying oil by themselves can this change. Threat of new entrants: This threat is also low to moderate because of the enormous resources in terms of money, manpower, and technology needed to be successful in this industry. Conclusion: It can be seen that there are several critical factors for success in the oil industry with regard to exploration and production. Resources in terms of money, technology, and manpower are necessary to withstand the period and even losses that may arise from the start of exploration till the commencement of production. In many cases, explored fields may not yield commercially exploitable deposits. The industry is oligopolic and hence seen to be dominated by cartels. These cartels are formed by the companies and also along with the OPEC. International and national politics has a large influence in the production and availability of oil. The industry is generally buoyant and prices and demand increase from year to year. The one great exception is the current year when the world is hit by an economic recession. Technology that improves extraction and exploration processes is also important. The need to explore new deposits is also necessary to keep a balance between demand, supply and price. The supply power in the market is high with buyers having little option but to pay what is demanded by producers. There is no proper substitute in sight and oil will dominate the energy sector for many more years. APPENDIX (OPEC Share of World Crude Oil Reserves (2007). 2009) FIGURE 1 (World Marketed Energy Use by Fuel Type, 1980-2030. 2008). FIGURE 2 (Inflation Adjusted. 2009). FIGURE 3 (Porter’s Five Forces. 2009). FIGURE 4 Bibliography GILAD, Benjamin. (2008). Companies at Risk. [online]. Early Warning. P.28. Last accessed 25 February 2009 at: http://books.google.co.in/books?id=aEsRHcyOKnkC&pg=PA28&dq=porters+five+forces&ei=KaekSYrCBo7ClQT_rL2NAg GOLDTHAU, Andreas., and WITTE, Jan Martin. (2008). 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