Weeding the Oil Patch

Not long ago it looked to most observers–including yours truly–that the oil industry had reinvented itself so thoroughly the major producers would be able to make profits even if oil prices fell to historic lows. Oil companies are far leaner than they once were and the advent of dramatic new technologies for finding and accessing oil reserves makes each company’s fields more valuable than they once were.

What no one really anticipated was just how low historic lows could be, and how long oil prices would stay down. Easier to anticipate was OPEC’s inability to maintain strict production limits, but the combination has meant that we’re watching the tragedy of the commons in action in the oil patch. As oil prices drop, each producer needs to sell more oil to make the same amount of money. But the more oil that comes on the market, the lower prices drop.

OPEC, of course, came into existence as a way to stop this kind of competition, and is, at least in theory, the sort of cartel U.S. antitrust law is designed to prevent. In the absence of collusion, though, it’s difficult to restrain the kind of price competition that we’re witnessing in the industry. Oil is, after all, a commodity, and no company has a strong enough brand name to protect either its market share or its profit margins. As a result, every firm in the industry is a price-taker rather than a price-maker, which means simply that each company charges what the market will let it charge, much as wheat farmers do.

It’s in this context that the proposed merger between Exxon and Mobil has to be understood. Given the fact that we know how unsuccessful most mergers are, and looking at the less-than-enviable recent record of Royal Dutch Shell, the world’s largest independent oil company, combining two firms the size of Exxon and Mobil would seem to be a recipe for disaster. And so it may in fact be. But the merger, if it goes forward, is an attempt to rationalize production by removing capacity. In other words, this is one merger that makes no sense without job cuts and refinery shutdowns.

Ideally, after all, a company will run as close to full capacity as possible, with some leeway for unexpected spikes in demand. When oil prices are as low as they are now, a company the size of Exxon has a much harder time covering its fixed costs. Buying Mobil expands those costs, of course, but in theory by less than the additional revenue the company will be taking in.

At the same time, size may confer an advantage going forward, since the costs of new exploration projects will be prohibitive for smaller companies. Although oil companies have done a great job of expanding the world’s useable reserves, the simple reality is that as time goes on, it will become harder to get to the oil that remains. Only companies able to spend billions on exploration will prosper.

The paradox here, then, is that an Exxon-Mobil merger is at once a way of growing bigger in order to be smaller (that is, eliminate capacity) and a way of growing bigger in order to be bigger (that is, have the muscle to open up new fields). But although the latter concern may be of greatest importance going forward, it’s the former that’s clearly driving the deal. This is the wrong time to be a commodity producer in the world. And until that situation improves, we’re going to see a lot more deals like Exxon-Mobil.