1997 ANNUAL REPORT
The Big Picture

The Big Picture:
Worldwide Restructuring Signals Rebirth of Oil Industry
Essay by Phil Verleger, Jr.

As Bill Rusnack and Doug Henderson note in their introduction, 1997 marked a year of important change for the petroleum industry on the West Coast. This change is part of a worldwide restructuring that signals the rebirth of the oil industry; a restructuring that will have profound implications for everyone from consumers to stockholders. It is a change that promises to be uncomfortable at times, but one that will yield enormous benefits to all in the long run.

This rebirth of the industry has a number of dimensions. Among them are the diminished stature of the vertically-integrated energy company, the growth of specialized mega marketers of diesel, the creation of hypermarkets and the emergence of a large number of well-capitalized independent oil and gas producers. The most obvious example of this transformation in 1997 were Unocal’s exit from refining and marketing, the emergence of Tosco as a major refiner/marketer and the proposed consolidation of Shell and Texaco’s refining and marketing activities.

The Information Revolution

It is not an overstatement to identify the "information revolution" as a major factor undercutting the stature of the integrated energy company. For decades, critics have attempted to prove that petroleum companies were anticompetitive, invariably identifying the integrated structure as the primary source of the problem. The critics never proved their case and the integrated structure remained solid.

Today, however, the information revolution has accomplished what the critics could not--the break-up of integrated companies. It has done so by cutting the cost of communication dramatically. This structural shift was anticipated 50 years ago by the economist Ronald Coase who explained that integration in any industry would proceed until the costs of conducting transactions within the firm exceeded similar costs outside the firm. Now, new on-line news and data services have cut the costs of external transactions, removing one of the justifications for integration. The deintegration of the energy industry has followed.

Technical Change

Technical changes have also contributed to fashioning an entirely different industry. The spread of advanced, low-cost exploration, development and advanced recovery techniques has enable both existing firms and new entrants to find, develop and produce large volumes of reserves that would have remained untapped until recently. The consequence has been a proliferation of small, medium and large producers of oil and gas.

Technical changes demanded of refiners by environmental regulators have had the opposite effect. These regulations have increased the scale required for a refiner to be profitable, as well as in raising the required investment. Fewer and fewer firms have had the financial resources or the will to remain in the game, and the number of refineries has declined.

Introduction of computer technologies has lead to a dramatic increase in the optimal scale of operations and a coincident decline in the number of outlets in the retail sector as well.

Efficiency of Capital Markets

The increased efficiency of capital markets has made an enormous contribution to the rebirth of the petroleum industry. Entry into the industry on a significant scale was prevented by the structure of capital markets until perhaps 1980. As these barriers have fallen, a number of smaller firms having the knowledge and skills have flourished. The dramatic growth of Tosco, Torch Energy and Triton, for example, demonstrate the importance of this change.

Privatization

Finally, the wave of privatization and the shift from state economic management to dependence on markets that have swept the world is a fundamental driving force in the rebirth of the petroleum industry. It is leading to an expansion in the sources of supply and to a decline in the ability of organizations such as OPEC to dictate price levels or control markets. The growth of trade that has accompanied increased reliance on market forces is perhaps the most important development in the last third of the twentieth century.

Competition in the product markets will also increase as efforts by large independent marketers to reduce their costs continue. And while the West Coast is often described as an "island," isolated from the rest of the petroleum world, the facts disprove this claim. Indeed, in 1996, one of the largest outside suppliers of products to the West Coast was a Finish refiner.

Increased Competitive Environment

In this increased competitive environment, it will be the consumer who benefits. However, the benefits to the consumer will be transitory, if the economic forces causing restructuring ultimately eliminate the historic cohesion that has characterized the industry’s relationship with government. Everyone recognizes that there is a strong and cohesive force pushing aggressively to achieve both specified and unspecified environmental goals. At times the success of these advocates have resulted in benefits to consumers. Often, however, these efforts have resulted in increased costs with little or no benefits.

The risk to the industry is that the changes now occurring will increase the friction between its various elements and reduce the capacity of the industry to meet its opposition effectively. If this is allowed to happen -– if the industry allows itself to be divided and conquered -– everyone including consumers, producers, refiners and marketers, stands to lose.

Thus the challenge for all segments of the industry is to embrace the economic forces that must inevitably lead to a new industry structure while recognizing that all share a common goal of being able to negotiate effectively with government authorities for reasonable, fair and equitable treatment. The industry’s leaders need to be able to deal with heightened competition while presenting an united front in legislative and regulatory debates.

In these times, the widely quoted motto of the American Revolution should become the motto of the petroleum industry: "United we stand, divided we fall."

1997 WSPA Annual Report
The Big Picture
Essay by Phil Verleger, Jr.