By David Strahan. First published in the The Independent on Sunday, 15 July 2007.

BP and Shell are finally about to merge. That’s if you believe the tittle-tattle in the Square Mile. Of course rumours that the two giant companies might wed are hardly new and have been the stuff of bankers’ fevered imagination for years. But there is now an increasingly compelling case why the two energy groups should be integrated. At 4.5 million barrels per day, the oil output of a combined Shell-BP would dwarf that of American behemoth Exxon-Mobil and even major oil-producing countries such as Iran. Some analysts make a positive case for such a merger on the basis of massive economies of scale, claiming it it could save $5bn. But when it happens the real motivation will be far darker: desperation.

Both companies have suffered a variety of well-publicised troubles in recent years – Shell in Nigeria, BP in the US, both in Russia – but their fundamental problem is identical: the inability to adequately replace the oil they produce with fresh reserves. This matters because the reserve replacement ratio is one of the most important factors affecting an oil company’s stock market valuation, and a rough-and-ready guide to how long it can survive. Shell’s difficulties here are well known – in the five years to 2005 its reserve replacement ratio was just 67% – but BP is also struggling. Although its reserve replacement ratio is still positive, it has fallen every year since 2002. And without the contribution of its fabulously risk Russian joint venture TNK-BP, the figure last year would have been just 34%.

Shell and BP’s troubles are neither unique nor surprising, but are exacerbated by these groups being some of the biggest fish in a shrinking pond. The simple fact is that they are substantially excluded from OPEC countries, which control 75% of the world’s proved reserves. And their plight is worsening as resource nationalism takes hold from Russia, where Gazprom has just wrested control of both Shell’s Sakhalin-2 project and BP’s Kovykta field, to Venezuela, where international oil company interests have simply been expropriated.

So the supermajors – ExxonMobil, Chevron, Shell, BP and Total -are largely restricted to operating in non-OPEC countries where oil production is mature and generally already in decline. Speaking at Chatham House in London recently recently ExxonMobil chief executive Rex Tillerson admitted that continued growth of non-OPEC production was now “very challenging” and unlikely to continue past 2010, while the International Energy Agency last week predicted a global oil upply “crunch” within five years, driven in part by the crawling pace of non-OPEC supply growth.

In these circumstances, the outlook for the world’s biggest oil companies looks dismal. In a recent interview with Le Monde, the IEA’s chief economist Fatih Birol said: “The supermajors will be in difficulty. They will no longer have access to new production capacity. They must redefine their strategies otherwise if they remain concentrated on oil they will have to be satisfied with niche markets”. The respected Houston-based consultant Henry Groppe puts it even more bluntly: “the major, publicly traded oil companies are in long-term liquidation”.

Shell recently announced the start of a major drilling programme in the Beaufort Sea north of Alaska in the Arctic Ocean. The move raises the stakes in its post-reserves-scandal strategy of trying to explore its way out of trouble. But recent history suggests this plan is likely to fail. In the past decade it has been the companies “drilling for Oil on Wall Street” – replacing reserves simply by taking over other companies – that have managed to increase their oil production; those that relied solely on exploration have got into trouble. Consolidation was always likely to be the more effective strategy since global annual oil discovery has been falling for 40 years. It was precisely Shell’s failure to find a partner in the late 1990s when Exxon merged with Mobil, BP took over Amoco and Arco, and Total snapped up Fina and Elf, which led to the pressures that produce the reserves scandal of 2004, when Shell admitted it had overstated the proven oil and gas on its books by billions of barrels. Shell cannot have failed to have learned that lesson; the company admits to having conducted “scenario planning” a merger with BP.

The problem with growing by acquisition is that it is addictive, and BP needs another fix. The initial impact of the TNK-BP deal is evidently wearing off, because BP has admitted that in 2007 its oil and gas production will fall for the second year running. The company claims output will pick up marginally by 2009, but according to brokers Dresdner Kleinwort even that would mean average growth during 2005-2009 of just 1.4%, against BP’s previous target of 4%. So it looks as if BP and Shell are made for each other, and if and when it happens the deal will be lauded for busting all stock market records. But it should also be seen for its real significance: a warning light for the imminent peak of non-OPEC oil production.

Of course the situation could be transformed – temporarily at least – if peace were to break out in Iraq and its parliament passed the hydrocarbon law allowing access to international oil companies. In his interview with Le Monde, Mr Birol made clear that Iraq is the only country on the planet with the potential capacity to save the world from the IEA’s predicted supply crunch: “If by 2015 Iraqi production does not increase exponentially, we have a very big problem, even if Saudi Arabia fulfils its promises. The figures are very simple, there’s no need to be an expert”. This fact of course explains much recent history, but given the chaos and butchery of post-invasion Iraq, the country’s full oil potential is likely to remain untapped for the foreseeable future.

The IEA insists its predicted supply crunch is driven by factors above ground like Iraq and does not amount to peak oil – the geologically determined onset of terminal decline in worldwide oil production. But that distinction may come to feel academic. According to Mr Birol, “the oil industry will be facing a very serious test by 2015…the gap between supply and demand will widen significantly”. At which point mega-mergers between the likes of BP and Shell will be exposed as entirely powerless to combat the global energy crisis, whatever its cause.

David Strahan is the author of The Last Oil Shock: A Survival Guide to the Imminent Extinction of Petroleum Man.

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