Jeremy Warner's Outlook: Oil at $50 but still the oil industry won't invest

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The Independent Online

As the oil price rises steadily skyward, it can only be a matter of time before calls begin anew for a windfall profit tax as a big stick to beat the big, bad oil majors with. This is more especially the case as the oil industry has yet to respond to higher prices with any kind of a significant increase in investment spending.

As the oil price rises steadily skyward, it can only be a matter of time before calls begin anew for a windfall profit tax as a big stick to beat the big, bad oil majors with. This is more especially the case as the oil industry has yet to respond to higher prices with any kind of a significant increase in investment spending.

With oil at a headline grabbing $50 a barrel, the oil majors, together with the main producer nations, are coining it as never before, yet their financial and business disciplines remain unwaveringly tight. BP's benchmark for new investment - that the development must be economic at $16 a barrel - is unchanged on where it has been for years. There is little sign of any of the others easing similarly demanding benchmarks either.

A cynic would suggest that this is because the oil industry makes more money by restricting supply than responding to demand, yet the truth is that the big oil companies have been burnt once too often to be persuaded to throw caution to the winds. Historically, the oil price cycle has followed a familiar pattern. As the price rises, developments that had previously been thought uneconomic suddenly look commercially attractive.

The oil industry then lets rip on investment. Higher oil prices will meanwhile be having a depressing effect on economic activity. At the same time they will be feeding inflation, leading to higher interest rates. As economic activity slows, demand for oil abates, and compounded by the extra supply brought on stream by the development of more marginal fields, the price begins to fall, making much of the new investment look uneconomic once more.

In such circumstances, it is no surprise that the oil industry should be exercising restraint. Most oil industry executives have yet to be convinced that the price is at sustainably higher levels. There is a quite widely held belief that it is only where it is because of speculative activity.

The present conflagration of supply problems and threats - from meltdown in Iraq, to political unrest in Venezuela, civil war in the Niger delta, to hurricanes in the Gulf of Mexico and the powder keg of Saudi Arabia - is virtually unprecedented. With Opec production at close to full capacity, stock piling by both the US and China has greatly exaggerated the problem. Yet few in the industry think that the present tightness in supply will persist much beyond the next year.

Given that it can take anything up to eight years to develop a field, with the oil expected to flow for a further twenty thereafter, oil companies would require a fair degree of certainty that high prices are here to stay before they embark on costlier projects.

Yet although it might be unwise to bank on an oil price quite as high as it is now - oil production in Iraq must surely return to more normal levels at some stage over the next year - we are plainly not heading back to the depressed crude prices that ruled through much of the 1990s. With growing demand from both China and India, the official Opec target range of $22 to $28 a barrel, is already history. The world must get used to a price which is permanently above $30 a barrel.

The good news in such a price is that it would still provide a powerful incentive for transport and industry to use less oil, thus putting off the fateful day when the black stuff runs dry. At that level it would also be too low to allow for a very sizeable increase in levels of supply. The great tar sands deposits of Canada and elsewhere, one of the last great untapped reserves of oil, wouldn't be economic for development at much under $50 a barrel. This might not be much of a consolation for campaigners against global warming, but from their point of view it is surely better that price equilibrium be established at a level which doesn't allow for further massive increases in supply than it does.

In the meantime, oil at $50 is capable of doing quite a bit of economic damage. No wonder the stock market remains so reluctant to move onto higher ground.

P&O ferry cuts

The still gloriously named Peninsular & Oriental Steam Navigation Company is taking the axe to is cross-Channel ferries business, but although the cuts are deeper than even the most hawkish City analysts were expecting, are they enough to stem the tide of red ink? P&O is reducing its cross-Channel fleet of ferries by about a third to 23 and closing four of its 13 routes with the loss of 1,200 jobs and the transfer of a further 350 to Brittany Ferries.

In so doing, the company reduces its operating costs by about a fifth, or £100m per annum. The net benefit after subtracting the revenue lost on the closed routes will be about £55m. This year, the cross-Channel ferry business is expected to lose some £10m to £15m so, all other things being equal, the action should be enough to return the operation to a relatively healthy level of profit on a much reduced capital base.

Unfortunately, P&O cannot expect its leading competitors to follow suit. The two main rival ferry operators, Britanny Ferries and Sea France, are state owned, while Eurotunnel is heading for yet another refinancing. The consequent debt forgiveness programme may allow the Channel Tunnel further to reduce fares in an effort to grab market share and boost revenues. Although P&O is taking an awful lot of pain in pushing through cuts in capacity, the lead it is taking may not ease the company's plight unless matched by similar action by others.

The ferries have been in decline ever since the Channel Tunnel opened. Compounding the adverse effect of this massive increase in cross-Channel capacity and capital have been changes in alcohol and tobacco duties, which have all but destroyed the "booze cruise" and greatly decreased the attractions of nipping over to France to stock up on ciggies. As if all this wasn't bad enough, Ryanair, easyJet and other low cost airlines have further eaten into a market which the ferry operators used to have all to themselves. To top it all, P&O's main rivals are state owned and though you never get to the bottom of these things, very likely state subsidised.

Given this cocktail of negatives, it might seem surprising that P&O is still in the cross-Channel ferry business at all. If it could, it would have sold long ago, allowing the company to concentrate on a thriving business in ports and logistics. Yet the only obvious trade buyers would face big regulatory obstacles while few in private equity would touch a loss -making operation. With yesterday's raft of announcements, P&O, still chaired by the redoubtable Lord Sterling of Plaistow, hopes finally to lance the boil. I only wish I could share in this optimism.

Invensys chalice

Rick Haythornthwaite knew he was taking on a big challenge when he agreed to become chief executive of the engineering leviathan Invensys, yet I'm quite sure he would never have taken the job had he even half suspected how big. He's struggled to produce the turnaround miracle the City wanted of him. With last year's rights issue, Mr Haythornthwaite seemed to get the breathing space he needed to give it a go. Finally the pressure was off. The fire sale of assets could cease, the living at the beck and call of his bankers was over, and Mr Haythornthwaite could finally get on with running the business, confident in the belief there would still be one to run in a year's time.

Now the doubts are multiplying again. Trading conditions have remained unrelentingly tough, the pension fund deficit has further mushroomed, and the shares are trading at less than half the level at which investors supported the rescue rights issue. Yesterday, Deutsche Bank put an insulting 5p target price on the shares. In a recent circular, Merrill Lynch said the company would ultimately need another £500m of equity to survive. Mr Haythornthwaite is dismissive of their analysis, yet the share price - down to just 11.5p last night - tells another story. It would cost only £650m to buy Invensys at this price, which is little more than the company raised in last year's rights issue. Oh that Mr Haythornthwaite should be so lucky as to attract such a mercy killing.

jeremy.warner@independent.co.uk

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