An oil well pump jack is seen at an oil field supply yard near Denver.© Rick Wilking / Reuters
Killing your consumers sounds like a very bad idea, but it's a problem that many great enterprises have learned to live with for centuries.
Merchants of tobacco and alcohol have learned to dance the fine line of legality, dodging the mud hurled by moralists while acknowledging, sotto voce, that there is a bit of an issue with the product. From a political perspective, selling dangerous but popular drugs works and government can enjoy the fiscal high, riding piggyback on the addicts. A shrinking population of consumers (in the case of tobacco) isn't really a problem because you can raise market share and, what a surprise, governments just love a big bad monopoly that pays lots of taxes.
You can even welcome the day when your product disappears, like the chief executive of Philip Morris, who says he want to work toward the "phase-out" of cigarettes. He is touting an alternative product, a new kind of e-cigarette, which heats rather than burns tobacco, thus avoiding the health risk of tar.
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But what if the combustible product is essential, a basic commodity consumed by everyone. Last week, the world's biggest oil producers came together and agreed to a pact to raise prices by curbing production. We don't know if it will work to their advantage – the OPEC agreement is precarious and dependent on the co-operation of Russia, not a member of the cartel.
OPEC has two problems: There is a short-term product glut that the cartel would seek to remedy with output restrictions. Success is not guaranteed, cartel cohesion is very weak and U.S. shale oil producers are yearning for an oil price rise to restore their margins, potentially unleashing a new flood of crude. Over the longer term, OPEC has a tobacco-like problem: The health issue over noxious emissions and the carbon problem pose the biggest dangers and the biggest opportunity for the largest oil producers.
The penny has dropped at Royal Dutch Shell; the multinational believes that demand for crude oil will peak before supply of crude becomes a problem, and this month the company's chief financial officer, Simon Henry, said that the watershed could be between five and 15 years away.
Shell is certainly correct about the big issue being peak demand, even if the timing is speculative. We know oil consumption in the most mature economy, Europe, has been shrinking for years. Engine efficiency, urbanization and public transport is killing the road fuel business and we have not even started to consider the future impact of electric vehicles. Of course, like tobacco the death will be very gradual and, initially, very local as legislators ban certain noxious fuels (such as diesel) and create clean vehicle zones.
If you are a big oil producer, the job is to manage transition. It could last 50 years or even a century – countless millions of smokers have died of respiratory disease since Sir Walter Raleigh brought tobacco to England from Virginia in the 16th century. This week, Britain's tobacco barons lost an appeal against a government ban on the appearance of imagery and trademarks on tobacco packaging.
Yet, there are still millions of smokers and the good news for Shell and others is that tobacco companies are in very good health. BAT sold 663 billion cigarettes last year, earning £5-billion ($8.4-billion) in profits and the company paid £27-billion in taxes to governments.
But the most important number for oil producers to think about when considering the "phase-out" of oil is market share. BAT raised its share of the global cigarette market by 4 per cent last year, an interesting achievement when you consider the effort expended by governments to stop the advertising of tobacco brands.
For oil producers, the question is what kind of company manages best a period in which product is likely to remain in oversupply while demand slowly shrinks.
If tobacco is a guide, the answer is to be the cheapest producer and the biggest friend of the government. As the regulatory net tightens on sellers of road, air and marine transport fuels, small producers will no longer be viable and the cost of refining crude into acceptable fuel products will soar. Some oil companies have made bets on electric vehicles, notably Total, which has bought a battery manufacturer. But it seems more likely that money will be made from technology that manages the transition. Just as Philip Morris is pushing a "safer" way to smoke, oil producers need to find a way to promote "safer" diesel and gasoline.
The bigger question is whether the profitability of oil exploration will ever return to previous peaks. That must be unlikely given the vast untapped resource in the ground. Growing enough tobacco to satisfy the world's smokers has never been a problem and for countries such as Canada and Saudi Arabia, the business of oil production is beginning to look a lot more like farming than exploration.
Carl Mortished is a Canadian financial journalist based in London.