Oil fields of plenty?

Despite making £93m a day, Royal Dutch Shell has not impressed the markets, concerned by resource nationalism and rising extraction costs. By Danny Fortson

If understatement were an art, Jeroen van der Veer would be given a seat among the masters. In unveiling the largest-ever annual profit for a UK or Dutch company yesterday, the chief executive of Royal Dutch Shell deemed the group's $27.6bn (£13.9bn) annual profit thus: "Overall these are satisfactory results."

One can understand why he wasn't keen to crow. Even before he unveiled the record profits, groups including the UK's biggest union Unite and the environmental campaign group Friends of the Earth had issued calls for the Treasury to take a chunk out of the "obscene" profits with a windfall tax. Other groups used the announcement to argue against the Government's proposed 2p tax on petrol.

The public outcry was predictable. Aided by the recent record oil price and asset sales, the company's fourth-quarter earnings came in at $8.47bn, 60 per cent better than a year ago, or about £93m per day. There are more recriminations to come. ExxonMobil reveals its annual figures today, with analysts expecting it to publish profits that will leave both Shell and BP, which reports next Tuesday, in the shade with around $40bn for the year.

The analyst community however was far less entranced by the figures. Indeed, many were downright underwhelmed by Shell's performance, which fractionally missed what they had expected. The company's shares ended the day flat at 1791p.

The market's tepid response can be explained in part by the fact that Shell and its rivals are facing a difficult future as they seek to slake the world's thirst for oil amid a rising tide of resource nationalism and soaring costs of extraction.

At Shell, production is falling, by about 1 per cent last year and, by Mr van der Veer's estimation, around the same this year and the next until some very large projects, such as Sakhalin 2 in Russia and the massive Pearl gas-to-liquids project in Qatar, begin operating. Most of its big projects will not begin to bear fruit for five or seven years yet and will require a huge amount of cash to get off the ground.

Since the company's reserves debacle in 2004, it has shifted into high gear to rebuild its reserves and resource base. Last year it received approvals from governments around the world to explore for new fields. Mr van der Veer confirmed that he has been in contact with Iraqi ministers about a range of onshore oil and gas projects there but until the country's new law governing the industry is passed, no final decision will be made. "We have to know the rules of the game," he said. The company's final decision to invest in a gas project in Iran meanwhile has been put off by "political considerations".

Yet as the industry struggles to keep up with rising demand, the cost of increasingly scarce essentials such as oil rigs, not to mention the people who operate them, has soared. Costs have doubled since 2000. The chief financial officer Peter Voser said that cost inflation last year alone hit more than 10 per cent. In 2000 the company devoted about $10bn to capital expenditure, or money spent on developing new projects. That figure last year was $23.8bn, and could rise to $25bn this year.

In light of such mammoth investments, Mr van der Veer questioned the idea of the windfall tax. "I don't see the logic," he said. "Yes we are making large profits, but with the investments we need to make, if it's all taxed away I don't have a clue about how we're supposed to finance these huge projects."

The spending increase is indicative of a fundamental shift affecting the entire industry. According to research from Deutsche Bank, oil companies spent a combined $250bn to produce 30 million barrels of oil per day in 2002. By 2006, the industry spent $550bn to get just 20m barrels per day. While part of that change can be explained by cost inflation, the fundamental reason is that most of the easy oil – close to the surface and relatively straightforward to extract– has been found.

Mr van der Veer reiterated his view yesterday that by 2015 the world will have reached peak "easy oil", which is why the company has plunged headlong into much more expensive, technologically challenging areas such as oil sands and deep-water drilling. Derek Butter, of Wood Mackenzie, said: "People are accepting that higher oil prices are here to stay, maybe not at $90 per barrel, but probably at $60 a barrel. So what were marginal projects that need a high price to achieve to return are getting the green light."

The other problem for Shell and others is the increase in resource nationalism. One form it can take is tax hikes imposed by governments seeking a bigger slice of the pie. Canada recently pushed through a significant tax increase on oil sand revenues. Earlier this month, the Kazakh government forced Shell and its partners on the massive Kashagan project to sell some of their ownership stakes to the government. In the wake of Russia's success in taking a greater stake in the Sakhalin 2 gas field, it was a blow. The growth of national oil companies has also made gettting at new resources more difficult. Groups such as Saudi Aramco or the Chinese state-owned firms that were once reliant on the cash and expertise of international groups like Shell are in much less need of either now. To counter that, Shell is spending heavily to build up capabilities to entice national oil groups who no longer need their help on less complicated projects. Mr Butter said: "The way Shell in particular are looking at it, they are investing to very much be at the technological leading edge."

And then there is Nigeria. Mr van de Veer met last week with the Nigerian president to discuss the continued problems there, where 140,000 barrels a day of capacity remain shut down amid the unrest and violence, forcing the company to write down $716m for the year. The government, which holds 55 per cent of the joint venture with Shell, has also failed to keep up on its obligation to pay its share of the costs. "We are having discussions with the government because this is not a sustainable way to go forward," said Mr van der Veer. He added: "We have been in Nigeria since the 1950s and have overcome many difficulties. I have confidence we'll find a solution."

So far Shell and the rest of the industry have easily weathered the higher capital costs because over the same period the oil price has quintupled. Yet what happens if the oil price stabilises or falls sharply? Mr van der Veer, pointing out that the economies of Asia and the Middle East would be able to offset a US-led drop in demand, isn't worried. He said: "I don't see how world oil demand will go down this year, even if something happens in the US."