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The Re-Intermediation of Oil, Gas and Finance

There are quite a few parallels I think we can draw between the rise of SWFs and the rise of National Oil Companies. More specifically, I think SWFs could do to the financial services industry what NOCs did to oil & gas. And that could be a very good thing. Let me explain…

There are quite a few parallels I think we can draw between the rise of SWFs and the rise of National Oil Companies (NOCs). More specifically, I think SWFs could do for the financial services industry what NOCs did to the oil & gas industry... and I think that could be quite a good thing for finance. So let me explain what I’m going on about...

If you go back four decades, NOCs controlled less than 10% of oil and gas reserves (despite the fact that those assets were sitting under the ground in their own territories). In fact, right up until the early 1990’s, even the big NOCs, such as Saudi Aramco, typically only operated their proven, low-risk reserves and then relied on international oil companies (IOCs) to operate moderate- to high-risk oil assets. And for these riskier assets, the NOCs would often sign costly "equity" deals with the IOCs to extract their resources.

But this all changed when the NOCs began to rely on a new set of intermediaries to help them access their riskier assets: oil field service (OFS) companies, such as SLB and Halliburton. Indeed, NOCs started to use OFS companies in the place of IOCs, which meant that NOCs began paying a "fee for a service" instead of being forced to enter into equity-like compensation arrangements. Indeed, the OFS companies began to reduce the need for the expensive IOC-NOC JVs by offering the NOCs the same (if not higher quality) services without production-sharing agreements.

Saudi Aramco was the first NOC to test this business model with its employment of Schlumberger’s integrated services in the 90’s. As a result, the "seven sisters" that dominated the oil industry for the better part of a century have seen their power greatly reduced; today the NOCs control 90% oil and gas reserves!

As a recent Bain report noted:

"This dramatic reversal has increased the ability of NOCs to source financial, human and technical resources directly—once the exclusive domain of the large integrated oil companies (IOCs) and independents—and to build internal capabilities... As NOCs gain greater confidence in their ability to manage ever larger and more complex projects, the recognition that they no longer have to enter into production-sharing agreements with other companies will fundamentally alter the competitive landscape in the industry and force participants to reexamine their strategies (where to play) and their business models (how to win)."

In sum, the rise of NOCs and a new set of intermediaries in the oil & gas sector has resulted in a rather dramatic restructuring of the intermediation of oil and gas and the fee structures used to compensate those intermediaries. Contracts have moved away from "percent of liquid" compensation for operators toward service fees.

And this raises the question: Couldn’t SWFs do to the financial services industry what NOCs did to oil & gas? I think that’s possible.

I’ve already argued that SWFs could have profound repercussions on the broader community of institutional investors for the simple reason that SWFs are new and, as a result, they have the potential to do ‘old things in new ways.’ Moreover, SWFs are generally large and take intergenerational time horizons, which also positions them uniquely to think about accessing markets in creative ways. Finally, SWFs see the existing fees and costs charged by existing "service providers" in finance as being downright insane; very similar to the NOCs' reaction to the IOCs in the 1990s.

As such, like the NOCs did a decade ago, many SWFs are leading a trend toward the professionalization of institutional investment. This includes more direct investing; more oversight of external service providers and (as a result) more aligned contracting between asset owners and asset managers. SWFs seem to be kicking off a sort of "re-intermediation" of finance. (As examples, see NZSF, the Future Fund, ADIA, Kuwait, and there are many more.) And I think this could be a good thing.

As I see it, much of the financial system would benefit from healthy dose of dis- and re- intermediation. But questions remain. For example, who in financial services will play the role the OFS companies played in oil & gas? That is, who are the intermediaries that will provide institutional investors with more aligned access to investment opportunities? Watch this space...

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