Development displaces exploration

Upstream study: Oil and gas companies are putting focus on higher-risk regions to build reserves; more mergers on horizon

Gary Park

Petroleum News Calgary Correspondent

Bulging cash flows pose tough challenges for public oil and natural gas companies as they grapple with higher costs, heightened shareholder expectations and the need to build reserve bases to meet rising global demands, says a report by energy research firm John S. Herold and upstream corporate adviser Harrison Lovegrove & Co.

The biggest challenge facing energy executives is how to find the best use for unexpected upstream profits and cash flow, said Arthur Smith, chairman and chief executive officer of Herold at a news briefing to unveil the 2004 Global Upstream Performance Review.

Harrison Lovegrove Chief Executive Officer Martin Lovegrove said the best returns have traditionally come from grass roots exploration and the discovery of new fields.

But the mature basins, concentrated in relatively low-risk Organization of Economic Cooperation and Development countries, do not offer the expansion opportunities that larger companies need to attain growth and satisfy investors.

“Pacesetter oil and gas companies will continue to shift funds to higher-risk regions offering world-scale reserves or will pursue aggressive acquisition programs to become the dominant operator in a region,” Lovegrove said.

Prices up 23 percent in 2003

• Prices realized by the 194 companies in the study rose 23 percent in 2003 to US$23.45 per barrel of oil equivalent, spurring a 27 percent hike in worldwide revenues to $395 billion.

• Cash flow rose 24 percent to $197 billion, more than $35 billion above upstream capital spending, posting the fourth consecutive year where cap-ex lagged behind cash flow.

• Development spending was up 21 percent to $100 billion, but exploration was flat at $30 billion.

• With mega-deals in the dumps, the value of merger and acquisitions dropped 16 percent to $29 billion, 40 percent below the 2000 peak and just 18 percent of overall spending. For the first time in eight years, the value of asset deals surpassed that of corporate deals. The implied value of reserves involved in M&A transactions dropped to $3.53 per barrel of oil equivalent, pulled down by Asia-Pacific transactions in the $1 to $3 range.

• Since 2001, capital spending in the United States and Canada has dropped 22 percent, while climbing 60 percent in South and Central America, Africa and the Middle East. In the United States companies took in $54 billion in cash flow and spent $42 billion; in Europe cash flows totaled $35 billion, while $17 billion was spent, Asia-Pacific cap-ex consumed $22 billion of $36 billion in cash flow and in South and Central American $15 billion of $20 billion was spent.

• Oil and gas reserves and production increased about two percent worldwide in 2003, with only Canada and the Asia-Pacific region showing reserve gains.

• Reserve replacement costs were up 20 percent to $6.36 per barrel of oil equivalent and have increased by 19 percent a year since 1999, while the reserve replacement rate dropped to 150 percent of production from 206 percent in 1999.

Reinvestment not at pace of prior bull markets

“Companies are investing relatively cautiously and seeking to maintain capital discipline.”

The industry has made a pronounced shift to toward investment in development projects to maximize deliverability in a time of strong product demand and high commodity prices, they said.

Although describing development of the existing asset base as rational, the authors said exploration spending has been relatively static at 15 percent of total outlays and acquisition spending has declined.

Eventually the challenge of creating new investment opportunities “should spur increases in exploration investment and M&A activity,” they said.

Smith argued that the industry has been “investing wisely because total production of the surveyed companies has risen in pace with world demand at the same time, the industry has been increasing its reserve base. The industry has learned that sharp increases in upstream investment lead to rampant oilfield cost inflation and an inevitable commodity price whipsaw,” he said.

Smith told the briefing that as cash begins to build up for companies and drilling opportunities diminish, there could be a fresh wave of merger activity as companies look for ways to grow profits and production.