INVESTOR'S BUSINESS DAILY
MONDAY, MAY 12, 2008
Spot crude oil prices
U.S. Natural Gas Wellhead price
High (Priced) Energy
Oil and gas prices have surged as demand outpaces supply. Oil prices have shot up 624% over the last decade to more than $110 per barrel, while natural gas has risen 285% to around $7.50 per thousand cubic feet.
Per thousand cubic feet
Worldwide U.S. Average barrels per day, in millions
Average barrels per day, in millions
Source: Energy Information Administration
INDUSTRY SNAPSHOT TREND WATCH
As Oil Hits New Highs, Foreign Fields Tighten Venezuela’s takeovers reflect a broader trend to government control BY ALAN R. ELLIOTT INVESTOR'S BUSINESS DAILY
Striking workers outside the Grangemouth oil refinery in Scotland. The strike, which took 700,000 barrels of oil per day out of the global supply in April, is just one example of how complicated the global oil market has become as governments move to cash in on sky-high oil prices. AP
OIL AND GAS EXPLORATION AND PRODUCTION
Oil Fuels Global Power Shift Rising demand complicates rules for exploration and production firms BY ALAN R. ELLIOTT INVESTOR'S BUSINESS DAILY
The Forties pipeline is a 3-footwide steel straw that pokes 170 kilometers into the North Sea. It makes landfall at Cruden Bay, Scotland, then finds its way over land to the refinery at Grangemouth. In April, the refinery’s workers walked out on strike against its owner, heavyweight chemical maker Ineos. The strike was the first to shutdown a U.K. refinery in 70 years. It also forced operator BP to shut down the Forties, squeezing 700,000 barrels of oil a day out of the U.K.’s fuel supply. Almost a third of that supply flowed from North Sea fields operated by NexenNXY. The Calgarybased operation had ramped up production at its new Buzzard field platform, which it operates with a 43% ownership interest, through 2007. The field had climbed to 54% of Nexen’s net income during the first quarter, surpassing operations in Yemen to become the company’s largest-yielding project. Nexen’s change in emphasis, from the less politically certain Yemen to more home-field plays like the North Sea and Canada, is just one example of a trend within the International Exploration & Production industry group. Behind the trend is the migration of oil-producing countries toward greater control over their domestic oil industries. The shift includes extreme moves, such as those made by Venezuela (see related story on this page). But it also includes a long list of players such as Nigeria, Libya and Algeria that want to attract investment but have a greater say over what those investments might produce. One group player that runs against that trendis ChinaNational Offshore Oil Corp.CEO, or CNOOC. Majority-owned by China’s communist government, CNOOC has expanded rapidly into new international territories the past several years. It snapped up petrochemical companies, built liquefied natural gas facilities and christened a $2.3 billion offshore development operation in Nigeria. It has attempted, but so far failed, to stake a large claim in the Caspian region.
1. Business Exploration and production means finding and delivering oil and natural gas — no matter where it sits. The international E&P group is small, with only two of 32 stocks topping $10 billion in mar-
ket capitalization. Compare that with the U.S. E&P group, with 11 stocks above $10 billion, or the International Integrated group, with 18 $10 billion-plus plays. The companies can bid for exploration contracts from host countries or they can buy out operators with existing shares of exploration or production agreements. Host governments care about bid prices, but are increasingly interested in other ways a company is willing to benefit their country. Hiring local labor and expertise is a big plus. So is a clean environmental record. Companies with expertise in particular geologic regions or in specific types of geologies often can better convince governments they are capable of finding and producing their claim. 00 Name Of The Game: Cherish your crystal ball and your drill bit. Lawyers and engineering expertise run a close second. Forecast oil and gas prices conservatively. Identify and invest in projects that promise the best return on investment with minimal risk. Find and hold the talent capable of fast, cheap, innovative project development.
2. Market Refiners are the biggest customers for oil producers worldwide. The buyers of natural gas vary: marketers, gas utilities, power production facilities, petrochemical refiners or industrial customers feeding local or regional markets. Liquefied natural gas is expanding the potential gas markets. But LNG is a small fraction of the overall natural gas market — it represents only 2% of the gas to northeast markets in the U.S., for instance. Refiners and governments are the biggest customers in the oil business. Internationally, there is sometimes a more active market for middlemen and speculative buyers. “But even companies the size of Nexen are generally contracting directly with the refiners,” said Randy Ollenberger, an analyst with BMO Capital Markets Canada.
3. Climate Robin West, founder and chairman of Washington-based advisers PFC Energy, told a recent industry conference that in 1970, integrated oil companies had access to 85% of the world’s total reserves. By 2007, that figure had slipped to just 7%. The remainder rested in the hands of national oil companies and Russian firms. In the vast movement toward na-
tionalization of oil industry resources, CNOOC sits at the opposite end of the spectrum from most other companies in its group. The company manages China’s offshore oil and gas activities, generally under partnerships with foreign companies. It also has become a key procurer of resources to secure China’s energy supply. Thecompany is, in itself, nationalized — two-thirds owned by the Beijing government. It netted a cool $1.2 billion in cash when it went public on the NYSE in 2001. In 2003, it launched an $18.5 billion bid for Unocal, the old Union Company of California. The offer topped an earlier, $16.8 billion pitch made by ChevronCVX. But money isn’t everything, even in the oil business. The CNOOC move ran into a great wall of opposition to acquiring a U.S.-based oil company. Controversy stirred, and CNOOC eventually withdrew its bid, leaving Unocal to settle at a $17 billion final deal with Chevron. The key target of CNOOC’s offer were Unocal’s major holdings in Kazakhstan, home to the vast and largely undeveloped Kashagan field. CNOOC made a second run at the region in 2006, offering $2.3 billion for the Nations Energy. The independently held Nations wasbased in Canada, but was Kazakhstan’s ninth largest oil operation. A group of western-based companies that lead the development partnership blocked CNOOC’s purchase. But Nations was later bought by CITIC Group, oneof China’s largest independently owned conglomerates.
4. Technology Big Oil always has been seen as the keeper of the keys to the industry’s latest and greatest technology. But most of the technology was developed by service operators like SchlumbergerSLB and HalliburtonHAL in the process of developing new resources or making existing plays economically feasible, says BMO’s Ollenberger. “That technology diffuses pretty rapidly out to the other players,” Ollenberger said, which means any technological advantage is short-lived. “There really isn’t a big technology advantage for the large guys vs. the smaller guys,” Ollenberger said. “I think the advantage that the large guys have is essentially their balance sheet.” Big oil clearly holds the advantage on projects like deepwater drilling or in the massive build-up required to make areas like Russia’s Sakhalin Island an economically feasible producing region.
But the narrower focus of smaller players such as Nexen, Dragon Oil or Harvest Energy mean top technology is well within reach. “We’re looking at very different types and sizes of properties,” said Harvest Chief Financial Officer Steven Tholen. “What is material to Harvest is certainly not material to Exxon.”
5. Outlook One question hangs over the oil trade like a thunderhead: Where will the price of oil settle? Every company and every expert has a different view. Some expect an eventual settling to as low as $65 a barrel. Others see a spike to $200 followed by rodeo-style volatility. Big oil producers have reluctantly raised their long-term operating models from the $20 range at the end of the 1990s to above $50. Many smaller producers use $75 as their yardstick. Here’s what is certain: The industry’s operating culture has grown much more complex. Remaining oil and gas reserves are becoming more difficult to find and develop. The rising energy needs of China, India and other developing nations are intensifying competition for resources and services. The trend of resource-bearing nations taking greater control over their assets is shifting the industry’s balance of power. Does this complexity, coupled with the industry’s steep cost inflation, mean smaller players are likely to be squeezed from the market? BMO’s Ollenberger says smaller players stand to benefit from the increasing number of hand-medown opportunities worldwide. “Either the project isn’t big enough to move the needle for the super major, or the area is too mature and the super major is moving on to where they think there are better prospects,” Another element, the paradigm shift caused by increased national ownership within the industry, also plays to the little guy’s favor. Thequestion is— according toJoseph Stanislaw, a private industry consultant to Deloitte & Touche and the former chief executive of Cambridge Energy Associates — how do you partner? “Smaller guys know they have to be real partners. When the big guys are negotiating, they want to be dominant and with a controlling share,” he said. 00 Upside: Demand could continue to rise as emerging markets such as China and India continue to develop. 00 Risks: A global recession could dampen demand and lead to a supply glut.
Hugo Chavez is no oil man. But the head of Venezuela’s leftist Bolivarian Revolution, first elected president in 1998, has come to represent a broad psychological shift in the oil business. The Venezuelan leader sacked much of the long-standing management and expertise at the stateowned oil giant Petroleos de Venezuela, or PdVSA, in 2002 and 2003. Three years later, his government bluntly revised the rules under which foreign oil producers profit from locating and producing oil and natural gas in the country. Media coverage has helped cast Chavez as a kind of grand marshal presiding over resource-bearing countries marching toward greater control over their assets and bigger shares of the profits those assets earned. But the trend is a long-standing challenge in the oil business. Case in point: Mexico’s nationalization of its production in 1938. Through the 1970s, Saudi Arabia took ownership of Aramco from what were then Exxon, Mobil, Texaco and ChevronCVX . The world’s largest offshore operator, Statoil, was established in 1972 with Norway as its majority shareholder. The rate of nationalization has more recently tracked skyrocketing oil prices. Ecuador ousted Los Angeles-based Occidental Petroleum OXY in 2006. Russia’s GazProm that same year grabbed a majority chair of the massive, $20 billion Sakhalin-2 liquid natural-gas project, forcing developers Royal Dutch Shell RDSA, Mitsui and Mitsubishi into minority positions. Nigeria told oil companies early this year it planned to renegotiate its production-sharing agreements, looking to increase its current, 55% stake in national production. In Venezuela, in 2006, a gaggle of heavyweights including Chevron, BPBP and TotalTOT conceded to the new terms, becoming minority players in projects they had developed. Exxon MobilXOM and ConocoPhillipsCOP refused. Rather than give in, they claimed breech of contract. Retaliating, Venezuela forced them to surrender assets across the country, including thosein the prolific, thick-crude fields of the country’s Orinoco belt. The holdouts focused their efforts elsewhere — including international courts, where they have fought to force Venezuela to pay for the broken agreements. Smaller players, including Harvest Natural ResourcesHNR, had fewer options. The Calgary-based company had moved into Venezuela in 1992, picking up rights to several fields in the northeast just above the Orinoco. PdVSA mothballed the fields in 1987. But before the shutdown, the properties had produced 73 million barrels of oil and had an estimated 12
million barrels in reserve. Harvest applied new technologies and methods. By the time Chavez rescinded the company’s production deal in 2006, Harvest had squeezed 113 million barrels of oil and 64 billion cubic feet of natural gas out of the properties. Proved reserves still in the ground had ballooned to 10 times original estimates. The Venezuelan project accounted for all of Harvest’s revenue through 2005. The company kept producing after the Chavez edict, as PdVSA and Venezuela’s government worked to fashion a “mixed company” to operate the project. Harvest delivered the crude and natural gas to PdVSA. PdVSA withheld payment but reimbursed Harvest’s operating costs. Company revenue toppled from $237 million in 2005 to nil. Still, Harvest chief financial officer Steven Tholen says he understands why governments would want to renegotiate contracts. Prices and long-term forecasts for oil were both around $20 a barrel when Harvest entered its initial contract. They’re more than $120 a barrel now and rising. “That whole curve shifted upward,” Tholen said. Prices had reached well into the $60 range when Venezuela nullified the deal. The mixed company, Petrodelta, finally formed in the fourth quarter of 2007. “The thing that was disappointing from our standpoint, and I think from the Venezuelan’s standpoint as well, is the amount of time it took to get from point A to point B here,” Tholen said. For its share, PdVSA contributed three new fields to project, boosting Harvest’s reserve base. PdVSA owns 68% of the total picture. Harvest’s share of production was more than halved. “We went from an 80% share to a 32% share,” Tholen said. Harvest, through Petrodelta, has begun seeing payments on its Venezuelan production. It is waiting for a lump-sumpayment for the hydrocarbons produced since April 1, 2006. Throughout the process, the company judiciously minded its cash. Its balance sheet fared surprisingly well. The first quarter filing showed $117 million in cash and no longterm debt. It also showed that Harvest had broadened its focus. The company bought into offshore exploration contracts in Gabon and Indonesia. This month, following the trend of smaller North American companies focusing efforts closer to home, Harvest announced its first contract along the U.S. Gulf Coast. The biggest downside, Tholen said, has been the decline in production at the Venezuelan fields. Harvest halted new drilling projects until the new contract and company was finalized at the end of 2007. “Our production there has fallen dramatically,” he said. “If this process had taken six months instead of two-and-a-half years we would have been in the field drilling and production would be significantly higher.”
Who’s Who In Oil and Gas Exploration and Production Stocks ranked by a combined EPS and Relative Strength
1 2 3 4 5 6 7 8 9
Stock Mkt EPS Rel Price Val Revenue Qtr 2/3-yr Qtr Ticker Rtg ë Str (1 Day Ago) ($Mil) ($Mil) EPS% EPS % Rev %
Pretax ROE Margin
DRAGF 99 99 11.1 5662 596.6 67 70 84 19 64 Dragon Oil Ireland. Engaged in upstream oil and gas development and production in Turkmenistan. NXY 93 94 38.24 20293.4 7308 432 22 51 19.4 28.7 Nexen Inc. Calgary, Alberta. Explores and produces oil and gas in the North Sea and elsewhere. CEO 88 96 180.67 78416.112183.7 19 26.9 28 23.3 47.7 CNOOC Hong Kong. Explores, develops and produces crude oil and natural gas in China. STOSY 44 97 69.46 9932 2121.6 -26 16.8 0 25.7 46 Santos Australia. Engaged in oil and gas exploration and production worldwide. 4TYK 11 97 21.13 1047.1 35.9 .. .. 275 -4.1 -25 Tanganyika Oil Calgary, Alberta. Acquires, explores and develops natural resources in Syria and Egypt. ISRL 22 83 44.5 111.8 22.8 .. .. 488 -25.2 -51 Isramco Houston. Engaged in exploration and production of oil and gas in the U.S. and Israel. 363.6 11.2 .. .. .. 18.2 275.6 Harvest Natrl Rsrs HNR 47 36 10.27 Houston,. Acquires, explores, develops and produces oil and natural gas properties. APAGF 52 29 19.66 615.6 62.7 -15 26.2 7 18.3 64.1 Apco Argentina Tulsa, Okla. Explores and produces oil and gas in Argentina through joint ventures. 5NKO 16 65 88.44 4020.4 95.4 .. .. 8 -1.1 4.4 Niko Resources Calgary, Alberta. Explores and produces crude oil and natural gas in Asia.