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Oil: Too much discipline at $50

The Globe & Mail: Oil: Too much discipline at $50

“…Shell has now rejected this approach, in part because it has to. Its much-publicized scandal, in which it admitted to significantly overstating its oil and gas reserves, forced it to wipe the equivalent of 4.47 billion barrels of oil from its ledgers — a quarter of the total.”

The oil and gas industry’s prevailing dogma, which insists that any new projects must meet rigid financial benchmarks or be rejected, is having a negative effect on exploration and supply, and is a major reason behind sky-high prices, PATRICK BRETHOUR finds

By PATRICK BRETHOUR

Saturday, October 2, 2004 – Page B5

CALGARY — The oil world snickered when Petro-Canada paid — or possibly overpaid — for its first major international foray 2½ years ago, buying the overseas assets of Veba Oil & Gas GmbH for $3.2-billion. “You’ve got to believe that nine out of 10 companies said, ‘Boy, they’ve got size 2 hats,’ ” says energy analyst Wilf Gobert, recalling the derision heaped on Petrocan after paying such a hefty price. The same concerns were raised again in May, when Petrocan won the bidding for a 30-per-cent stake in the Buzzard field in the North Sea, shelling out $1.15-billion.

But the snickers have all but disappeared. Oil closed above $50 (U.S.) a barrel in New York for the first time yesterday. With the Middle East in flames, the Nigerian government facing a rebel insurgency in its oil-producing region, and almost a third of the Gulf of Mexico production still shuttered by the aftermath of hurricane Ivan, speculation of permanently higher crude prices are starting to look credible.

Petrocan’s hat may have just grown a few sizes, courtesy of its willingness to buck the oil and gas industry’s prevailing dogma, which insists that any new projects must meet rigid financial benchmarks or be rejected.

“The important thing is to have more than one dimension,” says Peter Kallos, Petrocan’s London-based executive vice-president of international operations. So, for a project such as Buzzard, Petrocan’s strategic goal of building a presence in the North Sea trumped the immediate arithmetic of the deal, which fell below the Calgary company’s standard threshold of a return on capital of 13 to 15 per cent, calculated in part by using the 10-year historical average price of oil.

That sort of flexibility has been exceedingly rare. Driven by the desire to satisfy investors, the industry has become increasingly focused on driving up short-term returns — an approach, critics charge, that has limited exploration for new oil and gas reserves, and helped to drive crude prices to their record $50 mark.

Called “capital discipline,” it has been the overriding philosophy of the industry since at least 1998, the last time that oil prices crashed. Instead of seeking to build reserves, oil and gas companies have focused on minimizing the possibility of being hurt by a sudden downturn, ensuring that any new projects remain comfortably profitable even at prices far from current levels. So, while many analysts expect crude to sell for more than $28 a barrel for years to come, most oil companies use a much lower benchmark, typically $20 a barrel, to evaluate the long-term economics of new projects.

An approach that seemed comfortably conservative six years ago is thus emerging as a major, underlying cause of today’s sky-high oil prices.

Wood Mackenzie, the Scottish energy consultancy, says the sector’s adherence to capital discipline has played a central role in squeezing exploration budgets. Among the world’s 10 biggest energy firms, spending is still only three-quarters as high as it was six years ago, despite a long run of comparatively high prices since then. Spending on developing and producing new reserves is up considerably in the same period, but the paucity of exploration has crimped the growth in global supplies.

Although supplies of natural gas and oil have continued to rise, as energy firms pour billions into squeezing production out of existing fields, supply growth would have been sharply higher if greater investment in exploration had yielded new reserves.

More worrisome are Wood Mackenzie’s projections: Production from the 10 supermajors will peak in 2008, as the ability to wring more output from existing fields wanes. By 2013, it predicts, output from the supermajors will be lower than in 2003 — unless exploration spending picks up.

Mr. Gobert, vice-chairman of Peters & Co. Ltd., is one of those convinced that capital discipline in the energy sector has pinched supplies. He says the companies with natural gas reserves in the Mackenzie Delta doubtless wish today that they had moved earlier to develop the infrastructure needed to bring the gas to southern markets. And it is almost impossible to gauge how much growth in reserves has been either forfeited or delayed, when companies such as Royal Dutch/Shell Group scrapped new initiatives in the name of capital discipline.

Adds Mr. Gobert: “You can imagine how many projects they passed on that would have been wildly successful.”

But there are signs that the grip of capital discipline is starting to loosen. Last week, Royal Dutch/Shell broke ranks with its fellow supermajors, boosting the cutoff price used to evaluate oil projects to $25 from $20 a barrel.

“Shell sees an environment where oil prices have shifted structurally higher,” chairman Jeroen Van der Veer explained during the strategic update announcing the change, adding that he views the energy sector as a “growth” industry.

“If we do it on a lower oil price, we may under-invest,” he said, summing up the peril posed by rigid adherence to capital discipline. Analysts promptly downgraded the company and, in an apparent rebuke to Shell — and a warning to any other producer tempted to follow suit — its shares dropped 3 per cent that day.

Yet professional investors seem curiously oblivious to the consequences of the pressure they are exerting on the oil industry. In a conversation with a London energy equity analyst, one investment manager recently asked why companies weren’t ramping up their exploration programs. The analyst’s retort: “They’ll do that when you stop rewarding them for giving the money back, and looking at the short-term gains.” Wood Mackenzie analyst Derek Butter agrees: “The financial market has a lot of influence in terms of what the companies are doing.”

It’s not only investors who benefit.

To some extent, the phenomenon of capital discipline and the focus on quarterly performance is also influenced by industry compensation, because senior executive packages are typically linked to bottom-line results. But other factors, too, impinge on exploration budgets, including the impact of mega-mergers, the emphasis on development, and the lack of obvious major opportunities.

Still, Mr. Butter wonders if the emphasis on capital discipline has become damaging to the industry’s future — that the relentless focus on short-term results has produced short-sighted thinking. “Potentially, it’s gone too far. The question for investors is, do you want the company that’s getting the highest return on capital employed, or would you like a bigger company but a smaller return?”

Dale Tremblay, chief financial officer of Precision Drilling Corp., has witnessed the impact of capital discipline first hand. From the point of view of Precision, the world’s second-largest oil-field services company, “discipline” in spending by oil producers means a squeeze on its own revenues. Mr. Tremblay said he believes the approach has increased the sector’s volatility, as producers place less emphasis on exploration and more on pumping out current reserves as fast as possible. Periods of low exploration activity (and high production of current reserves) lead to tightening supplies, and then a scramble to find replacement reserves.

That scenario may allow a firm to meet financial benchmarks, but it comes at a cost, Mr. Tremblay says. “At the end of the day, there aren’t as many reserves developed.”

However modestly or tentatively, Shell has now rejected this approach, in part because it has to. Its much-publicized scandal, in which it admitted to significantly overstating its oil and gas reserves, forced it to wipe the equivalent of 4.47 billion barrels of oil from its ledgers — a quarter of the total. Petrocan has, of course, had no such scandal, although the company has stressed its determination to reduce, and eventually halt, the rate at which its international reserves are declining. Petrocan and Shell, then, have at least this much in common: both are seeking growth, and both are willing to shed the shackles of capital discipline, at least occasionally.

Petrocan’s Mr. Kallos says a “run-of-the-mill” proposal must still meet the company-wide threshold of a percentage return in the “low teens,” somewhere between 13 and 15 per cent. And he clearly does not want to imply that Petrocan is at all hostile to the idea of capital discipline, maintaining that the company is, like its peers, in business to make money for its shareholders. Petrocan has certainly shown its willingness to rigorously apply capital discipline, most notably when it scaled back plans last December to expand its Edmonton refinery to process oil sands output.

But the deal in May to buy into Buzzard, like the Veba assets in 2002, was different, Mr. Kallos says. The acquisition might seem pricey if price were the only benchmark, but the Petrocan executive — in an ironic choice of words — says the company “could not afford” to take such a singular focus when evaluating the prospect. The strategic imperative of growth, and the likelihood of boosting reserves and thereby improving the project economics, tilted the balance in favour of investment. “Look, this is a strategic investment,” Mr. Kallos explains.

“It’s a major piece of new production for the company, it’s in an existing core area and it’s a world-class asset.”

Wood Mackenzie’s Mr. Butter thinks the industry is now approaching a tipping point, where prices have been high enough for long enough to convince companies to free themselves — in part — from the constraints of capital discipline, following the path laid out by Shell and Petrocan. “It’s taken its time to get to the point where the companies are happy that they’re now operating in a higher oil price environment,” he says. “I think there will be some up-tick in exploration, but not a huge one.”

Oil patch spending

The top 10 energy firms have boosted spending on the development of existing fields this decade — but at the expense of exploration efforts, where investment has yet to bounce back to 1998 levels. Consultancy Wood Mackenzie predicts exploration will have to start rising, or production by the 10 will peak in 2008.

1998: YEAR WHEN EXPLORATION SPENDING PEAKED FOR 10 LARGEST OIL AND GAS FIRMS

30%: PERCENTAGE DROP IN EXPLORATION SPENDING SINCE 1998

$25: OIL PRICE SHELL USES TO EVALUATE PROJECT ECONOMICS

2008: YEAR WHEN PRODUCTION WILL PEAK FOR THE TOP 10 FIRMS

http://www.theglobeandmail.com/servlet/ArticleNews/TPStory/LAC/20041002/RCOVEROIL02/TPBusiness/International

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