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Financial Times: Lex Column: Southfork in the road

Published: November 7 2006 02:00 | Last updated: November 7 2006 02:00

Back when ‘Dallas’ ruled the airwaves, Big Oil was a racy mix of big hats, bigger hair and even bigger money. J.R. Ewing would have been horrified to think of his business becoming more like a dull old utility.

Historically, upstream oil and gas – as opposed to downstream businesses such as refining and marketing – generated the sector’s highest returns on capital. Investments made in the 1970s and 1980s provided accessible reserves for conversion into cash. Relatively light, fixed tax regimes meant leverage to the oil price.

As areas such as the North Sea enter decline, though, that is changing. Oil companies are struggling to replace reserves and expand production. The best resources are either off-limits or subject to punitive fiscal regimes.

By 2010, Europe’s integrated oil companies are expected to produce more than half their oil and gas under production-sharing agreements, buy-back contracts and other low or fixed-margin regimes, up from about a third three years ago. PSAs and buy-backs are common in the politically riskier areas oil companies have to target these days. While these mitigate investment risk, they also cap potential gains by linking the company’s share of production to the oil price. Furthermore, while many of the majors’ new projects are healthily longer-lived, they are also more complex, subject to delays and overruns and dependent on more aggressive long-term assumptions. For investors, therefore, this means a triple whammy: less sensitivity to the oil price owing to PSAs; higher risk; and structurally lower returns on capital employed.

Oil companies threatened with a change of this magnitude also have a tendency to try to spend their way to safety – particularly as high crude prices mean buoyant cash flows into their older fields. Royal Dutch Shell is betting big on long-lived, but low margin and technically challenging, Canadian oil sands. Smaller rivals such as ConocoPhillips and Repsol have also paid up for growth or commodity price leverage via pricey acquisitions. The upstream is becoming more utility-like but that does not mean it is low risk.

Copyright The Financial Times Limited 2006

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