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Financial Times: Independents wrestle with a shift in power: shares in Royal Dutch Shell fallen by 19 per cent in 2008

By Javier Blas, Ed Crooks and Stanley Pignal
Published: March 12 2008 02:00 | Last updated: March 12 2008 02:00

It is a potent sign of the problems facing the oil and gas industry that the world’s hottest region for acquisitions last year was North America, and these problems could make the next couple of years a much more active period for corporate deals than the past few have been.

US oil production is in decline, and gas production is stagnating. Discoveries in the Gulf of Mexico, the focus of much of the recent exploration activity, have been disappointing, according to Wood Mackenzie, a consultancy.

Canada has huge potential thanks to Alberta’s oil sands, but the resources are costly to develop and pose huge environmental challenges. The federal government this week proposed regulations that would force new oil sands projects to capture and store their carbon dioxide emissions after 2012, a requirement that could scupper companies’ expansion plans.

Yet the US and Canada accounted for 62 per cent of all upstream oil and gas merger and acquisition deals by value last year, up from 55 per cent in 2006, according to John S. Herold and Standard Chartered. The value of deals, including both corporate and asset transactions, in Canada jumped from $25.3bn in 2006 to $45.6bn in 2007, and in the US rose from $43bn to $49.2bn.

Meanwhile, the value of deals in Africa and the Middle East, which hold 70 per cent of the world’s proven conventional oil reserves, fell from $6.7bn to $4.4bn.

The numbers can be erratic from year to year, but the trend is clear: buyers go where they are allowed to buy, not necessarily where the best resources are.

PFC Energy, another consultancy, has calculated that international oil companies have free access to only 6 per cent of the world’s oil reserves, and face restrictions of varying severity for the rest.

This is not an unprecedented problem – the industry has always faced difficulties with access. But it has been getting worse in recent years, with many resource-rich countries, led by Venezuela and Russia, taking greater control of their reserves and pushing to increase the returns they receive.

Samir Brikho, the chief executive of Amec, the UK oil services and engineering group, said yesterday there had been a shift of power away from the international oil companies.

“Countries with oil have traditionally invited in IOCs because they could offer balance sheet muscle and engineering talent. Against that, [the IOCs] wanted equity sharing,” he said. “Now, with the oil price at $100-plus [a barrel], these countries can get all the financing they need, and the engineering they can get without giving up as much.”

One consequence is that the equilibrium level of oil prices has been raised.

The International Energy Agency, the rich countries’ energy watchdog, said in its latest oil market report yesterday that the traditional economics of the oil industry had been “turned on [their] head, with the world developing high-cost but accessible reserves before it fully exploits low-cost oil”.

The US government’s En-ergy Information Administration has estimated the average cost of finding and producing oil offshore in the US, for example, is $64 a barrel.

The exclusion of oil companies from some of the lowest-cost areas, and their consequent expansion into higher-cost regions, added to soaring costs as a result of shortages of staff and equipment. This means that the profitability of oil and gas assets has not risen anything like as fast as the oil price.

The prices paid for oil and gas assets in M&A deals were broadly unchanged last year. The worldwide average price paid for a barrel of proven reserves fell from almost $13 to $10, according to the John S. Herold/ Standard Chartered survey.

Prices fell in almost every region, with the declines being steepest in the former Soviet Union, where they were down almost 15 per cent, and in Latin America, where they were down 20 per cent.

That pressure on profitability is reflected in corporate valuations, too. So far in 2008, while oil has risen 14 per cent, shares in ExxonMobil, the world’s biggest private sector oil company, have fallen 10 per cent, and Royal Dutch Shell, Europe’s biggest, has fallen 19 per cent.

Although futures prices suggest oil is expected to stay at about $100 a barrel for the next decade, companies are not using anything close to that in their planning. BP and Total, for example, have both said they plan on an assumption of $60 oil.

They test projects at a range of prices, however, and they would be happier if prices were higher. Neil McMahon, of Sanford Bernstein, suggests BP and Shell need an oil price in the “low $70s” to pay their dividends and meet their capital spending commitments without having to borrow more.

The IEA said yesterday that “only a protracted and severe global recession would justify a sustained dip in oil prices” below about $60 a barrel.

If that happens, the logic of mergers to cut costs is likely to become highly persuasive.

Industry executives have long said that a fall in the oil price could be the trigger for a fresh round of consolidation. It now seems that might be true at a much higher level than anyone would have guessed even a year ago.

Additional reporting by Javier Blas and Stanley Pignal

Copyright The Financial Times Limited 2008

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