A Battle for Oil Production Is Brewing

By the Casey Research Energy Team

High oil prices have put record earnings into the coffers of the world’s big oil companies, but those splashy headlines are masking an industry-wide decline in oil production. Exxon Mobil (N.XOM), Royal Dutch Shell (N.RDS-A), BP (N.BP), ConocoPhillips (N.COP),Chevron (N.CVX), and others reported surging third-quarter profits alongside production decreases – an unsustainable situation that is setting the stage for a battle to buy producing assets.

Almost across the board, major oil companies are producing less oil now than they were a year ago. It’s not due to a lack of exploration and development – these companies have all devoted billions of dollars to finding new oil deposits. The problem is that for the most part it will still take years – and many more dollars – before those investments start producing.

In the meantime, big oil’s output will keep declining unless majors start using some of their record profits to buy up producing assets from smaller companies. Oil wells produce less each year; Exxon’s oil fields, for example, are declining by 5 to 7% each year, which means the company needs to add 200,000 to 300,000 barrels of production a day just to break even. This year, Exxon has not come close – its production levels are down 8% compared to a year ago. Some of the production decline stems from contractual limits on Exxon’s production, but even without those limits production would have still been down more than 1%. Over the first nine months of the year, Exxon’s production averaged 2.33 million barrels of oil per day, the company’s lowest average since 2005.

Things are even worse for other major oil companies. BP said oil production dropped 10.6% in the quarter, in terms of barrels of oil equivalent (BOE). Shell’s BOE production fell almost 2% in the quarter. ConocoPhillips produced 6% fewer BOEs.

There’s an important note to add about BOEs. The BOE concept combines a company’s oil, natural gas, and condensate output into a single production number, based on energy equivalence. It takes roughly 6,000 cubic feet (cf) of natural gas to release the same amount of energy that is in one barrel of oil, so companies book gas reserves as "barrels of oil equivalent" using a ratio of 6,000 cf:1 barrel. A problem arises when a company then values its reserve books using oil prices. One barrel of oil may have the same energy content as 6,000 cf of natural gas, but in North America the barrel of oil is worth something like US$86, while the 6,000 cf of gas is worth only about US$22. Adding lots of natural gas to the books is an easy way to make it appear that oil reserves are growing, but at a fraction of the typical cost. And there are lots of inexpensive shale gas deposits for sale.

The Casey energy team hates being misled in this way, so we’ve created programs that calculate the real value of a company’s reserve book; using our methods often gives some very different results when it comes to company valuations. We think this is one of the biggest frauds to hit the energy sector in decades, and we make sure to steer our subscribers away from companies that try to pass off gas reserves as equivalent to the black gold that is crude oil.

Getting back to the story, oil output may be stalling but oil prices have remained high enough to more than cover the cracks. Exxon’s profits jumped 41% in the third quarter to US$10.3 billion because the company sold oil in the US for an average of $95.58 a barrel, a 35% increase compared to Q3 2010. For the same reason, Shell doubled its earnings this Q3 compared to last, bringing in $7.3 billion. BP earned $4.9 billion in the quarter, a 175% year-over-year increase. Chevron pulled in $6.2 billion in the third quarter, 74% more than last year. ConocoPhillips exited Q3 with $3.5 billion in earnings, a 59% increase over 2010.

The pattern is pretty clear: big oil companies are producing less but profiting more. With oil prices expected to remain range-bound for the medium term (assuming no major supply disruptions), these majors cannot rely on rising prices to keep their profits aloft in the future. They need to boost production instead, especially given that global oil demand is expected to increase by approximately 1.5% annually for the next five years. Since it takes years to bring new discoveries online, the short-term fix is to buy production.

With big oil’s bank accounts full to the brim with cash, the stage is set for some significant acquisition activity… or, to put it another way, for a battle to buy producing assets. There are quite a number of contestants in the battle – big oil companies are not only competing against each other to sweep up good assets but also against the national oil companies of developing, energy-hungry nations like China, South Korea, and India. Oil demands are rising in these nations so quickly that just to cover expected annual demand increases those three countries would have to jointly spend $30 billion on acquisitions each year.

BHP Billiton’s (N.BHP) move last quarter to buy Petrohawk Resources for $15 billion is exactly the kind of purchase we are talking about. So is Statoil ASA’s (N.STO) recent $4.4-billion acquisition of Brigham Exploration. And the stars are aligning just perfectly for big oil: They are making record profits; oil prices are expected to remain strong; and the world’s market turmoil has only pushed their share prices down by some 20% over the last six months. Small to mid-sized oil companies, on the other hand, have fared much worse, losing an average of 35% to the economic uncertainty. The Statoil-Brigham deal is a perfect example: Statoil offered a 34% premium over Brigham’s 30-day average trading price, yet the offer was still almost 4% below Brigham’s 52-week high. With that kind of discount available, the time for majors to start bidding on small and mid-sized producers is ripe.

The Casey Research energy team is analyzing all of these small and mid-sized producers to determine the most likely takeover candidates. We will publish our results in a special edition of our flagship publication, Casey Energy Report.

[Make no mistake, the end of easy oil is looming ever closer. But savvy investors can profit handsomely from this turn of the tide…learn how you can be among them.]