Drilling on Wall Street
Dec 13th 2005
From The Economist Global Agenda
ConocoPhillips, one of the world’s leading privately owned oil firms, is paying almost $36 billion to acquire Burlington Resources, a smaller American producer. As profits boom and access to new reserves dwindles, energy firms are likely to pay top prices to get their hands on new sources of oil and gas
AT FIRST sight, the decision on Monday December 12th by America’s ConocoPhillips to pay $35.6 billion for Burlington Resources, a natural-gas and oil producer also based in America, seems to be an indication of the strength and buoyancy of the global energy industry. High oil prices have led to bumper profits that have left the world’s big producers wallowing in cash. Most, including ConocoPhillips, have chosen to return some of this largesse to shareholders in the form of share buybacks and special dividends. Reinvesting a portion of this windfall may also seem like a wise decision, given the rewards on offer.
Conoco is not the only one to splash out on a rival this year. Chevron, America’s second-largest oil firm, bought Unocal, a mid-sized producer, in April, trumping Chinese and Italian bids with an $18 billion offer. Unocal's oil and gas assets are mainly located close to Asia’s booming energy market. Burlington’s resources are placed much nearer to home: some 80% of the firm’s gas reserves are in North America.
The success of both acquisitions will depend partly on oil and gas prices remaining at present high levels for some time to come, a bold bet in a notoriously cyclical business. But the deals will also be motivated by concern among the big publicly listed oil companies that access to new reserves, vital in the long term, is becoming increasingly difficult to secure. That is because countries with lots of oil and gas under their soil are taking a more nationalistic view of those resources, and because their own (often state-owned) oil giants are flush with funds and thus no longer need as much outside help to get the stuff out of the ground.
ExxonMobil, BP and Shell may be household names, but much of the oil business is still dominated by the state-run giants of the Middle East; two-thirds of the world’s proven reserves are buried around the Persian Gulf, OPEC’s centre of gravity. It was a desire to keep the oil cartel’s market power in check during the oil-price shocks of the 1970s that led western oil companies, denied access to the bounties of the Gulf, to begin extracting oil from the North Sea, Alaska, the Gulf of Mexico and elsewhere. Now these fields are coming towards the end of their most productive periods, and as decline sets in, the big private oil firms’ thirst for fresh reserves is becoming ever more acute.
To their chagrin, many of the places where proven and potential reserves abound remain off limits. Russia, with 5% of the world’s known oil and huge reserves of natural gas, had seemed like a good opportunity. Boris Yeltsin opened energy assets to private investment in the 1990s, as the country threw off the shackles of its communist past. However, Russia’s current president, Vladimir Putin, has made life much tougher for western oil firms by restricting exploration by foreign outfits, making conditions stricter for joint-venture partners, and showing what would happen to dissenters with the dismemberment of Yukos.
Similarly, the oil minister of Venezuela, one of the world’s leading oil exporters, recently crowed of “snatch[ing] the world’s biggest oil reserves from the mouth of imperialism” after the government decided to force foreign oil companies into new contracts and a new tax regime that are far more severe than those agreed when the country opened its doors to the energy giants ten years ago.
Recent moves by big oil and gas consumers such as India and China, keen to acquire the energy assets that they believe will ensure supplies for their booming economies, have further limited the opportunity for the oil majors to replenish reserves. The leading companies in both countries are on the lookout for new sources of oil and gas. CNOOC, a state-run Chinese firm, tried to buy Unocal, but scuttled away as China-bashing reached fever pitch in America’s Congress, leaving the door open for Chevron. Also this year, China National Petroleum Corporation outbid Indian and Russian oil firms to pay $4.2 billion for PetroKazakhstan.
Big western producers have responded by looking for oil in more volatile parts of the world, including the Caspian region and West Africa, and geologically tricky places like the deep waters off Brazil. Unconventional sources of oil and gas that are set for further exploitation include Canada’s tar sands, shale and coal-bed methane deposits around the world. In Burlington, ConocoPhillips is buying a firm that gets some of its gas from unusual sources, such as pockets trapped in underground rock formations. But extraction of such resources can be technologically challenging and expensive.
The oil giants hope to use their expertise to tap remote gas sources and transport it as liquefied natural gas (LNG). However, this form of energy requires expensive plants to turn the gas into liquid at source. Recently, Shell announced that its Sakhalin II LNG joint-venture in a remote part of Russia would require an investment of $20 billion rather than the $10 billion originally mooted for the project.
Cooling off?
Will energy prices stay high enough to make the purchases of Burlington and Unocal look smart? At the moment there are few signs that oil prices will fall dramatically from their current level of around $60 a barrel. But this week OPEC, which is pumping out the black stuff at somewhere near full capacity, signalled that it might rein in production early next year, if demand falls following the winter months, and scheduled a special meeting for January 31st to discuss the matter. Oil prices have stayed high because supply is tight and demand has surged, not only in fast-growing China and India, but in America too. In 2004, world demand grew by 3.4% rather than the 1-2% that is more usual.
Some suggest that this level of growth is unsustainable, particularly as the Chinese government is making some attempt to cool the economy. Moreover, fresh supplies of oil are set to come on stream in the next few years as big projects from both private and state-owned producers kick in. And pension funds and other investors that have entered the oil market in recent years, thus helping to prop up prices, could decide that it is time to quit.
Both Chevron and ConocoPhillips have insulated themselves against falling energy prices to some extent by using their own highly valued shares to finance their deals (though the latter will pitch in half the cost as cash). Nevertheless, there is a rich history of oil companies overpaying for assets in times of plenty. It is likely that other second-tier oil producers will make tempting targets for rivals with deep pockets and limited options for growth. And as with any gamble, there is a chance that it may not pay.
Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.
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