Big oil, big problem

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Big oil: Big Oil has a big problem. It may not be apparent from the profits energy companies are churning out. But the industry's future depends on its ability to rove the earth in search of new reservoirs of oil and gas.

Yet as energy resources grow scarcer, governments are restricting western drillers' access to their fields. They're fostering their own champions, many of whom are flush with capital, have learned from the majors over the years and can easily hire drilling expertise from service firms like SchlumbergerSchlumberger.

There at least three logical responses by the oil majors to the rise of National Oil Companies (NOCs). The first, already underway, is to invest in countries where they're unlikely to see assets expropriated. The second is to consider buying service firms themselves. Lastly, they could seek mega-mergers, along the lines of an ExxonExxon-ChevronChevron or BPBP-ShellShell, to counter the increasing heft of the NOCs.

None of this will happen overnight, of course. But there are already signs of a flight to friendlier climates by western producers. It's easy to see why. Consider some the past month's developments: Algeria booted Spain's RepsolRepsol out of a major project; Kazakhstan stepped up the pressure on Italy's Eni in its huge Caspian find; and ExxonMobilExxonMobil took its fight to the courts against Hugo Chavez's decision to nationalise assets in Venezuela.

That's why ConocoPhillipsConocoPhillips, ShellShell and others are increasing investments in countries like the US and Canada. But this presents complications of its own. Deep in the Gulf of Mexico or Alberta's oil sands it's far more difficult, and costly, to extract energy. This has two consequences: it reduces profits for the majors and it accelerates the transfer of treasure and technology to the oil service providers.

What's wrong with that? After all, it's efficient to outsource the extraction of natural resources to these firms, leaving the valuable task of finding new gushers to the exploration companies. The problem is that as service firms get better at what they do, it becomes easier for the national oil groups to view them as better partners than Big Oil.

In the past, the majors were valued for their capital, their ability to locate new reserves and their project management skills. But think of it. A country like Algeria has seen its coffers fill with petrodollars in recent years - it doesn't need capital. And its petroleum engineers have learned project management skills by working closely with the majors.

So if it can hire SchlumbergerSchlumberger to do the dirty work to exploit the country's reserves, why pay ExxonExxon or RepsolRepsol a chunk of future royalties? This becomes especially critical as service companies have increased their edge. In recent years, they've filed twice as many technology patents as the oil majors, according to Weatherford, a service firm.

That's why nearly all the majors have discussed acquiring service providers. They haven't pulled the trigger, though, for good reasons. First, there's price: SchlumbergerSchlumberger trades at 21 times 2008 profit estimates, compared to 14 times for ExxonExxon. Furthermore, the worry is that if ExxonExxon owned SchlumbergerSchlumberger, most of ExxonExxon's rivals would cease to do business with the Franco-American service provider.

That leaves the majors with a final option: mega-mergers. With a $510bn market cap, ExxonExxon's no wimp. But if it bought $200bn ChevronChevron it would create an energy champion on the scale of a Gazprom or Saudi AramcoSaudi Aramco. It would also create tons of value. If it extracted synergies from ChevronChevron in line with the 2.5% of costs that it squeezed from Mobil, there would be up to $12bn of savings. After taxes, these could be worth $70bn to shareholders today. A BPBP-ShellShell combination would offer similarly juicy cuts.

Sure, there would be antitrust issues, particularly in the refining business. And with oil prices at $80 a barrel, energy executives may not feel pressure to move anytime soon. But as energy resources dwindle and the world gets smaller for western producers, it gets easier to see a day when Big Oil gets a lot bigger.

Author: Rob Cox and Cyrus Sanati
Email: rob.cox@breakingviews.com

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