Oil and natural gas industry cash flow is setting all-time records, but upstream spending in North America has declined 22% since 2001, as capital budgets shift toward more investments in South and Central America and Africa and Middle East regions, according to the latest sector survey by consultants John S. Herold Inc. and Harrison Lovegrove & Co. Ltd.

Herold’s 2004 Global Upstream Performance Review found record cash posed new risk-reward challenges for public oil and gas companies confronting higher costs, heightened shareholder expectations and the need to expand their reserve bases to meet rising global petroleum demand.

“In an industry now generating more cash than it can apparently spend sensibly in an opportunity-constrained market, companies are seeking an appropriate mix of actions that will expand their opportunity base,” said Herold CEO Arthur L Smith. “The primary challenge facing energy executives now is to find the best use for the unexpected, and some would argue overdue, surge in upstream profits and cash flow. Herold estimates that funds used to buy back shares could match or even exceed the industry’s investment in global exploration activities in 2004.”

Martin Lovegrove, CEO of Harrison Lovegrove, noted that “historically, the best returns have been earned through grassroots exploration and the discovery of new fields,” but the mature basins in low-risk regions “do not offer the expansion opportunities that the larger oil companies need in order to attain growth and satisfy investors. Pacesetter oil and gas companies will continue to shift funds to higher-risk regions offering world scale reserves or will pursue aggressive acquisition programs to become the dominant operator in a region.”

The 147-page report, Herold’s 37th annual study of upstream performance by substantially all public oil and gas companies, is based on data filed with the Securities Exchange Commission, and it measures industry-wide performance in several key areas. Among other things, the report found that prices realized by the 194 companies surveyed increased 23% in 2003 to $23.45/boe, spurring a 27% increase in worldwide revenues to $395 billion.

Cash flow at the surveyed companies also increased 24% to $197 billion, more than $35 billion above upstream capital investment, and for the fourth consecutive year, capital investment was less than cash flow. However, as the producers aimed toward maximizing deliverability in a time of high prices, production development spending rose 21% to $100 billion, while exploration was flat at $30 billion.

The survey also revealed that in the absence of mega-deals, merger and acquisition (M&A) transaction value declined 16% to $29 billion, 40% below its 2000 peak and just 18% of overall spending; for the first time in eight years, the value of asset deals surpassed that of corporate deals. Since 2001, spending in North America has fallen 22% while investment in South and Central America, Africa and Middle East regions has increased more than 60% and the Asia-Pacific region moved to second place behind the United States in total three-year spending by survey companies.

Oil and gas reserves and production both increased about 2% worldwide in 2003, but only Canada and the Asia-Pacific region showed reserve gains, according to the survey. Also, reserve replacement costs surged 20% to $6.36/boe in 2003, and have increased about 15% per year since 1999, while the reserve replacement rate continued declining, reaching 150% of production compared with 206% in 1999. These trends have emerged already in mature regions, but in 2003 frontier areas such as Africa and the Middle East and South and Central America began to experience significant cost pressures.

The Herold survey noted that as equity markets worldwide recovered in 2003, energy shares from oil to coal were among the best-performing industry sectors, with median total shareholder return for the majors recovering to more than a 30% return.

“With cash pouring in, reinvestment has not risen at nearly the pace of prior oil and gas bull markets,” according to the survey. “Companies are investing relatively cautiously and seeking to maintain capital discipline. For example, upstream operating cash flow climbed by 27% last year to a record $197 billion, whereas upstream investment increased by a modest 9% to $161 billion.”

The industry also made a pronounced shift toward investment in development projects to maximize deliverability in a time of strong product demand and high commodity prices.

“We view the development of the existing asset base as rational behavior,” said the study, but “at the same time, exploration expenditure has been relatively static at 15% of total outlays, and acquisition spending has declined. As the available opportunity set within companies is more fully exploited, the challenge of creating new investment opportunities should spur increases in exploration investment and M&A activity.”

Many companies are continuing strategies of placing less emphasis on production growth and more on directing capital to areas where they are able to create superior returns. For some surveyed, this means withdrawing funds from maturing areas, such as North America and Europe, to finance expansion of operations in other regions.

To explain capital flows out of North America, the study points to superior returns on cumulative capital costs (upstream net income divided by upstream cumulative capital costs) in areas outside the United States and Canada. High returns in the Asia-Pacific region were attributed to the low-cost basis of reserves inherited from government entities in Russia and China, which has produced annual returns there of 30% or better since 1999.

“With continuing high commodity prices and companies still looking for growth, there is every likelihood that energy M&A activity will increase…at least bottoming-out a six-year decline in total upstream deal values — as companies seek to renew their asset base,” the report said.

“Over the three years since 2001, the proportion of corporate (versus asset) deals has fallen from 84% to 48% of total upstream transaction value,” said Lovegrove. “However, this trend may be reversed in 2004 due to increased activity in North America where both the absolute amount and the proportion of corporate deals has increased. We anticipate strong balance sheets and ambitious growth targets will continue to fuel acquisition activity particularly from the larger independents.”

The implied value of reserves involved in M&A transactions worldwide declined to $3.53/boe in 2003, due mainly to the dominance of Asia-Pacific transactions with implied values in the $1.00 to $3.00/boe range. However, in North America, implied reserve values rose, fueled by high-cost acquisitions by high-yielding Canadian Royalty Trusts targeting short-lived producing properties.

With strong commodity prices, North American implied reserves costs continue to soar, according to the report. “Because these deals represent 80% of the reserve value in year-to-date transactions, the worldwide implied cost of reserves could rise significantly in 2004 without major deals in lower-price regions.”

Despite rising levels of investment by oil and gas companies, upstream operating cash flow today “remains far in excess of capital outlays,” which suggests that the industry is under-investing. “We believe the industry has been investing wisely because total production of the surveyed companies has risen in pace with world demand and, at the same time, the industry has been increasing its reserve base,” said Smith. “The industry has learned that sharp increases in upstream investment lead to rampant oilfield cost inflation and an inevitable commodity price whipsaw.”

The report noted that investors in the major oil companies expect cash dividends as a part of their return, and dividend payments have increased modestly relative to capital investment over the past five years, “not surprising in light of the surge in net income.” In addition, share repurchases have soared since industry profits reached a low in 1998 and, according to the survey, now account for roughly 25% of capital returned to shareholders. “We expect share repurchases to become a more important component of shareholder return, and for more companies to employ the strategy.”

Having the opportunity to make wise decisions with record cash flow is a lot better than where the petroleum sector stood six years ago. “Then the challenge was simply survival. Now, it is to thrive against a background of geopolitical risk and to avoid the complacency that can result from times of plenty.”

According to the study, BP plc was the most active company in 2003 with $14.7 billion of total upstream expenditures, including $6.1 billion for proved reserve acquisitions. Rounding out the top 10 in global upstream investment were: ExxonMobil ($11.1 billion); Royal Dutch/Shell Group($10.8 billion); Devon Energy ($8.1 billion); PetroChina ($6.7 billion); Petrobras ($6.5 billion); ENI ($6.4 billion); Petroleos Mexicanos ($5.9 billion); TOTAL ($5.5 billion) and ChevronTexaco ($5.3 billion).

©Copyright 2004 Intelligence Press Inc. Allrights reserved. The preceding news report may not be republishedor redistributed, in whole or in part, in any form, without priorwritten consent of Intelligence Press, Inc.