Arthur L. Smith, CEO of the venerable energy research firm John S. Herold Inc., offered a prayer for the new year to oil and gas executives meeting in Houston this week: “Lord,” he pleaded, “let 2003 be boring.”

Smith’s appeal provoked laughter during the one-day Deloitte & Touche Oil & Gas Conference, however, while 2002 had been “one of the more challenging environments” he had ever seen, several obstacles still remain going forward. The first challenge, said Smith, is the dwindling number of energy companies, which in turn has reduced the number of employees. “Are we merger-ing and acquisition-ing ourselves to extinction?” he asked. “I hope not.”

Herold’s company coverage originally numbered 86 oil and gas producers in 1970. By 1980, the universe had merged to 45; as of December, the original number of companies had become five. And even though there was a “most remarkable retreat in 2002,” especially a heavy fall off in the “big deals,” he expects more mergers will be announced. “All of the major regions are contracting,” although the value of the mergers is “up sharply,” he added.

And while the number of companies shrinks, the “projected number of employees is expected to continue the downward trend,” said Smith, which will “manifest itself in 2003.” Faced with fewer companies, fewer job seekers will consider embarking on a career in the energy sector, and that spells trouble down the line. He said that overall, energy employees have been treated “shabbily,” but warned that more problems are ahead unless better incentives are offered to entice potential candidates.

Accessing capital markets also challenges the energy industry, Smith said, especially after the past 12 months. Stock market volatility has been fueled by the “manic-depressive behavior” of investors, which has drastically reduced equity. “There was 25% equity in the stock market in 1982 in energy stocks. Now, it’s 7%,” although he noted that it had been as low as 4.9% during the technology stock peak of a few years ago.

For the upstream, the “overwhelming challenge” said Smith is to ensure profitable growth and the generation of free cash flow. Reserve replacement peaked in 1978, and the finding costs in the United States “shot up” to as much as $8/boe. In 2001, producers spent $140 billion on acquisitions, but not all of the spending offered a good return.

Smith also reported on the disturbing drop in upstream profitability in North America, where net income per boe began a continuous decline beginning in the third quarter of 2001. In the second quarter of last year, U.S. net income/boe was about $6.50/boe (after reaching a high of $10.50/boe in 1Q01). However, by the third quarter, it had fallen sharply to about $2/boe.

“We ought to talk about capital investment and not capital spending,” Smith said. “We need to pay more attention to investment.” With the “disturbing level of reserve replacement rates,” he said success had been “particularly poor.” One idea could be to listen to BP’s CEO, Lord John Browne, he said. Citing BP’s third quarter announcement in October to retreat to 3% growth from earlier production growth forecasts as high as 6%, Smith said that Browne announced the oil major would not “retain or acquire barrels just to meet production growth,” and said that the reserves were there, but he was unsure whether it was worth spending $1 billion more to find it without more research.

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