In order to attract new investors by providing better returns, the oil industry might have to restructure its upstream operations into pure exploration companies that find and sell new reserves and pure production companies or royalty trusts that liquidate those reserves.
Both types of companies would pay bigger returns more quickly to investors than the historical industry practice of putting all earnings and new investment capital back into the ground to increase reserves and production, said Malcolm Butler, advisory director for HSBC Investment Bank PLC, London.
"With demand for oil growing at a slower rate than the gross national product, this is not a growth business," Butler told the annual energy industry symposium sponsored by Arthur Andersen LLP Dec. 5. "The new [financial] model for E&P companies may be to stop reinvesting their revenue and deliver that cash flow to their investors."
Especially among small independents, Butler said, "There's a strong argument that exploration should be separated from production, since exploration creates value and production capitalizes it."
Industry unbundling
With other industries outpacing the upstream oil and gas sector in the rate of financial returns on investments, he said, "It's difficult to convince the financial market that you're a going concern because it's difficult to convince the market that you can keep replacing your reserves."
The integration, or "bundling," of exploration, production, and even refining and marketing operations makes sense in immature markets where there are "too many barriers, too few players, with no open market," said Butler. But in mature markets such as North America, he said, investors are able to "pick and choose" the industry sectors that can deliver the best returns.
That has given rise to independent refiners that operate without the countervailing upstream involvement of major integrated oil companies, Butler said. It also has rewarded some niche independents that focus on exploration for reserves to sell to other producers or who acquire reserves that they then produce.
"Royalty trust models are becoming more popular as a way of returning more cash to shareholders," Butler said. "I think that's where the industry may have to go."
Producers also will probably have to return to the practice of paying dividends as a means to attract and reward stockholders, he said.
Butler acknowledged, "The market now does reward integrated companies. There's really no reason why the supermajors are given higher ratings, but they are. Perhaps because they did what they said they would do-they grew bigger."
Supermajors, independents
The bigger companies with their deeper pockets tend to have better access to the best exploration and development acreage, along with other synergies of scale. But Butler and others during the 2-day meeting noted that it's harder for the supermajors to replace production, forcing them to hunt for the elusive potential "elephant" discoveries in frontier areas around the globe.
A few companies such as Anadarko Petroleum Corp. and Apache Corp. have done good jobs of growing into "superindependents" through shrewd acquisitions and drilling programs. At least one of those companies is "almost certain" to be acquired by one of the supermajors at some point, Butler predicted. However, he and others questioned how far the supermajors can go in reducing staff and operating costs through such mergers. If investors come to view upstream operations "as not a growth business," the trend toward supermajor mergers could change, Butler said.
"Upstream earnings among the majors have consistently been strong and the bigger part of their total earnings. However, E&P companies traditionally are not really valued for their earnings as much as for their growth of reserves and production," he said.
So it makes sense for a major to spin off its upstream operations as an independent to provide better returns to investors. "Vastar [Resources Inc.] was a great model for that, while it lasted," said Butler.
Moreover, he said it "makes more sense" to combine production with refining in a separate entity than the traditional pairing of refining and marketing.
Other views
Other industry representatives presented a different outlook at a later session.
"Smaller companies won't just compete but will even flourish," said Clarence P. Cazalot Jr., president of Marathon Oil Co., Houston.
"If this game was really won or lost because of size, we should just give ExxonMobil [Corp.] the trophy and the rest of us go on home," he said.
However, Cazalot said Marathon benefits from "the technology and financial strength of a major" while retaining "the speed and agility of an independent."
He said the market also rewarded many companies for their contributions, including energy marketers such as Dynegy Inc. for creation of "an energy value chain."
Apache has been rewarded for its "demonstrated success" in growing through acquisitions by the same market that penalized other companies for their acquisition efforts, he said. Anadarko benefited from its "unique exploration technology and expertise" in the subsalt and other plays. "The key is to develop an uniquely advantageous opportunity to create value," said Cazalot.
"Analysts will follow a company that demonstrates good strategy," said Arthur L. Smith, chairman and CEO of John S. Herold Inc.
He dismissed dividends as "an ineffective way to return value to shareholders. I don't believe E&P companies should pay dividends."