Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

Seek and ye shall find. Or maybe you won’t find anything. That’s the gospel according to oil.

Searching for oil and gas is expensive, but ultimately necessary when your business consists of pumping out and selling off your main asset day-in, day-out. Sometimes, though, business is so bad that you really just don’t want to go looking. Now is one of those times.

When excess supply crashes oil prices, it is hard to justify spending billions of dollars to find even more of the stuff, particularly in harsh neighborhoods. Hence, recent decisions by both Royal Dutch Shell and Statoil to stop looking in the furthest reaches of Alaska.

All the oil majors are pulling back on exploration, which is kind of like Apple and Google taking a breather on research and development. In other words, the energy world is about to find out what happens when its equivalent of the next iPhone doesn’t show up on the shelves.

The majors’ mantra on third-quarter earnings calls was: Shareholder payouts good, spending bad. Collectively, eight large oil companies -- Exxon Mobil, Chevron, Shell, BP, Total, ConocoPhillips, Eni, and Statoil -- will spend roughly $19.5 billion on exploration this year, according to estimates from Rystad Energy, a consultancy, and Tudor, Pickering, Holt, an investment bank. That is about half the level of just two years ago. Judging by all the talk of belt-tightening, spending will likely fall again next year.

Looking Down
Actual and estimated exploration spending by 8 large oil companies
Source: Tudor, Pickering, Holt

Shareholders actually won’t mind if Big Oil takes a break from doing what it is ostensibly supposed to do. The reason payouts are front and center for the majors is that they haven’t exactly covered themselves in glory when it comes to spending the windfall from triple-digit oil prices. Return on capital has slumped.

Their exploration spending rose sharply after 2006, when oil was racing toward its all-time peak, and by 2013 it was more than three times the level of a decade earlier. And for all that seeking, the finding was somewhat lacking.

Excluding acquisitions and disposals, the eight oil companies in question added 35.4 billion barrels of oil equivalent of proved reserves organically between 2010 and 2014, their reports show. That is enough to meet U.S. oil and gas demand at current rates for about three years. Not bad.

Except that it didn’t replace all the oil and gas the companies pumped out of the ground in that same period, just 92 percent of it. Even if you exclude BP -- which in the aftermath of 2010’s Macondo disaster replaced barely half of its output organically -- the reserve replacement ratio still comes in just shy of 100 percent. Some companies hit that mark, notably Statoil and Conoco in oil and Eni, Total and Chevron in gas. Overall, though, investors aren’t buying the majors for their powers of divination.

Falling Behind
For many oil majors, organic proved reserves replacement lagged production from 2010 through 2014.
Source: Company reports

Ultimately, though, dividends flow from barrels that flow from the ground, and those have to be obtained somehow. It is all very well hearing oil executives say they can somehow cut costs, pay out dividends and still grow output over time, but it looks like voodoo math.

For example, these eight oil majors collectively produced 8.3 billion barrels of oil equivalent last year. Their expected exploration budget this year of about $19.5 billion implies replacing those barrels for just $2.34 apiece. Next year’s anticipated spending implies closer to $2. TPH, meanwhile, estimates the real cost to these companies of finding a barrel of oil equivalent of reserves is at least $5.50 and may range up to $10. And just replacing barrels one-for-one doesn't mean growing.

This conundrum points to two big outcomes.

First, it sets up the next eventual upswing in oil markets. Saudi Arabia’s strategy of suppressing prices by keeping output high is often seen as being directed at the smaller U.S. shale drillers, but they are secondary targets at best.

What Riyadh really wants to rein in are the big projects that the majors develop. These require so much upfront investment of time and money that they tend to keep producing, no matter happens with oil prices. That isn’t the case with shale, as slowing U.S. onshore oil output shows. A prime target is deepwater drilling, which has accounted for half the world’s discoveries of conventional oil -- not including shale or sands -- over the past decade, according to Sanford C. Bernstein.

BP said pointedly on its earnings call that deepwater wasn’t "played out" even at today’s low oil prices. If Saudi Arabia took the point, it will have to keep the the pressure on for longer, suggesting 2016 will also be ugly for oil prices. Equally, though, the lack of exploration spending will eventually make itself felt in the market. After all, if you choose not to find or make new supplies of anything -- oil, gas, wine, iPhones -- the existing inventory becomes more valuable.

That dovetails with the second outcome. The majors must take the medium-term into account, not just today’s pressing needs. They are still oil and gas companies, so foregoing the job of replacing reserves isn’t an option, even if they haven’t excelled at it.

Luckily for them, the crash in oil prices makes it cheaper to buy barrels by acquiring smaller rivals. Looking at their enterprise value compared to just proved reserves, E&P companies still look relatively expensive versus a notional exploration cost of $5 to $10 a barrel. Factor in probable reserves, though, and the equation changes, with many potential U.S. targets now valued at below $10 or even $5 a barrel.

Probable reserves, as the name implies, aren’t exactly a rock-solid bet. For the majors, though, that is largely beside the point. Much of that base of probable resources likely resides in U.S. shale, where the reality of reserves is more a function of making the economics work rather than whether the oil and gas is there in the first place.

The whole point of a larger oil company buying a smaller one is to bring its bigger balance sheet and, hopefully, technical capabilities to bear on developing those probable reserves faster and more cheaply. That, along with hopes of an eventual recovery in energy prices, is what justifies the deal. In foregoing exploration in favor of a little amalgamation, the majors could score on both counts.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in San Francisco at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net