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.

Thirty years to the day since Ronald Reagan and Mikhail Gorbachev concluded an unsuccessful summit in Reykjavik, an alarming 1980s revival has taken hold in U.S.-Russian relations.

Apart from the threats and accusations being thrown around regarding Syria, there are missiles being deployed on NATO's doorstep, as well as Washington formally accusing the Kremlin of trying to hack the U.S. election process, something Moscow has denied. Regarding the latter spat, it's unlikely to have helped endear Moscow to the front-runner in the race for the White House -- who wasn't that stoked about President Vladimir Putin to begin with.

All of which is a bit of a problem for all of us. It is also a problem for one oil major in particular: Exxon Mobil.

Russia has special significance for Exxon. Early in the 2000s, former CEO Lee Raymond came close to buying a stake in Yukos only to watch its CEO Mikhail Khodorkovsky fall out with President Vladimir Putin and get arrested.

Raymond didn't get his big Russian deal. But his successor, current CEO Rex Tillerson, did.

Tillerson had spent time in the 1990s overseeing a flagship Exxon project in Russia. And he flew there in 2011 to meet with Putin and announce a strategic partnership with Rosneft, the national oil company that absorbed Yukos' main assets after Khodorkovsky was thrown in jail.

The two companies were to jointly develop potentially massive oil reserves in Russia's Arctic waters, the Black Sea, and Siberian unconventional resources. Putin spoke of investments from the deal eventually reaching perhaps $500 billion -- a big number even for Exxon. No sooner had the venture struck oil beneath the Kara Sea, though, than Exxon was forced to down tools as U.S. sanctions over the Ukraine crisis kicked in.

Exxon is no stranger to dealing with inconveniences like sanctions, nationalizations, and wars. But if Russia remains frozen out by sanctions for years, then Exxon may need a plan B for 2020 and beyond.

Ostensibly Exxon is awash with drilling opportunities. At the end of 2015, it had proved reserves of almost 25 billion barrels of oil equivalent but claimed overall resources of 91 billion.

When you produce around 4 million barrels of oil equivalent a day, though, it is a constant struggle to find that next big pool of resources to offset declines in old fields with fresh ones for years to come. That struggle gets even harder when oil and gas prices collapse and you have to cut investment to help protect a sacrosanct dividend.

Even when oil and gas prices were high, Exxon kept missing ambitious production growth targets. Overall production last year was actually lower than in 2006, Tillerson's first year as CEO; output of higher-value oil has dropped by roughly a fifth.

In addition, Exxon's reserves replacement ratio plunged below 100 percent last year. Granted, much of that reflected the impact of lower natural gas prices causing Exxon to de-book some U.S. reserves. Still, this was a reminder that Exxon had mistimed another big deal aimed at refilling its tank -- namely 2010's $35 billion acquisition of shale gas driller, XTO Energy.

And, looking at Exxon's cumulative record on replacing reserves, it's clear these metrics have been slipping in recent years. Since 2006, reserve replacement including acquisitions has been 129 percent (not including the effect of disposals). Organic reserve replacement, though, has been 101 percent.

Some Reservations
On an organic basis, Exxon has replaced 101 percent of its production since 2006, but the trend in recent years has been downward
Source: Bloomberg
Note: Cumulative reserve replacement data since 2006.

Coming off a wave of investment, Exxon actually has quite a lot of new projects starting up: At its analyst day earlier this year, it boasted of six that got going in 2015 and another 10 by the end of next year. Tellingly, though, the growth ambitions of yesteryear are gone, with Exxon projecting essentially flat production out to 2020.

The challenge is even starker when you look at the projects Exxon has teed up at present for 2018 and beyond, as outlined in its financial and operating review for 2015 and aggregated by analysts at Tudor, Pickering, Holt:

The Day After Tomorrow
Exxon's project queue for 2018 onward is weighted to resources challenged by low prices or higher costs, such as LNG and oil sands
Source: Tudor, Pickering, Holt

Oil sands and LNG alone account for more than half of the anticipated production from these future projects. Neither look like great bets absent a sustained recovery in energy prices. The global LNG market is glutted for the foreseeable future, while oil sands are relatively high-cost to develop and produce.

Exxon clearly also has large U.S. shale resources that could be developed quicker, but the legacy of the XTO deal is that many drilling locations are gas-weighted.

What Exxon, like any major, really seeks are very large, oil-focused prospects that play to its strengths, where reserves can be booked periodically to top up the tank and high upfront costs can be defrayed over decades of production. In other words, exactly what Russia potentially offered. 

Whether focusing on such mega-projects is a good way to go is debatable, but for now that is Exxon's way. And the company's judgment on this score has notably been called into question this year. For example, as Wolfe Research analyst Paul Sankey has pointed out, the cut to Exxon's triple-A credit rating by Standard & Poor's was directly linked to concerns around the huge spending required to replace its reserves.

If relations between the U.S. and Russia keep worsening and sanctions stay in place -- or even get sharpened -- then that puts a big question mark over where Exxon's next wave of production will come from and how profitable it will be. 

The obvious solution, as it has been in the past, is for Exxon to make another big acquisition, most likely in a less politically fraught, but still huge, resource such as U.S. shale (Texas' Permian basin, say, although that's looking crowded already).

One upshot of the worsening stand-off in Syria, and elsewhere, could be that those persistent rumors around Exxon buying the likes of Anadarko Petroleum, Apache or Occidental finally become more than just talk.

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

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

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