Tuesday, February 8, 2011

Trading Places: Who's Getting Oily, Who's Getting Gassy

One of the big stories in the domestic energy industry over the past year was the "race to liquids" by independent E&P companies who tout their growing positions in oil plays.  Most of these companies are spending big bucks to establish these positions, and they are doing it largely to placate analysts.  It makes some sense when oil is trading at $100 per barrel and gas is staring down $4 per MMBtu, but it is very expensive for a small to mid-sized independent to snap up tens of thousands of acres in a hot new play.  I've often wondered if this herd mentality strategy shift is a wise move.

The interesting flip-side to this story is that the E&P majors are moving from oil towards gas.  Shell, Exxon, BP and others have made big investments in natural gas, specifically shale gas.  There are many reasons, key among them that finding and producing oil in foreign countries is becoming very difficult with the rise of national oil companies and other geopolitical risks.  Don't you think Shell, which expects to produce more gas than oil by 2012, would rather go up against environmentalists in Pennsylvania after its purchase of East Resources than gun toting, pipeline blowin' up militants in the corrupt nation of Nigeria?

Beyond these major inconveniences, the big guys have a long-term view of the future and because of their vast resources are less dependent on pleasing mid-market Wall Street analysts.  What the future tells them is that natural gas will be in high demand worldwide in the coming decades, especially in power generation.

It's all very ironic that the independents, which proved shale gas, are slowly giving way to the majors.  But it is the evolution of any high capital venture is that the deep pockets eventually muscle their way in and take over.  One can argue that by getting into oil the independents are becoming more diversified and following in the footprints of the larger E&Ps (although I'd recommend against full integration and buying a refinery...although BP is putting a couple up for sale), but is it a good move for a smaller player with limited resources?

There is no doubt that the independents are burning through capital and outspending their cash flow to establish shale gas fields.  Much has been made recently about how much capital has been destroyed by drilling in this low commodity price environment.  But when you think about it, it's a big shift of strategy for a natural gas independent to become an oil company.  How much more will it cost?


Anonymous said...

Can you comment on the implications of this phenomena on dry gas supply over the next 1-2 years? The majors are buying companies and leases for shales, but that does not mean they feel obligated to drill on them immediately. Rather I view them as being patient and disciplined, with the flexibility to direct cap-x at the best returns. Which today, does not appear to be dry gas. Agree/disagree?

Robert Hutchinson said...

I agree. The majors are less dependent on telling the growth story to keep stock analysts interested and the circumstances of timing and commodity prices are very favorable for them.

If gas prices had remained high (~$8/MMBtu), they would have looked foolish buying into the gas at what would have been peak valuations. Now they can buy large reserves at what effectively is a discount. The majors have a very long term view of the energy market. It's like driving down a bumpy street. Where the smaller guys are focused on the potholes immediately in front of them, the big guys are looking blocks ahead. They don't see the world in terms of $4 gas and they have the liquidity and diversification that they are not forced to drill to pay the bills.

It also worked out well for the majors that the independents worked so hard to hold the leases by production. Now a major stepping in can allocate capital in a prudent manner, something the independents wish they could have done.