TWST: Do integrated energy companies really exist at this point?

Mr. Khan: It's good question. Historically, integrated oil companies had to be involved in the entire vertical value chain. Today the impetus for the integrated structure is being called into question. In theory, some of the integrated oil companies are operating very distinct businesses that are not well integrated.

TWST: We have to start with the recent Gulf oil spill. What will it mean for the space longer term?

Mr. Khan: It probably means that the cost of drilling, completing and exploring for oil and gas in the deep waters of the Gulf of Mexico will get more expensive over time. I don't know what sort of regulations are going to be passed to deal with this catastrophe, but the level of scrutiny is going to be much higher than it was in the past. And with more regulation, generally comes more cost. That being said, as long as regulations are designed to improve human and environmental safety, then new regulations are probably all positive for the industry.

TWST: But it will be more costly.

Mr. Khan: It will be. The way we set our oil price forecast here at Citi is based on an asset replacement analysis. When we survey almost 400 companies around the world that drill and explore for oil, costs have been rising over the last 10 years, and more so over the last five years, at an almost exponential rate. Form 2000 to 2004, we saw finding and development, F&D, costs rise from $4 to $6 per barrel. By 2008 we saw those costs rise to $18 per barrel. This is massive cost inflation. In order for companies to meet their cost of capital at $18 per barrel in F&D costs, we need an $80 oil price. So far these costs have been flattening out. A higher level of regulation could add to that. However, in the grand scheme of things ,it's hard to say if the Gulf of Mexico will have a huge impact on the overall cost structure across the world.

TWST: Are these same regulations likely to spread worldwide due to the high visibility?

Mr. Khan: In some countries, regulations are already more onerous, so it's hard to say. I would say that the sort of rules and regulations that will be passed here in the U.S. could probably be spread across the rest of the world.

TWST: We saw the administration take a step toward loosening up on drilling. Will we see now a pullback because of the spill?

Mr. Khan: Yes, this is really the wrong time to have this sort of incident. Just when the Democratic administration is getting on board with the need to produce more hydrocarbons in the U.S. and increase domestic supply, this event happens. The BP (BP) incident really puts a logjam in that whole process. There's no doubt that any sort of comprehensive energy legislation that we see come out of Congress will not be as constructive as we thought. California and Florida have already pulled back from the table.

TWST: There will be spike in that concept for a while probably.

Mr. Khan: Yes, in order to meet the energy needs of the U.S., you need both renewable and additional domestic hydrocarbon production - both oil and natural gas. From a monetary and fiscal policy standpoint, it does not make sense for the U.S. to be importing the amount of oil it does. It's a huge drag on the U.S. economy. If you can add domestic oil, gas and renewable sources, it can be a stimulant for the economy. This is all internally driven resources. The longer you put off these areas of potential resources of oil and natural gas, the more we will pay for energy in the future.

TWST: I guess natural gas is more onshore, so less of a problem.

Mr. Khan: Yes, right now it's still very much onshore. Shale gas is a growing source of supply. New shale sources could add another 40 Bcf per day of new supply over the next 10 to 15 years. You've heard about some of the states on the Eastern Seaboard wanting to open up their shores to natural gas production. There is a tremendous amount of natural gas in Alaska, too.

TWST: That can work even in light of what's happened here in the Gulf?

Mr. Khan: Yes. What we worry about is that even though gas is a cleaner fuel to produce, this whole issue in the Gulf could taint the onshore industry also.

TWST: Will it change the industry's liability? BP said they would foot the bill, but what's the long-term outlook here? Will companies be forced to pick up the tab for their errors going forward?

Mr. Khan: A lot of the super majors are already self-insured. That's how the industry works. For the smaller E&P companies that are insured, it makes the risks of drilling offshore that much greater. To some degree, it might give the super majors more of a competitive advantage when it comes to drilling offshore in these deeper horizons because the costs are so high and the risks are so high that essentially someone with a massive balance sheet becomes the only party that can drill and produce in such extreme conditions.

TWST: So it may change the dynamics?

Mr. Khan: It could, and you've certainly seen a number of independents sell out of some of their deepwater positions in and around the world.

TWST: Just because of this issue?

Mr. Khan: Not necessarily. Drilling offshore is a very costly exercise. While the operating costs are fairly low, the initial upfront costs are large and the drilling is more complex, and it requires a lot more upfront capital.

TWST: Are the majors out there spending money and doing work, or are they sitting on what they have?

Mr. Khan: No, you have to go back and look at the last few cycles in this industry. If you go back to the 1990s and look at the majors back then, they did trade closer to parity in terms of valuation on proved reserves to a lot of the independent oil and gas companies because they were perceived to have growth. Mobil (XOM) had growth; Conoco (COP) had growth; Chevron (CVX) had growth. These were companies that were growing production at mid-single digits every year, and that basically was in a low oil and gas price environment. What you had happen in the latter part of the 1990s and the early part of the last decade was that all these guys consolidated because prices were so low after the 1998 Asian currency crisis. So the general philosophy in the industry was that if prices are going to be low for a long time, they'll need to consolidate and take costs of the system. So the big talking points 10 years ago were synergies and cost reductions - how much will drop through to the bottom line? I think the industry was not prepared for the huge amount of demand growth that came out of the emerging markets. And in 2004 and 2005, they got it completely wrong. What happened is that you had the industry taking capacity out of the system at precisely the time when the world needed it. And OPEC wasn't exactly expanding their production capabilities either. So the industry was not prepared for the type of growth that was going to come out of China, India, Brazil and the rest of the world.

I think what's happened is that as you look past the consolidation phase that ended in 2002, the industry didn't have the resources or the people on the ground to grow production the same way they did in the 1990s. So prices rose from 2003 all the way through 2008, and the majors tried to put capital to work - not all of them, but most of them tried to put capital to work at a time when demand was already growing. The problem is when you initiate a project, it takes five to 10 years for that project to come online. And so now you're starting to see a lot of these projects come online. You're seeing a lot of the projects in Qatar come online; you saw a lot of big projects in the Gulf of Mexico come online last year and late in 2008; you saw a lot of projects in the Caspian area come online in 2008 as well. So basically you're seeing a ramp-up in these projects after the horse has left the barn. I mean, it's not to say that we still don't need these projects, it's just that we could have used these projects four years ago. So what happened is if you look from 2004 to 2008, you had such a massive increase in finding and development costs that was driven by everybody putting capital to work, all at the same time. So all these oil sands projects, all these LNG projects in the world, all these deepwater projects, I mean, it just drove the cost of materials, labor, engineering and procurement. Everything went through the roof. As we talked about earlier, if you look at the curve for F&D costs over the last 10 years, it was kind of growing at a steady pace from 2000 to 2004, and then it hit this inflection point where costs took off. So when you run these costs through our model, we estimate you need an $80 oil price to continue to expand production. You can always whittle down the oil price to supply and demand, and replacement cost.

I think that the majors are poised to grow production over the next few years, but they are going to have to do more. A lot of the new production coming online is natural gas, so it varies from company to company. But for the most part, there's a tremendous amount of resources coming online from LNG, and that's going to continue to be a driver for the majors. A lot of the national oil companies are going to be the ones that will account for most of the oil production growth for the foreseeable future.

TWST: Because they are sitting in the resource space?

Mr. Khan: Yes, Iraq, Brazil, Colombia, Russia, Canada and the Caspian are all sources of incremental non-OPEC production growth. They are sitting on untapped resources. OPEC countries, such as Saudi Arabia, Kuwait and Venezuela, can clearly bring more supply to market. OPEC is sitting on 900 billion barrels of reserves, or 65% of global proved oil reserves. This is almost all primary recovery. You now see some countries in the Middle East now coming to the majors and some of the independents to extract more oil from older fields that have become tired. And so you need to go to the next level of production, which is secondary and tertiary recovery. Most of the new global supply will have to come from these parts of the world. The U.S. is doing its part. Besides the Gulf of Mexico, unconventional areas for crude oil, such as enhanced oil field recovery and shale oil, represent new sources of supply.

TWST: All of which are more expensive?

Mr. Khan: Yes, they are more expensive. But in the Middle East, they are not as expensive as you might think. Instead of pumping oil out of the ground for less than $5 a barrel, maybe it'll cost you $10. So it depends on the country. Chevron is involved in a project in the partitioned neutral zone between Kuwait and Saudi Arabia; there's certainly much more oil to come out of the ground there through steam flooding. Occidental (OXY) is involved in enhanced oil field production in Oman and Bahrain, and so you should get much more production out of the ground there. Exxon is involved in production out of the UAE. So I think the majors will increasingly be called back to the Middle East, along with some of the independents, to help stabilize production and add more resources.

TWST: So there's no shortage of opportunity.

Mr. Khan: I don't think so. I think it's a time factor. If can you bring on new projects to offset the decline from older fields, then companies can grow. In fact, there is a natural decline rate of oil production in the world, and no one knows exactly what that is, but the range is between 4% and 7%. So depending upon what that decline rate is, that's how much oil you have to replace every year. So in a lot of the conventional places around the world, we've gotten to the primary source of recovery. And now there is the other 70% to 90% we left in the ground.

TWST: Does the industry have the expertise to go ahead and develop these other sources?

Mr. Khan: Absolutely, yes they do. Exxon, Chevron and Occidental, and of course the majors in Europe, have the engineering and technical expertise. Exxon invests almost $1 billion a year in R&D, and the vast majority of that goes towards trying to find better ways to produce oil out of the ground. Chevron spends a little less than $1 billion a year in R&D. So all those efforts are designed to give the majors a competitive advantage when it comes to technology in the industry.

TWST: What about the capital point of view? Are the funds available to carry out all these different projects?

Mr. Khan: Yes, right now Exxon and Chevron have almost no net debt on their balance sheets, and they are producing free cash flow. At $80 crude, Exxon and Chevron produce free cash flow above and beyond their dividend and their stated share repurchase program.

TWST: So no capital constraints for the space?

Mr. Khan: No, the returns on capital at $80 crude can vary. If we're talking about long-lived projects, 10 to 20 years, then the returns on capital are probably in the mid- to high teens. On the higher-risk projects, you're probably looking at returns on capital somewhere in the low 20s at $80 crude.

TWST: What about new competition? We see and read a lot about China and India, and their energy needs. Are they becoming tougher competitors for these opportunities?

Mr. Khan: Definitely, they want to be a part of everything. But they realize that it's better to partner up than try to do new projects alone. We've seen Chinese companies enter into deals in South America with Pan Energy, Syncrude in Canada, coal seam gas to LNG in Australia. These are all joint venture investments. These are examples of how the Chinese want to get involved, but they don't want to be the operator. It appears at this point that it may be easier to partner up with one of the majors and get into these projects, rather than go it alone. The Chinese oil and gas companies have become providers of capital.

TWST: And they seem to have lot of that problem?

Mr. Khan: Yes.

TWST: Will gas become more important for these companies going forward?

Mr. Khan: It is. At the end of the day, I think gas is going to grow. Gas demand in and around the world will grow at a much higher pace than oil demand. I think that with oil being where it is, at $75 to $80 a barrel, it does put a cap on the type of growth rate we can get out of that sort of hydrocarbon. Gas is cheaper, it's more available, it's a cleaner fuel and, at the end of day, this is going to be a carbon-constrained world. And I think that's the way we're headed. And whether the emerging markets want to get on board or not, it's a different story. But from my perspective, the emerging markets, whether it's China or India, are massively exposed to the dangers of increased carbon in the atmosphere. And if they don't get on board, they risk endangering their own coastal cities and their own development plans just because it will be that much more costly to fix the problem on their own. So I understand that the emerging market countries don't believe they need to go through or should have the same sort of restriction when it comes to carbon emissions because they're going through their own industrialization process right now. At the end of the day, the damage has already been done; it is making the world worse. So if they don't get on board and fix the problem, it gets disproportionately worse for the emerging markets in the long run.
Carbon is one offshoot for gas. Gas is a much more efficient fuel to use for power generation. And when you look at the potential of the electric car, the opportunity looks even more logical. If you are producing electricity from natural gas that is being used to power an electric vehicle, the savings are immense.

TWST: So times will come around here?

Mr. Khan: Yes, the electric car is a valuable new technology. It could represent a huge inflection point for the integrated oil industry. This is a game-changer. It's not priced into the market yet because I think people have a healthy level of skepticism around the deployment of this technology and the comfort level at which consumers will be able to adopt it. But for the most part, this is coming. The U.S. government is putting a tremendous amount of capital behind this program. Venture capital and private equity is behind this thing, too. At $80 oil, there is a lot of stuff that works. It's incentivizing development of technology into the electric vehicle, so we will see how it takes place.

At the end of the day, we are looking for oil in much more difficult places to find it, and OPEC has not been forthcoming with opening up their land to more development and more exploration. What's happening is that technology and the industrialized counties are looking for ways to get away from oil. Japan has been doing that for the last 25 years, and their oil consumption is down almost 20% over the last 20 to 25 years. So they have become a less energy-intensive industry, not only on a per capita basis, but on an aggregate basis.

TWST: Because they don't have the resources?

Mr. Khan: Right. As the U.S. finds out that we don't have the resources either, that we don't have the trade balance to import oil and that our consumer dollars at the pump are ending up in less hospitable countries, we will have to change.

TWST: You mentioned consolidation in the industry. Will we see that again, with companies' current cash flows?

Mr. Khan: I think there are projects that the majors can invest in. I think they want to invest, and they are investing. You have seen Exxon ramp up their spending program, and Chevron has a huge backlog of projects they are working on. There is no shortage of projects to work on. So I don't think we are going to see any consolidations in the majors any time soon. But I think that we could see selective transactions, like the XTO (XTO) deal with Exxon. It's possible we could see that. We've seen Shell (RDS-A) go after Arrow (AOE.AX) with one of the Chinese oil companies, and so I think we will see these selective acquisitions take place. The bigger guys buy smaller guys. Ten years ago, we saw bigger guys merge with each other. There is no reason to do that today. It's a competitive environment, and I don't know how that would be viewed by the regulators.

TWST: Will we see the majors continue to take away E&P companies?

Mr. Khan: Yes, I think that's basically how it works. In the absence of organic growth, you might see some majors pick up some of these E&P companies. That's kind of always the way it's worked.

TWST: As you talk with investors, do you find they're interested in this space?

Mr. Khan: I think a lot of investors really had been focusing more on the independent oil and gas space because I think they believed that's where you could get the most bang for your buck. The smaller companies are more transparent; it's easier to see. You are talking about looking at companies that are $10 billion to $50 billion of market cap versus companies that are between $100 billion and $300 billion in market cap. It's a lot easier to look at that the smaller companies and figure out where the inflection points are, where the discoveries could be made and how production growth is trending. It's a lot harder to see that with the majors, and they have done themselves no justice by effectively taking capacity out of the system from 2002 to 2008. None of the majors really met their production growth targets during that time frame. And so people are very skeptical of whether these guys can actually grow production in this next decade because the last 10 years were somewhat bad. But in the 1990s, these guys grew.

TWST: So given the skepticism, what should investors be doing at this point?

Mr. Khan: I think as commodity prices kind of flatten out here, we've been range-bound between $70 and $85 per barrel for oil. I think when prices are flat, we used to hunt for value. And I think when you look at it from that perspective, I think the majors look attractive on valuation and on cash flow. The fundamentals are telling us that the majors are trading at a much cheaper price, both on proved reserves and other relative valuation metrics that we have not seen in a long time. We don't think this discount is sustainable. We've seen some of the performance catch up, but this issue in the Gulf of Mexico certainly puts a lid on some of that performance.

TWST: So opportunity?

Mr. Khan: Yes, absolutely.

TWST: Where should they be looking? What names do you like?

Mr. Khan: Our preferred name in the group is Chevron. It's one of the cheapest names in the group, based on their relative value and also on proved reserves. They have a visible production growth rate over the next six to seven years. We see them growing between 1% and 6% over the next seven years, and these are all projects that we have a high level of visibility on. These are projects that are under construction right now or are in the front-end engineering and design phase.

TWST: So it's not guesswork?

Mr. Khan: It's not guesswork. We do not have to bank on some future projects that hasn't been thought of yet. These are all projects that are way passed the drawing board and into the construction phase, with Chevron on the ground. The other thing that we like about Chevron is that their overall production of hydrocarbon will remain levered to oil, despite most of its growth coming from LNG. From today to 2017, on average, Chevron's total production will be over 70% linked to oil prices. Even though their liquids volume will stay flat, a lot of growth will come from LNG. Almost all this LNG is linked to oil.

TWST: So they are better positioned?

Mr. Khan: It makes their profitability that much higher because the global LNG gas market is in its early phases. So we can look at spot LNG prices around the world, and the floor is the U.S. gas price and the ceiling is the Japanese crude cocktail, which is high-priced LNG in the Asian market. So there is a very large spread between those prices. If one is stuck with the spot LNG price today, you are looking at a Henry Hub-equivalent price. That's not a very attractive price to get for LNG. But if you can link your contracts to crude oil price, then I think that that justifies spending the type of capital needed to build these LNG projects. So you can comfortably get to returns on capital on those LNG projects, which are multibillion-dollar projects, between 14% and 20%.

TWST: So there is very attractive return long term?

Mr. Khan: Yes, absolutely. But these projects could not move forward unless they were signed with oil-linked contracts, and so that's what got us very comfortable with Chevron. We were very surprised to see the Chinese come in and sign contracts last year for all these LNG facilities at an oil price formula.

TWST: Just a recognition that they needed?

Mr. Khan: Exactly, yes. And then Exxon is a stock we like, too, but the stock has really hurt since the announcement of the XTO deal, and I think that's what really concerned a lot of people. Unlike the Mobil deal, which was basically accretive the next year, Exxon has publicly stated that this deal will probably not be accretive in the first year or the second year, and the value will only be apparent a few years out. And so I think to some degree, people were going to give them a pass on that statement. But I think over time, what has happened is that investors have become much more skeptical, given where U.S. gas prices are. I think time will only tell. Generally, over a long period of time, Exxon has made more of the right decisions than wrong decisions. So while this is a very large transaction for them, 8% to 9% of their valuation, it's an asset that fits their game plan over the long run. Exxon has specifically said that they believe that natural gas demand will grow at a much faster rate than any other hydrocarbons, except for renewable energy, over the next 10 to 20 years. And so when you think about your business plan over the long run, you are basically saying, "If I want to manufacture a product, what do I do? Well, I am going to manufacture a product where I see the most demand growth." Oil is not where the demand growth is. It's really natural gas.

TWST: So you've got to be there?

Mr. Khan: Yes. The problem is that we don't know when they will really derive the fruits of this acquisition. Is it two years out, three years out, five years out? We don't know.

TWST: And investors want some assurance?

Mr. Khan: Yes, investors obviously are looking at the next 12 months, and so that's as far as people really want to see. And it's very difficult to look out past 24 months in this sort of market, where the stocks are moving around 10% in a day. XOM can keep production flat without the XTO deal, and they can grow production 4% this year. XOM has plenty of projects that are under construction, that come online in the next few years, that will keep production flat and maybe grow at low single digits, excluding XTO. In the end, it's very difficult to get Exxon to grow production more than 2% or 3% a year. It's a possibility, but it's hard to do that. It is a very large company, so it's moving that snowball up the hill that becomes tough.

TWST: Anything else we should touch on?

Mr. Khan: The other name that we haven't talked about is Marathon Oil (MRO). The company has been labeled as a refining company with an E&P company. The company has a massive exploration program going on this year. It's more than any other company in our group on a relative resource base. They have the ability this year and early next year to really change the perception of their company to a company that is a large explorer of oil and gas from a company that was a mostly a refiner a year or two ago. People currently view the company as a refiner.

TWST: What will it take for investors to pay attention?

Mr. Khan: They've got a number of wildcat wells being drilled this year. I think if you get one or two successes out of this drilling program, I think people will start to buy into their upstream story.

TWST: Thank you. (TM)

Note: Opinions and recommendations are as of 05/10/10.

FAISEL KHAN
Director

Citigroup Investment Research & Analysis

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