Majors Explore New Frontiers & Develop North American Shales
TWST: As you look at the space, what are investors focusing on?
Mr. Molchanov: Day to day the stocks still trade predominantly on oil prices. And because oil has been linked almost one to one with macroeconomic dynamics, unemployment, the dollar exchange rates, consumer confidence - things like that - the stocks have generally been drifting in recent months ever since oil prices peaked at around $115 and began to decline. These stocks really have been drifting.
From a more substantive, longer-term standpoint, there are couple of interesting themes in this space. One is that, after neglecting North America for about a decade to focus entirely on international opportunities, these companies are engaged in a big homecoming. And we're seeing that overwhelmingly in their investments in unconventional resource plays, mainly the shale plays. Just yesterday we saw Marathon Oil (MRO) plunged down $3.5 billion for some acreage in the Eagle Ford shale. And that's only the latest example. In fact, in the last 12 months, there has been over $30 billion of M&A by integrated majors in U.S.-based unconventional resource plays such as the Eagle Ford, the Bakken, the Haynesville and the Marcellus - that's theme number one.
Second theme is frontier exploration. This is something that a little bit closer to what the majors have historically focused on, which is international exploration, but with a twist. In general, the modus operandi of the majors has been to wait until a smaller company discovers a significant resource base in a new producing area before swooping in and buying them out. In this case, more recently, what we're seeing is the fight for resource access is so intense that the majors are not taking a risk that someone will swoop in ahead of them, and they're actually going out to drill these frontier exploration areas themselves. What we mean by frontier exploration is countries and territories that have never produced oil. Not just today - they have never produced oil.
TWST: So a real frontier?
Mr. Molchanov: Real frontier. So examples of this would include: Ghana had been a frontier country, no longer a frontier country, because it has graduated - so to speak - into becoming a full-fledged producer. But that had been a frontier. Elsewhere in Africa, Madagascar, Tanzania, Uganda.
TWST: These are names we've never really heard before in this field.
Mr. Molchanov: Places you've probably never heard about when talking about the oil market. So the exploration activity going there today. Outside of Africa, New Zealand, little bit of oil production, but hope to find a lot more, the Philippines. In South America, there is Suriname. And my personal favorite Greenland - which in terms of climatic conditions and geography, just the remoteness is just about the harshest environment you could imagine - there has been exploration activity there as well. So if the name of the game is getting hands on resource, the majors have figured out that simply hoping that a smaller a player will make a discovery and the big player can use their balance sheet to just buy them out. They can still work by, but there are many factors which can impede that from happening. A good example that we saw last year was private exploration company called Kosmos Energy (KOS) made a very large discovery in Ghana as a matter of fact called the Jubilee Field. Exxon (XOM) tried to buy Kosmos' stake in Jubilee for $4 billion, which is no small change even by Exxon standards. The government of Ghana mixed that deal on political grounds, so Exxon did not get their hands on one of the biggest oil discoveries anywhere in the world in the last 10 years.
TWST: Did anybody else come in or the government just said "we can't sell it"?
Mr. Molchanov: No one ended up acquiring that asset. Kosmos actually ended up going public in a very large IPO a few weeks ago, as a matter of fact. So Kosmos still retains ownership of their stake in Jubilee. Jubilee is now a producing field which by, in fact, Ghana is no longer a true frontier country. That's an example of where the ultimate of the big majors tried to get their hands on an attractive resource base and did not get a chance to do it.
TWST: Are we going to see more of that take place in these frontier markets because the governments don't understand the game?
Mr. Molchanov: There is certainly room for the majors to come in after a smaller player makes a discovery. That's not going to go away completely. For one thing, there are some companies that have the balance sheet to make a discovery but do not have the balance sheet to take it through to development, which is half the time the more expensive part of the project. So in that case for the country to benefit from the oil revenue and the taxes and jobs and so on, clearly a larger player has to be brought in, even if politically that may not be the most convenient thing to do. So it will still happen. But my point is, because there are political hurdles and because competition for those newly discovered resources is very intense, what the majors have started to do is begin to conduct some of their own frontier exploration rather than waiting for a smaller competitor to get there first.
TWST: Do the majors have the expertise to go and do that after stepping aside for years?
Mr. Molchanov: They absolutely have the expertise to do it. Historically, they have not leveraged that expertise to the extent that in retrospect they probably should have, because the perception was that they will always have the advantage of a big balance sheet. But of course what's happening now is, Exxon and BP (BP) have a big balance sheet, but so does PetroChina (PTR)and Rosneft (ROSN.ME) and Petrobras (PBR) and all these emerging markets' companies that have not traditionally gone overseas to developing resources. They've tended to stay in their home markets. But now those companies have a global footprint, and they are competing for scarce resources with the Western majors. Because of that the Western players are really compelled to be much more aggressive in pursuing their own exploration programs. To be clear, they've always been - there has always been an element of exploration that they have done, but the degree of emphasis that they are placing on it right now is really much more visible than it would have been five years ago.
TWST: With that new competition, are they likely to devote even more resources to the domestic market?
Mr. Molchanov: The U.S. and Canada are very much of a focus area for these companies for one thing: the political risk is obviously lower. That's not to say that there isn't political risk. We just went through a deepwater moratorium in the Gulf of Mexico. That's a classic political risk of a sort. But in addition to the lower political risk, the reality is there is a lot of resource to play with that five years ago was simply not there, or it was always there but it was not perceived to be there.
TWST: Was it accessible with the old technologies?
Mr. Molchanov: It was not accessible with the old technologies. So with fracturing and well-stimulation techniques, just night and day versus what they were five years ago, areas like the Bakken and the Marcellus shale both oil and gas are getting developed very aggressively. So here the M.O. of the majors is to partner up with independents. The companies, the majors, would love to get their hands on the acreage from day one, which is of course the custody entry ticket. It's a lot cheaper. Unfortunately, because they have been late to the party, they have to pay up for the ticket and that needs buying acreage or in some cases producing assets from independent companies that were there as the first mover. So Marathon yesterday - buying $3.5 billion of acreage from a private-equity-backed company called Hilcorp Resources - paid a very rich multiple, almost $25,000 an acre, which sets a new high watermark or the new high watermark for the Eagle Ford shale. So that's the downside of coming back to North America. The independents were here first, and therefore they are able to extract a very rich price for the acreage that is in hot demand.
TWST: In the domestic market, are we seeing these international non-U.S. players come in or is that not happening yet?
Mr. Molchanov: Absolutely, because the resource booms has not been lost on companies from overseas. So we have seen first of all the European majors - that is to say, BP, Shell (RDS-A), Total (TOT), Statoil (STO), Eni (E) - coming in, all of this typically happening in the last 18 to 24 months. Then, what we're also starting to see is Asian players coming in, and this would include Mitsui (8031.TYO) from Japan, CNOOC (CEO) from China and Reliance (RNRL.BO) from India. So just as they are competing with the Western majors for scarce resources overseas in places like Ghana and South America, they're also becoming a forceful competitor in North America, competing on the other companies' home turf, so to speak.
TWST: Do these shale plays make sense given current pricing?
Mr. Molchanov: For oil and liquids, they make every sense in the world, absolutely. At $100 oil, they're printing money in places like the Bakken. If it's a natural gas play, then of course the economics are a lot worse, but there are certainly natural gas plays that work with gas in the $4 to $5 range. The Marcellus shale is a good example. As I said, the economics are far inferior to an oil play, but the economic opportunity is not meaningless either. And then kind of in the middle, what we have are the liquids-rich gas plays. The Eagle Ford is a good example of this. This is an area where there are parts of acreage that are more gas prone and others that have a higher liquids component. So even in the more gas-prone areas, there is a liquids component, which helps the economics. But there the name of the game is trying to zero in on the parts of the acreage that have a higher liquids component. That's different between getting most of your revenue in $4 of gas or most of your revenue in $100 oil. So companies have become very skilled at really zeroing in on the most economic parts of those kinds of resource plays.
One more thing that needs to be pointed out here, when you asked about the international players coming to North America, those companies, even if they're drilling for gas with U.S. gas prices at $4 to $5, they're still willing to pay a pretty penny for their acreage. You might say, "Why would they do that?" The answer is this: It's not that they expect to make a lot of money drilling those U.S. gas wells. What they want to do is acquire a skill set that they can only get in North America, because it's the only part of the world where a shale gas is being drilled on a commercial scale currently. There is a lot of shale gas - but not everyone may realize at this point - a lot of shale gas worldwide. The country that actually has the largest shale gas resource according to the U.S. geological survey is not the United States - it's China. There are other countries that are smaller, but very meaningful amounts of shale resource, including France, Poland. And why is that important? Because China is a gas-importing country. France and Poland are not just gas-importing countries. They're almost completely dependent on imported gas - including, by the way, Russian gas, with all the political risk that that entails. So for a company like Total, from France, that wants to drill for shales in Europe, where does it learn the operational skills - that of how to do it, so to speak, getting its apprenticeship. The only place to get that is North America, and the only way to do it is to pay off. So paying $1 billion for maybe a lower rate of return opportunity in the U.S. shale play is essentially the price they're willing to pay to work with U.S. independents that have done this for a long time, learn how to do it, and then take that skill set and redeploy it to their home markets. Same thing for China.
TWST: So maybe noneconomic reasons make them high bidders.
Mr. Molchanov: That's exactly right.
TWST: We talked about shale development. We are now beginning to hear rhetoric regarding regulation and water pollution. What is happening there and what will the cost be?
Mr. Molchanov: The environmental argument against shale drilling - and more specifically the fracking that is done as part of shale drilling - has been made for many years, in fact decades. It has consistently been debunked. It has been debunked by not just the industry, but it's been debunked by outside independent observers like the EPA. So that's not to say that there can never be environmental contamination, but those are exceptions when something goes wrong, just as an oil spill in the Gulf of Mexico is not the rule, but literally it has happened. So the environmental groups who oppose shale drilling really do it against a great deal of scientific evidence that indicates that this is an overwhelmingly safe and environmentally responsible process, but their opposition persists. And that's a reality. In the U.S., that opposition has been met with very little success in terms of influencing policy. There has been a little bit of pushback on the part of states and local governments in the Northeast in places like New York, Pennsylvania. But even there it has been more rhetoric than in substance. In places like Texas and Oklahoma, any substantive policy against shale drilling has been practically nonexistent.
Europe is a somewhat different story. In Europe, the green movement is much stronger, much more politically powerful. And France is a good example of a country where, as I noted before, has a tremendous amount of shale resource that's untapped. On economic grounds, you would think they would want to develop it, but it was actually just last month that the French government voted to ban fracking, which essentially means that there is no hope for shale drilling in France while the current policy is in effect. So who loses from that? The companies that were hoping to drill in France like Total, a French company, or Hess (HES), which is an American company, they will lose out on that opportunity. But candidly, the biggest loser is the people of France and the French economy, because they will continue to rely on expensive imported gas - including gas from Russia, with all the risk of political disruptions that entails - instead of having their own domestic resource being developed. And by the way, creating a lot of jobs in the process. So it's their right to make that decision, but let's not forget ourselves countries that forbid or severely restrict shale drilling are going to pay for it in the form of higher energy prices.
TWST: With the industry investing all this money in these new plays, will they be able to generate adequate returns?
Mr. Molchanov: As I said, any oil- or liquids-rich plays are extremely profitable and phenomenally profitable at current prices. That's why companies like Marathon are willing to pay astronomical multiples for the acreage. With natural gas, as I said, the economics are much more mixed. But the reality is these companies have to go over the resources or the resource not just exist physically, but it's accessible for political and other reasons. And the focus on North America right now is undeniable.
TWST: We've recently seen political rhetoric against industry profits. Will this amount to anything or is that the usual political rhetoric?
Mr. Molchanov: It is the usual political rhetoric that emanates from Washington whenever consumers get upset about high fuel prices. We have seen this movie before, and we will see it again when fuel prices are high. You will notice that gasoline prices tapered off amid the oil price pullbacks in recent weeks, that rhetoric has almost completely disappeared as Washington focuses on other things. So it is cynical, but that's politics for you.
TWST: What's your view at this point on pricing? Where do we go from here?
Mr. Molchanov: On oil, we are very constructive long term, while recognizing that in the short run prices will of course be essentially a function of day-to-day macroeconomic news flow- as I said, unemployment and other factors. So our forecast for WTI crude, $101 average for 2011, essentially where we are today. And then we see that increasing to $118 in 2012 as the global oil market gets tighter. Natural gas, which is certainly for the integrated majors, is much less relevant in North America. We are very bearish for a forecast of $3.72 in 2011 and $4.25 in 2012. So still depressed pricing.
TWST: So it's not pretty on natural gas?
Mr. Molchanov: Not pretty on natural gas. But for most of these companies, even with their shale investments, their exposure to North American natural gas as a percentage of their overall resource base is less than 10%.
TWST: What are you telling investors to do in this space at this point?
Mr. Molchanov: Focus on the companies that have visible growth opportunities and visible catalysts. Hess would be my top pick based on its very strong exploration portfolio, as well as its position in the Bakken and the Eagle Ford shale plays in the United States. Murphy (MUR), similar story. A lot of international exploration opportunities together with sizable acreage portfolio in the Eagle Ford, as well as an emerging play in Alberta, Canada, called the Exshaw/Bakken. And then looking at the mega caps, BP as a deep-value play stock has still not recovered fully from its trivials. Last year, in the wake of the oil spill and that, less than seven times earnings - I think the entry point is very interesting. And then Chevron (CVX) is just a good high-quality company that also happens to have significant exposure to the Asian LNG market with its Australian resource developments that of course benefit directly from the increased LNG demand following the Japanese earthquake.
TWST: Thank you. (TJM)
Note: Opinions and recommendations are as of 06/02/11.
Senior Vice President
Raymond James & Associates, Inc.
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