Exxon Will Start Drilling Russian Oil In 2013

Jun.18.12 | About: Exxon Mobil (XOM)

It had been talked about for many months, and now it is becoming a reality. Exxon Mobil (NYSE:XOM) and Russian oil company Rosneft (OTC:RNFTF) are nearly done with their paperwork and they are ready to collaborate. For the moment, the agreement includes drilling for oil in Western Siberia, opening a joint research center and keep exploring north of Russia to find new sources of oil. This could be a giant step for Exxon as the convenient oil reserves in the world are very limited. Most of the oil rich countries have their own government-operated oil companies - such as Saudi Aramco - and there is very limited room for public companies to play. Russia has one of the largest untapped oil reserves in the world, however most of Russia's oil is located in locations that are very difficult to reach for most oil companies in the world. It would take the technology of companies such as Exxon Mobil to extract oil safely from environments like northern sea of Russia.

Exxon's experience of extracting oil in difficult geographies and the company's technical expertise won the company this potentially huge opportunity. Some of the oil will be extracted from within non-porous rock, making it a very difficult process for most companies. Exxon will also need to design vessels, pipelines and structures that can withstand extremely harsh weather conditions in order to be successful in this project. I am not worried at all regarding the quality of work Exxon can put together.

Oil companies are having trouble finding new oil reserves. Many times they use new techniques to increase life of their existing reserves. Russia is a huge geography that is almost untapped and the country has the potential to be the largest oil producer in the world for decades. However, this opportunity comes with many risks such as political ones. What I am more worried about is the political conditions in Russia. We've all seen what happened to Exxon's assets in a number of countries including Venezuela and Saudi Arabia in the past. We've also seen what BP (NYSE:BP) went through in Russia when it fell into a disagreement with the government.

Initially, Western Siberian reserves are expected to yield 300,000 barrels of oil per day. Most of Western Siberia was never open for exploration and it is very possible to find reserves supporting a much higher yield than this after a detailed exploration in the area. Igor Sechin, the president of Rosneft appointed by Vladimir Putin, is expected to increase dividends of the company. The company is mainly owned by the Russian government, and the government's revenues will increase significantly if the company is able to increase its dividend payments. Russian government heavily relies on profits from oil trades for its operations. The health of the country's balance sheet also depends on the oil prices which tend to be very volatile in the short term. The high reliance of the country on oil prices stems from the fact that the country has very little if any spare capacity to boost production when needed.

Exxon is increasing its focus on unconventional oil and gas reserves in order to get ahead of the competition. Recently the company announced interest in conducting exploration in countries like Germany, Argentina, Colombia and China to extract gas and oil in unconventional geographies. This also relates to the company's $25-billion worth acquisition of XTO Energy, which focused on extracting natural gas all over the U.S. using a controversial technique known as fracking. The plunging natural gas prices hurt the company's profits in the short term; however the company is expected to benefit greatly when natural gas prices bounce back up.

Exxon's stake in Russian production will be around 33% which can be quite profitable for the company. As I mentioned before, my biggest worry is that the company will be dealing with the Russian government, which might not be all that trustworthy from a business perspective. Normally, Exxon is known as a very conservative company with a very conservative management team. If a company as conservative as Exxon is doing business in Russia, is it because the company is desperate for new oil reserves or is it because the company holds some guarantees BP never enjoyed in Russia? Time will tell, but the Exxon management I know of wouldn't take huge risks unless they found a way to subsidize the risk.

Only time will tell if Exxon's Russian gamble will pay-off or not. Either this will be a very profitable trade, or a bad gamble resulting in huge losses. While I don't trust the Russian government, I trust Exxon's management enough to say that the company has learned lessons from the past and will not take unnecessarily high risks. I believe that the risk-return ratio must be in Exxon's favor in this instance. I am long Exxon and I will stay that far for a long time unless something devastating happens with the company.

Disclosure: I am long XOM.