Dividend Income And Value Investing: Exxon, Shell, BP Take On Petro-States

by: Ramon Vredeling

We may be in the midst of a European sovereign crisis, but business could hardly be better for the world’s biggest oil and gas "supermajors." A barrel of crude oil is again hovering above $100 and cash is gushing in. In the last month alone BP Plc (NYSE:BP), currently yielding 4.26%, announced quarterly profits of $5.1 billion; Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B), currently yielding 5.19%, reported profits of $7 billion; and Exxon Mobil (NYSE:XOM), currently yielding 2.54%, reported $10.3 billion. Given the current volatile market climate, it pays dividends, literally and figuratively, to be overweight commodities and the energy sector.

Part of the success of these three companies, as detailed in my recent articles on BP and Shell, lies in the fact they are at the forefront of R&D in the oil and gas arena, increasingly focusing their investments on exploration, deep water operations, shale gas, oil sands, liquefied natural gas and the management of giant oil and gas fields. With good reason, as competition for resources is fierce and not merely limited to the usual suspects.

50 years ago, life was much simpler for the supermajors. Countries with massive oil reserves often lacked the technology, capital and proper management skills to locate and extract them, especially offshore. Western oil companies were more than willing to come in and supply all of the above. But when the OPEC was founded in 1960, the balance of power slowly started to shift. The so-called "petro-states" started their own state-backed national oil companies to take charge of their reserves.

Fast-forward 50 years to 2011, these state-backed national oil companies now dominate the industry. Public listed firms like Exxon Mobil, Shell and BP have some of the world’s biggest market caps, but if you start to measure the reserves they actually control, they suddenly seem rather tiny compared to juggernauts like the National Iranian Oil Company (NIOC), Saudi Arabian Oil Company (Saudi Aramco), PDVSA of Venezuala or Gazprom (OTCPK:OGZPY), currently yielding 3.08%, of Russia.

Measured by reserves, the only privately held oil majors to make it into the Top 20 are Exxon Mobil, as the 11th-largest oil and gas company in the world, with Shell and BP also in the Top 20. It may be hard to believe, but state-backed oil companies control approximately 80% of the world’s remaining oil.

Obviously, private oil companies are more than willing to work with these national giants, but as recent history shows state firms aren’t necessarily the most reliable partners. If a government suddenly turns nasty, as in Venezuela, contracts can be torn up and private oil firms sent packing.

One of the most publicized disputes of recent years concerned the Sakhalin-2 project, a massive Russian oil and gas project, which includes development of the Piltun-Astokhskoye oil field and the Lunskoye natural gas field offshore Sakhalin Island in the Okhotsk Sea. The project is managed and operated by Sakhalin Energy Investment Company Ltd, which until the end of 2006 was majority owned by Shell, Mitsui (OTCPK:MITSY), currently yielding 4.34%, and Mitsubishi (OTCPK:MSBHY), currently yielding 4.69%.

Sakhalin-2 also includes the first LNG plant ever constructed in Russia, which went operational in March 2009. Therefore, the project was considered of vital importance to Russia's energy policy. Initial the Sakhalin Energy consortium had a contract to produce gas without a local partner. However, in 2005 the consortium was suddenly heavily criticized due to environmental issues and legal proceedings were initiated.

Under legal and political pressure, the consortium was forced to sell a majority stake, and at the end of 2006 Gazprom took control over a 50%-plus-one-share stake in the project by signing an agreement with Shell. Russian President Putin attended the signing ceremony and casually mentioned that the environmental issues had been resolved.

The latest example of escalating tensions between a private oil company and a petro-state is the threat by Baghdad to bar Exxon Mobil from further work on the West Qurna Phase-1 field in Iraq, where Exxon is currently producing oil under a service contract, if it follows through on a deal to explore for oil in the Kurdish region of the country. This week Iraq’s oil ministry went one step further, threatening to replace Exxon Mobil with Shell, which is a partner in West Qurna Phase-1.

In some other cases, the state oil firm is simply incompetent. After the huge Kashagan oilfield was discovered in 2000 in Kazakhstan, Shell, Exxon Mobil, Total (NYSE:TOT), currently yielding 5.81%, Eni (NYSE:E), currently yielding 5.29%, and ConocoPhillips (NYSE:COP), currently yielding 3.99%, all jumped at the chance to work with the Kazakh state oil company. Billions of dollars later, the field has produced delay after delay, but no oil as of yet. Costs increased from $57 billion to $136 billion and first production is now expected in 2012.

However, not all state oil firms are badly run of course. And the properly managed ones are arguably a bigger problem for the supermajors, since they are competing globally, with very deep pockets to boot. And after years of working with the supermajors, their technical expertise is growing. Norway’s Statoil (STO), currently yielding 4.03%, is a match for almost anyone. Brazil’s Petrobras (NYSE:PBR), 2011 FY yield approximately 3.07%, is developing its own technologies to exploit ultra-deep water. Both companies are also forming partnerships with other state-backed companies.

The supermajors also face competition from smaller private companies, which are starting to broaden their horizons. A few are offering full-service contracts, along the same lines as the supermajors. One example is Petrofac Plc (OTCPK:POFCY), an oil-services company currently yielding 1.49%, which is also taking stakes in oilfields.

State firms that don’t control domestic reserves, such as those from China and South Korea, are nowadays bidding for the same licences as the supermajors. These firms have patient shareholders who see oil as a matter of national security rather than merely a source of profits. In 2010, China’s CNOOC (NYSE:CEO), currently yielding 3.36%, bought a stake in Chesapeake Energy (NYSE:CHK), currently yielding 1.56%. The deal not only gave CNOOC access to the Eagle Ford shale in Texas, but also better technology to facilitate extraction of recently discovered shale gas back home in China.

Despite all these developments it would be wrong to assume all is gloom for the supermajors, because that's certainly not the case. Their cash and technology are still in great demand. Middle Eastern oil firms such as Kuwait Oil Company, Abu Dhabi’s ADNOC and previously mentioned Saudi Aramco still require help, particularly in refining and other downstream activities, despite hardly being technologically challenged.

The newer petro-states, on the other hand, countries like Uganda and Ghana, still need all the help they can get, foremost focusing on increased reliability and output of their infrastructure. They prefer to do deals with companies with a long track record of funding and managing big projects from start to finish, which are key selling points for the supermajors.

Because oil is so expensive, it makes sense to pump it from difficult places, another area where the expertise of the supermajors comes in. Despite the best efforts of state firms like Petrobras, the supermajors still have the best technology for finding and extracting oil from harsh environments, such as the Arctic or deep oceans, and from unconventional sources such as Canada’s oil sands.

The supermajors also have an advantage over smaller firms when it comes to the biggest and most capital-intensive projects, such as Shell’s huge Pearl GTL project in Qatar and its floating Prelude LNG project in Australia, or the Shtokman gas project in Russia, where Total and Statoil are helping Gazprom.

Given the current competitive environment, and as the unrelenting quest for oil and gas continues and intensifies, supermajors will likely take on more risks. Not only technically speaking, but as recent examples in Russia, Kazakstan, Libya and Iraq are showing, also politically. Few would have thought it possible, but the recent agreement between Exxon Mobil and Rosneft (OTCPK:RNFTF), currently yielding 1.26%, to extract oil and gas from the Russian Arctic, which includes an option for Rosneft to invest in the Gulf of Mexico and Texan properties, shows that when it comes down to securing resources, and generating healthy returns and dividends for shareholders, the oil industry will sometimes produce the most unlikely of bedfellows!

Disclosure: I am long RDS.A, RDS.B, BP.