Wednesday, July 28, 2004

Where To Spend It All
The major oil companies have begun releasing their earnings figures for the second quarter.  Earnings are expected to be up from the same time last year, and the first to report confirm this.  The Financial Times tallies the total from the top five companies at $17 billion dollars.  With oil and gas prices near record levels, and with most of the companies having merged and trimmed to lean fighting weight, how could they not now be rolling in cash?  Where will they spend it all?

Clearly some of this windfall will be go into financing: higher dividends, stock repurchases, and debt reduction.  BP's Chairman, Lord Browne, is quoted as saying, "Now is the turn of the shareholder." But even after satisfying investors and polishing balance sheets, there will be lots left over, adding to the accumulation from the last year of strong results.  There are really only two options that are likely to be considered, higher reinvestment and acquisitions. 

The former looks like an obvious choice, given global concerns about oil demand outpacing supply for the next few years, or longer.  But are there enough attractive opportunities in which to invest?  The best lie behind walls of state control or high risk, as in Saudi Arabia and Russia.  Absent enough star prospects, will companies really want to dig far down their lists of opportunities to invest in the kind of projects they've been busily divesting in the last five years?

That leaves M&A, which may look like a better deal.  After all, the stock prices of these companies currently reflect oil valuations far below current market levels.  If you believe in efficient markets, further consolidation at these prices would not be arbitrage, but folly.  However, as concern grows that oil production is approaching some sort of limit, whether imposed by geology, access to resources, or geopolitics, the industry starts to look like a zero-sum game.

How much more consolidation will regulators tolerate?  As long as buyers are happy to dispose of enough refining and marketing assets to keep the retail gasoline market looking competitive, there seem to be few impediments to higher concentration of exploration and production, particularly when the bulk of these activities falls outside the US or EU.  So does this portend the further rolling up of the second- and third-tier companies, or are we on the brink of the Super-Super Major?  Materiality will probably the decisive factor.

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