In search of value

Oil and gas producers are spooling up cash from high oil prices, now that downstream operations are providing the kind of margins that reflect higher pump prices. What are they going to do with that pool of capital?

Historically, producers paid out excellent dividends, and were well rewarded with solid share valuations. Today, markets are driven by equity growth, and the crowd valuing dividends grows smaller by the day. Institutional investors, among the more conservative, aren't paying much attention either. So what are producers' options for this cash:

• Buy other producers: Undoubtedly, this is the most consistent pursuit in business today. Unfortunately, making the union make economic sense, avoiding anti-trust and regulatory pitfalls, and working through the ego problems can wreck momentum and paralyze operations.
• Buy back stock: This is the second-most active pursuit by producers, and is highly recommended for companies with under-valued stock, surplus cash flow, and without the first option. However, stock values aren't getting much credit for buybacks, and many producers have abandoned the effort.
• Invest in Middle East: What started out as an excellent route to add low-cost reserves has grown cold in recent months. Even though the pursuit is worthy, it's obvious that negotiations toward development partnerships in the Mideast will require lots of cash and an equity compromise.
• Invest elsewhere: To the extent charters or boards will allow, producers are buying and selling other stock inside and outside the petroleum business. There is a concern that producers, lacking investment expertise, will take a steep hit if market growth reverses. A bigger fear is that a producer's core functions will atrophy and some prized experts will drift away if the company is disengaged too long.
• Downstream investment: Higher oil prices proved to be difficult to pass along to consumers, precisely because downstream refining and petrochemical facilities are in surplus all over the world.
• Upstream investment: Compared with sitting on cash, ratcheting up upstream spending doesn't sound too inviting. And OPEC still has the power to make or break oil prices at any time.

But there is another point of comparison for focusing on upstream investments - contractor, leasing, and equipment prices. The difference between prices now and when the industry decides to go back to work is 50-100%. By the time confidence in higher oil prices returns to the market, everyone will be thinking the same thing - get a rig and drill. That herd mentality is how costs get driven out of sight.

Leaseback strategies

Increasingly, oil and gas producers are turning to leaseback arrangements to plan their business. Leaseback involves selling off an asset and then leasing it back from the new owner, who is more likely to be a leasing agent of specific types of assets - new and used.

The strategy takes advantage of three trends: (1) smaller reserve accumulations with shorter production lives; (2) decreased time between discovery and first production; (3) floating and producing assets have life spans beyond those of most fields.

Decreasing the time between discovery and first production is hugely dependent upon the availability of existing equipment adequately suited for the application, or fabrication slots in the event a newbuild is the only reasonable option. Despite contracts however, new construction rarely offers cost predictability. A contractor's financial condition, oil and gas prices, and other costs can change a great deal during the 1-3 years required for new construction.

Historically, fields, environmental conditions, and reservoir conditions were so unique that standardization was not considered. To accommodate unique approaches today, more equipment now can be modified in the yard or field to fit second or third applications. Floating systems, spars, and drilling units converted to production are relatively insensitive to depth and environment conditions, and thus can be easily re-deployed.

Leasebacks were pioneered by smaller producers who were so financially sensitive to cost shifts they had to grant equity positions in order to weather risks. Today, producers simply are picking business arrangements that provide equipment quickly, that have price predictability, and do not depend on other conditions. They then can focus on a core function - evaluation and management of resources.

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