Profit when oil's have-nots crash

By Jim Jubak

It's getting easier to separate the "haves" and the "have-nots" in the oil and gas sector.

Well, at least it was before the threat of regional war in the Middle East sent the share prices of just about all oil producers running higher, along with the price of a barrel of oil.

But once the region settles back down to its now, unfortunately, normal state of grinding small-scale slaughter, the basic trends in the industry will again come to the fore.

And you should be looking through the current disaster to own the long-term winners. It doesn't hurt that these same stocks should do well in the short term from financial markets' Middle East fears.

What are the long-term trends?

The have-nots are in a panic. These companies haven't been finding enough new oil and gas to replace what they pump. They're afraid of losing significant portions of their existing reserves to political upheaval in unstable regions -- if they haven't lost them already. And their portfolios of new projects don't promise to add enough reserves to make up for the shortfall. They'll pay almost any price to acquire more oil and gas.

The haves are sitting on their hands. They've been able to replace what they've pumped and more in recent years. The bulk of their existing reserves are in relatively stable regions. And most importantly, they've been successful enough at exploration and development to line up a portfolio of new projects that promises to keep production growing over the next decade.

If everything works out as they plan, the have-nots will survive and even profit from their current strategies of desperation. But the risk is high -- oil and gas profits in the near and long term have to be "just right." If not, some of these have-nots will wind up selling assets, if not their entire companies, at fire-sale prices.

The cynical, if canny, strategy of doing nothing

Who will be there with armfuls of cash if that happens? The oil companies that have the luxury of doing nothing right now -- except count the cash as it comes flooding in. These companies' do-nothing strategies are, in fact, a bet that some of today's aggressive deal-makers will blow up, leaving the companies that have hoarded their cash to pick up the pieces at 50 cents on the dollar.

Guess which group of oil and gas stocks I think smart investors should be buying now?

Desperation was on full display last week when Repsol YPF (REP, news, msgs), the Spanish energy company, bought BP's (BP, news, msgs) stake in the Shenzi field in the Gulf of Mexico for $2.15 billion. According to oil industry analysts at Wood Mackenzie, this price values the oil and gas that BP estimated it could recover from the field at a stunning $97 a barrel of oil equivalent. Repsol has said that it believes it can add enough extra reserves once it finishes drilling to cut the price to about $68 a barrel.

Spending $97 a barrel to acquire oil that's still in the sea floor underneath 4,300 feet of water in the hurricane-prone Gulf of Mexico? (By the way, it will cost about $4.4 billion to develop the field over the next nine years.) That's either extraordinarily bullish or just plain desperate.

After looking at Repsol's reserve numbers, I'd vote for desperate. In January 2006, Repsol revised its proved reserves downward by 25% thanks to legal, political and technical changes in Bolivia (the source of 52% of the downward revision), Argentina and Brazil. That brings Repsol's three-year organic reserve replacement rate to a negative 95%, according to Standard & Poor's.

Is ExxonMobil right or missing the boat?

Contrast that to what passes for big moves at ExxonMobil (XOM, news, msgs). In the first quarter of 2006, ExxonMobil paid out $2 billion in dividends and spent another $5 billion on buying back its shares. For the second quarter, it upped its share repurchases to $6 billion.

With cash flow from operations of $14.6 billion in the first quarter of 2006, ExxonMobil has been raked over the coals by some on Wall Street for not doing more with its cash -- even after those buybacks and dividends, the company closed its first quarter of 2006 with $32 billion in cash and cash equivalents on hand.

ExxonMobil's reply boils down to "Why should we?" It's not as if the company isn't spending anything on capital projects and exploration. That part of the budget climbed to $4.8 billion in the first quarter, up 41% from the first quarter of 2005. And the company isn't hurting for either current or future production. The company has been able to both increase oil and gas production -- up about 7% in the first quarter of 2006 from the first quarter of 2005 -- and add to reserves faster than it pumps oil and gas. From 2003 to 2005, ExxonMobil replaced 108% of reserves, according to Standard & Poor's.

The company is on record saying that it doesn't think current high oil prices will last -- and that it doesn't see the point of buying reserves or spending capital on risky exploration projects at current prices. (On the other hand, the company has been perfectly willing to spend money on relatively low-risk liquefied natural gas projects. On July 10, for example, the company announced plans to spend $3 billion on the second phase of its liquefied natural gas project in Qatar. First production is scheduled for 2009).

The rich will get richer

I've written in the past that I think ExxonMobil is wrong on future oil and gas prices, and I still think the company is wrong. But, increasingly, that doesn't matter. ExxonMobil and other cash- and reserve-rich oil companies are in a great position to pick up even more assets and at cheaper prices when oil and gas companies that have aggressively bet on higher prices hit the wall. The rich, as so often happens in this world, will get richer.

Why should any oil and gas production companies hit the wall, even if oil prices aren't headed significantly lower any time soon?

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