Gazprom in the News: Despite statements by Russia's finance minister that Gazprom would consider sharing its pipelines with other Russian independent producers, Gazprom has flatly said that it won't happen. Russian president Vladimir Putin hasn't weighed in yet on this current flap, but he has sided with Gazprom on the issue before. The EU wants other producers to gain access to Gazprom pipelines to Europe because they see such a move as further insurance against disruption of natural gas supplies like the one from early January when Gazprom slowed down deliveries due to a dispute with Ukraine. Putin's desire to be viewed as a statesman and friend of Europe may lead to a change in his stated position. More likely, though, is a spending spree by Gazprom to gobble up the independent producers once Gazprom completes its IPO later this year.

CNOOC in the News: China National Offshore Oil Company (CNOOC, NYSE:CEO) has created a joint venture with another Chinese company to manufacture steel pipelines. The new venture will include a research and development department and is expected to produce 300,000 metric tons of pipeline. CNOOC plans to use the pipeline to meet internal demand as the company develops future acquisitions both inside and outside China. The total investment by both partners is expected to be about $1.2 billion.

Competition from National Oil Companies

National oil companies (NOCs) have been around since the 1920s and are now moving beyond their traditional roles as managers of the oil resources of their respective countries and diversifying in all sorts of ways. NOCs looking at other fuels, and they are moving beyond national borders; many NOCs have been established by countries looking to import fuel rather than export it. There are currently more than 100 NOCs owned or controlled by the governments, far outnumbering integrated international oil companies (IOCs) and creating many new challenges for the IOCs.

The changing relations between countries and IOCs has important implications: today, IOCs own less than 5% of global oil and gas reserves and less than 15% of total global production, which gives them very little control over production levels and price. That the IOCs are still able to post record profits is less a testament to their skillful management of the new order than it is a testament to high prices. How the IOCs choose to spend those profits now will determine to some degree whether they have a future, and what kind of future it might be.

Ranked by production, the world's five largest oil companies are Saudi Aramco, National Iranian Oil Company, Pemex, PDVSA, and Exxon Mobil Corporation (NYSE:XOM). The five largest oil companies ranked on the basis of reserves are Saudi Aramco, National Iranian Oil Company, Iraqi National Oil Company, Kuwait Petroleum Corporation, and Venezuela's PDVSA; in 13th place, XOM holds the highest position for IOC reserves. Reserves are generally believed to be the single best predictor of an IOC's future prosperity but virtually every IOC is now pumping more oil every year than it is replacing with new discoveries, leaving them with diminished prospects for the future. This situation is unlikely to improve because new reserves are harder to find and smaller than what the IOCs consider economically viable. Most sovereign governments are also less willing to give away their reserves just to get them developed.

NOCs were initially formed by governments in oil-producing countries to control oil production, but now many governments, even in energy-importing countries, are making use of them to implement the country's energy policy, often looking beyond their countries' borders for additional reserves. Producing countries still use NOCs to maintain oversight of their oil fields and manage the life span of those fields in order to wring out the most value for the longest period of time, but NOCs such as Saudi Aramco, National Iranian Oil Company, and PDVSA are often called on to implement broader government policy rather than simply maximizing revenue from oil reserves. The political role changes the goals of an NOC, and it also means that financial accountability is often lacking. In an oil-importing country, an NOC -- such as CNOOC, China's Sinopec (NYSE:SNP), or India's ONGC -- is most concerned with national energy security; political considerations play a dominant role as countries jockey to control energy supplies beyond their borders and form useful alliances.

In contrast, IOCs -- such as XOM, BP plc (NYSE:BP), and Chevron Corporation (NYSE:CVX) -- are primarily interested in creating shareholder value. This can be a disadvantage when bidding against an NOC for new leases because the IOC must meet certain financial benchmarks that don't stand in the way of an NOC, which is often willing to pay more for the security of owning an asset. The resulting costs of new reserves are beyond what an IOC projects to be a sufficient return on investment. In addition, a government's cost of capital is typically lower than what an IOC can match, increasing an NOC's advantage.

This doesn't mean that NOCs always win the bidding. One of the biggest energy-related stories of 2005 was CNOOC's attempted purchase of Unocal Corporation and its reserves, which were eventually acquired by CVX. The threat of U.S. government intervention in a possible Chinese takeover of Unocal caused shareholders to reject CNOOC's higher offering price in favor of CVX's bid. An IOC won this one, but it ended up paying more than it had anticipated. Paying more for acquisitions also limits the returns on investments in new oil reserves. In 2005, India's ONGC won oil and gas leases in Libya, at return-on-investment rates of less than 10%. No IOC will compete at those prices; rates of return usually need to be 15% or better before an IOC will compete.

Smaller U.S. companies are doing slightly better. In the 2004 bidding for 15 Libyan leases, 11 were won by U.S. companies, but CVX was the only IOC among the winners. Independent exploration and production companies like Occidental Petroleum (NYSE:OXY), Apache Corporation (NYSE:APA), and Anadarko Petroleum Corporation (NYSE:APC) have competed more evenly on these types of leases because the smaller companies don't need to make the higher rates of return that IOCs need to make up for lower returns from their refineries and other downstream operations.

An IOC's traditional strong points were deep pockets, expertise, technology, and access to global markets. NOCs don't need as much capital any more, so the expertise, technology, and market access have become the big selling points. Advantages in expertise and technology have begun to evaporate as oil services companies like Schlumberger (NYSE:SLB) and Halliburton (NYSE:HAL) make significant inroads into that portion of the IOC's traditional business. Service companies working for an NOC typically are willing to accept a flat fee or a "cost-plus" contract, leaving the NOC to reap the profits from the resources; even in joint ventures, IOC's have been unwilling to work on this basis and it has cost them business.

The most compelling thing IOCs have to offer now is access to markets, and that is where IOCs and NOCs are joining hands. This is especially apparent in NOC attempts to develop markets for the huge quantities of LNG that are scheduled to begin shipping in the next few years. Qatar Petroleum, an NOC, has partnered with XOM and France's Total SA (NYSE:TOT) to develop Qatar's vast North Field natural gas deposits. Along with development capital and expertise, TOT and XOM brought access to North American and European markets for Qatar's gas. On its own, Qatar Petroleum would have had to spend more capital, and more time, building markets of its own.

It's the Gas, Gas, Gas

No one, except perhaps the Saudis, expects to find another giant oil field that will significantly alter the tight supply of oil. But finding and developing sizeable deposits of natural gas is still likely. The IOCs generally require discoveries of significant size in order to justify their exploration and production (E&P) expenses. If oil won't provide the needed scale, the IOCs will look to natural gas. Depending on its composition, gas also affords the possibility of NGLs and other oil products. Recall last year's bidding for Unocal: the company's oil reserves received most of the attention, due mainly to the rising gasoline pump prices then rattling the consumer market. Yet more than 60% of Unocal's 1.75 billion BOE reserves were natural gas.

It's not a big stretch for an IOC to move away from oil E&P to exploring for natural gas. Production costs, even for developing new fields, are significantly lower for natural gas than for oil, and recent gas prices have been high enough to support major exploration. Virtually all IOCs are investing billions of dollars in developing LNG liquefaction or regasification facilities. An anticipated shortage of natural gas by 2009 in major consuming countries like the United States, China, India, and many European countries is driving this development, but the investments may be leading to a glut: Royal Dutch Shell plc (NYSE:RDS.A) has delayed building a third LNG production facility at its Sakhalin-II project until at least 2013, citing potential over-supply issues.

Alternatives to Oil and Gas

If NOCs have locked up oil resources and are prepared to buy more, and if the market for LNG may be getting over-supplied before it even gets started, what is a poor IOC to do? So far, recent profits have gone to fat dividends and stock buybacks, neither of which brings in new reserves. Rather than becoming even more heavily invested in natural gas or lowering their sights to smaller oil fields, IOCs could consider developing alternative assets. Even the U.S. president, a former oilman himself, has called for the U.S. to break its addiction to oil.

President Bush's call to arms has garnered a mixed response, but the analogy he drew is apt, and it's not just consumers who are addicted to oil. What else do Saudi Arabia, Iran, and Kuwait have to offer besides hydrocarbons? The other point the President could have been making is that now that oil markets are driven by demand instead of supply, the IOCs can no longer dictate the price. For decades, the IOCs set the price of a barrel of oil until the NOCs and their governments wrestled the power away from them in the 1970s; until recently, even the price set by OPEC has been based on supply rather than demand. Although Saudi Arabia claims that it can raise production 2.5 MMb/d by 2015, that won't be enough oil to meet the anticipated growth in consumption.

There could be better ways for IOCs to make the mountains of money they are used to. IOCs should resist the temptation to chase the short-term profits that might come from drilling for oil and gas in the Arctic and start looking more seriously at alternative energy for long term returns. Instead of paying off investors with higher dividends and stock buybacks, maybe the IOCs should consider investing some of their windfall billions in alternative sources of energy. There is still a lot of research and development to be done, especially on ways to scale up the alternative energy business [see Observations, June 22, 2005, and July 6, 2005], and Big Oil does know something about scale. In the face of "unfair" competition from the NOCs, Big Oil needs to begin thinking of itself as Big Energy and make investments that it can control and from which it can reap the benefits.