The challenges faced by oil and gas companies in trying to profitably grow their businesses are numerous. Maturing basins, increasing costs, increased taxes and the threat of resource nationalism, increased competition from national oil companies and various barriers to access in resource-rich regions of the world are some of the key themes.

Over-riding all of these considerations has been the rapid rise and continuing strength of oil and gas prices. Companies have posted record profits and used the cash to strengthen balance sheets, pay out large amounts to shareholders in buybacks and dividends, fuel the M&A market to white-hot levels and fund significant increases in exploration and development spending.

However, there has emerged a marked difference in the strategies of the largest international oil companies (IOCs) in relation to the lattermost-the relative extent of the increase in upstream spending. This is driven by different outlooks on future oil and gas prices and attitudes to the appropriate investment strategy in an increasingly high cost and competitive business environment.

Spending patterns of the four largest IOCs were examined. For relative spend, in relation to the size of each company's upstream business, the average upstream development spend per barrel of production was analyzed. For historic spend, development costs incurred and production as reported to the SEC were used. Future spend is based on Wood Mackenzie's forecast, which is built from a database of individual projects in which the companies participate. These include all projects in production and under development that have received project sanction or are expected to receive sanction.

Among the four largest IOCs there is a clear differentiation between Shell and Chevron on the one hand and ExxonMobil and BP on the other. Between 2001-05, these companies had roughly the same upstream development expenditure on a relative basis. This ranged in a very tight group between $5.93 per barrel of oil equivalent (BOE) for BP to $5.36 for Chevron.







Looking forward, the picture changes dramatically. Shell and Chevron's relative spending levels are set to increase dramatically-to $11.50 per BOE for Shell and $11.20 for Chevron-while BP's and ExxonMobil's show modest increases-to $7.20 for ExxonMobil and $6.25 for BP.

Upstream development spending between 2004-06 rose by more than 110% for Chevron and 80% for Shell, but by only 30% in the case of BP and ExxonMobil. Given the level of cost inflation in the industry, it is questionable whether BP and ExxonMobil's real levels of development spending have risen at all during this period.

Shell and Chevron's bullish strategy is also reflected in that their exploration spend per unit of production in 2006 was nearly double that of ExxonMobil's and 50% to 60% more than BP's, on a relative basis.

Clearly Shell and Chevron are investing at much higher relative rates than ExxonMobil and BP, and look set to continue to do so. In large part it is a function of the strength of the current development pipelines of each of the companies.

Wood Mackenzie built its forward view on a project-by-project basis, and found few further opportunities for ExxonMobil and BP that could be developed in the near term to organically boost spending levels. This is not something that can be changed dramatically through exploration spend, nor does there appear to be an abundance of new large-scale opportunities for IOCs to access new projects.

The current development pipeline is the consequence of the strategic decisions taken by the companies over a number of years. It appears that Shell and Chevron's behavior is predicated on an acceptance that higher levels of government take and costs are going to erode returns, but that a continued high-price environment will enable them to nevertheless easily exceed their cost of capital and internal returns criteria.

Furthermore, these companies' project pipelines include significant investments in longer-life, but relatively lower-return, areas such as global liquefied natural gas (LNG), gas-to-liquids (GTL) and oil-sands projects.

The companies' attitudes to risk and price are exemplified in their relative exploration spending. Although constrained to some extent by acreage portfolio and human resources, this spending can be fairly quickly increased, unlike development spending where projects can take years to mature. ExxonMobil's relative exploration spend has not as yet seen any marked increase, whereas BP's has only recently jumped.

ExxonMobil is best known for its capital-discipline and has recently pulled out of several projects, for example an LNG project in Angola and a GTL project in Qatar, saying they do not meet its returns criteria. In contrast, Chevron remains in the Angola LNG consortium and Shell pushes ahead with the Pearl GTL project in Qatar.

Of course, adding value is also about potential for generating returns. The weighted average return on future projects in each company's portfolio was examined. These include all-new, stand-alone projects currently under development or expected to be sanctioned.







The return calculated is the weighted average internal return on the projected cash flow. For BP, Chevron and ExxonMobil, there is little difference in the return generated. The results for BP are a little higher due to its greater exposure to the high-return deepwater Gulf of Mexico. Shell shows a markedly lower return due to heavy spending during the forward time frame on relatively low-return/long-life projects in the Canadian oil sands, at Sakhalin in the former Soviet Union and in Qatar in the Pearl GTL project.

What is the consequence of these differing spending strategies? In a high-price environment, the high-spending companies will generate additional value from their investments at a return that is above their cost of capital and is acceptable to shareholders, thereby growing the value of their upstream business faster than their lower-spending peers.

While metrics such as return on capital employed and finding and development costs will be lowered for these companies due to the higher levels of spending, in a high-price environment with abundant capital these efficiency measures become less important than the opportunity to spend free cash flow and participate in the high returns that the industry still has to offer.

In a low-price environment, the winning strategy would be that of the companies that have husbanded their capital and returned it to shareholders rather than make investment decisions that require a higher break-even price than would be available in this scenario.

As the high-spending companies push the boundaries of what they are willing to accept in fiscal terms, development scenarios and M&A transactions, oil and gas prices will tend to track steadily upwards, driven by these competitive pressures.

Are we in a new paradigm? Time will tell. However, it is clear that we are seeing some different investment strategies in response to this fundamental shift in the business environment.



Derek Butter is head of corporate research for U.K.-based energy-research and consulting firm Wood Mackenzie.