Oil sector prepares for long-term pain

As Hurricane Katrina deals a devastating blow to oil production
infrastructure in the US, and prices climb to record levels in excess of $70
(£38) per barrel, first impressions should suggest that oil companies are primed
to benefit from the commodity’s soaring value.

Indeed, oil groups are certain to profit in the coming months. Terrorism and
instability in major oil developing countries should sustain high prices, and
the wrecked refining capacity in the US has caused shortfalls that will keep
demand high. Meanwhile, the insatiable appetite for oil from the burgeoning
economies of China and India continues.

Nevertheless, the aftermath of the hurricane disaster in the Gulf of Mexico
has provided hints that oil groups could find conditions far tougher over the
longer term.
According to analysts, resources are going to become scarcer and competition for
exploration sites stiffer, while an imminent change to the way in which oil
exploration costs are accounted for will soon be in place to harshly expose any
groups that fail to strike it rich.

Michelle Dathome, an analyst at credit-rating group Standard & Poor’s,
says topping up oil and gas reserves is becoming more difficult as
long-established sources for oil come under increasing pressure.

‘Based on cost trends observed since 2000, it is getting harder and more
expensive to replace reserves,’ Dathome says in the report, Industry Report
Card: Canadian Oil and Gas Companies. ‘Reserve additions from the traditional
OECD basins, like North America and the North Sea, are not keeping pace with
production.’

A team of oil analysts at Morgan Stanley, meanwhile, says that as traditional
basins begin to approach the end of their life-cycles, the scrap for resources
will become more fierce than ever.

‘Falling reserve replacement is a significant issue that essentially
highlights the underlying problem facing each boardroom of the oil industry ­
access to resources,’ Morgan Stanley says in a research note. ‘

Resources are becoming more scarce as the basins that dominate the European
company portfolios are maturing fast, and competition to access the world’s
remaining resources is now very hot.’

As competition for diminishing resources becomes tougher, the number of
exploration failures is likely to increase, and these failures will be visibly
exposed by an accounting treatment that is scheduled for introduction next year.

The majority of oil companies have, up until now, accounted for exploration
using the full cost accounting method, where exploration sites are capitalised
and then amortised if they do not deliver a return.

However, it is anticipated that by next year, IFRS will require oil groups to
adopt ‘successful efforts’ accounting for exploration. The method requires
groups to expense failed prospecting attempts immediately in the profit and loss
account, and will hurt any company that unsuccessfully drills for oil.

The first indications of the extent of the impact have already emerged as
Premier Oil proactively adopted the new accounting system ahead of schedule.
Restating its 2004 accounts under IFRS, the FTSE250 group voluntarily included
the impact of the imminent change in its IFRS accounts, which resulted in a
downgrade in post-tax profits from $43.8m (£24.3m) to $22.1m.

‘Successful efforts accounting is a more conservative method that brings more
transparency,’ says Phil Corbett, oil analyst at Numis. ‘Failed exploration
sites are not capitalised, but expensed as incurred. The bulk of the reduced
profits after Premier Oil’s restatement related to this change.’

Although the anticipated standard will not affect the cash balances of
companies, it will provide a much clearer picture of how successful oil
exploration is and provide investors with a better idea of whether companies
have hit oil ­ or spent millions drilling a dry well.

Other mid-cap oil and gas groups ­ the companies that are most likely to be
impacted ­ have yet to adopt successful efforts accounting, and further profit
reductions could be on the way when they do.

The new standard is not all bad news though, according to Premier Oil FD Tony
Durrant. He says successful efforts accounting could benefit oil companies,
because of the way the method groups oil wells.

The method looks at oil exploration sites on a well-by-well basis rather than
on a field-by-field basis. Durrant says this will be beneficial because in
fields where there was a mixture of oil rich and dry wells, the lucrative ones
will not be grouped with the wells that yield nothing and have their value
reduced as a result.

‘IFRS looks at wells on an asset-by- asset basis. Premier has a series of
assets around the world and successful efforts accounting will show the
performance of each individual well, so high performing assets will not be
encumbered by unsuccessful areas of the business,’ Durrant adds.

Dathome says that, although companies would find it harder to find oil
resources, which would be reflected in the accounts, if and when they do,
commodity prices would be in line with the expenditure required to find the
resources.

‘One argument suggests that finding and development costs are expected to
rise in tandem with crude oil and natural gas prices,’ Dathome says. ‘As
hydrocarbon prices increase, so the value of the commodities; therefore,
producers should be willing to spend more to find them.’