It defies business sense to let lower supply raise costs and encourage energy alternatives but a study released today by Rice University's Baker Institute for Public Policy finds that the "Big Five" international oil companies (IOCs) are spending less money on oil exploration in real terms despite a four-fold increase in operating cash flow since the early 1990s.

Why would that happen? It may be knowledge that political upheavals in places like Venezuela and Russia could invalidate the investment entirely, making it unattractive for large companies who would be at risk. It may be that environmental concerns make new efforts unattractive or it may just be that maintaining margins on high prices are better.

Either way, the study also finds that second-tier oil companies are spending more in exploration than their large counterparts.

The analysis is based on Baker Institute research on investment expenditures by the IOCs, the next 20 largest U.S.-based oil firms and national oil companies (NOCs). Data were culled from U.S. Securities and Exchange Commission filings going back to 1995 and, in the case of NOCs, to news reports and other public data.

The study found that the Big Five (ExxonMobil, Royal Dutch Shell, BP, Chevron and ConocoPhillips), used 56 percent of their increasing cash flow on share repurchases and dividends, which were good for investors in the short term but put at risk the companies long-term oil reserves.

“The handwriting is on the wall. The oil majors are not replacing reserves,” said Amy Myers Jaffe, co-author of the report and the Wallace S. Wilson fellow for Energy Studies at the Baker Institute. “It’s as if they are slowly liquidating their long-term asset base. They may see a declining rate of production over time and eventually that is bad news for both their shareholders and consumers.”

State-owned monopolies, known as national oil companies (NOC), represent the top 10 oil reserve holders internationally. By comparison, ExxonMobil, BP, Chevron and Royal Dutch Shell are ranked 14th, 17th, 19th and 25th, respectively.

The IOCs still rank among the largest oil and gas producers worldwide, and these Western majors have also achieved a dramatically higher return on capital than national oil companies of similar size.

“The Five Big IOCs are still an important force in the market. Their production represents over 20 percent of non-OPEC production,” notes Jaffe. “But, investors are placing a higher premium for the stock shares of emerging national oil companies, despite the measurable edge the majors have in terms of operational efficiency. Clearly, they are betting on who will own the oil in the future. Last week’s announcement that Brazil’s state oil company had an 8-billion-barrel discovery is a case in point.”

Study findings summary:

  • Exploration spending of the five largest IOCs has been flat or lower in the aftermath of OPEC’s reinvigorated effort to constrain market supply in 1998. Given the uptick in costs of material, personnel and equipment such as drilling rigs, the five largest IOCs have cut spending levels in real terms over the past 10 years. This trend appears, however, to be easing, with exploration spending by the five increasing IOCs rising by 50 percent in 2006 over 2005.
  • Instead of favoring exploration, the five largest IOCs used 56 percent of their increased operating cash flow in 2006 on share repurchases and dividends. They have also increased spending on developed resources, presumably to monetize these assets quickly while oil prices are high.
  • The next 20 largest privately traded U.S. oil firms have not followed a similar pattern. Instead, they have steadily increased exploration spending since 1998 and their spending now equals that of the five largest IOCs. This differing pattern comes despite the fact that the five largest IOCs have access to operating cash flow that is three times the size of the next 20 largely traded American oil firms. This trend indicates that these 20 next-largest privately traded American firms will control an increasing portion of non-OPEC oil production in the coming years.
  • Oil production of the five largest oil companies has declined since the mid-1990s. Oil production for the five largest IOCs fell from 10.25 million barrels a day (b/d) in 1996 to 9.45 million b/d in 2005 before rebounding to 9.7 million d/b in 2006. By contrast, for the next 20 U.S. independent oil firms, their oil production has risen since 1996, from 1.55 million b/d in 1996 to about 2.13 million b/d in 2005 and 2006.
  • Since 1994, the nine NOCs who actively participate in international exploration invested more than $66 billion abroad in upstream, or exporation and development, activities. Chinese firms alone announced foreign projects worth $9 billion in 2006, most of which was in the form of access to oil fields in Russia, Nigeria and Kazakhstan -- comparable to the total amount spent by the Big Five on exploration that year but still small compared to the $59.4 billion they spent on exploration and development combined.
  • Wall Street investors increasingly recognize these new exploration investment trends and the value of shares of NOCs have risen at a much faster rate than those of the largest IOCs.
  • Parallel restraints on exploration spending by the Big Five and major OPEC producers could lead to less competitive global oil markets in the next decade.
  • The wave of consolidations in the 1990s of the largest publicly traded oil firms has not led to related success in completion of large, complex oil projects and reduction in costs for those projects. Several of the world’s largest oil companies merged in 1998, arguing for the need to cut costs, enhance efficiency and grow capital strength to tackle the massive spending requirements for multi-billion dollar mega-projects in places like Russia, Venezuela and Saudi Arabia. However, spending patterns of these companies since the mergers failed to show any appreciable increase in exploration spending from the previous levels of their pre-merger entities. One explanation for this trend is that companies may now be constrained by significant political changes in major oil producing countries such as Russia and Venezuela.
  • Given the superior record of the next 20-largest publicly traded American oil firms for reserve replacement and exploration activity, there appears to be a level of consolidation that suggests that firms can become too large to effectively exploit the kinds of reserves currently available for private capital.

The study's authors are Amy Myers Jaffe, Wallace S. Wilson Fellow in Energy Studies, at Rice University's Baker Institute, and Ronald Soligo, professor of economics; Baker Institute Rice Scholar.

Get the complete study here.