Revenues for upstream oil and gas companies grew by a solid 19% in 2006, compared with the previous year, but "a relentless upward march of costs" significantly bit into net incomes during the same period, according to the "2007 Global Upstream Performance Review" by energy-analysis firm John S. Herold Inc. and M&A advisor Harrison, Lovegrove & Co. The report focuses on the global upstream investment performances of 228 energy companies.

While the oil and gas industry posted a record $243 billion in upstream profits-nearly $13 per produced barrel of oil equivalent (BOE)-higher lifting costs ate up more than a third of that gain. "Gains in profitability and cash flow were all positive," the firms report, "but their respective percentage changes from 2005 to 2006 were much lower than historical averages as costs continued to increase."







Specifically, lifting (or production) costs increased 31% on the year, while exploration expenses advanced 26%, and DD&A (depreciation, depletions and amortization) added 22% to the net drain. Likewise, government income-tax receipts surged 12%, ultimately consuming 50% of pre-tax profits.

Still, demand for petroleum boomed worldwide due to continued global economic expansion, while constrained production and refining capacity squeezed delivery. This resulted in a 16% jump in the average price per BOE. Revenue from oil and gas production surged to $843 billion, a $133-billion increase from the year prior and more than double sales from 2003.

But finding opportunities to invest the growing cash flow remains a challenge, the firms report. "The key challenge facing the petroleum industry continued to be replacing reserves and growing production due to the combination of maturing basins and reduced accessibility to new acreage."

In response, the industry stepped up its upstream investments by a significant 45%, both through expanded drilling efforts and by an "aggressive approach" to acquisitions. "Total outlays soared to $401 billion, an increase of $125 billion over 2005, and capital investment exceeded cash flow for the first time since 1999."

New opportunities are scarce, the firms add, and acquisition costs for proved and unproved reserves increased by a "remarkable" 85% to $139 billion. The figure is due in large part to two acquisitive companies, ConocoPhillips and Anadarko Petroleum, which together accounted for 40% of the total upstream transaction activity in 2006.

Per-unit, implied costs for acquisitions of proved reserves topped 55%-more than twice the increase in oil prices. "Increased competition for attractive assets drove unit acquisition costs for proved reserves to $11.42 per BOE."

While companies increased spending for proved-reserve acquisitions nearly 80%, this spending resulted in proved-reserve increases of just 15%. "Reserve replacement and finding and development costs surged globally in 2006 as the large increase in capital spending did not translate into equivalent reserve additions," the firms report.

Investment in unproved acquisitions almost doubled to $47.4 billion, "possibly foreshadowing an acceleration in exploration spending in the coming years," Herold and Harrison Lovegrove report.

The U.S. accounted for about half of the total acquisition spending during the study period.

"Capital investment was slightly greater than cash flow for the first time this decade," the firms report, "but only as a result of the flurry of North American acquisitions. Spending patterns in the other five regions were little changed from prior years. No doubt the geographic differences reflect the fact that the eight giant oils have very different patterns than the smaller oils, which comprise the bulk of investment in North American projects."

Even with the record capital spending, reserve volumes increased a scant 2% globally, while reserve replacement costs climbed 33% to $13.60 BOE. Global reserves would have fallen if not for additions of natural gas and Canadian oil sands.

Gas increased in the industry's portfolio. Gas extensions and discoveries added more than 48 trillion cubic feet, far surpassing production that was up a strong 5%.

While growth in oil reserves and production remains flat, growth in gas reserves and production continued at a 3% pace. Half of this growth is attributed to the success of "resource" plays in the U.S.; expanding liquefied natural gas operations in the Asia-Pacific region account for the other half.

Gas is now 35% of BOE of production, the highest level this decade.

Shareholders fared well as companies increased capital outlays while paying down debt. "There was plenty of cash to go around," the firms report.

"Returns to industry shareholders during 2006 were robust: dividends reached record levels at $83 billion (up $7 billion)." Meanwhile, share repurchases "drew the lion's share of the gain, jumping to $88 billion from $64 billion in 2005 and overtaking dividends for the first time." The industry has spent more to repurchase its own shares during the past two years than it has to acquire proved reserves.

"The industry has been able to generate enormous wealth for its shareholders over the last several years, both from the upstream and downstream sectors. However, questions are emerging as to the sustainability of this performance. We see the primary challenges lying in reserve maintenance, particularly for oil, and in controlling the costs of finding and producing hydrocarbons in a fiercely competitive environment."

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