Exxon’s First-Mover Edge in the Arctic

On the heels of Exxon Mobil’s (NYSE:XOM) record-breaking CAPEX announcement, the world’s largest oil company continues to impress. The integrated giant’s latest deal gives the giant first-mover access to a major find of unconventional assets: Russia’s Kara Sea.

The partnership with Russia’s Rosneft (OTCBB:RNFTF) provides access to nearly 90 billion barrels of oil equivalent (BOE) in the Arctic Ocean and the Black Sea. Drilling activity in the Arctic Circle is expected to increase considerably over the next few years. The region, which encompasses nearly one-sixth of the world’s landmass and stretches over 24 different time zones, has the potential to be a game changer within the energy sector.

A $500 Billion Partnership

The deal between Exxon and Rosneft has been in the works for more than a year and comes on the heels of a similar, now-canceled joint venture between BP (NYSE:BP) and the Russian oil giant. Initially, Exxon and Rosneft struck a deal last August to search for oil in three blocks of Russia’s Arctic that are estimated to hold 36 billion barrels of oil. This latest partnership expands on that deal.

Overall, Exxon-Rosneft will invest up to a half-trillion dollars to develop fields off Russia’s north coast. The project will drill its first wells in the Kara as early as 2014, with a final decision on full-scale development by 2016. Full-scale production from the region is estimated to begin around 2027 after all the necessary sub-sea infrastructure is in place.

While full production from the Kara is still far into the future, the potential is huge. The initial field the partnership will tackle contains nearly 9 billion barrels of oil equivalent, while the full region is estimated to hold 85 billion to 90 billion barrels.

That’s important for Exxon. Like many other major integrated oil companies, Exxon is under pressure to add to its current reserves of 25 billion BOE. Despite spending big bucks on capital expenditures and exploration efforts, many of the majors face dwindling production. And when E&P companies can’t find oil quickly enough, they’re stuck with aging fields where overall output is declining. Considering the current high-priced oil environment, that can lead to poor earnings.

Exxon CEO Rex Tillerson said it best when the company announced its historic CAPEX program: “An unprecedented level of investment will be needed to develop new energy technologies to expand the supply of traditional fuels.” While operating in the Kara will be expensive, these costs are a necessary evil for Exxon if wants to stay in business.

Russia is getting a great deal, too. Rosneft will now have access to Exxon projects across North America. These fields in West Texas, Alberta and in the Gulf of Mexico fall under the category of hard-to-recover reserves. So why would Rosneft want in? To gain the technological skills needed to tap these sorts of fields, which will be crucial for Russia’s energy future.

The nation is currently the world’s largest oil producer, with oil and natural gas its largest sources of revenue. However, like many of the oil majors, Russia is starting to see dwindling production at its legacy fields. Since Russia runs a trade surplus based on energy production, that’s a problem.

The nation’s big energy producers, including Rosneft and Gazprom (OTCBB:OGZPY), don’t have the offshore or fracking know-how to tap Russia’s unconventional fields. By 2020, Russian energy analysts project, about 5% of oil output will come from new regions and up to 40% by 2030. This is where Exxon’s expertise will come in handy.

The deal wouldn’t have been possible without Russia’s new tax policies. To attract foreign energy investment, Prime Minister Vladimir Putin has begun relaxing tax rules and reforming the tax code. The new tax standards eliminate various export duties and reduce the rates of the nation’s Mineral Extraction Tax.

Tax rates for the Exxon-Rosneft deal fall under two types of operational conditions: The J.V. projects in the Kara Sea will have a royalty rate of 5%, and the deep-water projects in the Black Sea will pay 10% in taxes.

The Investor Angle

This new tax schedule could mean the beginning of a longstanding relationship between American energy producers and Russia’s vast reserves. Already, Chevron (NYSE:CVX) seems to be eager to follow Exxon’s lead and has been talking to the Russian government about partnering in the Arctic.

Still, while more deals are likely — Russian officials basically said so at the project’s announcement — Exxon’s first-mover status makes it the new leader in the region. As it did with natural gas, the company went into uncharted territory before anyone else — and that’s what investors should focus on. These sorts of deals are exactly why investors should continue to own and hold the energy giant.

At the same time, Russian energy producers look as though they now have a way to overcome their dwindling prospects and could be a buy. The Market Vectors Russia ETF (NYSE:RSX) is still the easiest way to tap the nation’s equities and features a roughly 40% exposure to energy producers, including Rosneft.

Article printed from InvestorPlace Media, https://investorplace.com/2012/04/exxons-first-mover-edge-in-the-arctic/.

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