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Cosmic Easter Eggs

"Mineral exploration, like a kind of cosmic Easter egg hunt, becomes increasingly difficult the longer the hunt proceeds. Today, most of the world's oil explorers are finding that the best chocolate eggs are long gone. The only goodies remaining are a few stray jellybeans and some candy wrappers."

God did not post any beacons or billboards above the world's mineral deposits. Man had to find them all on his own. Unfortunately, as our resource-hungry world has depleted its inheritance of metals and petroleum, large resource deposits have become increasingly difficult to find. The world's largest oil companies have responded to this geological predicament by reducing their exploration budgets and boosting the acquisition budgets. In other words, they are going shopping in the world's stock markets for the oil reserves they cannot track down in the wild.

As the big oil companies transform themselves from explorers into mere "shoppers," every mid-size oil or gas company with a sizeable reserve base becomes a an attractive "bauble." Resource investors would do well to determine which mid-sized oil companies the shoppers will consider most appealing, and try to pick up a few shares while they're still "on sale."

Mineral exploration, like a kind of cosmic Easter egg hunt, becomes increasingly difficult the longer the hunt proceeds. Today, most of the world's oil explorers are finding that the best chocolate eggs are long gone. The only goodies remaining are a few stray jellybeans and some candy wrappers. So the big oil companies are turning their attention, instead, to the candy store known as Wall Street to satisfy their permanent craving for new reserves.

"The world's biggest oil companies are failing to get value for their money," the Financial Times observed recently, citing a study by the Scottish energy consultant, Wood Mackenzie. The newly released study shows that oil and gas exploration has produced relatively dismal results over the past few years. Specifically, as the chart below illustrates, the commercial value of oil and gas discovered by the 10 largest energy groups over the last three years is well below the sums spent to find them. In 2003, for example, the top 10 oil groups spent about $8 billion hunting for oil, but only found about $4 billion worth of the stuff.

As a result of these dire results, several oil companies are bumping their capital expenditure budgets this year to squeeze additional production out of KNOWN fields. Development spending on existing oil and gas properties has jumped from about $35 billion in 1998 to a record $50 billion in 2003. During the same time frame, exploration spending has fallen from $11 billion to $8 billion. Of course, development spending is a self-limiting process, as it merely depletes previously discovered reserves without adding any new ones.

But to ensure their survival, oil companies must find new reserves, either by drilling for them or by purchasing them. Over the last few years, buying reserves has been much more fruitful than exploring for them. Another of Wood Mackenzie's illuminating studies, entitled, "Value Creation through Acquisitions," analyzed nearly 170 international acquisitions and mergers to determine their "value creation" for the acquiring company.

"Exploration has typically been the method by which the industry has replaced reserves," Wood Mackenzie blandly observes. "Many companies in the study group have, however, added significant commercial reserves through their acquisition strategies." The 25 acquiring companies in the study group spent about $140 billion on acquisitions between 1996 and 2002, which, according to the study, "resulted in a total value creation through acquisitions of $23 billion (NPV as at 1-1-03)."

Clearly, shopping for reserves beats exploring. The major oil companies will continue searching for new discoveries - of course - but the shopping season is underway in the oil patch.

-- Eric J. Fry, the Daily Reckoning's 'man-on-the-scene' in New York, is the editor of Apogee Research(formerly Grants Investor) - an online investment publication devoted to hedge funds and other professional investors. Mr. Fry has been a specialist in international equities since the early 1980s. He was a professional portfolio manager for more than 10 years and authored the first comprehensive guide to American Depositary Receipts, International Investing with ADRs.

Mr. Fry appears regularly on television financial news programs and contributes his insights to selected investment research publications.

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