Only Oil Insiders Are Looking At This Play

U.S. oil men usually love their home turf. Especially today, with U.S. shale plays yielding some of the best production and reserves numbers on the planet.

But one industry insider made a surprising comment last month. Showing that U.S. oil firms may be looking in an unexpected direction for growth.

The brief mention came during the quarterly conference call for Energy XXI (Nasdaq: EXXI)-a leading exploration firm in the Gulf of Mexico that I've discussed in the past.

President John Schiller was asked about growth opportunities for his company. To which the industry veteran replied that he is seriously looking at Malaysia.

This seems an odd jump for a Gulf-focused oil producer. But Schiller noted that Southeast Asia in fact has the same geology and structures as companies like Energy XXI see in the GOM.

He even pointed out that Asia was the offshore destination of choice for U.S. E&Ps after these firms initially developed the Gulf in the 1960s.

Put that way, the opportunity in Malaysia starts to make sense. Even more so once you dig into some of the recent developments in this nation-under-the-radar changes that may be positioning it as a go-to exploration destination for a new generation of junior E&Ps.

Big Potential, Small Production

Malaysia's petroleum potential is certainly proven.

In fact, the nation is a powerhouse in one segment of the business: liquefied natural gas. In 2011, Malaysia passed Indonesia as the second-largest LNG exporter on the planet-with Malaysian petro-major Petronas shipping a record 25 million tonnes of liquid gas. That puts Malaysia behind only LNG superpower Qatar.

The country also boasts another statistic that is oddly promising for oil explorers: falling crude production.

Last year, the country pumped just under 660,000 barrels of oil per day. An 11% drop from the 2008 production level of 740,000 b/d.  

You wouldn't think so, but this declining output could actually be a driver for opportunity in the Malaysian oil sector. With production falling, Malaysia's crude imports have surged 20% since 2010. The country is looking for more supply at a time when it is producing less.

The interesting thing is, Malaysia has a lot of in-ground oil. Between 2001 and 2010, some 167 oil fields were discovered here. Along with 242 gas fields.

But hefty taxes on production-which can run up to 38%--have left many of these fields undeveloped. As of 2012, only 76 oil fields and 48 gas fields were in production. Meaning that 55% of Malaysia's known oil is sitting untouched. Along with a whopping 80% of the country's gas reserves.

This has led to some big regulatory changes. Tax-friendly policies aimed at jump-starting oil and gas output to meet rising demand.

In 2012, regulators dropped the tax rate for undeveloped "marginal" fields to just 25%. The government has also cut export duties on oil from marginal fields-and allowed developers of such projects to accelerate their recovery of capital costs from production profits.  

These development-friendly tax rules may be unlocking a big prize. The reason why U.S. oil industry pros are eying the opportunities here-especially juniors like Energy XXI.

Look at the numbers. Malaysia's marginal fields contain an estimated 580 million barrels equivalent in oil and gas reserves. Which could add up to 55,000 boe per day in production once developed.     

While those figures wouldn't be material to a super-major like BP or Exxon, they would have a big impact on the bottom line of a smaller producer.

This potential is why international E&P spending in Malaysia has been rising. Up over 25% between 2009 and 2011. Foreign investors are seizing the obvious opportunity afforded by known oil pools in a place that desperately needs supply.

A Ground-Breaking Production Model

The opportunities in Malaysian marginal fields are particularly interesting given a novel type of agreement the government is using for these projects: risk service contracts (RSCs).

This new type of contract works differently than traditional production sharing contracts. Under the old type of arrangement, foreign investors would own a specified percentage of the in-ground oil. The partner would pay for expenses in developing the field. Then as crude was pumped, the firm would simply divert a share of the oil (or the profits from selling it) to the government.  

But risk service contracts work a bit differently. Under these schemes, the incoming partner doesn't actually own the oil field it is developing. It just acts as a contractor to the government in bringing the field to production and then maintaining it.

That has a few implications. First, the developing company isn't on the hook for capital expenditures in building the project. Partners are required to pay costs out of pocket initially. But all expenses are then reimbursed by the government.

Judging from the financial statements of current RSC operators, it appears this payback mechanism works quickly and effectively. In many cases, expenses are reimbursed within the same quarter they are paid.

Once the field is operational, an RSC owner receives payments from the government based on production. The firm doesn't actually own or sell the oil per se. In theory, the government does that. But as long as production is maintained steadily at agreed levels, the operating company gets a regular income stream in the form of fees.

This may in fact make RSCs the perfect vehicle for today's high-cost global E&P sector. With services rates rising, capital expenditure overruns are a major concern. The RSC structure however, removes all of this risk for the operator. With the government ultimately bearing all development costs.

RSCs probably won't be attractive to large E&Ps, because the contracts don't allow for field ownership. Meaning that operators won't be able to book reserves. A factor very important to majors who need to show reserve replacement to their investors.

But that may simply mean less competition for smaller companies-firms that could do very well under the RSC arrangement. In fact, Malaysian petroleum consultants Worldvest estimate that internal rates of return on RSCs may be higher than for traditional PSCs-at 7% to 20%.   

We should get an idea soon of industry appetite for the new RSC scheme. The Malaysian government carried out a new bidding round for RSCs on marginal fields this past summer. Which could add some new international players to this space-particularly juniors.  

Major Petroleum Players Are Moving In

Early-mover E&Ps in Malaysia's re-vamped petroleum sector are getting a lot of attention these days.

Particularly Coastal Energy (TSX: CEN).

Coastal was the only North American-listed E&P to sign an RSC with Malaysia through the initial bid rounds. In fact, it's one of only three companies in total that have been awarded RSCs to date-the others being London-listed oil field services firm Petrofac (LON: PFC) and Australian E&P Roc Oil (ASX: ROC).

Coastal signed its RSC in mid-2012, and has moved quicker than the others to exploit its awarded marginal fields, the KBM Cluster.

Since the fourth quarter of 2012, the company has spent nearly $11 million getting KBM ready for production. So far, all of these development expenses have been reimbursed by the government as per the RSC arrangement. A good sign that the new contracts are working as expected.

Start-up of production from KBM is expected before year-end, and should give the first indications on whether return rates for the RSC contracts are as high as predicted.

But major petro-players aren't content to wait for those numbers. This month, Compania Espanola de Petroleos-a wholly-owned subsidiary of the Abu Dhabi government-announced it will acquire Coastal Energy for $2.3 billion.

The move shows how international interest is increasing in Southeast Asia-this being one of the largest deals in the region recently. For a government like Abu Dhabi to be lured so far afield, they must see considerable potential.

Unfortunately for investors, the deal will make it more difficult to get data on the performance of Coastal's RSC operations going forward. But it is a big vote of confidence for Malaysia's new regime. Expect interest here to be running high as the nation awards its next round of contracts-expected any time now.