The search for oil on "the roof of the world" got more serious.
Over the weekend, Norway's Statoil ASA (NYSE:STO) signed a massive exploration deal with Russian behemoth Rosneft in a venture that may require more than $100 billion in investment over the next few decades.
Specifically, the company is aiming to help Rosneft develop untapped oil resources in the Arctic, as Moscow struggles to gain a competitive advantage given declining conventional oil and gas production in Eastern Siberia.
The deal highlights a number of key issues for both companies and for Moscow moving forward.
For Russia, some of its most mature conventional oil basins are declining in output rapidly, at a pace that could reach 8% a year within this decade. With production waning and concerns about long-term supplies accelerating, Russia has no choice but to venture into the north.
But they know that they cannot make this push alone.
Such a radical change in procurement is technologically sensitive… and very expensive. Moscow needs outside investment and the most advanced technology to push into the hostile, energy-rich environments of the vast Arctic and East Siberian basins.
At the same time, Statoil has been scrambling to find new ways to get more involved in this push north. In recent months, oil giants Exxon Mobil Corp. (NYSE: XOM) and Italy's Eni SpA (NYSE:E) had been very active in working with Moscow to develop in these oil-rich environments.
In the wake of Russia's slumping reserves and production in Siberia, the Kremlin has been looking for ways to incentivize producers to help Rosneft replace waning production. Tax breaks have been one way, but companies also want a little bit of insurance when they work with Moscow.
The major question, of course, is this: How can shareholders know that Moscow won't expropriate any major resource finds, should the exploration deal succeed?
The answer is "hostage taking."
Taking Hostages in the Arctic
A key feature of this Statoil deal is a strategy known as "hostage taking." And it says a lot about the future of energy production and the cooperation required between multinationals and political leaders.
Statoil and Exxon (in their respective deals) are convinced they can protect themselves against the risk of having any major reserve discoveries expropriated by Moscow.
Both deals allow Rosneft to buy stakes in Statoil and Exxon-led exploration projects in the Arctic and elsewhere in the world. By encouraging greater exploration project cooperation around the globe, the companies are better able to reassure their individual shareholders.
This requires a lot of trust.
The real risk here comes if Statoil-led projects fail to produce any significant resource discoveries, while the Rosneft-led projects lead to massive reservoir finds. In that case, the hostages have no value.
But even if Rosneft were able to "freeze" Statoil out of the Arctic find, there's one major problem. The Russian behemoth is in no position to actually produce the resources itself, given the lack of technological expertise and ongoing capital concerns.
So the Statoil-Rosneft agreement is yet another massive deal that we've seen develop in the Arctic with a sound economic and political risk strategy to boot.
Just last month, Exxon and Rosneft agreed to begin finalizing their initial $3.2 billion Arctic deal that would require about $200 billion for joint projects in the next decade alone, and the development of 10 ice-proof platforms for the Kara Sea that would cost about $15 billion each.
That deal was the latest in a string that included Royal Dutch Shell's icebreaker contracts with Finnish suppliers, and TNK-BP's joint ventures in the Yamal-Nenets region of Russia.
These deals point out the obvious. The Arctic is the last great frontier of energy production in the world.
The U.S. Energy Information Administration reports that as much as 22% of the world's undiscovered oil and up to 30% of its natural gas could be in the Arctic Circle alone.
But none of this exploration and production will be cheap, which can only mean one thing.
Unconventional Sources Are Needed Moving Forward
Oil prices have retreated right now to 2012 lows, while retail investors panic.
Concerns about Greece, Spain, and Italy are wearing down investor confidence. Meanwhile, the Iranian embargo looms large for July 1. The Saudis have guaranteed to meet the supply these three countries will lose, but they aren't going to guarantee the price.
The world, whether in a recession or in high times, still runs on oil. And the bottom line is that cheap, conventional sources are declining rapidly, while the influx of unconventional projects continue to ramp up. We'll see greater interest in Arctic production and greater cooperation between multinationals and governments in the coming months and years.
Multinational corporations don't enter the most hostile environments engineers have ever seen because they enjoy the challenge. They are doing so for profits, and because they are quite aware that the cost of energy in the future and the ongoing political stakes around the world require development of these resources.
The costs will be much higher to produce, the technological complications will accelerate, and political tensions can create significant setbacks.
But, over time, the investment opportunities and profits will be greater than ever.
Oil & Energy Investor