BP (NYSE:BP) recently signed a deal with the Government of the Sultanate of Oman for the development of a huge natural gas field. The project forms a key element of the government of Oman’s plan to ensure that the growing consumption of natural gas is mostly met through domestic supply. However, we believe that despite its huge resource potential, BP’s return on investment from the project might not be as attractive, due both to higher costs associated with the development of tight gas reserves and to pricing concerns. 
Headquartered in London, BP is one of the world’s leading oil & gas multinationals with operations in more than 80 countries. As a vertically integrated oil and gas major, it has both upstream and downstream operations. The upstream division primarily includes exploration and production activities for oil and gas, while the downstream division focuses on producing refined petroleum products such as gasoline.
The Growing Natural Gas Demand In Oman
Natural gas consumption in Oman has been growing rapidly over the past few years and is expected to grow further amid rising industrial demand. According to the U.S. Energy Information Administration (EIA), Oman’s natural gas demand increased by ~170% between 2002 and 2011.  More recent statistics from the Sultanate of Oman’s National Center for Statistics and Information (NCSI) show that natural gas consumption continues to grow strongly in the country. During the first nine months this year, Oman’s natural gas consumption grew by ~6% over last year on increased use in the ongoing Enhanced Oil Recovery (EOR) projects. 
The implementation of EOR projects has helped Oman reverse the decline in crude oil production since 2007, and these projects remain key to its future oil production growth as well.  Now, most EOR techniques involve the use of natural gas to create high pressure and temperature conditions for oil recovery. This is one of the key factors driving higher natural gas demand in the country, which is causing the government to focus on increasing its supply. According to the NSCI statistics, natural gas consumption in Oman’s oil fields surged by ~18% during the first nine months this year. 
Although currently Oman exports ~500 billion cubic feet (bcf) of natural gas every year as liquified natural gas (LNG), it plans to divert all of its LNG exports to meet the growing domestic demand by 2024. Oman also signed a 25-year natural gas import deal with Iran this August. 
Attractive Resource, But What About The Deal?
In 2007, BP entered into an exploration and production sharing agreement with the government of Oman for appraisal and development of Block 61, which includes the Khazzan-Makarem tight gas fields. These fields hold huge reserves that can boost Oman’s natural gas production for years to come. BP’s appraisal estimates suggest that there is between 15 and 20 trillion cubic feet (tcf) of recoverable natural gas in the play. The company plans to tap this huge resource at a peak rate of around 1 bcf/day, which is almost one-third of Oman’s current domestic supply rate. 
BP estimates the gross cost of the project at $16 billion, of which $1.5 billion have already been spent. The company holds a 60% stake in the project, while state-owned Oman Oil Company Exploration & Production (OOCEP) holds the other 40%. This implies that BP plans to invest ~$10 billion over the next few years in developing the Khazzan gas field, which is equivalent to around 40% of its target annual capital expenditure. According to the agreement, 55% of the project’s net revenue would go to the government of Oman, while the remaining 45% would be distributed between the two joint venture partners. 
However, there are significant technical challenges involved in the development of tight gas reservoirs as these are found in relatively impermeable rocks, and their recovery ratios are also small compared to conventional fields. While a conventional gas formation can be relatively easily drilled and extracted from the ground unassisted, tight gas requires more effort to pull from the ground because of the extremely tight formation in which it is located. Therefore, per unit development and production costs of the project will be higher than those associated with some of the conventional fields operated by BP.
Apart from this, while company did not reveal pricing details of the agreement, we are not particularly optimistic about it. This is because the government of Oman heavily subsidizes natural gas, gasoline and electricity for end consumers, which not only makes the country’s energy market inefficient by artificially boosting consumption demand, but also raises deficit concerns that weigh on the price delivered to private players. In a rare reform, the government of Oman recently decided to double the price of natural gas for some industrial consumers from $1.5 per million British Thermal Unit (mmBTU) to $3 per mmBTU by 2015. That is still below the depressed U.S. Henry Hub natural gas prices and extremely low by international standards. These factors lead us to believe that returns on the project might not be as attractive as the resource itself. Notes: