Big Worries for Big Oil

CARACAS Oct 24, 2006 (Dow Jones Newswires from the Wall Street Journal)

With crude prices falling and oil-field costs on the rise, major oil companies have a big problem: sustaining their phenomenal profit growth.

Exxon Mobil Corp., Royal Dutch Shell PLC and BP PLC have all relied on big oil-price jumps to fuel a streak of handsome earnings gains and, in many cases, record quarterly profits in recent years. The three companies reported combined earnings of about $25 billion in the second quarter; in the third quarter of last year, they earned about $25.4 billion.

Many of the world's biggest publicly traded oil companies report earnings this week and are expected to post strong results, thanks to high crude prices.

U.S.-benchmark oil hit a record of nearly $80 a barrel this summer. (In inflation-adjusted terms, oil was at its most expensive in 1980.) Since July, though, crude prices have fallen about 25%, sapping the momentum from short-term profit-growth potential at a time of rising costs and higher taxes. And if oil prices continue to drop, that could drive new thinking among oil executives over whether to pursue big tie-ups.

BP, which reports earnings today, estimates West Texas crude, a benchmark oil type in the U.S., averaged about $70 a barrel for the quarter. That is still higher than the average price a year ago of about $63. But current prices are now hovering around $58. U.S. natural-gas prices and gross profit margins from making refined products such as gasoline are also sharply lower than a year ago.

Even before the steep drop-off in prices, earnings had been blunted by side effects of the commodities boom. Oil-field costs have skyrocketed for many projects because of higher demand for everything from steel to software among energy companies eager to cash in on the boom. Competition for new prospects has heated up, ratcheting up auction prices for fresh exploration acreage.

If oil prices stabilize or drop further, cost inflation could also subside. But costs generally take time to catch up with swings in commodity prices. That poses a growing challenge to profitability in the short term.

Neil McMahon, a London-based oil analyst at Sanford C. Bernstein, says recent trends of lower commodity prices and higher costs mean quarterly results this time around aren't likely to offer much positive surprises for investors. In a note to clients Friday, he said he expects to see further evidence of cost pressure when companies report this week.

A handful of big companies suffered significant production shortfalls in the July-to-September quarter because of unplanned disruptions. BP partially shut down its big Alaskan oil field because of pipeline corrosion there, crimping its output and that of its biggest partners in the field, Exxon and ConocoPhillips. Shell continues to suffer partial shutdowns in Nigeria, amid violent insurgency attacks in that major oil-exporting nation.

Oppenheimer & Co. analysts expect the major oil companies to post third-quarter earnings about 10% above results from a year ago but about 10% lower than this year's second quarter because of production shortfalls, cost and tax increases and moderating oil prices.

Many companies are expected to post higher profit margins from chemical operations and from marketing, which includes sales as gasoline stations, partly compensating for lackluster commodity prices.

If prices continue falling, two other big questions for investors may emerge: Will the world's largest oil companies curb their generous share-buyback programs? And will they start looking for acquisitions, now that share prices have fallen along with commodity markets, making some targets look cheaper?

So far this year, BP has showered investors with $12.3 billion in buybacks and dividends. In July, Exxon said it would increase spending on buybacks to $7 billion in the third quarter, up from $6 billion in the second quarter.

But shareholder payouts can be sensitive to commodity-price swings. For instance, BP has said it expects to deliver about $65 billion to shareholders through 2008 if crude sticks at $60 a barrel and if U.S. natural-gas prices and refining margins stay lofty. Those expected proceeds would fall more than 20% if commodity-price assumptions were revised down to the $40-a-barrel level.

Jeroen van der Veer, Shell's chief executive, has said repeatedly that he didn't see value in making big purchases amid recent high oil prices. Yesterday, he announced Shell had made an approach to the board of Shell's main Canadian affiliate, with an offer to buy out minority shareholders for about C$7.7 billion, or about $6.8 billion.

In an interview, Mr. van der Veer said the timing of the approach was more about creating long-term value, not about getting a bargain at today's lower oil prices. He said the current oil price "is probably one component of a total mix" of factors determining the decision to pursue the deal, and said Shell hadn't changed its acquisition strategy.

Fanning speculation of a fresh round of oil-patch deals, Premier Oil PLC, a small British independent oil company, said yesterday it had received a buyout proposal from an unnamed party. Premier, with a market capitalization of about GBP 1 billion, or $1.9 billion, said negotiations were at "an extremely early stage."

Jeffrey Ball and Russell Gold contributed to this article.

Copyright (c) 2006 Dow Jones & Company, Inc.

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