Big Oil Faces Headwinds in 4Q Return to Profit

LONDON (Dow Jones), Oct. 30, 2009

This year's rebound in the crude oil price means major oil companies' third quarter earnings could mark the last in a long sequence of crushing year-on-year profit falls. However, big oil's path back to growth faces stiff headwinds from continued weakness in two key markets.

While average fourth quarter crude oil prices are currently up more than 25% from their year-ago level, natural gas prices and refining profit margins remain stubbornly unresponsive to expectations of economic recovery.

Figures from Royal Dutch Shell PLC, which reported a 62% year-on-year drop in third quarter net profit Thursday, illustrate the challenge this poses to oil companies.

Despite the oil price rising 14% from the second to the third quarter, weak natural gas prices meant Shell's total upstream earnings actually fell 26% over the same period.

"The environment for gas and liquefied natural gas trading is relatively poor and has deteriorated versus the second quarter this year and its year-ago level," said Chief Financial Officer Simon Henry.

Shell also gave a weak outlook for the other main segment of its business -- refining crude oil into products like gasoline or diesel. "Refining margins are unlikely to recover in the short or medium term," said Henry.

According to BP PLC data, the amount of money a refiner on the U.S. Gulf Coast can make from refining a barrel of oil has averaged $1.67, just two-thirds its fourth-quarter 2008 level.

Refined product demand was so weak that Shell's total refining throughput was down 4% on the previous quarter and 8% on the year, primarily due to voluntary output cuts, Henry said.

"This is the first time (throughput) has been below 3 million barrels a day in our entire period of analysis spanning nearly twenty years," said NCB Stockbrokers analyst Peter Hutton. "Shell has been badly hit by globally weak refining margins."

Other major oil companies face the same problems.

BP, which surprised the market with much better than expected third quarter profits Tuesday, secured an average price for its oil in the third quarter that was 20% higher than in the second quarter. But its average natural gas price fell slightly.

Italian oil company Eni SpA, which reported a 61% drop in third quarter net profit Thursday, suffered from a steep decline in gas consumption in its home market due to weak industrial demand.

And U.S. oil major ExxonMobil Corp. saw its third quarter refining and marketing earnings fall 90% year-on-year, far outstripping the company's overall earnings decline of 68%.

The prospects for a quick improvement look slim. "We would need to see a combination of a robust economic recovery, as well as significant refinery closures and sustained run cuts for margins to recover in earnest," something not likely to happen until 2012, analysts at Bernstein Research said in a report.

Demand for diesel, which is closely tied to economic activity in the U.S. and Europe, is key, said Bernstein. Yet even if that demand starts to grow, a large supply overhang and overcapacity remains.

"U.S. primary distillate stocks remain 10% above their prior peak in 1999 and OECD distillate inventories as of August were at their highest level in a decade," Bernstein said.

Economic growth in China and India is driving a recovery in Asian demand, "but that doesn't really help us because a very significant amount of refining capacity has come onstream in that area," said Shell's Henry. "Margins in Asia were negative for part of the (third) quarter," he said.

The outlook for natural gas is also weak. According to BP data, the average U.S. Henry Hub natural gas price this quarter has been $3.72 per million British thermal units, a little over half its price a year ago. The U.K. gas price is just 44% of its year-ago level at $4.13 per MMBtu.

In both countries, natural gas supply remains ample for domestic demand reduced by anemic industrial output. Stocks of natural gas in the U.S. are 13% above the five-year average and the U.K. continues to be a dumping ground for surplus cargoes of liquefied natural gas that are unwanted elsewhere.

On mainland Europe, demand is so weak that customers of Russia's OAO Gazprom have used less than the minimum amount of gas required under long-term contracts, leaving an overhang of undelivered gas worth $2.5 billion.

There is one bright spot for companies contracted to supply LNG into Europe or Asia, such as Shell, ExxonMobil or BG Group PLC. The price of LNG supplied into Asia or mainland Europe on long-term contracts is typically priced in relation to oil with a four to six month lag, said Henry.

This points to significant profit growth in these markets, said Collins Stewart analyst Gordon Gray, even if U.S. and U.K. gas prices remain stuck in a slump.  

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