Big Oil: Booming Profits, Climbing Costs

Oil companies are raking it inand spending it, too

Oil companies' financial results look great this year, thanks to high prices. But those healthy profits are masking costs that keep getting worse. A raft of companies trotted out stunning earnings in late July for the three-month period ended in June. Some increased their multibillion profits by more than 30% year over year; the Irving (Tex.) oil major Exxon Mobil (XOM), for example, announced on July 27 that it had a record net income of $10.36 billion during the second quarter, up from $7.64 billion during the same period of 2005.

One day earlier, Houston's ConocoPhillips (COP) reported second-quarter net income of $5.19 billion during the same period, compared to $3.14 billion for the second quarter 2005. European oil giant BP (BP) on July 25 said it had net income of $7.27 billion in the second quarter, from $5.59 billion a year earlier.


  Profits are booming, but energy outfits have to work harder—and spend lots more—to keep pulling ever-pricier oil out of the ground. That has fueled a spending competition for services such as drilling equipment, driving up companies' business costs for the past couple years.

And developments in recent months—such as higher taxes and new investment projects—are not the kind that will go away if oil prices fall. Meanwhile, experts are debating whether the global economic demand that's been boosting prices this year can be sustained.

"If oil prices go down or stay the same and you still have cost inflation, then there's the risk that margins will get squeezed in that environment" says Craig Pennington, global-energy portfolio manager at Schroders in London. Although high prices continue helping oil companies so far, Pennington noted that in a weaker environment, high-cost operators experiencing the biggest cost inflation will be among the first to suffer.

Are oil companies using their windfall to grow their businesses—or merely wasting it on inefficient projects? Credit Suisse (CSR) found in a July 19 report that almost all of the global integrated oil companies had higher return on gross invested capital, or ROGIC (i.e., money earned as a percentage of that invested), in 2005 compared to 2004. The companies that excelled in getting the most bang for their buck included the Austrian oil and gas group OMV and Houston's Marathon Oil (MRO), which increased their ROGIC year over year by 6% and 5%, respectively.

On the other end of the spectrum, Oslo's Norsk Hydro (NHY) and San Ramon (Calif.) Chevron (CVX) both decreased their ROGIC by 2%. (Chevron didn't respond to a request for comment by press time.)


  To be sure, oil company executives aren't assuming they'll always rake in more than $70 per barrel, as they have been this month on West Texas Intermediate crude oil contracts for delivery in September.

Norsk Hydro's spokesman Tor Steinum says that even if oil prices drop back to the $30 to $35 per barrel range, recent investments will remain "marginally" profitable. (One of the company's major recent purchases was Houston-based Spinnaker Exploration. Hydro expects to produce more in the Gulf of Mexico in the coming years as a result.)

Steinum pointed out that until two years ago, Norsk Hydro had assumed long-term prices of $18 per barrel when deciding to make new investments.

Industry executives have spotlighted the dark clouds amid the blue skies of high profits.


  "We don't have wiggle room" in our budget for cost inflation, said Jim Mulva, chairman and chief executive officer of Houston's ConocoPhillips (COP) during a conference call on Wednesday. Like other companies in the industry, escalating costs are pressuring every part of Mulva's business. Managing them is "difficult," he says.

During the past three years, ConocoPhillips has invested more capital into energy development than it earned in net income. After buying Burlington Resources earlier this year, the company's interest expense and other costs rose. Total debt amounted to $29.5 billion at the end of the second quarter, 27% of the company's overall capital, compared to only $12.5 billion total debt as of Dec. 31, 2005.

After adding in Burlington Resource's capital spending program to its own, ConocoPhillips expects to plunk down $18 billion for 2006. Despite its smaller overall earnings, ConocoPhillips' plans are now only $2 billion behind those of its rival Exxon, which announced on Thursday that it plans to hike capital spending for 2006 by $1 billion to $20 billion.


  Capital spending isn't the only worry. Taxes are among the newer cost problems that many companies face. Venezuela's President Hugo Chavez has been playing hardball with foreign oil companies this year, hiking their taxes and encouraging other countries to do likewise.

But Chavez isn't the only one to write up a new bill for oil companies. In July, the United Kingdom enacted higher income tax-rates retroactive to the beginning of the year. Meanwhile Gennadiy A. Zlivko, mayor of Korsakov at the southern end of Russia's Sakhalin Island, has fought to charge higher rent for operating a liquefied natural gas site in the area.

The tax collector isn't the only one to blame. Several companies have seen glitches in projects that needed fixing. Hess (HES), of New York, is saying that it faces higher costs due to "unique maintenance situations"—a spokesman declined to provide more detail to describe them. Earlier this year, Hess said it would cost between $17 and $19 to produce each barrel of oil in 2006. On July 26, execs said they thought production costs will be at the high end of the range for the year and more than $19 during the third quarter.

In another example, the Stavanger (Norway)-based Statoil has delayed by eight months to December 2007 the start of gas deliveries for its Snøhvit project, the first offshore development in the Barents Sea. The company explained that after delayed engineering, deficient quality, and other problems, it had to transfer work to Melkøya, where it takes longer and costs more to finish.

In their attempts to drill under the waters surrounding Russia's Sakhalin Island, oil companies have met with delays, heavy snow, angry environmentalists, protesting indigenous locals, and cost overruns. Royal Dutch Shell PLC announced in 2005 that it would have to double the price tag for the main phase of its Sakhalin II project, to $20 billion (See, May 15, 2006, "Sakhalin Island: Journey To Extreme Oil").


  The hangover from Katrina isn't even done yet. BP continues repairing facilities where the hurricane had blasted in late 2005. It found two leaks this May in subsea equipment at Thunder Horse, an offshore drilling site southeast of New Orleans. The company expects to replace the damaged pipes and start production in 2007. The British company said on July 25 that it plans to spend $15.5 billion to $16 billion on its business, up slightly from previous guidance of $15 billion in February.

Meanwhile the ongoing cost problems arising from booming profits continue getting worse. BP's Chief Executive John Browne also said during the company's July 25 conference call that the maximum price for using a drilling rig in ultra-deep water amounts to around $500,000 per day right now, compared to $200,000 per day toward the middle of 2004.

Schroders' Pennington, who must invest his entire portfolio in energy companies but has the freedom to decide which ones, has been underweight in the integrated oil-and-gas sector for the past 18 months. Instead, he's been overweight in oil-services companies during the same time period. They're the ones who sell equipment such as drilling rigs to oil companies. He declined official comment on specific companies.

While it isn't time to break out the violins for the oil majors, investors should be aware that increasingly heavy costs are accompanying the outsize profits—and may stick around even if oil heads back down.

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