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Oil groups face capital stagnation in spite of price rises

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Oil groups face capital stagnation in spite of price rises

By Ed Crooks

Published: September 4 2008 03:00 | Last updated: September 4 2008 03:00

Everyone knows that oil companies are making spectacular profits. Even John McCain, the Republican presidential candidate, has described their earnings as “obscene”.

That popular impression, however, is deeply misleading. While company profits have indeed risen to record highs as the price of oil has soared, their profitability as measured by return on capital employed has stagnated.

The IHS Herold/Harrison Lovegrove study of oil and gas companies’ upstream businesses found their average return on capital last year was just 1 percentage point higher than in 2004, even though the average price of oil during the year was $30 a barrel higher.

With the price of oil already almost $40 a barrel off its peak over the summer, and quite possibly headed lower, the profitability of the industry could signal trouble ahead.

“I think we are on the brink of some very dramatic changes,” says Bob Gillon of IHS Herold, a research firm. “Demand growth has exceeded supply growth for the past four or five years, leading to a decline in the margin of spare supply capacity. If demand weakens, it will probably weaken the price of oil, and that will put the industry into a very different investment environment from the one it has been in for the past five years.”

Oil companies’ revenues have, of course, soared in line with commodity prices over the course of the decade. But much of the benefit of those soaring revenues has not flowed through to their shareholders.

Capacity shortages in the supply chain, in everything from drilling rigs to steel pipes to skilled staff, have sent costs rising in line with revenues.

Services companies, which work for the oil producers, have typically done much better out of the boom in the industry.

Since the start of 2004 shares in ExxonMobil, the world’s biggest quoted energy company, have risen by 89 per cent. Shares in Schlumberger, the biggest quoted oil services group, are up 231 per cent. The other big winners from rising commodity prices have been the governments of resource-rich countries.

Governments from Algeria to the UK have been tightening the terms on which they deal with oil companies, through tax increases, contract renegotiations, and in the most extreme cases forced transfers of assets.

The IHS Herold/Harrison Lovegrove study found the companies’ average revenue per barrel was $13 in 2007, the same as in 2006.

Even after giving the service companies and the governments their bigger slice, oil company profits have still been rising to record levels. Their return on capital has been limited however, by the massive investment programmes these companies have been undertaking. Exxon will spend $25bn this year.

David Thomas of Citigroup points out that much of the spending oil companies have been making has been on projects that are not yet in production.

“These companies have been playing catch-up after the oil price collapse at the end of the 1990s. Low oil prices caused many of them to cut their capital spending, and now they are realising that to maintain production, they need to spend more. So a higher proportion of their capital is now non-productive.”

As the price of oil falls, some of the pressures that have squeezed profits on the way up will ease. New drilling rigs are coming into service, new engineers are being trained.

But Rodney Schmidt, a managing director of Standard Chartered bank, which owns Harrison Lovegrove, warns that that may not be enough to stop profits falling.

“Costs do tend to follow commodity prices, but the question is: what is the lag time,” he says.

“The government take has also increased around the world, and it tends to be stickier on the way down than on the way up.”

Colin Smith of Dresdner Kleinwort believes that as expectations about future oil prices decline, forecasts of oil companies’ earnings will be cut back.

High rewards

Big oil companies’ prospects have for years been overshadowed by their problems in getting access to resources to enable them to grow. If the oil price keeps falling, and the squeeze on profits continues, the pressure for change could be enough to prompt another round of restructuring.

Mr Gillon says: “It is an industry in transition. None of the managements of the larger companies are content with zero production growth, so they are looking for ways to change their businesses.

“I can see aggressive spending on organic growth, and organic spending on acquisitions.”

The highest returns in the world for oil and gas companies are to be found in the Asia Pacific region, Russia and the Caspian, and Africa and the Middle East, according to the IHS Herold/Harrison Lovegrove study. The lowest are in Canada, which includes the oil sands and the US.

In part this may be a reflection of the risk-reward trade-off. Returns need to be higher in Russia, for example, to persuade companies to invest there when there is the risk of having assets forcibly taken over, as happened to Royal Dutch Shell with its Sakhalin II oil and gas project.

However, the study’s authors believe the figures also reflect the privileged positions enjoyed by companies operating in countries where resources are plentiful and costs are relatively low.

Bob Gillon, of IHS Herold, said: “The high returns in some of these regions look like evidence of the profit potential available for companies with a legacy position in those areas.

“It speaks to the lack of access to opportunities in the most attractive locations. Everybody would like to have more access to oil in the Middle East, but how can they get it?”

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