[R-G] Oil Groups Face Capital Stagnation in Spite of Price Rises

[Yoshie Furuhashi]

<http://www.ft.com/cms/s/0/a165ad24-7a19-11dd-bb93-000077b07658.html>
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?"