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THE WALL STREET JOURNAL: Oil Sector's Next Big Test: 2006

Strong Profits Again Expected,
But Challenges Await Industry;
Dodging Capitol Hill's Bullet
January 23, 2006; Page C1
How long will the gusher last?
Most oil companies are likely to shatter records when they post fourth-quarter earnings over the next several days. But the market already is looking beyond those results to the challenges the industry will face trying to maintain its boom.
Those are many. There is the difficulty of repeating last year's stellar rate of earnings growth given that oil prices, though they jumped last week on fears about potential supply disruptions in Iran and Nigeria, aren't expected to achieve the percentage gains in 2006 that they did in 2005.
There also is the possibility of renewed pressure in Washington for higher taxes on industry profits as this year's midterm congressional elections approach.
And there is the continuing challenge of finding enough new oil and natural gas to replenish what the industry is pumping out of the ground.
Other industries, of course, would love the oil patch's problems. Last year, riding soaring oil and natural-gas prices, the Dow Jones Oil & Gas Index racked up a 32% return, more than seven times the return of the Dow Jones U.S. Total Market Index and more than double the return of any other industry-specific Dow Jones index.
Some sectors within the energy industry — notably dedicated refiners, which turn crude oil into finished products like gasoline and heating oil — saw their stock prices more than double, partially because last year's hurricanes knocked out much of the nation's refining capacity, sending the market prices of those finished products soaring.
Moreover, though the high prices prompted much consumer bellyaching, they didn't meaningfully damp consumption. U.S. gasoline demand slipped below year-earlier levels when pump prices spiked immediately following the hurricanes, but now it is back above year-earlier levels, according to the Energy Information Administration.
ConocoPhillips is scheduled to kick off the major oil companies' fourth-quarter reporting when it releases its results Wednesday. Fadel Gheit, oil analyst at Oppenheimer & Co., sees average fourth-quarter earnings gains of 25% for the major international oil companies, 86% for the smaller firms that focus on exploration and production, and more than a doubling for refiners. Mr. Gheit owns stock in Exxon Mobil Corp., BP PLC, Royal Dutch Shell PLC, Chevron Corp., ConocoPhillips and Devon Energy Corp. Oppenheimer doesn't have investment-banking relationships with oil companies.
As for 2006, it is likely to be another good year for the energy industry, though probably not as good as 2005. The administration predicts that the price of West Texas Intermediate crude oil this year will average $63.27 a barrel. That would mark a 12% rise from last year's average price. While that is a significant jump, it is nothing like the 36.3% price surge in 2005 over 2004. Even if concerns about possible supply disruptions push crude prices this year higher than the EIA predicts, that jump would have to be significant to match the price surge that the oil industry enjoyed in 2005 over 2004.
For natural gas, the EIA forecasts an average residential price this year of $14.57 per thousand cubic feet, up 14.5% from last year, a bit weaker than the 18.6% price jump in 2005 over 2004.
According to Oppenheimer's Mr. Gheit, annual 2006 earnings are expected to jump 7% for the majors, 30% for the exploration-and-production independents and 10% for the refiners.
An industry sector worth watching will be refining. Analysts expect that refining profit margins generally declined in the fourth quarter from soaring third-quarter levels, but they also predict strong refining margins in the coming year, particularly as new federal regulations requiring cleaner fuel take effect.
One wild card is what happens on Capitol Hill. In November, after oil companies reported record posthurricane earnings, Congress held hearings on whether to restore a “windfall-profits” tax on the industry and called oil executives to testify in front of television cameras. Most of those proposals have faded away, but not all.
Still on the table are two provisions that would effectively raise the tax bills primarily of five major oil companies: Exxon, Chevron, BP, Shell and ConocoPhillips. The provisions have passed the Senate but not the House. One would reduce the companies' ability to trim their tax bills through a longstanding inventory-accounting method known as “last-in, first-out,” which ties the cost of goods sold to the cost of the most-recent purchases. The other would prohibit the oil companies from continuing to claim credits against their U.S. tax bills for the taxes they pay in certain oil-rich countries where they operate.
Kenneth Cohen, Exxon's vice president for public affairs, says the company sees the tax proposals as a “serious” threat. Exxon says today's high oil prices are based on market factors beyond the company's control, and the company isn't trying to take advantage of consumers.
Despite the industry's expressions of concern, many analysts say such anti-oil legislation has little chance of becoming law. Oil companies “pretty much have dodged the bullet. Most of the political rhetoric in Washington has died down,” says Jennifer Rowland, oil analyst at J.P. Morgan. She doubts the House will endorse the Senate-approved tax provisions targeted at the oil industry. Ms. Rowland doesn't own stock in any of the companies she covers. J.P. Morgan has investment-banking relationships with Exxon, Chevron and several other oil companies.
Longer term, perhaps the biggest issue facing the energy industry is its increasing difficulty finding enough new fossil fuel each year to replace what it is producing. In 2004, several oil companies failed to book enough new “proved reserves” to replenish the oil and natural gas they produced, at least according to the reserves-accounting method favored by the Securities and Exchange Commission. The oil industry, arguing the SEC's accounting method is too pessimistic, is trying to persuade the SEC to change its method.
Oil companies typically report their reserve-replacement ratios in the weeks following their fourth-quarter earnings reports. Generally, smaller companies find replacing their reserves easier than bigger companies, because they have a lower annual production level that they have to cover.
Write to Jeffrey Ball at [email protected]

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