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The Independent on Sunday: Oil’s big beasts dive for cover

Business Analysis

By Abigail Townsend
Published: 24 September 2006

Not so long ago, it was the best of times to be an oil company. There may have been the dark cloud of environmental issues, but that alone could not dent the cheerful corporate mood. Demand was high, prices were soaring and profits gushed.

Yet last week demonstrated just how much tougher things are getting as BP and Shell both hit the headlines, the former for delays to its Thunder Horse platform in the Gulf of Mexico and Shell for a run-in with the Kremlin. Nor are these one-off events but part of a mounting set of problems that could upset the status quo for the oil majors.

Take BP, whose Texas City refinery was hit by an explosion last year that killed 15 and injured many more. BP was heavily criticised and fined for health and safety failures, and it faces civil prosecutions. The company is also having to contend with the fallout over its new Thunder Horse platform in the Gulf of Mexico. This had been due to start production by the end of last year but that schedule had to be put back when the platform was damaged by Hurricane Dennis. Now, further tests have revealed that its launch will be delayed yet further, from 2007 to mid-2008.

“While not a bolt from the blue, the news confirms market fears and we are cutting our group forecasts,” said Oriel Securities in a research note. The broker reduced its production expectations by 175,000 barrels for 2007, while earnings were slashed by $1.1bn (£578m) for 2007 and by $500m for 2008.

Others were similarly downbeat. Merrill Lynch, for example, cut its forecasts for exploration and production volumes by 3 per cent and 3.5 per cent for 2007 and 2008 respectively, with analyst Mark Iannotti adding: “This is more bad news for BP and Thunder Horse. It will do little to steady investor nerves.”

Because as well as Thunder Horse and Texas City, there has been a federal probe into alleged manipulation of energy prices, and spills at BP’s Prudhoe Bay operations in Alaska.

Shell is also suffering. The company made all the wrong headlines in 2004 after the revelation that it had overstated reserves. While this prompted a shake-up in its structure, its problems aren’t over, with Russia being the latest issue to occupy management. The country tried last week to stop the development of Shell’s biggest gas project, its 55 per cent stake in the $20bn (£10.65n) Sakhalin 2 field in the frozen wastelands of Siberia. Russia said it had environmental concerns – the field is close to a breeding ground for rare grey whales – and that the oil and gas development agency had been asked to cancel Shell’s licence. The Kremlin then said that talks about Russian giant Gazprom taking a stake in the project had stalled.

Analysts, however, believe the problem is little to do with green issues and all to do with power and control, as Russia – after the sell-off of state assets in the 1990s – strives to take a firmer grip of its natural resources.

As Morgan Stanley points out in a research note called Twilight Zone: “The Russians are applying pressure to Shell at Sakhalin, [and] they appear to be applying pressure to both Exxon and Total as well.” Neither is the heat off BP. Although its Russian joint venture, TNK-BP, was created with the blessing of President Vladimir Putin, “there is still a risk of BP’s position in TNK-BP, or at least its influence on it, coming under pressure at some point”.

Coupled with this is the growing dominance of the Russian oil sector, with companies such as Gazprom and Rosneft international players in their own right. “Driving this process has been a clear thrust of government policy,” notes Morgan Stanley, “which favours domestic ownership of strategic assets and a sharp increase in the share of Russian oil and gas formerly under state control”.

But the news is not entirely bad. For one thing, we all need energy, and for another, investors still love the sector – and in particular the amount of cash that these companies generate, no matter what problems they encounter. As one fund manager, who holds both BP and Shell, says: “I can’t see any reason to sell out of them. They just have such good cashflows.”

Most also believe that BP, especially, will use this money wisely. The cost of replacing the affected systems on the Thunder Horse platform has been estimated at around $300m by analysts – the company has not yet confirmed what it is paying – but that is not stopping the cash-rich company from proceeding with its recurring share buy-backs. UBS, for example, has raised its forecast for the buy-back in 2006 by $500m to $17.5bn, and then by $2bn to $16bn next year.

Of course, things could, and probably will, get worse before they get better. Although BP has not spoken publicly at length about the various issues facing the company, reports last week claimed its chief executive, Lord Browne, had been addressing investors, bracing them for another six months of bad publicity.

There are also big risks outside corporate control that could dampen the enthusiasm of even the most adamant investors – primarily geopolitical issues or a major decline in the oil price.

Until then, however, the oil majors have little choice but to batten down the hatches and weather these latest storms.

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