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The Wall Street Journal: Breaking Views: Oil

October 27, 2006

Big Oil is at its peak. Investors in industry giants like Exxon Mobil, Royal Dutch Shell and BP have enjoyed a very good past few years as energy prices have climbed. But if the next few years are less rewarding, rising costs as much as lower oil prices will be to blame.

Look at Shell. Investors have raised their hats to the European energy giant, which just produced a stronger-than-expected rise in third-quarter earnings. Yet Shell’s underlying picture was more worrying. Margins thinned, as its cost of sales rose twice as fast as revenue, and Shell’s return on capital slipped from 26% in the second quarter to 23% in the just-ended quarter.

Other firms are also suffering. BP’s earnings fell from the second quarter, as did ConocoPhillips’s. Even at mighty Exxon Mobil, which just announced a record $10.5 billion quarterly profit, costs edged ahead faster than revenue.

The drop-off in profitability is inevitable. Costs are soaring as the industry catches up on two decades of underinvestment when oil prices were low. Oil firms are also moving into bigger and more complex projects to try to boost reserves. This has bid up the price of pipes, engineers, oil rigs and steel. Meanwhile, rising oil prices are no longer providing a helpful tailwind.

Investors have noticed the problems. In the U.S., oil shares have done no better than the broader market since the start of the year. In Europe, oil producers have even underperformed by about 12%. Falling profitability plus lower share prices are two reasons why another wave of consolidation could yet sweep the sector.

–Jonathan Ford, Edward Hadas, John Paul Rathbone

For a complete set of BreakingViews comments, see www.breakingviews.com.

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