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Investors Chronicle: Oil’s well that ends well?

For the first time in ages, Shell has pumped out a slicker performance than its rival BP. Has the oil giant’s tanker finally turned itself around, asks Daniel O’Sullivan?

Comment page 52: Oil & gas pages 52-53

CAN IT REALLY BE TRUE? The UK’s two oil majors have just updated investors on their latest progress, and Shell came out ahead of BP.

The company beat consensus forecasts in every part of its business. Production volumes of 3.25m barrels of oil equivalent per day (boepd) were up 1 per cent year-on-year, instead of a widely forecast decline. Revenues from active trading of liquefied natural gas (LNG) cargoes also beat expectations, while the refining division saw improved earnings despite lower actual refining margins.

Compared with Shell’s well-oiled machine, BP’s recent performance looks more like a spillage. Year-on-year production was flat at 3.8m boepd. Strip out non-operating gains and other non-operating items, and underlying net earnings fell some 5 per cent below consensus expectations, at around $4.5bn.

At first glance, this appears to be case of role reversal for the UK’s oil majors. Since the debacle over its proven reserves in 2004, Shell has had the reputation of a serial underperformer with deep-seated exploration and project management problems. By contrast, BP has been seen as the safe pair of hands with future production growth assured.

The tide has turned lately, though. BP’s limp third-quarter results come on the heels of its well-publicised operational problems in the US. The Texas City refinery fire, inadequate maintenance of its Alaskan pipeline network and the resulting shutdown, alleged price-fixing in its propane trading arm and delays on large-scale developments in the Gulf of Mexico have all conspired against the firm.

“Shell is delivering exceptionally strong near-term results, yet there remain material concerns about the longer-term outlook for its upstream business,” points out Citigroup’s oil and gas team. But even so, Citigroup’s analysts feel that Shell’s stronger-than-expected production figures, and quarterly net profit improvement relative to BP, should help to narrow Shell’s 13 per cent price-to-cash flow discount to its rival.

Still, the fundamentals have not changed. BP has assets that should generate long-term organic growth in production and reserves. Admittedly, its reserve-replacement ratio (RRR) – the rate at which it replaces production with fresh reserves – was just 95 per cent last year. However, Shell is still drastically short of reserves to assure its future, with an RRR last year of only 70 per cent. As a result, investors suspect that sooner or later it will have to buy new reserves, and that’s an expensive solution.

And while attentions have focused upon BP’s operational shortcomings of late, Shell still has plenty of problems with its own assets. The massively over-budget and delayed Sakhalin Energy LNG project in the Russian Far East is an embarrassment, with the Russian government set to grab a much larger share of the project than previously envisaged, a result of Shell’s environmental violations. The Russian natural resources minister recently said that Shell faces massive fines, and possibly criminal charges.

Nigeria is another quagmire for Shell. Despite new production recently beginning in the offshore fields, some 185,000 boepd of net onshore production to Shell in the Niger Delta remains shut owing to the ongoing insurgency. The company says that these facilities will probably remain out of action for the rest of 2006. So that’s some 6 per cent of current total production foregone for a whole year, with no guarantees of imminent relief.

Meanwhile, the legacy of the reserves booking scandal lives on in the form of legal risk. Having put aside $500m to settle aggrieved US shareholders’ claims earlier this year, Shell says that it has not reached a settlement and that it will review the provision it has made in due course. In other words, expect it to increase.

Overall, then, the direction of the two companies can be gauged by their latest progress reports. BP has just trumpeted what looks like a significant new offshore discovery in Angola. Shell, on the other hand, has announced the buyout of its minority shareholders in its Canadian subsidiary, which extracts heavy oil from tar sands. Such production is currently classified as too technologically risky to be included in reserve-replacement calculations. For now, though, it’s Shell’s only realistic option for growing attributable production significantly in the near term.

3rd November 2006: Investors Chronicle

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