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The Wall Street Journal: Energy, Once Hot, Now Not

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Strains on Growth Turn
Sector Sentiment Sour;
But if Oil Goes to $80…
July 30, 2007; Page C1

After years of booming commodity prices, energy companies have pristine balance sheets, exceptional credit ratings and gargantuan free cash flows as they continue to enjoy near-record oil and natural-gas prices.

A good place to find growth amid the broader-market credit-crunch storm? Not really.

High energy prices have meant big profits for this sector, and that has accounted for roughly one-third of the market’s earnings growth in the past two years. But rising costs, increased international taxes and a dearth of good exploration opportunities are shrinking margins.

There is a growing sentiment that the energy sector’s profits, while remaining strong, won’t grow much from here. “We have seen the peak in the earnings power unless we get another significant increase in the commodity price, and we don’t see that being supported by the fundamentals,” says R. Lewis Ropp, an energy analyst with Barrow, Hanley, Mewhinney & Strauss Inc. in Dallas. The firm holds large positions in Occidental Petroleum Corp. and ConocoPhillips, but went from being “market overweight” in energy last year to “market weight” this year.

A major reason for the shifting sentiment is that while rising commodity prices over the past few years have boosted earnings and stock prices, the large publicly traded energy companies have struggled to increase daily production of oil and natural gas. Last week, Exxon Mobil Corp. and Royal Dutch Shell PLC, the largest and second-largest nonstate-controlled oil companies, reported global production was down 1% and 2.3%, respectively, from a year earlier.

Moreover, rising costs have nibbled away at margins. Renting a state-of-the-art floating drilling rig in 2001 cost about $200,000 a day; the same rig now fetches more than $500,000 a day.

The bright spot for large oil companies over the past two quarters has been their refining operations, where crude oil is processed and refined for use. Even here, though, there are ominous signs. Claiborne Deming, chief executive of Murphy Oil Corp., said last week on a conference call that refining margins “have pulled back dramatically to start the third quarter,” according to a transcript provided by Thomson Financial.

The energy sector was the dominant driver of growth of the Standard & Poor’s 500-stock index in 2005 and the first half of 2006. Since then, energy companies’ contributions to earnings growth have declined, though they remain substantial. If this driver of growth disappears, the larger market could struggle.

“The earnings of big producers like Exxon are plateauing, and they’re really growing their earnings through share repurchases,” says Chris MacDonald, a portfolio manager in Dallas at WHG Funds. WHG owns shares of Exxon, Marathon Oil Corp., Occidental, Murphy and ConocoPhillips.

Mr. MacDonald says smaller producers such as Occidental and Marathon have better annual production-growth profiles over the long term, in the 7%-to-10% range, while giant producers such as Exxon are finding it difficult to expand production from their larger bases.

“Exxon is a fine company, but it’s certainly not growing very quickly outside of what commodity prices do,” says Robb Parlanti, a portfolio manager at Turner Investment Partners in Berwyn, Pa., that manages $25 billion in assets.

Two things could keep energy earnings strong. First would be if oil-field-service companies overbuild rigs and other equipment, driving prices down. Second would be a continuing rise in oil and gas prices, though that would require demand staying strong in the face of $80-a-barrel oil.

David Pursell, a partner with Pickering Energy Partners, a Houston energy-research firm, thinks demand growth will be modest and predicts an average $60-a-barrel price for oil next year. “I’m worried about demand, but I’m respectful of the fact that demand has been more resilient to high prices than I [would] have thought two or three years ago,” he says.

Still, there are many energy bulls in the market.

“Energy stocks are still undervalued relative to their assets,” says Rodney Mitchell, president of the Houston-based energy-focused investment manager The Mitchell Group, “and a credit crunch in subprime paper doesn’t change those values one bit, and they will ultimately be realized.”

–Guy Chazan contributed to this article

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