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Financial Times: Why mining has left oil sector standing

EXTRACT: The main reason the UK oil sector has underperformed is because of the sluggish performance of its two biggest companies – BP and Royal Dutch Shell.

By Neil Hume
Published: October 20 2007 03:00 | Last updated: October 20 2007 03:00

They both extract minerals, both have emerging markets exposure and both are in industries that have had big price rises. So why has the mining sector significantly outperformed the oil sector this year?

While the FTSE All Share mining index has gained 50 per cent, the equivalent oil index has risen just 14.6 per cent. But is that gap about to narrow? With the crude price at a fresh record high yesterday, should investors be looking to switch out of miners, which trade on 13.3 times 2008 earnings, into cheaper oil stocks, which trade on 11.5 times.

The main reason the UK oil sector has underperformed is because of the sluggish performance of its two biggest companies – BP and Royal Dutch Shell. They have gained just 7.7 per cent and 14.6 per cent respectively this year. In contrast the UK’s two largest mining companies, BHP Billiton and Rio Tinto, have surged 96 per cent and 55 per cent.

Exclude BP and Shell and the sector has not performed that badly. Shares in Tullow Oil have risen 56 per cent, taking it into the FTSE 100, on the back of exploration successes in West Africa. Burren Energy, which has rebuffed a takeover approach from ENI of Italy, has gained 32 per cent, while BG has gained 27 per cent on a mixture of takeover speculation and its ability to continue delivering volume growth.

So the question for investors is not whether to buy into the oil sector but whether to buy large, integrated oil companies such as BP and Shell – and in Europe Total and Repsol – on the back of record oil prices.

Some people have decided it is – this month BP is up 8.5 per cent and Shell ahead 2.9 per cent. However, with BP, it is difficult to tell how much of the rise is down to the crude price and how much is down to moves by Tony Hayward, its new chief executive, to address the company’s sagging profitability.

Many sector watchers believe the rally will quickly peter out if the oil majors cannot address the issues that have dogged their recent performance. These are reserve replacement – or production – and rising costs.

Integrated oil companies used to make their money by extracting oil and gas in developed countries. These countries had fixed tax regimes, so the oil companies benefited from high prices.

But production has levelled out in these countries. As a result, oil companies are now having to look for crude in more exotic places such as the Caspian, West Africa, Russia and in deep water off Brazil.

These new projects are complex, expensive and prone to over-runs. On top of that, developing countries usually have progressive tax regimes, which give the resource owner a greater share of the profits from rising oil prices.

“A very good commodity theme does not always translate into a good equity theme,” says James Neale, oil analyst at Citigroup. This week, Mr Neale found himself increasing his oil price forecasts but actually lowering his 2010 earnings forecasts.

“Despite oil prices being raised by $10 a barrel in 2008 and 2009, the surprise conclusion, and arguably key investment message, is that our estimates of free cash flow generation are not expected to show a material increase.” He believes the industry is facing cost inflation of at least 10 per cent.

Of course, the mining industry is also facing cost pressures. But unlike the oil majors, companies such as BHP and Xstrata are managing to make discoveries and increase production and reserves. BHP recently said reserves at its Olympic Dam mine in Australia were 75 per cent greater than first estimated.

That is the difference. Until oil majors can deliver production increases, it seems the market will continue to take a jaundiced view of their prospects.

So the gap between the miners and the oils looks unlikely to close soon even with crude at $90 a barrel.

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