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Financial Times: Shell and BP struggle to dig up returns

By Dino Mahtani
Published: October 25 2007 21:00 | Last updated: October 26 2007 06:45

Shell’s drop in third-quarter profits follows a trend seen elsewhere in the global oil and gas industry.

In spite of record oil prices, the major multinationals are struggling to book growth in profits, taking hits in their refining divisions or facing industry-wide cost pressures and delays to important new oil and gas projects.

John S Herold, an oil and gas research firm, and industry advisory group Harrison Lovegrove recently estimated that spending by the 228 global oil and gas companies increased 45 per cent to $401bn in 2006 but they generated only a 2 per cent increase in reserve volumes to 263bn barrels of oil equivalent.

The majors are still recording multibillion-dollar profits, but not at the levels they enjoyed before cost inflation took off.

BP’s announcement this week of a 45 per cent reduction in third-quarter replacement cost profits was followed by drops in earnings at ConocoPhillips. And analysts predict similar gloomy news for Exxon’s results next week.

At both Shell and BP, Europe’s two biggest oil companies, upstream production has fallen since 2005. This week Shell reported third-quarter production of 3.14m barrels of oil equivalent per day from 3.25m boe/d a year ago. BP reported a 4 per cent drop to 3.65m boe/d.

Shell’s refinery processing intake was down 1 per cent while BP’s refining throughput was also slightly down.

Yet companies such as Shell and BP seem to have beaten market expectations on profits, prompting some in the industry to question whether their prognosis has been too severe.

Others say Shell’s $413m earnings – which reflect higher insurance underwriting income, improved interest income and favourable foreign exchange movements – mask weaker performance in its operating divisions.

“Do not be fooled,” says Jason Kenney, senior oil and gas equity analyst at ING. “The potential for deals, reserves replacement [and] exploration upside all look cautious.”

Other analysts disagree, saying Shell is in a strong cash position to keep pushing on with new projects. It had $14bn in hand at the end of September.

With Shell and BP both expected to spend more than $20bn on capital projects next year, the question is where and what kind of return they will generate.

Peter Voser, finance director of Shell, says that in the long term 60 to 70 per cent of cash flow is expected to be generated from projects with low or very low risk.

But in this category he includes projects that have already been affected by government intervention, such as: Canadian oilsands refining; a multibillion-dollar, technologically complex gas-to-liquids project in Qatar; the Sakhalin-2 project in Russia; and Kashagan in Kazakhstan.

Shell’s framework for production growth in the near term is 1 to 2 per cent a year, and longer-term 2 to 3 per cent a year. Its 2006 reserve figure of 12.9bn barrels of oil equivalent was buoyed by Canadian and Qatari reserves.

The company says it is not in the business of chasing reserve volumes at the expense of profitability, but is focusing on the highest long-term value possible in a context where oil companies everywhere are having to look to new frontiers.

BP is similarly bullish about production plans. It told investors this week that revenue streams and production figures were expected to increase now projects that had long been delayed were due on stream.

But it, too, has had to look away from its traditional assets, and this week announced job cuts in the North Sea.

“Both companies are in a mode where they have to go to parts of the world to get new growth, moving on from old assets. The challenge is looking at delivering very complicated projects in the non-OECD world,” says James Neale, an analyst at Citigroup.

Both companies can also expect to take hits in the years to come when production-sharing contracts hit maturity and they have to begin to split profits with the host countries that the projects are in.

But in the meantime, Shell may be facing more immediate problems.

The provincial government in Alberta is considering raising taxes on Canadian oilsands projects. In Nigeria, where Shell holds a significant portion of its reserves, the government is also looking at altering contracts.

Copyright The Financial Times Limited 2007

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