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The Wall Street Journal: Big Oil’s Profits May Have Peaked

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PRICE PER SHARE, PRICE PER BARREL
Through Oct. 30

Amid High Price of Crude,
Exxon, Rivals Are Pressed
By Margins, Costs, Nations

By RUSSELL GOLD and GUY CHAZAN
November 2, 2007; Page A3

Even as oil prices continue their climb, profits for Western oil companies appear to have peaked for the moment — as underscored by a surprisingly weak earnings report from Exxon Mobil Corp.

The reasons include aggressive governments that are grabbing a bigger slice of the oil pie, as well market dynamics that are somewhat sheltering consumers in the U.S. and elsewhere from the full effect of oil’s rise.

Exxon said its profits slid 10% in the third quarter. Exxon, the largest nonstate-controlled oil company in the world, is hardly in the poorhouse: It made $9.41 billion in just three months, still one of the most profitable quarters in U.S. corporate history. But the news drove down Exxon’s stock 3.8%, contributing to a 2.6% decline in the Dow Jones Industrial Average. (See related article.)

Other oil companies, including BP PLC and ConocoPhillips, reported falling profits last month. Until recently, the companies were able to achieve significant profit margins when they turned crude oil into gasoline and other products for the end user. Outages earlier this year crimped supplies and sent fuel prices soaring at a faster rate than oil. But the world’s refineries now are running closer to their full capacity, adding more supplies of fuels like gasoline to the market.

“The secret ingredient of record profits was refining, and that’s gone away,” said Paul Sankey, an analyst at Deutsche Bank. “We’ve entered a phase where the higher the crude price, the lower the refining margin.”

This was the second consecutive quarter that Exxon’s results fell below expectations, following a string of record profits in the fourth quarter of 2005 and throughout 2006.

Crude-oil prices have risen more than 50% this year, although the benchmark crude-oil futures price fell $1.04, or 1.1%, to $93.49 per barrel yesterday on the New York Mercantile Exchange. Normally the rise in prices would be good for Western oil majors, which pump tens of millions of barrels out of the ground every year that they can now sell for more money.

But the upheaval in the oil market has unleashed a series of challenges. Oil-field costs have risen steeply as rigs, steel and skilled personnel are in high demand. Producing countries are demanding a bigger cut of profits, sometimes by jacking up taxes and other times by using political pressure to expand the state’s ownership of projects.

Russia recently raised its already hefty oil-export duty, which combined with other levies boosted the state’s marginal tax take to almost 90 cents on the dollar. This has particularly affected London-based BP, which has more exposure than its peers to Russia and to other countries where tax rates are so high it derives limited benefit from red-hot crude prices.

In the past two weeks, the provincial government of Alberta raised royalties for oil-sands deposits, and the U.S. raised royalties for future Gulf of Mexico lease sales.

What’s more, Exxon and its peers are finding it hard to boost production in response to higher prices. Exxon said its production of oil and gas fell 2% from a year earlier. That is partly because Exxon was booted out of Venezuela after refusing to modify its contract so the government could take a majority stake.

But Exxon was also affected by oil-production contracts in western Africa, one of the few bright spots for Western oil companies in recent years. The contracts contain provisions that as oil prices rise, the companies can claim fewer barrels. Exxon is getting 14% less oil there this quarter versus the year-ago period.

“Under a production-sharing agreement, if you incur $20 of costs and the oil price is $20 you get one barrel of oil,” said Pedro van Meurs, who advises oil-producing countries on their contracts with oil companies. “But if you incur $20 and the oil price is $80, you only get a quarter of a barrel.”

Exxon Mobil did a little better than Royal Dutch Shell PLC and BP, the second- and third-largest nonstate-controlled oil companies, respectively. Both reported a 4% drop in output in the third quarter compared with 2006.
 
The falloff could accelerate. With access to most of the world’s largest resources now off-limits to those companies — known as international oil companies, or IOCs, as opposed to national oil companies like state-controlled Saudi Aramco — they are finding it harder to replace oil reserves.

“Look at the top five IOCs’ reserve-replacement ratios over the last five years compared to the oil price — there’s a huge decline,” said Fatih Birol, chief economist at the International Energy Agency, the energy watchdog based in Paris.

Perhaps the most challenging factor is that operating expenses are rising faster than the price of oil. Exxon’s third-quarter revenue rose 2.8% from a year earlier to a record $102.34 billion, but its costs rose 5.1% to $85.58 billion. The results show the high standards to which the Irving, Texas, company is being held. Its profit, one of the best quarters ever by a public U.S. company, was down from the $10.49 billion profit a year earlier.
 
Separately, the Associated Press reported that the Alabama Supreme Court threw out nearly all of a record $3.6 billion verdict the state government won against Exxon Mobil in a dispute over natural-gas royalties. In an 8-1 decision, the state’s highest court awarded Alabama $51.9 million in compensatory damages. The court threw out all punitive damages. Jere Beasley, one of the state’s attorneys, said the state likely will ask the court to reconsider.

Write to Russell Gold at [email protected] and Guy Chazan at [email protected]

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