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Time for big oil to explore places it would rather avoid

 

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Financial Times: Time for big oil to explore places it would rather avoid

By Neil Hume

Published: May 3 2008 03:00 | Last updated: May 3 2008 03:00

Big oil was back in the spotlight this week and not just because petrol prices hit £5 a gallon on the forecourts. BP and Royal Dutch Shell both reported first-quarter results that smashed market forecasts and then enjoyed sharp share price gains.

One broker calculated that it was the biggest quarterly earnings surprise from BP, with profits $1.4bn higher than expected,

But long-term investors were unlikely to be jumping for joy. They have had to endure years of sluggish performance even though oil prices have experienced a record-breaking run.

Since March 2003 (the start of last bull market), Shell has risen 71 per cent and BP 63.5 per cent, lagging behind the FTSE All Share index 12.6 per cent and 16.8 per cent respectively.

Over the same period the price of benchmark US crude has risen from $30 a barrel to a peak of $119.93 last month.

BP and Shell have also underperformed their smaller rivals. Shares in BG, production arm of the former British Gas, have risen 441 per cent since March 2003, outpacing the wider market by 175 per cent, while exploration companies Cairn Energy and Tullow Oil have risen a dizzying 877 and 827 per cent respectively.

In fact the best-performing oil companies globally have been the ones that have had exploration success, such as Petrobras in Brazil.

Rising costs and taxes, and limited access to new supplies help explain why BP and Shell have performed so badly and underperformed US peers ExxonMobil and Chevron. But other factors have been at work, such as the fatal accident at BP’s Texas City oil refinery and the reserve misreporting scandal at Shell.

Analysts estimate that underlying operating costs and capital expenditure across the oil industry are increasing 10 to 20 per cent a year.

Taxes have also been rising. The Labour government has increased corporation tax on North Sea oil profits from 30 to 50 per cent in the past few years.

Another way to look at rising costs and taxes is the impact on returns. Return on average capital employed at Shell was 24.5 per cent in the first quarter of 2008. That is only 10 percentage points higher than a decade ago. Yet in that time oil rose by $80 a barrel.

Finding oil is also more difficult, and big western oil companies are forced to explore in places they would rather avoid. One of Shell’s big projects is extracting oil from tar sands in Canada, and BP is drilling in ultra-deep waters in the Gulf of Mexico. In these large, complicated projects costs per barrel are high.

Production at Shell has almost stood still in the past 15 years and BP’s first-quarter figures showed production flat at 3.9m barrels of oil equivalent per day. A step change in output at both companies is not expected until 2011 when new but risky projects come on stream.

Big oil is also facing lower returns in projects that are already running. Oil-rich nations no longer feel they have to call in one of the large integrated oil companies to exploit natural resources. They can buy expertise in large project management direct from oil-field services companies such as Schlumberger. This puts host governments in a very strong position to demand better terms from production-sharing contracts.

The two oil giants do have one thing in their favour: they are cheap and throw off bucketloads of cash. BP and Shell trade on prospective price/earnings multiples of just over nine and BP’s prospective dividend yield is 4.5 per cent. Also upgrades could be in the pipeline if analysts start to base forecasts on $100 oil.

But investors should remember that the underlying story for big oil remains one of slow structural decline. The brutal facts are that BP, Shell and their peers are experiencing greater difficulties finding oil and when they do are making less money from it.

There is also the debate about peak oil – the theory that the world has exhausted about half of all crude supplies and that output will soon peak and an irreversible decline follow.

In other words, the halcyon days are over unless the two groups can reinvent themselves as alternative energy companies.

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