For Big Oil Firms, a Silver Lining

THE WALL STREET JOURNAL

As Crude Price Falls, Political Issues Ease, Refining Margins Widen, Partners Relax

By RUSSELL GOLD and GUY CHAZAN

Falling energy prices are good news for consumers. The trend could also provide surprisingly welcome relief to another constituency: big oil companies.

Surging crude oil and gasoline prices powered global energy companies to a string of record profits in the past year. On Wednesday, ConocoPhillips continued the pattern, kicking off the industry’s third-quarter earnings season with a 41% jump in profit. But commodities markets have changed direction. The economic slowdown spreading around the world has lowered demand for fossil fuels and sent prices into a tailspin. Since peaking at $145 a barrel in July, the price of crude oil has halved to $70 now. Many believe it could fall even lower.

That will trim profits at the major Western oil companies. Though oil prices averaged about $118 a barrel over the last three months, the European majors will see net income per barrel based on U.S. dollars fall by 7% in the third quarter from the second, according to estimates by Sanford Bernstein.

Nevertheless, the drop in oil prices could hold some benefits for Big Oil. Red-hot crude led to unprecedented cost inflation in the energy sector, stoked political pressure for windfall-profit taxes and made it harder for companies to land long-term deals with resource-rich countries to get at untapped reserves. All of these headwinds are receding as oil prices sag.

Meanwhile, the majors’ finances have rarely been stronger. The long run of high energy prices has allowed them to fortify their balance sheets, reducing their debt to historically low levels and building large cash hoards. The global oil leviathans “are built to survive” the downturns in oil-price cycles, says Gary Adams, vice chairman of the oil-and-gas business at the Deloitte consulting firm.

And while falling oil prices will damp income from oil production, those declines will be partially offset by stronger profits from refining and marketing. Earlier this year, companies struggled to pass on the rising cost of crude to consumers. That reversed itself in the third quarter, when pump prices fell more slowly than crude prices and boosted the profit margins of big, integrated oil companies that not only extract oil but refine it and sell the gasoline to customers.

“The ideal environment for the majors is when prices are high but falling,” as they were in the third quarter, says Mark Gilman, an analyst at Benchmark Co.

Houston-based ConocoPhillips reported a $5.19 billion third-quarter profit Wednesday, the 41% gain driven by a surge in profit from producing oil and natural gas. The company’s refining profit fell due to the absence of a one-time tax benefit and lower production of gasoline, diesel and other fuels. Strong cash flow enabled Conoco to buy $2.5 billion of its own stock during the quarter, while increasing its cash reserve by 42% to $1.1 billion.

Big oil companies stand to gain from the current low-price environment by using their strong financial position to buy companies and assets from smaller distressed rivals.

“For those companies with a hole in their production profiles, in the longer term this will be the time to seize the day and replenish the portfolio with quality reserves at low prices,” says Neil McMahon, an analyst at Sanford Bernstein. Key targets would be companies with exposure to hot resource plays like Canadian oil sands and Brazil’s recently discovered deep-water oil fields, he says.

For the past couple of years, the majors have complained that high prices have encouraged oil-rich nations to limit access to new exploration opportunities. Tom Curran, an energy analyst at Wachovia Securities who tracks foreign-government licensing activity, expects this to change as cash flows dwindle and some countries begin to have trouble financing big development projects.

With their hefty balance sheets, fiscal discipline and operational experience, major oil companies could once again become the partners of choice for resource-rich countries under increasing pressure to deliver key projects on a tight budget.

“We could see a turn away from the breadth and intensity of resource nationalism,” he says. “Over the next 18 to 24 months, you will see a trend in improving terms and conditions for international oil companies in licensing rounds.”

One example he cites: As its oil production and prices drop, Iraq is displaying a growing “sense of urgency” to speed up the entry of foreign companies into its oil fields.

Another expected trend that should help Western oil companies is falling costs. Competition for resources in the industry is easing as smaller firms cut capital spending programs and struggle to find funding. That should bring down the cost of oil-field services, such as shooting seismic images or leasing drilling rigs. Raw-materials costs are also falling; steel prices have plummeted 65% since the summer and cement prices are down too.

“As risky, more-leveraged companies fall by the wayside, that will bring down cost pressures and make some of the majors’ big projects more economical,” says Lysle Brinker, co-director of equity research at consulting firm IHS-Herold.

That economic benefit could disappear, however, if oil continues to decline, since many projects will break even only with an oil price of at least $50 or $60 a barrel.

The companies themselves say they aren’t at risk. “Nothing that we had in our plans has been affected by the change in price,” Exxon Mobil Corp. Chairman and Chief Executive Rex Tillerson said Monday at a meeting in Scottsdale, Ariz. “We were never planning on $100, $150 oil. That is just not the way we run the business.”

The political heat felt by oil companies as their profits swelled on rising prices could also ease. Congress has been mulling a potential windfall-profit tax to tap into major energy companies’ robust cash flows. But pressure to act is expected to recede as constituents pay less to fill up their tanks.

“You won’t see the obscene profitability, and the lower costs at the pump will help things,” says Frank Verrastro, director of the Energy and National Security Program at the Center for Strategic and International Studies.

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

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