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Europe’s Oil Majors Plead for Patience

August 5, 2012

By ALEXIS FLYNN

Downbeat quarterly earnings from Europe’s major energy companies are a reminder that the bumper returns of two years ago are a long way from returning, as the sector expends time and money trying to secure new oil and gas fields.

While the market was braced for a drop in profits from a year ago, given that crude prices averaged 7% less than in the corresponding period in 2011, the scale of the future challenge faced by companies like BP PLC, Royal Dutch Shell PLC, Total SA and Eni SpA was yet again in evidence, analysts said.

The impact was particularly pronounced in the profit margin per barrel produced and sold in the U.S., as the cumulative effect of lower gas prices and lower margins per barrel of oil produced ate into the bottom line. Shell’s profit per barrel there all but disappeared, falling to just $1 from $9 three months earlier, an analysis from RBC Capital showed. That of BP halved to $11 from $24, while that of Statoil slid to $13, from $30.

Although the long-term outlook for “Big Oil” still remains attractive, energy firms are balancing investor impatience, a weak consumer environment and the cost of adding fresh production to their diminishing reserves.

“These companies invest with a long-time frame in mind,” said Jason Kenney, an Edinburgh-based analyst with Spanish bank Santander. “Over a 10-year or seven-year period, returns look positive, but not in the next two to three years when you consider the ongoing lags in the downstream, bleak macro picture, gas asset structural shift…. The outlook for energy demand use isn’t certain.”

Across the European oil sector, only Repsol SA beat analysts’ expectations for earnings, said Peter Hutton, an analyst at RBC Capital.

He said that while companies are starting to have more success boosting output than in the past, profits are being stymied by higher costs.

“Volume growth across the sector was the highest for five years, but despite operational momentum, this was a quarter of earnings misses,” he said.

This is in part because firms are still paying the higher costs of hiring drilling rigs and other services when crude prices were much higher a few months ago. Those prices are only likely to translate into cheaper costs, if current price levels are sustained or fall further. The cost of producing oil tends to rise and fall in tandem with the commodity itself, though it takes time for this to be reflected, given pre-existing contracts between oilfield services firms and producers.

And with the key theme that has dominated the sector over the past 10 years—access to resources—in no danger of disappearing, companies are unlikely to get much respite on the cost front.

With international oil firms no longer having easy, cheap access to the giant fields in Saudi Arabia and Russia, a greater share of their production now comes from unconventional sources, like Shell’s giant Pearl plant in Qatar, which turns natural gas into more valuable oil-linked fuel products like diesel.

Although Pearl now contributes 260,000 barrels of oil equivalent a day to Shell’s overall output, it came with a $20 billion price tag. It is a project that few firms other than the Anglo-Dutch giant, which spent eight years building the complex facility, could afford.

“The real challenge for large caps is on delivery [of profit growth]. Ten years ago, the issue was access to resources, which prompted the move into unconventional,” said Santander’s Mr. Kenney.

However, sometimes these moves to secure new patches can backfire, as the example of U.S. shale gas illustrates. Prices have tumbled as supply has expanded.

But despite the weaker profits, the fact that production volumes are cumulatively increasing year on year suggests that the long-term prognosis of fattening profits will materialize, But in the short term, companies will likely be caught in a double bind of relatively flat prices and high production costs.

For now, the sector will continue to deliver the steady, predictable returns that make companies like Shell and BP mainstays for many pension and similar long-term funds.

Meanwhile, however, investors looking for faster returns will likely be disappointed.

“You look at the large-cap oil sector for dividend yield, and the mid-cap, exploration-focused sector for growth,” Mr. Kenney said.

Write to Alexis Flynn at [email protected]

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