http://www.businessweek.com/stories/2007-11-01/big-trouble-for-big-oilbusinessweek-business-news-stock-market-and-financial-advice

Big Trouble for Big Oil


Even as oil prices soar, earnings at Exxon, BP, and ConocoPhillips are coming back down to earth. Are lower profits here to stay?

Even as oil prices break records and test the $100 mark (BusinessWeek.com, 10/16/07), profits aren't gushing for major oil companies.

On Nov. 1, ExxonMobil (XOM), the world's largest integrated oil company, reported a 10% drop in profits for the third quarter from a year ago. Last week British Petroleum (BP), Europe's second-largest oil company, reported a 29% drop in third-quarter profit, while ConocoPhillips (COP), the U.S.'s third-largest oil company, reported its third-quarter profit fell 5% (BusinessWeek.com, 10/26/07). Chevron (CVX), which reports earnings Nov. 3, warned last month that profits would fall sharply for the period.

Exxon shares tumbled more than 3.5% on the news, and contributed to a steep fall in the Dow Jones industrial average, which dropped more than 360 points Nov. 1.

Refining Margins on the Decline

What's ailing Big Oil? This round of lower profits was caused by low refining margins, or the difference between the price of crude oil and that of refined products like gasoline. Because gasoline prices haven't been rising in tandem with soaring crude, integrated oil companies and refiners are suffering a major blow in refining and marketing profits. Some analysts say refining problems are here to stay.

"Gasoline prices can't keep pace with the sharp runup in crude oil prices," says Fadel Gheit, senior energy analyst for Oppenheimer & Co. (OPY). "Going forward, whatever an oil company can get for crude oil [production], it will forfeit at the pump."

Still, analysts say it's important to keep the industry's woes in perspective. "Only in this crazy bull market do people think that Exxon making $9.4 billion is some sort of problem," says Peter Beutel, president of the energy risk management firm Cameron Hanover in New Canaan, Conn. "I'm personally not shedding any tears for Exxon; it'll keep making plenty of money."

International political developments have been causing more problems, too. From Russia to Nigeria to Venezuela, private energy companies have been struggling to get access to oil as governments become more difficult to work with. In June, Venezuelan President Hugo Chavez forced international oil companies to hand over equity stakes in their local operations to the state oil company Petróleos de Venezuela (PDVSA), prompting Exxon and ConocoPhillips to pull out of the country altogether (BusinessWeek.com, 6/26/07). That contributed to a 2% drop in Exxon's production in the third quarter, despite the sharp runup in crude prices.

Crude Highs Have Mixed Impact

Crude oil prices, which have been on a bull run throughout 2007, are having a dual effect on oil majors, benefiting their exploration and production businesses while compromising refining segments. Amid tensions between Turkey and Iraq, fear of a U.S. confrontation with Iran, and supply concerns, crude oil prices have broken consecutive records in the last month. A barrel of light, sweet West Texas Intermediate benchmark crude settled at $93.49 on the New York Mercantile Exchange on Nov. 1, having surpassed a record $96 in overnight trading.

But high crude oil prices are only good news for refiners if they can charge high prices for refined products like gasoline. And relatively soft demand for gasoline is holding down prices at the pump, at least for now. Since the end of August, the wholesale price of crude oil has risen 60¢ per gallon, while gasoline is up only 16¢ a gallon.

Not long ago, integrated oil companies were basking in the glow of record profits. In the third quarter of 2006, for example, Exxon reported the second-largest quarterly profit ever for a U.S. company. Also last year, Exxon set a record for the highest ever annual income, with earnings of $39.5 billion.

A New Era for Integrated Oil?

Some analysts say the golden era of sky-high profits could be over for integrated oil companies. A combination of factors, including higher material and labor costs, increased competition from national oil companies, and potentially falling oil prices could dim future prospects for oil majors. The market cap for Chinese national oil company PetroChina (PTR) hovers at $446 billion, threatening some day to top ExxonMobil ($491 billion) as the world's largest oil player by market value.

With national oil companies coming on fast, U.S. energy leaders are calling on the government to take action. ConocoPhillips CEO James Mulva has joined other leaders in the industry calling on the U.S. government to create a more robust energy policy (BusinessWeek.com, 10/26/07) to help U.S. oil companies compete with national oil companies. "We don't have a national energy policy," says Mulva. "The Chinese have a very coordinated strategy that allows them to support economic growth and their standard of living."

Other analysts warn that the golden era for oil majors' profits may be in the past because oil prices could drop. "For now we're just seeing a normal seasonal wiggle and jiggle, but at some point Exxon's profits will decline, decline, decline," says Cameron Hanover's Beutel. "Ultimately this [oil] market will peak, and prices will start to move lower. Refining margins will provide some relief, but profits won't be the extraordinary ones we've seen."

Exxon: The A Student

Despite the gloomy earnings news, Exxon's vice-president for investor relations, Henry Hubble, was upbeat on a conference call with analysts and investors. "These results highlight the fundamental strength of our business and our ability to deliver superior performance," said Hubble. "We are well positioned for demand growth and continue to create value for shareholders."

Analysts like Gheit agree. He says that even when trouble arises, the world's largest oil company will be positioned to compete. "Exxon has no control over commodity prices, but it will always be the best-prepared student for whatever test comes its way," says Gheit. "It doesn't matter how difficult the test will be—it will always be at the top of the class."


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