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Oil Majors Face Long-Term Challenges

It is quarterly earnings season and the latest figures are in. The world’s major oil companies posted mixed results. Some were good, some were bad, some showed signs of short-term optimism, but several have once again hinted at some worrying underlying trends that could play out over the long-term.

First, BP (NYSE: BP) saw its profits increase by more than 65 percent from a year earlier, a highly impressive number. The British oil giant posted over $3.37 billion in second quarter profits, up from $2.04 billion in the second quarter of 2013. The gains came largely from its 19.75 percent stake in the Russian oil company Rosneft, which is owned by the state but is the largest publicly traded oil firm in the world by production.

While BP’s assets in Russia paid off over the past year, Rosneft is suddenly in the crosshairs of the western world, with the United States and the European Union enacting strong sanctions targeting Rosneft’s access to long-term finance as well as high-tech equipment needed for offshore drilling. Rosneft’s stock price dropped after the sanctions were announced in late July, and while its production may not be affected in the short-term, it may face difficulty acquiring technology that could block investment in new projects, thus cutting into the company’s long-term production capability.

“In Russia, recent geopolitical events have continued to create levels of uncertainty,” BP’s CEO Bob Dudley cautioned investors. “At the business level, Rosneft had a good quarter.”

But it’s not just the geopolitical events in Russia that should worry investors in regards to BP. Profits from actually producing oil and gas declined by 8 percent, and downstream operations (refining) also dropped 8.1 percent. That is because its production from its portfolio is declining. Oil and gas production for the quarter averaged 2.1 million barrels of oil equivalent per day, a drop of 6.1 percent from the year before.

ExxonMobil’s (NYSE: XOM) results looked pretty similar. On the surface the Texas company posted surging profits of $8.78 billion, beating analysts’ estimates. This was a result of a good performance from ExxonMobil’s upstream unit, which saw profits rise 25 percent. But when you look underneath the hood, ExxonMobil doesn’t look quite as good as it seems. Its profits rose due to higher global oil prices – accounting for an additional $580 million in revenues. It also pulled in $1.2 billion from one-time asset sales.

But the metrics that count – production – were very much negative. ExxonMobil said that its total liquids production declined by 5.7 percent. Natural gas production was also sharply down, bringing ExxonMobil’s total worldwide production down to 3.84 million barrels of oil equivalent, the lowest total in years, and the continuation of a decade long slide. The company’s stock price has fared so well for such a long time because of rising oil prices and aggressive share buybacks and dividends, but declining production is a worrying sign.

The story was similar for Chevron (NYSE: CVX). Quarterly profits jumped 5.6 percent to $5.67 billion from the second quarter of last year. These numbers also beat analysts’ estimates. But the improved performance came on the back of rising oil prices and asset sales. It pulled in $1.3 billion from selling off assets in Chad and Cameroon. But its production declined, albeit by a much lesser degree than its peers. Total production dropped from 2.58 million barrels per day last year to 2.55 million barrels per day in the second quarter of 2014.

ConocoPhillips (NYSE: COP) reported perhaps the most optimistic results compared to the other majors. Its earnings were only slightly up, increasing from $2.05 billion to $2.08 billion year-on-year. But the company’s numbers are much more solid – its production actually increased from a year before, due to its huge exposure to unconventional oil and gas in the United States. ConocoPhillips is drilling in the Bakken and Eagle Ford, allowing its production there to leap by 38 percent. Worldwide, total output climbed by 6.5 percent. In a call to investors, ConocoPhillips’ CEO Ryan Lance said that the company has strong momentum moving forward.

Royal Dutch Shell (LON: RDSA) has a bit of a different story. It made headlines at the beginning of this year when it reported its 2013 numbers, showing escalating costs and declining production. Shell’s new CEO pledged to divest the company from high-cost “elephant projects,” and given the latest figures, the early results look much improved. Its second quarter earnings jumped by 33 percent compared to a year before, reaching $5.15 billion. This was the result of a huge 127.3 percent increase in profit from its exploration and production unit. The impressive growth figure was due to higher oil prices, a reduction in costs, and a surprising increase in production from its assets in the Gulf of Mexico. But big obstacles still await Shell – it wrote down nearly $2 billion in U.S. shale assets. And it is in the midst of a massive $15 billion divestment program, which over the long-term could reduce costs, but also production.

The French oil company Total (NYSE: TOT) released perhaps the most damning results. Its profit for the second quarter dropped by 12 percent from a year earlier, and its total oil and gas production hit a record low. The company’s output fell off by an unsettling 10 percent, hitting just 2 million barrels per day. Total’s downstream business has been hit pretty hard, as margins are razor thin in Europe due to overcapacity. The company is embarking upon a cost-cutting program. Investors shaved off 5 percent of Total’s share price on the news.

Taken as a whole, the oil majors reported a bit of mixed news. While a few – ConocoPhillips, BP, Shell – posted numbers that were better than their peers, the trend in the industry is clear. Over the last several years, big oil companies have become overextended. Capital expenditures have been out of control and costs have climbed too high.

Take a few examples:

•         Royal Dutch Shell’s Arctic drilling campaign has cost the company more than $6 billion over the last decade without a single drop of oil produced.
•         The Kashagan oil field in the Caspian Sea – which is a joint operation between ExxonMobil, Shell, Total, Eni, and the Kazakh government – has been called a “nightmare.” It has cost over $50 billion, and suffered years of delay. Just this year, corroded pipes set the project back another year at least.
•         Chevron’s Gorgon LNG project in Australia has faced delays and cost overruns. The massive LNG project is the largest natural resources project in Australia’s history. It has so far cost $54 billion, more than 45 percent over budget.

High spending would be justified if production expanded commensurately, but by all indications, production is flat.

Moreover, many of these companies have grim prospects for growth. Their oil and gas producing assets are aging, and nearly all of them are struggling to find promising new projects. Oil prices have stabilized over the past year, and while they could still rise further in the years ahead, the evidence suggests that any significant rise from current levels leads to demand destruction – i.e., consumers begin to use less oil.

And share repurchases and hiking dividends can only go so far if production cannot keep up. At some point, the value of these companies will begin to decline as the underlying fundamentals become too obvious to ignore.

That leaves just one option – shed assets and shrink to a more manageable level. Nearly all of these companies are divesting assets, removing themselves from far flung and unwieldy places. That may allow them to focus on more stable and predictable investments, allowing them to keep costs in line with expectations.

We are at an interesting crossroads in the oil sector. After years of growth, the strategy going forward will be to focus on profitability – which will likely involve leaner operations and lower capital spending. Some companies may be able to successfully pull this off; others may face a future of red ink.

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