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Not-So-Great Expectations for Producers

ConocoPhillips on Wednesday was among the first in line among U.S.-based producers to issue a 4Q2006 earnings report, underwhelming investors on the news that its profit slid 13% from a year ago. However, the Houston-based company probably won't be the last to report tempered profits during a quarter with warmer-than-normal temperatures, soaring service costs and falling energy prices.

ConocoPhillips' 4Q2006 net income fell to $3.2 billion ($1.91/share) from $3.68 billion ($2.61) in 4Q2005. The company placed some blame for its earnings shortfall on a 44% drop in the natural gas prices since it completed its $35 billion merger last year with Burlington Resources Inc.

CEO Jim Mulva, who presided over a conference call with analysts, also spoke about what's ahead for the industry. "What we're faced with is increased fiscal take, increased costs...[and] difficulty...in terms of getting access to new resources," said Mulva.

The producer had its share of problems the quarter, many of which were made worse by high finding and development (F&D) costs. Merrill Lynch energy analyst John Herrlin Jr. estimated ConocoPhillips' overall F&D costs in 2006 were about $18/boe, including its acquisition costs. The costs were nearly double ConocoPhillips' average F&D costs over the past five years. And even at those prices, it only replaced 10-15% of its reserves by sanctioning new projects and discoveries, Herrlin said.

Overall, the oil and gas industry is expected to report profits for the final quarter of 2006 when all is said and done. However, a lot of things chipped away at the bottom line of North American-based producers, large and small.

Bank of America energy analyst Daniel Barcelo is predicting an overall 10% decline in income for the top producers. Doug Leggate, an energy analyst with Citigroup, offered a harsher forecast: average declines of around 23% year-over-year and 28% sequentially for the U.S. majors. Leggate also expects the Canadian-based E&Ps to post average year-over-year declines of around 28%.

"There remains no shortage of crude," Leggate said. For natural gas, "the weakness in 2006 mainly reflects high storage levels..." Weak U.S. gas prices "have left average levels below our prior expectations ($8.50/Mcf), and should continue to hinder upstream earnings for companies with high leverage to natural gas."

The softer oil and gas prices also could challenge credit quality in the exploration and production (E&P) sector into 2007, said Standard & Poor's (S&P) credit analyst Andrew Watt. "As of mid-January, the near-term crude oil contracts had fallen to less than $52/bbl... Meanwhile, natural gas prices remain relatively tepid, even in the middle of the winter heating season, at less than $7/Mcf. Mild weather, large storage volumes, questions on whether OPEC quotas will be enforced, and financial flows have all contributed to the low prices." Poor organic reserves replacement and high F&D costs also could pressure credit quality in the sector.

"Assuming prices stay at these levels or soften further, E&P companies' profit margins will be squeezed heading into 2007 and credit measures will deteriorate, particularly for those companies that are largely unhedged," said Watt. "A key question will be how willing companies are to scale back capital expenditures to be in line with internally generated cash flow."

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