The strength of the upstream sector holds the key to the performance of integrated oil and gas companies going forward, as poor quarterly earnings and lower forecasts going into 2003 require independents and majors to rethink their operating strategies.

Given the weak performance in the refining sector, maintaining large downstream operations is “difficult to justify,” according to one energy analyst, and exploration and production (E&P) for new sources may help to rejuvenate lackluster income statements in the coming year.

“While E&P profits were driven by strong oil and gas prices, with year-over-year increases in price realizations offsetting unanticipated tropical storm-related volume declines in the Gulf of Mexico, refining and marketing continued to be overwhelmed by weak markets and depressed demand for refined product,” said Reena Mithal, an energy analyst for CreditSights.

Moving more capital in the E&P business may be a consideration for BP plc, the London-based super major, which reported its third quarter earnings on Tuesday. CEO John Browne said the company is looking at its upstream sector in detail for the next few weeks because the forecasted production targets keep falling. As late as July, BP said it remained on track for 5.5% in production growth. Tuesday, the production guidance was dropped for the third time in two months. Now, BP expects to produce 3% more this year than in 2001.

BP’s organic reserve replacement rate of 156% over the past three years “comfortably exceeds that of our major competitors,” said Browne, who added that reserve replacement this year should be similar. However, to move up the ladder at a pace he would like, Browne said BP may have to spend more money than it did in 2002, in which about $13 billion was set aside to boost production.

“The key question we are asking ourselves now is: should we?” Browne queried. “What is the optimum way to monetize the resource base that we have built up through our exploration success and acquisitions of the last decade?”

Going forward, the performance of BP and other larger integrated companies may depend on their upstream strength. Like BP, all of the major Gulf of Mexico players had to shut in production during some of the many storms in the past two months, which has impacted reported third quarter earnings, and required revisions to fourth quarter guidance.

“For natural gas, weather conditions this upcoming winter are the wild card over the next three months, but tightening inventories will still support prices to some degree,” said CreditSights’ Mithal. “We don’t see prices treading back to the $2/Mcf range, but any sustained increase from current levels will be dependent on how the winter shapes up.”

Analysts noted that the commodity price outlook “clearly calls for overweighting the E&P sector, as well as major integrateds with strong upstream platforms.” Most of the integrated companies already are leveraged to the upstream, and many are diverting more capital to E&P because of their poor downstream performance.

“Sector consolidation has put existing companies in a stronger competitive position, and exploration programs in progress will enhance and diversify reserves. Although there have been fewer large [merger and acquisition] M&A transactions year-to-date (compared with numerous high-profile deals in 2000-01), post-merger asset rationalization programs have resulted in a wave of smaller asset sales, as companies have sought to restructure portfolios and bring leverage down.”

Weak refining margins resulted in third quarter net income reductions at several of the integrated majors that reported earlier in October, including Amerada Hess, ConocoPhillips and Marathon Oil. Refinery utilization fell in the low 90% area, according to CreditSights, because of reduced demand, turnaround activity and storm-related cutbacks. Meanwhile, the larger U.S.-based integrated producers have higher production targets in their upstream. Besides more profit in E&P, some companies will have to consider how to pay for refinery upgrades that will be required by the Environmental Protection Agency’s new gasoline and diesel guidelines, which take effect in 2004.

Despite the drop in its production forecast, BP still reported strong third quarter earnings, totaling $2.29 billion, compared with $2.65 billion in the 2001 third quarter. E&P performance was “similar” to a year ago, but BP said its refining and marketing segment was “significantly less favorable.” Hydrocarbon production, which includes oil, natural gas and liquids, increased by about 4% for the quarter.

BP scored during the quarter with several discoveries, including one in the Gulf of Mexico, as well as in Trinidad and Angola. Overall hydrocarbon production for the quarter was 3,445/M boe/d, reflecting new production in Alaska, the deepwater Gulf, Trinidad, Angola and China. During the quarter, King’s Peak in the Gulf of Mexico and Trinidad LNG train 2 came on stream. Horn Mountain, Aspen, Princess and the Vietnam integrated gas project are due to come on stream in the fourth quarter.

For sales, BP said its overall natural gas realizations were down by 24 cents/Mcf. “North American natural gas realizations suffered from widening regional differentials to the Henry Hub marker caused by continued transportation capacity restrictions and weak local demand in the Rockies region,” BP noted. In North America, BP announced a multi-year agreement with Kinder Morgan that will provide BP with natural gas supply and gas transportation and storage facilities on Kinder Morgan’s Texas intrastate pipeline systems.

“The world economy sustained its gradual recovery in the third quarter, and some modest growth is expected to continue in the fourth quarter, though the current environment has little upside and significant downside risks,” said Browne. “BP’s overall trading environment remained broadly at ‘mid-cycle’ during the third quarter. Though storage levels for U.S. natural gas remain high relative to seasonal norms, prices have strengthened recently. This reflects declining production and the expectation of firming seasonal demand.”

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