ConocoPhillips on Wednesday was first in line among U.S.-based producers to unveil 4Q2006 earnings, underwhelming investors on the news that its profit slid 13% from a year ago. However, the Houston-based producer won’t be the last to report tempered profits during a three-month period of 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 after completing its $35 billion merger last year with Burlington Resources Inc.

CEO Jim Mulva, who presided over a conference call with analysts last week, said a host of problems are ahead not only for ConocoPhillips, but the entire industry this year. “What we’re faced with is increased fiscal take, increased costs…[and] difficulty…in terms of getting access to new resources,” said Mulva.

ConocoPhillips’ problems in the quarter were aggravated 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.

Occidental Petroleum Corp. also delivered an uneven earnings report last week, announcing a 19% decline in quarterly earnings despite strong production gains. Oxy put the blame for its downturn on lower oil and gas prices, as earnings totaled $928 million ($1.09/share) in the quarter, down from $1.15 billion ($1.40) for the same period of 4Q2005. Output, however, increased nearly 14% to average 616,000 boe/d.

Overall, the oil and gas industry is expected to deliver another profitable quarter for the final three months of 2006. However, a lot of things last year 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.”

Energy analysts with Morningstar expressed optimism that producers will overcome price volatility this year. In a report, analysts said the energy sector in 2007 is showing “long-term legs and plenty of forward momentum…thanks to frontier oil and gas discoveries and projects” in the deepwater Gulf of Mexico (GOM), onshore gas shale basins and Canada’s oilsands.

Morningstar pointed to the ramp-up of the Independence Hub in the deepwater GOM, as one highlight ahead for 2007. The hub will initially hook up 10 deepwater wells to transport natural gas production onshore (see NGI, Oct. 23, 2006. More gas production also is expected to come from drilling in the Woodford Shale gas shale basin in Oklahoma. And analysts pointed to startup of the first phase of oilsands production at Nexen’s Long Lake project in Canada, which remains on track for 2007.

“Oil and gas producers can now get a better understanding of underlying oil and gas structures using 3D seismic drilling and then directional drilling to reach deeper zones, as well as new fracturing (or well stimulation methods) to extract more oil and gas from formations,” analysts wrote. “These advances help reduce exploration costs or increase production per well by getting more oil and gas out of the ground. This has opened the door to more economic fields, even at lower-than-current oil and gas prices. E&P companies can forge ahead with production growth plans over a long-term price cycle.”

©Copyright 2007Intelligence Press Inc. All rights reserved. The preceding news reportmay not be republished or redistributed, in whole or in part, in anyform, without prior written consent of Intelligence Press, Inc.