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The Oil Patch Profit Squeeze


Crude oil prices have surged especially in recent months, but the earnings of big oil stocks have not.  Certainly the shrink in the drilling spread (revenue potential minus increased costs from wages, rig costs and increasing taxes) is partly responsible for this divergence.  These are integrated oil companies where refinery margins are as important as retail gasoline volume.  Of course, excessive trader speculation and rising geopolitical tensions have boosted the price of crude oil, but not the stock prices of the major oil patch players.


Of the world’s oil reserves, 80% are owned by governments, and much, if not most, of the rising benefit of crude oil prices flow to them, not the big oil patch operators.  One example is, an oil company benefits only from the first $20 of a barrel's price.  With crude at $80 to $90 per barrel, governments receive all or most of the next $60 or so.  In some countries, the government's take is 90%.  In terms of royalties paid to countries, the trend is up, even in Canada and the U.S.  Alberta is raising royalties on tar sand oil (tar sands oil is considered dirty oil and requires significantly more heavy duty refining, which is more costly, and therefore margins are lower).  Nigeria is currently renegotiating the amount of royalties it receives.  Even the royalties being charged by the U.S. government on recently-awarded offshore leases are rising.  These are now over 18%, up nearly 45% from the 12.5% rate being levied on new leases of a year ago.


Integrated oil companies are being hit from both sides.  As governments’ take and royalties have been rising in recent years, the integrated oil company's costs have been rising as well.  Shell Canada claims the cost of the first phase of the Athabasco Oil Sands project has increased by nearly 50% in one year (from $7.5 billion to $11 billion).  The Sakhalin Oil and Gas Project in Russia was first estimated to cost $9 billion to $11 billion.  Shell recently revised the estimate on this project to $20 billion.


Fortunately for these integrated oil companies, prices for refined oil products that these companies produce and sell such as gasoline, refined motor oil and heating oil have been rising as well.  Unfortunately, prices of these products are not rising as fast as the companies’ costs are rising.  That is why these companies’ earnings are expected to decrease in 2008.  Correspondingly, the companies’ stock prices will probably decrease as well.  In our opinion at Legend Financial Advisors, Inc®, oil service companies such as drillers and equipment suppliers will perform much better since oil rigs, especially deep offshore drilling rigs, are in short supply.


(A significant portion of the information for this article was obtained from Leuthold’s Perception publication –November, 2007.)

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