The Shrinking Role of Price

Oil and gas companies are reporting healthy financial results for the second quarter and first half of 1997. Performances naturally vary from company to company, but an important trend is apparent in the early reports: The industry makes money with volume and cost control; price is not the sole factor of profitability.

Companies shouldn't let the experience pass without noting to their customers and investors how the business has changed. And they shouldn't expect market fundamentals underlying current profitability to last forever.

Price patterns

In the U.S., prices for crude oil and natural gas at the wellhead weakened during the course of the first half. As the Midyear Forecast on p. 45 notes, they started the period above year-earlier levels and ended lower. Prices for major products followed the same general pattern. Further weakening in the price of crude seems likely.

Yet even independent producers, whose profits tend to track wellhead prices, are reporting good, if reduced, profits in the second quarter. In many cases, growing production volumes cushioned or offset price effects. The volume gains reflect the revival in oil field activity of the past several years. This activity isn't fully represented by rig counts, which also happen to be running nicely ahead of last year's averages. With wells better-located than ever before and a growing share of them cutting pay horizontally, reserves and production volumes per active rig have zoomed.

Integrated companies are pointing to downstream operations as the primary force behind recent profits. Chemical earnings are generally strong. And refining margins, while not robust, have improved. Product netback values at least exceed crude prices enough to cover transport and operating costs for most refiners, and capacity utilization is high, especially in the U.S.

This is very significant-and not just to refiners and marketers. For many years, a slump in crude prices just pulled down product prices and did little for refining margins. Refiners had too much distillation capacity relative to product demand and too much pressure, from investments in equipment needed to upgrade resid and meet environmental requirements, to generate cash by running crude.

A period of sustained margin improvement means these relationships have changed for the better, largely because of demand growth and adjustments to distillation capacity. It also gives crude values room to grow if and when production-capacity surpluses dissipate.

The current financial results show that crude-price slumps don't necessarily devastate producers. Smart producers have oriented costs to a range of price possibilities and can make money for investors anywhere along a reasonable spectrum.

The results also show that refiners and marketers earn profits by means other than ratcheting up prices of gasoline and heating oil; indeed, refiners and marketers lack the ability to ratchet up prices. Consumers and politicians need to hear this message. More than a few of them would be surprised to learn that gasoline prices in the U.S. fell through the Independence Day holiday, when, according to popular suspicion, oil companies traditionally gouge their customers.

Prepare for change

Companies, meanwhile, should prepare for change. Markets never hold still. Upstream costs are pushing against weak crude prices, with rig fleets operating at capacity and service providers and suppliers straining to meet demand. Technological and procedural improvements have lowered total costs but can't immunize operators from cost increases associated with tightening markets for specific supplies and services.

That doesn't mean an early end to this period of industry health. An inevitable turn in costs just combines with perpetual political hazards to remind a solidly profitable industry that there's never an end to the call on its creative resources.

Copyright 1997 Oil & Gas Journal. All Rights Reserved.