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Crude Prices Producing Caution

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The major oil producers have been turning in monster profits once again but nearly all have warned that current forecasts for future quarters are too high. That obviously stands to reason since oil was $147 at the beginning of Q3 and still over $100 when the quarter closed. It would be very tough to beat those earnings since oil has declined more than 50% since those July highs.

Oil companies have also announced budget cutbacks until they see where oil prices are going to settle. They don't want to spend billions developing fields with an average cost per barrel of $75 if the price of oil is going to be under $60. The marginal cost of a lot of new fields is over $75 per barrel and that is especially true of deep-water fields. This is the self-limiting process for peak oil. Production will slow for lack of investment until the price of oil justifies bringing those high cost fields online.

Occidental Petroleum (OXY) posted earnings that rose +71% for Q3 but said it would not increase capital spending above the current $4.7 billion level. Refiner Valero said it was cutting back on capital expenditures by 33% and cutting its 2009 budget. Valero and the other refiners were hit hard by the sharp spike in oil prices. The price for refined products like gasoline and diesel did not rise as fast or as far as oil prices. This squeezed the crack spreads into negative territory in some cases. With the extreme volatility we saw in Q2 Refiners buying oil at one price could see that price change by $10 or more before they got it. What they did not want to do was buy oil for $140 and then see it fall to $120 before they could take delivery. With a crack spread sometimes in the $1-$2 range a big drop put them into negative territory instantly. Valero said they were going to raise cash for buybacks, dividends and paying off debt. They implied they were going to manage their purchases a lot better in the future. You can bet there are a lot of refiners loading up on futures at today's prices to protect themselves against future spikes. That takes a lot of money to do it in any volume.

Conoco said they were going to keep their 2009 CapEx at $15 billion. Conoco is the most aggressive integrated at finding and acquiring reserves. BP is the least aggressive and has already admitted they were growing smaller by using their profits to buy back stock as reserves dwindled. These are the two ends of the spectrum and Conoco is my pick for the right strategy. I routinely recommend Conoco but I am currently worried about their Russian investments in Lukoil. They own something like 20% and have invested over $15 billion and possibly as much as $20 billion in their stake. That stake could be gone tomorrow if Putin decided to erase them like he has the other oil majors. This is a serious risk but Conoco seems to think they can deal with it. Of course Shell, Exxon and BP also thought they had a lock on their deals and were kicked to the curb when Putin decided he no longer wanted them in control.

Another factor causing a decline in forecasts is the lack of financing. Many smaller firms rely on financing for their deals, expenses and infrastructure build outs. They go to the banks/brokers with a proven lease and borrow millions to drill it out, build the infrastructure and begin production. With credit lines locked or cancelled many of these firms have gone nearly dormant while waiting for the credit thaw. Some are doing cooperative deals with other companies to utilize equipment in exchange for participation. However, overall the exploration and development rush has cooled until prices begin to rise and credit lines return.

The overall decline in exploration intensity today will be felt 3-5 years in the future when there will be a corresponding drop in new production coming online. A new field where drilling started today will not reach full production for a minimum of 3-5 years, sometimes 5-7 years or even longer in the case of deep water. If exploration continues to decline in 2009 it won't be felt on average until 2014. With peak oil currently expected to hit in 2010-2011 that lost production will be seriously missed.

Jim Brown

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