2007 article on Big Oil profits

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Oil Companies May See an Ebb In Profit Gusher --- Producing Nations Win Tougher Deals, Limiting

Potential for Windfalls

By Russell Gold and Bhushan Bahree1,442 words10 April 2007The Wall Street JournalJA1English(Copyright (c) 2007, Dow Jones & Company, Inc.)

The doubling of oil prices over the past few years has produced enormous windfalls for oil companies. But thoserecord profits are likely to recede in the years ahead -- even if oil prices don't -- as oil-producing nationsincreasingly demand a bigger share of the wealth.

Last year, the five largest U.S. and Western European oil companies had a combined profit of $120 billion,roughly double what they earned in 2003, and they are likely to be rolling in cash for some time to come. But theproduction contracts they are signing today aren't likely to be as lucrative as the ones they signed in the 1990s,when oil prices were low and looked likely to stay that way.

Some of the new deals essentially give the oil companies a fee for their services, leaving them little room to gain ifoil prices soar. Countries like Algeria and Venezuela have gone a step further, altering existing contracts to clawback some of the profits from high oil prices.

As these changes take their toll, it is possible the oil industry is enjoying its last run of windfall profits. Of course, asevere disruption in supply could send oil prices above $100 a barrel and yield staggering returns, but anincreasing percentage of those profits would flow into state coffers, bypassing the big Western oil companies.

In the past, oil companies typically generated profits by taking on the risk and expense of finding newunderground sources of oil or natural gas. In return, they got an ownership stake in new fields and the potentialfor a windfall if prices soared.

Today, oil-producing nations can extract better deals because they have the upper hand. Three-quarters of globaloil reserves are under the control of increasingly capable state-owned oil companies, and the West'sinvestor-owned oil companies -- like Chevron Corp. and ConocoPhillips -- typically have to accept much lessgenerous terms to gain access to those reserves.

As a result, the major oil companies are being forced to operate less like wildcatting entrepreneurs and more likeservice companies. These days, says ConocoPhillips Chief Executive James Mulva: "Big Oil is not so big."

The trend toward putting the squeeze on oil companies transcends both geography and ideology. Last year, theanti-American socialist government of Venezuelan President Hugo Chavez raised the royalties Venezuelacharges on production of the nation's heavy crude. Meanwhile, near the opposite end of the political spectrum,the U.S. and Britain raised their offshore royalty and tax rates in the Gulf of Mexico and North Sea, respectively.

"There is resurgence, a new focus on a higher government take as a result of higher prices," says Pedro vanMeurs, a Nassau, Bahamas, consultant who has negotiated contracts for producer governments for more thanthree decades. "If I were an investor, I would carefully monitor this."

Over past decades, many national oil companies have picked up valuable technical expertise, and are now ableto tackle complicated projects on their own. "National oil companies now have the competence to do things, so


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why should they pay others to do these things," said John Browne, chief executive of BP PLC, in an interview lastyear.

The trend moved into the spotlight in late 2006 when Russian natural-gas giant OAO Gazprom said it didn't needoutside help to develop the giant Shtokman gas field in the Barents Sea, turning away suitors such as Chevronand ConocoPhillips of the U.S. and Total SA of France.

Gazprom subsequently invited the Western oil companies to participate as technical advisers, without an equitystake in the project or the potential for a windfall profit. Discussions are continuing.

Behemoths like Exxon Mobil Corp. may be able to hang tough for a while, avoiding contracts that don't offerequity stakes. Even so, Exxon Chief Executive Rex Tillerson says he expects governments to continue pressingfor better terms as long as oil prices remain high. "Until you get a change in the price environment, I don't see thepressure coming off much," he said in an interview last month.

Even some nations that are new to the oil game are demanding stiff terms. Some of the biggest finds in recentyears have been in Angola, which has popularized an oil-production contract built on progressive taxation. As oilprices rise, boosting an oil company's rate of return, Angola's share of the proceeds also goes up.

On top of the tougher demands, Western oil companies are getting into bidding wars for the limited prospects thatare open to them. The stiff competition has forced the companies to give up large chunks of potential future profitto win exploration licenses.

In a round of bids for exploration rights in Libya held in December, most successful bidders offered the state morethan 85% of any future oil revenue right off the top, despite what an energy analyst for Scottish oil consulting firmWood Mackenzie termed "inferior" acreage. For one offshore block, Exxon offered 75% of discovered oil to thestate. Those terms were easily eclipsed by Gazprom, which offered 90% and won the license.

In some nations where contract terms were set years ago, governments have realized they can raise taxesretroactively without fear of chasing the big oil companies away. In December, Algeria imposed an exceptionalprofits tax and passed a law giving its state-owned oil company a majority stake in all energy explorationcontracts.

Anadarko Petroleum Corp., the largest foreign producer in Algeria, protested the changes. Anadarko estimatesthe tax cost is between $103 million and $190 million in the final four months of 2006 -- potentially knocking offbetween 12% and 23% of the company's Algerian operating income before the deduction of administrativeoverhead, according to a regulatory filing. Anadarko, which is based in the Woodlands, Texas, declined tocomment on the situation.

Marathon Oil Corp. faces a new requirement in Equatorial Guinea that foreign producers be required to pay "anywindfall tax that may be imposed by the state." Houston-based Marathon worries about what will happen to itsprofits if oil prices drop again. Company spokesman Paul Weeditz said, "We would expect and believe it is onlyfair for host governments to recognize price volatility and be agreeable to a lesser share of revenues if commodityprices drop."

In some places, the producer nations are simply taking majority stakes in existing projects away from Western oilcompanies. Even when the Western company is paid for its property, future profits are erased. In December,Royal Dutch Shell PLC was forced to turn over a majority stake in Russia's giant Sakhalin 2 project to Gazprom.

Venezuela has raised taxes and royalties and is now requiring Western companies to cede a 60% stake in heavyoil projects to the state. These projects were among the most profitable in the world for Western oil companies,

according to industry analysts.

In the 1990s, capital-poor Venezuela lured Western oil companies into the country with generous terms -- a 34%tax on income and a 1% royalty on oil production. As crude-oil prices soared, the companies' investments inVenezuela turned into gushers of cash.

"The Venezuelan production, when you compare it to the rest of the operations of these companies, issignificantly more profitable," says Fadel Gheit, senior energy analyst at Oppenheimer &Co. He estimates thatConocoPhillips was clearing a profit of $22 on each barrel produced, more than 50% higher than its per-barrelprofit in the Gulf of Mexico.

ConocoPhillips declined to comment.


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To grab more of that profit for itself, the Venezuela government broke existing contracts. Income taxes onheavy-oil projects over the past couple years rose to 50% and royalty rates doubled to 33%, having previouslybeen raised from the original 1%. The government also legislated that the state-oil company, Petroleos deVenezuela SA, be given a 60% stake in existing fields by May -- and thus a majority of future profits.

Mr. Gheit, the Oppenheimer analyst, says Venezuela's response to the oil companies' windfall profits wasn'tunreasonable from Mr. Chavez's point of view. "This is like drafting a kid to the major league and he's making

$100,000 a year. All of a sudden, he is hitting 50 home runs. Guess what, he wants to renegotiate his contractand under the circumstances, one can understand the way Chavez feels."

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