Production Costs Hampering Energy Companies' Appeal to Investors

As the price of crude oil flirts with $100 a barrel, investors might be tempted to keep a close eye on the commodity as a sign of where energy stocks are headed.

A better idea? Keep closer tabs on production costs. These costs have been soaring lately, thanks in particular to rising prices for equipment and labor, and it is having a dramatic impact on corporate earnings growth.

Consider this: At a time when the price of crude oil has soared from $42 a barrel at the start of 2005 to about $92 on Thursday, the per-share net earnings for most large Canadian producers have gone nowhere. In other words, rising costs have eaten about $50 a barrel - and the controversial higher royalty rates in Alberta cannot take the blame since they have not yet kicked in.

From Talisman Energy Inc. (TLM) and Petro-Canada (PCZ), to Suncor Energy Inc. (SU) and Canadian Natural Resources Ltd. (CNQ), net earnings per share generally peaked two or more years ago, and have since stabilized in a highly profitable, though narrow, range. Meanwhile, their stock prices have risen between 60% and 160%, putting them in-line with rising oil prices but out of whack with earnings growth.

"Guys are finding it harder and harder to grow their overall production and their cost structure is going up," said William Lacey, managing director for institutional research at First Energy Capital Corp. "Commodity prices are great, but cost structures are accelerating very quickly and it's getting more difficult to maintain production."

Fund managers who have turned their backs on energy stocks note that it does not really matter where oil prices head next or whether they finally break the psychologically wowing level of $100 a barrel. Without meaningful cost reductions, the sector holds little appeal.

Can Canadian oil producers shave costs? They are certainly in a tough bind right now, given the high demand for workers around the world. Curiously, lower oil prices could help alleviate some of the problems if they pricked inflation. So, too, could production cutbacks, at least in the longer term.

Canadian Natural Resources made some headway on this front when it announced this week that it will cut back on capital spending in Alberta next year, leading to a decline in production for the first time in a decade. The shares have since fallen nearly 7%.

"We have always argued that it would be difficult for Canadian Natural Resources to deliver on its growth plans given the concentration of its assets in a highly inflationary basin like Alberta," said Menno Hulshof, an analyst at Blackmont Capital, in a note to clients on Wednesday.

He has maintained a relatively unenthusiastic "hold" recommendation on the stock, even as he has bumped up his pricing assumptions for crude oil from $67.50 a barrel to $80 in 2008, an increase of nearly 20%.

If Canadian Natural, and other companies in the oil patch, can cut costs meaningfully in the near future, they will become attractive investments again. In the meantime, the price of oil has become little more than a sideshow.

Comments

[terrythepirate]

The high royalty rates may not have kicked in, but the message to investors that the Alberta govt will not allow you to make profits without taxing them away is very clear. The market tanked last spring when it became clear that Alberta couldn't keep its hands out of the cookie jar. You can't tax your way to prosperity but you can tax yourself out of it.