To the surprise of absolutely no one, fiscal 2004 was a banner year for the major integrated oils in terms of financial performance-on the heels of equally stellar gains the prior year. Net sales revenues for the 18 largest majors rose 27% last year versus 2003 while net income and earnings per share shot up 50%, according to London-based Evaluate Energy, a supplier of financial, operating and strategic-planning data to the oil and gas industry, consulting firms and investment banks. Concurrently, the return on average capital employed (ROACE) for the 18 majors edged up to 17% from a year-earlier average of 14% while their return on equity averaged 23.6%, a modest increase from a 2003 level of 21%. "The biggest factor in these gains, of course, was higher oil and gas price realizations by the group," says Richard Krijgsman, Evaluate Energy's chief executive officer. The average price for West Texas Intermediate (WTI) oil rose to $41 per barrel last year from $31 in 2003, while the group's realized price-what each actually receives for its crude-increased on average by $7.40 per barrel. To a less significant extent, natural gas price realizations for the group were also up, by an average 12.6% or 45 cents per thousand cubic feet (Mcf). This uptick caused the group's upstream earnings to climb an aggregate $30 billion, to $126 billion, in 2004. But there's more to their 2004 income story. "If one looks at the group's downstream earnings, year-over-year profitability in that segment was up 80%, with refining and marketing (R&M) earnings rising to $39.3 billion in 2004 from a prior-year level of $17.6 billion," says Krijgsman. "Very simply, the group benefited from tighter R&M margins worldwide. In addition, the weaker U.S. dollar helped the group's downstream earnings outside the U.S. "What's notable is that returns in the downstream last year weren't a million miles apart from those that the majors achieved in their upstream business. That's a real departure from historical norms. Typically, the upstream has far outstripped the downstream in profitability." He also points out that 2004 earnings per share for the group, in many cases, soared even faster than net income due to so many major share-buyback programs by the top majors. Among the leaders in 2004 financial performance were Chevron Corp. and ExxonMobil. Chevron's 2004 net sales revenues rose 27% to $142.9 billion; net income shot up 84.3% to $13.3 billion; and ROACE climbed to 23.5% from 15.9% the prior year as return on equity soared to 32.7% from 21.3%. Similarly, ExxonMobil's 2004 net sales revenues were up 23.8% to $264 billion; net income rose 18% to $25.3 billion; and ROACE jumped to 24% from 18% in 2003 as return on equity remained flat at 26%. Reserves, production These impressive financial gains notwithstanding, the top 18 majors in Evaluate Energy's analysis failed to show any meaningful growth in production volumes and reserves. Indeed, aggregate liquids production for the group in 2004 was up only 2.1% to 18.6 million barrels per day-and essentially flat if one excludes BP's acquisition of Russian oil giant TNK, which added 400,000 barrels per day to BP's oil output. "What's interesting is that all this occurred during a year when the demand for oil worldwide was up 3.5%," says Krijgsman. Equally lackluster was the 18 companies' 2004 reserves-growth profile. Their oil and other-liquid reserves were down 3% last year while their natural gas reserves edged up only 4.7%. On an oil-equivalent basis, that's essentially a wash. This doesn't mean that they didn't do a good job of finding reserves through the drillbit. On the contrary, PetroChina added 1.3 billion barrels of oil equivalent (BOE) through extensions and discoveries; Royal Dutch/Shell, 604 million; Total SA, 540 million; ENI, 324 million; and ExxonMobil, 221 million. "Overall, the 18 biggest integrateds found 5.3 billion BOE and sold 1.5 billion BOE in 2004, so the bulk of their reserves replacement last year was the result of extensions and discoveries-not revisions and acquisitions," observes Krijgsman. That said, he believes the majors face some major challenges in terms of boosting future reserve replacement and growing output. "Despite high commodity prices and realizations, the majors have become very cautious, preferring to focus on the shareholder by spending their money on stock buybacks and increasing dividends," he says. "Also, if we look at the supply side of the industry, it looks like the majors are becoming more marginalized, at least in terms of crude oil production. Going forward, oil supply is increasingly going to come more and more from the state-owned oil companies." Downward pressures Some U.S. analysts also believe the majors face challenges going forward. One of them is Frederick P. Leuffer, senior managing director and senior energy analyst for Bear Stearns & Co. in New York. "We're seeing signs of weakness in energy demand and ever since the beginning of 2004, a very strong build in U.S. oil inventories." Demand for oil in China in first-quarter 2005 slowed to a 4.5% annual growth rate versus nearly 20% a year ago, he says. Also, several major oils reported in first-quarter 2005 that the growth in same-store gasoline sales slowed versus the like 2004 period. And according to the American Petroleum Institute, U.S. gasoline sales in April were down year-over-year. Meanwhile, citing recent U.S. Department of Energy statistics, the analyst points out that the domestic oil and gas industry currently holds 324 million barrels of crude oil in above-ground storage while the Strategic Petroleum Reserve holds 691 million barrels. "Since the start of 2004, U.S. crude inventories have increased to record highs; nonetheless, crude prices have gone up." Leuffer attributes this market behavior to three factors: a fear that terrorism, strikes or political unrest might cause supply disruptions; a view that spare productive capacity within OPEC might be tight; and a perception that the demand for oil is far less sensitive to price changes than in the past. The analyst notes, however, that production in Saudi Arabia, Iraq, Nigeria, Algeria, Russia and Venezuela has risen more than expected; that OPEC has usable spare productive capacity of about 2 million barrels per day; and that although the demand for oil is relatively price-inelastic, at some trigger point-such as $50 oil-demand should weaken. With rapidly rising inventories and signs of weakening demand, Leuffer believes a $45 to $50 oil price isn't sustainable. In fact, he sees $30 oil by year-end 2005 as a more likely case. "The same fundamentals apply to natural gas, and we could see spot prices for that commodity averaging $4.50 next year." The implication for integrated oils? "If commodity prices come down, we can expect to see negative revisions to earnings and cash-flow estimates and a pullback in stock prices." Leuffer suggests a barbell approach to investing in the sector. Translation: on one end of the barbell, investors should focus on financially strong majors with excellent reserve-replacement records, low finding and development costs, superior volumetric growth and a record of raising dividends and buying back stock. "BP, ExxonMobil and Total all fit this profile." On the other end of the barbell, an investor should recognize that amid low interest rates, high cash flows and high stock valuations, which can be used as acquisition currency, the industry is ripe for consolidation. "Majors like Italian oil giant ENI and (China's) CNOOC, which were interested in buying Unocal, are still looking for a bride," contends Leuffer. "Also likely buyers are Royal Dutch/Shell and ConocoPhillips." Possible takeover targets? The analyst cites Murphy Oil, whose oil and gas production is expected to grow at an average annual 12% rate during the next five years and whose exploratory acreage in Malaysia is adjacent to acreage held by Royal Dutch/Shell and Total. He notes that Marathon Oil, whose 2007-10 production growth will come from Equatorial Guinea and Norway, would fit well with those of ENI, Royal Dutch/Shell, ConocoPhillips, Total or CNOOC. Underperformance ahead Gene Gillespie, integrated oils analyst for Howard Weil in New Orleans, shares much of Leuffer's supply/demand outlook for 2005. "We see declining growth in oil demand this year, to 1.7%, due to both recent high crude prices and slowing economic growth in North America, Europe and Japan," he says. "Meanwhile, OPEC and non-OPEC productive capacity is growing, so there's more than adequate crude supply to meet demand. In fact, we look for the 2005 call on OPEC, ex-Iraq, to be around 26.5 million barrels per day-about what it was 10 years ago-and the cartel's current output is already well above that." Against this backdrop, the analyst sees WTI oil prices this year dipping to around $35 per barrel as natural gas prices trend directionally lower, toward an average $5.75 for 2006. "For the integrated oils, this decline in commodity prices means that second-half 2005 earnings will be 10% to 15% lower than in first-half 2005, and 10% to 15% lower again in 2006 versus 2005," says Gillespie. The market implications for major-oil stocks? "Given that they're not reflecting anything close to recent high commodity prices, there isn't as much risk in them as there is in the underlying commodities," he says. "Nonetheless, I do expect these stocks to move lower on an absolute basis as well as to underperform the rest of the market." Despite this forecast, the analyst has Buy ratings on Murphy Oil and ConocoPhillips. In the case of Murphy, he expects low-teens annual production growth for the next five years from upstream projects already in hand from discoveries made in Malaysia, offshore Congo and in the deepwater Gulf of Mexico. "When you combine this with the very exciting exploration prospects the company has in these three regions, its reserve and production base is small enough that any future discoveries can have a meaningful impact." His 12-month target on Murphy shares is $100. ConocoPhillips is more of a value play relative to its peer group. The stock sells at a 15% discount on a price/earnings and price/cash flow basis versus larger integrated oils like BP, ExxonMobil and Total, Gillespie says. "At the same time, the company, which has upstream operations in Venezuela and Southeast Asia and an investment in Lukoil, has the potential for above-average annual production growth of 4% to 5%." His 12-month target on shares of ConocoPhillips is $112.