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BLOGGER CONFERENCE CALL TO DISCUSS INDUSTRY EARNINGS

FEATURING JOHN FELMY, CHIEF ECONOMIST, API

MONDAY, APRIL 23, 2007

Transcript by:

Federal News Service Washington, D.C.

Following is the transcript of the conference call. It was moderated by Juan Palomo of API, who introduced John Felmy.

00:00:30 JOHN FELMY: I’ll just make a brief introductory statement.

As you know, earnings are going to be released for the companies, the bulk of it this week and next week. While I can’t forecast what the individual earnings performances will be of each individual company – first of all, I’m not a financial analyst; second of all, it’s a complex calculation – we do know that we saw our crude oil and natural gas prices down this quarter, first quarter year over year. We have also seen refining margins up. So how the individual company’s performance will be will be a function of what share of your business is in those individual categories. Some of the initial statements from analysts were anticipating a decline, but we’ll see as we go forward.

It’s possible that you’ll see the performance that we’ve seen recently where in terms of cents on the dollar you see the oil industry coming in around 9, 9.5 cents. That’s important because in noting what our earnings are, the numbers of course are first of all very large, because the companies are very large. Exxon Mobil could be one of the top 20 countries in the world in terms of size if it were a country. So very often we find that these numbers are so large that people tend to misunderstand and misinterpret them.

But if you look at the history of the industry going back several years, you see that in many cases our performance in terms of cents on the dollar of earnings are probably a little bit like Lake Wobegon’s children: above average, but not significantly so.

In fact, if you look in 2006, the average earnings for the industry were 9.5 cents on the dollar and that compares to all manufacturing, which is roughly 8.2. Now, when you take out the car companies, which of course have had a challenge over the past year, and you take those negatives out, if you look at the average for manufacturing it works out to 9.5 cents on the dollar also. So the industry earnings are very much in line with that of manufacturing, less than many other industries, and certainly not out of line in terms of everything they have to do to find, produce, refine, market, transport oil to consumers. So that’s my first point.

The second point is that what do we do with earnings? Well, we continue to reinvest. The industry invests vast amount of money in terms of finding oil and gas, in terms of developing infrastructure to ship, refine, transport, get it to consumers 24 hours a day, seven days a week. The Oil and Gas Journal, for example, last year estimated that the total capital expenditures in the industry was $176 billion. And this year they are estimating in a survey that they have that it’ll be $183 billion.

Now, the industry invests in both oil and gas to find more fuels to continue flowing for the future as most forecasts indicate that we’ll need, but they also invest in alternatives. We invest in emerging energy technologies such as frontier hydrocarbons,

energy efficiency. We invest in gas to liquids, LNG, and in renewables such as cellulosic ethanol and solar, wind, geothermal and so on. So the industry in the five years of 2000 to 2005 invested about $98 billion in those emerging energy technologies.

So we are all looking forward to supplying energy for the future in terms of what we’ll need because virtually all the forecasts from the conventional organizations such as the EIA, IEA, and so on indicate that you’re going to have continued demand growth for energy of all types and also petroleum in the future. That’s my second point.

The third point, very briefly, is that the industry has been attacked numerous times over the past few years as though the industry is some kind of inanimate object and people and politicians have threatened to take money away from the industry via increased taxes or penalties or something along that line. We find that especially unfortunate, because our companies are owned by millions of Americans who have put their hard-earned savings into retirement accounts that own these companies. For example, 41 percent of the equity of the oil companies is owned by retirement plans alone. And then we have millions of other Americans in their other savings instruments have also invested.

As I like to say, you know, our companies are not owned by space aliens. They are owned by millions of Americans who rely on these dividends and rely on performance of the equities, and also performance in terms of stock buybacks to support those equities. So fundamentally, when you hear folks saying they’re just going to take money away from the industry and do whatever they say they are going to do, we find that especially unfortunate, because it’s really Joe and Martha out in America who are invested in these companies and it is fortunate for those folks that they do have earnings to be able to support their secured future.

With that I will stop and be happy to take any questions to start.

00:05:48 SKYMUTT: Yeah – this is – go ahead if you want – I’ll go ahead then. This is Skymutt on Daily Kos.

I have a question to your last point about the investment of retirement accounts in big oil. Last year, Exxon Mobil alone bought back $30 billion of its own stock, which seems to be taking money out of – taking stock out of the pool that could be invested by the public, which would reduce the stake American retirees in oil companies. I want your comment on that.

00:06:34 MR. FELMY: Well, the fiduciary responsibility of the executives of these companies is to manage their businesses so that they have good returns to their shareholders.

You do that by several ways when you have cash flow that you’re working from. You invest of course, as we mentioned, which is a vast amount; you pay dividends, which is a return to your shareholders in terms of their earnings; you can buy back stock, which

what that does it boasters the share price of the individual company’s equity and that helps your shareholders; or you keep retained earnings in terms of – for a rainy day or cash flow for what you need.

So what individual companies do is a function of what their perception of is best for their shareholders. They have been heavily criticized for doing stock buybacks, but in fact if you compare the stock buyback rate of the oil companies with that of the S&P industrials, on average you’ll find that the share of net income that goes to stock buybacks is much less than that of the average S&P industrial. So many of the criticisms we feel are just – do not take that into account and are unfortunate, but it’s really the fiduciary responsibilities of trying to get to that point.

00:07:54 MR. PALOMO: Josue, you had a question?

00:07:58 JOSUE SIERRA: Yeah. You talk about refining margins being up. We’ve been hearing a lot on the news that one of the big challenges to the – one of the reasons for the rising price in gasoline is the limited amount of refineries.

Considering that, where is the rise in refining margins coming from? How are the oil companies achieving that?

00:08:22 MR. FELMY: Well, what we’ve seen so far this year in terms of supply and demand fundamentals is the following: while we have heard a lot about outages and unplanned outages and planned outages, what we saw actually was a case where the industry produced record amounts of gasoline in the first quarter, but we had very strong demand.

Gasoline demand year over year was up 1.7 percent year over year, which is higher than it was, say, for example, in 2006 when it was only 0.8 percent. You combine that with a decline in imports of gasoline, primarily from Europe, either due to some unplanned or planned outages there or a strike in one instance. We saw imports of gasoline decline.

So what we saw was a tighter market. We saw increases in crude oil costs, for example, of about 37 cents a gallon. We saw increases of ethanol cost that could be, if you blend the 10 percent, an additional five cents per gallon. And you compare that, for example, to gasoline prices, which were up about 70 cents. So we did see some margin improvement from low levels at the beginning of the year and that’s reflected in what you’ll see from earnings from the refining sector of the industry, but it was due to the supply and demand fundamentals for gasoline.

Now, that’s different in diesel. Diesel was a little bit different because you saw both record production of diesel fuel, you saw demand up pretty strong because we continue to use a lot of diesel fuel with a booming economy, but finally what was – and it was a bit surprising – we actually saw imports of diesel fuel up significantly, so that

market was considerably softer and in fact you saw diesel prices up about 40 cents a gallon.

So you have two different markets that are driving the margins for the refineries at this point.

00:10:25 MR. SIERRA: Follow up to that: what is being done about the limited amount of refineries available and how is that challenge going to be dealt with in the future with the rising demand and obviously the rising price because of limited refinery? What are oil companies doing about that?

00:10:42 MR. FELMY: Well, the first thing that oil companies are doing is looking forward and thinking about expansion.

By reference, if you look over the last 10 years, it’s true that we haven’t built a refinery in that period – in fact, we haven’t built a brand new, state-of-the-art, grassroots refinery in 30 years – we have succeeded in expanding the existing capacity by the equivalent of a new refinery every year within the existing refinery fences.

If you look forward to the announcements that the refiners have made, it looks like that trend will continue over the next five or so years. If it does, we’ll actually reach a point where we’ll have record refinery capacity that will exceed the higher level of capacity we had in the early 1980s when small refineries were heavily subsidized, and when those subsidies disappeared so did those refiners.

So the industry is looking very carefully about what the growth is, because DOE is forecasting a growth in demand for petroleum over the next 20-some years to 2030 of about 28 percent, so we’re going to need more capacity or we’re going to need to import more.

Now, importing may be a cost effective way to do it, get product in the United States, but then you have to be sure that the product that you’re importing meets our very strict clean air requirements. And so there’s a balance in terms of how you want to have refinery capacity here versus product that you can import. Fortunately, Europe has been switching to more and more diesel engines and diesel cars and that has left some excess gasoline that could be exported to the U.S.

00:12:27 MR. SIERRA: When you talk about expanding refinery capacity within the U.S., how is that being achieved? Simply through process improvements or are we talking about technological progress that is helping these old refineries produce more?

00:12:41 MR. FELMY: It’s a combination. It’s both capital expenditures in the sense of having bigger pipes and bigger tanks and increases in size, but it’s also technological improvement in terms of getting greater yields from, for example, the crude

oil so that you get more product out of the same barrel of crude and you reduce the product that you don’t use as much.

So for example, we’ve seen yields this year of gasoline and diesel fuel both go up and yields of the less usable products of residual fuel or petroleum coke or things like that go down and so what you see is both a combination of the sizing along with the technology and yield adjustments in terms of creating that. That includes a whole host of new catalysts that you introduce and new learning processes that you go through, for example, on how you take more and more sulfur out of gasoline and diesel fuel.

00:13:42 MR. SIERRA: Thank you.

00:13:44 SKYMUTT: This is Skymutt again. I want to ask you about what’s sometimes known by critics as corporate welfare. For instance, there’s a provision in the 2005 Energy Bill that’s going to be under effect this year that’s going to give up to $1.5 billion over the next 10 years to a consortia of energy companies for researching the ultra-deep undersea gas drilling.

How would you respond to your critics who say that that’s less warranted given high prices for energy and high profit level for the industry?

00:14:23 MR. FELMY: Well, if I remember correctly, those provisions for developing deep-sea technology for exploration and production primarily go to universities. I don’t believe that they are destined for the companies themselves.

They were largely, I think, intended for technological development in universities in like Texas, for example. I could be wrong, but that’s what memory serves me on what the intent of that was and the industry itself was not destined for those funds.

00:15:04 MR. PALOMO: Any more questions?

00:15:06 SKYMUTT: Yeah – maybe a question about a particular area. I’ve been interested about the Williston Basin in North Dakota and Montana. I am interested in why hasn’t there been more production there to date?

It is increasing rapidly, but levels are still pretty low compared to some estimates of the amount of resource in the area. And I was just wondering what are the limits to production in the area and what potential effect could they have on the amount of domestic production and the bottom lines of the oil companies?

00:15:47 MR. FELMY: I don’t have a good estimate that I can share with you in terms of what the total potential is there, but my understanding of that area is that it’s limited by transportation capacity.

You don’t really have extensive pipeline networks that come out of there and so it really does limit the amount you can produce. It also can have an impact on the price of that produced oil because of course it’s isolated.

So my sense is that they have had some good discussions about moving forward on expanding pipeline capacity and you may see considerably more production. As I recall, also, it’s a pretty good quality of oil, so it’s desirable in that sense and so one would expect that you see more development of it, but as I said I think it’s primarily a transportation limitation that had limited production there.

00:16:46 MR. PALOMO: Anything else you guys would care to know about earnings that john could answer?

00:16:53 SKYMUTT: I have one more question about – I guess it’s sort of related to that. I’ll go ahead and ask it. Why hasn’t domestic investment increased more rapidly than it has given that the price for a barrel of oil has basically tripled within the past decade? Why has there not been more investment in domestic production?

It doesn’t seem that areas for investment have been taken of the table. I know that there’s been complaints by the industry that there’s not – the most attractive areas are not opened for investment, but – maybe I can just get your comments on why there hasn’t been a bigger ramp-up in domestic investments?

00:17:49 MR. FELMY: Well, I think your last comment is really on the mark:

that the most attractive areas indeed are not on the table and if you want to expand investments, you need places where you can invest.

We have the East Coast, West Coast completely off limits, the Eastern Gulf of Mexico, and of course everyone knows that parts of Alaska that are off. In order to be able to make investments, you need to have resources that are promising, so that you get a return to your shareholders.

But also we have had pretty substantial increases in investments. For example, according Oil and Gas Journal it went up about 35 percent last year in exploration and production. That’s a pretty sizable increase and it could have been more if we had more prime areas that we could go to. So I think it’s a combination of limitations.

It’s also a function of the prudence of the executives who are making these decisions because while oil is today at $63 or over $64 as the last one I checked, it’s not clear it will always be that point. Just five years ago or six years ago we had $17 oil, so these companies that are managing their business are looking to make investments that last for 30 years on average, and so you have to be able to make an investment that you’re sure you’re going to make a return to your shareholders and so expectations about pricing being high forever or just being automatic are a challenge in terms of what you do with capital spending because I remember back when I was working on energy consulting in the early 1980s and everybody forecasted that we would have $100 oil by

2000 and then shortly after that we had $8 oil. That’s the experience that the senior managers of these companies are facing with and so they are being very prudent with other investments.

00:19:48 MR. PALOMO: We’ve gone about 25 minutes. We have five more minutes to go if we’re going to do the 30-minute time limit, but if you have any more questions we’ll keep on going.

00:19:58 MR. SIERRA: I was wanting to – I don’t know if this is totally investment earnings related, but I am just wanting to hear more about what sort of investments the oil industry is doing in terms of environmental care – not just direct environmental care, but environmental stewardship in how they operate.

And related to that perhaps a comment/question is, what are doing to communicate and make the public stakeholders aware of these? This is obviously a growing concern in our culture today and so I was just wondering if you could tell me something interesting about that.

00:20:37 MR. FELMY: Well, that’s an excellent point. It is related to earnings because if you look at the investments that the industry has made over the last 10 years in environmental expenditures, it’s been roughly on the order of about $90 billion. Of that, about $50 billion is investments in refineries, for example, to either reduce emissions or to change the fuels to cleaner burning fuels.

And those are investments that have potentially large payoffs. For example, the ultra-low sulfur diesel program this year will allow the introduction of clean burning, efficient diesel engines in the United States for the first time significantly potentially in a couple decades, so that could have an important effect in terms of reducing emissions and improving efficiency. We also make major investments in terms of these environmental expenditures, so you have fewer releases, so that your communities are affected less, your workers are safe, and things along that line. So we have invested substantially in that area.

What are we doing about this? Well, I have been engaged in terms of talking with anybody who will talk to an economist about what the industry is doing, and a host of things across the industry whether it be the earnings, whether it be what’s happening with gasoline prices, whether it be expenditures – on and on and on – and trying to reach out to tell people what the facts are, just as I am doing right now with this conference call, and we’re committed to continuing to do that – to educate folks in what’s going on.

And an important point about the investments in environmental expenditures, of course, that’s an investment that you can’t then spend on a piece of capital equipment for expanded capacity, so we’ve got that tradeoff going on in the industry also.

00:22:36 MR. PALOMO: Any more questions?

00:22:38 SKYMUTT: I don’t have any additional questions.

00:22:40 MR. SIERRA: That’s it for me.

00:22:42 MR. PALOMO: Well, I again appreciate you joining us. A reminder: if you have any more questions you think of after the call has ended, send me an email and we’ll try to get it answered. We will have more conference calls on different subjects and we’ll notify you and hope that you can join us again.

00:23:00 MR. SIERRA: All right. Would it be possible to get my hands on the recording?

00:23:04 MR. PALOMO: Yes. I’ll get back to you on that.

00:23:08 MR. SIERRA: Right. It’s kind of hard to type notes as I am listening and talking and it would be helpful if I could relisten to the questions and answers and all that.

00:23:14 MR. PALOMO: Yeah. We’ll have the transcript and the recording on the web, so –

00:23:18 MR. SIERRA: Great.

00:23:20 MR. PALOMO: Great. Thank you.

(END)