Profits of major U.S. energy companies in 2002 lowest since 1998

Feb. 19, 2004 — Profits of the major U.S. energy companies were $20.6 billion in 2002, almost 50 percent lower than in 2001, according to data released by the Energy Information Administration (EIA) in “Performance Profiles of Major Energy Producers 2002.”

The primary reason for the drop was the $2.2 billion loss recorded by domestic refining and marketing operations, which was a record-low net income level (profit) for the 26-year history of EIA’s Financial Reporting System (FRS).

These losses for domestic refining/marketing are notable because 2001 was the second-most profitable year for that segment of the energy market.

The year 2002 was unusual for the FRS companies in that both upstream and downstream petroleum profits (exclusive of asset write-offs and other unusual items) were lower in 2002 compared to year-earlier levels. Net income from oil and gas operations was down by more than $4 billion, a 21-percent drop, largely due to an excess supply of natural gas in the United States in the first half of 2002, which resulted in lower natural gas prices.

Refining and marketing operations showed an income drop of $16.8 billion, or 111 percent, in 2002.

Domestic refiner margins for the energy industry were squeezed in 2002 because petroleum product prices declined while crude oil prices increased.

Although net income from the foreign refining/marketing operations of the FRS companies remained positive, both foreign and domestic operations registered steep declines.

Other key findings reported in “Performance Profiles of Major Energy Producers 2002” include:

• Oil prices rose through 2002, which somewhat offset the effect of lower natural gas prices on energy company profits. Net income from worldwide oil and gas production declined by 13 percent in 2002, to $27.9 billion.

• Operations associated with the “other energy” line of business lost $1.5 billion in 2002 as the collapse of energy trading operations overwhelmed profits from electricity operations.

The “other energy” line is mainly electricity supply and trading, natural gas wholesale and retail trading, and associated services such as risk management.

• In contrast to the many losses, net income for the majors’ chemical operations more than doubled in 2002 as a result of higher sales volume.

Other topics covered in “Performance Profiles of Major Energy Producers 2002” include:

• Involvement of U.S. energy companies in energy production from renewable energy sources and in the developing U.S. liquefied natural gas market. • Recent developments in the Gulf of Mexico. • Recent trends in resource development strategies with a special focus on natural gas. • Role of mergers and acquisitions in the replacement of oil and natural gas reserves.

How the demise of energy trading impacts financial results

In Chapter 1 of the report, EIA reported that the market turbulence energy traders were experiencing caused a large drop in cash flow from company operations in 2002 of the few energy traders in the FRS group.

Many of the overall financial results of the FRS companies were affected by the demise of the energy trading business in 2002.

Late in 2001, the Enron Corporation made revelations of improper financial disclosures going back four years. The abuses of financial reporting standards included deliberate inflation of revenues, misclassification of liabilities to hide debt financing, and manipulation of reported earnings to meet earlier forecasts.

Many of the abuses were related to Enron’s energy trading business, Enron being the largest energy trader at the time.

Enron’s energy trading customers withdrew their business on a massive scale, having lost confidence in Enron’s ability to guarantee future contracted trades at stated terms. Following the accounting revelations that began with its report of third quarter earnings on October 16, 2001, investors lost confidence in Enron and its ability to generate future earnings.

Consequently, Enron’s share prices plunged in value to less than $1 a share on November 28, 2001, from a peak value of $84.87 a share on December 28, 2000. The demise of Enron’s trading business, its rapidly declining net worth, and its growing debt repayments led the company to file for Chapter 11 bankruptcy in November 2001.

The loss in investor confidence in energy trading activities rapidly spread beyond Enron to other energy companies engaged in these activities. Customers who had utilized energy traders to contract for future deliveries of energy commodities and manage the prices of future deliveries also lost confidence.

The financial impacts of the Enron aftermath were severe for companies that depended on energy trading as a core source of revenues and earnings.

As customers cut back on their use of energy trading services, an important source of revenue shrank, reducing the net income of energy trading companies. Prior to the Enron collapse, revenue from energy trading was the main source of reported revenue growth for companies with significant trading operations.

Energy traders gained profit by tailoring future deliveries and purchases of energy commodities at contracted prices to their customers’ particular needs.

A key component of these transactions was the trader’s assurance to the customer that the stated future conditions would be fulfilled. The energy trading customer was essentially purchasing assurances of future deliveries and sales at specified prices or within price ranges.

In order to assure that future transactions could be completed, the energy trader had to take positions in contracts (i.e., the buying and selling of multiple contracts, such as in the futures, commodities, and other markets), both financial and physical.

The energy trader’s position often entailed borrowing funds in order to provide ready cash to expeditiously settle contracts. As long as the cash flow from the trading business was growing, or at least steady and predictable, payback of borrowed funds was done in the normal course of business.

However, should the trading business go into a rapid decline and associated cash flow diminish, the energy trader could be in a situation in which the cash needed to pay back prior borrowings exceeds the cash currently coming in from the trading business. In this situation, the trader must borrow more or sell assets to pay back its borrowings.

Following the Enron debacle, energy-trading customers lost confidence in the process, concerned that future contracts might not be wholly fulfilled. The loss of business had a double-edged effect.

The first effect is simply that loss of customers means loss of revenue and lower bottom-line results. The other, more adverse effect stemmed from paybacks of borrowed funds and associated interest expense that exceeded current cash flow from the trading business. To make paybacks in excess of cash flow, energy traders borrowed more, moving the trader into a riskier position.

With higher risk comes a higher cost of capital for additional funds. Increased borrowing at higher interest rates further eroded the financial results of energy trading companies.

Selling assets is another way of raising cash. Energy-trading companies priced some of their assets for quick sale to raise cash, often at prices below the assets’ balance sheet value.

In corporate financial reporting, when a fixed asset (e.g., a pipeline) is sold for a price below its book value, the loss reduces net income, resulting in lower reported profits. Traders sold other assets because they were profitable with many ready buyers. In this situation, the energy trader was reducing its profits in order to raise cash.

Again, the need to raise cash reduced reported profits as well as the company’s stock of productive assets.

Thus, massive defection of trading customers, increased borrowing costs, and negative bottom-line impacts of hurried asset sales reduced the net income and cash flow of companies engaged in energy trading in 2002.

Although only a small minority of FRS companies were significantly involved in energy trading, the demise of the energy trading business appeared to have effects on overall financial results for 2002.

For example, as discussed in the chapter 2 of the report, the drop in cash flow from company operations in 2002 of the handful of energy traders in the FRS group exceeded that of all other FRS companies combined.

“Performance Profiles of Major Energy Producers 2002” is available electronically on the EIA web site at: http://www.eia.doe.gov/emeu/perfpro/

The report presents data and analyses of the major energy companies’ financial performance by lines of business, resource development issues including regional costs of finding and producing oil and gas, and trends in energy industry restructuring.