Energy investors are smiling. Crude prices are skyrocketing, energy companies are enjoying record earnings, and share prices are climbing.

But those smiles may be gone soon. Big oil profits may not last.

Record energy prices have diverted attention from the oil industry's dirty little secret: Production is falling and reserves are on the decline. Rather than address the problem, most oil companies are sinking their money into share buybacks and dividends to boost their stock prices.

Without new investment, companies run the risk of not having enough oil to sustain record profits and may hasten a far worse energy crisis. The country's national security, based largely around cheap and plentiful oil, could be put at further risk if oil becomes scarce and prices rise.

"From a national security standpoint, they'd be better served to continue drilling," says James Williams, an energy analyst at WTRG Economics in London, Ark.

Oil prices have doubled over the past two years, driven by growing demand from recovering American and Asian economies and lower supply levels caused by hurricanes, rebel attacks and wars. On Wednesday, oil closed at $62 on the New York Mercantile Exchange.

At the country's largest energy companies, revenue has soared thanks to high oil prices. Exxon Mobil ( XOM), the world's largest oil company, reported record earnings of $36.1 billion -- the highest for any American public company last year -- and beat its previous record of $25.3 billion in 2004. Earnings at the four other supermajors were just as stellar. Net income climbed 37% at Shell ( RDS.A), 31% at BP ( BP), 13% at Total ( TOT) and 6% at Chevron ( CVX).

"The surge in oil prices took companies by surprise," says Fadel Gheit, an oil analyst at Oppenheimer & Co. in New York. "They didn't expect the windfall profits and were ill prepared to handle the instant wealth. It's like winning the lottery."

Some of those record profits are being funneled into share buybacks and dividends. Every time a company repurchases stock, it reduces the number of outstanding shares and increases an individual stakeholder's position. Buybacks can also pump up a company's earnings per share and stock price.

Last year, Exxon gave back $23.2 billion to shareholders, a 56% increase over 2004. Yet the oil giant sank only $17.7 billion in capital and exploration expenses, according to the company. BP distributed $19 billion in buybacks and dividends, but devoted $14 billion to investments. Shell invested $15.9 billion in capital expenses, and sent $17 billion to shareholders. Only Chevron spent more on its capital and exploration program to the tune of $11.1 billion, vs. $6.8 billion in shareholder distributions. But many investors see nothing wrong with this corporate largesse and contend oil giants are doing the right thing for shareholders.

"Instead of wasting money on a project, they're giving back to shareholders," says Lanny Pendill, an energy analyst at Edward Jones in St. Louis. "Ultimately, their fiduciary responsibility is to their shareholders."

In this era of record profits, exploration budgets have barely budged. Oil companies spent $57.7 billion in 2004, compared to $50.8 billion in 1998, figures from the U.S. Energy Department show. Their leeriness to invest is a holdover from the 1980s when Middle Eastern countries flooded the market with crude and drove prices down by 50%.

At the same time, production at the oil giants dropped between 1% and 7% last year. (BP posted a slight increase of 0.5%.) Output is falling because many oil fields are mature and are not producing as much as they used to. That means oil companies now have to drill deeper, in unconventional areas and in risky countries that require more money, time and technology.

"Production growth for most companies has been very elusive or nonexistent," says Bruce Lanni, an energy analyst with AG Edwards in San Francisco. "Keeping it flat is a major feat."

Companies, to compound the problem, are pumping more than they are replacing. The oil giants aim to replace 100% or more of their reserves each year, but Total and BP each restored 95% of their natural gas and oil reserves, while Shell added 70% to 80%. Chevron replaced a dismal 40% to 50%, according to company filings. Only Exxon found more oil and gas than it pumped last year, but its 143% replacement rate was largely dependent on one natural gas field in Qatar.

"If they can't replace, it's a big deal," says Charles Maxwell, a veteran energy analyst at Weeden & Co. in Greenwich, Conn.

Worse still, outsiders have no way of knowing whether these figures are accurate. Companies release their "reserve replacement ratios" once a year, often in their annual reports, yet don't disclose the production numbers or seismic data used to calculate them. That makes it nearly impossible for investors to verify a company's reserves, particularly when the numbers are not audited.

The supermajors, rather than drilling, have snapped up other companies to boost reserves. Last year, ConocoPhillips ( COP) purchased Burlington Resources for $35 billion, raising reserves by 24%. Chevron devoured Unocal for $18 billion and got a 15% boost to its reserves. For $8 billion, BP received a 50% stake in Russian oil company TNK and increased its reserves by 11% in 2003.

"The bulk of the replacement in the last three years was through acquisitions," says Gheit. "The easy oil has been discovered."

Ironically, it may be shareholders who have spurred the drive to spend more on distributions than exploration. That may be short-sighted because it leaves energy companies more vulnerable to plummeting production rates and could help lead to higher oil prices.

"If anyone's at fault, it's the shareholders who don't want to hold a stock for a decade," says Williams.

Exxon and Chevron, at their annual meetings with analysts last week, each pledged to spend more on exploration to quell growing criticism they were not doing enough to boost supplies. Chevron will invest $15 billion to $16 billion each year over the next three years, up from $11 billion in 2005. Exxon vowed to hike its spending by $2 billion to $20 billion between 2007 and 2010.

Altogether, oil companies likely will shell out 15% more or $238 billion this year, according to a Lehman Brothers report. But that may not be enough. The International Energy Agency, which advises 26 industrialized countries on energy policy, estimates companies will have to invest $250 billion per year over the next 25 years to avoid shortages.

The oil giants need to take a hard look at how they spend money if they want to resuscitate sluggish production rates. While they invest in shareholder distributions, they're losing new reserves to Indian and Chinese state-run oil companies eager to pay top dollar to feed their growing populations. Oil supplies are getting tighter, demand is rising and prices are going up on the few companies for sale.

If the supermajors remain unwilling to invest, get ready for even higher oil prices.

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