Energy Industry May Drill More Than Anticipated

By Eric Fox | May 07, 2009 AAA

The energy patch has seen a sharp drop in capital expenditures for drilling, as falling commodity prices caused both the major integrated oil and independent exploration and production companies to cut back. The logical assumption is that this will lead to less supply, a rebalancing of the market and higher prices once demand recovers. (For an industry reference guide, refer to Oil And Gas Industry Primer.)

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Lower Costs Could Mean More Wells
This rebalance will probably occur, although the time frame is not clear for such a cyclical adjustment. However, one thing that investors should consider is that service and drilling costs are falling sharply, which means that operators may be able to drill more than expected as each well will cost less to drill and complete. The cheaper cost to drill may delay a supply response, and thus a recovery in prices.

As an example, let's assume that if an operator had a $100 million capital budget last year then it would be able to drill 20 wells at $5 million each. This year, that operator announces that it would only spend $50 million, which would be enough for 10 wells. However, during the year, prices for oil services dropped to such an extent that the completed well cost was only $3 million, which means that the same $50 million can now cover 16 wells.

Companies Seeing Significant Cost Reductions
Several companies reporting earnings have confirmed these declining price trends for rigs and oil services in the first quarter of 2009.

In its Q1 2009 earnings call, Marathon Oil (NYSE:MRO) announced that it saw "spot rates reductions and drilling rates down 30%" in the quarter. The company said that it was also seeing costs for stimulation services down 25%. Due to the nature of some of the basins being developed in North America, stimulation services are a significant cost for the industry.

Apache Petroleum (NYSE:APA) discussed reduced service costs in detail on its recent conference call. The company reported the following year-over-year declines in various areas where it is involved:

  • Canada - fracturing costs down 40%
  • Gulf of Mexico - jack up day rates down 50%
  • Liftboats - down 30%
  • Anadarko and Permian Basin - rig day rates down approximately 35%
  • Western Oklahoma - drilling and completion costs down 30%

Steve Farris, the CEO of Apache, also indicated that service costs were still falling, and have not yet reached bottom.

Costs Falling Internationally
Costs are also falling for large international projects. Noble Energy (NYSE:NBL) is currently soliciting bids for its Benita project, which lies off the coast of Equatorial Guinea. Noble reported that bids for major components of the projects are coming down by 20-30%.

These trends obviously don't help the large oil service companies like Schlumberger (NYSE:SLB), Halliburton (NYSE:HAL) and Weatherford International (NYSE:WFT), which may see lower margins as prices come down for contracts that are rolling over.

Final Thought
The precipitous drop in oil service and drilling costs may allow the industry to drill more wells than planned. If this happens, it might lead to less of a supply shock than investors are counting on to correct the cycle. (In addition to supply shocks, learn how a different kind of shock can affect the economy in our article Deflationary Shocks: Helping Or Hurting The Economy?)

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