Cost Watch 2011
Jan 25
This issue of Cost Watch reflects current estimates of inflation pressures in the oil and gas industry through the end of 2011. Results from September through December 2011 are subject to revision but key conclusions are not likely to change.
Key Conclusions
Base line costs (costs before learning curve benefits and economies of scale) in the North American upstream sector are rising at significant rates and have been throughout most of 2011.
The upward pressure is building. Costs are now rising in all input sectors and not just drilling costs. The spread of cost pressures is seen in rising oil & gas support activity costs and machinery costs.
Up to this point the adverse effects of cost inflation and lower natural gas prices on company results have been at least partially offset by rapid progress along the learning curves in each major unconventional oil and gas sector. Moreover, producers have counted on rising volumes of gas to mask or offset the damage caused by falling prices.
The capacity to offset cost pressures by exploiting the learning curve is not universally available to all companies.
Differences in the size and quality of company acreage positions defines each company's ability to offset market cost inflation pressures. Some companies are not able to achieve these economies and are now re-considering their strategies. Realizing material cost savings to offset rising baseline costs through progress along the learning curve and economies of scale is also not unlimited. These opportunities are exhausted as drilling programs evolve and mature. The nearly universal aggressive drilling programs in the industry have accelerated the rate of progress along the learning curves and the rate of exhaustion of those opportunities for the future.
Chesapeake's announcement that it will cut operated rigs targeting dry gas by 52% in 2012 compared to 2011 and curtail operated gas production is clearly in response to the combined adverse effects of three forces. These are:
- Rising base line costs documented in this issue of Cost Watch
- Falling gas prices
- Exhaustion of learning curve savings in a number of the more mature dry gas plays
The fact that Chesapeake plans to reallocate the savings in capital expenditures to drilling in liquids-weighted plays is critically important for two reasons.
- First, it signals a continuing shift of supply side pressures from gas to oil in North American unconventional plays.
- Second, while the target of this capital reallocation is oil, large volumes of new natural gas supply will also continue to enter the market as a consequence.
OPEC, the oil and gas producers, and the service sector should take note of the likely results.
- Rapidly rising oil, condensate and NGL production from North America will be added to oil supply growth from Brazil, Iraq and Venezuela and other sources competing for a share of global oil demand.
- New North American liquids supplies will be world class in scale and rapid growth is likely over an extended period of time.
- Additional gas supplies from liquids-weighted plays will continue to keep gas prices lower than one might expect in the North American market.
Base Line Oil & Gas Cost Inflation Indices
Figure 1 shows year over year percentage changes in key industry costs by month since January 2007. The direction of change in oil and gas sector upstream costs in the past year is clear.
On a year to year basis drilling costs and oil & gas support activity costs have been rising since the end of first quarter 2010. The rate of increase in drilling costs rose steadily until the last quarter of 2010 and has remained stable since. The cost of oil & gas support activities lagged behind drilling costs in 2010, but has been catching up throughout most of 2011.
These upward cost pressures began to be compounded by a resumption in rising machinery costs after March 2011. Here, too, the rate of increase has risen throughout most of 2011.
Annual rates of change in the average cost index for each period are summarized in the following table:
Figure 2 shows the cost indices from January 2004 through December 2011. The results show base line drilling costs have effectively returned to the levels very near their pre-crash peaks and are continuing to rise. The same is true for costs of oil & gas support activities and production machinery.
The only bright spot from a cost perspective is that, although primary metals costs are up, the cost of tubular steel as reported by US Steel are up somewhat but continue to lag other base line cost indicators. Cuts in gas targeted drilling programs are likely to continue to restrain inflation of tubular steel costs.
Project Cost Indicators
The base line cost inflation indicators in figures 1 through 3 are weighted towards the costs of drilling programs in the United States. We also follow the economics of major new oil and gas upstream projects on a global basis. This section addresses the status of costs associated with these projects.
Figure 4 shows a frequency distribution of global new project costs drawn from PRISM, our upstream analytic system. These include a large number of projects cutting across all types of development methods and a wide range of countries.
The average cost is US$35,000 per peak daily boe output and the median is US$30,000.
As one might expect, capital costs associated with major new projects vary widely and for many reasons including differences in project types and conditions. Many of the projects in the two lowest cost brackets are Iraqi redevelopment projects, are located onshore or in shallow waters.
A critically important feature of the new project cost distribution is that it has a very long and thick tail.
Our analysis has found that global project costs have been rising significantly due to two operative factors.
- Baseline costs associated with major global projects (especially offshore and more complex project types like LNG) have been rising and, in fact, never fell when onshore costs in the United States dropped radically in 2009. (see Global Exploration & Production: Focus Areas of Growth)
- The effects of price expectations on management decisions. Specifically, due to high oil prices and the widespread expectation of an indefinite continuation of high oil prices, more costly resources are being moved from possible to project sanction. In other words, companies are increasingly betting on high or rising future oil prices. As a result projects are being approved for development that are marginal outside of this high price case. The thick tail at the top of the distribution is both a result and an indicator of the extent to which expectations are being ratcheted up.
Most of the major JV alliances and acquisitions in unconventional resources since 2008 fall into this category of projects that involve large exposure to price risk. The varying extent of company exposure to crude oil and natural gas price risk is the subject of an upcoming Industry Perspective report that will be available in the first quarter of 2012.