Dialing it down

by Paul Stastny
Jan 2008
Source: Oilweek Magazine
http://www.oilweek.com/articles.asp?ID=508

Most pundits see weakening activity levels in the gas-conscious Western Canadian Sedimentary Basin in 2008, as oil prices stay high, gas prices remain depressed, and winter weather continues to be a non-factor

As the oil and gas industry sails into 2008, it will be under pressure to change the way it works in the face of an increasingly complex operating climate—royalty hikes, environmental pressures, labour constraints, infrastructure renewal and capital availability issues, commodity pricing, and a strong Canadian dollar.

New and existing projects will require careful anticipatory planning. Paying attention to industry forecasts—and there are no shortage of those—can play a role, but a key ingredient to successfully riding out an increasingly volatile working environment, according to professional services firm Deloitte, is incorporating proactive thinking into long-term project plans.

“It is clear that the entire energy market is in the midst of significant upheaval,” a recent Deloitte report on the Alberta royalty review states. “As resources such as air, water, and land [formerly perceived as mostly unconstrained] become more constrained, governments may find themselves stepping in to refocus market attention and prevent negative impacts to certain markets or sectors. Consequently, producers and other stakeholders will be challenged to evolve the way they assess the market, plan projects, engage in internal and external dialogue, and strengthen their respective positions by anticipating change instead of reacting to it.”

Drilling

The Petroleum Services Association of Canada, in its benchmark drilling activity forecast for 2008, is projecting a continued and dramatic slowdown in petroleum industry field activity this year.
http://www.psac.ca/media_centre/pdf/20071031.pdf

For the year, the association is predicting only 14,500 completions in western Canada, which represents a 17 per cent drop from the 17,550 completions it said would be drilled in 2007. The 2008 figure, PSAC president Roger Soucy said, encompassed at least a certain degree of activity erosion flowing from Alberta’s new royalty regime.

“While producers and the industry as a whole are still calculating the impacts of the new royalty regime, all indicators are for some negative impacts, which we had to take into account in further reducing 2008 well counts—which were already low due to low natural gas prices,” Soucy said.

On a provincial basis, PSAC estimates 9,575 wells will be drilled in Alberta in 2008, representing a 25 per cent decrease over 2007. However, drilling activity in the three other western provinces is expected to increase in 2008 over 2007. In British Columbia, drilled wells will be up by 10 per cent to 900 wells, while Saskatchewan and Manitoba can each expect to see a 3 per cent improvement to 3,600 completions and 350 completions, respectively.

The Canadian Association of Oilwell Drilling Contractors’ forecast mirrors that of PSAC. CAODC is also expecting a dramatic reduction in field activity in 2008 under the pressure of continued weak natural gas prices, high operational costs, and a very strong Canadian dollar. Assuming no material change in average well depths (7.4 drilling days per well), CAODC expects 13,735 wells will be drilled in 2008.
http://www.caodc.ca/PDF/Forecast-Oct07.pdf

Fleet utilization will come in at just 34 per cent in 2008, according the CAODC. This is well below the average annual utilization level of 50 per cent. Importantly, the association expects first-quarter activity to only reach a utilization level of 50 per cent.

“The winter drilling season, normally the busiest time for drilling and service activity, has been lost due to the uncertainty created by the Alberta royalty review,” the CAODC says. “An average of 445 rigs out of a fleet of 890 will be drilling. The last time utilization was at, or lower than, this level was 1992.”

Somewhat more optimistic drilled expectations have been posted by investment house analysts as well as the Canadian Association of Petroleum Producers. CAPP expects about 17,000 wells to be drilled in 2008.

Oil prices

BMO Capital Markets’ managing director, Randy Ollenberger, says his firm remains quite bullish on the oil patch in light of strong oil prices. He predicted oil prices will likely hover in the US$90-plus range over the next five years or so, even if such prices are not supported by economic fundamentals.

“About $10 to $15 per barrel can be attributed to speculative forces, driven by gasoline demand and the lack of global refining capacity,” he says. “The United States essentially has to import gasoline 365 days a year. That has added some tension to the overall system and it has given rise to the situation we’ve never seen before in the world market—where we’ve run out of refining capacity.”

And gasoline demand is expected to grow stronger as developing countries buy more cars. Vehicle penetration in the United States in 2004, Ollenberger says, was about 800 cars per 1,000 people. In the same year, China hit roughly 30 vehicles per 1,000 people, which is the same level the United States had in 1917.

“If you just extrapolate that to where China has the level of vehicle penetration that Eastern Europe currently has, that represents another 12 million barrels a day of gasoline demand,” he says.

This many additional automobiles would require another 12 million barrels of gasoline refining capacity, which is “simply not in the cards. There’s simply no plans to build 12 million barrels a day of refining capacity,” Ollenberger says.

For oil prices to go down would require petroleum companies to spend a lot of money on refinery expansion. But they are reluctant to do so in light of rising replacement reserve costs over the last six or seven years.

“[Increasing replacement costs] are really not being driven by service rig cost inflation,” Ollenberger says. “They’re really being driven by not finding replacement reserves.”

The other component of high oil prices is the high associated costs of producing oil, from services to royalties. North America has generally been more expensive than other places in the world, with Canada weighing in as the most expensive basin in the world to operate in, according to Ollenberger.

Canada’s unfavourable ranking is drawn out in greater detail by CAPP’s vice-president of western Canadian operations, David Pryce. In terms of global oil and gas five-year investment returns on cumulative capital costs, Canada sits at the bottom of the list along with Argentina, at just 12 per cent. The United States averaged returns of 15 per cent. The worldwide average is 18 per cent (22 per cent without North America). Saudi Arabia and North Africa are each at 22 per cent, while the highest returns can be found in Brazil at 35 per cent and in China at 39 per cent.

Natural gas

Brian Purdy, senior analyst with National Bank Financial, echoes a widely held view on natural gas—and not a particularly promising one—for 2008.

“The natural gas inventory situation appears in danger of reaching full storage similar to 2006, dimming the prospects of a turnaround in natural gas prices,” Purdy says.

Most weather forecasts are suggesting that this winter will be two per cent warmer than average, which won’t help generate higher demand, while rising liquefied natural gas (LNG) imports will keep supply concerns in check. LNG imports in the U.S. climbed 44 per cent in 2007 (approximately 200 billion cubic feet), offsetting lower Canadian production, Purdy says.

The biggest jump in LNG imports came in the spring and summer of 2007, when imports swelled to more than three billion cubic feet per day from less than two billion a day. The International Energy Agency (IEA), however, says import levels retreated in September and October as strong foreign demand drove up prices outside of North America, thereby shifting flow of LNG away from the United States.

Without a cold winter, natural gas is expected to continue floundering at current levels in the range of sub-$5 to $6-plus per thousand cubic feet throughout 2008. The U.S. sub-prime mortgage collapse and the ensuing slowdown in U.S. house building is further slackening natural gas demand for space heating.

Lex Kerkovius, portfolio manager and senior resource analyst with McLean and Partners Wealth Management, says he is possibly even less optimistic about natural gas in the coming year, although he expects a price recovery some time in 2009.

“But there are a lot of ‘ifs’ that have to happen before I would hang my hat on a recovery,” he says.

Some of those uncertainties include a reasonably cool winter this year followed by a warm summer and less LNG landings in North America. “In other words, LNG demand needs to stay relatively robust in Europe,” he says. “And that depends on how cold the winter is in Europe. Last year, European gas prices were weak in the middle part of 2007 after a warm winter there and as a result all European Union countries were in a surplus natural gas inventory position.”

As for LNG landings in the U.S., National Bank’s Purdy points out that North American regasification capacity continues to grow. And LNG imports are expected to keep pace with that additional capacity.

The IEA expects another 170-billion-cubic-feet increase in LNG imports in the U.S. in 2008, despite stronger European LNG prices. (The difference in prices is partially levelled by lower shipping costs to the United States from its largest LNG supplier, Trinidad. It costs an additional US$0.40 cents per million British thermal units to ship from Trinidad to Europe than to the U.S.).

If anything may slow the imports of LNG into the United States, it is the rising costs of LNG liquefaction. According to Purdy, they are up three-fold at $900 per tonne of LNG per year (or $18.5 million per billion cubic feet per year).

“Another crucial variable [to a natural gas price recovery] is the drilling complexion in the United States,” Kerkovius says. “To date, U.S. drilling hasn’t really come off.”

In fact, gas production is still increasing in the United States. An immense amount of activity is taking place south of the border, where the focus has been on unconventional basins in the Rockies and Texas. The reason for the robust activity, according to BMO’s Ollenberger, is the difference in economics between conventional and unconventional basins.

“You have a break-even price of about $9 on conventional gas and about $7 on unconventional,” he says. “In the United States, they’re chasing a lot more unconventional gas and in Canada, we are chasing more conventional gas.”