Musings: ConocoPhillips Cuts Gas Drilling in Canada

ConocoPhillips' experience with natural gas has been marked by poor timing. In December 2005, ConocoPhillips offered to purchase independent oil and gas explorer, Burlington Resources, Inc., in a $33.9 billion cash and stock transaction. The rationale for ConocoPhillips' purchase was to obtain the substantial North American natural gas proved reserves, production and exploration prospects of Burlington Resources. At the time of the deal, ConocoPhillips Chairman James Mulva stated it was his firm conviction that natural gas was going to become a more important fuel source in the North American energy mix. Because ConocoPhillips was not as well positioned in the North American gas business as others, it was deemed worth the high cost to purchase Burlington Resources.

Exhibit 16. Burlington Deal Marked High Point For Gas Prices
Burlington Deal Marked High Point For Gas    Prices
Source: EIA, PPHB

As can be seen from the graph in Exhibit 16, natural gas wellhead prices in the United States had been steadily rising from the low during the warm winter of 2001-2002. The impact of the damage to Gulf of Mexico gas supplies due to Hurricanes Katrina and Rita led to a spike in gas prices during the fall of 2005. Since the time of the Burlington Resources acquisition, natural gas prices either have either traded flat or lower than suggested by then market trends. The exception was during the commodity boom in late 2007 and early 2008 before the onset of the financial crisis. While the acquisition of Burlington Resources was announced during the 2005 hurricane-induced price spike, the deal's economics were based on the trend in natural gas prices and projections of where they were headed. Those projections have not worked out.

Last week, in response to the extended period of low natural gas prices, ConocoPhillips, the third largest natural gas producer in Canada, cut the number of new gas wells it plans to drill and will shift the funds into increasing its oil sands output. Neither move was a big surprise given the relative levels of crude oil and natural gas prices and their expected trends. ConocoPhillips had already taken drastic action in response to low natural gas prices by shutting down wells accounting for 12% of its Canadian output for three months late last year. It also restructured its natural gas operations by laying off 80 employees and shifting others into oil sands work.

ConocoPhillips' strategy for its natural gas portfolio is to reduce new investment and allow attrition to shrink its production output. As confirmed by ConocoPhillips' Canadian unit president, Joe Marushack, the number of wells the company is drilling is down. ''We're not really necessarily focusing on maintaining production,'' he said. Mr. Marushack pointed out that, ''If you go back to 2008, folks were drilling under the assumption of $8 gas. That's a very different capital profile than what you'd use when you have $3.50 gas.''

In discussing the future for ConocoPhillips in Canada, Mr. Marushack cast doubt on the near-term prospects for the construction of the Mackenzie Valley natural gas pipeline. This project, which was once pitched as the most economical way to move Alaskan North Slope gas to market while also moving the huge northern Canadian gas reserves down to the oil sands area where they could power that fuel's development, has struggled with the escalating cost to build the pipeline. Mr. Marushack did suggest that liquefied natural gas exports from the proposed Kitimat, British Columbia, terminal is a ''pretty new concept, but I think it warrants folks looking at.'' He went on to say, ''We've looked at it here. It might be something we consider again in the future.'' But he also said that the company's focus would be on its oil sands assets.

Last year, ConocoPhillips sold its 9% stake in Syncrude Canada Ltd. to Sinopec of China for $4.65 billion. It is now investing heavily in developing new oil sands projects. One expansion comes through its 50% partnership with Cenovus on several projects and the other is its Surmont development, which is owned along with Total E&P Canada, a subsidiary of Total of France.

This year, ConocoPhillips will launch tests of several new oil sands technologies, including the use of solvents to help boost recovery of oil sand bitumen, and well improvements that use ceramic membranes and vacuum tubing to better separate oil from water and help reduce heat loss. These are interesting new technologies that could improve the economics of oil sands projects, enabling the industry to extract more of the resource. This is important as globally the oil industry has left behind a large portion of reserves in fields because both the technology to extract the additional oil did not exist and the economics of the processes were not profitable. Already discovered oil in older fields is potentially the most profitable oil an oil company will ever produce. While the percentage of oil extracted from fields steadily improved over time until it averaged about 35% today, boosting it to 70% would have a huge impact on the global oil resource base for the petroleum industry. We anticipate a greater focus among oil and gas companies in the future to improve oil recovery technologies and economics, much as the industry has done and continues to do with its gas shale developments.