Why is Drilling Activity Flat Despite High Commodity Prices

Abstract:Commodity prices are at the high end of their historical range but field work remains flat. This is a disconnect from the century-long history of oil and gas where the number one maxim holds that field work follows commodity pricing.

Analysis:Attend any conference. The number one question—and usually the first—in Q&A sessions is: "Why aren't operators more active in the face of historically attractive commodity prices?" After all, field work traditionally follows commodity pricing.

But not this year. In an industry where rig count always is either going up—or going down—drilling activity has been flat since late June, one of the longer sideway runs in recent memory. So what gives?

Here is a list of the more common theories.

Lack of Capital—Wall Street has turned away from the exploration and production (E&P) side of the business, partly because of industry scandals, partly because of poor returns, and partly because Wall Street is undergoing its own contraction as investors lose confidence in capital markets and the financial houses.

Similarly, the pool of private money is also shrinking. Smaller E&P firms have always been able to place deals with private investors, but private investors have grown conservative because of a declining stock market and tighter investment climate. That relegates capital investment to the volume of cash generated by oil and gas operations, and those monies are being diverted elsewhere, notably to debt reduction. Meanwhile, early word is the annual spending surveys will show oil and gas investment next year to be only incrementally higher than this year.

Lack of Prospects—This view bounces around the financial community among analysts who talk to the large independent E&P firms from whence the theory originates. It goes straight to the heart of life in a mature hydrocarbon province where it takes more money, effort, and technology to keep hydrocarbon production flat, at best. Unless additional areas in the Rockies or offshore are opened, the U.S. lacks attractiveness as a place to explore for hydrocarbons. That could explain why there has been no corresponding activity increase in the seismic industry to replenish the prospect pool.

On the other hand, most U.S. drilling is developmental in nature, so it can't be that big a leap geologically to move equipment over to the next spacing interval. The most intriguing part of this shrinking prospect theory is that it indicates those independents who grew large through acquisitions over the last seven years are now facing the same challenge the majors ran into in the early 1990s. Namely, their critical mass is so large that it is difficult to realize significant returns from a percentage standpoint unless they go overseas or north to Canada in search of world class reservoirs. Assuming that multi-year process unfolds, it should bring new opportunity to smaller firms with lower cost structures and technological savvy who can squeeze additional returns out of cast-off properties deemed uneconomic by their larger brethren.

Economic Uncertainty—Most of the official agencies insist the economy is recovering but when it comes time to itemize the proof, the details have been tenuous and contradictory. Economic growth equals energy consumption. While U.S. consumers have done their patriotic best to keep the economy afloat through spending on SUVs, homes, and consumer goods and services, industrial production continues to trend downward. When business begins to reinvest, energy demand will grow. Watch for positive changes in the Federal Reserve Board's industrial production index.

Mergers—The one thing everyone hears about is consolidation savings. The one thing no one ever talks about is the ensuing organizational paralysis as priorities and staffing are rearranged. Field work languishes as mergers and acquisitions lead to a period of underinvestment that lasts from 12 to 24 months, and is usually followed by divestitures of non-core assets.

Lack of Confidence in Commodity Pricing—There are enough greybeards in the industry to recall the perennially tenuous nature of energy commodity pricing, which has a tendency to regress to the historical mean over time. Right now, the industry is enjoying a pricing regime in oil and gas that is well above the historical mean. While the industry talks of potential scarcity as demand overtakes supply, particularly in the North American natural gas market, the main challenge historically for oil and gas has been the threat posed by excess capacity. During the 20th century, that threat drove the Texas Railroad Commission—and later OPEC—into programs aimed at restricting production to market levels, preventing a collapse in commodity pricing. OPEC's discipline since 1999 has been the most remarkable feature of the current oil and gas environment even as it appears to be eroding of late.

Furthermore, oil prices were buoyed from March to October this year over war talk with Iraq. The debate over the size of the war premium ranged from $2 to $5. When it looked as though the threat of imminent war lessened in October, oil prices fell from $29 to $25, which is an accurate gauge of the so-called war premium.

Ample Energy Supply—This is the flip side of the previous theory. The good news is U.S. natural gas storage is less than last year's record levels. The bad news is that it is still above the five-year average. Demand continues to drop. As much as 6 bcf/d in demand has disappeared from the market according to various estimates. On the petroleum front, a stagnant global economy battered by contraction in Latin America, the absence of growth in Europe, and paralysis in Japan dampens global energy demand at about 76 mmbbls/d while supply remains ample thanks to OPEC cheating and an increase in Iraqi production.

Corporate Governance/Balance Sheet Issues—It started with Enron. Where it will end nobody knows, but let's assume the worst is behind us for now. The main blowback at the moment involves diminished investor confidence in corporate entities, particularly those involved in energy. This issue requires management to devote time and effort to creating super clean balance sheets. Some of the companies scrambling to contain the damage from their energy trading adventures also rank among the nation's more active land drillers. Even in companies without trading operations, cash flows from higher commodity prices have been diverted to pare down debt, and those cash flows are down as much as 20 percent compared to the prior year.

Flat or falling production further distorts debt ratios. A Lehman Brothers study this summer found debt-to-capital ratios among the largest independents actually rose to more than 50 percent—contrary to the accepted wisdom that E&P firms were in far better shape during this downturn than in 1999.

Weakening Financial Performance—The economics of field work have changed as excess capacity in the form of used components and machinery left over from the 1978 to 1982 boom disappears from the market. It costs more to get oil and gas out of the ground because contractors are finding labor costs higher. So, too, are they finding the cost of insurance. The irony at the moment is that operators can get the best equipment, crews, and performance at reasonable day rates, but are reluctant to move forward with field programs because of the overall economic picture.

That seems to affirm one of the great contradictions in the oil patch. That contradiction is that operators are invariably least profitable when day rates are lowest. They are most profitable when day rates peak.

There are many other theories as to why operators won't pull the trigger on field work, including geopolitical uncertainty and declining operator profitability. Ultimately all these little theories combine into one grand unifying maxim: Uncertainty pervades the business climate, not just in oil and gas but everywhere globally. Uncertainty increases risk and acts as an economic brake. Until economic growth resumes, drilling activity will continue at maintenance levels only.