Lower Oil Prices Give Power to Producers in Contract Talks

HOUSTON (Dow Jones Newswires), November 20, 2008

Energy producers are attempting to use lower oil prices to grab back negotiating power from oilfield service companies in order to cut costs and secure cheaper deals.

In the past four years, as oil prices skyrocketed, the energy industry saw an upswing in global drilling due to the rush of crude oil and natural gas companies to build production capacity.

Some of these companies borrowed heavily to fund their drilling programs. This resulted in a shortage of rigs and key technology to evaluate new discoveries and enhance oil production from older fields worldwide. Costs of these products escalated to unprecedented levels, with rigs in the Gulf of Mexico being rented for up to $600,000 a day. This helped the oil and gas service sector gain negotiating and pricing leverage.

But as oil prices has fallen more than 65% from an all-time high in July, and several producers have cut their capital spending and drilling programs in order to preserve liquidity amid the worsening financial crisis, the oil service sector is poised to see an increase in renegotiation of contracts, analysts said.

"Given the correction in oil prices, and what is likely to be a slowdown in drilling activity, negotiation power have reversed back to the oil companies," said Bill Herbert, an analyst at Simmons & Co. "We are in the early stages of seeing contracts renegotiated on more favorable terms for the oil companies."

Shares of some of the largest oil-service companies fell Thursday as crude oil settled 7.5% down at $49.62 on the New York Mercantile Exchange. Shares of Schlumberger Ltd. (SLB) traded 16.3% down at $39.60, while shares of Transocean Inc. finished 17.6% down at $55.40.

Shares of major oil companies also suffered, but to a lesser degree. Exxon Mobil's shared closed Thursday 6.7% down at $68.51 while Chevron Corp.'s (CVX) shares finished 8.8% down at $64.40.

Over the past few weeks, several major oil producers have announced delays of important projects, or have scaled back their expansion plans in the hope that market conditions will help them secure better deals from contractors.

State-owned Saudi Arabian Oil Co. (SOI.YY), or Saudi Aramco, the world's largest oil company by production, for example, recently reviewed its 900,000-barrel-a-day offshore Manifa oil field expansion. This decision could affect firms like Halliburton Co. (HAL), the world's second-largest oilfield services company, which won a large three-year contract for that project.

On Nov. 6, ConocoPhillips (COP), the third-largest U.S energy company by market value, and Saudi Aramco officially halted bidding on its 400,000-barrel-a-day refinery at the Yanbu Industrial City, in Saudi Arabia. Both companies cited the uncertainty of the financial markets as the driver of the decision, but analysts saw the delay as a move by both firms to wait and take advantage of lower operating costs.

Royal Dutch Shell PLC (RDSA) also recently said the company would defer to an unspecified date a decision on whether to expand its Canadian oil-sands operation. It said the delay will give overheated costs there time to moderate.

"I'm sure there are a lot of negotiations going on between oil companies and oilfield service companies to reduce prices," said Sal Ilacqua, an energy analyst at Monness Crespi Hardt & Co.

The first things oil producers are likely to do is defer any projects that have yet to be awarded. They might also renegotiate the terms of existing contracts so they reflect the dramatic drop in materials, such as steel, which is one of the biggest costs of drilling projects, said Kurt Hallead, an oilfield services analyst with RBC Capital Markets.

"The first thing that is going to be renegotiated or delayed will be the infrastructure projects," Hallead said.

Another approach of oil producers to reduce costs of existing contracts could be trying to change the length of contracts. That would allow producers to pay the same amount of money to oil service companies, but have the benefit for a longer term, Hallead said.

Deepwater Pressure  

Analysts expect to see more pressure to make changes in U.S. deepwater drilling contracts, where rig rates went through the roof.

"There has never been a cancellation of a deepwater drilling contract, but now there are a lot of individuals that are worried that that might happen," Hallead said.

Asked about the possibility that oilfield service companies' clients, especially in deepwater, will be asked for substantial changes in contracts, the chief executive of Transocean said on Nov. 5 that he doesn't consider it a likely scenario.

"Most of our customers are the big international oil companies who honor their contracts," Transocean Chief Executive Robert Long said. "They have been in this business for a long time; they are not going to come and just breach a contract."

Transocean owns the world's largest fleet of offshore drilling rigs.

But even if contracts are honored and renegotiations aren't productive, the near future for oil service companies is gloomier that past years, as oil drilling activity is expected to shrink due to lower oil prices.

"Whether contracts are renegotiated or not, pricing in general for the service industry is going to be more of a challenge," said Simmon's analyst Bill Herbert. "There is not going to be as much work to go around."

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