Beer's on Us: Commodity Pricing and Operator Profitability
by Richard Mason
|Tuesday, November 18, 2003
Strong cash flows from high commodity prices and stable field costs indicate this is a great time to be in the E&P business. At least one industry study shows that E&P firms' internal return rates for capital expenditures are at 50 percent, given current natural gas prices.
Get your local E&P firm to buy you a beer. Better yet, bring a friend when you go. Judging by third quarter earnings announcements, operators can afford it. Production is up for the most part. Commodity pricing is higher--and so are profits.
Pick a publicly held E&P firm. Look up its third quarter earnings. Now repeat the process for another firm, or just read the analyst reports. They contain terms such as "reported better than expected 3Q03 EPS (earnings per share)," or "exceeded both our estimate and the consensus estimate," or occasionally "upside surprise."
Life is good for most oil and gas operators. While comprehensive data is still not in on how the sector did as a whole--including the various subparts such as independents, majors, or energy merchants--the bottom line is that exploration and production activities were very good this last quarter, especially for operators working in North America.
It is hard to imagine a better time to be an operator in oil and gas with the possible exception of the late 1970s. Indeed, there is little to dispute an argument that these are the best overall conditions for oil and gas operators in a couple of decades.
High commodity prices mean cash continues to roll in. Field costs are dormant. In fact, some pricing power has actually eroded from field services because capacity exceeds current demand, particularly in pressure pumping. The story is little better for contract drillers. The last significant move in day rates was five months ago in most markets. As a result, there is little inflationary pressure facing operators.
Usually the contract drilling industry is in a mad scramble to find someone--anyone--to work a drilling rig during high commodity price environments. Not so this time. Because of the "jobless economic recovery," the hands are out there willing to work. Contractors have not had to resort to the same expensive incentive packages they needed in 2001 to attract people into the industry.
Beyond the opportunity that higher revenues and flat service costs provide, there are broader macroeconomic fundamentals favoring E&P firms.
Globally, oil supplies are tight and likely to remain so for the foreseeable future. In North America, the natural gas picture remains tight with operators rushing to stay ahead of an accelerating decline curve. That picture is not going to change soon.
It now appears that the U.S. Congress could pass a stimulative energy bill that would lavish billions of dollars in tax incentives on an industry already demonstrating above average profitability.
So don't be shy when it comes time to ask operators to buy that next round. After all, one of the more prevalent myths in oil and gas concerns the rule of thumb that operators passed on to the financial community during the down market in the early 1990s. Namely, the slightest upward movement in field costs jeopardizes oil and gas field activity. Under this scenario, service costs determine an E&P firm's profitability and any attempt by contractors to increase those costs is reckless and potentially damaging to the industry.
There are several reasons why this is not so. The first is practical. Commodity prices determine E&P profitability. Operator profitability historically has always been highest when day rates are highest. This usually coincides with peak cycle commodity pricing. Conversely, operator profitability has been lowest or nonexistent when day rates were lowest, generally at the low commodity price portion of the cycle.
Second, operators determine day rate direction in a rising market. It is a matter of human behavior. Generally as waits on rig availability reach 90 or more days into the future, operators develop anxiety about getting equipment in a timely manner and begin to bid rates higher. Competition for rigs among operators moves day rates higher. Think of it as Econ 101.
Finally, operators invariably cite two sets of books when discussing oil and gas. E&P field managers point to dry hole costs, or basic single-item profitability plus the cost of failure spread among successful wells. E&P mid-level managers often argue that any change in field costs will have drastic impact on their ability to employ rigs and keep programs going.
In contrast, senior management at E&P firms generally refer to the profitability inherent in life cycle economics for their geologic plays when soliciting investors from the financial community. Under the latter scenario, field costs are only an incremental part of an economic picture that will last years.
Turns out that the dry hole cost factor is losing credibility. As Exhibit "A," consider the latest piece from the oilfield services energy analysts at Raymond James & Associates. This group operates one of the most prolific research houses in the energy business with a widely quoted "Stat of the Week" report on some aspect of oil or gas. The oilfield services research shop at Raymond James & Associates has demonstrated an uncanny ability to pose penetrating questions, identify the best data sources, and interpret the information in a way that often punctures some long-standing myth.
Thus the group this week argued that commodity prices will support higher field costs and still provide solid returns for E&P firms in 2004. The report follows a similar piece six weeks ago in which the firm detailed the economics behind gas projects. The report demonstrated that a typical U.S. gas project offers an internal rate of return (IRR) of 50 percent at gas prices near $5.
The Raymond James report cites U.S. Energy Information Administration studies that show the drilling and equipping portions of E&P spending amounted to 45 percent of total exploration and development expenditures in 2001. Currently, average industry finding and development costs are roughly $1.50 per million cf equivalent. Therefore, basic service costs to drill and complete a well are less than 70 cents per million cf equivalent.
"Accordingly, a modest rise in oilfield service costs should barely move the needle on the exceptional current E&P investment returns," the report says.
At $4 gas, the industry can support a 25 percent increase in service costs above present levels and still generate an IRR of 20 percent or better.
The Raymond James piece implies that $3.50 gas is the basic threshold at which IRR begins to drop below 20 percent, assuming no rise in field costs beyond current levels.
The oilfield research group at Raymond James tends to be among the most optimistic in the oil and gas industry. Looking at the fundamentals of declining gas production, the group argues that commodity prices will remain high throughout 2004.
That will be good news for operators and their vendors.
Maybe E&P firms ought to buy the folks at Raymond James a beer, too.