What the industry expects in 2007

Bad biorhythms throw contractors out of sync with independent operators

Douglas C. Nester, COO, Prime Offshore L.L.C., Houston

Characterizing the state of the industry in 2006 is akin to characterizing someone whose biorhythm cycles are out of sync. Instead of the traditional physical, emotional and intellectual cycles associated with biorhythms, our industry this year was dominated by the cycles of commodity prices and service costs. Throughout the year, these two cycles oscillated and remained out of phase. This, in turn, created opportunities and strife for independents and service companies operating in the Gulf of Mexico during 2006.

At the beginning of the year, the commodity price curve was at its peak, due largely to the devastation and production shortages caused by the hurricanes of 2005. At the same time, the curve associated with costs of services was still lagging and had yet to reflect our industry’s full response to these storms.

Demand for services hits a peak. What occurred early in the year was an unprecedented demand for support services in the Gulf of Mexico. This demand came from all aspects of our business. Due to the favorable gas prices, there was an increased demand for drilling and completion services, as companies scrambled their budgets to fund exploration and production projects that only now made economic sense. There was also the need for offshore survey and construction services to assess and repair the infrastructure damage that now existed in the Gulf. Lift boats, dive crews, barges and welders became, and remain, precious commodities.

Costs surge. Supported by this extraordinary demand, and also by increases in contractor insurance premiums, rates for nearly all services surged throughout the year. Before peaking in the fourth quarter, rates leaped on a weekly basis, and in many instances doubled from the summer of 2005 to the summer of 2006. As an example, day rates for 250-ft IC class rigs that averaged nearly $60,000 per day in early 2005 were now going for $120,000 in mid-2006.

Contract terms also changed, as the pendulum swing placed the upper hand firmly on the side of the contractor. With utilization rates for construction and survey vessels at 100%, requests for terms traditionally favorable to operators, such as the assumption of weather downtime by the contractor, were no longer being considered.

As presented earlier, the commodity price curve and service cost curve remained out-of-phase all year. Just as the service cost curved neared its zenith in October, the price of natural gas dropped to the 2006 low of $4.39/MMbtu. Within one year, we experienced a complete flip in cycle conditions. While starting the year with high gas prices and modest service costs, we ended the year with weak natural gas prices at a time of very high service costs. Depending on which side of the operator/ contractor fence you reside, and the timing of your offshore operations, the year looked really good for at least half the time.

At Prime Offshore, we were very fortunate to capture the high prices early this year after completing a major development project in December 2005. We were even luckier that our project, which consisted of drilling four wells, setting two platforms and installing over 50 mi of pipeline, was located in an area of offshore Texas that was away from the path of the 2005 hurricanes. As a result of our fortuitous timing, we completed this offshore operation with pre-hurricane construction rates and then placed gas hedges during the January peak prices.

Re-assessing projects today. As they say in acting, timing is everything, and it is certainly true in our business. If we had to make the decision today to repeat the same project for the same reserves, but at today’s costs, I am frankly not sure if the project would have received a green light. Across the board, our industry is chasing quality opportunities that are dwindling in number and contain reserves that are often modest in light of the risks being taken. There was a quote I read early this year that stated, “By 2007, 90% of new production will be from reserves once considered marginal.” Whether you’re looking for a handful of Bcf on the shelf, or millions of barrels in deep water, project decisions come down to weighting the variables of reserve size against the estimated cost to capture and produce them.

If we theoretically repeat our 2005 offshore Texas project based on today’s conditions, the biggest change in our economic model would be cost. Surprisingly, there is not a real significant difference between present gas prices now and those in the summer of 2005. However, substituting today’s rates for the actual work that was performed in 2005 increased our total project costs by just over 50%. A cost increase of this significance for any project that is chasing “marginal reserves” can easily cause an expected return to fall below the economic cut-off set by companies.

Balance may be restored. So what is in store for 2007? Right now there are signs that our industry’s biorhythms are becoming better aligned. The weakening of natural gas prices and post-hurricane MMS restrictions has caused operators to slow down their exploration programs. Many are now sitting on the sidelines, waiting to see if this winter will bring the cold weather needed to reduce storage and firm the long-term price strips.

Even though some 13 to 15 jack-up rigs are scheduled to leave the Gulf through 2007, day rates are showing signs of downward pressure. In November, operators signed short-term contracts for IC jack-ups at day rates that were just 25%-30% of those being charged during the summer months. Many publications are predicting that day rates will flatten out and likely drop during 2007, if operators continue to defer projects. Offshore construction day rates are also under pressure, as new projects are delayed and post-hurricane clean-up work is completed.

Hopefully, our curves will align in the proper direction, and we will have an industry better in balance, and one where service companies are still thriving and operators are comfortable in moving forward with exploration and development projects. However, we live in an ever-increasingly fragile world. It seems that the commodity price curve for gas is more sensitive to temperatures in the Northeast US last Wednesday, and a kidnapping in Nigeria, than to how many reserves are being replaced or depleted during the previous year.

So, while we appear to enter 2007 in a favorable light, one where both the operator and service providers prosper, I expect somewhere along the way our cycles will once again find themselves out of sync. Now that I had more time to think about it, perhaps we should be incorporating the traditional biorhythm emotional and intellectual cycles when characterizing the state of our industry.

THE AUTHOR
	Douglas C. Nester is chief operating officer at Houston-based Prime Offshore L.L.C., previously known as F-W Oil Exploration L.L.C. Before joining Prime Offshore, Mr. Nester served as vice president of international exploration at Devon Energy. Prior to Devon, he helped to co-found 3DX Technologies Inc. in 1993, serving as vice president of exploration. Prior to that, he worked at Pennzoil. Mr. Nester received a BS degree in geology from Indiana University of Pennsylvania and performed graduate studies in geology at the University of Houston. He received an MBA in finance from the University of St. Thomas in Houston.