What the industry expects in 2007

Volatility dominates the E&P market

David A. Pursell, Research Principal, Pickering Energy Partners, Inc., Houston

For most E&P companies, 2006 has been a very good year. Commodity prices remain high enough to ensure large amounts of investment, and activity levels are at 21-year peaks. Nevertheless, oil and gas prices have been volatile, and operating costs are higher.

2006 summary. Several factors have affected the upstream industry’s performance this year. Some of them will continue to affect E&P activity in 2007:

• Gulf of Mexico (GOM) hurricane-damaged infrastructure is now mostly repaired
• Commodity price volatility is not going away
• First, there was not enough oil, as production disruptions and fear of them ruled oil markets
• Then, there was too much oil, as demand growth moderated, and high inventories mattered. OPEC had to defend prices via the first output cut since early 2004
• Oilfield services are in short supply, but this should ease as new equipment hits the market in 2007
• Manpower – it’s easier to build rigs than to find people to run them. Industry will remain short of manpower in 2007.

The really big story. 2006 saw industry’s Herculean effort to repair post-hurricane devastation to infrastructure on the US Gulf Coast. Damage that had to be repaired included:

• 3 million bpd of refinery capacity were off-line, due to physical damage and/or power outages
• Nearly 8 Bcfd of gas plant capacity were damaged
• More than 100 large gas pipelines were damaged
• Oil and gas output – more than 170 million bbl of oil and 830 Bcf of gas production were impacted
• 113 production platforms were permanently destroyed.

A primary lesson is that the market worked. High prices created an incentive to accelerate repairs. Thus, there were no widespread outages of oil or gas (after the first few days). It is hard to quantify, but there was also some industry pride, to show consumers that energy infrastructure can take a direct hit and still deliver. Job well done!

The big story. Commodity price volatility (see Table 1) has been the top 2006 story, as commodity prices saw significant swings throughout the various months. Many variables contributing to this volatility are discussed in the remainder of this article. Volatility makes long-term planning more difficult. One high-profile hedge fund lost billions of dollars trading natural gas during 2006. 

Demand . . . price does matter. The market found the price ($3/gal, retail), where consumers begin to not only whine about high prices, but actually change driving habits. Although their “bark” was worse that their “bite,” high prices did result in US demand declining during the first eight months of 2006 (-1.5%). Global demand grew, but at a moderated pace compared to 2004 and 2005. With energy prices moderating in late 2006, price-induced demand fears have subsided. Our outlook is for 1.5% global demand growth in 2007.

It is a tough business. Among this year’s issues have been pipeline leaks in Alaska; deepwater project delays; slow post-hurricane production ramp-up; unrest in Nigeria; higher tax bills in Russia; and governmental re-negotiating of existing deals. Throw in decline rates, and the large production growth that some analysts forecast for 2007 will be very difficult to achieve.

OPEC. A combination of high inventory levels, softening of global demand growth, and oil prices falling from the high $70s/bbl to the high $50s/bbl, prompted OPEC to defend prices via production cuts. High inventories trumped fears of supply disruption and became relevant after an 18-month hiatus. The market is mixed on the impact of the late 2006 OPEC cut:

• Bulls say “great,” as OPEC is defending prices in the high $50s
• Bears say “wait a minute.” Oil prices are high, because strong demand growth and a lack of spare production capacity create a market with no margin for error on the supply side (some would say “fear premium”). Slower demand growth and OPEC cuts are decidedly bearish for oil prices
• Our view is that global demand is strong enough that OPEC output cuts will be short-lived, and winter inventory draws will be larger than normal. Oil is not going below $50/bbl.

Badges? We don’t need badges! Oil markets were fearful that an attack on oil infrastructure, with limited excess production capacity, would send oil prices over $100/bbl. Security increased as a factor in all segments of the energy sector. Saudi Arabian security forces had a “near miss,” as terrorists unsuccessfully attempted to blow up the giant Abqaiq production facility. Fears of a Nigerian output disruption before the 2007 elections remain.

Orwellian nightmare? Many countries with significant reserves/ exports are extracting a higher percentage of economic rent from existing fields (by rewriting contracts) and future developments (by tougher negotiations). Major oil companies with lots of cash are having a tougher time finding places to re-invest earnings. Venezuela and Russia are two examples, where the rules have changed meaningfully on existing projects. As long as oil prices remain high, this trend will not reverse.

Natural gas production growth. Don’t adjust your reading glasses – yes we said production growth. This was not an issue in 2006, as GOM post-hurricane production impacts were the story. Record gas drilling has created onshore production growth that will outpace GOM output declines in 2007. Production growth, combined with record storage levels heading into December, makes us want an early invitation for “old man winter.”

Got horizontal? More than two-thirds of wells drilled in the prolific Barnett Shale (Fort Worth basin) were horizontal. The ability to drill and complete horizontal wells has allowed this area to extend outside the original core, to become North America’s hottest gas play. Barnett Shale horizontal technology is being exported to emerging shale plays (Fayetteville, West Texas Barnett, Woodford and Floyd) and existing shale plays (Atrium and New Albany), as well as conventional areas.

Productivity gains from horizontal wells can be significantly greater than vertical wells. However, these shale plays’ technical intensity is significant. Microseismic fracture mapping, multiple hydraulic fractures, optimal horizontal azimuth and slickwater vs. gelled fracs all add to the increasing technical knowledge required to optimize unconventional gas plays. 2007 will be “The revenge of the nerds!”

Manpower. Building new equipment is easier than adding qualified personnel. Industry will continue to do more with less, not because firms want to, but because they have to. An old boss once commented on flex time – “as long as you come in before 7:30 a.m. and leave after 5 p.m., you can be as flexible as you like.” Operators will have to lean increasingly on service firms to provide expertise on drilling, well completions and post-completion evaluation. Fewer people will sneak out early to play golf in 2007.

The rigs are coming, the rigs are coming. Service availability – owning a rig or having one under contract was a significant competitive advantage during much of 2006. However, a large amount of new equipment (drilling rigs, pressure pumping, etc.) is coming onto the market in 2007 and 2008. We expect more than 300 new rigs to enter the US market in the next 18 months. Gas prices must remain strong to absorb this new capacity.

Iowa . . . the energy state? It used to be illegal to make moonshine from corn. Now it is big business, except it goes in your gas tank and not a highball glass, thanks to a mandate in the 2005 energy bill to replace gasoline additive MTBE with ethanol. During 2006, it seems like Iowa and the entire US corn belt geared up to produce ethanol. Gulf Coast storm damage made this transition more challenging.

Obstacles facing the refining industry were even more daunting, as new regulations that took effect late in 2006 reduced maximum sulfur content in motor diesel from 500 ppm to 15 ppm. The refining sector proved it was up to the challenge, as no one ran out of gasoline – the ethanol transition went smoothly. Hail the refiners!

Forecast . . . do we have to? Given the uncertainty and volatility of 2006, we’d rather eat all our peas than provide a forecast for 2007. But, here goes. First, volatility remains. Oil prices will stay firm, as consumption remains strong (in the US and globally). OPEC will defend prices near $50/bbl, while 2007 oil production growth outlooks will continue to be too aggressive.

Additionally, gas production growth will surprise the market. Couple this with record storage and sluggish industrial demand, and gas prices are more likely to be lower in 2007 (lower than the $8-plus/Mcf NYMEX futures price in effect as this article went to press). Politicians will continue using “Big Oil” as a punching bag to score political points for the 2008 elections. Last, but not least, major oil companies will increasingly be shut out of opportunities around the world, and thus will refocus their efforts in the US.

THE AUTHOR
	David A. Pursell is research principal at Houston-based Pickering Energy Partners, Inc., responsible for macro energy analysis. Previously, he was the director of Upstream Research at Simmons & Company International. Earlier in his career, Mr. Pursell was manager of Petrophysics at S.A. Holditch & Associates (now a division of Schlumberger) after beginning in Operations and Field Engineering at ARCO Alaska, Inc. He earned BS and MS degrees in petroleum engineering at Texas A&M University and is chairman of IPAA’s Supply and Demand Committee.