Investing in oil drilling equipment

Dan Amoss - Thu 21 Dec, 2006

...This confirms that the trend of declining US oil well productivity is being felt in basins around the world...

 
 
- "Oil demand is too young, supply is too old," according to oil industry expert, Matt Simmons. Most of the presenter’s at last month’s ASPO-USA conference agreed with Simmons assessment. ASPO stands for the "Association for the Study of Peak Oil and Gas."

- The conference brought together some of the world’s top minds in the fields of both conventional and alternative energies. A great amount of research was presented and many platforms were proposed, but one key conclusion was communicated by several speakers: there are no "silver bullets" for the world’s long-term oil and natural gas supply challenges.

- An audience of 450 listened intently as Matt Simmons, a top global oil industry expert, mentioned two key technologies that greatly expanded the capabilities and the reach of oil and gas explorers: 3-D seismic and deepwater drilling. The problem is they’ve already existed for decades.

- Through his 37 years of experience in energy sector investment banking, Simmons has lived through several booms and busts, witnessing the evolution of oil field technology from the front lines. So his view that "the technology pipeline is nearly empty" does not bode well for those waiting on a great free-market solution to the ever-present challenge of depletion.

- Most oil field innovations of the last 40 years sought to accelerate oil production rates. That’s because one of the highest priorities of corporate executive teams is to maximize the internal rates of return for their companies’ expansion projects. The best way to achieve this goal is to shorten the "payback" period of prospective projects: Profits generated next year are far more valuable than profits generated 10 years down the road.

- Technologies that advance future production include multilateral well-bores, sub-sea satellite tieback fields, and tertiary recovery methods like water flooding.

- To quote Simmons from his presentation, the downside of these technologies "is that they brought production to 'just in time,' maximized internal rates of return. It avoided the need to properly define reservoir sizes through added appraisal wells that were 'cored' and flow-tested, which led to a lot of overbooking of what we thought were proven reserves because we didn’t have enough data over the last 15 years to know the difference...the reality of future oil field R&D is that there are very few breakthrough ideas on the drawing board.

- "The major oil companies basically backed out of this area and shut down their labs, assuming the oil service companies would take over their responsibility. The oil service companies effectively quit because they never got paid any premium [for their research efforts]."

- In another part of Simmons’ presentation, he laid out the primary thesis behind a long-term upward trend in necessary drilling activity (emphasis added):

- "An uncomfortable fact is that too many regions are now in decline. Modern oil field production programs were all aimed at maximizing 'net present value,' which is basically 'get it out of the ground as quickly as you can.' This tactic has accelerated field decline profiles. Once declines begin, the number of wells drilled needs to accelerate, which is why we’ve used up the entire population of high-quality drilling rigs. They are all now at work."

- The number of wells drilled has indeed accelerated in mature basins including the US, where peak oil was reached on a local scale in the early 1970s. Oil production in the US has become more and more drilling-intensive ever since. This leads right into the key conclusion in Simmons’ presentation: "The nub of the problem is what I would call a clash of ages: Demand is too young, and supply is too old."

- Most everyone is familiar with the "demand is too young" part of his conclusion. Even though the price of crude oil has tripled over the last four years, global demand continues to boom. The robust economies of China, India and other developing countries have become robust consumers of oil.

- For energy investors, the "supply is too old" part of Simmons’ conclusion is very important to consider. At the conference and in public interviews, he repeatedly refers to the rusted state of the global oil infrastructure. Specifically, dangerous over-reliance on very mature super-giant fields and the old age of the global drilling rig fleet put future oil consumers in a precarious position.

- In its 2006 Global Upstream Performance Review, John S. Herold, a leading oil and gas industry research and consulting firm, concludes that capital intensity is gradually rising. The study includes data from over 200 publicly traded oil and gas companies from around the world. One of its recurring themes — one should not assume that more dollars invested in the oil patch automatically leads to growth in production.
 
- To quote from the study: "Reserve replacement costs surged by 73% as increased capital spending did not translate into incremental reserve additions. A 36% increase in finding and development expenditures generated just an 8% increase in reserve additions via the drill bit for the over 200 companies in this study...Proved reserves worldwide were up by 2% in 2005, to 257.7 billion boe.

- Arthur Smith, chairman of John S. Herold, included the graph entitled Global Upstream Performance Review Activity in his presentation at the October 2006 ASPO-USA conference. The total number of exploration and development wells drilled has grown from about 33,000 in 2002 to about 50,000 in 2005, yet as the bars in the graph show, reserve additions per well have trended down, from 450,000 barrels to 300,000 barrels.

- After Peak Oil, this trend is likely to accelerate, increasing the demand for available rigs and hastening the depreciation of the drilling rig fleet. This confirms that the trend of declining US oil well productivity is being felt in basins around the world.

- This adds to the investment appeal of drilling equipment companies.


Regards,

Dan Amoss
for The Daily Reckoning