Study sees leap in prices needed for US drilling

By OGJ editors
HOUSTON, Apr. 7 -- Rising finding and development (F&D) and operating costs have created sharp increases in the oil and gas prices producers need to support US drilling, said a report by Lehman Bros. Equity Research.

"We estimate the industry needs $45/bbl oil and $6.25-6.50/MMbtu gas to earn a 15% pretax return on US drilling after fully allocating overheads and exploration costs," analysts said in the Apr. 7 report.

The price thresholds are $10-11/boe higher than those calculated in an earlier Lehman Bros. study of 2000 F&D and operating costs.

The increases, according to the new report, result from higher service and operating costs, maturation of the asset base, and higher prices, which drive up operating costs and allow producers to drill less-attractive prospects.

The report, by Lehman Bros. analysts Thomas R. Driscoll and Sangita Jain, included costs attributable to acquisitions of unproved properties with the costs of drilling.

Cost increases
In the US, drilling-only F&D costs rose to an estimated $10.38/boe last year from $7.63/boe in 2000, the report said. The same costs in Canada rose to $12.25/boe from $19.28/boe in the period.

Drilling costs have been higher in Canada than in the US in 4 of the past 5 years, the study noted, partly due to strengthening of the Canadian dollar.

Outside the US and Canada, drilling-only F&D costs rose to $10.31/boe in 2004 from $5.03/boe in 2000.

To calculate the US price thresholds, the report added to US drilling-only F&D costs a nominal 5% for costs of developing proved undeveloped reserves to yield a total capital outlay. This allows for development of reserves added but not developed in a specific year.

To the capital outlay the report added a required cash flow that assumed a typical oil and gas well duration of 6 years and a 15% return. It further added average cash costs excluding interest expense, income taxes, and exploration expense. And it included an adjustment to reflect differences between actual prices and those assumed by companies in performance projections.

The resulting prices required to generate a 15% pretax rate of return on US drilling in 2004 were $44.46/bbl for West Texas Intermediate crude and $6.35/MMbtu for gas at Henry Hub.

Costs vs. performance
The Lehman Bros. analysts said F&D costs haven't closely tracked performances of company shares over time.

"We believe that a lot of the difference in reported F&D costs reflects the basins companies operate in and the value of the reserves found," they said. "Thus a high F&D cost is not a negative if the value of the reserves found is also high."

They said companies willing to sacrifice growth in production volumes or to shrink volumes "are likely to outperform those that emphasize volume growth over value creation."

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