Worldwide drilling activity will increase in 2003 with more than 20% higher rig forecasts in North America, solid gains in international markets, and slightly higher offshore rig utilizations.
North American gas prices will trend higher next year. Oil prices will remain at current high levels in the next few months but should trend lower in the longer term. Exploration and production spending will grow by more than 10% in 2003, following the 2.5% 2002 worldwide decline.
The drilling industry is well positioned for profitable growth as economic recovery gains momentum in 2003.
These were the opinions of industry analysts during a panel session on the world outlook for oil and gas in late September at the International Association of Drilling Contractors (IADC) annual meeting in San Antonio.
Commodity prices and industry activity will likely remain volatile. The analysts point to a myriad of interrelated factors and variables influencing supply and demand forces. The petroleum industry should view the volatility as normal and build it into future plans.
Global oil markets
Citing a significant war premium built into the price of oil and relatively low current inventories, Mark Urness of Salomon Smith Barney Inc., New York, said "We expect oil prices in the near term to remain quite robust."
Lower than normal crude inventories for OECD (Organization for Economic and Cooperative Development) countries are contributing to crude oil price support.
Fig. 1 shows the OECD crude oil inventories for 2002 trending about 2% below the 10-year average.
Urness commented that the trend was counterintuitive given that demand has been relatively weak and OPEC (Organization of Petroleum Exporting Countries) member country compliance has been low compared to the organization's published quotas. He noted, however, that the US has added over 30 million bbl to the US Strategic Petroleum Reserve (SPR) since September 2001, which accounted for 50% of the oil removed from global inventories over the past year. The SPR addition replaces oil that was withdrawn in 2000.
According to the US Department of Energy, the US will fill the SPR to its 700 million bbl capacity by July 2005. This will require an average delivery of almost 3.5 million bbl/month to fill the reserve starting from its mid-October inventory of 587 million bbl of oil.
War premium
Urness highlighted the uncertainty that a US-Iraq conflict would impose on oil pricing and offered three potential outcomes, which could be a successful regime change, continued political chaos, or destabilization of the entire region.
He pointed out that a successful regime change would lower oil prices, while continued political chaos or destabilization of the region would send prices higher.
He said, "The ultimate impact and timing on oil prices will depend on when the war starts, how long it lasts, and how 'user friendly' (would be) the new regime."
Dan Pickering of the Houston-based Simmons & Co. International pointed out that the war premium on crude oil is hard to quantify or even prove that it exists. He felt that the market had imposed a war premium that one could judge by watching the oil price response to Iraq-related news events.
Pickering said, "The financial markets believe a conflict will happen, it will be short, and large volumes will be available when Iraq comes back. This will have negative (oil) price implications." He highlights OPEC's importance, in how it negotiates Iraq's return to the organization.
Susan Farrell, senior director of the Petroleum Finance Co., Washington, DC, did not think a US-Iraq conflict would lead to any oil supply disruptions or long-lasting price concerns.
She cited oil-price behavior after Iraq had invaded Kuwait, from January 1990 through June 1991. The prices spiked up for 3-4 months but then came down to resume the prewar trend.
Lower oil prices
Urness expects long-term crude oil prices to decline to $20/bbl explaining, "It comes down to economics 101." Higher prices weaken demand and stimulate supply.
Upon resolution of the Iraq conflict, he noted that oil prices would ultimately come down to the average level that we've observed in the past 10-15 years.
Pickering's longer-term crude price prediction is $25/bbl, with a downward bias and a "huge error bar." He pointed out that incremental oil volumes, from various sources and locations in addition to Iraq, would be entering the market in the next 2-3 years.
An issue that could put downward pressure on crude prices, Urness highlighted OPEC's historical compliance with its quotas, noting that compliance had dropped to 57% during July and August, which was the lowest level in 2 years (Fig. 2).
He said, "OPEC is currently over producing to the tune of 2.1 million bo/d."
Urness pointed out that some of the OPEC countries have significant spare production capacity, with Iraq having the most followed by Saudi Arabia, Kuwait, and the United Arab Emirates.
Urness said he was puzzled by high Middle East rig counts in the past couple of years that have trended to 200 rigs in 2002.
He speculated that Middle East countries have needed the additional drilling capacity to maintain their production capacity, in addition to their focus on natural gas development to fuel local economies and free oil for export.
Farrell noted that Iraq could quickly add 1.7 million bo/d following resolution of the current conflict and 3-5 million bo/d within the next 5 years depending on the stability of a new regime.
She said, "The full return of Iraq to OPEC, which hasn't been really in the OPEC group to a full extent for 10 years, is going to put enormous strain on the cartel."
Contributing to downward pressure on oil prices, Farrell listed incremental oil production that had come onstream from Russia, West Africa, and South America within the past year. She also cited planned capacity increases from Algeria, Libya, and deepwater Nigeria to come onstream in the next few years.
Referring to OPEC's target oil price, Farrell said, "We see a surge of new production coming on market which is going to cause a shift in strategy that will not sustain $22/bbl."
In a material balance exercise, Pickering explained his rationale for 1.3 million bo/d of oil demand growth and 1.9 million bo/d increase in crude oil supply for the period 1999-2002, with the over supply putting downward pressure on market price.
In Pickering's view, current crude prices are too high, which discourages demand on the margin, provides high revenues for producers, and encourages additional supply. In the longer-term horizon, 2003-2005, the market will not sustain this condition, he explains.
Gas supply, demand
Highlighting issues affecting the North American natural gas market, Urness explained that US gas storage remains at record levels.
He noted, however, that positive fundamentals on both the supply and demand sides of the issue provide a strong upward bias to his 2003 price prediction of $3.50/MMbtu.
Fig. 3 shows the working gas in storage. Urness noted that gas injection volumes were ahead of last year and that the US could have as much as 3.25 tcf in storage by the end of the fill season, exceeding last year's level.
Due to reduced drilling activity in 2002 and increasing gas demand, however, he predicts that the supply surplus will disappear by March 2003.
The law of diminishing returns applies to natural gas drilling. Fig. 4 shows the active rig count's effect on incremental production, for each year 2000-2003.
Although the trend applies to both onshore and offshore drilling arenas, Urness felt that the issue was particularly important for land rigs.
He said, "Once you get beyond 500-600 rigs drilling for gas, you see a dramatic reduction in productivity per incremental rig. In fact last year we averaged about 930 rigs drilling for natural gas, barely being able to move the needle on deliverability."
Urness is forecasting 708 US gas rigs for 2002 and 850 gas rigs in 2003 (Table 1).
He said, "When we get to that 800 plus rig level, we're looking at some fairly marginal production."
He presented other data that showed a similar correlation, highlighting productivity decline with time. In the early 1990s, an average active rig yielded 25 MMcf/d, however, in 2001 and 2002 the average rig generated only 14 MMcf/d.
US natural gas decline rates are clearly increasing every year (Fig. 5). The 2002 gas production decline is 31%. Urness observed that the upward trend appeared to be leveling off to some extent at 30-31%.
Fig. 6 shows the correlation that the US natural gas rig counts have followed relative to the trailing 12-month natural gas price. At the forecasted price of $3.50/MMbtu, the graph suggests a rig count in the 700-800 range. Urness pointed out that sustaining the 1,000 gas rigs that the industry had mobilized in 2001 would require much higher gas prices.
Gas forecast
Due to stronger economic growth and the return of switchable demand that was lost with the higher gas prices, the demand fundamentals for gas are improving.
Urness said, "Power generation is up as well year-over-year." The industry can expect electricity demand to grow at 80-85% of the growth rate of GDP (gross domestic product). He noted that Salomon Smith Barney economists had lowered their GDP growth estimates from 3.4% to 2.7%, the week prior to the IADC meeting.
Urness noted that a very important assumption built into his company's $3.50/MMbtu gas price forecast is that oil prices will decline early next year towards $20/bbl and result in loss of the 4.0 bcf/d of fuel switching, gained earlier this year.
He noted that it was a huge swing factor. If oil prices remain high this winter, the switching may not occur, creating a higher upside case for gas prices. He said, "We do think there is someU upside to gas prices this winter depending on the weather and switching."
Pickering said the Simmons & Co. gas price forecast was upwardly biased from $3.30/MMbtu.
Capital spending
Urness reported that worldwide capital spending declined 2.5% in 2002 and was comprised of 15.6% decline in North America, offset by 5.8% increase internationally. This was based on $22.70/bbl and $3.04/Mcf oil and gas price assumptions.
One third of the capital spending was in North America, with two thirds internationally.
The major international oil companies and national oil companies accounted for more than 60% of the spending, with Canadian and US independents responsible for 25%.
He explained that with heavy focus on development projects and gas drilling, Salomon Smith Barney's preliminary 2003 outlook is for capital spending to increase more than 10%. Urness said, "The focus on gas is not just American, it's a world wide phenomenon."
Looking longer term, Farrell said the top five international oil companies would spend $12 billion/year for deepwater exploration and development by 2004.
If one considers some of the smaller players and national oil companies, the capital invested will be $20 billion/year in the 2004 and 2005 time frame. Farrell said, "That's going to change the profile of the new production coming out of those companies dramatically."
Responding to a question why companies are investing so much money in deepwater when a potential surge of oil could be coming onto the market, she responded that international oil companies must replace the mature areas where they had operated in the past.
She explained that technology is the enabling issue that has allowed these companies to find the large deepwater fields and the financial returns on individual projects are extremely attractive.
The analysts explained that oil companies tend to act together in a herd mentality. Based on the same market conditions and information, everyone acts in unison, which will cause large oil volumes to enter the market at the same time.
Complexity, volatility
Pickering said "Simplistically the drivers for the business should be supply and demand and that should be relatively easy to analyze." He noted that forecasting has become increasingly difficult, however, given the interaction of many variables. He made the point by showing a slide listing the words "E&P (exploration and production) cash flow, rig counts, oil prices, OPEC, the stock market, Iraq, and gas prices."
Using a 3D spider web arrangement he tied each of these issues to the words "THE ECONOMY," to emphasize his point that the analysis has become increasingly complex, demand and price interactions have become more closely linked, and that volatility has become systemically constant.
He said, "The economy was not as big a variable 1 year ago as it is today."
To further illustrate volatility, Pickering graphed various market indices and commodities for the number of trading days during the past 4.5 years that its price movement was greater than 3% (Fig. 7).
According to Pickering, crude oil is six times more volatile than the Standard and Poor's 500 Index. Natural gas is two times more volatile than crude oil (Fig. 7).
Further emphasizing his point on volatility he noted the US drilling rig counts had declined 38% in 1998 and 1999, combined.
Rig counts increased 48% in 2000 and another 26% in 2001. He notes that this trend has a long history in the drilling business.
Correction
In "Level 6 multilateral numbers increase" by Cliff Hogg (OGJ, Sept. 30, 2002, p. 63), Fig. 2 and 3 were inadvertently reversed. The text reference to Fig. 2 is actually to Fig. 3, and vice versa.
