Despite the recent record gas and oil prices, it is remarkable that E&P activity remains stuck at a relatively low level. It seems that the Industry does not believe that these price levels are here to stay. Yet two market fundamentals are providing support for these higher prices.
One factor has received widespread coverage. The OPEC nations now have little spare production capacity to cope with rising demand. Countries that were once renowned as quota busters are struggling to reach the production levels that they enjoyed 2 years ago.
The second driver is more subtle. The relatively low oil prices throughout the 1990s led to the unusual situation that it was cheaper for oil companies to buy reserves than to drill for them. Or to put it another way, finding costs were higher than acquisition costs on a per barrel basis. We might ask ourselves why companies sell their reserves for less than it cost to find them? This untenable situation arose because the markets assigned unrealistically low valuations to oil company stocks, and by inference oil properties, based on the perceived downside risk to oil and gas prices.
In time the market will eliminate this opportunity for buying reserves in the ground, just like any other arbitrage play. Since most disposable capital in the 1990s was spent buying existing barrels rather than finding new ones, the worldwide reserve replacement ratio has fallen to just 50%. There is now simply too much cash flow in the system chasing fewer remaining barrels. This will keep pressure on prices, increase oil company valuations, and redirect spending back to E&P activities.
It follows then that oil and gas prices will continue to remain high; with demand adjusting to balance the market until the renewed E&P effort brings new supplies onto the market. However, the largest oil companies are concentrating their efforts in long lead time, deepwater exploration projects. It will be many years before the market sees the fruits of their labors. Perhaps the quickest growth will come from international activity where production rates are generally higher.
Steve Horner
Houston
