IPAA: Lack of good prospects undermines drilling activity, heightens US gas supply concerns

Nov. 4, 2002
The relatively low US rig count this year is due in part to the lack of good prospects, said speakers at the 73rd annual meeting of the Independent Petroleum Association of America Oct. 28-29 in Dallas.

The relatively low US rig count this year is due in part to the lack of good prospects, said speakers at the 73rd annual meeting of the Independent Petroleum Association of America Oct. 28-29 in Dallas.

While such opportunities are getting scarcer, that trend contributes to tighter natural gas markets in North America, which in turn brightens the outlook for independent producers, according to the CEO of one leading independent.

Beyond commodity prices and drilling activity, much of this year's IPAA meeting focused on concerns over the merchant energy sector and the uncertainty spawned by the meltdown of several key players in that sector.

EPGT Texas Pipeline LP Pres. Jerry J. Langdon
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Emergence of major integrated oil companies as key players in the merchant energy industry should be a matter of concern to the Federal Energy Regulatory Commission, said Jerry J. Langdon, a former FERC commissioner now employed at El Paso Energy Partners LP. Other speakers detailed the difficulties the gas industry continues to cope with in the aftermath of implosions at key merchant energy firms.

And a new FERC commissioner speaking at the meeting pledged to uphold market principles in the troubled US gas sector while ensuring fairness for producers.

Lack of prospects

Low-risk drilling projects in developed plays are "harder and harder to come by," said M. Scott Cone, president of Tri-C Resources Inc.

Tri-C is a privately held Houston-based independent whose operations are strategically divided into 25% high-risk wildcats, 50% moderate-risk exploration close to existing production—"next fault block up, next fault block down"—and 25% low-risk extensions and additions in developed areas along the Texas-Louisiana Gulf Coast.

Lack of low-risk and even moderate-risk projects "skewed our (operations) model" during 2000-01, Cone said. "We shifted to sheer exploration, and we got our heads handed to us. We learned a lesson and got our portfolio in order."

Tri-C's strategy is to explore for new resources, get them into production, and then sell the properties "while production is flush" to fund more exploration. "We're a supplier of producing properties," said Cone, during IPAA's CEO roundtable session Oct. 29. "We started doing that because at first we had no choice, with no access to capital."

Being under the gun "to constantly produce results is a brutal way to make a living," he acknowledged. However, the small company—20 employees—has a 66% success rate on the 563 wells it has drilled. Successful completions this year exceed 70%, Cone said.

At that same session, Cloyce Talbott, CEO of Patterson-UTI Energy Inc., Snyder, Tex., the second biggest US land drilling contractor behind Houston-based Nabors Industries Inc., said, "More companies are asking us to take a piece of their prospects (as payment for drilling) than I've ever seen in my long career in this industry. The small independents are having a hard time selling their prospects."

Market outlook

At a later session Oct. 29, Robert Morris, a market analyst with Salomon Smith Barney Inc., New York, said US producers "don't have the prospects to put another 50-100 rigs to work" without some indication of a significant increase in natural gas prices. "Companies have not been investing money to tee up new projects," he said. US producers this year have keyed about 21% of total exploration and production budgets toward exploration, down from 27% last year, he said.

A projected average price of $3.50/ Mcf next year will support a US fleet of only 800-850 active rigs, said Morris. Baker Hughes Inc. reported 856 rotary rigs were working in the US the week ended Oct. 25, down from the year's peak to date of 883 during the first week in January.

However, if oil prices hold at their current levels instead of dropping back to $20/bbl as projected, Morris said, "We're probably looking at $4-5(/Mcf) gas next year."

Among investors and financial analysts, "commodity prices, particularly oil, are perceived as more likely to fall than rise," said Thomas A. Petrie, CEO of Petrie Parkman & Co., at an Oct. 28 session. "I'm not at all convinced that's right, but most see compelling evidence."

An oil price of $25/bbl is "supportable," said Petrie. Anything above that level constitutes "an insecurity premium."

Industry's crisis

Petrie claims a "crisis of confidence" in the US energy industry apparently is "morphing into disfunctionality" in the wake of the Enron Corp. scandal and the resulting impact on the energy trading industry. Petrie cited as evidence:

Congress's failure to enact "effective energy legislation" prior to recessing for election campaigning.

Congress's failure to fund a new budget for the Securities and Exchange Commission "at a time of obvious priority."

Usurpation of the SEC's authority and functionality by New York Atty. Gen. Eliot Spitzer and his counterparts in other states who filed—or contemplate—lawsuits and charges against investment banks.

The SEC's "overreaction" in broadening the "definition of insider trading in the Martha Stewart case, without considering the adverse impact that will have on the market."

Meanwhile, Petrie claimed, the "window" for access to outside capital for oil and gas producers "is not closed, but there's a higher bar that companies must hurdle (to qualify), and the cost of that capital is high." Moreover, he said, "The industry must demonstrate it can generate sustainable, credible returns."

Sophisticated investors still "look at this sector as a value play," said Petrie. "But the Enron fallout has made lots of people skeptical."

"Commercial banks continue to play an important role in financing small-to-midsize independents," said D. Martin Phillips, managing director of EnCap Investments LLC. However, he said, there is a limited number of banks available because of consolidation. "Some $500-600 million of annual available capital has been pulled out of the market," he said.

IPAA Chairman Diemer True
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IPAA members at the meeting were cautiously optimistic about the future. As IPAA Chairman Diemer True said in the opening session, "IPAA has the wind at its back, although there are a lot of challenges before us."

Brighter outlook

"It will be better to be a provider of energy than a consumer of energy for the next 20 years," Aubrey K. McClendon, chairman and CEO of Chesapeake Energy Corp., Oklahoma City, told the IPAA meeting Oct. 29.

"We haven't replaced (US oil and natural gas) production with new discoveries in 35 years," McClendon observed. Any maintenance of production levels has been primarily through revisions and adjustments to original estimates of potential production of existing fields, he said.

"Now it's time to pay the piper," said McClendon, "and I think the industry will benefit."

That's especially true of US gas production, which is expected to be "down 5% this year, if not 6%. That production has been going down for the last 4-5 years, and it's not likely to change," he said.

A look at the 10 companies with the biggest gas drilling programs shows that the same companies, majors and independents inclusive, are also among the top gas producers. Yet their combined third quarter gas production is expected to be down overall, McClendon said.

"If these guys can't hold their production level, neither will the others," he said. "To ask independents to overcome the production decline curves of ExxonMobil (Corp.) and ChevronTexaco (Corp.) is not realistic."

McClendon said, "In time, gas production will not be responsive to price." As is now the case with oil, he said, the US at some point will be producing less than half the gas its market demands.

Meanwhile, in Canada, the US's primary gas supplier, gas production per well also is in sharp decline. Although total Canadian gas production has increased steadily over the years, he said, the number of producing wells has skyrocketed, resulting in a widening gap between the number of wells and total production.

Because gas producers have little chance to increase reserves and production through the drillbit, McClendon expects another wave of mergers and acquisitions as companies attempt to grow through "serial acquisitions." The present tier of large "superindependents and small majors are too big for North America but too small for the world (of extensive international operations). They probably will compound the issue by getting bigger," he predicted.

The next wave of mergers and acquisitions will be aided by the fact that some aging corporate heads now find that "it's not as much fun or as rewarding to be a CEO," said McClendon. "I think a lot of those guys will chuck it in on the next (declining) price run."

Volatile prices for both gas and the stocks of gas producers "are here to stay," said McClendon. But unlike many other producers, he claims, "That's a good thing," because it "gives producers a chance occasionally to sell gas for more than it's worth." Price volatility also gives consumers opportunities to "buy low," as well as letting producers "sell high," said McClendon. Moreover, it "keeps new capital away from the industry, reducing supply" and discouraging new entries. That's good for the industry as a whole, although not for the individual companies impacted, he said.

McClendon even is comfortable with the fact that higher gas prices may dry up some markets. "I don't want to supply the fertilizer manufacturer who sees gas as 70% of his production costs," he said. "I want to sell to the homeowner who flips on a light switch without realizing how many of those electrons were generated by gas."

Promoting industry

In the interim, McClendon warned, independent producers "must become more proactive" in promoting the oil and gas industry to the public and elected officials, "or the government and attorneys will take all of our money from us." Some activist attorney somewhere likely is contemplating a punitive class action suit against the oil industry for products "harmful" to consumers and their environment, similar to those filed and won against tobacco and other industries, he said.

"Independents are indistinguishable from Enron as an 'energy company' in most people's minds," said McClendon. "But the reality is that we are small to midsize businessmen producing a clean fuel (natural gas) that has benefited the public. We produce a 'green' fuel, a cheap fuel that will get more expensive if legislators keep denying our access to public lands," he said. "We should unite around those 'good guy' concepts."

McClendon recommended a nationwide industry public relations program similar to one mounted—and funded—by Oklahoma producers in that state. "We need to redefine our industry," he said. "The milk producers and the meat producers were able to do it, and they have less money and less brains than we do."

Meanwhile, he advised, "Stop wasting time on (attempts to gain exploration access to) ANWR (Arctic National Wildlife Refuge). Don't even talk about it. It's not going to happen."

At least not until the next major energy crisis, said McClendon. "This country always reacts well to a national crisis," he said, "but it just can't anticipate a crisis."

Merchant energy concerns

Some majors are combining their equity natural gas with third-party gas in a 2-2.5:1 ratio to mitigate credit risk and match pipeline capacity, Langdon told the IPAA meeting Oct. 28. The result, he claimed, amounts to an "unregulated branch market" that is "less transparent and less liquid. Fewer players mean more volatility."

Langdon also worries about the growing role of large commercial and investment banks in providing risk management services to independent producers. Bankers, he warned, "know how to charge for their services." In a later response to questions, Langdon added, "When you deal with those who know how to charge fees, buyer beware."

Langdon, president of El Paso Energy Partners unit EPGT Texas Pipeline LP, was part of a panel discussion on the implications to producers of the devastation of the merchant energy business in the wake of the Enron scandal.

Although the top tier of energy marketers was badly impacted, some big players "such as BP (PLC) and Duke Energy (Corp.) are still hanging on," while "overall volumes haven't changed much," said David Pruner, president of Axiom One LLC, a risk management unit of J.M. Huber Corp. "The industry will survive," he predicted, "but not without a lot of casualties along the way."

However, James M. Donnel, president and CEO of Duke Energy North America, warned that natural gas marketers must "restore investor confidence, or we won't be around much longer."

The number of credit downgrades among utility companies has nearly doubled in the last 2 years, Pruner said. "Profits are down across the board," he said.

Langdon noted that several pipeline companies are abandoning the energy marketing business, in part "due to the expense of providing credit support." As a result, he said, the gas market will be less liquid and less transparent, while price volatility will increase.

With the virtual collapse of some of the top energy marketing operations, Pruner said, "More and more people are using (futures contracts on the New York Mercantile Exchange) to hedge (prices on future production), but that's not the right vehicle for everyone." NYMEX was used to hedge against short-term price fluctuations before; "there's just more volume now," he said.

Analysis of recent trading activity shows 69% of the open-interest contracts are concentrated within the first 12 months of the trading spread, with 90% occurring in the first 24 months.

Many US producers took advantage of high commodity prices in 2000 to hedge forward production, but most "pulled the trigger on the downside" of that price peak, leaving behind some potential profit on the upside, said Pruner.

Currently, he said, "Only about 25% (of anticipated US gas production) is hedged for 2003 because producers are bullish about future rates." Nevertheless, he advised IPAA members to "hedge early and hedge often. The market is so volatile that no one position (for locking in the best potential price) will do it."

Langdon claimed master limited partnerships (MLPs) remain the principal and best source of capital for the midstream sector of the industry. In addition, he said, "It is the ideal surrogate for regulatory oversight." Regulators historically provide investment confidence to capital markets for pipeline infrastructure, and MLPs traditionally give a 9-12% return on equity, he said.

Despite talk of reregulating the natural gas industry, Donnell said, "I don't think you can put that genie back in the bottle." Moreover, he disputes arguments that deregulation has been a failure. "The market is much softer on the demand side," he acknowledged. "The market didn't foresee the highs being so high or the lows being so low. But the companies who best maintain control are the best able to withstand cycles."

He told the independent producers, "All is not lost. Your segment (of the industry) looks very attractive."

FERC view

"We are committed to making markets work," FERC Commissioner Nora Mead Brownell told the IPAA meeting.

But FERC doesn't want "to be intrusive in the gas market. Where things are working, we want to get out of the way," said Brownell, who was appointed to the commission in April by President George W. Bush.

Responding to questions about a major issue among US producers of natural gas, Brownell said FERC will "look at" the adverse price differential to which Rocky Mountains gas is subjected.

"We're trying to get a better understanding of what the (market) drivers are," she told IPAA members. "I can't tell you now that we have the answers. We'll have more to say about that in the not-too-distant future."

FERC also will guard against any attempts by pipeline companies to jack up transportation costs through regional monopolies, via the spin-down or spin-off of unregulated units. "That's absolutely on the agenda" to protect both producers and consumers, Brownell said.

Acting on recommendations by an administrative law judge, FERC recently reasserted its jurisdiction over a pipe- line system operated by Williams Cos. Inc.'s subsidiary Transcontinental Gas Pipe Line Corp. and set a "reasonable" rate for its unbundled gas gathering service in the Gulf of Mexico off Padre Island along the Texas coast (OGJ Online, Sept. 10, 2002).

In taking that action, government officials stressed that FERC policies for gas gathering systems are not to be "used to circumvent or undermine regulation of interstate transportation of gas" under the Natural Gas Act or the open access provision of the Outer Continental Shelf Lands Act.

FERC intends "to be sure you're treated fairly," Brownell told the independent producers. "Economic development is what it's all about, and that's something that we (as a nation) have forgotten," she said. "We (at FERC) do share your aim in which we expand production."

Botched efforts to deregulate the natural gas industry in California and the meltdown of the energy trading business in the wake of the Enron scandal have produced "huge mistrust" of the industry among "customers and policymakers at the state and national levels," but not at FERC, Brownell said.

"Cleaning up California" is FERC's first priority. "We are going to bring this to closure," said Brownell, possibly "by the first quarter of next year." One of the problems in California, she said, is that no one had effectively monitored the marketing and pipeline infrastructures to determine if they were capable of meeting the market's needs.

Another important mission at FERC is to help restore the public's and investors' faith in the gas marketing industry following the Enron scandals. "No one anticipated that meltdown and the (resulting) devastation," said Brownell.

FERC will investigate what transpired, "find some bad guys and hang them in the parking lot," she said.