Producers facing dramatically higher capital costs

Feb. 12, 2007
The costs of major oil and gas production projects have risen more than 53% in 2 years, and no significant slowing is in sight, said a benchmark index developed by IHS and Cambridge Energy Research Associates (CERA).

By OGJ editors
HOUSTON, Feb. 12 -- The costs of major oil and gas production projects have risen more than 53% in 2 years, and no significant slowing is in sight, said a benchmark index developed by IHS and Cambridge Energy Research Associates (CERA).

The IHS-CERA Upstream Capital Costs Index (UCCI) tracked nine key cost areas for offshore and land-based projects. The UCCI climbed 13% to 167 during the 6 months ending Oct. 31, 2006, compared with an increase of more than 17% in the previous 6 months.

Since 2000, the UCCI has risen 67%—with most of the increase in the last 2 years—while the Producer Price Index-Commodities for finished goods (excluding food and energy) moved up 7.5% during the same period.

The continuing cost surge is central to every energy company's strategic planning, analysts said.

CERA Chairman Daniel Yergin said, "Rising capital costs rank right alongside more widely recognized issues such as world market trends, geopolitics, globalization, and new technologies at the top of the agenda for the energy industry."

An all-in measure of project costs, the UCCI is up 53% since the end of 2004. While strong commodity prices are expected to continue, this rise in costs is causing firms to reevaluate the economics and viability of many projects.

Index data
The UCCI is a model based upon a portfolio of upstream projects worldwide. Cost engineering software was used to predict costs for those projects. Analysts plan to update the UCCI every 6 months and probably release updates in May and November.

The UCCI tracks the costs of equipment, facilities, construction materials, and personnel in more than 24 onshore and offshore oil and gas development projects. Specific projects in the portfolio were not disclosed.

The UCCI is similar to the consumer price index (CPI) in that it provides a tool for tracking and forecasting, Yergin said.

Richard Ward, CERA senior director and UCCI project manager, said 2007 is shaping up to be a year of additional increases.

"Despite a slight slowing in the rate of increase during the 6 months to Oct. 31, we expect project capital costs to continue reaching new record levels during 2007," Ward said. "With high oil prices driving new development projects, capacity constraints continue to support increases in the cost of equipment and services."

The analysis shows capacity is tight in all markets, Ward said. Hot spots for capacity constraints are the deepwater regions, such as West Africa and the Gulf of Mexico.

"While oil prices stay above $55/bbl CERA expects that confidence to remain. Should prices slip below $50/bbl, the industry should expect some expansion projects to be cancelled or delayed," he said.

Deepwater projects experienced the largest cost increases, rising 15% in the last 6 months. Ward attributed cost increases to rig rates, technology limits, and skills requirements. These costs are expected to continue to rise due to tight industry capacity.

Onshore facilities, including LNG, have seen the slowest rates of increase, 12%, he said.

"Higher costs, combined with the recent drop in gas prices, have made some projects uneconomical and triggered a reevaluation of plans." Ward said. "This has produced a slight relaxation of tight support service or commodity markets, particularly in the US."

Cost drivers
Of the nine primary drivers of project capital development costs, steel is the only segment to decline over the past 12 months, primarily because steel prices began accelerating globally before the recent increase in oil prices and demand.

Most of the others—except equipment and bulk materials—are specifically focused on the oil and gas business and are at near maximum capacity.

The primary drivers are:

-- Steel. With oil industry steel less than 2% of total steel production and special mill runs required for oil industry grade steels, the industry faces premium pricing and constrained capacity.

-- Offshore rigs. A rush by drilling contractors to expand their fleets has produced plans for construction of over 100 new rigs during the next 4 years. If demand stays high, the majority of these rigs will come to market and some additional rigs may begin construction. This should ease rates, but not until mid-to-late 2009. Because drilling accounts for 40% to 50% of development costs, a 25% rise in the rig rate can produce a 10% or larger increase in total project cost.

-- Equipment. The market for long lead time oil and gas equipment—such as generators, compressors, vessels, towers and exchangers—is very tight with extended delivery times and premium pricing.

-- Yards and fabrication. Specialized, oil and gas fabrication encounter premium pricing in competition with container demand and also cruise ship demand. Yards are at capacity. Even with an expected 15% expansion by 2012, utilization will remain high as will demand for LNG tankers.

-- Offshore installation vessels. Plans announced by pipeline installation companies to expand capacity of the current 56-vessel fleet by 8%, or three new vessels, is insufficient to meet short-term demand. The world's fleet of 26 heavy lift crane vessels is projected to expand by one in 2009, increasing total lift capacity by about 15%. If demand for installation projects should soften due to a decline in oil prices, previously delayed decommissioning projects are likely to claim the available capacity at reduced rates.

-- Design and project management. Although vigorous efforts to attract new talent into the detailed design arena, particularly in Asia and the Middle East, CERA anticipates at least 5 years will be required for the new entrants' experience to reach the level required.

Analysts expect design and project management costs will escalate until then. Meanwhile, specialists in deepwater, subsea, and project management will receive premium pay.