The Wall Street Journal: High Oil-Field Costs Crimp Search for New Supplies

Inflated Gear Prices
Almost Guarantee
New Crude Records
By BHUSHAN BAHREE
August 1, 2007; Page A3

•  Pumping Prices: Oil companies are encountering cost run-ups and delays as they compete for scarcer, pricier field equipment and services.

•  Demand Disconnect: The trend complicates oil-industry efforts to tap new projects to capture higher prices.

•  Off Balance: Projects driven by higher prices have helped quell oil’s rise in the past.During past surges, higher oil prices pinched consumers and the economy but also made a greater amount of untapped oil economical to pump.

THE ARTICLE

Fierce cost escalation in the oil patch is complicating the industry’s ability to respond to higher prices with new supplies, setting the stage for still-higher prices in the months and years to come.

As a result, new supplies eventually came online, putting downward pressure on prices. That dynamic helped tame the high oil prices of the early 1980s.

But during the current four-year rise in oil prices, inflation for equipment, labor and other crucial oil-field needs has largely kept up with the rise in oil prices. In recent quarters, this has crimped results at the world’s oil producers, including Western majors such as Exxon Mobil Corp. as well as the world’s biggest state-run oil companies, and has also led to delays and cancellations of major projects. While plenty of activity remains in place, the high prices are nibbling away at other projects that were expected to bring significant new supplies of oil and natural gas to the world.

“Supply is going no place, and demand is rising 2.5% to 3% a year,” says economist Philip Verleger Jr. of Aspen, Colo.

U.S. benchmark crude for September delivery reached a new settlement high yesterday of $78.21 a barrel, beating the previous record of $77.03 reached July 14, 2006. It remains far short of the inflation-adjusted record of more than $101 a barrel in April 1980.

Prices for things including drilling rigs and skilled laborers have largely kept up with the oil-price rise. Research firm Cambridge Energy Research Associates estimates capital costs for the oil industry’s exploration and investment have risen nearly 80% since 2000. The average price of West Texas Intermediate crude roughly doubled over the same period, to about $61.60 a barrel in the first half of this year from an average of about $30.30 in 2000, according to Barclays Capital.

Rising prices for equipment and services are expected to lead to more investment in those areas, picking up the slack over the long term. Until that happens, consumers could see prices continue to rise.

Ed Morse, chief energy economist at Lehman Brothers in New York, reckons that “we have not yet seen the top in prices.” He expects the cost of oil to keep rising by $5 to $10 a barrel on average annually for several years. After that, he estimates, the oil industry’s ability to meet demand may be enhanced by the addition of biofuels and other nontraditional fuel sources.

The renewed rise in oil prices comes at a difficult time for the U.S., the world’s largest petroleum consumer. Falling home prices are already making consumers feel poorer, causing them to cut spending. Meanwhile, government data suggest businesses are having a harder time increasing productivity, a factor that has helped them offset higher prices in the past. As a result, higher prices could both slow the economy and hit corporate profits.

“It’s another negative in an environment that has a lot of negatives already at work,” says Joseph Carson, chief economist at investment management firm Alliance Bernstein in New York.

Oil-project cost inflation has contributed to project delays and postponements, while facilities operating flat out to meet demand are shutting down for unplanned maintenance. Many of today’s projects are bigger and in tougher environments as oil producers search farther afield for new supplies, further straining budgets.

A survey of the oil industry’s exploration and production spending by Lehman Brothers last year concluded that some 299 oil and gas companies were planning to increase their spending by 9% to $292 billion in 2007 from $268 billion in 2006. A second Lehman report concluded that the industry’s costs to find and develop oil in 2006 averaged about $20.40 a barrel, four times the $5 a barrel cost in 2001. As a result, the report said, incremental oil supply growth barely will be able to keep up with demand growth until 2011.

In Kazakhstan, the world’s biggest oil find in nearly 40 years has suffered delays, with costs for the first phase spiralling to $19 billion, or nearly twice the original estimates. Now oil is expected to start flowing in 2010, some five years late.

In Russia’s remote eastern Sakhalin Island, Royal Dutch Shell PLC was forced to cede majority control in a huge project to state-owned OAO Gazprom after a massive cost overrun of some $10 billion.

Oil industry officials say that prices will have to keep rising to curb consumption, matching energy use with available supply. If the world economy continues to grow strongly, it will be able to absorb higher energy costs, as it has done so far, but there would be a massive transfer of wealth to oil producers, further empowering countries like Russia, Saudi Arabia, Iran and Venezuela.

Yesterday, the Organization of Petroleum Exporting Countries disclosed that its members’ revenue from petroleum exports rose 22% to a record $649 billion last year.

–Mark Whitehouse and Guy Chazan contributed to this article.

Write to Bhushan Bahree at [email protected]

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