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North America Drives Capital Spending Drop

When industry analysts predicted a $1 trillion decline in capital expenditures for international exploration and production, it was easy to say, “They must be exaggerating.”

They weren’t.

In fact, they might have been sugarcoating the outlook.

IHS said its overall forecast for oil and gas capital expenditures in the 2015-19 time frame has now been reduced by $2 trillion from the forecast before the collapse in oil prices.

That’s counting spending for all international upstream projects, planned and projected, said Bjorn Hem, IHS principal researcher. Hem is stationed in Norway and Houston, but lately has been working out of Costa Rica.

“A lot of that is basically projects that have been pushed back, delayed, cancelled,” Hem said. “Especially this year, you’ve gotten into a lot of destructive capacity reductions.”

North America Plummet

IHS has issued the latest quarterly updates to its “Global Upstream Spending” and “North American Upstream Spending” reports. Both show a big decline in upstream capital spending, but not in equal measure.

“It’s dropped a lot. But if you look at the total spending, a lot of the drop is driven by North America,” Hem said. “Things have just moved very quickly there. It’s a different market than other regions.”

One major difference is the speed of reaction to lower prices. National oil companies and large overseas energy operations tend to have a long planning horizon. Independents in the United States react much more quickly to a price downturn.

“As long as they’re not making money, their activity is cut back. It happened very quickly. You’ve seen a large drop right through 2016,” Hem noted.

By comparison, the Middle East is much less affected, with several countries in the region spending to maintain market share and no drop in investment by Saudi Arabia, according to industry research and consulting firm Wood Mackenzie.

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When industry analysts predicted a $1 trillion decline in capital expenditures for international exploration and production, it was easy to say, “They must be exaggerating.”

They weren’t.

In fact, they might have been sugarcoating the outlook.

IHS said its overall forecast for oil and gas capital expenditures in the 2015-19 time frame has now been reduced by $2 trillion from the forecast before the collapse in oil prices.

That’s counting spending for all international upstream projects, planned and projected, said Bjorn Hem, IHS principal researcher. Hem is stationed in Norway and Houston, but lately has been working out of Costa Rica.

“A lot of that is basically projects that have been pushed back, delayed, cancelled,” Hem said. “Especially this year, you’ve gotten into a lot of destructive capacity reductions.”

North America Plummet

IHS has issued the latest quarterly updates to its “Global Upstream Spending” and “North American Upstream Spending” reports. Both show a big decline in upstream capital spending, but not in equal measure.

“It’s dropped a lot. But if you look at the total spending, a lot of the drop is driven by North America,” Hem said. “Things have just moved very quickly there. It’s a different market than other regions.”

One major difference is the speed of reaction to lower prices. National oil companies and large overseas energy operations tend to have a long planning horizon. Independents in the United States react much more quickly to a price downturn.

“As long as they’re not making money, their activity is cut back. It happened very quickly. You’ve seen a large drop right through 2016,” Hem noted.

By comparison, the Middle East is much less affected, with several countries in the region spending to maintain market share and no drop in investment by Saudi Arabia, according to industry research and consulting firm Wood Mackenzie.

Overall, the cuts in international exploration and production capital spending have led to concerns that the industry might not be investing enough to meet future oil consumption demands.

“Even remaining flat could be a challenge for the industry, let alone meeting any expected growth,” said John England, vice chairman of Deloitte LLP.

One Deloitte study found that the international oil and gas industry has slashed spending below the levels required to replace reserves. The industry’s projected capital-project expenditure level is especially worrisome, Hem said.

“Even if it’s not increasing, you need to make very large investments in the oil and gas industry to meet demand,” he observed.

Brutal declines in oil prices following years of falling natural gas prices have left much of the industry in a tight spot for capital project development.

“The industry faces a conundrum in that many of the projects our clients plan to build, or are in fact already building, now cost too much to be commercially viable unless oil prices rise considerably,” said Chris Pateman-Jones.

“At the same time, the market and investors expect oil companies to grow, or at the least to maintain production levels/market position, meaning that eventually almost regardless of oil price, new projects to replace aging and decommissioned assets will need to be built,” he noted.

Pateman-Jones is director of oil and gas capital projects for management consulting firm Ernst & Young in London. The company has tracked international oil and gas megaprojects in recent years.

“It is key for the industry to focus on selecting the best projects – that is, the ones which deliver the highest returns, but also those which are most likely to be delivered on time and budget, and it’s important to note here that these two factors are not always positively correlated – and then to deliver them as efficiently as possible,” Pateman-Jones noted.

“It is equally important to recognize that to be truly successful, improvement initiatives must be driven throughout the entirety of the project team, seeking to motivate and collaborate with key contractors and suppliers to drive improvement in a way which is not yet natural across the industry,” he said.

Positioning for the Rebound

With the mid-2016 pullback in oil prices from the $50 level, many industry observers and analysts essentially have thrown in the towel. “Lower-for-longer” appears to be a consensus opinion.

“Our main story now in terms of the forecast is, there’s no quick turnaround,” Hem said. “We see the recovery as being a long, slow, drawn-out recovery.”

Not all the upstream spending reduction has come from budget cutbacks. Oil and gas companies saw a significant drop in their cost of doing business as service and supply companies reduced prices. In U.S. unconventionals, analysts estimate operator costs are 25-40 percent lower on average compared with their peak in 2014.

Also, the industry has cut employee costs through reductions in headcount. But that might become a future problem.

“One of the interesting things we’re looking at now is what’s going to happen when things start rebounding,” Hem said.

“If you look at the labor market, the engineering market, those are very flexible in terms of capacity. Getting those engineers or laborers back is much more challenging,” he noted.

Industry investment in international exploration and production hasn’t come to a standstill. In July, Chevron Corp. announced it would proceed with a $37 billion expansion of its Tengiz oil field project on the Caspian Sea in Kazakhstan. BP said it had approved funding for the addition of a third LNG process train at its Tangguh Expansion Project in Indonesia.

But the number of large projects approved by the oil and gas industry has plummeted from previous years. Wood Mackenzie estimated the global oil industry approved 40 large international projects a year between 2007 and 2013.

That number dropped to eight in 2015, and only a handful of megaproject budgets have been approved in 2016.

Deepwater drilling looks especially vulnerable. In a forecast of U.S. Lower 48 production that needs to be developed to offset field declines and to meet future demand growth, Wood Mackenzie said only 20 percent of commercial volumes at $60/barrel comes from deepwater projects. By contrast, tight oil accounts for 60 percent of future production commercial volumes at $60.

“Key plays such as Eagle Ford and Wolfcamp dominate the lower end of the cost curve, the latter averaging under $40/barrel,” it said.

Reduced capital project spending makes efficiency crucial, and there’s good news for the industry in that regard. Project efficiency has been so terrible, so absolutely dismal, that things are unlikely to get any worse.

Ernst & Young evaluated the oil industry’s effectiveness in handling large projects coming out of the boom years and issued a report in its Spotlight on Megaprojects series.

“We researched the performance of 365 oil and gas megaprojects and found that 64 percent are facing cost overruns and 73 percent are reporting schedule delays,” the EY report said.

Those failures “raise serious questions as to the industry’s ability to develop accurate, unbiased FID (final investment decision) budgets/schedules and subsequently to deliver on them,” it noted.

Pateman-Jones said “there is no single silver bullet to solve all the problems afflicting project development.”

“Instead, there is potential to access the additive effect of many smaller improvement opportunities which collectively could revolutionize development and execution performance,” he said.

“Despite the abundant challenges the industry faces, there are many opportunities to improve performance and reduce waste, utilizing learning from other industries and selected new technology to drive efficiency and standardization into project development and execution,” Pateman-Jones noted.

Hem blamed a scramble to chase projects during the oil boom for some of the industry’s inefficiency woes.

“If you look back at 2013-14, a lot of the big operators weren’t doing that well financially. They were going after everything, so to speak,” Hem said.

“In a way it’s healthy, what’s happening. The oil and gas industry enjoyed so many years of success, and that caused things to become inefficient,” he observed.

In the end, analysts expect deep cuts in capital spending to create future declines in production. That normally leads to consumption-driven price increases, which ultimately cause increased investment and overproduction.

Everyone recognizes this as the oil industry boom-and-bust cycle, and it hasn’t gone away.

“You can say, the lower things go at the moment, the higher things will go in the future,” Hem said.

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