The cost to drill and complete a well is obviously the most critical cost category from the prospective of operator’s economics. This capital expenditure is incurred upfront whereas operating cash flows from the well are received over a long period of time and are heavily discounted as a result. The undiscounted upfront cost therefore has a strong effect on the IRR and is “grandfathered” (locked in) in the event the cycle turns and commodity prices improve.
The Upstream industry’s success in achieving fast cost cuts is evidenced by the recent reports by oilfield service providers according to which the recent drop in both activity levels and margins for Lower 48 is unprecedented in its speed. These are comments that came from both Schlumberger and Halliburton in the service majors’ conference calls in the past several days. Pricing for tubular goods and completion services were among the first to roll over as these, as well as certain other, oil service categories traditionally have weak contract and price protection. Premium rigs, on the other hand, had very strong dayrate and utilization protection under contracts going into 2015. As a result, cost reductions to E&P operators will continue to be realized on the drilling side as rig contracts roll over to lower dayrates. The same is true about the remaining service contracts on the completion side.
While these very deep cost reductions for the E&P sector are unlikely to be sustained in the long run, the very favorable cost environment may last, possibly through the end of 2016. Even if drilling activity begins to gradually pick up again towards the end of this year, it will take time for the service industry to restructure its capacity, without which pricing power will be weak. In the most immediate term, the vector of the cost change should remain in favor of E&P operators, until the pricing for services reaches its cyclical bottom, most likely in Q3 2015.
It should be noted that the service industry is also taking radical steps to respond to the macro challenge and has announced very deep layoffs and operating base consolidations in the U.S. As a harbinger of retirements of older, less efficient equipment, Helmerich & Payne recognized a loss in this morning’s quarterly report on the decommissioning of its 17 SCR FlexRigs.
The need to re-hire personnel and re-establish regional operational presence may again become a bottleneck and source of increasing costs for the industry as a whole, should the cycle turn around again.
