WHAT THE INDUSTRY EXPECTS IN 2008

... And I say to myself, what a wonderful world (at least for now anyway)

Douglas C. Nester, COO, Prime Offshore L.L.C., Houston

When one considers $90 oil, $8 gas, two consecutive, non-eventful hurricane seasons and dropping service prices, it is difficult for independents playing in the GOM to say many bad things about 2007. In fact, industry conditions today are nearly the exact opposite of what they were at the end of 2006. As I reported in last year’s editorial, the industry exited 2006 in an undesirable environment where natural gas prices were reaching yearly lows, while the cost for services, including rigs, construction vessels and offshore personnel, were peaking

That was then, this is now. At the end of 2007, the pendulum has swung to the side of the oil companies as the commodity price and service cost cycles have shifted 180 degrees. Oil is at all-time highs, and gas has been inching above $8 during the second half of the year. While the price of oil grabbed the most attention, I believe the most dramatic industry change occurred in the precipitous drop in service costs.

Rates for 250-ft IC jackups, which cost small independent companies like Prime Offshore over $110,000 per day in January of this year, are now running below $70,000. This drop in price coincides with a jackup utilization that has declined to a low of 57% in October. The total number of jackups, either idle or in shipyards without contracts, totaled 20 by the end of October. This represents the highest level of idle
jackups since March of 2003.

While exploration activity on the shelf declined during 2007, activity in the deep water continued to grow. The demand for semisubmersibles remained strong, with a flat 97% utilization and day rates that are still averaging above $500,000.. The continued deepwater growth is evidenced by the active bidding by the super-majors and large independents during the Central Gulf of Mexico Sale 205. Shell made a statement as to intent to be the dominant player in this arena by exposing over $554 million on 69 blocks in deep and ultra-deep waters. Their bid of $90.4 million for a single block was the highest in the sale. The sale’s total high bid of $2.9 billion was the second highest in US history.

What goes around, comes around. While we all know that our industry is cyclic, I think the speed of this most recent flip has taken some of us by surprise. As evidenced by the drop in service prices beginning in the early 2007, the cycle has now changed to where oil and gas producers have a stronger hand in negotiating contracts and terms with service providers. For some individuals in the service industry, 2008 will prove to be a lesson in humility. In the post-Katrina and -Rita year of 2006, service companies clearly knew they held a position of strength since there was a large demand for their products. Even into December 2006, some were eager to capitalize on this position, as was demonstrated when one company in the field stopped work in the middle of our project and refused to continue unless we agreed to pay them an increased day rate. While I strongly believe it is fair for all companies to prosper during cycles when they can, I also believe in my partner’s saying that “pigs get fat and hogs get slaughtered.”

Now where? The pendulum, however, continues to swing, and its resting place in 2008 is uncertain. While it is a safe bet that activity in the deep water will continue to grow well beyond 2008, I am not as comfortable making any growth statement for activities on the shelf. The aggressive deepwater bidding in this most recent sale is just another indicator that the mass exodus from the shelf is continuing. While independents like ATP and Gryphon, which were founded as shelf players, are now turning to the deep water in the search for large reserves, others like Cabot and Walter Oil and Gas are leaving the GOM completely and moving onshore in search of more stable production and longer-life reserves.

Biggest challenge for independents. Perhaps the biggest challenge facing independents on the shelf is the scarcity of quality opportunities. Due to the maturity of the shelf as an exploration province, many of the remaining opportunities have modest reserve potential. As a result, the shelf is becoming a game of small numbers that remains attractive to generally those smaller independents that can properly manage cost, as well as house the technological expertise needed to find these objectives. Small changes in reserves that become burdened with unexpected small changes in cost and small fluctuations in the price of natural gas can take a project from the fringe of acceptability to one that becomes completely uneconomic. Much of what will be developed on the shelf in 2008 would have been considered marginal just 2 or 3 years ago.

If favorable natural gas prices extend through 2008, we may see increased drilling activities on the shelf as companies feel confident enough to harvest some of these small reserve opportunities. The MMS needs to provide royalty incentives to companies operating in shallow waters, much in the same way it provides economic incentives for companies playing in the deep water. The MMS also should make a bold policy change and offer royalty relief on the first 5 Bcf produced from any new well drilled on the shelf. Such action would stimulate independents to capture many of the remaining low-risk and low-reward accumulations scattered across the GOM that are not economical today.

As I said earlier, the pendulum continues to swing. When we scrape away all that is traditional about our industry, we see that fundamental changes have been occurring during the cycles of the past few years. Gone are some basic business guidelines, such as oil and gas sales that no longer trade near to a 6:1 ratio. Replacing them are new guidelines, such as planning for insurance rates that consist of over 60% of our ongoing LOE for offshore operations.

Time will tell whether these changes represent skies of blue and clouds of white, but for right now, I say to myself, what a wonderful world. 

THE AUTHOR
	Douglas C. Nester, Chief Operations Officer for Prime Offshore, previously F-W Oil Exploration, is responsible for the company’s operations and new venture activities. Mr. Nester was previously with Devon Energy. Prior to Devon, Mr. Nester worked for 3DX Technologies Inc., where he served as Vice President of Exploration. Prior to starting 3DX in 1993, he was employed at Pennzoil. Mr. Nester received his BS degree in geology from Indiana University of Pennsylvania, and performed his graduate studies in geology at the University of Houston. Mr. Nester received an MBA in Finance from the University of St. Thomas in Houston.