OUTLOOK 2003: United States
E&P Spending

Unknown factors make plans tentative

 Geoff Kieburtz, Andrew Hoffman, W. Michael McNair and Megan L. Bissell, Salomon Smith Barney, New York

 Salomon Smith Barney (SSB) published its 21st annual E&P Spending Survey on December 16. The 36-page report involving 226 oil/gas operating companies analyzes reported spending for 2002 and plans for 2003, focusing on the US, Canada and Outside North America. The data comprises 53 tables and figures, plus SSB’s commentary, survey highlights, the survey process and results, and oil/gas company observations. 

 The authors say the survey, encompassing more than $133 billion of global upstream spending, indicates a modest 2003 spending increase of 3.8%. This follows similar growth of 3.4% in 2002, when spending was tempered by political, economic and commodity price uncertainty. North American drilling plans appear conservative in light of present commodity prices and budget assumptions, while international upside potential seems limited by both a refocusing among the majors and heightened political and economic uncertainty, not the least of which is the potential crisis in the Middle East involving military action in Iraq. 

 Assumed oil/gas prices are historically high, but well below late-2002 futures strips. Respondents assumed a $23.42/bbl oil price for 2003, 20% above the 13-yr average, but 8% below the futures strip of $25.40. The $3.54/Mcf gas price by respondents was 59% above the 13-yr average, but 22% below December’s futures strip of $4.55. North American spending is forecast to rise by only 1.5%. Under strong near-term gas fundamentals, independents have cautiously budgeted modest spending growth. Spending cuts among domestic US energy merchants, such as El Paso and Williams, will negatively affect North American spending plans by 4 to 6%. 

 International spending is projected to increase by 4.9%. This growth is slower than a year ago due to Latin American economic uncertainty and more restrictive UK taxation. However, significant growth appears likely in Mexico, Russia and China. Based on a separate SSB price assumption for 2003 of $22.75/bbl and $4.10/Mcf, and respondents’ heightened upside sensitivity to oil/gas prices, the authors see upside potential to the initial projections. However, they conservatively reduced the base-case growth forecast to 4 to 6%, from 8 to 10%. 

 Survey highlights. This year’s survey indicates respondents plan a 3.8% increase in 2003 spending, compared to a similar increase of 3.4% in 2002, and the 20-yr high of 24.8% experienced in 2001. The modest growth rate in 2002 comprised 10.7% growth in international markets and an 8.5% decline in North America. US and Canadian rig counts bottomed in the spring following significant declines from the preceding summer, when economic activity turned downward. In international markets, rig counts have been relatively flat all year, but deepwater field development activity remained strong. Moreover, Pemex of Mexico has been particularly active, raising its rig count by 30% during 2002, and its spending by nearly 40%. 

 Combined, the 226 oil/gas companies surveyed plan worldwide E&P expenditures of $133.2 billion, up 3.8% from the $128.3 billion level now forecast for 2002. Of the planned spending, 67% is earmarked for international markets, 24% for the US and 9% for Canada. 

 Notably, the actual percentage of international spending is greater than 67%, as the large majority of the spending not included in the survey comes from OPEC nations such as Iraq, Iran and Saudi Arabia. In some of these nations, such as Saudi Arabia, selected oilfield equipment and services providers have a strong presence. The data does not include acquisitions; historical numbers have been adjusted to reflect acquisitions as if they had occurred at the beginning of the survey period. 

 It should be noted that this summary article presents only four of the 50 tables detailing results of survey returns, and other related questions and analyses published in the complete December 16 report. Principal conclusions from data in the four tables, and other key observations are described here. 

 US majors. The nine firms designated as major oil companies (down from ten last year due to the merger of Conoco and Phillips) plan to increase US spending by just 0.9% in 2003, to $14.33 billion. Over the past few years, this group has continued to de-emphasize their US operations in favor of more prospective deepwater and international opportunities. These companies divested a significant number of US properties during the late 1990s, but have slowed this pace in the past two years. 

 SSB expects a continuation of this international trend over time, except in prospective regions such as the deepwater Gulf of Mexico. In the meantime, however, significant growth from the majors’ shallow onshore and offshore properties is not anticipated. Notably, several large majors have recently struggled with production shortfalls, most notably BP and Amerada Hess. Consequently, it is believed that some of these companies may pause to refocus long-term production targets, which could cause a temporary slowdown in spending growth. 

 US independents. In the US, the 137 independents surveyed plan a 0.6% decline in 2003 upstream expenditures, to $17.1 billion. This compares to a 15.5% decline in 2002, and an enormous 45.2% growth rate in 2001. Despite strong oil/gas prices and above-average planning assumptions, 2003 spending plans are essentially flat. This weakness is largely a result of sharply reduced spending by energy merchants such as El Paso, Williams and Dominion, which consequently reduced the aggregate US independents’ spending growth rate by 4 to 6 percentage points. 

 However, broadly weak balance sheets (following a multiyear acquisition binge), lack of quality drilling prospects and concerns about the war premium have all contributed to the low early expectations.

2002-2003 US expenditures by independents, $millions

 In Canada, 81 companies plan a 5.7% spending increase in 2003, to $12.4 billion from $11.7 billion, following a 9.3% decrease in 2002. The same factors affecting US drilling plans are applicable in Canada, except that no major energy merchants are based there. Similarly, just 21% of Canadian respondents plan to outspend cash flow in 2003, the second-lowest survey response ever for this group and well below the 37% forecast for 2002. As in the US, the acquisition pace has been blistering, with major deals such as PanCanadian/Alberta (now EnCana), Devon/Andersen, Burlington/ Canadian Hunter, and Canadian Natural Resources/Rio Alto all closing in the past year. As these deals settle over the next few years, a heightened level of Canadian drilling activity is expected. However, US demand and gas prices will continue to be the most important near-term variables. 

2002 – 2003 Canadian E&P expenditures, $ millions

 International. Outside North America, the 85 companies surveyed plan a 2003 spending increase of 4.9%, to $89.3 billion from $85.1 billion, compared to a 10.7% increase in 2002. Excluding Pemex of Mexico, 2002 spending growth was just 8%, while the 2003 forecast improvement is just 2%. Only a few companies forecast significant international growth in 2003, led by Yukos (+37%), Pemex (+33%) and Lukoil (+27%). In the case of Yukos and Lukoil, which focus solely on the former Soviet Union, oilfield service opportunities are limited. 

 The largest spending decline outside North America, at $1.1 billion, is forecast for Agip, primarily due to completion of the giant Girassol development offshore Angola. Notably, three of the four largest international declines are expected from BG, Norsk Hydro and ConocoPhillips, all major players in the North Sea. Due to the recent implementation of a 10% tax increase on UK offshore revenues, SSB expects activity in this region to be flat to slightly down in the near term.

2002 – 2003 International (outside North America) E&P expenditures, $ millions

 Some key observations. These selected points of interest emerged from the survey, in addition to the preceding analyses:

•  The average oil price assumption for 2003 spending plans is $23.43/bbl. Although responses from majors on this question were fewer than normal, the average remains well below those of the independents. National oil companies, such as Pemex, also tend to use low oil price assumptions, as the revenues are utilized to fund social and military programs. The long-term oil price expectation rose to $22.49/bbl from $20.93/bbl a year ago. This 7% increase is relatively in line with the 13% increase in the near-term oil price assumption
•  For natural gas, the average planning assumption was $3.54/Mcf, or 18% below the present futures strip. This is 59% higher than the 13-year survey average, and second only to the $3.86 figure in 2001. Despite weak economic activity, gas prices have remained strong for most of 2002. Rising depletion rates, weak rig counts and a lack of attractive drilling prospects have been significant contributors to this strength, as well as the war premium that presently is entrenched in crude oil prices. SSB attributes part of the rising gas price assumptions to heightened optimism among operators regarding gas fundamentals. 
•  Similarly, the long-range gas price assumption jumped to $3.51 from $3.18 a year ago, directionally mirroring the increase in short-term price assumptions during this period. When asked what gas price would trigger a 10% increase in spending, average responses were $4.20 in the US and $4.45 in Canada. The implication is that a sustainable price above $4.00 will likely cause a spending budget increase of at least 10%.
•  Gas vs. oil drilling. As expected, US and Canadian companies continued to shift their focus toward gas drilling. The percentage of US rigs drilling for gas vs. oil has risen from 40% ten years ago to more than 80%. SSB would not be surprised to see this trend continue over the next decade, in light of strengthening gas fundamentals and ongoing uncertainty regarding OPEC policy. Outside North America, oil accounts for about 75% of drilling activity, as most nations do not have the necessary infrastructure to utilize gas as a primary fuel. 
•  Offshore spending is presently favored in most geographic markets. Relative to a year ago, US respondents appear to be shifting more toward offshore activities. Those shifting focus to offshore, at 26%, were twice those shifting to onshore. Operators are increasingly looking offshore for bigger prospects, particularly in deep water and deep gas formations. Outside North America, 17% indicated a focus shift toward offshore vs. 12% onshore, the offshore market’s smallest lead in the survey since 1995.
•  Seismic demand may start to improve during 2003. In total, 44% expect to allocate a higher budget proportion to seismic than in 2001, compared to just 16% expecting a lower proportion. This is consistent with the response that a mild trend toward exploration is anticipated, but an increasing portion of the seismic market relates to production-related surveys, such as 4D, and data processing. Thus, an increase in seismic budgets, in SSD’s view, does not necessarily portend a significant increase in exploration spending. 
•  Drilling over acquiring. As has been the case in nine of the past ten years, more than 70% believe the economics of drilling are more attractive than those of purchasing reserves. Interestingly, this response appears to contradict what most companies have been focusing on in recent years. As a percentage of cash flow, E&P spending has fallen markedly since 1998, while acquisitions have occurred at elevated levels. Predictably, most acquisition targets relate to gas rather than oil, and by a wide margin. 
•  Amid strong oil/gas prices, industry optimism remains high in relation to the coming three years. Global population growth, emerging technology and rising depletion rates are all contributing factors to this perception, in SSB’s opinion. This appears to be particularly the case in North America, where the sustainable gas price appears to be rising. International markets, as usual, are more dependent on the actions of OPEC, but even at the current low level of demand, OPEC’s spare production capacity is just 15%. 

 Note: Salomon cautions that, since actual companies surveyed vary from year to year, it is not statistically accurate to compare total estimates with those from prior-year surveys.