OUTLOOK 2004: United States
E&P Spending

Higher oil/gas prices boost spending

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

The Smith Barney division of Citigroup Global Markets Inc., Citigroup Smith Barney (CSB), published its 22nd annual E&P Spending Survey on December 12. The 36-page report involving 224 oil/gas operating companies analyzes reported spending for 2003 and plans for 2004, focusing on the US, Canada and outside North America. The data comprises 50 tables and figures, plus CSB's commentary, survey highlights, the survey process and results, and oil/gas company observations.

The authors say the survey, encompassing nearly $149 billion of global upstream spending, indicates 2004 E&P spending growth of 4.4%. This follows an estimated 9.4% increase in 2003, revised from the year-ago forecast of 3.8% due to incremental growth in all markets, compounded by the weaker US dollar. Respondents assumed a $25.68/bbl oil price for 2004, 27% above the 15-year average, but 14% below December's futures strip of $29.88/bbl. Gas price is assumed to be $4.39/Mcf, 75% above the 15-year average, but 17% below the futures strip of $5.32/Mcf.

North American spending is forecast to rise by just 0.7%. For the second straight year, North American operators have budgeted for limited US and Canadian growth. International spending is projected to rise by 6.4%. Based on the relative constancy of the majors' spending plans, and projections of strong growth in Latin America, China and India, International spending is expected to continue its upward trajectory. Typically, such spending plans have more stability than those in North America. Oil and gas price sensitivities are very similar to a year ago, indicating material upside potential to the survey indication of 0.7% North American spending growth, and to a lesser extent, 6.4% international growth. Consequently, the authors are maintaining their base-case growth forecast of 6 – 8%.

Survey highlights. This year's survey of worldwide E&P expenditures indicates that respondents plan a 4.4% increase in 2004 spending, compared to a 9.4% increase in 2003, and the 20-year high of 24.8% in 2001. A year ago, 2003 spending was forecast at 3.8%; however, actual growth was stronger in all geographic regions due to higher-than-anticipated oil and gas prices and, secondarily, the weaker US dollar. Currency effects may have inflated spending growth by about one percentage point.

During 2003, the worldwide rig count rose by 19%, but this was heavily skewed toward the less service revenue-intensive North American land drilling market. In fact, the US land and Canadian rig counts were expected to be up 29% and 41%, respectively, at year end, countering a 4% decline in the Gulf of Mexico. In international markets, rig count was up 8% and the offshore count down 1%. A significant offshore bright spot was Mexico which, during 2003, accounted for nearly 40% of total growth in international E&P spending.

In 2004, CSB anticipates 7% growth in the worldwide rig count, but with a more balanced mix of onshore and offshore, domestic and international. As opposed to 2003, international growth is expected to be more diversified. In addition to Mexico, solid growth is expected in China, India, Brazil and Venezuela.

Combined, the 224 companies surveyed plan worldwide E&P expenditures of $148.9 billion, up 4.4% from the $142.6 billion level now forecast for 2003. Of the planned spending, 67% is earmarked for international markets, 22% for the US and 11% 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, where reliable data has not been available. The survey 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.

US majors. The eight firms designated as major oil companies plan to decrease US spending by 2.0% in 2004, to $13.7 billion. Over the past few years, this group has continued to de-emphasize US operations in favor of more prospective deepwater and international opportunities, particularly related to development of major discoveries. These companies divested a significant number of US properties during the late 1990s, but have slowed this pace in the past two years.

CSB expects a continuation of this international trend over time – except in prospective regions such as the deepwater Gulf of Mexico – as well as increasingly stable and inelastic spending budgets. In the US, one notable 2004 change will be a reduction in BP's spending due to a peak in its capex profile – caused by the timing of its Thunder Horse/ Atlantis/ Mad Dog/ Holstein developments.

US independents. In the US, the 132 independents surveyed plan a 2.4% increase in 2004 upstream expenditures, to $19.6 billion. This compares to 8.2% growth in 2003 and a 15.5% decline in 2002. Despite historically high oil and gas prices, 2004 spending plans are very modest. Energy merchants such as El Paso and Dominion, traditionally among the largest market participants, continue to be constrained by cash flow issues, while the remaining group of independents continue to be broadly conservative. Weak balance sheets, war and economic uncertainty were significant wild cards a year ago, but are not so today, in CSB's view. Thus, it believes the initially conservative forecasts are principally due to declining North American prospects, and secondarily, a heightened emphasis on investment returns.

In the coming year, the largest spending increase, of just $185 million, is projected to emanate from EnCana. Other significant spending increases, on an absolute basis, are projected from Williams Production and Westport Resources. Notably, most of the large independents such as Apache, Devon and Burlington Resources are, at best, projecting very modest growth. Conversely, large declines are anticipated from El Paso, Kerr McGee and Dominion. On a percentage basis, the largest increases by far emanate from the smallest independents.

Aggregate US spending (Majors and Independents) is forecast to increase by 0.6% in 2004, to $33.3 billion, compared to a 4.1% rise in 2002. Of the 40 respondents, 59% expect higher spending, 22% expect lower spending and 19% expect no change. Much of the growth is coming from small, incremental increases at a large number of companies.

In Canada, 80 companies plan a 1.0% spending increase in 2003, to $15.6 billion, following 31.7% growth in 2003 – half of which was likely due to the sharp increase in the Canadian dollar value, relative to the US dollar. The same prospectivity factors affecting US drilling plans are applicable in Canada, validated by the fact that just 23% of Canadian respondents plan to outspend cash flow in 2003 – in line with the response from US independents. This would represent the lowest percentage in a decade.

M&A activity declined significantly, yielding a market dominated by several large Independents. Thus, CSB expects more inelastic spending plans than in past years, though not nearly to the extent of the much larger integrated majors. Notably, oil sands are becoming a significant area of Canadian spending growth which, as a whole, has relatively low oil service intensity. However, in coming years, most new oil sands projects are anticipated to be steam-assisted gravity drainage which, generally speaking, is far more service intensive than strip mining.

International. Outside North America, the 85 companies surveyed plan a 2004 spending increase of 6.4%, to $100 billion from $94 billion, compared to an 8.2% increase in 2003 and 10.7% growth in 2002. Excluding Pemex of Mexico, estimated 2003 spending growth was just 5%, and will be the same in 2004, reflecting a broadening of spending growth in international markets, as Pemex accounted for nearly 40% of spending growth in 2003, but is projected to account for less than 20% in 2004.

In total, Latin America is expected to account for 60% of 2004 spending growth, with relatively equal contributions from Pemex, Petrobras and PDVSA. Petrobras' growth is attributed to project timing and the acquisition of Perez Companc, while PDVSA's is largely due to the sharp reduction in 2003 resulting from the first quarter strike. Other companies expecting significant international spending increases are CNOOC, Petrochina, Yukos, BP/TNK, and ONGC. The largest declines are projected from BHP Petroleum, Agip and Lukoil.

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

• The leading drivers of upstream spending are expected to be operating cash flow, the availability of attractive drilling prospects and energy prices. Some 55% of the respondents cited these factors, while 42% cited targeted production growth. Availability of capital continued to be a relatively minor consideration, likely due to the extended period of high oil/gas prices over the past five years.
• The average oil price assumption for 2004 spending plans is $25.68/bbl, up more than $2.00 from a year ago and at the highest level in the survey's history. Similarly, the average long-term oil price expectation rose to $24.55/bbl from $22.49 a year ago, a nearly 10% increase. This suggests that the high oil prices of late 2000 were deemed to be more temporary than the present, and could cause several projects that were previously viewed as uneconomic to become viable.
• Regarding gas prices, the average planning assumption of $4.39/Mcf rose by 24% from last year's $3.55, and is 14% above the previous survey record of $3.86 in December 2000. Even the majors increased their assumption by 17%, to $3.85/Mcf from $3.29, in CSB's view due to sharply higher finding and development costs. The long-term gas price assumptions also rose sharply, to $4.21/Mcf from $3.61 a year ago and $4.42 in December 2000. As the current futures strip is $5.32, it would appear that initial budgeting assumptions are quite conservative.
• For the first time in three years, about the same amount of respondents expect to shift their focus to oil-related projects as gas-related projects. However, these expectations are quite different among the three respondent regions. In the US, 27% expect to shift toward oil compared to 19% that plan to shift toward gas. Conversely, Canadian respondents continue to focus on gas, with more than three times as many shifting toward gas as toward oil. Outside North America, as usual, significantly more respondents are shifting toward oil-related projects, likely because most markets do not have the infrastructure to support gas consumption.
• The shift toward exploration that commenced a year ago appears to be gaining momentum, as 34% expect to move toward exploration in 2004, vs. 19% planning to shift toward development. Consistent with this shift, twice the number expect to increase spending on lease expenditures as those that expect to reduce lease expenditures. And, for the second straight year, three times more respondents expect to increase seismic budgets than those that expect to decrease.
• For the second straight year, respondents deemed the economics of drilling to be more favorable than those of acquiring reserves. In light of the run-up in both oil and gas prices, acquisition prices have clearly increased significantly. However, the percentage seeking to purchase reserves (70%) was about flat with responses of the past three years, with a clear bias toward acquiring gas.
• North America is where respondents see the most potential. After two years of waning attraction, interest in the Gulf of Mexico and the US is on the rise, with 75% listing it as one of its top three focus regions. These results are heavily skewed by US independents, 92% of which listed their home regions. Europe was not listed as a major focus area, while interest has grown modestly in Russia, the Middle East, Latin America and Asia. Only 6% listed Africa as a primary focus, likely driven by continued political turmoil and instability in the region.
• With historically high commodity prices, respondents are incredibly optimistic about the future. In particular, optimism about the oil-intensive international markets is back to 2000's level of 100%, but it has remained above 95% for the past five years as OPEC's production discipline has remained strong. In the gas-intensive US, optimism grew from 92% last year to 98% this year.

Note: CSB 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.