What's Ahead in 2006

Other than that Mrs. Lincoln...

Doug Nester, COO, F-W Oil Exploration L.L.C. , Houston

Once again, our inabilities to predict our industry’s status from one year to the next have been made painfully clear. This year, however, we were not reminded gently of this shortcoming; instead it was slapped upside our heads.

Like other independents operating in the Gulf of Mexico (GOM), my company, F-W Oil Exploration L.L.C., began the year with high expectations, due to favorable commodity pricing and a strong inventory of drilling opportunities. These expectations ended abruptly for many, just seven months later, when the summer hurricanes delivered a system shock whose reverberations continue, and whose long-term consequences remain unclear. As the shock wears down and reality sets in, our industry is presenting mixed health signals. On one hand, the industry shows record profits. On the other, it shows just how fragile we truly are.

Record earnings do not tell the whole story. By reading the record third-quarter earnings reports, one would think that the industry could not be healthier. When compared to a year ago, Exxon‘s quarterly profit was up 57%, Shell’s was up 68%, and BP’s was up 34%. Not to be out-done, many independents have reported earnings that matched or exceeded these percentage gains. These impressive gains are due more to increased commodity prices associated with existing output than improvements made in operations.

Lost in the media and political hype surrounding these record profits are the hardships that GOM operators continue to face. It is understandable that this receives little attention and sympathy, when it appears everyone is flush with cash. As the reverberations of this summer’s shock continue, the fragility of our industry in the Gulf will become more apparent to everyone.

It will be interesting to see how companies perform in the fourth quarter, when their reports will reflect extended production losses and lower commodity prices. Output losses for majors and large independents in the GOM will be somewhat offset by receiving still favorable prices for production in other basins or countries. The story will be quite different for smaller independents that have little to no alternative production sources outside of the Gulf. Some of these firms have hedged a large portion of their output and are now in the precarious position of not having sufficient volumes to meet commitments.

As of Nov. 1, 2005, nearly 1.0 million bpd, or 67%, of GOM oil production still remained shut-in. Also, over 5.3 Bcfd, or 53%, of the Gulf’s gas output remained shut-in. Misery not only loves company – it is also indiscriminant in whom it affects. Whether at ExxonMobil or F-W, we all suffered together. At F-W, we certainly contributed our share, as these two storms shut-in over 95% of our company’s production. We were fortunate, however, in that no damage occurred to our facilities and pipelines. Thus, we restarted some of our output in early November, once the land-based terminal facilities were returned to operation.

A tight market gets tighter. Damage caused by these storms to platforms, rigs and shore-based facilities was unprecedented. The impact will be felt by all GOM operators through 2006.

As mentioned earlier, 2005 started with high expectations for many in the Gulf. With a gas price deck above $6/Mcf and equipment available, F-W began a large development program that included drilling multiple horizontal wells, setting two platforms and installing a 48-mi. pipeline. We are very fortunate to have scheduled our project’s start in January 2005 and not in January 2006. Devastation to drilling rigs, supply vessels and shore-based infrastructure has made it essentially impossible for others to duplicate in 2006, what we accomplished in 2005.

As reported by US Interior Secretary Gail Norton, “Of the 4,000 platforms that the MMS administers, 3,050 plat-forms were in the path of Hurricanes Katrina and Rita.” The damage numbers are humbling – 108 facilities destroyed, and another 53 platforms sustained significant damage. On November 1, 2005, about 215 platforms and five rigs remained evacuated.

The storms destroyed or severely damaged nine jackups, causing a 100% effective utilization rate for this rig class. The 2006 outlook for GOM rig availability is concerning. As 2005 began, there were 92 rigs working in the Gulf. If we subtract the nine damaged jackups and eight rigs scheduled to leave for other countries, there is only a 75-rig supply left to start 2006. Our drilling contractor said that there is a demand for 95 rigs in first-quarter 2006. While a few jackups are set to enter the market during 2006, they are said to be already under contract. Based on simple supply and demand, it is easy to support the 20%-to-50% increase in rig day rates anticipated throughout 2006. Since 2004, some jackup rates have already increased by over 250%.

Day rates for supply vessels and construction barges are also rising. Prior to the storms, offshore supply vessel utilization was already 86%, and nearly every available vessel was scheduled to be under contract. While little supply vessel damage has been reported, effective utilization is also 100%. This can be expected to continue for supply vessels, including construction barges, through all of 2006, as operators attempt to return fields to production and also drill new wells.

There is little doubt that the industry’s 2006 drilling plans are affected by equipment availability. Operators that expected to drill one or two wells are now looking at multi-well contracts. The fear of not being able to secure rigs to capture high prices, or prior to lease deadlines, is pushing operators to grab as many rigs as they can and accelerate drilling projects. Hording of equipment, already underway, will certainly extend into next year.

F-W was already on a waiting list for a jackup prior to the storms, and is now considering extending its contract for at least six months, to ensure meeting our 2006 objectives. Even with a rig set to arrive in January, we still face obstacles. One is securing support vessels for drilling and completions. I dread the thought of the rig arriving on location, but work cannot start because support vessels are not in place. Our search for these vessels is hindered by some companies’ actions – placing long-term contracts on boats to simply remain on standby while they evaluate how to address damaged assets.

Another obstacle for firms to overcome is their ability to secure permits for planned offshore operations. The MMS just reopened its Elmwood Park office (New Orleans) in November, and is still trying to catch up on filings put on hold after the storms. At this time, it is unknown if MMS can respond to the large number of permits headed its way. Another thought that I dread is that the rig is on the way, and I still do not have an approved location. Those caught in this predicament may lose the rig to the next company on the list.

Moving on. So what will life be like for GOM operators in 2006? As long as commodity prices support higher operating costs, I think the year can be good for many of us. Majors and large independents will absorb this body blow in stride and continue searching for big prizes that the Gulf reluctantly gives up. For some firms, this summer will be the final straw, and they will forgo rebuilding and take this opportunity to exit the Gulf. Others will stand by to step into the shoes of those exiting.

There will also be many opportunities for entrepreneurial companies to participate. The limited equipment available will push companies to create new partnerships to share these resources. New partnerships will also emerge, as firms accelerate drilling projects. Those facing lease terminations or other limitations may have to partner with firms with access to rigs.

Not including another destructive hurricane season, the one thing that could spoil 2006 is greed. Greed for more vessels, more rigs, higher commodity prices and higher day rates has the potential to cause problems. As we enter 2006, perhaps a good slogan to remember is that “pigs get fat, but hogs get slaughtered.”

THE AUTHOR
	Douglas C. Nester is chief operating officer at Houston-based F-W Oil Exploration L.L.C. Mr. Nester was previously with Devon Energy, where he served as vice president of international exploration. Prior to Devon, he helped to co-found 3DX Technologies Inc. in 1993, serving as vice president of exploration. Prior to that, he worked at Pennzoil. Mr. Nester received a BS degree in geology from Indiana University of Pennsylvania and performed graduate studies in geology at the University of Houston. He received an MBA in finance from the University of St. Thomas in Houston.