OUTLOOK 2005: United States
E&P Spending

Spending boost to continue in 2005

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

The Smith Barney Division of Citigroup Global Markets Inc., Citigroup Smith Barney (CSB), published its 23rd annual E & P Spending Survey on December 13, 2004. The 39-page report, involving 183 oil/gas companies reporting, analyzes spending for 2004 and plans for 2005, focusing on the US, Canada and Outside North America. The data comprises 57 tables and figures, plus CSB’s commentary, survey highlights, the survey process and results, and company observations.

The authors say the survey indicates initial plans for 2005 worldwide spending growth of 5.5%. North American spending is projected to rise by 8.6%, and international spending by 3.9%. Estimated 2004 spending growth of 10.3% exceeded initial expectations of 4.4% due to higher investment in all regions, compounded by the weaker US dollar. Average oil and gas price assumptions used for 2005 budgets soared to $36.69/bbl WTI and $5.66/Mcf Henry Hub, both record highs for the CSB survey, but well below the current futures strips.

Survey highlights. This year’s survey indicates respondents are planning a 5.5% increase in 2005 spending, compared with increases of 10.3% in 2004 and 9.4% in 2003. A year ago, 2004 spending growth was forecasted at 4.4%; however, actual growth was stronger in all geographic regions due to higher-than-anticipated oil/gas prices and, secondarily, the weaker US dollar. Currency effects may have inflated spending growth by about 1%.

During 2004, the worldwide rig count rose by 10%, up to the survey date, but for the second straight year was heavily skewed toward the less-service-intensive US land drilling market. The US land rig count is expected to finish the year up 18%, countering an 11% decline in the Gulf of Mexico, a 16% decline in the North Sea, and a 2% decline in Canada (following a 41% surge in 2003). In international markets, the rig count was projected to rise by a more steady 9% in 2004, with the land rig count up 10% and offshore up 6%. Worldwide shallow-water activity remained weak in 2004, but the deepwater rig count has risen by 13%.

In 2005, CSB expects 7% growth in the worldwide rig count, still with a greater emphasis on onshore. In light of the respondents’ decided focus shift toward offshore drilling, CSB views its offshore rig count forecast as conservative.

Outside North America, pricing continues to gradually improve, boosted by rising rig counts but muted by the long-term nature of many international service contracts. Key growth areas should be Brazil, India, the Middle East, and possibly the North Sea and Venezuela. Conversely, Mexico is slowing down after two years of surging growth, while the outlook for Yukos of Russia was “murkey at best,” near year-end. On an absolute dollar basis, the expected incremental investment in international markets is just slightly below expected growth in North America.

Combined, the 183 oil/gas companies responding plan worldwide E&P expenditures of $172.5 billion in 2005, up 5.5% from the $163.6 billion level now forecast for 2004. These expenditures, encompassing major, national and independent companies operating on six continents, represent the most comprehensive survey of forecast 2005 investment. Of the planned spending, 65% is earmarked for international markets, 24% for the US and 11% for Canada.

Notably, the actual percentage of international spending is greater than 65%, as the large majority of the spending not included in the survey comes from Middle Eastern nations such as Iraq, Iran and Saudi Arabia, where reliable data have not been available. In some of these nations, such as Saudi Arabia, selected oilfield equipment and services providers have a strong presence. And, the data do not include acquisitions, so historical numbers have been adjusted to reflect acquisitions as if they had occurred at the beginning of the survey period.

US majors. The nine firms designated as major oil companies plan to increase US spending by 3.5% in 2005, to $14.2 billion. In recent years, this group has de-emphasized its US operations in favor of more prospective deepwater and international opportunities, particularly related to developing major discoveries. However, in 2005, this group is, surprisingly, forecasting that its international spending growth will be roughly the same as in the US.

These companies divested a significant number of US properties during the past decade, but they appear to have slowed this process in light of record-high gas prices. Project timing also can play a significant role in the majors’ growth profile based on the large scale of projects such as deepwater developments.

US independents. In the US, the 109 independents surveyed plan a 9.7% increase in 2005 upstream expenditures, to $27.0 billion. This compares with growth rates of 24.6% in 2004 and 8.2% in 2003. Despite historically high oil and gas prices, 2005 spending plans appear modest, but initial spending plans in both 2003 ( – 0.6%) and 2004 (+2.4%) were extremely conservative.

Aside from the impact of record-high oil/gas prices, the US market is benefiting from a stabilization of spending by energy merchants such as El Paso and Dominion, traditionally among the largest market participants. Weak balance sheets, the Iraq war and economic uncertainty were significant wild cards in prior years, but are not so today. Instead, the key constraints appear to be the lack of attractive drilling prospects and rig capacity tightness. Pricing sensitivity remains skewed to the upside, so the initial spending plans are conservative.

In the coming year, the largest spending increases ($300 million each) surprisingly emanate from foreign operators BHP Petroleum and EnCana. Other significant increases, on an absolute basis, are projected from ConocoPhillips, Chesapeake Energy and XTO Energy. Conversely, large declines are anticipated from the El Paso/ Nabors/ Lehman joint venture, which is winding down (although El Paso’s non-JV spending should be flat); plus Agip and Devon Energy. 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 7.8% in 2005 to $41.3 billion, compared with a 15.7% rise in 2004. Of the 118 respondents, 72% expect higher spending, 13% expect lower spending, and 15% expect no change, for a total increase of $2.4 billion from last year’s survey. Two companies, as noted, are expected to spend $300 million more, and only two others – Chesapeake and XTO Energy – are expected to spend in excess of $150 million more. Thus, much of the growth is coming from small incremental increases at a large number of companies.

In Canada, 66 companies plan an 11.0% spending increase in 2005, to $18.7 billion, following growth rates of 8.9% in 2004 and 31.7% in 2003. In 2003, the Canadian rig count surged by 41% to a record level and, in 2004, was essentially unchanged as it consolidated those gains. Thus, the higher spending was primarily due to higher service pricing and, secondarily, strength in the Canadian dollar (which added about 1% to growth).

Despite the fact that 69% of respondents view the availability of attractive drilling prospects as an impediment to growth (the highest-ever percentage in response to this question), a healthy spending increase was planned in 2004. Once again, pricing should play a key role, as could the Canadian dollar, which already is up sharply from 2004.

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 expected to be steam-assisted gravity drainage, generally more service-intensive than strip mining. For 2005, the largest incremental spending increases are expected from Devon Energy, Canadian Natural Resources, Nexen, Burlington Resources and Shell Canada, with only Anadarko forecasting a material decline.

International. Outside North America, the 75 companies surveyed plan a 2005 spending increase of 3.9%, to $112.5 billion, from $108.3 billion, compared with increases of 8.7% in 2004 and 8.2% in 2003. Roughly 10% of the 2005 spending increase is from Latin American oil companies, with increases for Petrobras and PDVSA partially offset by a decline from Pemex. Petrobras’ $1 billion, 20% increase is the largest among international respondents, closely followed by Statoil’s $900 million, representing a 22% increase. For each of these companies, increased development spending is driving the increases.

Despite the planned 9% spending decline, Pemex’s 2005 budget of $9.6 billion is the largest spending plan outside North America. Other companies expecting significant international spending increases are CNOOC, Woodside Petroleum, Royal Dutch/ Shell and Repsol. The largest declines are projected from Agip and EnCana.

Some key observations. The following selected points of interest derived from specific survey questions and responses supplement the above analysis.

• This year’s survey reflects some interesting shifts in operator sentiment. In prior surveys, energy prices and operating cash flow were deemed to have about the same impact on spending plans as the availability of attractive drilling prospects. However, this year, prospect availability rose sharply, to its highest level in at least a decade, while operating cash flow and energy prices – as well as targeted production growth and availability of capital – declined to their lowest levels of this period. Despite rising finding/ development costs, just 7% deemed higher operating costs to be a significant factor in their near-term spending plans, in light of record energy prices and operator cash flows.
• The average oil price assumption for 2005 spending plans is $36.69/bbl, up $11.00/bbl from the prior year’s record response and 80% above the average response of $20.29/bbl over the past 14 years. All respondent categories increased their assumptions sharply, most notably the typically conservative US majors, who raised their assumption to $26.60/bbl from $21.91/bbl. Smith Barney’s official 2005 oil price projection is also $36.00/bbl.
• Similar trends are seen in natural gas price assumptions, as the average planning assumption rose by 29%, to $5.66/Mcf, from last year’s record response of $4.39/Mcf. All respondent groups sharply raised their assumptions, in CSB’s view due to higher finding/ development costs.
• From 1998 through 2002, E&P operators shifted their spending focus toward gas-related projects. However, since 2003, they have been shifting toward oil-related work, with this survey’s responses indicating an acceleration of this trend. In the present survey, 27% cited a focus shift toward oil-related drilling in 2005, compared with just 12% increasing focus on gas.

Aside from record oil prices, the lack of attractive gas drilling prospects in mature regions such as the Gulf of Mexico has caused operators to increase their focus on oil. The percentage of US rigs drilling for oil (14%) remains near its record lows, but operators’ appetite for such activity is clearly on the rise.

• The shift toward exploration that commenced a year ago appears to be accelerating, as 42% of respondents expect to shift toward exploration in 2005, compared with just 22% that plan a shift toward development.
• Respondents also indicated a marked focus shift toward offshore projects, to its highest level since 2000. Worldwide, 32% expect to shift their focus toward offshore vs. just 16% shifting toward onshore, representing a significant change from a year ago when both responses were roughly equal.
• For the third straight year, respondents deeming the economics of drilling to be more favorable than those of acquiring reserves increased. A total of 92% agreed with this supposition, up from 88% a year ago, to its highest level in more than a decade. With the run-up in oil/gas prices, acquisition prices have increased significantly.
• For the first time ever, 100% of the respondents are optimistic about the next three-year outlook. Over the past 10 years, there have been periods when certain classes of respondents have had 100% response, but never all three classes at the same time. Certainly, the strong commodity price environment over the past two years is driving the level of optimism.

Note: Citigroup Smith Barney 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.