Despite high oil and gas prices and a significant increase in drilling in recent years, a new report by Lehman Brothers predicts that independent producers are likely to follow the majors in reducing spending on North American exploration and production in future years. Not only have drilling returns been disappointing, but investors also are beginning to frown on large domestic drilling budgets.
"The overwhelming conclusion of this year's report is that higher oil/gas prices have not helped boost per share growth rates much," said Lehman Brothers analyst Thomas Driscoll in his report titled "What Drives E&P Shares." He cited production and reserves per share growth rates of 7-10% in 2004, which was only marginally higher than in previous years despite higher commodity prices in 2004.
A maturing asset base in North America and "dramatically higher" drilling costs have created "a tough environment where shareholders, at least among the bigger E&Ps, penalize companies that drill aggressively."
Driscoll believes the industry may be at a turning point because spending on drilling is not resulting in higher shareholder value. Producers are beginning to conclude that lower drilling levels combined with debt reduction and share repurchases are the formula to improve shareholder value.
"A lack of attractive drilling opportunities did not prevent E&P companies from spending over half of cash flow over the past few years. However, the dearth of economic drilling prospects has led to poor investment results. With the benefit of hindsight, we believe it is fairly clear that a lot of projects were funded that should not have been," said Driscoll.
"We believe that poor marginal returns in North America will likely lead E&P companies to emulate different parts of the major's strategies of the past two decades."
Driscoll said the large independent E&Ps are now expected to reduce the North American capital spending to levels well under cash flow. In 2001 and 2002, they spent nearly 90% of cash flow on E&P activities, excluding acquisitions. Drilling budgets fell to 70% of cash flow in 2003 and 2004. Driscoll is expecting drilling budgets to be about 60% of cash flow in 2005 -- a lower percentage of cash flow but a high actual dollar amount.
"While the temptation to increase budgets will prevail as long as prices stay strong, we believe that the companies are unlikely to spend as large a share of cash flow as in years past."
The remaining cash is likely to be spent on acquisitions and international E&P projects, he said, or to pay down debt, increase dividends or buy back stock.
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