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Canadian Producers Struggle with Climbing Finding and Development Costs

Canadian natural gas finding and development costs have tripled in the past 10 years, prompting an industry alert to guard against "hyperinflation." The trend stood out as a surprise result of the latest in a periodic series of industry performance surveys commissioned by the Canadian Association of Petroleum Producers.

Member companies suspected expenses were on the rise across the board, but few had a clear idea that the pattern deserves to be called "skyrocketing," CAPP Vice President Greg Stringham said.

Average Canadian gas finding and development costs hit C$3.00 (US$2.55) per thousand cubic feet in 2005, estimates the study by ARC Financial, a Calgary investment bank and private equity manager that founded prominent CAPP member ARC Energy Trust.

The new report, building on three previous ARC reports for CAPP that were known as Canadian industry "competitiveness" surveys, shows costs consistently rising almost every year since they were C$1.00 (US$0.85) per Mcf in 1996.

ARC historical records show finding and development costs were negligible from the 1960s, when gas was largely an unwanted byproduct of oil drilling in Canada, until the "energy crisis" and boom years of the late 1970s. The Canadian industry average took until 1980 to top C$0.50 (US$0.42) per Mcf. The figure stayed well below C$1.00 (US$0.85) until the second half of the '90s, a period when the industry was selling off a supply backlog -- known then as "the bubble that stretched into a sausage" -- that was caused by export restrictions and shortages of long-distance pipeline capacity.

As exports, production and drilling in the western provinces accelerated after 20 years of energy free trade with the U.S. and new pipeline construction, Canada developed an acute case of a syndrome that was spreading everywhere in the international industry, said study author Peter Tertzakian, ARC's chief economist.

Drilling targets are naturally shrinking as gas fields age, automatically raising unit costs of discovering and developing new reserves. At the same time, rising gas demand and prices are stimulating competition for targets and field services and equipment.

ARC concludes that in Canada, and especially Alberta (source for about 80% of the nation's production), "the industry has had to work progressively harder to replace natural gas reserves."

ARC estimates average reserves booked per successfully completed Canadian gas well have dropped by 60% to 400 MMcf from 1 Bcf over the past six years. "That means two-and-a-half times as many wells must be drilled to find the same amount of reserves," straining the capacity of the Canadian field service and supply sector. "Well costs have been rising steeply, especially since 2002."

While the infant coalbed methane branch of the Canadian gas industry is still too new for final verdicts, few expect it to reverse the cost trend unless there are major technical breakthroughs. Canadian coalbed methane requires less processing equipment because it comes out of the ground clean, but it requires large numbers of wells and significant compression because reserves are dispersed and pressures are considerably below pipeline specifications.

Not the least of the cost drivers is competition for drilling targets at provincial auctions of Crown leases, the Canadian counterpart to public lands in the U.S. In Alberta, where auctions are held every two weeks, ARC records show average land prices stayed in a range of C$162-$205 per hectare (US$55-$70 per acre) until 2000.

Except for 2002, a year of market setbacks, Alberta land prices have jumped every year since, reaching an average C$633 per hectare (US$215 per acre) in 2005. The average jumped 74% last year alone. "Compounded over the past three years, land prices have been increasing by abut 50% per year," ARC calculates. "It's quite possible the trend could continue, especially if commodity prices stay robust."

Stringham described the new report as "an awareness piece" which sends all producers a message that everyone needs to focus on costs. A second but not incidental message is that Canadian governments are taking their fair share out of the industry, counting land sales revenues on top of royalties and taxes, the CAPP vice president said.

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