Even with the “unlimited” money available to spend by oil and natural gas producers in the last five years, only gas has gained volume-wise on a global basis, which indicates gas, mostly in the form of liquefied natural gas (LNG) and gas-to-liquids products, will continue to take a bigger share of the market, a John S. Herold energy researcher said Friday.

Bob Gillon, Herold’s co-director of equity research, said Herold’s review of about 200 public oil and gas companies measured the “true” changes in oil and gas reserves over the past five years. The conclusion: “oil reserves simply are not being replaced,” Gillon said. Even with the restructuring changes by several of the majors, anecdotal evidence suggested “reserves are not growing at the pace of world demand.”

However, “natural gas is a different matter,” Gillon said. “The reserve gains there are in excess of 100%.” Herold expects gas to gain in market share everywhere but in transportation. “We can’t solve the transportation fuel dilemma that we have, which is largely oil-based and will remain so.”

Land access issues and geopolitical problems have hindered exploration, but Herold also affirmed that rising costs are an industry problem.

“This really shouldn’t come as any surprise to us,” he said. “Prices went up 17% on a nominal basis in 2006, on a real basis, and we’ve seen about a 15% increase in reserve replacement costs.” What is surprising are the costs for the “larger independents group,” which Gillon said “is showing a monstrous 50% increase in reserve replacement costs…higher than oil price escalation.”

When Herold researchers reviewed how the independents invested their capital, Gillon said “the group in 2006 spent 30-42% more than they did in 2005, just in drillbit exploration and development spending…not counting acquisition spending. But we really shouldn’t expect anything different. Utilization rates were already high, and the major players came in with additional budgets, and they are not going to have any other outcome than that.”

On the “good news” side, he said, “the cost per well is rising steeply, but the reserves-per-well drilled are steady. Total [finding and development] F&D [costs] have gone up from about $2.7 million to about $3.3 million, or about a 25% increase.”

The average reserves added per well over the past few years have stayed “fairly steady,” at about 300,000 boe per well, said Gillon. “That’s a very different picture than we saw in the late 1970s and early 1980s. Industry has maintained its technical criteria… They are spending their per-well dollars not just to pursue growth” but also to maintain their financial discipline.

The escalating costs “are all on the completion side,” which is a “good news sort of category.” Gillon pointed out that “pure” finding costs, which are costs spent only on exploration, extensions and discoveries in any given year, have fluctuated only slightly. “Technology is reducing the cost to find oil and gas,” he said, but other factors are squeezing the other side: targets are smaller; producers are operating in “difficult” environmental and political environments; more drilling is done in “difficult” reservoirs. “And that takes more steel, more labor, more costs to develop. Those development costs are what’s pushing up the cost side, not exploration.”

Gillon said it was “clear” that the return on capital peaked about a year ago, with “higher and higher service costs driving down returns in the upstream. The returns in the downstream are staying up nicely. But I don’t see any reason to expect any change in this pattern unless prices escalate dramatically. For now, that means E&Ps will be more steady among those with downstream [operations]…integrated producers.”

Gillon affirmed comments by Herold CEO Art Smith last month, when he said there are fewer explorers (see Daily GPI, Jan. 24).

“In exploration, we’ve seen a clear pattern over the last several years, that there’s been less and less,” said Gillon. “Producers are investing two times as much in share repurchases as in exploration. Either they can’t find the opportunities, or they are risk averse, or they see higher returns in exploitation of their known assets. In any case, exploration needs to increase if the industry is going to sustain itself.

“It’s fine to say [that exploration is impossible] where there is no access. That’s a harder question to answer.” However, “if a company is not exploring to a sufficient extent, they will be putting themselves at a competitive disadvantage to those that do so.”

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