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Analysis Predicts Further Producer Capital Cost Increase in 2007

The costs of major oil and gas production projects have risen more than 53% in the past two years, and no significant slowing is in sight, according to a new benchmark index developed by IHS and Cambridge Energy Research Associates (CERA).

The IHS/CERA Upstream Capital Costs Index (UCCI), which tracks nine key cost areas for offshore and land-based projects, climbed 13% to 167 during the six months ending October 31, compared with an increase of more than 17% in the previous six months. Since 2000, the UCCI has risen 67% -- with most of the increase in the last two years -- while the Producer Price Index-Commodities for finished goods (excluding food and energy) moved up just 7.5% during the same period.

"This continuing cost surge is central to every energy company's strategic planning and to every energy user's expectations for supply security in the coming years," said CERA Chairman Daniel Yergin. "Rising capital costs rank right alongside more widely recognized issues such as world market trends, geopolitics, globalization and new technologies at the top of the agenda for the energy industry," he said. "And this will be a central issue at CERAWeek in Houston," the firm's annual conference, which opens Tuesday.

The UCCI tracks the costs of equipment, facilities, construction materials and personnel used in a geographically diversified portfolio of more than two dozen onshore and offshore oil and gas development projects. As a tracking tool, the UCCI is similar to the consumer price index.

During a Monday press briefing, CERA senior director and UCCI project manager Richard Ward said the index is more heavily weighted toward projects outside of the United States and larger projects of the international and national oil companies. The index contains three North American projects, two in the Gulf of Mexico and a conventional natural gas project in the region of the Arkoma Basin, Ward said.

He said that CERA will be doing more research into the impact of unconventional gas development on project costs in general. "The role of unconventionals and how we move forward the costs and the balance of this thing is something that we're going to be looking at in the coming year and doing some more research...," he said.

CERA will be updating its index the first week of May and November. The index will be released as one number; however, the data CERA gathers will lend itself to the creation of regional sub-indexes, which the firm may use on a case-specific basis.

Earlier this month CERA reported that rising costs are undermining North American natural gas wells (see Daily GPI, Feb. 5), and some North American producers have warned that their budgets for 2007 could be curtailed because of high costs in the field (see Daily GPI, Feb. 2).

"If current trends continue, 2007 is shaping up to be a year of further increases. Despite a slight slowing in the rate of increase during the six months to Oct. 31, we expect project capital costs to continue reaching new record levels during 2007," said Ward. "With high oil prices driving new development projects, capacity constraints continue to support increases in the cost of equipment and services."

Deeper water projects have experienced the largest cost increases, according to the UCCI data, rising 15% in the recent six month period, primarily due to drill rig rates, technology limits and skills requirements, and are expected to continue to rise due to tight industry capacity. Onshore facilities, including LNG, have seen the slowest rates of increase, 12%, but are still only slightly behind the overall averages.

"Higher costs, combined with the recent drop in [natural] gas prices, have made some projects uneconomical and triggered a re-evaluation of plans." Ward said. "This has produced a slight relaxation of tight support service or commodity markets, particularly in the U.S. And most noticeably for natural gas projects, where development costs have remained high. However, the slight additional capacity made available was rapidly mopped-up by other geographical areas where these resources were required."

Of the nine primary drivers of project capital development costs, steel is the only segment to decline over the past 12 months, primarily because steel prices began accelerating globally prior to the recent increase in oil prices and demand. Most of the others -- except equipment and bulk materials -- are specifically focused on the oil and gas business and are at near maximum capacity.

Capacity across all markets is tight, CERA said. Capacity expansions are under way but will take a while and could be delayed or canceled if oil prices slip below $50/bbl, the firm said.

"While commodity prices are still strong, and are expected to continue to be strong in the near future, this rise in costs is causing firms to re-evaluate the economics and viability of many important initiatives," said Ward. "CERA's analysis indicates that for the remainder of 2007 costs should continue to escalate, but perhaps not as rapidly as in previous years, a situation we shall continue to monitor for change."

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