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Inflation, Weather Expected to Guide E&P 1Q Reports

A shortage of onshore drilling equipment capable of blasting into shale is contributing to double-digit inflation in some of the big U.S. unconventional plays, an issue expected to be played out over the coming weeks as North American exploration and production (E&P) companies unveil earnings for the first three months of 2011.

Lots of talk also is expected to center on E&P's transition from gas to oil and liquids plays, a move that Encana Corp. highlighted in its report on Wednesday.

For the financial markets, the new mantra has become "good oil/bad gas," said Canaccord Genuity's John Gerdes and his team. At a recent conference the talk was of $90-110 crude oil prices long term, and "sub-$5 gas prices for the next few years." However, there were "suggestions that we are in the 'early to middle innings' of shale play" mergers/joint ventures, and "wide-open capital markets with cheap money continuing to flow to industry."

One of the "common themes" expected to be heard in the quarterly reports "is continued service cost escalation," said the analysts. "With the major shale rig count growing from 570 rigs in 4Q2010 to 740 rigs in April and incremental frack [hydraulic fracture] fleet capacity expected to come on largely in the second half of 2011, we anticipate service cost escalation in the order of 10-20% quarter/quarter.

"In our view this range is biased to the upside as we are consistently seeing operators increase the [frack] stage count in nearly all of the major oil plays, including the Bakken, Eagle Ford, Wolfberry and Wolfberry trends."

Foul wintry weather in 1Q2011 should mute the earnings expectations for some of the large E&Ps; several already had cut their first quarter guidance over the course of the three months, noted FBR Capital Markets. However, "positive commentary around the U.S. pressure pumping market could engender a favorable reaction from the equities. Moreover, we expect announcements of pressure pumping capacity slippage could start to resonate with investors and help assuage fears of an oversupply scenario."

Analysts with Tudor, Pickering, Holt & Co. Inc. (TPH), who attended the recent Independent Petroleum Association of America's Oil & Gas Investment Symposium, said they too heard that "costs are increasing as labor, chemicals, rope, soap and dope all are getting tighter in North America." There were "rumblings of 20%-plus increases" in costs in the Permian Basin, where the rig count could jump to 400 from the current 350 by year's end.

For North American oilfield service operators, business couldn't be better. Onshore service requests are steady and shows no signs of leveling off, Halliburton CEO Dave Lesar told analysts during the company's quarterly earnings conference call (see Daily GPI, April 19). Although there is cost creep, the industry is on the verge of a major upcycle, he said.

Halliburton "demonstrated the power of capacity adds and additionally moving some crews to 24-hour frack operations from daylight operations on top of pricing improvement" in the first quarter, the TPH analysts said. Halliburton "was also unequivocal" in its view of North America: that there's "still room for revenue and margin gains."

The "bottom line," said the TPH team, is that E&P capital spending associated with each U.S. rig is "working its way up." Over the past four quarters Halliburton's revenue per active U.S. rig (using Baker Hughes Inc. numbers) is 37%-plus, a combination of "pricing/capacity/more wells per rig/more 24-hour work."

Over the past four quarters Halliburton's North American operating margins "increased from 21% to 24.5%," held back by some Gulf of Mexico decline, "so net pricing is up but it's not like it's gone crazy if margins are this flattish...Doing more, plus inflation, is increasing costs a bunch to E&Ps."

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