North American natural gas drilling is up 30% from the beginning of the year and is on course to reach its 2001 peak by the fourth quarter, Merrill Lynch said in a new report on the oilfield service sector. Canadian drilling activity, which often is a good indicator of upstream spending going forward, is heading for a near record level this year.

However, even with high gas and oil prices, spending plans remain conservative and most of the activity is being driven by small independents, Merrill Lynch said. In order to kick the trend into overdrive some changes need to be made in technology, drilling costs, but the analysts question whether those changes are likely to happen.

“We forecast trend-line upstream spending growth of 8% in 2003 driven by expected oil demand growth of 1.5% and the need to increase North American natural gas supply,” the analysts said. “However given the underinvestment by the integrated and large independent oil companies, 8% growth may be difficult to achieve in 2004.”

The analysts said the industry has assumed a conservative approach to spending on E&P for a variety of factors: 1) uncertainty as to how soon Iraq exports will return to pre-war levels; 2) the implosion of the U.S. energy merchants; 3) ongoing consolidation of the independent oil companies; 4) a focus on return on capital and balance sheet management rather than production growth by the independents; and 5) a shortage of technical staffs to efficiently plan and implement new projects.

“Until the integrated oil companies (which account for about 33% of worldwide spending) change their ‘mindset’ and adopt a higher normalized oil price assumption, capital investment is likely to be constrained.”

Offshore drilling activity also is expected to remain sluggish until the Gulf of Mexico begins a meaningful recovery. But according to another study released this week by consulting firm ODS-Petrodata, the world’s largest offshore drilling market, the U.S. sector of the Gulf of Mexico, will experience a slow decline in rig demand following a short-lived rally triggered by current high gas prices.

“We don’t see a huge change [going forward],” said Tom Kellock, senior research consultant at ODS-Petrodata. “It is going to improve, but we don’t think that’s going to be the start of a long-term boom or anything like that, quite the opposite. There are indications that a turnaround is beginning but then again we thought last December that it was starting to happen, but it turned out to be just another end-of-the-year uptick as people were finishing off budgets and using up funds. The precise timing of the short-term increase in Gulf drilling is extremely difficult to say.”

While many producers claim there is no shortage of drilling locations in the Gulf, improvements in technology, particularly seismic and horizontal/directional drilling, have led to extremely steep decline rates. Simply replacing production requires a significant increase in the amount of new resources found in the Gulf. According to Merrill Lynch, new technologies have led to North American natural gas declines of about 30% per year on average.

“This has led to increased maintenance capital spending to replace declining production.” In order to help producers improve their finding success rates and increase their desire to spend more on exploration, Merrill Lynch said oilfield service companies have to add value in the form of new tools that lower finding and development costs as opposed to maintenance costs. “However we do not see any of these potential technologies having sufficiently large near-term impact for this to occur.” F&D costs have increased at a rate of about 7%/year since 1997, according to the analysts.

The analysts said they expect oilfield service company earnings to accelerate in the second half of 2003. “However, we believe that unless the mix of upstream spending improves to include higher margin business (i.e., more offshore and more exploration), 2004 consensus estimates may be too high.”

For more details from ODS-Petrodata’s “World Rig Forecast: Long Term Trends Report,” which has a $16,000 annual subscription cost, contact Paul Large (832) 463-3061.

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