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Upstream Costs Fall, but Further Plunge Expected

The costs to build and operate upstream facilities have plunged over the past six months, but they still have further to fall, according to IHS Cambridge Energy Research Associates (IHS CERA).

Since the beginning of the year, IHS CERA's Upstream Capital Costs Index (UCCI), which tracks costs associated with new facility construction, has fallen 8.5% to 210 points, the energy firm said Friday. The Upstream Operating Cost Index (UOCI), which measures facility operating costs, nearly mirrored the decline, falling 8% to 187.

The indexes, which use proprietary data to benchmark costs around the world, measure cost changes that are similar in concept to the Consumer Price Index. Values are indexed to levels in 2000, meaning that $1 billion in capital costs in 2000 now is estimated at $2.1 billion. Likewise, the annual operating costs of a project that in 2000 were $100 million have risen to $187 million today.

"The first signs of a downward shift in costs were evident in a moderation that we observed in the last two months of the third quarter," said IHS CERA Chairman Dan Yergin. The latest analyses "place into clearer view the impact of the financial crisis, spending cutbacks and the fall in crude oil prices."

The decline in capital costs was driven by the drop in upstream oil and gas activities and a "sharp" decline in the cost of steel and subsea equipment, the analyses showed. For instance, after jumping 32% earlier in 2008, upstream steel costs plunged 25.2% from 3Q2008 to 1Q2009.

Subsea equipment costs fell 7.8% over the period after many development projects were placed on hold, IHS CERA noted. Demand was on the decline in both West Africa and South America, which previously were high on the list for new projects. The lower costs for steel also loosened the market when the lower prices were passed on to manufacturers. Lead times, which had remained steady, decreased by as much as four months since the last three months of 2008.

Operating costs likewise declined because of a "slackening of project activity and lower levels of resource utilization," noted the report. Transportation and consumables costs registered some of the biggest cost drops, triggered by falling energy prices and the downturn in the global economy. Costs for well services also fell significantly when the economic downturn led to lower production costs for oil and gas companies.

Though the costs for both offshore and onshore projects have fallen, offshore operating costs have remained comparatively higher because of "sustained activity levels and a limited number of deepwater vessels." Costs for offshore fields in the UOCI portfolio fell 6% in the past six months, compared with a 15% decline in the costs for onshore fields.

However, the decline in capital and operating costs for upstream projects has not kept pace with the fall in oil and gas prices, IHS CERA noted. The general trend for upstream costs has shifted downward, but "certain" areas have remained relatively firm, thus preventing costs from following commodity prices lower.

"By their nature certain operating costs, such as personnel costs and deepwater vessel contracts, are more firm," said Jeff Kelly, associate director for the IHS CERA Operating Cost Analysis Forum. "Wages and salaries are rarely cut to recover costs. And deepwater vessels, because of their limited numbers, are usually contracted out for longer periods such as three-to-five years."

Capital costs held firm in similar areas, said Pritesh Patel, who directs the IHS CERA Capital Costs Analysis Forum.

"Offshore costs, lead by strong demand for rigs, continue to challenge the market," Patel said. "And companies have so far been reluctant to shed workers amidst hopes of an economic recovery."

Further declines in materials costs and slackening demand likely will lead to a bigger drop in both capital and operating costs in the near term, IHS CERA analysts said.

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