COLUMN-Time and money, rebuilding oil's global supply chain: Kemp

Mon Jun 10, 2013 10:24am EDT

By John Kemp

LONDON, June 10 (Reuters) - Lack of specialist equipment and skilled personnel have been the biggest barriers to raising the supply of oil over the last decade, contributing to the steady escalation in prices.

Exploration and production (E&P) activities have been hit by shortages of everything from drilling rigs and pressure pumping equipment to the guar gum used for hydraulic fracturing, experienced geologists and drill team leaders.

The result has been soaring cost inflation. But with oil prices now in the eleventh year of a bull market, the supply situation is starting to improve, shortages are easing and upward pressure on costs is beginning to abate.

TIME AND MONEY

Oil production is subject to long cycles. Part of the problem stems from the long lead times for large capital investments. It can take 7-10 years from discovery to put a major offshore oilfield into production and a similar time to design and build a gas-to-liquids plant.

However, some of the most intractable challenges lie in the supply chain. Oil and gas exploration and production require substantial amounts of equipment and specialist personnel, few of which are shared with other industries.

E&P budgets have to sustain a complex eco-system of prime contractors and sub-contractors to provide drilling, surveys, chemicals, specialty steel tubing, pressure pumping equipment and more mundane items like guar gum and fracturing zeolites.

Many of the problems that have hampered production over the last 10 years stem from decisions made during the prolonged period of low oil prices in the 1990s to slash budgets, lay off skilled engineers, drillers and geoscientists, and cut recruitment.

The result was a rapidly ageing workforce and badly reduced supply chain which struggled to respond to the sudden return of demand from E&P companies.

Shell's outgoing chief executive, Peter Voser, explained the long-cycle dynamic in a recent interview with my colleague Andy Callus.

"One learning out of all this, for every person in this organisation now, is you spend capex through the cycle. Don't try to read it, don't slow down. It will cost you more when you want to grow afterwards," Voser warned.

"I know a lot of investors and analysts. They all think they can read the market ... slow down, grow later, shrink to grow, all these buzzwords, but one thing in our industry is very clear; it takes you five to seven years to recover a strategic slowdown... The market changes its views in three to six months, and you can't change that fast in our industry."

Rebuilding supply chain takes both time and money. Fortunately, the oil industry now has plenty of both.

Using Brent as a benchmark, average crude prices have risen in 10 of the 11 years between 2002 and 2012, with only a brief decline in 2009 (Chart 1).

High prices mean buoyant cash flows. In 2013, oil and gas companies will spend a record $678 billion on exploration and production, up 10 percent from 2012, according to a recent survey by Barclays Capital.

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Chart 1:

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Chart 3:

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GLOBAL DRILLING

In the early years of the bull market fears about a return to low prices restrained capital expenditure. As the boom has endured, however, E&P companies have become more confident and shown more willingness to undertake spending programmes that will take years to pay back.

The drilling boom has been most obvious in the shale plays of North America, where it has also resulted in a big build out in the supply chain for everything from modern drilling rigs and seismic crews to pressure pumps and fracturing sand.

But the drilling boom is gradually going global. E&P budgets outside North America are predicted to rise by 13 percent in 2013, compared with just 2 percent in North America itself, according to the Barclays survey.

The gradual globalisation of the E&P boom is reflected in monthly rig counts published by oilfield services company Baker Hughes.

The number of onshore rigs actually drilling for oil and gas outside Canada and the United States has almost doubled to 960 in the first five months of 2013, from just 500 in 2002. (Chart 2)

The biggest increase has been concentrated in the Middle East, where traditional producers such as Saudi Arabia, Abu Dhabi and Kuwait are now drilling much harder to replace declining output from their aging fields.

But drilling activity has more than doubled in both Europe and Africa, according to Baker Hughes. Onshore drilling in Europe and Africa is at the highest level since the beginning of the 1990s and around 80 rigs are now working in both regions (Chart 3).

BUILDING CAPACITY

Because wages and prices have been escalating, the activity has risen more slowly than E&P budgets let alone output, which has erroneously led some analysts to conclude that the finding and lifting costs of oil and gas are inexorably rising.

In fact, cost inflation is the inevitable price for rebuilding a shrunken supply chain and labour pool. E&P firms have paid premium prices to attract new workers and suppliers into the oil and gas patch. But as the rebuilding of the supply chain is completed, cost inflation should slow, and prices in some areas are likely to come down.

Different elements of the supply chain have been built out at different speeds.

The volume of pressure pumping equipment in the United States has grown so rapidly the market was suffering from 25 percent overcapacity by the end of 2012, according to one estimate by a market intelligence firm. In other areas, shortfalls persist and prices are still rising rapidly.

Cost inflation therefore remains problematic for the major E&P companies, but there are signs it has started to decelerate, and it should slow further in 2014 and 2015 as the investment cycle matures.