Overall, we expect a 25-30% gain in the average efficiency of onshore upstream capital investment in 2015 versus 2014, and a gain of 45% when comparing 4Q2015 to 4Q2014. This substantial improvement results from many forces, although the key driver is the compounding effect of high-grading of drilling locations and the continued reduction in drilling and completion costs.
- As oil prices have plummeted, the entire value chain of the oil and gas sector has suffered with cuts to capex budgets, layoffs, low utilization and decelerating growth. Looking forward we see a turning point emerging, one of the key dynamics of which will be the role of capital efficiency. With substantially fewer dollars available to invest, the fate of companies and markets will depend on how far those dollars can stretch.
- Overall, we expect a 25-30% gain in the average efficiency of onshore upstream capital investment in 2015 versus 2014, and a gain of 45% when comparing 4Q2015 to 4Q2014. This substantial improvement results from many forces, although the key drivers are the effects of high-grading of drilling locations and continuing service cost deflation. We estimate high-grading of drilling locations has led to a 9% efficiency gain since December 2014. We expect drilling and completion costs to fall by about 15% on average in 2015 and almost 25% by year-end.
- The key for E&P companies will be the way in which high-grading and cost deflation leverage each other; a 15% drop in costs turns a 9% high-grading improvement into a total production efficiency gain of 28%. More impressively, toward the end of the year when we expect the drilling and completion discounts to reach 25%, it leads the productivity index to reach 145%. This excludes further gains due to other variables such as bigger, smarter, faster or more highly fractured wells. Incremental progress in those areas would further increase the overall improvements in capital efficiency.
- These improvements in capital efficiency do not fully offset lower prices for E&P companies. Producers would still be much better off at $100. Furthermore, the gains are not irreversible and are a function of the down-cycle.
- Capital efficiency gains will act to lower breakeven prices and raise activity levels (at least modestly), which should lead to improved oil production growth at a given price. This should make a material difference in 2016 and plays an important role in our view that US production is likely to rebound in 2016 even if capital budgets remain muted.
- E&P companies are relative winners as margin migrates out of services to the E&P sector. Even in a flat commodity price environment, getting more for each dollar invested should allow producers to experience improved profit margins. Service companies may see some rebound in activity, but in general capital efficiency works against them, at least in the short-term.
By Raoul Leblanc, April 15, 2015