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Hyper-inflation eating into company profits Canadian upstream revenues break C$100 billion threshold, but camouflage rapidly rising finding and development costs Gary Park For Petroleum News
Upstream revenues topped C$100 billion for the first time in Canada last year — they were actually C$22 billion better than the 2004 record — and are expected to stay there through 2008, says a study by ARC Financial Corp. commissioned by the Canadian Association of Petroleum producers.
Just for good measure the cash flow of publicly traded oil and gas producers grew by 40 percent in 2005 to C$49.27 billion, capital spending climbed 9 percent to C$51.7 billion and producers pumped C$30.1 billion into field work, up 41 percent from 2004.
A sky’s the limit scenario, right? But before anyone gets too carried away with those numbers, the report delivered a wake-up call.
It said finding and development costs are “hyper-inflating” in Canada, making it one of the most expensive hydrocarbon regions in the world, where profitability is expected to lag three or more percentage points behind global peers over the next three years.
The feast of returns from the upstream masked a trend where the profits on new barrels of production aren’t keeping pace with realized prices, said the study, authored by Peter Tertzakian, chief energy economist, and Kara Baynton, senior investment analyst, for ARC Financial.
Costs compounding at minimum 15% annually Analysts have already been cautioning that the F&D outlays could make some higher-cost production uneconomic, especially as the shift to unconventional plays accelerates.
The outlook said the costs of drilling, oilfield services, equipment, wages, pipelines and prospective land compounded at a minimum 15 percent annually over the past three years, with outlays climbing to C$10.30 per barrel of oil equivalent in 2003 and forecast to top C$11 per boe this year.
F&D costs in the Western Canada Sedimentary Basin, which accounts for more than 80 percent of Canadian production, climbed to C$17 per boe last year from C$6 in 1995, according to a separate study by Ziff Energy Group.
Ziff project manager Fernando Gomez and FirstEnergy Capital analyst Steve Paget are among those warning that rising F&D costs threaten to make higher-cost production uneconomic in a basin where the future depends on oil sands and unconventional gas, led by coalbed methane.
M&A costs up for Canadian reserves The pattern was mirrored in an M&A review released at the end of March by John S. Herold and Harrison Lovegrove which said the cost of acquiring proved reserves in Canadian deals last year averaged just over US$20 per boe, with 30 percent of the transactions exceeding US$30 per boe, compared with an average $12.50 per boe in the U.S.
Among the most telling figures identified in the ARC report, the gap between cash flow and capital spending widened to C$14.24 billion in 2005 from C$10.75 billion in 2004, partly resulting in reinvestment of gross cash falling to 74 percent last year from 96 percent in 2001, although CAPP predicts a return to 80 percent this year.
The changed pattern of spending stems from expansion of the royalty trust ranks, which ARC believes has leveled off, and the practical limits to cap-ex in the oil sands.
The report expects trusts will maintain their production, currently about 800,000 boe per day, through development and acquisition, keeping their production volumes constant through 2008.
Average return on capital 13%, 9% on equity It said the current average return on capital for producers is about 13 percent and the return on equity is 9 percent.
But such profitability can be “deceiving” because 80 percent of the oil and gas being produced and sold today is from “earlier, lower cost discoveries,” leaving incremental production “hostage” to the new cost structure and sensitive to a drop in prices, the report said.
Based on oil prices of US$70 per barrel, gross revenues will climb to C$135.5 billion in 2008, compared with C$99 billion at US$52 per barrel or C$67.45 billion at US$35 per barrel, the outlook said.
Production is forecast to climb for oil and liquids to 3.19 million bpd in 2008 from 2.96 million bpd this year and 17.3 billion cubic feet per day for gas from 17.2 bcf over the same period. Oil sands output is currently 1 million bpd and is targeted to reach 2.7 million bpd by 2015 from C$60 billion in direct capital spending.
Land costs affecting F&D costs The report said that for the first time, land costs were affecting F&D costs, with the average price rising to C$633 per hectare (C$256 per acre) last year from C$200 in 2002, with oil sands leases surging to C$1,219 per hectare from C$279 over the same four years.
It said that although inflation in the cost of labor and equipment is likely to ease “good prospective lands will continue to be in short supply.”
Operating costs, after a sharp hike over the past few years, are expected to remain flat under the ARC Financial scenario.
Despite the negatives, the report rated the petroleum industry as the most profitable sector in Canada, with return on capital for producers averaging 13 percent and the return on equity about 19 percent in an environment where the weighted average cost of capital was a modest 4.5 percent.
As well as the industry, governments are feasting off close to a doubling of royalties, land sales and cash taxes paid by E&P companies, which reached C$27 billion in 2005 from C$14 billion in the 2000-2003 period. That count does not include taxes from the C$39 billion paid by E&P companies to oilfield service firms.
Total corporate tax for 2005 was calculated at C$10.1 billion vs. C$4.8 billion in 2003, but those returns are forecast to drop beyond 2006 as commodity prices decline and tax changes take effect, including a drop in the federal corporate tax rate to 22.12 percent in 2007 from 26.12 percent in 2005, the phase out of the large corporation tax and an accelerated oil sands capital cost allowance.
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