Navigating the new price environment

Jan. 14, 2015
When I was a youngster, a popular expression used by adults around me was, "There are lots of ways to skin a cat."
Dick Ghiselin • Houston

When I was a youngster, a popular expression used by adults around me was, "There are lots of ways to skin a cat." I was horrified, thinking, who would want to skin one of those furry little creatures? Later, I found out the true meaning of the expression, and it made good sense. Before technology and before regulations, operators were free to make just about any kind of deal they wanted to achieve their objectives. Because there were more ways than one to skin a cat, the oil and gas industry has managed to survive down-cycles that would've brought other industries to their knees. What will we do this time?

Farm-outs and farm-ins have been an accepted way for companies to buy work or buy expertise to get wells drilled. This became a life saver when the drill-it-or-lose-it lease terms emerged. Designed to keep wealthy operators from trying to corner all the leases, this practice prevented successful bidders from sitting on their leases. Particularly effective in tough economic times, companies busy on their active leases could hire another operator, even a competitor, to drill a well, thereby holding the lease. The operator making the deal viewed it as a farm-out; accepting the deal was viewed as a farm-in.

There are multiple benefits to this practice. The most obvious one is the ability to meet one's obligations in accordance with the lease terms. The farm-out operator gets the technical and operational experience equipment and personnel needed to drill the well. The farm-in operator gets work, and may not have to lay off staff in tough times.

Another valuable way to skin a cat in tough times is the secondary market for offshore drilling units. Say Company-A plans to drill a very promising prospect in deepwater. Rigs are scarce in this market, so a two-year commitment is made with a drilling contractor, for $500,000/day plus spread costs. Unfortunately, the first well comes up dry. Company-A needs to rethink objectives, but first it must deal with this half-million per day drain on its coffers. By entering the "secondary market" for drilling units, Company A can sub-lease the rig to Company B who has been looking for a deepwater rig to drill a single exploration well, thus offsetting much of the rig costs during the sub-lease period. This can go on until the two-year contract has been satisfied, or Company A may have found work for the rig in another more promising area. It is a true win-win situation. Company A divests itself of a costly contract, and Company B gets a deepwater rig without having to sign a two-year agreement.

The secondary rig market has been a lifesaver for operators whose rigs are damaged by hurricanes. They can quickly obtain a qualified rig for the length of time their rig is in the shipyard undergoing repairs. Often the drilling contractor owning the damaged rig can suggest a replacement from its fleet.

Companies that have prepared for a downturn are much better off than those who haven't done so. As the market price falls, one can see knee-jerk reactions alongside carefully managed planned downsizing. Reactions range from massive lay-offs and divestitures to "business as usual, only less of it." It's been suggested that the current situation has been a reaction to the domestic energy boom and the US's declining need to import foreign oil. Exporting countries miss the Red, White, and Blue cash cow they have enjoyed for decades. They have ramped up production to flood the market, hoping to punish us with the expected ramp-down of prices. Already, producing countries who have not managed their businesses (those whose economies are overwhelmingly dependent on petro-dollars) are in danger of economic disaster.

Who will be left when the dominoes stop falling?

The recent mid-term election may bring dramatic changes as the oil and gas industry stops being Congress's whipping boy and more opportunities open up for domestic exploration and development. The playing field might tilt severely if the US government allows a free market of oil exports. Many smaller producers cannot compete with the sheer volume capacity of the US to export. Not only is there plenty of oil in the export pipeline, but the US industry enjoys a huge, well-organized infrastructure. The balance of payments deficit may turn into a balance of payments surplus overnight.

Countries and companies that have prepared contingency plans for a price collapse will be rewarded. Those that haven't will be punished. The previously stated examples of tactics for cost-cutting are but two of dozens that have been tried and used successfully by the industry to weather previous down-cycles. This is not our first rodeo. And it won't be our last.

Cost-Value is the name of the game. Economic downturns have always attracted a minority of doom-and-gloom philosophers who sit around, wringing their hands and wishing for a return to the good old days. The oil and gas industry is unique among technology industries because its chief product is sold on the commodity exchange which also determines the price. Essentially, what this means is that any company that feels the pinch of today's market cannot simply raise prices to boost cash flow. That leaves few options. One can give up, or one can reduce costs.

Fortunately, several recent technological advances give operators the opportunity to make a significant dent in costs. Some of the most elegant are revolutionary new bit designs. Not only do many of the newest designs improve penetration rates, but they also increase bit life. On many deepwater wells, saving even one bit trip can save more than $1 million. To be sure, the bit company expects to get a good price for these advantages, but a quick cost-value calculation shows that the cost is well worth it. These bits also offer several intangible benefits that vary with the geology and geomechanics of the formations being drilled. Benefits like reduced drilling risk, cleaner, less rugose boreholes, larger cuttings for better on-site analysis – all add value.

Over the years, many have tried simply to cut costs. This often amounts to false economy. Cutting costs adds risk, and all too often more money is spent un-doing the damage done by ill-conceived economy efforts.

Companies that perform cost-value analyses before making decisions have the advantage of deep insight into the profitability of every decision. If it isn't profitable, don't do it. Look for another alternative that is both effective and profitable. Operators who engage with their suppliers can develop performance incentives that, if met, benefit both parties. Simply going cheap usually winds up costing more. The records are full of case studies showing how taking a better approach that may cost more pays off in the long run.

Back in the days of the Austin Chalk development, it was stated that drilling a horizontal well might cost about 1.7 times that of a vertical well. But it was quickly proved that the horizontal well produced about 10 times more than a vertical well. A similar rationale applies in hydraulic fracturing. Technology exists today that allows operators to reduce the risk and improve the performance of their frac jobs by spending a little more on geomechanics analysis to ensure frac clusters are in the right place to exploit reservoir sweet spots. Users have been rewarded with 40% to 60% production improvement as well as increased recovery factors. Small added cost equals huge added value.