When More Is Less: Oil Production And The Increase In Service Costs

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A trio of reports from Barclay's and oil industry consultants indicates E&P budgets will increase by low single digits.

The higher budgets likely won't translate to much higher production as oil service costs increase.

Increase in service provider costs inevitable, and already showing. Shale breakeven to rise $10/barrel.

A trio of reports published last week paint a picture of higher exploration and production (E&P) budgets for oil companies in 2017. We, however, believe any increase will largely be absorbed by higher oil service provider costs and dilute the impact of the higher spend. Let's explore why.

Rising Budgets

Barclay's published a report last week on the results of an oil and gas industry survey it conducted last year. Based on the survey, oil and gas industry executives anticipate that E&P will increase on average by 7% in 2017.

Separately, Woods Mackenzie reports that 2016 will mark the bottom of the oil investment cycle, and E&P spending will increase by 3%. Woods Mackenzie states "Yet this is still 40% below the heady days of 2014, reflecting deep cost-cutting and a move toward smaller, more incremental projects."

Evercore ISI's own annual industry health check, which surveyed 300 companies, expects E&P capital expenditures (capex) to increase 2% in 2017.

Thus, taken together it's very likely E&P spend will increase by only single digits. Now most investors would look at this and say that production should follow budgets, higher spend will translate to higher oil production in 2017. Additional efficiencies will even further drive production as oil producers continue perfecting their extraction methods. We see these reports, however, and think the opposite. A single digit increase in 2017 capex is tantamount to a flat/decline in E&P year-over-year spend because the increased spend will be largely offset by higher service provider costs.

Increasing Costs

Not long after the survey results came out, Wall Street Journal reported that service costs were beginning to increase by 10-20%. The paper stated:

"However, the cost to hire an experienced drilling crew and source critical oil-field supplies, including the sand used in hydraulic fracturing, has surged between 10% and 20% this winter, experts say. Shale companies could face even higher prices if crude keeps climbing to $60 a barrel, they add."

We've noted before that service costs are something to watch all along and it will dictate the cadence of the oil production increases. In contrast, oil bears have argued that the US shale industry will ramp up production dramatically, but if E&P capex spend is flat, and oil service providers are charging 10-20% higher fees in the most prolific areas (e.g., Permian), absent a dramatic change in oil extraction efficiency, this will eventually mean less wells drilled, and less oil extracted.

David Pursell, head of macro research at investment bank Tudor, Pickering, Holt & Company stated "Prices have to go up if activity is going to increase," Pursell said. "You're going to have to put more equipment to work, and you're going to have to put more people on that equipment." The bank projects shale breakeven costs to increase by $10/barrel in 2017.

This isn't surprising. The laws of supply and demand are immutable. On the supply side, rising oil prices will mean service providers, pressured by years of austerity will need to recover financially and rebuild balance sheets severely weakened in the past two years. Moreover, a historic number of oil service providers have gone bankrupt, leaving every surviving service provider with more leverage. As oil prices recover, providers will have the motivation and the leverage to negotiate for higher fees.

While we expect US production to grow by 4-5% in 2017, we believe that increasing service costs will play a large role in subduing overall growth in shale production. So at the end of the day, yes E&P budgets will rise, but don't expect this to translate to surging production. Oil service companies now want theirs.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.