2011 drilling outlook: 3 analysts, 3 takes

By Linda Hsieh, managing editor

Oil rig count on land to surge to 50% of total in 2011

Held by production and joint venture spending in the shale basins have kept the US land rig count higher this year than you might expect, judging from natural gas prices, said James Wicklund, principal at Carlson Capital. But come 2011, industry will have to look to horizontal drilling in oily plays to keep the pace of activity up, he said.

Especially in the Haynesville, which appears to be having the biggest impact on gas over supply in 2010, activity should start to roll over by the end of Q1 2011. “Considering it’s costing $10-$11 million to drill a well and gas is selling for $4, it is cheaper for you to go ahead and lose the $4 million to drill the well than let the $6 million you paid for the property to expire. So drilling to hold acreage will keep up through the first half of next year, but you might see the first signs of weakness in the first quarter.”

But those rigs will just go elsewhere, he added, especially to the horizontal oily plays. Industry has come to realize that it can take its horizontal drilling and completion technology, honed over the past few years of drilling in tight gas shales, and apply it to tight oil reservoirs. “The realization has been hitting through this year that the returns on drilling for oil with today’s technology are much greater than the returns on drilling for gas,” Mr Wicklund said.

“Now you’re looking at suddenly the Permian Basin becoming one of the hottest basins in the US. A year ago if you told anybody on Wall Street that the Permian Basin was going to be the hottest basin going, they’d have rolled their eyes and laughed at you.”

According to Mr Wicklund, the oil rig count on US land has increased from 20% of the total in January 2009 to 40% now. He’s confident that number will go up to at least 50% next year. “That’s a big shift. A couple of years ago, everybody was claiming we’re not in the oilfield service business, we’re in the gas field service business. Nobody wanted to be associated with oil drilling. Boy, that’s changed in a hurry.”

The hot plays in 2011, he believes, will be the ones with oily reservoirs, such as the Permian Basin, the Eagle Ford, the Bakken and the liquids-rich portion of the Marcellus. With natural gas, he expects to see a slow decline in activity start anytime now. However, “it won’t pick up any meaningful traction until middle of 2011. Even then I’ll only see it fall a couple hundred rigs.”

He continued: “That will be overshadowed by crude oil drilling. I actually look for domestic onshore drilling activity to pick up by 5% to 8% next year, with the skew definitely going toward more oil than gas.”

PRODUCTION & DEMAND

The emergence of the shale plays has completely changed the paradigm for the US natural gas market, Mr Wicklund said. A common belief was that industry was running on a treadmill. If we slowed down at all, production would drop significantly. “The idea was that if the rig count dropped 5% to 10%, production would drop 10% to 20%. Instead, the rig count dropped 57%, and gas production went up – and has consistently gone up ever since the rig count bottomed.”

Going back to 2001 and 2002, the biggest complaint in the E&P industry was that there were no prospects in the US to drill. “Today we have a 15-year inventory of gas prospects already identified by the industry,” he said.

Because the price of natural gas remains soft – and Mr Wicklund doesn’t believe it will rise above $5.50 anytime soon – demand should start to pick up next year. “You usually do when something gets cheap,” he said.

The problem with that is, because natural gas had been portrayed for years as a scarce and expensive resource, Americans haven’t geared up to use it. It will take years to move the consumption needle, especially when it comes to using compressed natural gas (CNG) as a transportation fuel. Putting infrastructure in place will be key to moving that process forward. A plan unveiled in September 2010, backed by House Republicans, would spend $55 million to transition Pennsylvania’s 16,000 vehicles to run on natural gas instead of gasoline and provide tax breaks for private businesses to convert their vehicles. The legislation would also mandate the construction of natural gas fueling stations along the Pennsylvania Turnpike.

“I think those types of plans make sense,” Mr Wicklund said. “If we can come up with an incentive for private enterprise to develop the natural gas distribution network, that would be huge.” He believes that a company can expect a payback period of about 18 months for converting a fleet of 70 vehicles to CNG – even without government subsidies. “I think you are going to see a gradual shift to more use of natural gas for transportation purposes, but you do need more infrastructure.”

Outside the United States, there is potential for shale drilling in numerous areas – but that’s just a long-term potential for now. First, most countries don’t have the same level of natural gas infrastructure in place as the US. Second, there’s the issue of mineral rights. “If I’m going to drill in your back yard, you don’t mind because I’m going to send you a check. But if it’s Poland, Australia or China, I’m going to drill in your back yard and, by the way, you don’t get any of it. You’re not going to like that nearly as much,” he said.

He believes that shale drilling will be tested in many countries outside North America, but there won’t be meaningful production over the next five years.

OFFSHORE DRILLING

Although Mr Wicklund sees the US land drilling market continuing next year “at a decent pace,” he predicts the Gulf of Mexico offshore segment will have to struggle a bit more. “I don’t think we’ll see a deepwater well drilled until April (2011) at the earliest, and that’s probably optimistic.”

In the shallow water, he commented: “I think it will pick up, but it will still disappoint. It will be slower than people expect.”

Additionally, the number of companies that operate in the Gulf of Mexico will begin to decline. “That’s just a guarantee,” he said, pointing to Plains E&P as an example. The company announced in September that it was selling its GOM shallow-water properties to McMoRan Exploration for approximately $818 million. “I think they’re just going to be the first of several,” he said.

And it looks as if Plains E&P has decided to put more emphasis on onshore prospects instead. In October, the company announced plans to spud up to 19 horizontal wells in 2010 in the Texas Panhandle Granite Wash development and to boost that number to 25 in 2011. It also acquired approximately 60,000 net acres in the Eagle Ford in South Texas for $578 million in cash.

Outside North America, Mr Wicklund sees steadier markets in the North Sea, the Middle East and Asia/Australia. “Saudi Arabia surprised everyone recently by paying very competitive rates for jackups to develop their gas markets. Indonesia has been a bit of a surprise, too. You’re seeing a lot of the equipment and subsea companies expanding their presence in Southeast Asia because of the higher-than-expected activity in the South China Sea, Malaysia, Indonesia and Australia.”

For deepwater, West Africa seems to be going strong, he said, while Brazil could be the saving grace – if Petrobras decides to hire existing deepwater rigs for their offshore development programs rather than build additional rigs locally.

“It depends on whether Petrobras is more concerned with competitive economics or nation building,” Mr Wicklund said. “I’d go for nation building.”

Jump in gas prices is coming – just a matter of time

George Littell, partner at Groppe, Long & Littell, has some good news for US land drillers: He believes there will be a big increase in natural gas prices, followed by a substantial increase in dayrates, next year. “It’s just hard to pin down the timing,” he said.

He points out that, over the past couple of years, there has been a significant decrease in drilling activity in every onshore area outside of the shales. That’s now coupled with an ongoing de facto moratorium in the shallow-water Gulf of Mexico, which no definite end in sight. Yes, shale gas production has grown very fast, he acknowledged, “but shales are still less than 20% of total production. Once the declines in all the other production overwhelm the shales … the bottom will drop out on production.”

He adds that over 40% of shale gas production is in the Barnett. “Production in the Barnett is flat… They cut rig activity in the Barnett in half. Just adds up that, at some point, you won’t get enough from the Haynesville and others. At some point, you probably will get a substantial rollover in US gas production.”

When that point is reached, “it will put tremendous pressure on gas prices. They might double. It’s just under $4 at the Henry Hub now, so it will go to $8 at some point,” Mr Littell said.

As that happens, land operators will be looking to increase their drilling activity by 30% to 50%, he projected.

“After this prolonged downturn, I seriously doubt the drilling contractors can respond to that very quickly. Even if you had the iron, where do you get the crews?” He believes there will be a period of increased dayrates, perhaps in the range of 20% to 30%, followed by a gradual increase in activity.

For 2011, Mr Littell is projecting a 10% to 15% higher rig count over 2010. “This depressed period is very similar to the late ’90s. After that, there was a big adjustment in gas prices in 2000. It took two to three years to really ramp up. This (downturn) has been so traumatic.”

As for what Mr Littell calls the “gold rush” in the shale basins, he believes a lot of shale drilling “will settle down” next year.

Operators have been stuck with an inventory of leases to drill before they expire, so they have been going through a process of sorting out what gets drilled and what is marginal. “Is anybody making any money when Henry Hub’s at $4?” he asked. “It’s just wildly uneconomic.”

As for the growing trend of drilling oily reservoirs using horizontal drilling and completion techniques, Mr Littell believes that will continue to be hot in 2011. Yet he also believes “that’s already happened to the extent it can be done.”

“I think everybody would love to have high liquids content shales. They’re just hard to find,” he said.

Limitations with frac services could also prove to be a bottleneck as activity tries to pick up next year. “They just keep building up more and more of a backlog of wells that need to be fractured, just because there aren’t the crews and the equipment to do the fracturing,” Mr Littell said.

Are the stimulation and other well servicing companies not expanding their businesses enough? “I think a lot of them are scratching their heads about just how much of this they want to do. In the sense that you get geared up for the gold rush, then it goes away. You put all this money into the trucks, equipment and people, and all of a sudden you don’t have as many frac jobs to do. I think they’re very leery of it,” he said.

PRICE OF OIL

Mr Littell projects oil prices will average in the low $70s in 2011. “The tricky thing is to figure out what the range will be. I haven’t tied that down yet, but it’s $60 to $85. That’s an interesting oil market.”

What OPEC does could be an important influence too. “They really are restraining somewhere between 4 and 5 million (barrels) a day of producing capacity… That’s an unstable situation. There will be a big temptation when everything’s looking better to go up on the production – a lot rather than a little. That’s something that can be corrected, but, in the meantime, it gives you a nasty short-term drop in prices,” he said.

Surging demand may push frac industry up 20% in 2011

Hydraulic fracturing activity has grown tremendously through 2010 – and so have prices. According to John Spears, president of Spears & Associates, costs for frac jobs have risen by 25% to 30% over the course of this year. “A lot of service companies that provide frac services have begun to very aggressively add to their fleet of equipment. We think the frac fleet size will increase about 25% this year and another 20% next year,” he said.

At the same time, due to the remarkable increase in demand, lead times for frac jobs have also risen steadily. “Right now we’re probably looking at six weeks or a little bit longer in a lot of places where you’re talking about big, multistage frac jobs or a new well… In fact, you may be scheduling the frac job before you begin to drill the well.”

His company estimates that overall land drilling activity in the US will increase by 12% to 14%: The oil and oil-related rig count will grow by about 50% from 2010 to 2011 while the gas-directed rig count will fall about 10% over the same period. “Overall we think it will go up about 12% to 14%,” he said, adding that the average total rig count for 2011 is projected to be approximately 1,725. “We think it will probably top out somewhere in the 1,800 range, maybe 1,900.”

The growth part of the market will continue to be the horizontal drilling plays, including both gas shales and oil shales. “Rigs geared for that type of work will continue to see very high utilization, probably in the 90% range. Whereas the more conventional rigs will probably see their utilization remain in the 40% to 50% range next year.”

He thinks the shift that started this year toward oily reservoirs or reservoirs with liquids-rich gas will sustain through 2011. “The Bakken play in the Williston Basin of North Dakota has sort of been the poster child for these new oilfields … as operators make use of horizontal drilling techniques and frac jobs to get after these oil zones that had been ignored in the past… I think we’ll continue to see a number of announcements over the next year or so as operators come back and say, we’re now going into these older oil zones and looking at what they may have passed over.”

At the same time, Mr Spears urges the industry to pay attention to a couple of potential hurdles to land drilling. One is the still-ongoing fight over hydraulic fracturing. “Taken to its extreme, it could be a real threat to the industry,” he said, adding that he’s hopeful reasonable regulations will be adopted. But industry also must do more to educate regulators and the public so they understand the fracturing process, he said.

Another issue is access to water, which is a significant requirement for hydraulic fracturing. “The industry has to work out what to do with both the volumes of water being used and what you do with the frac water once it’s recovered. Access to water for fracking is becoming a big issue.”

OFFSHORE OUTLOOK

In the Gulf of Mexico, the outlook isn’t nearly as healthy as that for land drillers. “The offshore market will be a head scratcher for all of us for a long time,” Mr Spears said. “We think the deepwater part of the Gulf of Mexico will be very slow to come back. I think it will be about two years before we see deepwater activity even half the level that it was before the Macondo blowout.”

In the shallow water, too, he thinks it may take six to 12 more months to return to the pre-Macondo level of permitting and drilling activity.

Outside of the GOM, “we see a much steadier picture. We see activity up in most markets outside the US,” he said. Brazil, West Africa and parts of Southeast Asia will be good markets for deepwater rigs. “The big question will be what kind of rates they can get for their rigs. We may see rig rates weaker next year than anticipated,” he added.

In the Middle East, most operators have held steady through 2010, after going through a period of retrenchment in 2009. “I think we’ll see levels next year at or maybe slightly above what we’ve seen in 2010,” he said.

Gas exploration in the Middle East should also be monitored. “There’s a lot of gas-related work going on. They’re trying to use it for their own consumption to support the exports of the petrochemicals industry and to free up some oil for exporting. It’s a slightly different mix of work than what we’ve seen in the past.”

Mr Spears adds that, because natural gas is priced relative to oil in most places outside North America, gas prices can often be twice the level seen in the US. When it comes to LNG, this has helped to keep LNG imports from coming into the country. “If you’re an LNG producer, you’d rather sell your cargo someplace other than the US because you’ll generally get a higher price for it.”

In the US, he projects natural gas prices to stay within the $4-$5 range for 2011 while oil prices will likely continue to trade within $70 to $80. “We don’t see a lot of movement in oil or gas prices next year,” he said.

Mainland CEO: Early birds get the worms in shale gas plays

As of mid-October, natural gas prices were still hovering well below the $4 mark. Yet many of the shale basins – the Haynesville, the Marcellus, the Eagle Ford – are bustling with more activity than ever. How are operators making the economics work?

For Mainland Resources, established in 2008, the answer is simple: Get in early.

“Everybody can do their best to drill cost-effectively, but what you can’t change is what you paid for the leases. If your cost basis before you even start to drill a well is high, then really there is nothing you can do other than to wait for product prices to increase,” said Mainland CEO and director Nicholas Atencio. Early entrants, like Mainland with the Haynesville, pay industry-standard prices. Those later to the game will end up paying quite a bit more, he said.

The company, along with partner Petrohawk, became a major player in the Haynesville in the East Holly field of Louisiana over the past couple of years before selling that acreage. “We sold that level,” he clarified. “We kept everything above the Haynesville,” where the company is trying to quantify reserves now in order to plan additional wells to drill in 2011.

Mainland drilled three wells on its East Holly acreage this year and is drilling another now in Jefferson County, Miss. The latter will consist of a deep test of a Haynesville prospect; the proposed depth for the well is 22,000 ft.

Although the company is now drilling just for Haynesville gas, Mr Atencio said they are looking into other types of shale activities in the Mississippi that have the potential to produce oil.