Logic says that when oil prices are high, oil exploration occurs at a rapid pace, with both small wildcatters and Big Oil motivated to find new supply as fast as possible. But when oil prices are low, some exploration still needs to happen if the industry is going to survive. It takes years to take an oil well from the exploration stage to production stage, and new supply will always be needed eventually, as oil fields age and their productivity slows.
So how much exploration are we seeing? Less than you might expect, given the prices we saw last summer.
Oil Exploration For Dummies
Before the first drop of oil comes out of a well, even before a drill bit touches the ground, thousands of man hours have gone into a project that has at best a 1 in 3 chance of resulting in actually finding any oil, and only a 1 in 6 chance of finding something that could be considered commercial.
The process starts with geologists conducting surface surveys. From there, geophysical surveys are done (think seismograph machines and explosive shock waves for underground mapping) to pinpoint prospective areas for drilling. Those two sentences are big line-items on the budgets of Big Oil, and it's no accident that fundamentally all of the world's nonacademic geologists work in the oil & gas business.
Once likely areas are identified, drilling teams are called out and the real fun begins. Most wells that are drilled come up dry – not a drop of hydrocarbon to be found. But just because well A is a dry hole, doesn't mean that well B a mile away will be, so a number of test wells are drilled before a target area is declared a bust. If oil is found, the oil well is either capped (to be completed later) or upgraded to a fully functional well, and the team moves on.
Because drilling activity is the only tangible way to measure exploration activities (beyond press releases and TV commercials), the most commonly used way to measure what's actually happening is to look at weekly drill statistics. Here's a handy chart from our friends at the U.S. Energy Information Administration (EIA).
It puts into graphic relief the statistics that the American Petroleum Institute released last week – which aren't encouraging. According to the API, 11,071 wells were drilled in the U.S. during 1Q 09. That seems like a large number, but it is down 22% from the same quarter last year, and down 35% from last quarter (4Q 08). That number includes oil and natural gas wells and all the dry holes that were drilled during oil & gas exploration. Hazem Arafa, director of the statistics department at API, said in the press release:
"The lower U.S. drilling activity indicates that the exploration and production sector is not immune to the current economic downturn, and that they, like most industries, are facing tough business choices."
Apparently, some of those choices include reducing exploration. Mr. Arafa goes on to note:
"The estimated number of new exploratory wells - drilled for the purposes of discovering new reserves in unproven areas - fell 11 percent from the first-quarter of 2008, while the estimated number of deep wells (15,000 feet or deeper) and shallow gas wells slipped 13 percent and 36 percent, respectively, from last year's first quarter."
If you look at a chart of all the active oil rigs around the world, not just the U.S., you see the same kind of drop-off.
It's obviously a global phenomenon, and the U.S. may actually be in better shape than other parts of the world. In a recent Investors Chronicle article, research by Deloitte was cited that reported that the number of exploration wells in the North Sea dropped 78% in 1Q 09 compared with 1Q 08. Derek Henderson, a Deloitte senior partner, stated:
"The decrease in activity can be wholly attributed to the sharp drop in exploration drilling in light of the difficult economic conditions. Cash continues to be a priority as credit conditions remain extremely tough."
But there are places that are seeing increased activity. For example, on the Norwegian continental shelf, which includes part of the North Sea, the Norwegian Sea and the Barents Sea, exploration continues. In the first quarter of 2009, a whopping 16 wells have been drilled for exploration purposes – 13 of them in the North Sea area. In 2008 there were 52 wells drilled off the coast of Norway, and if drilling continues at pace, some 60 holes will be drilled this year, mostly in the North Sea. The most active explorer in the area at this point is StatoilHydro, a Norwegian oil company, which has drilled 12 of the 16 wells.
Right now, the market is much more concerned with inventory levels in the U.S. and demand trends than the number of exploratory wells being drilled. And given that U.S. oil inventories rose higher than expected (again) on Wednesday, it makes a lot of sense. But at some point, if exploration continues to decline, the industry, and the energy market, is going to have to pay the piper.
But until that happens, the reduction in exploration impacts primarily one industry: oil services and drilling companies.
Halliburton (NYSE:HAL) is one such company, and they're keenly aware of what's going on in exploration. And the picture they paint is interesting. It's not that no wells are being drilled at all, it's that they're being "banked" in a sense. They're being partially drilled, then mothballed, ready for completion as soon as there's money to be made.
In the transcript of Halliburton's Q1 2009 conference call (supplied by Seeking Alpha), CEO David Lesar said the following:
"I think you are seeing a variety of behavior in the marketplace today. You have some customers that are just flat shutting gas production until the pricing gets better. We have a subset of customers that are drilling but not completing wells. We have some customers that are drilling and completing and then shutting their production in. So the discussions we are having with them are on a day-to-day basis, on a rig-to-rig basis about what their plans are for that rig, where it is going to go, what it is going to be doing and what services we are going to get on that. So, I am not sure that we are getting any clearer of a picture as to where ultimately it might go but the communication is a lot more intensive than it has been."
Executive VP Tim Probert went on to say later in the call:
"Taking a look at the API data, the API data sort of tells us that there has been actually a slip in the correlation between drilling and completions over the last quarter or so, which sort of adds to the kind of support of the view that there is an inventory of wells in place which are drilled but not completed. Certainly the anecdotal evidence from our field operations provides some support for that too. So, yes, but I think the idea is those will get completed into a rising price environment, and clearly we will benefit from a service standpoint from that when it takes place."
Halliburton paints as rosy a picture as it can, of course, but they did take a hit on the reduced rig count, which led to its operating margin dropping from 21% to below 16%, and although it managed to beat analysts' expectations on earnings, the 42 cents a share is 40% lower than earnings this time last year.
So bottom line – short term, the market is well-supplied with oil and gas, and for now, the effect of reduced exploration is a ways off. If oil prices remain low, we may see a serious consequence of less investing in exploration, and weaker oil services companies may be hit hardest. Once oil prices stabilize and begin to edge upward again, investment in exploration will pick up again, and if you believe Halliburton, might be able to restart much more quickly than a reduced rig count suggests.
Just when that will be? Just yesterday the Oil & Gas Journal published data from Douglas-Westwood Ltd. and Energyfiles prognosticating that very thing. Look for spending on drilling to be up 32% by 2013.