Jan/Feb 2012

Prospects for 2012 are rotating through the air like the coin toss that begins an athletic contest. Only in this case, the coin in question is the price of crude oil.

If 2012 exhibits similar oil prices to 2011, that coin will turn up heads after it bounces on the turf, favoring the oil services sector. If oil prices drop below $80 — and stay there — well, it will be a different ballgame altogether.

These days crude oil is the new coin of the realm to mix a metaphor. The domestic oil and gas industry has undergone a remarkable evolution during the last two years that places greater emphasis on liquids, whether it is natural gas liquids (NGLs), high Btu wet gas or better yet, crude oil.

Basins that exhibit a high liquids component in the production profile will drive growth in the domestic oil and gas sector, and in particular, oil services. Basins without a significant liquids component are substituting out of the game and taking a seat on the bench.

So a 2012 forecast is really an exercise in gaming out what will happen in the oil markets.

Oil service providers will have plenty on the oil side to keep equipment busy in 2012.

Normally that would be an easy task if it were just supply and demand. Thanks to political eruptions in Africa and other international oil-producing flashpoints, global oil supply has not kept pace with expectations. Meanwhile demand continues to rise thanks to non-OECD economies in Asia and Latin America. That story line (supply troubles in the face of rising global demand) favors tighter crude oil markets over the next decade and an accompanying rise in oil prices. And that seems to be the story that most forecasters are buying even if Wall Street remains skeptical short term.

The U.S. Energy Information Administration (EIA) expects crude oil to average $102 in 2012 — about a dollar more than the 2011 average. The EIA bases that forecast on the cost of crude oil to refineries, which these days is a blend of WTI and imported crude oil. During the third quarter of 2011, WTI experienced an $11 per barrel discount versus imported crude, though the EIA expects that differential to narrow in 2012.

The EIA is actually in the middle of the range found at some of the investment banking houses where price expectations range from $85 WTI on the low end to well above $150 in the event of disruptions in global oil supplies.

Of course that range of potential outcomes suggests a potentially volatile market, thanks to variables such as geopolitics (Africa and the Middle East) and macro-economics (Europe). And don’t forget the third wildcard: 2012 is also an election year domestically in the increasingly contentious stalemate that comprises Washington, D.C.

No wonder the Mayans refused to forecast out beyond the conclusion of their 5,000 year long-count calendar in December 2012.

The good news
Those variables aside, let’s examine the good news. Assuming oil prices remain at $90 or better, its going to be a very good year, particularly for service providers in the Permian Basin, the Bakken Shale, the western Anadarko Basin in Oklahoma and the liquids rich portions of the Eagle Ford.

Of those, the Permian Basin remains the star player in the 2012 domestic line up. New completion techniques, coupled with high oil prices, have vaulted the region to all-star status, though other unconventional plays earn a greater share of headlines. The Permian Basin is really two plays. There is a conventional vertical Wolfberry play commingling production from multiple stacked formations and a new tight formation horizontal play. Both are poised for significant expansion in 2012.

After the Permian, operators plan to increase spending in the Eagle Ford and the Bakken shales in either the high single-digit or low double-digit percentage range.

Overall, 2012 oil and gas spending in the U.S. market should rise 10 percent to a record $112 billion, according to a Barclay’s Capital survey of 350 operators.

Actually the main issue in the domestic market concerns shortages of qualified labor and resources. In other words, the limiting factor on how quickly some of these plays develop is not external to the industry; rather, it is how fast the industry can meet the challenge of gearing up in a tightly stretched market. The Permian retains an edge versus all other regions because of a highly developed infrastructure.

There are several up and coming plays to watch in 2012. Some could reach critical mass by this time next year while others are more likely to evolve over the next two-to-five years.

The play closest to prime time in 2012 remains Oklahoma’s Mississippi Lime. Horizontal drilling and multi-stage fracturing are poised to boost field activity significantly over the next 12 months in a play that is well defined and underwent significant property consolidation in 2011. Operators are already moving from delineation to optimization in field programs and production should grow noticeably in 2012.

Elsewhere, operators are finding new oil in traditional gas provinces. Two plays to keep an eye on in 2012 are the Tuscaloosa Marine Shale in Louisiana and the Niobrara Shale in Colorado and Wyoming. Both face near term technical challenges, although a large liquids component helps the economics in each. Still, these plays will be the focus of significant “science fair” efforts over the next year as operators work to unlock complex tight formation geologies that exhibit promise in terms of initial production, but difficulty on sustaining volume. It appears that the challenge is less about the basic resource and more about engineering the best completion techniques.

Two other plays on the watch list a couple years out, post 2012, are the Lower Smackover Dense Brown in northern Louisiana and California’s Monterey Shale. The former is still in the land grab phase, though some operators will begin appraisal drilling as 2012 unfolds. The latter continues to present significant technical challenges, though operators may find that strong oil prices hasten a technical breakthrough.

Finally, there is the Ohio Utica Shale play. The liquids rich portion of the play, which parallels the Ohio/West Virginia panhandle, is gearing up for a large activity build and will exit 2012 at drilling levels that could be triple the 8 to 10 rigs working their now.
Gas markets
But as good as the 2012 story will be when it comes to oil, the narrative is different altogether when the topic turns to natural gas.

One has to search diligently for good news on natural gas. Production onshore still grows at a sobering 5 to 6 Bcf/d on a year-over-year basis. For this, the industry can thank the shales. Two examples illustrate the story. Pennsylvania’s Marcellus Shale should close out 2011 at 3 Bcf/d while the Haynesville Shale (and associated Bossier Shale) have added 6.5 Bcf/d to domestic production. What’s more, these exceptional gains come in just the first three years of field development with more — lots more — on the way in 2012. By the end of 2012, the Haynesville and the Marcellus will be the equivalent of adding two Barnett Shales to the U.S. gas production profile. That’s a lot of new gas.

One bon mot of good natural gas news, however, is that demand grows even in a soft economy. According to the U.S. Energy Information Administration, industrial natural gas demand was up one-half Bcf to 5.0 Bcf in the first nine months of 2011 when compared to the same period two years ago. Similarly electric power matched the gain, rising from 5.36 Bcf/d in 2009 to 5.87 in 2011. While residential and commercial gas consumption stays flat in a weak economy, the industrial and electric power sectors have grown to represent 65.4 percent of the market, up from 63 percent two years ago.

Still, the supply/demand imbalance in natural gas won’t improve in 2012. Consequently the 2012 forecast for natural gas prices by agencies like the U.S. EIA call for a drop to $3.70 per MMbtu for the upcoming year, nearly 30 cents below the 2011 average (which was 37 cents lower than the 2010 average). That means further pressure on dry gas markets in 2012, whether conventional or unconventional in nature.

There are some other positive indicators out there, though it is unclear how they will unfold in 2012. KKR’s $7 billion leveraged buyout of Tulsa-based Samson Resources in November 2011 is a bet not only on natural gas, but on the likelihood of domestic natural gas exports as LNG.

Additionally, Australian global mining magnate BHP-Billiton spent $19.1 billion on U.S. natural gas acquisitions in 2011, acquiring Chesapeake Energy Corporation’s Fayetteville Shale properties as well as Petrohawk Corp. and its holdings in the Haynesville and Eagle Ford shales. KKR and BHP represent a $26 billion bet on the long-term viability of domestic natural gas.

Finally, the majors continue to add acreage quietly in Appalachia’s Marcellus and Utica shales. Investments by the majors in the U.S. onshore market now total $25 billion since January 2010.

Add it all up and it appears there is a growing body of big time oil and gas operators who view the prospects for natural gas beyond 2012 as quite attractive. In the meantime, oil service providers will have plenty on the oil side to keep equipment busy in 2012.