Shale Oil Drillers Move From Gas and Strike High Cost

U.S. natural-gas companies are getting hit with the highest costs in four years as they shift more production to oil to escape low gas prices.

EOG Resources Inc., Chesapeake Energy Corp. and SandRidge Energy Inc. each have announced $1 billion transactions in the past year to ramp up onshore production of higher-profit oil and other petroleum liquids as booming gas production deflated prices.

The new oil rush is focused on dense rock formations that require the same mix of horizontal drilling and hydraulic fracturing as the fields that created today’s gas glut. Surging competition for these drilling-related services has pushed costs up 16 percent, and are expected to continue rising at least through the first half of 2011, analysts said.

A report today by Moody’s Investors Services predicted that the trend will continue through 2011. Costs will increase “not just because of strong oil prices, but also because natural-gas producers will have to keep working their plays amid unfavorable economic conditions,” the report said.

Prices are “outrageous,” Gary Evans, chief executive officer of Magnum Hunter Resources Inc., told analysts Dec. 27 after buying liquids-rich shale gas fields in West Virginia and Kentucky. “It’s the pumping services and completion costs that keep us all awake at night.”

Those include hydraulic fracturing that frees oil and gas from untapped reservoirs by pumping in millions of gallons of water, sand and chemicals at high pressure to crack the rock.

Gas producers opted for oil-soaked rock deposits as crude prices on the New York Mercantile Exchange rose 15 percent to $91.38 a barrel in 2010. Natural gas fell 21 percent to $4.41 a million British thermal units in 2010.

Reward and Punishment

Investors in 2010 initially snapped up energy producers that increased their crude output and punished those who didn’t. They proved willing to shed stock of companies that missed budget or production targets.

EOG shares closed at a yearly high April 23 after the company predicted April 2 that about two-thirds of its 2011 revenue will come from oil and petroleum liquids, compared with a fourth in 2010. The stock fell 9 percent on Nov. 3 after it forecast lower production and higher costs than expected. The shares ended the year down 6.7 percent.

“You’re dealing with a liquid that doesn’t flow as freely as gas,” Kurt Hallead, an Austin, Texas-based analyst for RBC Capital Markets, said in an interview. “Some investors view oil wells as less complex, and that is not absolutely the case.”

Early Bird Advantage

Southwestern Energy Co. stuck to its focus on gas and trailed the 13 other companies in Standard & Poor’s 500 Oil & Gas Exploration & Production Index with a 22 percent drop in 2010. Pioneer Natural Resources Co., one of the first gas producers to focus on oil drilling, lead the index with an 80 percent gain.

Companies that got into oil early benefit as rising crude prices yield more cash to accelerate drilling, Michael Bodino, director of energy research at Global Hunter Securities, said in a Jan. 4 interview.

Though oil remains more valuable than gas, the higher costs are cooling investor interest. Moody’s Investors Service said Nov. 17 it may lower EOG’s debt rating of A3, the fourth-lowest, citing the cost of switching to oil.

Price Effects

Argus Research Corp. cut its rating on shares of Chesapeake, the largest U.S. gas producer after Exxon Mobil Corp., to “sell” from “hold” on Nov. 30, citing “profligate spending.” Chesapeake said its cost for new wells may rise 11 percent to $5 billion next year as it accelerates shale-oil exploration.

SandRidge, based in Oklahoma City, fell by as much as half after announcing the $1.55 billion purchase of Arena Resources Inc., an owner of Texas oil fields. The shares rebounded after the company announced a $110 million asset sale to help fund 2011 drilling. SandRidge shares lost 22 percent last year.

Gas production from dense rock such as shale helped drive down the price of natural gas to about $4.41 per million British thermal units at year end from a high of $13.58 in 2008.

At the same time, average prices for fracturing in the first half of 2010 rose 16 percent from a year earlier and will rise further in 2011 on shortages of equipment, Hallead, the RBC analyst, wrote in a Dec. 1 note to clients.

Oil dominates production in three of the four most expensive rock deposits currently being fractured, the Eagle Ford, Permian and Bakken, RBC Capital said. The Haynesville Shale gas field in Louisiana is the other.

Average well cost in the Eagle Ford surged 49 percent in the past two years to $8.2 million, Halliburton Co., a drilling service provider, told investors in a Nov. 10 presentation.

Longer Waits

Rising demand led to a two-month wait on equipment and services, Hallead said. A record 762 rigs were drilling for oil on land in the U.S. as of Dec. 24, a 90 percent increase in a year, with almost all the added rigs in basins that require horizontal drilling, service company Baker Hughes Inc. reported.

Baker Hughes shares rose 41 percent in 2010 while larger competitor Halliburton rose 36 percent. Carbo Ceramics Inc., a maker of beads used to prop open cracks in oil-bearing rock, rose 52 percent.

Costs may begin moderating in the second half of 2011 as more equipment becomes available, Scott Gruber, an analyst with Sanford C. Bernstein Limited, said in a Jan. 6 note to clients.

High Costs

EOG signed long-term contracts for fracturing services to control costs. Pioneer formed two in-house fracturing crews, saving $300,000 a well, Chief Operating Officer Timothy Dove told investors Dec. 7.

Chesapeake sold a third of its Eagle Ford holdings to Cnooc Ltd. for $1.08 billion. Southwestern is selling acreage in the Haynesville Shale. EOG planned to sell $1 billion of gas fields to raise cash for drilling, though its first announced sale, for $405 million, fell through Dec. 22.

Many dense-rock oil deposits may prove to be too expensive to produce with current fracturing technology, said Bruce H. Vincent, President of Swift Energy Co., which has begun pumping oil from wells in the Eagle Ford.

“We’re all learning and anybody who says they know it all or has the magic bullet is deceiving themselves,” Vincent said.

To contact the reporters on this story: Mike Lee in Dallas at Mlee326@blooomberg.net; Jim Polson in New York at jpolson@bloomberg.net.

To contact the editor responsible for this story: Susan Warren at susanwarren@bloomberg.net.

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