The cost of discovering a new barrel of oil/gas has risen three-fold over the last decade as technology has pushed the frontiers of exploration into more remote areas. As old fields run dry, oil companies expand their exploration activities in harsh regions, where political, geological, geographical, technical and contractual risks are high, and they have had remarkable success.

The annual rate of new fields discoveries has remained remarkably constant at 15-20 billion barrels, more than enough to compensate for the loss of existing reserves that are declining at an average of 5 and 15 percent a year. But the cost of this success is staggering, and unless consumers pay more for oil in future, some analysts think we could face an energy supply crunch within a few years.

“The age of cheap oil has gone and it is not going to come back,” said Paul Stevens, Senior research fellow at the Royal Institute of International Affairs at Chatham House in London. “The world is not going to run out of oil tomorrow, but it is more and more expensive to find and will continue to be so… The worry is that investment may be squeezed as risks rise, and that could bring us to a looming supply crunch.”

Escalating Costs
The search for oil has always been costly and involved risk taking, but the challenges facing explorers have intensified as wells have moved further offshore.
According to figures of Wood Mackenzie in Edinburgh, the cost of finding oil has almost tripled over the last decade even though the rate of discovery has barely changed. For instance, last year, each barrel of oil equivalent costs approximately $3, compared to $1.18 in 2001.

 Though the previous figures seem low given that world spot oil prices are close to $75 per barrel, discovery costs need to be multiplied as oil is pumped out of the ground, processed at a refinery to be a fuel at a service station. Even established oilfields, such as those in the North Sea, have now breakeven costs of around $50 per barrel.
The new ultra-deep offshore fields that lie beneath oceans (more than 3 km depth) and in positions up to 5 miles from rigs impose even higher costs. Because the rigs work in deeper water, they use more steel, new technology and are operated by highly trained and expensive specialists.

Political and Contractual Risks
“New exploration is not just more technically difficult, it is also fraught with political risk that may lead to contractual uncertainty which can jeopardize investment projects. As bad need for energy grows, governments are sitting on potential oil and gas fields demand a fair price for their resources in a process economists call resource nationalism,” said Andrew Latham, of the Exploration Service team at Wood Mackenzie.

Britain, Russia, Venezuela and Algeria have all raised their take from oil over the last few years, either by imposing higher taxes or renegotiating contracts. Some developing countries have sought to change the terms of contracts entirely. Uganda has about 2 billion barrels of oil reserves but talks on production have been slow, partly due to a government demand that oil companies build a refinery to meet domestic needs. “We are now starting to see wells being drilled in countries which have had recent turmoil or civil wars or have an uncertain legal framework,” said Chris Wheaton, who runs energy-industry funds for part of insurance giant Allianz. “Easy oil has been over for a while and the critical and dangerous shift is to places with political, physical or geographical risks, and translates into higher costs. Finding oil is more difficult.”

As risks rise, the required rate of return goes up, which squeezes the investment pot for new discoveries. Stevens highlighted, “There is not a ‘Perfect Storm’ of risks yet, but a lot of things are making it more and more expensive to go out and find oil.

The actual costs depend on such factors as the location of possible oil reserves (onshore or offshore), how large the oilfield will be, how detailed the exploration information must be, and the type and structure of the rock below the ground. Exploration requires careful mapping of the surface in order to locate suitable sites (i.e. types of geological structures), deep formation surveys, and test drilling. It is not easy to determine a typical cost of such activities. OPEC has the lowest average production costs in the oil industry, due to the fact that some of its members have large amounts of oil in reasonably accessible locations. Yet OPEC Members will still need to spend billions of dollars in the future to meet the growing need for oil.

Finding and extracting oil and gas is becoming riskier as the “easy oil” is used up, oil companies are drilling wells that are deeper, longer, further below the sea or in more remote areas. For instance, in Nigeria, the exploration activities in deep waters in recent years have not been successful, as many of the companies have encountered dried wells.
Peter Voser, Shell Group Chief Executive Officer said, “There is good future for the petroleum industry (in Nigeria). It is very important for oil companies to be here now. The future of Nigeria is very promising because there is a lot of oil locked underground that are yet to be tapped.”
The race for new reserves has tipped the balance of cost negotiations between oil companies and contractors in favour of services providers. As oil reserves are depleting at an average of 5-15 percent a year, companies are increasingly under pressure to replace the depleted fields. As unit costs rise, so do the quantities of materials used, half of exploration spending is now focusing on deep or ultra-deep offshore.

Oil and Gas E&P spending to rise in 2010
Based on a survey of 387 oil and gas producers, global spending on oil and gas exploration will rise by 11 percent, counting for $439 billion in 2010, as energy prices increase. This raise reverses the 15 percent decrease seen in 2009, when oil prices dropped sharply. If prices are too low, oil companies have no incentive to initiate exploration and drilling projects. Without the development and production of new fields, however, supplies will decrease; that could in turn raise prices, unless demand falls by an equal amount.
The survey projected spending on exploration and development in the U.S. to rise by 12 percent ($79 billion). Spending in Canada is expected to increase by 23 percent ($23 billion). Globally, national oil companies in Asia, Africa, the Middle East, and Russia are expected to increase their budgets and raise exploration and development expenditure outside of North America by 10 percent ($337 billion).

The findings of the survey, conducted by Barclay’s Capital, fare reflected in Chevron’s recent decision to focus on exploration and development in favor of refining. The majority of Chevron’s $22 billion in planned expenditure for 2010 will be spent on upstream natural gas and crude oil exploration and production projects.

Ultra-Deepwater Drilling remains profitable
Oil and gas producers have cut back on drilling due to the economic recession, but the ultra-deepwater drilling segment has been profitable throughout and is likely to remain so. Transocean Ltd. (RIG), the largest offshore drilling rig contractor, had a 32% jump in its revenue from ultra-deepwater drilling ($890 million) during the Q4 last year. In contrast, revenue from its jack up rigs, which drill shallow water fields, fell by 40% to $422 million. The company announced that all of its rigs that can drill at depths greater than 7,500 feet are booked through 2010, even though more than 40% of its jack up rig fleet is idle.

The rift in the rig market underscores how oil companies that are hard-pressed to find new oil reserves are still willing to spend more, as long as it is in such frontier regions as offshore Brazil, West Africa and the deepwater U.S. Gulf of Mexico, where giant fields are thought to lie. Therefore, such companies as Transocean, Diamond Offshore Drilling Inc. (DO) and Noble Drilling Services Inc (NE), which maintain a fleet of deepwater drilling rigs, have been relatively shielded from the recent volatility in oil and gas prices.
Transocean’s new ultra-deepwater drilling rig “GSF Development Driller III“, which can drill to a depth of 35,000 feet, went to work on a seven-year contract in the Gulf of Mexico with oil giant BP plc. Although the exact terms of the rig contract were not disclosed, average day rates for the Transocean’s ultra-deepwater rig fleet are $486,200, up about 15% from the previous year.

Oil Prices: higher now, lower later
However, oil exploration and drilling are immensely expensive undertakings. To provide some sense of the costs involved, consider that Shell paid $2.1 billion just to acquire offshore Arctic drilling leases (just for the leases—not even to drill a single well). Given how expensive it is, no one would commit these kinds of sums unless they expected a good return, which means at least moderately high oil prices.

The comparatively low prices that dominated the first half of last year were a source of concern to industry figures. However, as was reported by the Associated Press, recent higher oil prices have encouraged energy companies to “dust off” idle rigs and increase production.

A major issue, though, is the sustainability of prices. As a number of industry observers have noted that prices are holding above the levels dictated by consumption and production. When oil inventories remain high and growing (showing that production is outpacing demand), benchmark crude contracts will increase too. The increase occurs in large part by the decline in the value of the US Dollar—since oil is priced in Dollars. If the increase does not have roots, then the push for increased development will be withdrawn. That could lead to rigs being idled again; leading to prices rising again when supply shrinks in the future. So one concern is whether today’s higher prices are sustainable enough to support vital forward-looking development.

By Mostafa Mabrouk
Vice Chairman Assistant For Economic Affairs, Ganope

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