Analysts foresee good US drilling returns despite high costs

The current US exploration and production operating environment offers good returns for new drilling activity despite rising finding and development costs, said Raymond James & Associates (RJA).
"With solid industry fundamentals driven by historically high oil and gas prices, exploration and production companies are generating massive amounts of cash flow. And yet, their market values are still trading at historically low levels," analysts Jeffrey Mobley and Wayne Andrews said in an Oct. 6 research note. They believe that it's a favourable time for both exploration and production companies and for investors.
"Our large [capitalization] exploration and production coverage universe is currently trading at only $ 1.30/mm cf of proved reserves. We believe this is significantly below a fair value range of $ 1.50-$ 1.75/mm cf, given that the 12-month natural gas strip is currently at $ 4.90/mm cf, and cash flows for 2003 are estimated to be 55 % higher than in 2002," Mobley and Andrews said.

They noted that some analysts suggest reinvestment risk could pose a problem for exploration and production companies. That argument is based on beliefs that rates of return on drilling new wells are too low to justify new investment, and that exploration and production companies will destroy capital.
"It is no secret that the US supply basins are relatively mature and most, if not all, of the 'low hanging fruit' has been drilled during previous cycles. With the best prospects already drilled, smaller average reserve targets per well and rising unit finding and development costs continue to be the norm in the industry," Mobley and Andrews said.

Acknowledging that higher finding and development costs are putting downward pressure on drilling returns, the RJA analysts emphasized that they believe current high commodity prices more than offset the higher costs.
"We believe drilling an additional well in the current exploration and production operating environment is highly economical," generating "very generous exploration and production returns," they said.

The two most critical factors affecting rates of return on wells are commodity prices and finding and development costs. Gas prices are at historically high levels, more than compensating for the increase in finding and development costs, they said.
Over time, we expect finding costs to continue trending upward as prospect quality continues to diminish," Mobley and Andrews said. "The industry as a whole is experiencing production declines, which is supporting high natural gas prices.... Far offsetting this trend, however, is the substantial surge in natural gas prices.... In other words, revenues are far outpacing costs."