How much does a recovery cost?

After a flurry of development activity in Q1 2017, the US Lower 48 onshore sector is beginning to feel the squeeze of cost inflation. Although this development was widely anticipated, forecasts vary significantly depending on the source as well as project location.

Our base case assumption of 15% cost inflation draws from an uptick in confidence around oil price, increased capital budgets for operators, and negative margins for oilfield services (OFS) companies resulting in deeply reduced pricing. But not all inflation will be distributed evenly.

Pressure pumping: squeezed for resources

With an estimated 37% increase in tight oil completions this year and a pressure pumping market at 90% capacity, this segment of the services sector remains the most exposed. Prices have been up 20% to 40%, and a lack of maintenance during the downturn will require significant capital investment before re-entering the market — in some cases, as much as US$7 million to reactivate a frac spread and up to three months for a fleet to re-enter the market.

After a flood of Q1 demand, a handful of private pumpers have looked to the public markets to fund the reactivation of fleets. However, if demand persists throughout Q2, new capacity could be quickly absorbed in the Lower 48, sustaining the 20% cost inflation we project for this segment.

Horizontal rigs: once bitten, twice shy?

With leaner practices emerging and rig growth nearly vertical from the May 2016 low, horizontal rigs will likely see half the cost inflation rates than pressure pumping. Although a number of rigs have been retired and fewer are going back into the field, they are operating with greater efficiencies and faster drilling times.

If operators can grow supply with longer laterals and fewer wells, they won't need to contract as many rigs as in previous years. Along with operators hedging oil price and choosing to drill within cash flow, rig growth may moderate in H2.

Despite our projections for a 10% cost inflation for horizontal rigs this year, it's unclear how much traction drilling contractors will gain on new long-term rig contracts. Many producers signed long-term rig contracts at peak prices in 2014, which are now expiring in a spot market that's 40% down, triggering deflation in some cases, and likely influencing contracting activity this year.

Proppant: the 2017 Gold Rush

With demand surging in Q1 and new entrants making a splash, we expect sand usage to grow in 2017. Short-term supply constraints at the top of the year and high demand for cost-efficient regional sand leads us to believe that operators may be forced to transition to higher-cost ceramics or Northern White sand to satisfy completions.  Although we expect a 15% cost inflation for Northern White, we're also seeing signs of eventual oversupply coming into the proppant market. Looking ahead into 2018, a supply glut could be reality should activity levels moderate or decline.

Not all inflation is created equal

Across the board, our assumption of 15% cost inflation as a base case for the OFS sector in the US Lower 48 looks at the big picture. When we take a more granular view at the basin level, the story changes. Areas such as the Permian, seeing tight oil leading breakevens and high levels of activity, will see much higher inflation than less active basins. The core sub-plays will continue to make attractive returns, however secondary sub- plays will struggle to keep up unless productivity improvements and efficiency gains can continue.

The future
Onshore service cost inflation will remain difficult to pin down throughout 2017, with three key  variables at play: basin of activity, product line and contract length. While we expect activity to continue to rise moderately in 2018, oil price volatility remains a significant factor in OFS sector pricing — we've already seen operators react to recent drops by pulling rigs offline. In general, we expect activity and pricing to increase over the medium term, but perhaps with operators being more selective about their drilling targets.

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