US upstream: what to watch for in 2017

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2016 was another tumultuous year that saw WTI prices bottom out at US$26/bbl in February before November's OPEC agreement boosted prices to above US$50/bbl. In our report, we present five of our predictions for 2017, focusing on the US upstream industry and including thoughts on cost inflation, onshore and offshore drilling, unconventional supply, productivity gains, and more.

1. Service costs will increase in 2017, yet remain short of 2014 levels

The OFS sector will reverse course as utilization rates continue to rise across the service sector. Firms with assets in West Texas could realize greater margins, and some have already felt the squeeze on labor and equipment driven by increased demand in Q4 2016. In our most recent 'Crude for Thought' podcasts, host RT Dukes discusses what to watch in US oil and gas throughout 2017, including the implications of ExxonMobil's US$6 billion spend to acquire the Bass Brothers' oil and gas company BOPCO.

Our base case well cost inflation is 10% with pressure pumping and proppant poised for the strongest recovery. Our 20% cost inflation call on pressure pumping is underpinned by increasing frac intensity and job size on the demand side, as well as cannibalization and lack of repair and maintenance on the supply side. The proppant market is expected to see ~15% inflation in 2017 thanks to a heavy increase in proppant demand due to continued gains in rig count and subsequent fracking, continued DUC drawdown, and flat to rising proppant loading.

We also expect a modest cost inflation of up to ~10% in the drilling rig market, backloaded to H2 2017. Drillers could see limited pricing power as more long-term contracts from 2014 are rolled off into spot market pricing and excess high-spec rig capacity is not fully absorbed until late-2017.

When activity increases, vertically integrated companies will be shielded, to some extent, from extreme re-inflation driven by service supply shortages. For more details, look for our upcoming Insight on service cost inflation in the US Lower 48.

2. GoM faces challenges from lower investments

Lower oil prices and the end of a major investment cycle in deepwater Gulf of Mexico (GoM) will finally take its toll on the region. We expect 2017 investment to drop to US$10 billion, a 36% decline from the 2015 peak and the lowest since 2011. However, heavy investment from earlier this decade will lead to a new post-Macondo production peak of 1.75 million boe/d this year.

Although leading-edge day rates are averaging US$250,000, the overall average for rigs in GoM is still US$450,000 — a legacy of contracts signed during the days of US$100/bbl. This US$200,000 gap between the leading-edge and average contracted rates will be the key driver for contract cancellations or renegotiations in 2017. Lower rig rates will help bring well costs down, but operators can only squeeze service companies so much more. Consequently, we expect operators will also focus on project design to bring costs down. Reducing well count, by high-grading development well locations and completing exploration and appraisal wells, will further help as companies prioritize lowering breakevens instead of increasing ultimate recovery.

Exploration will remain low priority. Thirty-five E&A wells were drilled in 2016, compared with 39 in 2015, but discovered reserves declined from 650 mmboe to 250 mmboe. In 2017, we expect independents will focus their limited budgets on development activities resulting in fewer wildcat wells — less than 15 E&A wells will be drilled in 2017.