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The Bright Side Of $40 A Barrel


Just when you think commodity prices can't go higher, the market proves otherwise. In the past week, crude oil prices rose to a record high of $41.74 a barrel, before settling back to about $41. Natural gas, too, stands at triple the average price of the 1990s. While prices are expected to recede, most pundits agree that strong demand and tight supplies have raised the floor on which they'll fall. "I think we're in new territory as far as oil and gas prices are concerned," says legendary energy magnate T. Boone Pickens Jr. "I don't see prices dropping to $30 a barrel again."

There's a silver lining to this costly cloud, however: The stubbornly high prices are finally encouraging companies to explore, develop, and produce more oil and natural gas. Ultimately, that should help bring prices down. Like Pickens, most analysts expect oil prices to remain above $30 and natural gas above $5.50 per 1,000 cubic feet through next year. And that means a host of new opportunities for prospecting could open, including some that were economically unfeasible before. "Clearly, a lot more projects are producible at these higher prices," says John Felmy, chief economist at the American Petroleum Institute.

Already, a burst of new spending on exploration and production (E&P) is getting underway. Lehman Brothers Inc. (LEH) analyst James D. Crandell estimates that worldwide E&P spending by some 335 oil and gas companies will rise 6% in 2004, to $147 billion. That's up from the 4% increase he forecast at the beginning of the year, when companies based their investment decisions on an average price of $25.29 for oil and $4.17 for gas.

Still, that's nowhere near the E&P boost seen in past price spikes, and the deeply conservative industry is unlikely to go hog-wild. Having survived several boom-and-bust cycles in recent decades, oil companies today hesitate to take development risks. Instead, they're using cash to buy back stock, pay down debt, and up dividends. In addition, analysts say the industry lacks quality drilling prospects, particularly in the U.S. "In past cycles, when we saw $40-a-barrel oil we saw a much more dramatic impact than what we are seeing this year," says Crandell.

Indeed, except for Royal Dutch/Shell Group (RD), which recently boosted its 2004 E&P budget by about 17.5%, to an estimated $11.8 billion, most of the larger companies are holding their budgets steady for now. Exxon Mobil Corp. says it's sticking with its $12 billion in planned E&P for the year; Occidental Petroleum Corp. is doing the same with its $1.5 billion. Says Occidental President Dale R. Laurance: "We continue to focus on maximizing profit."

"GO TO WORK"

But if most of the industry giants aren't changing plans based on what they consider short-term price movements, smaller, nimbler independents have been far quicker to react to higher prices this year. They tend to invest in smaller, cheaper domestic projects. In May, Fort Worth-based oil and gas producer XTO Energy Inc. (XTO) lifted its E&P budget 20%, to $600 million, for example, while Houston-based Newfield Exploration Co. raised its spending 8.3%, to $650 million. Meanwhile, higher prices have allowed Denver-based K.P. Kauffman Co., a privately held oil and gas concern, to raise its E&P from $80 million this year to $200 million next year, as the company brings the remaining 500 of its 1,100 oil and natural gas wells up to full capacity. Lower prices in recent years had made it too expensive for the company to operate the wells. "It took basically $40 oil and $6 natural gas to get the banks to step up and say 'go to work,"' says CEO Kevin P. Kauffman.

It's not just traditional wells that are being taken out of mothballs. Companies are also looking more closely at developing nonconventional oil and gas sources. Stepped-up efforts to extract natural gas from coal deposits in the Rocky Mountains and petroleum from Canada's so-called "oil sands" are underway, for example. Although oil and gas from these sources had been too costly to produce at lower prices, now money can be made dragging it out of rock and sand. By early 2005, for example, Devon Energy Corp. (DVN) expects to start developing an oil-sands field in Alberta. When running at full production in 2008, the $400 million project should produce an estimated 35,000 barrels a day. The company says the field has more than 300 million barrels of unbooked reserves. Syncrude Canada, a joint venture that includes subsidiaries of ExxonMobil and ConocoPhillips, (COP) operates the largest oil-sands project in the world in Alberta. President James E. Carter says that when it completes a $7.8 billion expansion project in early 2006, it will boost production by 44% to 360,000 barrels a day.

All of this activity bodes well for oil service and drilling firms, too. Simmons & Company International in Houston estimates the worldwide oil and gas rig count will increase from an average of 2,173 in 2003 to 2,371 this year, then rise to 2,506 in 2005. In the U.S. alone, rigs should jump 13.1%, to 1,161, in 2004; another 7% rise is likely in 2005.

The increased activity is already driving prices up throughout the sector. Starting May 1, both Halliburton Co. and BJ Services Co. (BJS) will boost prices 8% and 7%, respectively, for domestic pressure pumping, a technique that increases the flow from existing wells. Equipment maker Smith International Inc. (SII) has announced a 3% to 5% hike for such gear as drill fluids, bits, and downhole drilling tools. And rates to rent a deepwater rig have soared: According to analyst Kurt Hallead of RBC Capital Markets, rigs cost $120,000 to $150,000 a day in the fourth quarter of 2003. Now, those same rigs go for $150,000 to $170,000 a day. The only question: When is all that drilling going to produce enough new oil and gas to send energy prices back down to earth?

By Stephanie Anderson Forest in Dallas, with Peter Coy in New York, Christopher Palmeri in Los Angeles, and Laura Cohn in London


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