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El Paso Woes Show Capital Intensity Of US E&P Business

El Paso Corp. (EP), the largest U.S. natural gas pipeline operator and still one of the largest producers, recently disclosed a sharp decline in its quarterly natural gas production.

The company said that total gas and liquids volumes were 956 miilion cubic feet equivalent per day (Mmcfe/d) in the first quarter of 2004 versus 1,363 Mmcfe/d in the same period of 2003, a decline of 30% year-on-year before adjusting for some asset disposals.

The disclosure follows tumultuous months at the exploration and production division of the former high-flyer that, even after recovering from a liquidity crisis, trades at roughly 10% of its peak share price in 2001. A 41% writedown of reserves earlier this year and the departure of the head of its E&P division in 2003 have been accompanied by a sharp deceleration in drilling expenditure.

While overall U.S. natural gas production is in decline - various private sector analysts have calculated drops of roughly 5% in first quarter production year-on-year - El Paso's fortunes have been considerably poorer than average.

The decline reflects the geographic focus of the bulk of El Paso's production as well as a cutback in spending on development of reserves at the company in the last several months.

The company has slashed its drilling budget to $800-$850 million this year versus $1.568 billion in 2003 and $2 billion in 2002.

"It really isn't that surprising," said Michael Bodino, energy analyst at Sterne Agee. "You're going to have those kinds of declines if you don't drill." Bodino's firm doesn't cover El Paso but follows U.S. drilling activity closely.

"There's a significant concentration of their asset base in the Gulf Coast of Texas and the Gulf of Mexico and those areas are notoriously high in terms of decline rates," said Frank Bracken, natural gas analyst at Jefferies and Co. Jefferies doesn't cover El Paso but watches its production levels closely.

He said that El Paso's financial constraints and uncertainty about its E&P strategy have led to the sharper shortfalls than the rest of the industry. "When you take your foot off the gas as regards drilling then you have rapid declines and that's what's really going on here," said Bracken.

"You've gone from a period of time when the company was spending very aggressively under (former E&P chief) Rod Erskine to a period of slow spending," he said.

Both Bodino and Bracken believe that the rapid decline isn't linked to changes in the geology of El Paso's main production areas and they say they would have expected similar declines if drilling capital had been restricted in prior years.

"If you decelerate, those declines are going to eat you alive," said Bodino. "They'd always been in an acceleration mode."

Company spokeswoman Kim Wallace acknowledged that a slowdown in spending had resulted in a decline in production, but also pointed out that the company was shifting its focus to regions with more stable production and slower decline rates such as the coal bed methane.

Though the normal geological decline rates for given regions haven't changed, what has is the size of finds and the corresponding increase in finding and development costs.

Over 1999-2003, overall U.S. finding and development costs have risen by 42% to $7.77 per barrel of oil equivalent and by an even steeper 49% to $8.48 in Canada, according to a study by Lehman Brothers (LEH).

But the tightness of the market has more than compensated for this increase with higher prices, explained Bodino.

"Finding and development costs have gone up over that time materially, but gas prices have gone up more," he said. "The idea of having a sub-$3.00/MMBtu gas price in this environment doesn't work."

Indeed, the breakeven point for marginal gas drilling in North America is now estimated to be $4.50/Mmcf in North America, much higher than a few years ago, according to RBC Capital Markets oilfield services analyst Kurt Hallead. But he says that El Paso's cutbacks - while they may illustrate the effect of cutting spending - don't translate to any sort of trend in North American oil and gas production. Indeed, he expects drilling expenditure overall to keep rising through 2006 or 2007.

"You can't stop drilling - if the industry slows down its drilling, you're going to exacerbate the production declines," he said.

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