Rising capital costs putting big oil, gas projects in jeopardy

Even as their coffers swell with cash, oil companies are warning that rising costs could crimp spending on major projects needed to meet the world's ever-growing demand for energy.

MarketWatch: In-depth global business coverage Even as their coffers swell with cash, oil companies are warning that rising costs could crimp spending on major projects needed to meet the world's ever-growing demand for energy. Beginning with the price of steel going into a drill bit and continuing right up the value chain and into the labor pool, higher costs are dogging oil companies at every step. In some cases costs have nearly doubled anticipated expenses, prompting industry analysts to question whether many of the most ambitious projects will ever come to fruition. For example, earlier this year, ConocoPhillips announced it had signed a tentative agreement with Saudi Arabia to build a 400,000 barrel-a-day refinery on the Red Sea city of Yanbu. But during a conference call last month following third-quarter earnings, Conoco's Chief Executive Jim Mulva acknowledged that higher costs were forcing the company to reconsider some of the proposed projects. "In many regards we don't like what we see in terms of capital costs," said Mulva. "It's very likely that not all of these projects will go forward as we want to constrain our spending and they may get deferred for a couple of years until the aggressiveness for new projects lessens." Executives at Valero Energy Corp. recently sidestepped a question from analysts as to whether rising costs would cause the San Antonio-based refiner to defer projects in 2007 and 2008, but noted that it too was feeling pinched. "We've gone ahead and announced [capital expenditures] will be $3.5 billion but there's no question that costs have increased," said company executives. In the US Gulf coast region, oilfield project prices are up 30 percent to 35% and there's such high demand for people that there's been a "real fall" in contractor productivity, they said. Newcomers to the work force are less knowledgeable and therefore less productive than more experienced employees, which also negatively affects costs, said Valero. Labor and manufacturing costs have escalated so sharply this past year that projects' price tags are nearly doubling from when they were announced. Where the industry once thought it could complete a project at $10,000 per barrel of oil, actual costs are closer to $18,000 to $20,000, said Doug Terreson, managing director at Morgan Stanley, at a conference in Houston last week. A key factor pushing costs skyward have been surging steel prices, which have risen meteorically due to development in Asia. US prices for hot-rolled coiled steel, the industry benchmark, have shot up by about $200 per short ton in the past year to $630, passing an 18-month high of $650 in early August. Though there are signs that steel prices could soon come down that has not yet translated into lower material costs. Marathon Oil Corp. announced Tuesday that its board of directors approved plans to increase capacity at its Garyville, La.-refinery even though the price tag jumped by a staggering 45% since first announced last year, despite analysts concerns that the project may have become too pricy to justify. Last October, the Houston-based oil company said it intended to raise the refinery's crude-processing capacity to 425,000 barrels-per-day from 245,000 bpd at a cost of $2.2b. Since then the price has soared to $3.2b., about half of it due to changing the scope of the project, while the other half is pinned to rising manpower and material costs, said Paul Weeditz from Marathon's office of public affairs. The overall cost of the project comes in at about $17,780 per barrel per day, in line with the cost estimates of several of the major refinery development projects announced in the last year, JP Morgan analyst Jennifer Rowland said in a note to clients. "...This initiative is fairly far along compared with other front-end capacity expansion projects in the US," she said. During the summer, Tesoro Petroleum Corp. canceled plans to build a new 25,000 bpd coking unit at its Anacortes, Wash.-refinery because of spiraling costs. "As we reviewed the cost of the entire project, it no longer met our rate of return objectives ... because the cost of engineering, materials and labor had increased similar to escalations that have been announced on other projects both within and outside the energy sector," said Chief Executive Bruce Smith in a statement at the time. Though companies are currently flush with cash from skyrocketing oil prices, hitting record highs this summer of $78 a barrel from a mere $30 just a few years ago, the industry knows it must plan for both the valleys and the peaks. Even with the current high commodity prices, the amount of capital that energy companies need to pursue exploration, production or refining projects is far higher then originally thought, said Steve Arbogast, executive professor at the University of Houston's Global Management Energy Institute. And while development costs are almost certain to continue rising in the near term, commodity prices could prove more volatile, jeopardizing the underlying financials. "Commodity prices are high now but are they going to stay high?" said Arbogast. "If [the companies] don't think $60 is going to stay, then a lot of projects don't look so good," he said. Most at risk are projects trying to tap unconventional energy deposits such as coal liquefaction, which seeks to convert coal to natural gas, or oil shale projects in the Western US, said Arbogast. Conventional oil deposits can be pumped from the ground and sent via pipeline to refineries where it is turned into a variety of fuels and lubricants. But oil shale, for example, requires a blast furnace to free the crude trapped in the rock - a more costly enterprise. According to a Rand report, the amount of oil shale deposits under Colorado, Utah and Wyoming are believed to be more than triple the proven oil reserves of Saudi Arabia, the world's largest oil deposits. The potentially vast reserves lured Exxon into plowing billions of dollars into western Colorado in the late 1970s when oil prices reached the equivalent of $90 a barrel in today's money. But as oil prices collapsed and government subsidies dried up, Exxon walked away from its $5 billion investment on May 2, 1982, cutting 2,200 jobs. The day is still referred to as "Black Sunday" and is often used as a graphic example of a modern-day boom going bust. Royal Dutch Shell and Chevron Corp. are among those once again investing money into oil shale projects, though just how much is not known since most companies want to keep an arm's length from the business in case it again collapses. Projects most likely to make the cut in the harsher spending environment include plans to upgrade refineries to run heavy, sour crudes and to convert Canada's oil sands to liquid form. Most of the world's new oil finds yield low-grade crudes that can be highly corrosive to pipelines and require a far more intensive, and costly, refining effort to turn them into usable fuels. Additionally, they are often found in countries that carry high political risks, such as Venezuela or nations surrounding the Caspian Sea, making it harder to ensure a return on investment. Canada's tar sands, which yield thick, black sludge from oil-soaked sands, however, are particularly attractive because the deposits can easily be piped to US refineries and are not in any danger of being confiscated by politicians in Ottawa, said Arbogast. MarketWatch: In-depth global business coverage