RIL and exploration cost

In last 25 years world energy consumption increased by 66% with CAGR growth at 2.14% resulting in huge capex in E&P with the capital expenditure in the E&P industry estimated to be upwards of $ 300 billion per annum. However deep water exploration is a rapidly emerging frontier for oil and gas as the era of ‘easy’ oil seems to have come to an end.

RIL is the largest exploration acreage holder among private sector in India holding 34 domestic blocks covering 331,000sqkms. This is in addition to its interest in eight overseas exploration blocks with cumulative acreage of 87,000 sq km in Exploration interests in Yemen, Oman, East Timor, Kurdistan (Iraq), Colombia and Australia.

The scale of Reliance’s investment footprint in exploration and production is unprecedented in India and is the next frontier for its growth. As its KG-D6 gas is being pumped from April FY09, E&P is anticipated to become its key growth driver.

However, all has not been hunky and dory for Reliance Industries with its oil hunt. Its exploration plans have been hit by obstacles such as dearth of operational rigs, work force shortages and soaring input cost. However RIL has not only overcome these obstacles but has been able to double its gas find from 40mmscmd to 80mmscmd.

Increase in capex – A global occurrence

According to Cambridge Energy Research Associates estimates capex inflation in upstream projects in deepwater areas have more than doubled since 2002 and risen from a base of 100 to touch 198 in the third quarter of 2007 while PIRA Energy Group estimated that since 2002, finding & development costs have increased from $ 8/ bbl to $ 15/ bbl in 2006, an increase of 90%.

With most people believed that increased crude prices are going to stay now as US downturn not to affect Europe and other major countries. Thus capex inflation remains a key challenge for all the companies operating in E&P sector.

Similarly RIL had to face huge supply chain shortages and cost escalation along the supply chain. Since 2000 and till November 2008 the cost of various upstream inputs have risen by varying degrees which resulted in final project cost of the gas find almost doubling from the initial estimates.

Manifold jump in rig day rates due to supply tightness

A natural outcome of the firm supply and growing demand is the increase in prices of rig charter rates. The world average jack-up day rate index has increased 2–3x in the last three years. The increase in the day rate index for floaters has been even larger. The semisubmersible day rate index has increased more than 3–4 times while the increase in the day rate index for floaters has been even greater. The semi-submersible day rate index has increased more than 3x, while the day rate index for floaters capable of drilling in water depths of over 5,000 feet has increased 4x in the last three years.

Moreover the average contract length for rigs had increased for past 4 years, suggesting that demand was fairly strong.

Resource scarcity: Offshore rig economics are better than ever before

As per Macquarie Research, June 2007 reported that the GlobalSantaFe Score Index for all the rigs worldwide had reached the all-time high of 138% in April 2007. The GlobalSantaFe's score reflects current rig day rates as a percent of the estimated rate required to justify building new rigs.

GlobalSantaFe Score also compares the profitability of current mobile offshore drilling rig day rates to the profitability of day rates at the 1980–81 peak of the offshore drilling cycle. Thus a high index high usage of the rigs leading to higher prices with key driver for the sector being increase in exploration and development expenditure globally

 As per available statistics, a total of over 145 offshore rigs were on order or under construction until recently as compared to just 29 in April 2005. Fabrication yards that make rigs are running huge backlogs and some of the reputed yards are completely booked with current orders till 2010.

Poor rig supply and soaring charter rates have led to long delays developing new energy deposits, and most oil majors have had to pay a penalty or even relinquish blocks for not fulfilling the minimum work programme. Rig shortage has even forced the government to postpone the next round of bidding through New Exploration and Licensing Policy VII (NELP) by four months.

The Ministry of Petroleum had also proposed forming a rig pool for state-run oil companies to avoid exploration delays while some of the companies are buying rigs to overcome shortage. Faced with little option ONGC will be spending around $2 billion to purchase oil rigs and another $2 billion for hiring and upgrading its existing rigs while Essar Oilfields Services (EOSL) acquired a semi-submersible rig Essar Wildcat at a cost of $220 million, marking Ruias re-entry into rigs business.

An ASSOCHAM paper also highlighted that mismatch between demand of drilling rigs and their supplies on one hand if not addressed urgently; India’s crude import will go up by 20%.

Secular demand should absorb new builds

The offshore drilling services industry is cyclical. Commodity demand is the key to the continuance of the cycle, and the demand-led price fundamentals appear to provide extra sound economics for offshore drilling to see the most productive and extended cycle to date, thus leaving little scope of reduction of charter rates.

Deep-water wells warrant higher expenditure

As a higher proportion of RIL KG D6 expected to come from offshore deep-water fields the exploration and development cost to grow sharply as the E&P activity begins. Although the current gross shallow-water well spend is 4.5x that of deep-water spend, the future growth in offshore spend will come from deep water.

Workforce Shortages

In addition to the rising costs of supplies, global shortage of manpower is also marring the sector. According to estimates made by ASSOCHAM, the global exploration and production workforce shortage is alone is estimated to be 375,000 people which is nearly 20-30% short of total requirement.

As per the inferences drawn from ASSOCHAM paper on Indian Oil & Gas Sector, the Indian upstream sector faces workforces shortages to the extent of 30% against its total requirement. Out of 4 lac engineers, 90,000 MBAs and 7000 PhDs that India produces every year, only 10 to 25% of these are considered employable. Out of this employable lot, nearly 35% are absorbed by IT and ITeS sector while 45% join the manufacturing sector leaving very little scope of reasonable trained resource supply for Indian E&P Sector.

E&P being a highly risky profession, good engineers, geologists and geophysicist are always in demand. The demand and supply is further aggravated by the fact that there is very little intake of petroleum engineers in OECD markets while the existing workforce is retiring in the next ten years.

Further, concerns of energy security coupled with declining petroleum reserves in the world has necessitated presence of professionals who not only possess the technical know-how but are also capable of churning out innovative technology and process to meet the world’s ever growing energy demand. Looking at the current demand supply scenario of trained manpower for professional services in oil & gas sector by 2012, the manpower requirement would double.

Workforce Shortages has resulted into inordinate delays of their hydrocarbons discovery schedule, with projects cost exceeding about 30% in last 3 to 4 years for most of the companies operating in Indian E&P sector.

Weather play truant as well

The challenges facing developing a deepwater project are considerable. The deepwater environment is also very harsh for operations and equipment. In addition, operating in India‘s East Coast typically involves handling swells and cyclones with the weather window in the East Coast being very limited and operations are only possible for 4-5 months. Under these conditions RIL achieving the lowest Finding and Development Costs amongst the 60 odd deepwater projects around the world is a considerable achievement and in the shortest possible time frame.

The geopolitical issues have kept oil prices high, fuelling large exploration and production (E&P) capex. Thus all the companies operating in the E&P faced this issue of increase in capex.

RIL uses project management skills for being most-competitive

RIL has developed the most competitive structure for E&P among its global peers, primarily by leveraging its engineering excellence and project management skills. Typically deepwater projects of KG D6 magnitude have long lead times get completed in 9-10 years however Reliance’s KG D6 was able to RIL has complete this project in seven  years time.

Moreover RIL’s finding and development costs are also the lowest in the world. RIL costs were about $5/bbl while the average costs are $10.2/bbl.  This is on the backdrop of escalated cost of seismic costs which have risen over 200%, drilling and services 100-200% and field development equipment and services which have risen over 100-200% since 2002
Thus on time and cost parameter RIL is much ahead of global standards which to great extent compensated the increase in capex in the KD D6 gas field. 

Recently state-owned oil exploration major the ONGC has approved the revised cost estimates for developing the much-talked about Cairn India’s Mangla oilfield in Rajasthan to $2.396 billion from $1.241 billion and has further agreed to invest around $350 million more on the on-land fields.

The KG-D6 block is itself evolving

Reliance’s current development projects in the KG-D6 block have explored into 5% of the block’s area so far.  Niko Resources (10% partner) indicates that as many as 40 additional prospects have been mapped. The promise of KG-D6 is also evident from the progressive resource upgrades in the block over the past four years.

The project scope increasing leads to higher capex
The revised development cost of $8.8 billion over the life-cycle of the field as compared to the $2.5 billion capex proposed in initial development plan due to increase in scope and size of the development.

The initial development plan prepared in 2003 had anticipated a capex of $2.47 billion for 5.3 trillion cubic feet (tcf) of recoverable reserves at a plateau production of 40 day mmscmd. Subsequently RIL made some dozen discoveries between late 2003 and mid-2006.

With more than doubling the estimated recoverable reserve to 11.3 tcf and plateau production to 80 mmscmd,  it necessitated a revision in the estimated capex to 5.2 billion dollars with expected additional expenditure of 3.6 billion dollars to be incurred in subsequent phase to maintain a longer plateau and optimize recovery. Similar to other exploration projects globally, RIL has increased the capex on the KG exploration due to increase in project size and project scope.

Besides, one must appreciate the fact that the cost of the incremental production rate of 40 mmscmd is only 2.9 billion dollars, which is 42 per cent lower as compared to $5 billion for the first 40 mmscmd.

Reliance intends step-up its oil and gas exploration efforts and even if the total cost of project increases, it will ultimately lead to energy security for the country since the money is well spent.

Summing up
The US$5.2bn Phase I development is now nearly complete, RIL will spend another US$3.6bn over the next 2-3 years to keep plateau production at 80mmscmd by drilling and integrating 28 more producer wells.

While the development cost is high, this is reasonable in the context of deepwater developments given the significant well drilling, completion and equipment costs. In spite of the escalation in costs, RIL's KG-D6 project has been benchmarked by independent analysts such as Goldman Sachs to be amongst the lowest in the world.

KG-D6 exploration has not functioned on a cost plus principle basis where a return is guaranteed on all capital expenditure. By incurring capital expenditure, the contractor takes all risks including the reservoir performance risk and in case of failure, this expenditure is treated as sunk cost for the contractor. In case of a successful discovery and production, however, production is shared between the contractor and government.

With the input cost in E&P exploration has risen dramatically, RIL has faced the difficulties quite well with its E&P expertise remaining key to sustaining the value of the RIL E&P portfolio. Edelweiss Capital anticipates that RIL gas supply will positively impact Indian economy with savings of $ 9.7 billion and from lower fuel/feedstock cost and improvement in India’s trade balance by $16.8 billion through lower net imports.

Moreover with oversight of strong regulator, no player can take chance of going astray from the development cost approved by Directorate General of Hydrocarbon.