Oil company cutbacks may raise gas prices down the road

Americans battered by the recession have found modest consolation in low gasoline prices, a salve that's likely to last as long as the economic downturn.

But the oil industry is quietly sowing the seeds for a sharp run-up in gas prices once demand recovers.

Oil companies are slashing new investment and production far more sharply than analysts projected just a couple of months ago, a strategy analysts say could lead to shortages and higher gas prices when consumption rebounds. And, analysts say, a standoff between the oil giants and their suppliers over the cost of rigs, labor and other expenses could prolong the investment slowdown.

"The turnaround will probably come faster than people expect, and the supply won't be there," says Joseph Stanislaw, an adviser to Deloitte's energy practice.

Oil companies are shaving exploration and production spending 18% this year, including a 40% drop in the U.S., according to new estimates by analyst James Crandall of Barclays Capital. In December, the firm said budgets would fall 12%, 26% in the U.S. Drilling in the U.S. is down 39% from its September peak.

Dozens of projects have been put off, including oil fields from West Texas to Russia and oil-sands initiatives in Canada.

The precipitous drop in oil prices has curtailed the companies' cash flow, leaving less to invest in new wells. Oil prices have plunged 70% since hitting a record $147 in July. Crude closed at $40.15 Monday after sinking as low as $33.98 last month.

While many traditional oil fields can be profitable with crude at $30 to $40 a barrel, unconventional drilling is more expensive. New oil-sands projects in Canada, for example, require oil prices of about $80 a barrel.

The scaleback could reduce future global oil supplies by up to 7.6 million barrels a day in five years, or 9% of current production, according to Cambridge Energy Research Associates. That's nearly double its estimate in December.

Little incentive to drill

Many cutbacks are by small and midsize oil providers. Devon Energy dvn is spending $3.5 billion on exploration and production this year, less than half last year's total. Marathon Oil mro is trimming its capital budget 24%; Hess, 27%.

"We just don't see any reason to accelerate production in a very low-price environment," says Vince White, Devon's senior vice president of investor relations.

Major oil companies such as ExxonMobil xomand Chevron cvx, armed with healthy cash flows and cash reserves, are largely maintaining spending levels.

"We see this is going to come out on the other side and if we stay at it, we can do our part to mitigate" a supply crunch, says Gary Luquette, president of Chevron's North America exploration and production unit.

But even some oil giants are tightening their belts. ConocoPhillips cop is slashing capital spending 18%. Oppenheimer analyst Fadel Gheit predicts all providers, even the majors, will cut back, with industrywide investments chopped 30% to 40%. "They have not seen the blood on their results yet," he says.

The slowdown could be extended by an impasse between oil companies and their suppliers. Many oil companies are deferring projects until costs fall. During crude's meteoric rise last year, equipment and labor costs swelled up to fourfold, thanks to soaring prices for commodities such as steel and demand for limited services. Some offshore oil-drilling ships lease for up to $700,000 a day.

Since August, costs for steel, cement and other materials have tumbled as much as 50%. Oil field costs, however, have dipped only about 10%, Gheit says.

"I remember (five years ago), I thought $40 was a fantastic (oil) price, and the industry worked perfectly well," BP bp CEO Tony Hayward said at a recent Cambridge Energy Research Associates conference. "The only thing that's changed is we allowed our cost base to get away from us."

Royal Dutch Shell rds.a CEO Jeroen Van der Veer says the oil giant is delaying a Canadian oil-sands project "because we think we can build it later at a lower cost."

No rush to cut costs

Service companies are reluctant to lower their fees, largely because they boast huge order backlogs from the boom times, says Deutsche Bank analyst Michael Urban.

"We can wait, so we don't have to rush and sign a contract at a (rate) that we don't think is supported by our view of the current supply/demand situation," Greg Cauthen, chief financial officer of Transocean rig, the largest offshore drilling contractor, recently told a Credit Suisse energy summit.

There are other hurdles. Gary Flaherty of oil service company Baker Hughes says costs likely will not fall because drilling technology has improved, helping oil companies save money by speeding projects. And, Urban says, it's tough to cut oil workers' salaries.

Many service companies also expect oil prices to rebound in six to 12 months, says Argus Research analyst Phil Weiss.

Bottom line: Service costs might not decline substantially for a year or longer, Urban says.

At the Cambridge conference, Andrew Gould, CEO of Schlumberger, slbthe top oil field service company, said costs eventually will drop. But, he said in comparing service companies to plumbers: "And when did the bill from your plumber last go down?"