Rising costs jeopardize big oil, gas projects

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. U.S. 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.

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 U.S. Gulf coast region, oilfield project prices are up 30% to 35% and there's such high demand for people that there's been a "real fall" in contractor productivity, they 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 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. "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 U.S., said Arbogast. According to a Rand report, the amount of oil shale deposits under Colorado, Utah and Wyoming are believed to 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.

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.