A Floor Under the Price of Oil (and Gas)

This article demonstrates what we have always discussed regarding the floor on the price of oil. As compared to the early 80s when relatively high prices encouraged exploration around the world for easy to develop oil glutting the market, new discoveries are in hard to reach places, like 10,000 to 20,000 feet under the ocean. Even though the discoveries in deep water the past few years add to the known world oil supply, they will not get developed at lower (current) prices. This means we are stuck with the lower cost reserves that are dwindling around the world.

The Alberta oil fields are relatively inexpensive to develop and produce. They are generally profitable at $30-40 / barrel, depending on the formation and the oil quality (the amount of stimulation required to get it out of the ground). The really cheap oil that is profitable at $10 / barrel is just about gone in North America (light sweet crude near the surface, like West Texas crude, or "Jed Clampett" crude as I call it). So, when you hear people talk about oil going back to under $20 / barrel, they really don't know what they are talking about.

Some of the more adventerous or less proven drillers are not a good idea right now. But PWE, PVX and PGH have very good operations that don't have many questions.

Also, see www.mcdep.com for his educated opinions on the status of the oil market.

I have attached an article from Barrons Online titled "The Downturn's Impact on One Oil Driller, Callon Petroleum gets a downgrade after it blames economy for decision to terminate project."

"The Downturn\'s Impact on One Oil Driller";

CALLON PETROLEUM (Ticker: CPE) announced that it has decided to indefinitely suspend development of the Entrada field, located in the deepwater Gulf of Mexico. Management cited the recent collapse in oil and gas prices and higher-than-expected development costs as the reasons for terminating the project.

To date, Callon has successfully drilled two exploration wells at this field. The third well recently reached a total depth of 21,100 feet but needs to be sidetracked.

In March 2007, after owning 20% of Entrada, Callon acquired the remaining 80% interest from BP PLC (BP) for $150 million. Subsequently, in the first quarter of 2008, Callon sold 50% of the field to Japan's ITOCHU Corp. for $155 million, with Callon remaining the operator. At the time of the divestiture, Callon estimated Entrada's development costs to be approximately $300 million.

At year-end 2007, Entrada had an estimated 192 billions of cubic feet equivalent (Bcfe) of proved reserves (a total of 339.6 Bcfe of proved plus probable reserves). After adjusting for the divestiture, Callon's pro forma year-end proved reserves were 168 Bcfe. Therefore, approximately 57% (96 Bcfe) of the company's total proved reserves are now uneconomic in the current commodity price environment.

The field was expected to begin initial production in the first half of 2009. With the project now halted, we are lowering our earnings estimates, and our proved net asset value also decreases accordingly. Entrada was expected to double the company's production rate, and without this new source of cash flow, Callon will likely be forced to make major cuts in its capital budget for 2009.

After two years of planning, the suspension of the development of this large asset is a very negative event for the company. Ultimately, Callon may have the opportunity to divest its remaining interest to a company that has the balance sheet to see the project through to its conclusion, but in the near term, Entrada's economic value has diminished considerably. Based on the potential for a large reserve write-down, the minimal visibility on production growth, and the uncertainty about the company's post-Entrada operating strategy, we are downgrading Callon Petroleum shares from Market Perform to Underperform.