?Positive reserve revisions due to higher gas prices were the key to improved economics, he adds. The composite spot gas price at the end of 2007 was $6.77 per Mcfe, versus $5.47 at year-end 2006.


Calyon’s latest forecast calls for an average $8.20 per Mcfe this year, up 23% from the 2007 average of $6.64. In fourth-quarter 2008, he expects $8.25.


Reserve revisions will be more important as time goes by, “irrespective of the direction of commodity prices,” Armstrong says. “At the behest of the SEC, companies are starting to account for reserves gained by down-spacing and infill drilling as a performance revision as opposed to a field extension or discovery.”


Of the 41 companies studied, those with a focus on the Rockies (Ultra Petroleum, Bill Barrett Corp. and Questar) or shale plays (Quicksilver Resources, Carrizo Oil & Gas and Range Resources) had the lowest F&D costs.
Not surprisingly, the highest costs were reported in the Gulf of Mexico, affecting companies such as W&T Offshore, Mariner Energy and ATP Oil & Gas. “Shale plays are able to sustain the lowest price, although their hyberbolic decline curves would make any substantial price drop short-lived.”


Companies in Calyon’s U.S. onshore composite saw costs drop 4% to $2.52 per Mcfe.


Offshore costs fell 14% to $4.39, with jackup-rig dayrates off more than 50% since they peaked in late 2006. “Lower F&D costs enabled the recycle ratio (cash flow divided by F&D costs) to rebound from a five-year low of 1.4 to 1.7, despite narrower operating margins. This important metric should see further improvement this year.”


Drillbit costs excluding revisions rose 11% to $2.69 per Mcfe. But there are two sides to this number, he adds. Exploration success has improved since 2001 due to new technologies and increased drilling in resource plays. On the other hand, proved reserves per productive well have fallen 36% (excluding revisions), he says.


“Reserves per well are likely to continue to decline as unconventional resource plays continue to grow in importance, which will likely manifest itself in higher DD&A (depreciation, depletion and amortization).”
Relatively flat rig rates and rising oil and gas prices should keep any cost creep under control, with the bonus of creating more free cash flow, he forecasts.


Indeed, many E&P companies have already announced an increase in their 2008 exploration and development budgets due to higher-than-expected cash flow. Armstrong thinks “many may end the year with substantial cash balances and decide to issue one-time dividends or repurchase shares.”


The 13 companies the Calyon research team covers “could generate $5 billion more in operating cash flow than they plan to spend in E&D (exploration and development) capex,” he adds.


Improved economics, excess cash flow and an influx of external capital are likely to result in higher and sustainable valuations, so he reiterates his Overweight on the E&P sector.