CRAK - Upward Price Pressures Will Make Cost Savings Difficult This Year

Summary

• The cost of developing upstream oil and gas assets, as tracked by the IHS Markit Upstream Capital Costs Index (UCCI), increased by over 7% in the first half of 2022.
• The rising in costs was driven by several factors: the conflict between Russia and Ukraine (leading to rising energy and commodity prices), global project activity picking up, rising inflation, and supply chain issues.
• Cost savings will be difficult to find this year as every market is experiencing upward price pressure.

The cost of developing upstream oil and gas assets, as tracked by the IHS Markit Upstream Capital Costs Index (UCCI), increased by over 7% in the first half of 2022.

The rising in costs was driven by several factors: the conflict between Russia and Ukraine (leading to rising energy and commodity prices), global project activity picking up, rising inflation, and supply chain issues. Cost savings will be difficult to find this year as every market is experiencing upward price pressure.

All markets monitored by the UCCS increased in the second quarter of 2022 with the largest increase from the steel market, up by over 21% from the fourth quarter of 2021 to the second quarter of 2022.

With input costs (iron ore, scrap, metallurgical coal, pig iron, and semi-finished steel) rising and some materials becoming unavailable, steel prices continue to rise. Oil and gas activity and supply constraints are keeping upward pressure on the line pipe and OCTG markets; on average these markets increased about 130% over the first half of 2022.

The land rig index rose by 5% over the second quarter driven by increased drilling activity as oil prices climbed above $100/bbl. Drilling contractors have a lot of contracts in the pipeline and are incentivized to stick to spot rates rather than term contracts. Demand for super-spec rigs internationally has grown while supply outside of North America remains limited.

Like the land rig market, increased activity put upward pressure on offshore rigs and vessel rates, up by 7.5% so far this year. Most of the positive price movement in the offshore rig market was driven by jackup and deepwater rigs securing new contracts.

Offshore vessel day rates increased for all fleets during 2022. The sharpest rise was in offshore support vessel (OSV) costs, with the overall index for the market increasing by above 7% on average. European vessel rates shot up with the start of the busy summer season, especially in tighter vessel markets, such as AHTS boats and DSVs.

Costs in the equipment and bulk material markets were both up around 6%. The equipment market sustained higher inputs costs coupled with growing demand owing to rising oil prices and increased project activity. Bulk material prices have continued to rise in 2022 owing to supply chain disruptions, material input cost increases, and high inflation.

The subsea market and yards market rose more than 6% in 2022. Similar to the other markets, high inflation and rising raw material prices contributed to the price escalation. Inflation and higher input cost are making yards become more conservative in selecting and pricing bids in the second quarter after an eventful first quarter.

The rise in input costs affected older contracts as well. Many yards are making losses on almost all lumpsum projects (both offshore and shipbuilding) that were booked in the past two years.

Growth in the engineering and project management ((EPM)) and construction labor indexes was modest when compared to other indexes and partially driven by foreign exchange effects.

Inflation was a key driver of construction labor wages, up by 4% so far this year as a limited supply of labor is leading to companies raising salaries to hire more workers. The EPM index rose by 3% over the same period as increasing contracting activity and elevated inflation push up the index.

IHS Markit forecasts the UCCI to increase by 10.1% in 2022 as Russia's war in Ukraine keeps oil and gas prices high and adds to supply chain disruptions. Raw material prices will remain elevated through most of 2022 which will push up prices for energy sector building materials. The global economic recovery is aiding new project activity in the hydrocarbon sector as companies attempt to meet rising fossil fuel demand.

The global Upstream Operating Costs Index (UOCI) has increased by 6.7% in the first half of 2022 driven by rising raw material prices and continuing supply/demand disruption, which fed through into steel products, equipment, and chemicals. Activity, particularly in the US onshore and in offshore markets, is recovering driven by rising oil price.

The operations market has gained 5% over the second quarter of 2022 driven by a 13% escalation in the diesel index. The production chemicals index saw some relief this quarter rising only 3%.

As oilfield activity recovered encouraged by crude oil prices, the labor rates edged up 4% in US dollar terms during the quarter but rose 1% in local currency because of the European currencies' strong depreciation.

The maintenance market grew by 3% in the second quarter of 2022 in both US dollar terms. Overall maintenance demand is rebounding supported by higher oil prices and easing of COVID-19-related restrictions in some regions.

The FIM index escalation continued into the second quarter of 2022 with 4% growth. The index is being pushed up by almost all input factors including the rising cost of steel, materials, equipment, and labor.

This is combined with increasing demand for preventive and corrective maintenance. The DSV/ROVSV index grew by 2% in the second quarter and the offshore activity outlook looks encouraging through the last half of the year.

The logistics market increased 3% in the second quarter of 2022 and is expected to end the year up by 8%. The aircraft index was up by 5% as jet fuel prices significantly escalated in the second quarter of 2022.

The supply services index comprising of catering and warehousing rose by 2% this quarter as food and fuel prices escalated. The ongoing disruption in the global logistics chain continue to push cost higher.

The wells market registered 4% higher during the second quarter of 2022 in US dollar terms, while increasing by 13% year on year. Oilfield service sector continues to face major input cost inflation.

Despite renegotiated contractual agreements and increased activity, inflationary pressures show no sign of abating. Cost inflation will continue to be passed on to operators particularly in segments that face rising raw material costs. We expect that segments that rely on steel will see relief in late 2022.

The UOCI growth is expected to continue through the year with the UOCI ending 2022 up 10%. Rise of activity and raw material cost will support higher cost.

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Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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