Oil prices have been on the rise over the course of the last several months, and for the first time in a long time, rig count has been moving up instead of down.

With the price reaching $50 a barrel, the expectation is that oil and gas producers will likely stand rigs back up and put frac crews back to work as they begin to increase activity as economics permit. The industry remains in the trough portion of the revenue cycle, however, that is a lagging indicator relative to oil price.

The increase in activity has the potential to pull the industry out of the down cycle.

KLR Group highlighted this sentiment in a note to investors today. KLR’s expectation is that oil service companies have a “heightened sense of urgency around the alignment of labor, equipment, and inventories to manage both fast and slow recovery scenarios. These positive under currents suggest the early stages of an activity recovery, bullish for the services group.”

4,200 DUCs and Counting

Exploration and production companies scaled back the drilling of new wells, and have left many wells as drilled but uncompleted (DUC). Oil & Gas 360® explored the trend of DUCs in an article a few weeks ago. Companies with rig contracts often find that it is more economically viable to continue drilling wells but not completing them as opposed to paying a termination fee for the rig.

Current estimates place the number of DUCs in the U.S.at 4,219 wells waiting to be completed. The ‘fraclog’, as it is being called, has built up as production has increased in the U.S.

In the current commodity price environment, many companies have relied on legacy assets and increased production from those wells. Companies have curtailed capital expenditures and limited new drilling in hopes of conserving cash flow. However, this is not a sustainable practice, as David Demshur of Core Lab (ticker: CLB) likes to say, “The decline never sleeps, and always wins.”

Legacy assets will eventually succumb to the decline curve, and new wells will need to be drilled. This isn’t to say that new wells aren’t being drilled, but the expenditures required to drill new wells have decreased during the downturn, instead of constantly increasing.

Cost Inflation

As economics improve in the oil patch, companies will need to bring new production online to replace the assets that will fall victim to the decline curve, and the first place to look is toward the DUC wells.

KLR believes that the increased work flow for frac crews to complete wells will lead to pressure pumping cost inflation. “Upstream operators sense the emergence of tighter service markets in 2017, as excess equipment is absorbed,” KLR said. Service companies will need to increase labor and deploy capital to bring back stacked equipment as a result of an uptick in activity.

The ramp up in activity isn’t just relegated to onshore drilling and completions. KLR said, “One offshore equipment provider suggested that revised deepwater project plans focus on a scaled pace of infrastructure investment. The practice may reduce large initial expenditures and spread them over the course of the project. Lower up front costs improve NPVs and oil price break even math. The improvement in economics may bring projects to market faster than investors expect. With an improvement in the commodity and potentially lower project break-even costs, offshore drillers continue to reference inquiries for offshore rigs for work in 2017 and 2018.”

The discussion of scaling the infrastructure needs would be beneficial to both oil service firms as well as E&P operators. This trend could be seen in action in the deepwater efforts as well as making its way onshore.

With a new reality thanks to a depleted price environment, oil service firms are likely to work with E&P companies to construct agreements in a manner that limits any measures that may be drastic or overly-aggressive. Working in unison, the increase in activity will help both sides of the upstream oil and gas industry.

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