It has been a great run for oil and gas operators. High commodity prices coupled with efficiency improvements in the oil patch have opened the door for expanding margins.

But all good things come to an end, and for domestic oil and gas operators, the long respite from lower oil service costs appears to be waning.

Some hints are found among the pressure pumpers, with two of the Big Four multinational service providers promising investors that North American margins will increase in second-half 2014. Even the publicly held land drillers are discussing higher rig rates, although increases have been small for the most part, usually measured in incremental gains of $100 or $200 a day--just enough to cover increased labor.

But it’s a truism in oil and gas that oilfield service costs follow commodity prices, and both oil and natural gas are materially higher in 2014.

In response, the rig count moved higher in the first half of 2014 on the basis of expanding activity in tight formation plays. That has tightened rig availability, especially for higher spec rigs with self-mobilization packages suitable for pad drilling, where utilization now is virtually at effective capacity.

So, it may be time to revisit the mantra of steadily declining well costs that oil and gas operators have been citing in their public presentations over the past three years. Operators ascribed declining well costs to greater efficiency, initially on the drilling side, as operators shaved drill days, and more recently to greater effectiveness on the completion side. There has been a steady parade of press releases touting higher IP rates and improved decline curves, which suggest higher EURs.

Field operation personnel speaking on technical panels at Hart Energy’s DUG conferences in the Permian, Midcontinent, Rockies and Appalachia during the first six months of this year estimate half of the improvement in reduced well costs has come organically from efficiency improvements over the past three years, especially with the move to pad drilling and batch completions. The other half originated in the capacity oversupply plaguing oilfield services.

It is the latter that is changing as the first hints of service cost inflation reappear in the oil patch. For one, labor costs are up for contractors across all service lines. In the Permian Basin, an influx of new drilling and well servicing rigs has kept a lid on pricing, but many contractors now point to labor cannibalization and are raising wages to retain experienced employees or to fend off employee poaching.

A second inflationary factor is greater downhole intensity. While rigs are producing more wells, operators are also doing more within each well, such as packing stages closer together and significantly increasing proppant volume. It is not uncommon to find stage count on extended length laterals at more than three dozen and climbing--vs. half that many stages a year ago. Finally, operators are adding more perforation clusters between stages.

Increased downhole intensity has become the main industry narrative for the E&P sector in 2014 in the same way that the 2013 industry narrative focused on the transition to pad drilling and batch completions. However, greater downhole intensity is also creating higher costs per stage.

Hart Energy surveys of E&P operation managers and sales managers at oil service firms across the major tight formation plays recently discovered cost per stage reversing a three-year decline in second-quarter 2014. Those surveys are also finding more anecdotes about tightening demand for oil services. For example, pressure pumpers formerly described the Permian Basin as oversupplied with equipment. Those same respondents now describe the service market as balanced.

That change in response is subtle, but significant. The service industry overbuilt in the 2010-2012 era, creating enough capacity to meet strong demand in oil and gas. The decline in natural gas prices in 2012 became a significant factor contributing to the capacity-oversupply situation--and lower operator well costs.

The current flurry to refill natural gas storage, coupled with expansion in oil-related activity in regions like the Permian Basin, is coinciding with greater intensity in equipment use in all wells. Something has got to give, and service providers think it will be pricing, as the supply-demand balance moves in their favor.

Oil service pricing has not hit a significant inflection point yet, but contractors tell Hart Energy surveyors that day is coming. Soon.

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