The compounding effect of high-graded drilling locations and the continuing reduction in drilling and completion costs are helping exploration and production (E&P) companies substantially mitigate the damage to their balance sheets brought on by the 2014 oil price decline, according to new analysis from IHS.

IHS expects U.S. E&P companies to post a 25-30% gain in the average efficiency of onshore upstream capital investment in 2015, versus 2014, and a gain of more than 60% in capital efficiency, when comparing expected fourth quarter 2015 performance to fourth quarter 2014—a "significant improvement" in financial performance for the sector, IHS says.

(Read the IHS Unconventional Energy Blog.)

“This substantial improvement for E&P performance results from many forces, but the key driver is the compounding effect of the high-grading of drilling locations combined with the continuing reduction in drilling and completion costs, which we at IHS Energy estimate has led to a roughly 10% gain in capital efficiencies since December,” says Raoul LeBlanc, senior director of research at IHS Energy, and the lead author of the IHS Energy Analysis: Strong Capital Efficiency Gains Mitigating Damage to E&P Companies. “We expect those drilling and completion costs to fall by about 15% on average and climb to reach 30% by year-end.”

A significant part of this equation that works in favor of these E&P companies, says the IHS research, is the sharp fall in service sector costs involved in drilling and completing new wells. As utilization has fallen, service companies have lost pricing power, IHS says, and have had to provide increasing discounts amid fierce competition.

“Despite these discounts and other considerations, these improvements in capital efficiency do not fully offset lower prices for E&P companies,” LeBlanc says. “Producers would still be much better off if oil were at $100 a barrel. Furthermore, the gains are not irreversible, but rather a function of the down cycle.”

According to the IHS Energy analysis, capital efficiency gains by E&Ps will act to lower breakeven prices and raise activity levels (at least modestly), which should lead to improved oil production growth at a given price.

“This should make a material difference in 2016 E&P company performance and plays an important role in our IHS view that U.S. production will be able to rebound in 2016, even if capital budgets remain muted,” says Stephen Trammel, director, unconventionals research at IHS Energy. He conducted supporting analysis examining how E&Ps are coping with the fallout from success following the oil price decline in an IHS Energy analysis entitled Coping with Success, A New Energy Turning Point. “The E&P companies are the relative winners in this scenario as margin migrates out of services to the E&P sector. Even in a flat commodity-price environment, getting more for each dollar invested should allow producers to experience improved profit margins."

On the other side of this equation, service companies, says the IHS analysis, may see some rebound in activity, but in general, capital efficiency works against these companies, at least in the short-term.

As for specific plays driving the most capital investment, Trammel says the Eagle Ford, Bakken and Permian accounted for approximately 62% of capital invested from January 2013 to May 2014, but 75% of capital generating production had break-even costs less than $70 per barrel. He says a poorer return on capital was concentrated in other, smaller plays, making them prime candidates for cuts, but more attractive assets will be drilled once prices improve.

“Well completions are primarily focused on the larger unconventional plays, and IHS expects that, as costs continue to fall and oil prices begin to rise, the industry will start to drill the prime picks from the inventory of 2,500 to 3,000 drilled but uncompleted wells that exist in the U.S. unconventional plays. “This will generate efficient growth for operators and reduce idle capital.”