Published June 19, 2012

An Icy Saga Is Emblematic of Oil Price’s Inevitable Climb

By Marin Katusa, Chief Energy Investment Strategist

If anyone needs more proof that diminishing supplies of easy oil are forcing the world's oil majors to venture into ever-riskier, more complicated, and more expensive areas in their search for new reserves, look no further than Royal Dutch Shell's (NYSE:RDS.A) pending voyage into the Arctic.

Shell is about to set sail on a mission that has been eight years and more than $4 billion in the making… and all that is before first well is even spudded. Environmental wrangling, legal battles, regulatory changes, and technological developments have all played a role in the saga to date. But persistence pays: Shell now has two drilling rigs ready to go and is just waiting for the receding ice to expose its targets.

When Shell's drills penetrate those targets, they might tap into a vast wealth of oil. Alaska's outer continental shelf is thought to host billions of barrels of recoverable oil and trillions of cubic feet of natural gas. Those hydrocarbons, however, will not be easy to access.

The challenge is not water depth – Shell's Arctic targets sit beneath just 150 feet of water, which is nothing compared to the 5,000 feet of water that covers many drill targets in the Gulf of Mexico. But those 150 feet of water bring with them crushing ice floes, frigid temperatures, Arctic storms, and total darkness for 70 days a year. And those are just the technical challenges. On the regulatory side, Shell has had to contend with environmentalists and native groups vehemently opposed to Arctic offshore drilling, a complete overhaul of the US offshore drilling regulatory system that generated new spill preparedness requirements, and the reality that their rigs will be working in a delicate ecosystem alongside key migration routes for bowhead whales and walruses.

It's about as challenging as oil exploration can be. And yet there the company goes, setting off on an adventure that – if the company is lucky and all goes according to plan – will enable to Shell to start producing Arctic oil in another eight or nine years, and after a total investment of roughly $7 billion.

Shell is going to these incredible lengths to find oil because the company feels it has to. The world's oil giants are in a constant battle to find significant new oil reserves that they think can become tomorrow's producing fields. Since a century of oil production has depleted most of the world's easy oil deposits, the Shells of the world have no choice but to explore in increasingly challenging conditions to find those significant new reserves.

Just ten years ago it would have been inconceivable to spend $4.5 billion getting ready to test an oil target. But ten years ago oil was only worth about $25 a barrel. Today prices have almost quadrupled, reflecting rising global demand juxtaposed against sliding export volumes from many of the world's major suppliers. With Big Oil increasingly forced to search for oil in the frigid Arctic, in the ultradeep waters of the Gulf, in the shifting salt formations off Brazil, or in any number of unstable countries where politicians and terrorists pose almost equal threats, production costs are inexorably rising.

The result: oil prices cannot help but climb in the coming years. For a perfect example of why costs are climbing, read on.

Shell's Arctic Dream

Shell has been trying to spud these Arctic wells for almost a decade. In 2002 the federal government began selling offshore leases in Alaska; Shell purchased its first blocks in 2005 and has picked up additional acreage since. In late 2006 the company submitted a plan to explore its Beaufort Sea blocks; the Mineral Management Service (MMS) – the umbrella organization that has since been broken apart into the Bureau of Ocean Energy Management (BOEM), the Bureau of Safety and Environmental Enforcement (BSEE), and the Bureau of Ocean Energy Management, Regulation, and Enforcement (BOEMRE) – approved the proposal a few months later.

That first approval sparked the first court challenge, a pattern Shell would see repeated time and again in subsequent years. The Ninth Circuit Court of Appeals denied MMS's approval, claiming the offshore regulator had not required Shell to complete a sufficiently detailed analysis of potential environmental impacts. This derailed exploration for two years, eventually forcing Shell to submit a new exploration plan in 2009. The MMS approved the new plan, and this time the Ninth Circuit upheld the decision.

Things were starting to roll in the right direction for Shell, until the company's Arctic plans ran up against an unforeseen obstacle: the Deepwater Horizon disaster in the Gulf of Mexico. That fatal explosion and five-million-barrel oil spill led to a moratorium on offshore Arctic drilling that lasted through the summer of 2010 and resulted in a raft of regulatory changes. Shell had to start over again.

The company submitted its third Arctic exploration plan in May 2011. The BOEM and BSEE both eventually approved the plan. A coalition of environmental and indigenous groups again found reason to sue, but the court sided with the new offshore regulatory bureaus and upheld the permits.

The ducks are now all in a row and Shell is ready to go, but the company isn't taking any chances. In an attempt to head off yet another last-minute postponement, Shell has even filed a pre-emptive lawsuit against environmental groups that might file a legal challenge to Shell's oil spill response plan. By doing so, the company is forcing the courts to go through and essentially approve Shell's plans before anyone has a chance to challenge them. It's a lesson learned in time.

Big Gamble, Massive Potential

Before sinking a single well, Shell will have already invested eight years and $4.5 billion in its Alaskan project – $2.3 billion on equipment and personnel plus $2.2 billion for the leases – and yet the company is still years and billions of dollars away from a potential payday. The wells Shell will begin drilling in July are only to probe for hydrocarbons; they are not designed for production. If those drills do find oil, it would take another seven to ten years to drill production wells, install production platforms, and build the on- and offshore pipelines needed to move this Arctic oil to customers. By then, Shell's upfront investment could well top $7 billion.

Why is the company dedicating so much time and money to this project? For two reasons. First, the easy oil is gone, which means majors simply have to contend with risks and challenges of this nature if they want to replenish their reserve books. Second, if estimates are even close to correct, there is a heck of a lot of oil and gas in the Arctic.

The USGS estimates that the Beaufort Sea holds 2-7 billion barrels of economically recoverable oil and 3 -20 trillion cubic feet of economically recoverable natural gas. The Chukchi Sea could hold as much as 12 billion barrels of oil and 54 trillion cubic feet of natural gas. Alaska's outer-continental shelf as a whole is thought to hold 27 billion barrels of recoverable oil and 130 trillion cubic feet of natural gas.

More generally, the waters of the Arctic are thought to hold some 22% of the world's undiscovered oil and gas. With such massive hydrocarbon resources at stake, Big Oil is doing its utmost to prove that it can operate safely in the Arctic. But the shadow of BP's Deepwater Horizon oil spill still looms large over the entire offshore drilling industry. Nowhere are those shadows darker and longer than in ecologically sensitive areas like the Arctic.

Environmentalists and the peoples indigenous to the region are very concerned. They claim that any oil spill that seeps underneath the ice pack will be essentially impossible to clean up and will irreversibly damage a pristine ecosystem.

Shell is taking its environmental responsibilities seriously. For example, in the 1980s and 1990s the brave souls who attempted to drill in the Arctic often used icebreakers to plow a path to icebound drilling sites. Today, however, Shell has committed to avoid using icebreakers as a means of minimizing disturbances to wildlife, including polar bears.

Leaving the ice undisturbed is just one aspect of Shell's environmental planning. The company spent $150 million refurbishing the 29-year-old drilling rig that will probe the Berger prospect in the Chukchi Sea. Four new diesel engines and a series of filters and scrubbers mean the rig produces far less nitric oxide, nitrogen dioxide, and particulates than it did before the refit. The refurbishments also include a 4,200-barrel waste storage facility that will store all wastewater, ballast water, and drilling muds and cuttings. The rig will not discharge anything into the waters of the Arctic; instead all of these waste fluids will be carried to the lower 48 for disposal at a certified landfill.

In terms of emergency response, a preconstructed capping stack will be positioned on a nearby vessel, ready to deploy in case of a well blowout that can't be controlled using the beefed-up blowout preventers that will be installed on each well. The capping stack was modeled on the equipment that finally stopped the oil flowing out of BP's Macondo well in the Gulf of Mexico – now, instead of having to build one after a blowout occurs, one is prefabricated and ready to go.

Long-Term Vision

Permits are in place, a pre-emptive court challenge is under way, and Shell's extensively refitted drillships are almost ready to sail. Now the biggest obstacle in Shell's path is nature itself. In recent years the summer ice melt-off in the Arctic has often set new records, a pattern many climate scientists say is linked to global warming. This year, however, a high-pressure zone over the coast of Alaska, cold winter temperatures, and particular ocean currents have resulted in unusually large amounts of ice along Alaska's northern coast and down into the Bering Sea.

The National Weather Service says Alaska is an iceberg, covered in quantities of ice not seen in more than a decade. And that means Shell's already short window of opportunity may be even shorter than expected. Normally, the region of the Chukchi Sea that covers Shell's Berger prospect is accessible by mid-July. This year, it may be locked in ice until late July or early August.

Shell has pledged to stop drilling by October 31 in the Beaufort Sea. In the more northerly Chukchi Sea, the company has to be finished drilling by September 24. Both deadlines are intended to ensure that the wells are drilled, completed, and sealed off at least a month before the sea ice arrives, so that if a spill does occur the company will have time to implement a fix. But it also means that Shell will have less than three months to set up, drill and test its exploratory wells, seal them up, and depart. That is a very tight timeline.

How ironic. Shell has been working for years to get its Arctic opportunity. Now the moment has finally arrived, and the company will be in a frantic rush to get it done in time.

And years is actually an understatement. Shell's current Arctic endeavor may have started in 2005, but the company has been eyeing Arctic oil for decades. The company owned leases and drilled wells in the Chukchi and Beaufort Seas in the 1980s and 1990s, abandoning them only because the $20-a-barrel oil prices of the day did not justify further work.

Today, however, oil prices are four times higher, and Shell says it expects its 410 Alaskan offshore leases to become the company's biggest source of crude globally within 10 to 20 years. Shell knows there are huge oil resources in the Arctic and plans to make those resources a mainstay of its operations for decades to come.

The company has support from the state of Alaska, which has a strong economic interest in helping oil majors find more oil and gas in the Arctic. More than 90% of Alaska's state revenue comes from oil and gas; but oil production from state lands, which include the mega Kuparak and Prudhoe Bay oil fields, is on the decline after peaking at more than two million barrels a day in the late 1980s.

Lower production volumes are not only a concern because they mean smaller revenues flowing into state coffers. The bigger concern is that declining volumes are threatening the viability of the Trans-Alaska Pipeline, which takes Alaska's oil south. Last year the pipeline's operator, Alyeska Pipeline Service, released a report questioning whether the pipeline will be able to operate safely if throughputs continue to decline.

Lower volumes mean the oil moves through the pipe more slowly. The more slowly the oil moves through the line, the greater the risk that water will separate from the oil and freeze at the bottom of the pipe, causing corrosion and cracks. If volumes fall below 350,000 barrels a day, Alyeska says it cannot promise that it will be able to keep the line operational.

It all means there will be a lot of eyes on Shell this summer. Alaskans, indigenous peoples, environmentalists, global oil majors, US politicians, Chinese industrialists, analysts, and investors will all be watching to see if Big Oil can cleanly and safely find big oil reserves in the Arctic.

Big Oil will also be watching China, as the Asian powerhouse has been locking up energy deposits around the world at an alarming rate. Since 2005, it has spent over $75 billion and have closed no fewer than 45 oil deals – including one in the US. This energy grab has created intense competition with the US that some have likened to a new Cold War.

Additional Links and Reads

Oil Falls below $96 as Optimism Fades (Montreal Gazette)

The spot price for Brent oil – the European crude-oil benchmark – fell below US$96 a barrel on Monday to its lowest level since February 2011. The drop came as a pro-bailout vote in Greece failed to ease concerns about the Eurozone, in large part because even if Greece stabilizes and remains within the Eurozone, other larger economies – notably Italy and Spain – may still need to be bailed out. This tenuous economic outlook is driving oil prices far more than concerns over Iran, which is what drove prices up at the start of the year.

Saudi Arabia Keeps OPEC Spigots Open (Forbes)

Member nations of the Organization of Petroleum Exporting Countries (OPEC) will keep pumping 30 million barrels of oil a day (bpd) despite financial and political turmoil in Europe and signs of an economic slowdown in China. The decision to maintain current production levels stems from Saudi Arabia's unwillingness to cut its output volumes. The OPEC leader produced a staggering 9.9 million bpd in May and wants to continue at that level out of concern that a drop in Saudi production would send oil prices higher, threatening global economic growth and thereby hurting oil demand in the short and medium terms.

Oil Market Shrugs at Imminent Iran Tanker-Insurance Ban (Reuters)

In less than two weeks, Iran's biggest oil buyers will lose access to the London-based insurance market that protects 95% of the world's tanker shipments against catastrophic events. As of July 1 European insurers will be unable to insure vessels carrying Iranian crude, an unforeseen but ultimately critical side effect of EU sanctions. Ostensibly, exports from the second-largest supplier in OPEC could grind to a halt next month as the remaining buyers of Iranian oil cannot afford the risk of multibillion-dollar liabilities from an uninsured accident. Only Japan, which now buys about a fifth of Iran's exports, has announced a system of government-insurance guarantees to keep Iranian oil flowing.

More Nations Exempt from Iran Sanctions (Financial Times)

The Obama administration exempted seven more countries from its Iranian oil sanctions while still leaving open the prospect that China could be penalized. The state department said that Turkey, India, Taiwan, South Korea, Malaysia, South Africa, and Sri Lanka had all reduced their purchases of Iranian oil by enough to be given a six-month exemption from the sanctions, which take effect on June 28. Japan and ten European countries have already been awarded exemptions.

Japan Restarts Nuclear Reactors (CBC)

Japan's government on Saturday approved bringing the country's first nuclear reactors back online since last year's earthquake and tsunami led to a nationwide nuclear shutdown. Public opposition to the resumption of nuclear operations remains high, but Japan has been acutely short of power since ordering its 50 reactors offline, eliminating 30% of the country's power-generation capacity. The two reactors in Ohi town that are expected to resume operations in the coming weeks power an industrial area and provide power to Osaka, Japan's second-largest metropolis.

Apache Spots "Monster" Shale Gas Field in BC (Globe and Mail)

Houston-based Apache Energy thinks it may have found the richest natural-gas shale field in the world after a test well in northern British Columbia's Liard Basin produced 21 million cubic feet of gas per day for a month. The company believes the result is the "most prolific shale gas resource test in the world." The company now estimates that the entire Liard play could contain 210 trillion cubic feet of gas, of which some 48 trillion would likely be recoverable. Moreover, because the play is so large and the drilling so easy – the well required just six fracs, as compared to the 12 to 18 often needed to make shale wells flow – Apache thinks it could turn a profit producing gas from Liard with gas prices at just US$2.57 per thousand cubic feet.

Miners Hit by Coal Glut as Prices Tumble (Financial Times)

GenOn Energy, a power utility based in Houston, recently declared force majeure on coal purchases… because the company's coal piles are simply full. GenOn's overabundance of coal is emblematic of the state of the industry in the US: Utilities have been switching to natural gas to take advantage of low gas prices, and the move away from coal has pushed thermal coal prices to a two-year low.