Offshore O&G: Regulated to the Energy Backseat

This past March, the hopes of the oil and gas industry were boosted by President Barack Obama’s announcement that he and his administration were going to support an expansion of offshore exploration and production by opening up areas off the East Coast for drilling in the 2012-2017 leasing program.  Initially, President Obama suggested only allowing seismic data-gathering operations to be allowed to be conducted.  The oil and gas industry, however, firmly believed that once seismic operations commenced, it would inevitably follow that exploration and production would be allowed.  Barely three weeks later all these efforts were frozen as Transocean’s (RIG-NYSE) Deepwater Horizon drilling rig exploded in a fireball killing 11 workers following the blowout of BP’s (BP-NYSE) Macondo well that the rig was drilling and, which ultimately led to the worst oil spill in U.S. history and one of the globe’s worst environmental disasters ever. 

President Obama’s announcement, as he stood before a U.S. fighter jet at Andrews Air Force Base, was remarkable in that he said his decision to open up the East Coast and part of the Eastern Gulf waters off the coast of Florida, was not based on political ideology but driven by science.  The hypocrisy of the announcement was that the Obama administration and the Democratically-controlled Congress were working feverishly to secure Republican votes in support of pending environmental legislation.  Last week, when Interior Secretary Ken Salazar announced the reversal of the president’s decision, he stated, “As a result of the Deepwater Horizon oil spill, we learned a number of lessons, most importantly that we need to proceed with caution and focus on creating a more stringent regulatory regime.”  This decision continues a string of Obama administration actions demonizing the oil and gas industry, which are based on politics and not science. 

Sec. Salazar’s decision about the next five-year drilling plan means that not only will the East Coast and Eastern Gulf of Mexico remain off-limits to the oil and gas industry, but also that the government will postpone all planned Gulf of Mexico lease sales until late 2011 or early 2012.  No sales will occur until a new environmental assessment of the Gulf has been completed.  After canceling last August’s Gulf lease sale due to the continuing BP oil spill, the government’s action means the oil and gas industry will go nearly two years without being able to acquire new acreage for exploration.

Exhibit 4.  Lease Sale Plan Reverses Obama Decision
Lease Sale Plan Reverses Obama Decision
Source: The Wall Street Journal

That does not appear to be of concern to the Obama administration.  Sec. Salazar pointed out that the industry has nearly 29 million out of 43 million acres under lease that have not been developed.  He stated, “There’s plenty of opportunity for oil and gas companies to develop these additional resources.”  His statement displays a fundamental misunderstanding of the workings of the oil and gas business.  Companies acquire large blocks of acreage hoping that a discovery on one block may extend to adjoining blocks, but many times that does not happen.  Once a determination is made that the additional acreage doesn’t contain prospective oil and gas reserves, the leaseholder stops expending any effort on the additional acreage pending its return to the government at the end of the primary lease term.  As Jack Gerard, president of the American Petroleum Institute put it, “It’s a red herring to suggest there are resources sitting there yet to be developed.”

The de facto deepwater drilling moratorium presently in place following the lifting of the official deepwater drilling moratorium in October is beginning to bite deeper into the offshore business.  Last week, Ensco plc (ESV-NYSE) announced it had arranged a sub-lease for its new-build deepwater semi-submersible drilling rig that was recently mobilized to the Gulf of Mexico.  The rig will shortly begin sea trials and once rig acceptance procedures are completed the rig will mobilize to offshore French Guiana to drill an estimated three-month-long well for Tullow Oil plc (TLW.L) and its partners.  After drilling the well, the rig will return to the Gulf of Mexico to commence a two-year contract with Cobalt International (CIE-NYSE) the original leasee for the rig.  The original contract will not be shortened by the sub-lease, estimated to be 140 days, but Cobalt gains extra time to try to secure a drilling permit from the Bureau of Energy Management, Regulation and Environment (BOEMRE). 

At the end of last week, Noble Corporation (NE-NYSE) announced that Marathon Oil Company (MRO-NYSE) had notified the company of its intent to declare force majeure on its contract for the newbuild deepwater semisubmersible drilling rig Noble Jim Day due to the company’s inability to secure drilling permits.  A further news report over the weekend suggested that other oil companies were discussing their drilling rig contract commitments with the rig owners due to the lack of drilling permits.

Dave Lawrence, Executive Vice President Exploration for Royal Dutch Shell plc (RDS.A-NYSE), told attendees at the October meeting of the National Ocean Industries Association (NOIA) that while his company was optimistic it would receive deepwater drilling permits to start drilling before the end of 2010 it has been prepared to absorb the cost of keeping rigs and other equipment under contract in the interim.  But he cautioned there would come a time when Shell couldn’t justify spending money on idle equipment and he worried about what that would do to the offshore oilfield service industry’s ability to respond to the granting of future drilling permits. 

A senior executive from Cobalt also presented at NOIA and commented on how the company was not hearing from BOEMRE on substantive issues dealing with the permitting process.  A comment made by a member of the industry panel presenting at the meeting was that the new permitting process was proceeding slowly because whenever a question arises, the review stops and the permit and the question is returned to the company for a response.  Once an answer is provided, the review process then begins anew.  This “by the book” review is slowing the process dramatically.

Mr. Lawrence also expressed concern about Shell’s exploration effort in the Arctic where the company is proposing to drill a well off the coast of Alaska, but has yet to be granted all the necessary approvals.  Sec. Salazar said that the pending lease will be honored, but a drilling permit will not be issued until a new environmental review has been completed along with Shell providing information about how it will meet additional spill response requirements.  Combined, these additional conditions may push drilling back by a year or more.  The delay puts Shell’s investment in Alaska at risk.  So far the company has acquired 400 offshore leases at a cost of $3 billion, yet has not drilled one well. 

We suggested on April 21st while the Deepwater Horizon rig was still burning that the U.S. offshore oil and gas business had been changed forever.  It would never again be what it was before April 20th.  When the deepwater drilling moratorium was put in place, we speculated it would last at least as long as it took for the presidential commission appointed to investigate the causes of the BP Macondo spill to deliver its report and recommendations.  At the time the formation of the commission was announced, its life was to extend until December.  The fact that it took nearly a month to appoint all the commission members, and then several more weeks before its first meeting, the commission’s life span was extended into early January.  We assume it is still on that adjusted time schedule. 

We continued to hold to our original deepwater drilling moratorium timetable, but we failed to consider how political desperation would force the Obama administration to terminate the moratorium early to try to save the careers of some Democratic congressional politicians.  Since there remains a de facto moratorium because no new deepwater drilling leases are being issued, we’re-guessing our timetable for when the industry recovery might start is still pretty much on schedule – the end of 2010 or early in 2011.  Now it looks like the recovery may not start until early 2011.

Given our timetable, we never expected a mass exodus of drilling rigs and other offshore equipment to begin before late 2010.  The next big data point reflecting the health of the industry will be the release of Wall Street surveys of oil and gas company capital spending expectations for 2011.  Just how real will those initial projections be?  We suspect capital budgets will have more contingency plans associated with them than in any year in the recent past; therefore we will view these surveys with a high degree of skepticism.  Unless BOEMRE unleashes an avalanche of drilling permits by year-end, expect the Gulf of Mexico recovery in 2011 to be agonizingly slow.