Friday, May 7, 2010

Spill backlash could lift drilling cost, oil price

A bill of more than USD 10 billion to clean up oil gushing from BP's US Gulf well could be small compared to costs the disaster adds to producing oil offshore in coming years, enough to push world oil prices higher.

As regulators, oil companies and insurers plot their response to the US Gulf disaster, few experts expect offshore drilling to be halted or sharply cut, given its importance to global oil supply. Deepwater output accounts for around 9% of the world's oil, or double its contribution a decade ago, according to industry estimates.

As drilling procedures go on trial and rules are tweaked to hold the oil industry accountable for disasters, the economics of future deepwater drilling will be at stake.

The offshore oil industry may be in store for a new economic reality, with oil companies seeking to pass along higher costs to customers at the pump.

"There will be a tightening of regulations, potentially raising the cost of finding and developing a barrel of oil in deepwater by 10% to 15%, or USD 5 to USD 10 a barrel," said Edward Morse, a managing director at Credit Suisse in New York.

"We don't expect anything to impede drilling entirely, just delay it and potentially raise costs."

Prospects for tougher offshore standards have analysts and oil companies crunching numbers to determine how they may affect drilling economics, and ultimately world oil prices.

Geologists estimate that more than 100 billion barrels of tappable oil reserves lie beneath ocean floors in deep waters of 1,000 feet (304.8 meters) or more, accounting for about 10% of the earth's remaining usable crude. Advances in seismic imaging since the 1990s also make subsea reservoirs the most likely deposits yet to be discovered.

The barrels are central to oil supply fron non-OPEC countries, located in regions like the US Gulf, Brazil and Africa that often welcome tech-savvy Western oil companies willing to spend billions to bring the oil to market.

Deepwater oil is deemed "marginal production" because it is cost-effective only when oil prices are high. It is key to meeting spikes in world demand when oil from OPEC's mostly onshore fields is not enough. Because of this, the cost of deepwater oil can exert outsize influence on world oil prices.

"Are costs going to rise? Absolutely. Will it hurt oil producers? No, because they are going to pass the costs on to consumers," said Brad Samples of Summit Energy in Louisville, Kentucky.

US Interior Secretary Ken Salazar is expected to report on measures needed to cut the risk of future oil disasters by the end of May. Plans to offer drilling leases in several new US offshore areas, which the administration recently approved, could be scaled back or canceled.

Salazar's report could mobilize US lawmakers to enact new offshore standards, while a torrent of new liabilities may also raise costs.

The price of added safety components for oil rigs — like a USD 500,000 acoustic remote control to activate blow-out protectors and plug leaks when all else fails — is tiny in relation to multibillion dollar offshore projects. But new gear may be just the tip of the iceberg.

Since Brazil and Norway already require the remote controls, concern over more lax standards in the US offshore patch may prompt a broad overhaul of US regulatory agencies, according to a Bernstein research note.

Add up higher regulatory hurdles, long safety reviews, more manpower and soaring insurance premiums for offshore projects, and the run-up in costs may be large.

133-fold liability hike

The White House and US lawmakers have pledged to review a law that limits oil companies' liabilities, apart from spill clean-up costs, to USD 75 million, potentially raising them 133-fold to USD 10 billion.

"If that is approved, it will have a dramatic effect on insurance costs," said Morse.

As global oil demand rebounds following the worst economic slowdown since World War II, oil prices have been trading in the USD 75 a barrel range , more than double their price in late 2008, amid the worst of the crisis. Near-term oil futures have fallen more than 9% since the sinking of the Transocean Horizon rig, which was not pumping commercial crude.

But the futures curve for oil prices indicates that some traders may already be factoring in new costs that could make crude more costly down the line.

"Longer-dated oil prices should rise because of this event (spill), since they would reflect the higher cost of getting those barrels out of the ground," Samples said.

US crude futures for delivery in five years from the near-term delivery contract on Thursday traded at a premium of USD 15.16 to prompt barrels. The premium was only USD 8.94 a barrel on April 19, the day before deadly explosions rocked the rig and triggered the spill.

Subsea elephants

US offshore crude production is near 1.6 million bpd, or just 2% of the world total, but gains in the area recently halted a multi-year slide in US production, and the Gulf serves as a world nerve center for drilling technology.

The biggest multibillion-barrel oil discoveries in recent years, known in the industry as "elephants," have occurred in deep and ultradeep water areas.

Analysts estimate Brazil may need USD 400 billion to USD 600 billion to develop its newly discovered ultradeep reservoirs over the next decade. Norway and other producers want to expand offshore drilling in the Arctic, while companies are probing leagues under the sea off Africa.

"To the extent that marginal costs rise here, you'll get higher production costs everywhere, in Brazil and Angola and wherever the deepwater play is happening," Samples said.

BP, whose US activities are concentrated offshore, is the country's biggest oil and gas producer with around 400,000 barrels oil equivalent a day.

According to Morse, current regulations, taxes and royalties in the deepwater US Gulf — along with rig-lease costs that have more than tripled since 2003 — mean that

finding and developing new oil there already costs USD 45 to USD 50 a barrel.

A drop in the rate for deepwater rigs — which can cost more than USD 500,000 a day to lease — could still limit any higher drilling costs, Morse added, since a big batch of new rigs is set to become available soon.

Today, many producers are only compelled to build new deepwater projects when oil prices are projected to top USD 60 a barrel.

"I think we are in for a slowdown, particularly in the ultradeep water areas," said John Brodman, a former US energy official and consultant for The Abraham Group LLC.

"It's already some of the highest production cost area in the world, and this may take some prospects off the table."

Clampdown coming

BP and others may have to foot a clean-up and liabilities bill of more than USD 14 billion related to the spill, according to Bernstein analysts.

Experts are examining whether equipment failures or well-cementing practices contributed to the disaster, which could raise liabilities for BP's contractors.

The so-called industry-loss to insurers and reinsurers from the spill may be USD 800 million to USD 1.5 billion, according to a report by UBS insurance analyst Brian Meredith.

Premiums may rise as insurers such as Lloyd's seek to recoup the losses, and analysts say offshore operators may seek broader coverage amid higher liability risk.

Drillers may also face higher fees as the U.S. government bolsters a $1.6 billion federal "superfund" that provides aid to areas affected by oil spills. Oil companies now contribute around 8 cents for every barrel produced.

Growing public ire against Big Oil may translate into yet more costs. Even before the spill, the Obama administration had asked lawmakers to consider ending an estimated $36.5 billion in tax breaks and subsidies to the oil industry, transferring some of them to alternative energy producers.

As spilled oil encroaches on environmentally sensitive beaches and wetlands across the US Gulf Coast, the regulatory fallout may even hit natural gas producers on land.

Environmental regulators are already reviewing the practice of onshore hydraulic fracturing for shale gas. Bernstein analysts said suspicion of the oil industry may prompt more scrutiny of the technique, also called "fracking," which has boosted natural gas production but draws concerns over potential groundwater contamination.

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