Monday, June 28, 2010

Deep waters obscure case for oil investment

The damage inflicted on the BP share price since the Deepwater Horizon rig exploded nine weeks ago has been well documented. What has been less remarked on is the performance of its peers, which has been remarkably resilient.

While BP has lagged the London stock market by 47 per cent since the spill, Royal Dutch Shell has underperformed by just 1 per cent and BG has outperformed by 4.6 per cent.

That sanguine reaction is surprising because the disaster in the Gulf of Mexico has raised many questions about the oil industry and the risks of investing in oil companies.

At the very least investors should now be more wary of investing in a sector where a company the size of BP can see its share price halve in a little over two months and come under such political pressure that it feels the need to halt dividend payments and set up a $20bn compensation fund.

Clearly, big oil is no longer the dull, defensive sector it once was. Indeed, the BP share price has been trading like a penny share in recent weeks.

The Macondo spill has also highlighted the importance of deepwater exploration, which has been responsible for some of the biggest discoveries of recent years, such as the Santos Basin in Brazil.

Deutsche Bank estimates that, in the past 15 years, deepwater drilling has been the source of some 60bn barrels of so-called P2 reserves – reserves that oil companies are 50 per cent confident of producing economically. The bank also reckons deepwater exploration will account for 10 per cent of global oil production for the period from 2008-15 and is central to the industry’s ability to meet global demand for oil.

But BP’s inability to stop the flow of oil from Macondo raises questions about future costs, timelines and the depths oil companies will be permitted to drill to.

Norway has already said it will not allow any deepwater oil and gas drilling in new areas until the investigation into the explosion is complete, and the US government wants a six-month moratorium on deep-water drilling reimposed. Clearly an outright ban on deepwater drilling is unlikely for energy security reasons, but it seems certain that deepwater exploration will cost more, in the Gulf of Mexico at the very least.

Greater safety standards for equipment, additional fail-safe systems and better spill collection capacity will all result in higher costs. A sharper focus on clean-up costs could also lead to higher taxation as governments create funds to deal with environmental consequences of another Macondo.

But more important than the costs, which are manageable, is that future deepwater projects will take longer to develop and bring on line. In this respect, it is worth noting that deepwater exploration is set to become a very important source of growth for BG due to its exploration success offshore Brazil. Deutsche Bank estimates a third of BG’s P2 reserves are in deepwater.

Shell has a more diversified portfolio and most of its important developments – the Pearl gas to liquids plant in Qatar and Canadian oil sands – do not involve deepwater drilling. Even so, it still has material operations in the Gulf of Mexico. As for BP, its operations in the region accounted for almost 10 per cent of its total production, according to UBS.

Smaller exploration and production (E&P) companies such as Cairn Energy and Tullow Oil have steered away from deepwater drilling but, as Matrix Corporate Capital notes, Tullow’s Jubilee field offshore Ghana is in about 1,500ft of water and Cairn’s Greenland acreage is at about 1,000ft. “Even this water depth will still prove an enormous challenge in potential disaster recovery, if the equipment is not in place quickly and on a large enough scale.” So, even E&P companies will feel the impact of the spill.

Until there is greater clarity on the cause of the Macondo disaster it is difficult to assess how hard the industry will be hit. However, it seems likely that recent events in the Gulf of Mexico will cast a long shadow over the oil industry for years to come.

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