Iceland’s Offshore Oil Potential

In 2012, following several years of economic crisis, a mountain of debt, and ultimately a currency crisis, Iceland was looking for ways to diversify its economy. The tiny island-nation had become massively overextended into international finance, and needed to develop other industries.

Add to that the fact that Iceland is a huge importer of fossil fuels. The volcanic island is abundantly rich in energy resources that can be used for electricity. It has more geothermal and hydropower than it knows what to do with, making its electricity sector one of the cleanest in the world. However, it hasn't developed indigenous fossil fuel resources, forcing it to resort to costly imports for its transportation sector. As a result, there is a big motivation in Reykjavik to develop offshore oil and gas.

Another Arctic Producer?

Iceland would be one of a just a handful of countries looking to drill above the Arctic Circle. Royal Dutch Shell (NYSE: RDS.A) is currently drilling an exploratory well in the American Arctic. Russia's state-owned firms are further along in their Arctic territory. Norway's Statoil (NYSE: STO) is also drilling in the far north.

There are good reasons to think that Iceland has oil and gas potential. The key reason is the Jan Mayen Ridge, which once connected Greenland and Norway. Around 55 million years ago, the seafloor began separating, which pushed East Greenland, Western Norway, and the Shetland Islands away from each other. The tectonic shifts created the island of Iceland. Since the oil-rich areas of Norway, the North Sea, and Greenland share a geological past, it would seem plausible that Iceland - in the middle of these oil-producing regions - would also be well-endowed with hydrocarbon resources.

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Iceland's neighbors have been oil and gas giants for decades. Norway has had enormous success in producing oil and gas in the Barents and Norwegian Seas. Statoil has become a global offshore oil colossus. To the southeast, British firms, led by BP (NYSE: BP) have been producing in the North Sea for over forty years. Greenland too has demonstrated hydrocarbon potential, although tapping the reserves has proved to be much more difficult.

Iceland's Turn

With a related geological history, Iceland is beginning the search for its oil and gas reserves as well.

The most promising area for oil and gas exploration is in the Dreki (Dragon) region, located along the Jan Mayen Ridge where the other oil-producing countries in the region emerged from millions of years ago. If Iceland can find source rocks, the oil and gas would be highly matured, and potentially significant.

Following the financial crisis, Iceland wanted to develop its economy. But it wasn't until oil prices rebounded and spiked in the years between 2010 and 2012 that momentum picked up, as frontier oil became worth the risk.

In 2012 Iceland auctioned off blocks, with one license awarded to a joint venture between Faroe Petroleum (LON: FPM) and Iceland Petroleum. Another license was won by Ithaca Energy (LON: IAE) and Kolvetni, an Icelandic firm. Norwegian state-owned company Petoro holds a 25 percent stake in each license, due to agreements between Iceland and Norway on territorial management.

Ekyon Energy, along with its partners, won an exploration license last year. Ekyon holds a 15 percent stake, with positions held by China's Cnooc (NYSE: CEO) (60 percent working interest), and Petoro (25 percent).

As a side note, China's oil companies are always looking for exploration opportunities, but consider access to the Arctic as a strategic priority. According to the U.S. Geological Survey, the Arctic could hold 90 billion barrels of oil, most of which is untapped. China is obviously not an Arctic country, but to gain access, China has made Iceland a key partner, and the two signed a free-trade agreement in 2013. Cnooc's partnership with Ekyon and Petoro is consistent with China's pursuit of the Arctic.

Earlier this year Faroe Petroleum decided to relinquish its license after its exploration results disappointed. The company said that too much basalt (lava) stood in the way of finding potential oil reserves. That was a setback for Iceland's prospects, but it did not dispel the existence or viability of Dreki's oil and gas potential.

With Faroe throwing in the towel, that leaves two licenses. The 2013/02 license (Ithaca and its partners) and the 2014/01 license controlled by Ekyon and Cnooc.

The companies interested in the Dreki are conducting seismic data, which could be conclusive within the next year or so. After that, exploration could begin.

In addition to the Dreki region, Iceland also holds out hope for Gammur, another potential oil and gas region on the continental shelf. An environmental assessment is still underway for Gammur, so no licenses have yet been issued. As a result, the Gammur is much more hypothetical as an oil and gas producing region at this point.

Obstacles

Of course, like any frontier region, the costs are high. The Dreki region is remote, and a lot of infrastructure still needs to be built up in Iceland to scale up development. With oil and gas companies repeatedly taking the axe to their spending programs, few have the luxury of spending a lot of money on a risky new venture.

Moreover, drilling will be in deepwater. At 3,000 meters of depth (similar to offshore Brazil, West Africa, or some Gulf of Mexico prospects) drilling costs will be high.

Iceland has one interesting climate feature that works in its favor. Although Iceland is targeting potential oil and gas reserves north of the Arctic Circle, due to the dynamics of the Jetstream, which brings warmer water from the south, its waters are ice-free all year. This greatly eases the technical issues, especially compared to, say, Shell's project off the coast of Alaska.

Exploration companies won't have to deal with sea ice in the way that Shell or Russian companies have to, but drilling won't be a cakewalk either. The remoteness and the depths will raise costs. How companies will carry out development is unknown at this point, but a few studies have considered the possibility of subsea production with tiebacks.

Furthermore, the seismic and geological knowledge of what lies in the Dreki is still thin. Much of the excitement is based off of studies conducted in the late 1980s that showed modest oil and gas potential.

Conclusion

Iceland, like its neighbors to the east, west, and south, could have sizeable oil and gas reserves.

However, it will take at least a decade following the start of exploration before first oil comes online. And unfortunately, given how undeveloped it is at this point, offshore Iceland will likely require a higher oil price to be economical. The Icelandic government rightly points out that production will last decades if the industry can get going, making the current price slump not entirely relevant. In fact, exploration costs could be lower with deflationary pressure across the industry.

However, the big question is if companies will be willing to even get started, given the extreme caution during this period of incredibly low oil prices.