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Why Shell Isn’t Giving Up On The Arctic Just Yet

Introduction

As summer approaches, Arctic sea ice will start to melt away. That will open up the region for oil and gas exploration. In American waters, Royal Dutch Shell (NYSE: RDS.A) is the only company braving the remote location and unique conditions in the Arctic.

Shell is not new to Alaska – it drilled the state’s first offshore oil field in the Cook Inlet in 1963. The company moved onto the Arctic in the late 1980s, drilling in the Chukchi and Beaufort Seas only to abandon them after a few short years due to their high costs amid a period of low oil prices.

But Shell returned in a big way in the mid-2000s, buying up the rights to a lot of acreage offshore Alaska in 2005 and 2007. After several years of preparation and delays due to regulatory hold ups and sea ice challenges, Shell took the plunge in 2012. The year was plagued by mishaps and false starts. Shell narrowly escaped without a major disaster, after its drill ship ran aground during a rough storm.

After a cooling off period, Shell is back at it again, gearing up for the summer of 2015 to finally get things right.

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Exploration Plan

The Arctic near Alaska is thought to hold nearly 30 billion barrels of oil and over 221 trillion cubic feet of natural gas. Shell snatched acreage in both the Chukchi and Beaufort Sea, spending over $2 billion on Chukchi leases alone. It will limit its drilling focus to the Chukchi for now. The map below shows Shell’s acreage off the northwest coast of Alaska, depicted in orange.

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It’s all about the Burger

Shell is targeting the Burger prospect. Shell drilled its first well in the Burger prospect in 1989 and 1990. Despite encountering significant reserves of gas, Shell plugged the well and closed up its operations. But now that it is returning to the Arctic, Shell once again has the Burger at the top of its list.

Environmental group Oceana argues that the economics of Shell’s entire Arctic campaign – which for now, is limited to the Burger prospect – hinge on the possibility of finding a very large oil deposit. Oceana points to comments made by Shell’s CFO on the earnings call for the third quarter of 2013. Discussing project economics, CFO Simon Henry said “That allocation to Alaska will be…it’s a bit of a binary outcome, there is either bigger oil there or there isn’t,” he said. Backing up their claim that the Burger is not economical, Oceana points to a government study that found the Burger a highly speculative play. “Even under a very optimistic set of assumptions, Burger is a marginal development opportunity,” the now-defunct Minerals Management Service concluded in 2004.

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Still, much has changed since then. Oil prices are much higher than they were at the turn of the 21st century. More importantly, technology has come a long way. Shell has conducted more granular surveys of the area, and has a better understanding of what it is looking for.

Oceana concludes that the Burger prospect will yield a negative cash flow of $23.5 billion, assuming $32 billion in construction costs, $11 billion spent on drilling, and $7.5 billion spent on transit infrastructure. However, the group ignores the possibility that oil is indeed found at the Burger, which would upend that calculation.

Shell does feel confident about its chances. The “Burger J” well appears to be the one that Shell is the most confident about. It estimates that it would have an initial daily flow rate of 23,100 barrels. There are several other drill sites that Shell believes will be very prolific. See the table below, which Shell submitted as part of its exploration plan to federal regulators.

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Obstacles

Shell’s drilling ship, the Noble Discoverer, failed a Coast Guard test in April, forcing engineers to scramble to repair some parts. The equipment that separates out oil from water, which allows drillers to avoid having to dump polluted elements back into the ocean, was not working properly. Noble Corp. (NYSE: NE), the owner of the ship, was fined $12.2 million for a similar problem in 2014. The issue is a minor one, but after the error-ridden campaign in 2012, the incident does not exactly inspire confidence.

Shell will have to overcome another unexpected hurdle along the way. Environmentally-conscious activists in Seattle and their allies in the municipal government have objected to the storage of several of Shell’s drilling ships and support vessels. That came as a huge surprise. Seattle offers a good base for operations for drilling the Arctic, and has hosted ships for years. But with a new emphasis on greenhouse gas emissions, environmental groups are denouncing Shell’s Arctic campaign as a disaster for the climate. The pressure has apparently reached Seattle’s government, which just ruled that Shell will need an additional permit to store its vessels in the city’s port. A new regulatory review of the permit could delay Shell’s operations by a few crucial weeks.

But speaking at the Offshore Technology Conference in Houston on May 5, Shell’s executive vice-president for the Arctic issued determined remarks. Ann Pickard said now “is the right time for exploration,” the strongest comments yet regarding Shell’s drilling intentions. The Arctic offers the possibility of massive reserves in shallow water, which could provide Shell with a stable, long-term production base. Unlike highly sought-after onshore shale reserves, offshore production provides predictable long production profiles that don’t fizzle out after their first year of production the way shale drilling does.

Next Steps

Several of Shell’s ships, including the Polar Pioneer, are scheduled to arrive in Seattle by mid-May for refurbishment. They will have a few weeks to prepare for their departure to Alaska. Shell will need to find a workaround for its permitting problem with Seattle. Meanwhile, it is awaiting a final permit at the federal level from the Department of Interior, an outcome that is more likely to come out in Shell’s favor.

But to put things in perspective, drilling the Burger prospect in 2015 and then moving on to drill more wells in the Arctic is a long-term proposition. The first flows of oil will not begin until sometime in the next decade. That is why Shell has been so persistent and is willing to brave the risk even though oil prices are so low. Oil markets are oversupplied right now, but ten years from now Arctic oil will probably be needed.

Moreover, by drilling now, Shell can take advantage of the deflationary environment in the oil industry. Low oil prices lead to lower drilling costs, and Shell can put savings in the bank by finding cheaper drilling equipment, services, and other construction materials. Sometimes the best time to drill a long-term project is during a downturn.

Conclusion

The Arctic is one of the riskier projects that Shell has in its portfolio. But it is also one with arguably the largest upside. Shell is transitioning into a more “gassy” company after its purchase of BG Group (LON: BG), which, if approved, will leave Shell much more invested in natural gas and LNG relative to its makeup before the deal.

But the Arctic gives Shell a foothold in one of the last and most vastly underexplored oil basins in the world. The company is still smarting from its 2012 campaign, but assuming it has worked out the kinks, it could hit a big payday with stable, long-term oil production in the Chukchi Sea.




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