Commodity Investing

The Risks of Deep Water Drilling

The Risks of Deep Water Drilling

by Tony D’Altorio, Investment U Research
Wednesday, July 28, 2010

The Deepwater Horizon disaster serves as a tragic reminder of oil’s shortcomings.

In particular, it shows how the industry is trying to operate in very tricky conditions when it comes to deep water drilling. As oil executives say, at such depths, the seabed is as remote as the moon. And it has the added threat of much higher pressures.

Yet for all the hazards, production won’t move back towards shore anytime soon.

In the 1970s, oil majors like BP ADR (NYSE: BP) and ExxonMobil (NYSE: XOM) were thrown out of the Middle East. That meant that government entities such as Saudi Aramco and the National Iranian Oil Company has control of 77% of global oil reserves.

That forced private companies to drill in ever-tougher conditions, such as underwater.

The U.S.’s intake of oil has also played its part. With only 2% of the world’s reserves, it consumes over a fifth of its annual oil output…

In other words, BP drilled deep into the Gulf of Mexico because the U.S. wanted it to. Or as Steve Robertson, director of oil consultancy firm Douglas-Westwood, said:

“The oil majors need deep water developments and so does the U.S. They have nowhere else to go.”

The Increasing Importance of Deep Water Drilling

Deep water oil represents a small fraction of global supplies. Yet it gains popularity with every barrel of oil pulled from onshore and shallow water fields.

Lawrence Eagles, JPMorgan’s head of commodity research, says, “A large chunk of the future oil that people have been expecting comes from deep water.” That includes the “golden triangle” of offshore Brazil, Africa’s west coast and the Gulf of Mexico.

The industry expects to spend $167 billion on deep water development from 2010-2014. Douglas-Westwood reports that’s up 37% from the previous five-year period.

Much of that will go towards new technologies. Thanks to previous advances, the industry has been able to access oil it could only dream about five years ago, such as the “ultra-deep” water of 5,000 feet or more it has taken to lately.

But oil companies might have pushed their machinery and know-how too far too fast.

A 2004 report for the U.S. government’s Minerals Management Service highlighted the risk that the rams on the blowout preventer might not work properly in very deep water… exactly what happened with the Deepwater Horizon.

It could have been human error. But it may have simply been that the industry was drilling where it had no business drilling yet.

Deep Water Drilling Costs

Deep water drilling also costs a spectacular amount.

The Deepwater Horizon alone was valued at $560 million. And its Macondo well costs about $100 million, which is typical for the industry.

Yet all of that money was spent to find an oil field expected to hold only a few tens of millions of barrels worth.

The International Energy Agency estimated that deep water oil cost $35 – $65 to extract. And with tighter regulations sure to follow the recent disaster, it should rise even further.

What it comes down to it though, oil companies have very little choice. They can’t have a piece of the more easily accessible fields and they do still profit from deep water drilling.

So the question becomes: How high do oil prices have to rise in order to support safer deep water drilling?

Oil at All Costs?

Unfortunately, many more questions exist on the subject of deep water drilling. And as serious as the Deepwater Horizon accident was, it could have been worse.

What if the explosions had happened on BP’s Thunder Horse production platform? The size of a football stadium, it carries nearly 300 people on board and pumps out 250,000 barrels of oil a day.

Even BP admits that, “Everything about Thunder Horse is at or beyond the limits of the offshore industry’s experience.” That used to sound amazing; now it just seems scary.

Maybe it should have always sounded that way though. Drilling the deep for oil is not easy. And accidents there are even harder to correct.

Many industry insiders have likened BP’s efforts to stopping the broken well from gushing to the Apollo 13 rescue. And just like NASA, BP does have a control center in Houston with engineers staring at screens trying to work with remote craft.

Also similarly, the leaders in charge need to put their differences aside and work together. They need to give the American people the facts about energy and push for conservation.

Of course, the odds of that happening are unfortunately astronomical.

Good investing,

Tony Daltorio

*The views and opinions expressed in this article are those of the author and do not necessarily reflect the official position of Wall Street analysts.

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