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1 Way Shell Shouldn't Emulate ExxonMobil

It's often said that the definition of insanity is doing the same thing over and over again but expecting different results. So what should we make of Royal Dutch Shell's (NYSE: RDS-A  ) decision to return to the Chukchi Sea? Is this pure folly, or is there method in Shell's madness?

A comedy of errors
Shell's history in the Chukchi Sea reads like a rap sheet. Shell reached a settlement with the U.S. Environmental Protection Agency this September under which the company paid out $1.1 million for violations of the Clean Air Act. EPA cited "numerous violations" of Shell's air permits.

In a detailed report, EPA said that Shell had continued its Arctic activities despite management's awareness of technical problems. The report also questioned the security of Shell's post-accident oil collection and its control of air pollutant emissions, and said that the company had failed to manage its contractors.

Earlier this year, Shell suspended its Arctic offshore drilling program in the Chukchi and Beaufort Seas for the remainder of the year. While the company tried to sell this as a strategic and responsible move, the fact is that it had no choice after its Kulluk rig had run aground the previous December. A U.S. Department of the Interior inspection of Shell's Alaskan projects revealed more than a dozen deficiencies on the Kulluk, and generally concluded that the company was not in a position to drill safely in the Arctic.

David Lawrence, the executive vice president who was directly responsible for Alaskan operations, left his position in March by "mutual consent," according to the party line. Industry insiders speculate that Lawrence was fired, having become a scapegoat for potentially broader problems within the company.

A company of constant sorrow
Shell has had a tough time overall lately. The company's profits declined by almost 32% in the most recent quarter. About one-fifth of its earnings vanished into thin air, due in large part to a huge writedown on its North American shale assets. Shutdowns in Shell's Nigerian operations -- which the company has botched for years -- continue to cost Shell dearly. And with current CEO Peter Voser's plans to step down by the end of this year, Shell has succession plans to consider.

Shell is not alone in its difficulties. ExxonMobil (NYSE: XOM  ) , an old hand at Arctic drilling, has long clashed with environmentalists over its partnerships with Russian interests. Activist groups such as Greenpeace say that ExxonMobil's partners, including Gazprom and Rosneft, have outdated infrastructure and pose a particular accident risk that could threaten pristine ecosystems. The ongoing case of Russia's imprisonment of Greenpeace activists for their protests of Arctic drilling continues to shine an uncomfortable light on ExxonMobil.

Further still, Exxon also posted sharp profit declines in the third quarter, down 18% from the previous year. This was due in large part to sectorwide problems of rising costs and exploration charges. Taking all this into consideration, you might think that Shell wouldn't be itching to follow in Exxon's footsteps.

Where angels fear to tread
Quite the contrary, Shell has decided that this is a brilliant time to revive its Chukchi operations, which it expects to do in 2014. CFO Simon Henry characterized the Chukchi plans as "the single largest exploration prospect in the Shell Group." Shell will have to make do without the albatross of its Kulluk rig, which the company has finally acknowledged is barely worth its value in scrap. That means another write-off in the fourth quarter of a few hundred million dollars, but, hey, who's counting?

It all raises the question: Can Shell really concentrate hard enough on a project this important, especially given the sheer number of eyes that will be trained on the company? Regulators, environmentalists, and long-term investors will all be watching intently for the slightest slip.

Meanwhile, Shell's challenges are daunting. According to a rich analysis in the Alaska Dispatch, several serious issues loom large.

  • Because the Kulluk is toast, Shell must substitute a new drill ship, which means it needs a new exploration plan, which will require renewed approval from the Bureau of Ocean Energy Management, or BOEM.
  • Shell will need new permits, not only to operate around protected marine mammals but also for air emissions. Shell and its air permits have not had a good history.
  • The BOEM will be issuing new Arctic-specific rules for oil and gas activities by year's end. We don't know what they'll say, but the rules are a specific response to Shell's Kulluk fiasco.
  • The U.S. Coast Guard is still pursuing its own investigation of the Kulluk calamity, and it remains possible that this will lead to further legal action.
  • A pending court case questions the legality of the lease sale that allowed Shell to enter the Chukchi in the first place. A decision is due anytime now, and it's possible that it would invalidate Shell's lease altogether.

As if that weren't enough, Greenpeace has now trained its guns firmly on Shell because of its association with the detained activists in Russia. The environmental organization launched a series of protests at Shell stations around the United Kingdom this past weekend, and intends to increase pressure on the company.

Cause for pessimism
Taken together, this story should be enough to give investors pause. It looks to me as though Shell is striking from a position of weakness, stretching itself entirely too thin at a time when it should be getting its house in order. Time will tell, but I think a 2014 return to the Chukchi will prove to have been a mistake.

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9/27/2016 11:24 AM
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