The Gulf of Mexico accounts for 27% of U.S. oil and natural gas production. The shallow water on the continental shelf has been a prolific producing region for several decades. Drilling technology has opened the deepwater regions (up to 10,000 feet water depth) of the Gulf, where the Minerals Management Service (MMS) estimates reserves equivalent to 56 billion barrels of oil. Furthermore, the Gulf of Mexico has ports designed to accommodate supertankers with crude oil from world markets. The result: 46% of U.S. refining capacity is located near the Gulf of Mexico.
Unfortunately, this concentration of our energy infrastructure lies in the hurricane zone. To estimate the potential disruption to the industry, we can turn to two government agencies: the National Oceanic and Atmospheric Administration (NOAA) and the Energy Information Administration (EIA). NOAA predicts the intensity of the upcoming hurricane season using the Accumulated Cyclone Energy (ACE) index and estimates the number of tropical storms and hurricanes. Using this information, the EIA has developed two models to estimate the impact on the oil and gas industry surrounding the Gulf, and compiled them into this report, which is summarized in this week's petroleum report from the EIA.
Hurricane forecast
The current Atlantic ACE index is expected to range from 118 to 179, which corresponds to hurricane activity at 135% to 205% of the normal level. This is considerably lower than the level of 280, which occurred last year.
The ACE index, however, is based on conditions that are evolving. For example, in 2005, the May ACE forecast was lower than the current level and was revised upwards in August before Katrina. Actual storm activity after Rita and Wilma ended in the upper end of the revised range. If the current ACE index is not revised, there is an 80% chance of an above-average tropical storm season.
In addition to the ACE index, NOAA predicts the number and intensity of tropical storms. Using current data, NOAA predicts 13 to 16 named tropical storms. Of these, eight to 10 are expected to become hurricanes, with four to six being major hurricanes (Category 3 or higher). Again, these predictions will likely evolve as climate conditions change through the summer.
Impact on oil and gas industry
What we find is that 2005 was an exceptionally bad year. Both offshore oil and gas production, along with onshore refining, were severely impacted far beyond annual norms. Offshore, as hurricanes approach, personnel are evacuated, drilling platforms are secured, and the well head is plugged, resulting in "shut in" production. Onshore, refineries are shut down and secured, and personnel are evacuated.
As Katrina approached, 95% of the Gulf oil production and 88% of natural gas production were shut in. When Rita approached, 100% of oil production and 81% of natural gas production were shut in. In a normal year, temporary shut in production is a small fraction of annual production -- only 1.4% of oil and 1.3% of natural gas. In 2005, annual production losses totaled 19% of oil and 18% of natural gas. The damage has not yet been repaired. Year to date, 30% of oil and 21% of natural gas production has been shut in.
In the refining sector, damage in 2005 was without parallel. Looking back to 1985, the lowest refinery utilization rate on the Gulf Coast prior to 2005 was about 93% as a result of Hurricane Georges in 1998. After Katrina and Rita, Gulf Coast refinery utilization fell below 75% for both September and October. ConocoPhillips (NYSE:COP), Chevron (NYSE:CVX), Murphy Oil (NYSE:MUR), and others experienced significant damage and lost production.
Conclusions
The hurricanes of 2005 caused unprecedented damage to the oil and gas industry, both offshore and onshore. In the previous 20 years, hurricanes had caused temporary disruptions to oil and gas production and very little impact on the refining sector. There are climate models that suggest we are in a natural 30-year period of above average hurricane activity. Data correlating the impact of hurricanes and oil and gas production does not date back to the previous 30-year period. If the 30-year period model proves accurate, we do not know what may become the "norm" for shut in production or refinery shut-downs.
As an investor, I would be very careful to make investments based upon hurricane forecasts. Does it make sense to buy marine contractors like OceaneeringInternational (NYSE:OII) because their business has benefited from hurricane repairs? No, although there are plenty of other reasons to place this company on your watch list. On the other hand, reinsurance companies like Montpelier Re (NYSE:MRH) have been beaten into the ground because of fears that extremely powerful hurricanes will cause billions in losses again this year. With the bargain price, I'm willing to take the odds that higher rates, tighter policies, and random chance will allow Montpelier Re to survive 2006 and beyond.
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Robert Aronen owns shares of Oceaneering International and Montpelier Re. Please feel free to email him with comments . Fool disclosure rules are here.
