"Risk is what's left over when you think you've thought of everything else." – Carl Richards in The Behavior Gap.
Photo credit: Royal Dutch Shell Flickr page.
The Arctic is thought to be the last great undiscovered frontier for the oil and gas industry. It is estimated that 22% of the world's undiscovered conventional oil and natural gas resources lie deep within the region. It's a truly enormous prize that has drawn the eye of practically every major oil company in the world.
Unfortunately, for Royal Dutch Shell (NYSE: RDS-A)(NYSE: RDS-B), it appears to have picked one of the spots where there simply is no commercially viable hydrocarbons as its Burger J well has come up dry. It's a major disappointment for the company, its shareholders, and the promise of finding a new oil frontier. The company, which faced intense opposition from environmentalists over its Arctic drilling program, had invested upwards of $7 billion on its exploration program in the region. However, it has now plugged that well and will abandon its Alaskan Arctic exploration program for the foreseeable future.
The prize
Shell has been attempting to drill exploration wells in the Arctic for years. The company first set a stake in the ground in 2008 when it bid big to win exploration blocks in the Alaskan Arctic. It didn't start its initial drilling until 2012, but that program ended in failure after one of its vessels ran aground. The company vowed to come back despite intense opposition from environmentalists that warned that drilling in the Arctic couldn't be done safely. However, Shell pressed on due partially to the fact it had sunk so much money into the program already.
The other reason it pressed on despite the opposition is because the potential prize was so big. While there are several potential oil and gas basins still waiting to be discovered, the biggest of the Arctic prizes, in terms of oil, is thought to lie within the Alaskan Arctic. The U.S. Geological Survey estimated in 2008 that nearly 30 billion barrels of technically recoverable crude oil could be found and developed in the region. That's an enormous resource, and for perspective the current proved crude oil reserves that lie underneath the entirety of the United States is estimated at 36 billion barrels. Given the enormity of that prize, it's no surprise to see big oil giants such as Shell fight so vigorously for the right to drill in the region. In fact, the company estimated that at its peak the Arctic would be 10 times greater in size than what the North Sea has produced so far.
The risk no one anticipated
Given the enormity of the potential, the focus had been on the risk of actually finding oil and there being an oil spill. Much of the recent delays had been due to approving an oil spill response plan as a spill in this region could have been an environmental catastrophe as the weather conditions would make a clean-up very hard, which could have made the region's fragile environment devastated beyond repair. However, it turned out that an oil spill wasn't the biggest risk facing Shell.
Oil spill response training in Alaska. Photo credit: Royal Dutch Shell's Flickr page.
Instead, that risk was coming up dry in a region that was thought to be bursting at the seams with oil and gas resources. This is after the Burger J well only showed traces of oil and gas and not a hydrocarbon rich column that it was expecting to find.
It's a risk that could cost Shell upwards of $4.1 billion in impairment charges as it could write-off the $3 billion value of its landholdings in the region. Further, the company has $1.1 billion in contractual commitments for its drilling rig and other equipment that the company now needs to find other uses for as it presses pause on its Arctic exploration program. That's an enormous amount of money for a company that's already struggling under the weight of a 50% drop in crude prices. In fact, it represents more than the company's entire net profit of $3.4 billion last quarter.
Investor takeaway
Offshore drilling is a very risky venture for oil companies as it's enormously expensive and the industry's exploration success rate has been less than 50% in recent years. As Shell's missteps show, the costs can add up rather quickly and can cost shareholders dearly. Having said that, the prize, which is a bounty of oil and gas resources, is often too tempting to pass up. That's why it's unlikely that we've heard the last of Shell's attempts at finding oil in the region as that oil will be needed by our energy hungry world at some point in the not-so-distant future.
