Oil Slickonomics – Part 7

David R. Kotok
Chairman and Chief Investment Officer
Oil Slickonomics – Part 7
June 6, 2010

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“The oil industry’s experience base in deep-water well control is limited.” A massive oil spill “could easily turn out to be a potential show stopper for the (outer continental shelf) program if the industry and MMS do not come together as a whole to prevent such an incident.” Source: May 2000 draft statement of environmental analysis by the Interior Department’s Minerals Management Service (MMS). According to Newsweek (June 7) the statement was “dropped” in a subsequent draft. In 2005, MMS adopted regulations that assumed the oil companies could best evaluate environmental impacts. This legacy of the Bush-Cheney administration was continued by the Obama-Biden administration and led to a proposal to expand deepwater drilling by President Obama earlier this year. Everything changed on April 20.

“Can we as a society explore for oil and gas in safer and more reliable ways?” This was asked by BP CEO Tony Hayward in his Wall St. Journal op-ed on June 4. That question will frame the national debate to be held in the United States for, at least, the next two election cycles. It will certainly be the most important item this November in the five states bordering the Gulf, and may also have profound importance in the states on the eastern seaboard of the US if the oil spill gets into the Gulfstream.

At this instant the answer that American politics are giving to Hayward’s question is “no.” That answer is likely to continue to be “no” until after the Deepwater Horizon well is sealed by the relief wells and after the damage from the oil slick has peaked in impact and become old news. Until then we cannot see how any American politician can be elected or reelected if she or he answers this question “yes” when it comes to drilling for oil in deep water.

President Obama has reversed his offshore drilling initiative in face of the facts unfolding in the Gulf of Mexico (GOM). States like California have reversed their view that offshore drilling would gain them needed revenue (per Governor Schwarzenegger). Politics currently determine that the prospective revenue gained by a seacoast state is not worth the cost and the risk of an accident. Deepwater Horizon is the equivalent for oil of Three Mile Island and what it did to nuclear power. Three Mile Island is the political metaphor we are using. We have argued it in our writings and on CNBC (the June 2 segment anchored by Michelle Caruso-Cabrera is posted on www.cumber.com ).

This oil disaster is now a five-state affair. Florida has joined Louisiana, Mississippi, and Alabama in experiencing direct damage to coastline, cancellations of tourism, closure of fishing, etc. The fifth GOM state has been spared from direct spillage so far. It is still at risk depending on currents, winds, and events to unfold during hurricane season. But Texas is now impacted economically because of the drilling moratorium in place. In the rest of this chapter of “Oil Slickonomics” we intend to focus on the moratorium. It is driven by politics.

Right now all drilling in the waters of the United States has been stopped. Wells that are in the middle of drilling operations have been directed to stop once they can do so safely. A commission is being assembled to study the situation and make recommendations within six months. Notice the convenience of the politicians receiving the reports after the November elections. That allows them to duck any actions, accountability, and hard decision making by saying that they are waiting for the commission reports. The commission can also take their time because the ongoing GOM disaster has not run its course. Thus the commission will have the option of waiting to obtain more information as events unfold. Delay of a commission report is a normal political tactic, as is timing the report to follow an election cycle. We see no reason why this one will be any different.

Let’s distinguish between deepwater, which is the subject of the commission and the moratorium, and shallow-water drilling, which is technically not within the commission’s scope.

Shallow-water first; it has been defined in the moratorium as 500 feet. Drilling to that depth is not covered by the six-month Obama moratorium. But it has been stopped anyway by a procedural shift announced by the Interior Department’s Minerals Management Service (MMS). MMS ordered that all permitted and approved shallow-water drilling plans must be resubmitted with “additional information about potential risks and safety considerations.” MMS has 30 days under present law to respond. It also has fifteen days to review an application for completeness before the 30-day response period starts. MMS is proposing that timetable be extended to 90 days; the extension requires Congressional approval since the 30-day rule is in the present law.

Details of what the new requirements will be were not available at the end of last week. They are expected any day. Last week no driller or explorer in shallow water knew what to submit in order to comply. One driller’s permit for a well in 130 feet of water was rescinded last Thursday. The company was about to start drilling. They do not know what to do and can only await the new rules.

The Interior Department indicated that the new regulations will include blowout preventer requirements and contingency plans for worst-case scenarios. The Washington Post reported that “Shallow water rig operators argued that their risks are different from the deepwater drilling that led to the giant spill now fouling the Gulf. Jackup rigs stand on the sea floor and the blowout preventers are positioned on the rig decks, unlike the malfunctioning one Transocean and BP were using a mile below the water surface. In addition, the rigs are drilling in familiar territory since shallow waters have been explored since the 1950s. Much of the new drilling is tapping into natural gas reservoirs left behind by companies more interested in oil in the past.”

We can estimate the impact on shallow-water drilling that is not covered by the moratorium but is stopped by administrative procedures. There are 40 jackup rigs presently scheduled to drill or now drilling in the GOM; 31 more are available. Each of the rigs employs over 100 people on average. They are supported by service providers who also employ hundreds of people. The rigs are usually leased for shorter terms of 15 to 30 days. GOM lease rates for jackups vary by depth and are averaging about $70,000 a day (range $32,000 to $110,000). The rents are due to the companies, and the intervention by MMS triggers large monetary losses and may impose risk on the financing sources. We expect lots of litigation over this shallow-water drilling procedural halt development. Note that possible changes in the liability structure of drilling may render many jackup rigs uninsurable.

The deepwater drilling moratorium is supposed to be six months. We expect politics to extend it for as much as two to four years. Morgan Stanley uses 18 months for their base case when estimating costs; their worst case is an extension to four years. We believe the moratorium will be continued until after the 2012 presidential election or longer.

Deepwater drilling is conducted by floating rigs like the one used in the BP spill. There are 229 floaters in the world and 74 more under construction. The FT reports that there are 33 in the GOM; Morgan Stanley counts 35 with all but one in use. GOM floaters lease for between $350,000 and $400,000 a day. They employ between 800 and 1400 people per rig, plus they also generate large employment in the oil service sector. Note that wage rates on drilling rigs and in the oil service business are high. The FT estimates the average weekly wage lost per person is $1804.

Let’s sum this up to an estimate and admit right up front that this is more of a guesstimate, given the limited information we can obtain. We have not been able to find detailed employment numbers on the state websites. The moratorium is too new to measure job impacts in initial unemployment claims and income statistics. We should see those numbers next month, since they are usually reported with a monthly lag.

Okay, here goes. Total lease losses due to the GOM deepwater moratorium and GOM shallow-water procedural halt are $20-$35 million a day. Let’s call it nearly $1 billion a month. Furthermore, drilling rig lease rates for both floaters and jackups are now likely to fall substantially as the moratorium causes excess supply of rigs.

We estimate employment losses of about 50,000 to 100,000 if both deepwater and shallow-water halts continue for more than a few weeks. We already know that deepwater job losses will extend for many months. Monthly labor income lost will be between $500 million and $1 billion. States most impacted are Louisiana, Mississippi, Alabama, and Texas. Note that none of these numbers are includable in the estimate of BP’s liabilities, since these costs are due to political decisions by the US government.

How long can this continue? And what happens if it goes on for as long as we project? Remember, our assumption is that this deepwater moratorium will continue until (1) after the BP well is sealed and (2) after the environmental impact has peaked and is clearly under some control and damages well-assessed. We have some historical references or metaphors. In the 1979 Mexico spill the Mexican state-owned oil company, PEMEX, initially estimated it would take three months to complete the relief well. It took 11 months. And that was in 165 feet of water, not 5000 feet. Technology has much improved since 1979. Pipe and casing is far superior. The Mexican environmental damage took a couple of years to peak and about 4 to 5 years to be considered contained and mitigated. That was as much due to Mother Nature’s time clock to absorb an oil spill as it was due to cleanup efforts.

Another metaphor is the damage done when Saddam Hussein set fire to the oil wells at the end of the Iraq war. That large spill in the Persian Gulf took 4 or 5 years to contain. Damage is still observable; however, fishing and beach use and oil industry expansion resumed within a few years as cleanup started to succeed. Exxon Valdez was in much colder water; Mother Nature works faster on oil spills when the temperature is warm. Some remnants of Valdez damage are still observed; however, claims are long settled and Alaskan coastal activity is considered normal for fishing, tourism, and in the oil industry.

About 1.5 million barrels a day of US oil production presently comes from the GOM. 80% of that is from deepwater. If the moratorium is long-lasting, Morgan Stanley estimates that production would decline to just a few hundred thousand barrels a day within 4 to 5 years. By then drilling rigs would have moved to other parts of the world where relative lease rates might be higher and where there are no drilling moratoriums. Some of those floating rigs are already staging to move now that the 6-month moratorium has been announced by the Obama administration. One million barrels a day at world prices of $70 per barrel is the estimated loss in US production from a long-term moratorium. We will not address how our failure to achieve a national energy policy empowers our global adversaries or how we fund them by being so dependent on foreign oil. We all know that this is a national tragedy and policy failure. Suffice it to say a long-term moratorium exacerbates that problem at the rate of about $20 billion a month at present oil prices.

The energy sector of the US stock market has been underperforming, in part for the reasons outlined above. The BP spill piles onto an already weakening economic outlook. Energy is a large weight (11%) in the US stock market, so its poor performance impacts broader-based holdings negatively when it declines. At Cumberland we have been avoiding energy-specific ETFs during these last several months of difficulty. We have just changed our view and bought initial positions in natural gas and alternative energy exposure. We expect to be a scale buyer over time and as things continue to evolve in the post-Deepwater Horizon spill era.

At Cumberland, our portfolios reflect our outlook for a decline in deepwater drilling in the United States. Our energy-specific ETF positions are only in natural gas and alternative energy producers. We believe it is too early to build positions in the broad-based energy, oil, or drilling ETFs. We believe that BP and its partners carry particularly high risk, as the liabilities for this spill are still not estimable and may be huge. We have maintained this position from the beginning of this saga and watched from the sidelines as BP lost billions in market capitalization. Buying now is pure speculation: you may win but you may also catch a falling knife.

We thank the hundreds of readers who have commented on our series entitled “Oil Slickonomics.” The entire series is now chronicled on our website, www.cumber.com, so that newer readers may trace the sequence and the revisions to our forecasts as this dramatic environmental and economic tragedy unfolds. We also specifically thank Jim Lucier, his colleagues, and his research firm, Capital Alpha Partners. Their Washington intelligence service is among the very finest we have seen. Readers may find details at www.capalphadc.com.

We leave for Europe on Friday for the Global Interdependence Center meetings in Prague and then in Paris. Issues to be discussed include the sovereign-debt and banking crisis in Europe. Representatives from nearly half the countries in the European Union will be attending. Several governors of central banks are speaking and some are participating in the private roundtable discussions. There is still a handful of spaces left in the delegations in either city, if any reader can make a last-minute adjustment in plans and join us. See www.interdependence.org for details.

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David R. Kotok, Chairman & Chief Investment Officer, Cumberland Advisors, www.cumber.com