Atlantic oil is a bad investment

Last week, the Obama Administration released its 5-year offshore drilling plan, which included a proposal to open up drilling along the South and Mid-Atlantic Coast. The American Petroleum Institute says that drilling in the Atlantic Outer Continental Shelf (OCS) could bring $US 195 billion in investment between 2017 and 2035.

Environmental groups have decried the announcement, saying it is out of sync with the President’s environmental goals in that offshore drilling opens the Atlantic coast to the unacceptable risk of uncontainable oil spills and is incompatible with his goals of halting dangerous climate change.

There is no question that prospecting and drilling disrupts wildlife. Further, most of the oil and gas in the Atlantic OCS is in deep and ultra deep water—higher risk prospects by every measure than their conventional, shallower counterparts. But reasonable people can disagree about the risks of a catastrophic spill and the difficulty of containing it.

The climate impacts, by contrast, are incontrovertible, as are the risks to investors who choose to pour still more money into expensive oil and gas extraction projects. The reasons are straightforward—oil companies already have more than enough oil and gas reserves on their books to destabilize the climate. Any further investment in fossil fuel development is just another log on a fire that is already threatening life as we know it. In order to keep the world from breaking the 2 degree Celsius limit, the non-profit organization the Carbon Tracker Initiative estimates that the world can burn enough oil to release 360 gigatons of carbon dioxide—about 760 billion barrels of oil—and then it needs to stop.

Seven hundred and sixty billion barrels of oil is less than the total amount of reserves that companies have on their books already. This means that even without more drilling, some companies are going to be left holding the bag, likely the ones with the highest cost of production. As it is, pursuit of expensive resources has already put the world into oversupply, dropping oil prices to $US 50 barrel. These low prices are expected to continue through 2015. It is impossible to know what will happen beyond that horizon, but given the dynamics of climate change, countries with a long-term view will be changing their infrastructure to limit fossil fuel demand, not increase it.

But the oil and gas industry persists in its inverted view of the future. When questioned about the wisdom of drilling at such a low price, Erik Milito, the American Petroleum Institute’s Director of Upstream Industry Operations, was quoted by Washington Examiner as saying “The oil and gas industry ... is looking at investment windows of 10, 20, 30 years. And we're looking at these windows based upon the understanding that global demand for oil and gas resources is going to continue to grow.”

It’s not clear that Saudi Arabia holds the same view. Some have questioned why it hasn’t cut production in the price slump, but instead continued to endure low prices. But the answer is simple: because it can. If Saudi Arabia cut production, it would simply be yielding market share to higher cost producers. And why should it? Memo from Saudi Arabia to the arriviste oil powerhouses of the world: “This is what being a major oil producer looks like.”

This is as it should be. It is both economically and environmentally efficient that the lowest price assets sell first and the more expensive fuels stay in the ground. If the world is paying an oil price that reflects the cost of technically complicated projects when it buys its fuel, then it is overpaying. All of the oil in the world that we can safely use is available at a lower price. The Carbon Tracker Initiative has matched the 760 billion barrels of oil budget to a point on the cost curve. The result is that if we were to use our energy resources efficiently—least-cost first—then no oil over a market price of $US 90 a barrel is worth digging for. Paying for oil higher up the cost curve creates an epic deadweight loss to society. The case for environmental efficiency is more straightforward. The infrastructure needed to extract oil is already in place; one doesn’t need to dig up a boreal forest, or put a rig off an untouched coast just to take more oil out of the ground than the world can afford to use anyway.

So how bad a bet is Atlantic OCS oil? Quite bad, it turns out. Using the 2014 update from the Bureau of Ocean and Energy Management for its estimates of economically exploitable oil for the Atlantic, and extracting the data for the South and Mid-Atlantic regions named in the Obama Administration’s plan, it is clear that that only 28% of the oil is exploitable at less than $US 90 dollars a barrel. Further, more than 50% of the production requires a market price of over $US 100 a barrel. A detailed breakout of the price can be seen in the table below.[1]

Table 1. Atlantic OCS Economically Exploitable Resources

Let the buyer beware. Investors sometimes imagine returns as the function of a neutral market that operates according to economic laws, unbounded by politics and human nature. But of course this is not the case. The profitability of any investment is shaped by the policy environment, which in turn is shaped by the norms of a society. Oil and gas drilling in the Atlantic is unlikely to start until 2021. The current regime may be permissive, but the profitability of Atlantic oil relies on the continued negligence of the future governments of the world. The savvy investor should look at the high oil price needed for Atlantic drilling, consider the high demand that that price implies, and realize that they will only exist in a world where climate change is allowed to continue unabated.

And the Obama Administration should be ashamed of itself. Not only is it sending the wrong signals about fossil fuel development, but also in offering public waters up for oil and gas leases, it is putting public money behind a fossil fueled future. The expansion of American oil and gas development has been matched by the rise is subsides for exploration and drilling—$5.1 billion in 2013, up from $2.6 billion in 2009. The economy of a society is shaped by policy, and this policy is pushing us in the wrong direction.

The economic future of America cannot lie in competing with the Middle East for oil production; it has no comparative advantage there. But the United States has always had an advantage in technology and new systems development. It ought to be pouring resources into clean energy infrastructure. Instead it is creating a policy that will result in the squandering of public and private resources on an investment that carries a high risk of yielding meager to negative financial returns on an end product that endangers the future.

[1] Note that percentage of an exploitable resource is given in terms of oil and gas prices. This is because oil and gas are often found together. These two prices work together, i.e., if the given gas price for an oil price is lower than in the table, a higher oil price will be required for economic exploitation. If the gas price is higher, a lower oil price will be required and vice versa. Gas prices are not discussed in this article, as the Carbon Tracker Initiative has yet to do analysis on price points for stranded gas, though a report is forthcoming later this year. As per the EIA, the Henry Hub gas price for Jan. 30^th 2015 was $US 2.88 per MMBTU. 1MMBTU=1 MCF.

http://theenergycollective.com/sierenernst/2190141/atlantic-drilling-bad-investment