London, 14 June 2010

The catastrophic blowout at Macondo has sliced 40% off BP's market capitalization , and led analysts to speculate about lasting reductions in deepwater drilling and the resulting impact on both long-term oil supply and the fate of climate change legislation. The underlying fear is that Macondo is the oil industry's Three Mile Island, an accident that turned public opinion against nuclear power for three decades. Investors are right to fear the long-term impact on the company. But they exaggerate the impact on the wider industry and the prospects for climate change legislation. BP however faces a very changed operating environment in future.

Marginal Supply Impact

Deepwater and ultra-deepwater petroleum wells are just one of a suite of advanced technologies energy producers have been using to extend the peak in conventional oil production.

In its 2008 World Energy Outlook, the International Energy Agency ( IEA) estimated worldwide deepwater and ultradeepwater reserves at 200 billion barrels. This is relatively small compared with conventional oil reserves (2.1 trillion barrels) let alone total hydrocarbons (6.3 trillion barrels, excluding unproven methane hydrate technology)

(Download graphic below).

Even complete loss of deepwater and ultra-deepwater oil production would have only a marginal impact on total energy supply in the decades to come. In any event, it seems unlikely deepwater exploration and production will be abandoned. Most policymakers recognise there is no practical alternative. Lukewarm public support for climate change legislation shows how little appetite there is for measures significantly increasing the cost of fossil fuels or forcing reductions in energy consumption.

The industry actually has a good track record of operating in extremely challenging environments at huge depths and under massive pressures with few accidents. One reason Macondo has stirred such intense passions is because it is so unusual.

The public, regulators and the industry itself have become used to the miracle of pulling oil up from deep below the surface without any real understanding of the engineering challenges involved. It has bred complacency.

Higher Cost Not Decisive

Deepwater drilling will continue, probably under a tougher  permitting and inspection regime, with additional fail-safe and disaster-recovery systems, adding to the industry's costs. But higher safety and compliance costs will not materially affect oil prices going forward.

Extra compliance might add $2-3 to the price of a barrel of deepwater oil, but this is inconsequential compared with the vast expense of conducting seismic surveys under miles of seawater, mud and salt; rig hire; and the exploration risks of drilling dry wells.

Anyway, oil prices are set at the margin by the highest-cost form of production, and deepwater and ultra-deepwater are not the marginal source of supply. Other technologies such as tar sands, shale oil, and in the medium-term gasto-liquids (GTL) and coal-to-liquids (CTL) are all more expensive and will set prices, not deepwater.

If it does happen, slower development of deepwater resources would have its biggest impact in the three-six year timeframe, when other technologies are still relatively immature and unable to fill the gap.

For the moment, however, oil resources look comfortable in the medium term. The banking crisis and worldwide recession in 2007-09 have shifted the global economy onto a lower and slower growth trajectory, freeing up energy resources and improving the medium-term supply-demand outlook.

Macondo would have had an enormous impact if it had occurred in H1 2008. In the current environment, with spare capacity, the industry can absorb the potential loss of supply more easily.

Bill Still on Road to Nowhere

In the near term, Macondo complicates the passage of climate change legislation pending before the U.S. Senate. But the impact should not be exaggerated. The bill's prospects were already poor and it has been heavily watered down.

The emerging deal would have seen the Obama administration and congressional Democrats open up more offshore areas to drilling in exchange for at least some Republican and energy industry support for the modified capand-trade provisions set out in Senator John Kerry's renamed American Power Act.

That deal looks an increasingly hard sell, one reason President Barack Obama and senior officials are furious with BP. Even before the spill, however, it was far from clear the drilling-for-climate deal would secure the necessary 60 votes in the Senate to move forward.

(1) Despite revisions to cap-and-trade, delaying its introduction for manufacturers and promising greater offshore acreage, there has been no lessening of hostility from Senate Republicans. The only Republican to support the compromise initially, South Carolina's Senator Lindsey Graham, had already dropped his sponsorship under pressure from the party leadership and conservative activists.

(2) Coastal Democrats were more or less united in their hostility to more offshore drilling well before Macondo. Ten coastal-state Democratic senators wrote to Kerry in March to oppose putting drilling into the climate and energy bill.

They included Bill Nelson (Florida), Robert Menendez and Frank Lautenberg (New Jersey), Sheldon Whitehouse and Jack Reed (Rhode Island), Barbara Mikulski and Ben Cardin (Maryland), Ted Kaufman (Delaware), and Ron Wyden and Jeff Merkley (Oregon). the environmental and economic risks of drilling, experience has shown that no technology is foolproof ... Far from being a thing of the past, spills occur with alarming frequency", they wrote, with what now seems like horrible prescience.

With industrial and coal-state Democrats opposed to raising the burden on manufacturers and coal-producers, coastal Democrats opposed to drilling, and Republicans leery of a potentially unpopular compromise, the climate bill has a mountain to climb, and is running out of time before the mid-term elections.

Unlucky BP Set for Big Change

While Macondo will not have much impact on the wider industry, the effect on BP itself could be far more severe. Since the problems with Exxon Valdez (1989) and Brent Spar (1995), BP's rivals Exxon and Shell have largely avoided major accidents. Both were searing experiences, prompting an overhaul of internal controls and safety culture.

In contrast, BP's North American operations have been plagued by a string of accidents and scandals -- including the Texas City refinery explosion (which killed 15 and injured 170 others in 2005); the sinking of the celebrated Thunder Horse platform (2005); and leaks and corrosion on its Alaskan pipeline network. (2006) BP pleaded guilty to felony charges in the Texas City case, and was sentenced to $50 million fine and three-years probation.

As BP American Chairman Bob Malone accepted at the time "If our approach to process safety and risk management had been more disciplined and comprehensive, this tragedy could have been prevented". BP also received a fine and probation for Alaska.

The company has also paid a civil monetary penalty of $303 million for attempting to manipulate the propane market (2004). The settlement beguilingly concluded "all criminal investigations of BP America on matters related to propane, gasoline, crude oil and other commodity trading", implying the CFTC was looking at other issues as well.

The incidents may or may not reflect shortcomings in management and culture. Maybe the company has just been unlucky. But the number of them in quick succession is beginning to look disturbing. Rightly or wrongly, BP North America is being singled out by U.S. officials as a problematic part of the industry.

Deepwater drilling will undoubtedly resume, under a tougher inspection regime. But BP may cede ground to its less accident-prone peers and will come under fierce pressure to change its operating and management practices.

It is that fear markets are reflecting with the collapse in the share price. The direct costs of the clean up are only one of the company's problems.

BP'S number one priority now is to make sure that the next time a well blows, it belongs to someone else.

Ends --

By John Kemp, Reuters market analyst - for Commodities Now

The views expressed are his own.

Attachments:

HYDROCARBONS.pdf

6 Kb