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Why Shell Should Just Quit Its Alaska Drilling Fiasco

Christopher Helman, Forbes Staff: I’m based in Houston, Texas. Energy capital of the world.

Royal Dutch Shell is taking flack from all directions today as a team of salvage experts try to figure out how to free the $290 million Kulluk floating drilling rig that ran aground on the coast of Alaska Monday. The crew of the Kulluk has been rescued, and thanks to a 3-inch steel hull none of the diesel fuel onboard has spilled. But this latest fiasco in a long line of mishaps further underscores the risks of exploring for oil in the Arctic Chukchi and Beaufort seas.

Shell has sunk more than $5 billion into its Alaskan venture since acquiring leases for $2 billion four years ago, and has precious little to show for it. In 2010, when Shell thought it was ready to go, it was stopped by the federal offshore drilling moratorium in the wake of BP‘s disaster. Then there were years of delays as Shell made improvements to the Kulluk rig to meet draconian EPA regulations on diesel emissions. Then in 2012 Shell faced permitting delays on its Arctic Challenger barge, which is to meant to help capture oil in the event of a Deepwater Horizon-style blowout. Worse, the Challenger was damaged during testing in Washington state, requiring weeks of repairs. In July the anchors of the Kulluk’s sister ship, the Noble Discoverer, came loose and dragged across the seafloor. In the short drilling season between July and October, Shell managed only to begin drilling two wells, in the Berger and Sivulliq prospects, before having to pull up and clear out before ice set in. It only got that little bit of work after the Bureau of Ocean Energy Management approved Shell’s request that it be allowed to drill a little later into the season than is generally thought wise.

Perhaps most embarrassing was Shell’s social media nightmare in 2012, when Greenpeace activists hijacked its online image with a hoax site lampooning Shell’s “Let’s Go” slogan with fake ads like “Why go solar when you can drill polar. Let’s Go” and “Birds are like sponges… for oil. Let’s Go.”

It would be a comedy of errors, if the stakes weren’t so high. Shell has hoped that a successful Arctic drilling campaign would open up the province to broader oil exploration — and the potential of tapping tens of billions of barrels of oil. Proving its technical competence in Alaska could also open the door to lucrative opportunities in the Arctic reaches of Russia, where Rosneft has partnered with ExxonMobil and Statoil to commence exploratory drilling.

Russia will not impose environmental restrictions on Arctic drilling as tight as those the U.S. EPA has forced on Shell, which was required to spend millions to reduce diesel emissions from the Kulluk. But as Shell has shown in spades, the operational risks are enormous. Can it be done? Of course. Shell and others successfully drilled a handful of wells in the Alaskan Arctic in the 1970s and ’80s. But regulation and oversight were more lax then.

It’s different today, in this post Deepwater Horizon world. BP has shown that the cost of a deepwater blowout is upwards of $60 billion. The cost of a blowout in the Arctic, far from land, in frigid waters, is incalculable.

Is Arctic drilling worth those risks? Not yet. Not when the $5 billion spent so far is just an ante on a development project that would require at least another $5 billion to drill out the wells, and (assuming successful discoveries) to build out the infrastructure to get the oil to market.

And not when there are so many other options onshore. Granted, when Shell acquired the Arctic drilling leases from the Federal government, the U.S. boom in shale drilling was only just beginning. But for the same $5 billion that it’s plugged into Alaska, Shell could have bought up a massive position in a low-risk, oily shale play like the Eagle Ford or Bakken, the Permian Basin or Mississippi Lime — and started generating new volumes and cash flow in months, instead of decades.

A little further out the risk spectrum, Shell could have drilled nearly 50 wells in the Gulf of Mexico, where the waters are warm and equipment is plentiful and you don’t have to stop drilling for nine months because of ice floes. It could redouble its efforts to extract heavy oil in Oman.

Granted, frontier exploration is the kind of thing only the world’s biggest oil companies have the balance sheet to stomach. But that doesn’t mean they should risk investors’ capital in doing so.

It’s a dilemma that all of Big Oil faces. Is it better to take big risks in order to grow, or just milk the cash cow assets they already have and slowly but surely liquidate down to a smaller size? Not investing as much in tricky exploration will necessarily reduce long-term oil supplies and will thus push up the price of oil. That will make those cash cow assets even more valuable in the long-run.

No doubt the industry will eventually crack the Arctic drilling conundrum. But given Shell’s mishaps, it probably won’t happen in Alaska. A few months ago Norwegian oil giant Statoil announced it had postponed until at least 2015 its own plans to drill off of Alaska, and would instead focus its Arctic attention in Russia.

What would you do if you were Shell CEO Peter Voser? Cut your losses, or keep trying?

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