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A Big Chill for Shell’s Arctic Drilling Plans

A series of mishaps is putting billions of spending in jeopardy

Jul 31, 2012, 9:12 am EDT  |  By Aaron Levitt, InvestorPlace Contributor

With energy demand not abating anytime soon, energy companies have gone looking far and wide (and deep) for new oil and gas reserves to meet that demand. Perhaps the most ambitious — and costly — effort so far has been Royal Dutch Shell’s (NYSE:RDS-A, RDS-B) plan to drill for hydrocarbons in Alaska’s frozen seas. Europe’s biggest integrated oil company has spent about $4.5 billion since 2005 on leases, permits and various equipment to reach an estimated 20 billion barrels in fields off of the northernmost U.S. city, Barrow, Alaska.

The promise is certainly great as preliminary results for the Arctic Ocean are staggering. The region, including the Chukchi and Beaufort Seas, is estimated to contain enough reserves to fuel 25 million cars for 35 years.

While Shell trails rival Exxon Mobil in tapping the Arctic, it may have to wait yet a little longer. Hit by the trio of regulatory issues, environmental scrutiny and fast approaching sea ice, Shell may have to abandon its plans for beginning to drill in the Arctic this summer. The rest of the energy industry is watching Shell’s actions closely — and so should investors.

Elusive Goal

Shell was planning to drill as many as five exploratory wells this summer in the Chukchi and Beaufort seas during a brief window between July and October, when the waters are typically clear of severe ice. However, Pete Slaiby, Shell’s vice president for Alaska operations, recently reported that the company is unlikely to meet that goal due to regulatory challenges and stubborn ice.

Actually, it’s been one setback after another for Shell in the region. In early June, it announced that the generators on its Discoverer drilling rig — rented from Noble (NYSE:NE) — couldn’t meet Environmental Protection Agency emission standards for nitrous oxide and ammonia.

Then in mid-July, the Discoverer slipped its anchor in Alaska’s Dutch Harbor and drifted perilously close to the shore. Although Shell said the ship suffered no damage, the incident offered ammunition to critics. Greenpeace and Alaska’s Inuit native community have pounced on the mishap, contending it’s just a taste of what’s to come from the project and that an oil spill will pollute the waters and damage Alaska’s economy.

Additionally, in June the Coast Guard raised questions about the durability of one of Shell’s underwater oil-spill containment vessels in severe weather. The Arctic Challenger oil-spill containment barge was a key selling feature and a critical piece of equipment for the project. The vessel has been held at port in Washington, and the Coast Guard hasn’t yet certified it to operate.

Meanwhile, time keeps ticking as the thickening winter ice pack looms. Despite sparse coverage in most of the Arctic Ocean, ice in the Chukchi Sea this summer is still too thick to allow ship traffic. According to Shell’s permits, all operations must cease by Oct. 31,and drilling must be suspended during the fall Inupiat whale hunting season.

Additionally, drilling into the Chukchi Sea’s hydrocarbon-bearing zones must cease 38 days prior to the Oct. 31 deadline. This doesn’t give Shell much time considering all the setbacks.

Closely Watching

It has been seven years since Shell obtained its first leases for U.S. Arctic exploration, and the recent mishaps aren’t speeding up its operations. These problems could discourage companies such as ConocoPhillips (NYSE:COP) and Statoil (NYSE:STO), which also hold leases in the region, from pursuing Arctic opportunities. It may not be as critical as the shale revolution, but the revival in Alaska could be a major contributor to America’s pending energy independence. Wasting that opportunity is a cause for concern.

From an investor’s point of view, the setbacks are also hard to shallow. Much of my enthusiasm for Shell stock stems from the company’s willingness to think long-term and devote itself to these unconventional projects. Given the outlook for energy demand, it will clearly require developing alternatives, like drilling in the Arctic.

Yet, exercises like this are expensive, and so far Shell has had nothing to show for its spending. While I wouldn’t be selling my shares today, any additional mishaps or setbacks with Shell’s unconventional holdings might have me rethinking my position. Until then, I’m keeping the firm in my portfolio.

As of this writing, Aaron Levitt is long RDS-A, RDS-B.


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