A new battle is brewing over offshore oil drilling. Nine months ago, President Bush lifted a ban on new oil and gas leases off the nation’s coastlines, and the congressional moratorium on offshore leasing expired last September.

Now Obama’s Department of Interior officials are considering reopening the Outer Continental Shelf (OCS) to leasing, and once again the oil industry is pitted against environmentalists, as well as California residents who remember the ugly mess that a 200,000 gallon crude spill made of the Santa Barbara coast in 1969 after an offshore rig blowout.

I remember that mess. Some time in the mid-70s, when I was 10 years old or so, my family took a trip to California to visit relatives. After nine long hours in the car from our home in the Arizona desert, I wanted nothing except to frolic on the beach when we finally got there, and I wasn’t about to let my uncle talk me out of going there no matter how bad it was.

It was nasty. The beach was covered in globs of black goo—so much of it you couldn’t avoid stepping in it—and the whole place reeked. (If you haven’t ever smelled crude oil, it’s smells like exactly what it is: a combination of asphalt and gasoline and everything in between.) We had our fun on the beach, but when we got home, we had to endure a good scrubbing down with turpentine (or maybe it was gasoline) to get the gunk off of our skin.

So I have sympathy for those who don’t want to see that sort of thing happen ever again. I’ve also been an environmentalist all my life.

On the other hand, I believe our energy predicament is shaping up to be so dire as to render all such ideology moot. Taking a principled stance on environmental grounds may soon seem like a luxury of a far-gone age.

Outer Continental Shelf Potential

Let’s take a look at the numbers.

According to the EIA (2007 data rounded to billions), total US proven reserves of conventional oil are about 21 billion barrels, of which 4 billion are proved offshore reserves.

US demand is currently about 6.7 billion barrels per year, so if we relied solely upon our proven reserves and were able to produce it as quickly as we like, we’d only have about a three-year supply. Fortunately, we are able to import more than two-thirds of our oil consumption from elsewhere. Nature limits the rate at which we can pump our domestic oil, a rate which has been in steady decline since US domestic oil production peaked in 1970.

Three years’ worth isn’t much, so we have turned to the difficult and expensive stuff that remains, some of which isn’t even oil: low-grade tar sands from Canada, thin seams of shale in the Midwest, and the OCS.

Energy and Capital readers are no doubt familiar with our articles on tar sands and the shales (Bakken, Barnett, Marcellus, and others), but an update on the OCS is probably in order.

The EIA estimates that “technically recoverable undiscovered” offshore oil in the US is in the range of 59 billion barrels—nearly three times as much as our remaining “proved reserves.” Most of it, about 45 billion barrels, is expected to lie in the Gulf of Mexico.

The remaining 31% is what was unavailable under the Congressional moratorium, but according to a testimony before the House last month by acting EIA administrator Dr. Howard Gruenspecht, only about 20% of the total technically recoverable oil in the OCS has been under moratoria.

The United States Geological Survey (USGS) numbers are considerably larger, suggesting that some 85 billion barrels of technically recoverable undiscovered oil may remain offshore. (For the present article, I will avoid delving into the murky details of probabilistic reserve estimates and why they differ from source to source.)

In any case, it’s clear that the remaining oil prize in the US is offshore. So why aren’t we producing it?

Partisans like Sen. Kay Bailey Hutchison (R-TX) would have us believe that it is simply the politics of overzealous environmentalism, banging the drum loudly for offshore drilling and complaining that 85% of the OCS has been off-limits “leaving some of our greatest energy reserves untapped.” Indeed, the “Drill Baby Drill” crowd claims that if only we’d drill the OCS everywhere, we could achieve “energy independence.”

But if only 20-31% of the OCS has been off-limits, why hasn’t the rest been drilled yet?

Risky Business

One part of the answer is that there simply isn’t any oil in some of those areas. Last July, John Hoffmeister, former CEO and president of Shell Oil’s US operations, told CNBC “The industry is pursuing the leases it has, but to be blunt, the prospective nature of many of those leases is very low. And you don’t go drill oil where you know it doesn’t exist.”

The second part of the answer is also simple: poor economics.

Offshore oil is expensive, and deepwater oil—wells drilled in more than 1000 feet of water—is more expensive still. Leasing rates for high specification drillships able to produce oil from deepwater formations have run as high as $600,000 per day, which is why we have liked the deepwater drillers for a long time now.

Consider the economics of the Mars field as an example. At a water depth of 2,940 feet, it is believed to contain 500 million barrels of oil equivalent. The platform produces some 220,000 barrels per day, at a reported development cost of $100 million. Prior to the development of BPs Thunder Horse platform, it was the most advanced platform in the deepwater Gulf of Mexico, where the best prospects for new US oil production are. The Mars platform was destroyed by Hurricane Katrina, and rebuilt by Shell at a reported cost of $200 million.  (By comparison, the Thunder Horse platform produces oil at about the same rate, but has a total cost of around $5 billion.)

Deepwater oil also remains a very risky enterprise, even with modern seismic imaging technology. This week Contango Oil & Gas Co. (AMEX: MCF) reported that it would take a $12.5 million write-off for drilling a dry hole in the Gulf of Mexico. It takes a fluid and committed credit market to sustain that kind of risk, but the world is still in the grips of a credit market freeze.

Morgan Stanley recently reported that enough deepwater projects have been scrapped in the global economic downturn to reduce future crude supplies by as much as 2.4 million barrels per day (mbpd) by 2011, a substantial chunk of anticipated supply. Since August 2008, the company reported that no new lease contracts had been awarded, but 11 orders were canceled and 46 more were delayed.

Perhaps the largest project to be delayed recently is the Manifa project in Saudi Arabia. With a $9 billion price tag and a possible 900,000 barrel per day flow rate, it would be the country’s largest offshore oil development, but progress has been delayed by six months, probably to take advantage of lower construction costs.

How Do We Reach Energy Independence?

Finally, we must also address the flow rate of any new domestic oil. True “energy independence” would mean producing 18 to 20 mbpd, not the roughly 5.5 mbpd we are producing today. Could we do that?

Through drilling alone, the answer is “not even close.” In total, I estimate that if all limits on drilling were removed, including the OCS and ANWR, we could only increase US oil production by a maximum of 2-3 mbpd. That new production would come online slowly, and the additional flow would be hardly noticeable as it compensated for the loss in conventional oil production due to sheer depletion. If it lowered prices at all, it would be by a few pennies per gallon, at best.

Now I have no doubt that Sen. Hutchison understands this, but within the parameters of politics, she must state her case as strongly as possible and try to overcome the resistance to offshore drilling.

Nor do I have any doubt that the hearts of anti-drilling environmentalists are in the right place. Why continue down the doomed path of oil dependency when renewables appear to be right around the corner? Why would the good people of Florida want to court the disaster of oil spills, or look at oil rigs in the distance of their beautiful beaches?

Both sides of the issue, unfortunately, are wrong-headed, and would lead to poor policy. If the public were successfully convinced that we could drill our way out of our energy dilemma, it would stifle development of a renewable-powered infrastructure that will survive in a future of declining oil. Conversely, large oil spills from offshore drilling are a thing of the past, and if we do not drill our remaining reserves with all possible haste we will undoubtedly find ourselves without sufficient oil at an acceptable price within just a few years.

The IEA’s warning in February should remain foremost in our minds: If oil demand recovers in 2010, global spare capacity would fall to zero by 2013. And as the world’s largest nation dependent on imported oil, we could be in for a very difficult time. The last thing we should do is pull the plug on the majority of our energy supply, which is oil, before we have new forms of energy to replace it. To do so would have terrible consequences on the economy, and hamstring our capability to continue evolving to a new energy regime.

Our only real path to energy independence is to pursue all options, within acceptable emissions limits, and gradually phase out fossil fuels as we ramp up renewables and the electric infrastructure to support them. But while renewables remain less than two percent of our energy mix, we should be careful not to expect too much of them. We will need oil and natural gas for decades to come, and in time we will need to develop our offshore resources or face the prospect of shortages.

Next week, I will be attending the 2009 Offshore Technology Conference in Houston, by invitation and sponsorship of the American Petroleum Institute. Check in then for my impressions on the cutting edge of offshore drilling technology, and the industry’s next great challenges, like drilling the deepwater of Mexico and the Arctic.

Until next time,

Chris

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