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Gulf of Mexico treading water

The Gulf of Mexico's breakevens have plunged, but the region is struggling to compete with low-cost shale

As they do every year around early May, tens of thousands of oil executives, engineers and salespeople streamed into Houston for the Offshore Technology Conference (OTC), taking over the city's football stadium and most of its hotels. But this year's edition of the annual confab was a more muted affair. It's no surprise. The offshore business is two years into a deep recession and investment has dried up. To underline the depths of the downturn, the number of rigs drilling in the nearby Gulf of Mexico (GoM) has fallen to just 17, a level not seen since the dark days after the 2010 Macondo oil spill. The conference, usually buzzing about the latest technology that will lead the industry into new frontiers, was this year gripped with a restless uncertainty about when a recovery might come.

For now, the key question emerging for the GoM's future is whether it can compete for cash with America's vaunted shale industry, which has surged back into action at $50 oil. For those roaming OTC's corridors, it was hard to miss the symbolism of a frack truck parked in the middle of the conference's main exhibition area.

The GoM's boosters point to surging output to scotch perceptions of offshore gloom. It's true that production is rising, and has been just as important as the Permian to the US' recent output recovery. From last summer to February, GoM production rose by some 200,000 barrels a day to 1.75m b/d, roughly equal to the Permian. Output is up by around 350,000 b/d since prices crashed in late 2014. The Energy Information Administration expects output to reach a new all-time high of 1.98m b/d in the middle of 2018, after new projects have reached their full intended capacity.

But these production figures are a lagging indicator. For long-cycle investments like deep-water GoM oilfields, which can take as long as a decade from discovery to first production, today's output reflects the region's health years ago, when high prices fueled a steady stream of new project sanctions. In 2016, for instance, five new projects, highlighted by Shell's Stones field and Anadarko's Heidelberg venture, started up. But they were launched in the boom years. The average price when the companies fired the starting gun was $99 a barrel. When the oil started to flow, a barrel fetched just $42.

$40/b - Breakeven price for Shell's Kaikas development

Today's dearth of final investment decisions (FIDs) for new projects offers a better indicator of the mood in the patch. Over the past 18 months, investors have made just two significant FIDs: Shell's 40,000-b/d Kaikas project and BP's 140,000-b/d Mad Dog 2. Judging from the other fields now under appraisal for sanctioning the outlook doesn't much improve. Bernstein Research, an investment bank, reckons just five projects are being seriously considered for sanctioning, representing only around 5% of total global offshore projects. And those fields—with average output targets of 90,000 b/d—are smaller than past GoM projects, as well as those in areas like Brazil's pre-salt and West Africa's deep water. "Deep-water Gulf of Mexico looks in poor health," is how Bernstein summed things up.

A big reason is that America's shale business is sucking in capital that the GoM might once have claimed. Hardly a corporate presentation goes by without a company executive highlighting her company's shift away from long-cycle large projects, like deep water, to short-cycle tight oil and gas developments. ConocoPhillips, once a significant GoM player, has said it plans to get out of the deep-water exploration business altogether. Independent GoM producers, like Murphy Oil, have started up shale businesses in recent years, chasing barrels and investor dollars. Majors like BP, Shell and ExxonMobil, key players in costly deep-water development, say they're confident about the GoM's long-term future. But their spending shows they aren't so sanguine on the here and now.

Cascading costs

Some hope comes with falling drilling costs. Kassia Yanosek, from the consultancy McKinsey, reckons breakevens in the GoM have fallen to between $40/b and $45/b, down from $60/b to $85/b in the first half of this decade. It puts the GoM roughly on par with the shale plays. Falling development drilling costs have helped. Yanosek reckons these costs have nearly halved, from an average of around $26/b in 2014, to $15/b today.

Rig rates have sunk, also lowering costs. With only around 50% of the global fleet of deep-water rigs being used, it's a leaser's market. Daily rig hiring rates have fallen from as much as $0.5m a day a few years ago for top-of-the-line rigs to less than $200,000/d now. According to Rystad, another consultancy, GoM developers, like the shale players, are also getting a lot more efficient. Operators can drill around 800 feet a day now, double the figure in 2014, as drillers deploy their best kit to their best prospects to optimise drilling programmes. Productivity per well in the Gulf of Mexico, Rystad says, has actually improved more than in the shale patch, rising by more than 40% over the past two years.

Developers are also simply looking at cheaper options and projects involving smaller fields. Rather than ploughing billions into greenfield sites needing new platforms and supporting infrastructure, companies are developing smaller fields to connect them to existing platforms—so-called tie-back developments. Shell sanctioned Kaikas earlier this year and will be developing it by drilling three wells and tying them back to the company's existing nearby Ursa production hub. From there it will pipe the oil to shore. It is expected to cost around $1.35bn, half the original estimate—an outcome of Shell's more simplified field design. The company says the field will turn a profit at less than $40/b. Nearly all projects being appraised are looking at similar tie-back development options.

$9bn - Price tag of BP's Mad Dog 2 project

The notable exception is BP's 5bn-barrel Mad Dog 2 project, which received the green-light from all its partners in February. It looks more like the deep-water megaprojects of the past, with a price tag of $9bn and plans to sail in a new 140,000-b/d floating production platform. But plans for Mad Dog 2 underwent a transformation that reflects today's new, more austere reality. The original plan, developed around 2013, called for drilling 33 wells to support a new 130,000-b/d platform and a major waterflood programme. It would have cost more than $20bn and struggled to breakeven even at the $100/b oil price of the time. The new plan has simplified the engineering design, allowing for a smaller semi-submersible production platform rather than the much larger spar originally envisioned. It will need just 14 wells. BP says it can break even at $40/b.

Still, these projects are the exception and the dearth of new developments shows that the GoM is struggling with $50 oil and the emergence of new competition from the shale business. And it won't be easy for the deep-water play to win back investment from shale either, even with improving head-to-head economics.

The offshore is at a fundamental disadvantage to shale in two key areas. For one, the geological risk in the shale plays is virtually zero—a much more inviting prospect for investors now shy of betting $100m on a single deep-water GoM well that comes with far lower a chance of success. To justify the risks, banks and investors need far higher rates of returns on offshore fields, adding pressure to project economics. Even if exploration and development are successful, the payback period for a deep-water project will never be able to compete with quicker shale projects. GoM projects typically take at least six to eight years—sometimes longer-to start paying out. For shale, it's often about three years.

With these factors at play, it will take either much higher prices than today's implied breakevens—likely north of $65/b—or a step change improvement in costs for major new projects to see a significant amount of investment start flowing back into the GoM.

A fixture of every speech at May's OTC—repeated elsewhere, too—was an unbending confidence that "the world will need deep-water oil". That may prove true. But the confidence isn't being backed up with much cash today.

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