Energy investors have had to reassess their strategies as a result of the hammering that BP's (BP) American depository receipts and the shares of its deepwater competitors have taken since the explosion of the oil giant's Macondo well in the Gulf of Mexico on Apr. 20. While it's still too early to gauge how much more expensive deepwater drilling is about to get, some energy portfolio managers are starting to give careful thought to their continuing exposure to companies will significant deepwater projects.
As the higher costs of regulation, safety procedures, and insurance become clear, fund managers will almost certainly have to revise their return assumptions for certain holdings and may decide to adjust allocations within their portfolios.
The ISE Integrated Oil and Gas Index (PMP) dropped 19 percent from 242.36 on Apr. 20, the day the Deepwater Horizon rig exploded, to a low of 196.33 on June 9. The index bounced back modestly to close at 210.75 on June 18, following the announcement of BP's $20 billion escrow account to cover damage claims.
On June 18, BP had the fourth-largest weight in the index, behind Exxon Mobil (XOM), Chevron (CVX), and Total (TOT), all of which engage in deepwater drilling, too. As of the close of trading on June 18, BP shares had plunged 47.5 percent since Apr. 20, while Hess (HES) (which also has a large deepwater presence) has fallen 14 percent, Chevron is down 8 percent, Exxon Mobil has dropped 8.5 percent, and Total has fallen 15.7 percent.
In a June 6 research note, Deutsche Bank Securities (DB) said that over the next five years, the contribution to total production growth from deepwater Gulf of Mexico will be greatest for Chevron at 32 percent, or 93,200 barrels a day. Hess came in second with the Gulf accounting for 22 percent, or 41,200 barrels a day, of its total growth. BP ranked third, with the Gulf representing 21 percent, or 59,100 barrels a day. ExxonMobil has a smaller Gulf presence, while another major U.S.-based producer, Occidental Petroleum (OXY), has no exposure to the Gulf.
other players take fewer risks
Deepwater projects are the primary driver of global growth in oil reserves and production, both inside and outside of OPEC. Each six-month moratorium on drilling costs 2 percent of U.S. daily oil production and fundamentally shifts global oil supply pressure onto OPEC, Deutsche Bank said.
While none of the major oil producers with deepwater projects has a procedure for capturing oil once a spill of Macondo's magnitude has occurred, players other than BP "have much better safety procedures in place to prevent this," says Tim Parker, energy analyst for T. Rowe Price's New Era Fund (PRNEX). "BP chose to do things which created a greater chance of a blowout," he says. "They could have put a second plug in the hole—a cement plug closer to the surface—in case the first plug failed. Chevron does that as a matter of course in all its wells."
The $20 billion compensation fund that BP agreed to establish on June 16 makes Tom Nelson, co-manager of the Guinness Atkinson Global Energy Fund (GAGEX), feel more confident that BP and the U.S. government are moving in the same direction. "Until that announcement, BP was facing not only the challenge of trying to cap wells but the increasing challenge of appeasing the U.S. political lobby. There was a growing question mark about its ability to do both," he says. The reassurance from President Barack Obama that it's in the U.S. interest that BP survive, rather than go bankrupt, is an "enormous positive for the stock," and suspending the dividend is appropriate, Nelson adds. One reason he has chosen not to sell his BP holdings is that his equally weighted fund, in which each of 30 stocks gets a 3.3 percent weight, lowers the risk from any single stock.
It's also a relief that BP won't have to write one big check for $20 billion but will pay $3 billion in claims in the third quarter, $2 billion in the fourth quarter, and $1.25 billion per quarter thereafter until the end of 2013, Nelson adds. While the $20 billion is neither a floor nor a ceiling to the total fees BP might ultimately have to pay—and does not address potential costs from lawsuits—"it will go a long way to showing people that BP will meet its liabilities," he says.
T. Rowe Price's Parker believes there will be a 10 percent to 15 percent increase in costs resulting from the mandating of new procedures to comply with tougher drilling regulations. That would somewhat diminish the allure of the Gulf of Mexico's fiscal regime. Until now, fixed royalty and tax structures in the Gulf have let producers benefit more from higher oil prices than companies operating under production-sharing agreements with local governments in other parts of the world, which caps drilling profits at a certain level, says Parker. Being subject to such agreements defeats the purpose of deepwater projects, which is to get the scale that other reservoirs no longer offer, he adds.
Alaskan projects affected, too
In view of the offshore drilling moratorium—which has been set at six months but might get extended—and the prospect of future costs that have yet to be calculated, it's hard for oil producers directly involved in the Macondo well to know how to proceed, says Parker. For companies that drill in the Gulf but are on the fringes of the Macondo disaster, the road ahead is clearer.
The six-month moratorium on deepwater exploration wells—at least 500 feet deep—affects not only companies active in the Gulf of Mexico but those with projects off Alaskan shores, such as Royal Dutch Shell (RDS/A) and ConocoPhillips (COP).
Deepwater is one of the remaining locations in which major oil producers can find the reserves they need to replenish declining production from existing assets. It's likely that they will move to other geographic regions if deepwater drilling off the U.S. coasts becomes prohibitive, says David Ginther, manager of the $330 million Ivy Energy Fund (IEYAX).
As a result of the BP disaster, Ginther says he will likely focus on integrated companies with good deepwater acreage positions in places such as West Africa and Brazil. Chevron and Anadarko Petroleum (APC), both of which operate wells in the Gulf, could opt to shift capital spending to other deepwater locations. With a 25 percent working interest in the Macondo well, Anadarko will have to decide if it wants to continue drilling in the Gulf—and how much it would cost to do so.
Ginther speculates that drilling costs could rise 15 percent to 25 percent as a result of procedures such as the use of cement-bond logs is made mandatory instead of optional. "Deepwater wells are expensive to start with. [The Macondo] well cost about $100 million for exploration and it costs about $500,000 a day to drill these wells," he says. "That higher cost will have to be absorbed because most of the growth in production you're seeing right now is coming from deepwater, at least outside of OPEC."
pricing structures must be revised
Energy fund managers aren't the only ones who will have to modify the way they think about the industry. Until now, equity analysts who follow oil companies have focused on the technological capabilities and achievements in the deepwater sector, says David Whittall, portfolio manager of the Rydex/SGI Global Fund (SEQAX), who adds that the emphasis is clearly going to shift to the risks associated with deepwater drilling,
Although new regulations and procedures will pose a huge challenge to offshore drillers, Nelson believes they will be able to cope. And while there's likely to be a completely new pricing environment for deepwater drilling—demanding time for operators and drilling contractors to agree on pricing structures—contractors such as Transocean (RIG) will have to manage those costs appropriately to avoid pricing too many customers out of the market, he says.
The greatest cost impact will probably come from higher insurance premiums, even more than the higher cost of compliance with stricter regulations, predicts Pavel Molchanov, an analyst at Raymond James & Co. who covers the integrated oil producers. "With the liability cap about to be raised—apparently to $10 billion [from the current $75 million]—in Congress, I suspect what will happen for deepwater insurance coverage may be similar to what happened to terrorism insurance after 9/11," he says. "It not only will be extremely difficult to get, but it will also be dreadfully expensive."
The integrated major oil companies and large publicly owned independent producers are likely to continue drilling in the deepwater Gulf, but some small operators will probably be driven out, Molchanov says.
One compensation for the odds that deepwater drilling will become more costly and complicated is that the marginal price of oil that non-OPEC producers can charge will go up, says Nelson.
"bottom-fishing" Gulf-affected ETFs
A protracted challenge for deepwater producers may pose an even bigger problem for index funds that include BP and similar companies and—unlike actively managed mutual funds—aren't able to cut or eliminate those positions. The fallout in exchange-traded funds so far has been limited to four key ETFs that have direct exposure to BP, says Dave Nadig, director of research at fund information website IndexUniverse.com. The SPDR S&P International Energy Sector ETF (IPW), with 8.63 percent exposure to BP, was at the close of trading on June 18 down 16.3 percent from Apr. 20, while the WisdomTree International Energy Sector ETF (DKA), with 5.54 percent exposure, had dropped 14.9 percent. The iShares S&P Global Energy Sector ETF (IXC), with a 4.64 percent weight in BP, was down 11 percent and the iShares MSCI United Kingdom Index (EWU), with 7.1 percent exposure, had fallen 12.3 percent.
Some investors are clearly doing some "bottom-fishing" since the prices of these ETFs have dropped, says Nadig. The net money flows into each has increased substantially since the BP disaster, compared with year-to-date influxes as of Apr. 20. The most extreme example is iShares S&P Global Energy Sector ETF, which has attracted $418.6 million since Apr. 20, vs. $17.9 million during the first four months of this year.
Investors are also looking for parts of the energy sector that have greater potential for appreciation in stock prices. Nadig says he's hearing financial advisors and traders talking about getting more exposure to natural gas as an alternative to offshore drilling. One ETF that could benefit from this is First Trust ISE-Revere Natural Gas Fund (FCG), which tracks companies that focus on natural gas production, he says. That fund is down 5.3 percent since Apr. 20. The increase in the benchmark spot price of natural gas to around $5.20 per thousand cubic feet, from roughly $4 a month ago, has caught the attention of investors, who are showing more interest in exploration-and-production companies with greater exposure to natural gas than to oil.
Roughly 30 percent to 40 percent of the weight of the Guinness fund is exposed to North American natural gas production, says Nelson, through companies such as Chesapeake Energy (CHK), Newfield Exploration (NFX), and Bill Barrett (BBG). If the price of natural gas rises to from $6.50 to $7 per thousand cubic feet, Chesapeake will be a direct beneficiary, he says, making the stock especially attractive now. It trades at just seven times estimated 2010 earnings.
Molchanov at Raymond James thinks oil producers are even more attractive as long as a ban on deepwater drilling puts pressure on the U.S. oil supply. The moratorium could ultimately cut that supply by as much as 400,000 barrels a day, he says. That's roughly 0.8 percent of the 4.95 million barrels that the U.S. Energy Information Administration says is produced daily in the U.S. "Reducing global oil supply puts upward pressure on oil prices," and should encourage more oil drilling in places outside the Gulf—and outside the U.S.—says Molchanov.