Why Shell can’t quit the Arctic

Shell’s annual shareholders meeting last Tuesday (19 May) in The Hague seemed almost like a climate conference, some observers reported. Activist shareholders lined up to ask Shell to embrace the energy transition, or at least, as one of them put it, to “invest profits from oil and gas in new energy instead of more fossil energy”. Most of all, they urged Shell to desist from drilling in the Arctic Ocean off Alaska, which Shell got permission to do from the US government just a week earlier (on 11 May).

And the activists were not in a minority this time. At the meeting, 98.9% of the shareholders supported a resolution for the company to report henceforth on the climate risks of its business, which Shell has agreed to do starting next year. Some institutional investors also weighed in. Dutch pension management fund APG, which manages investments for the largest Dutch pension fund ABP and controls some $1 billion in Shell stock, explicitly asked Shell to halt its activities in the Arctic.

According to portfolio manager Jags Walia, Shell’s activities in the Arctic present not only unacceptable environmental risks, but also risks to the value of the company. Walia referred to the fate of BP after the Deepwater Horizon disaster. If a disaster like that were to happen in the Arctic, said Walia in radio and newspaper interviews, after all the warnings, the reputational damage to Shell would be “huge”.

Walia made the point that the risk Shell is taking in the Arctic far outweighs the possible reward. The company, he said, can only expect to start making profits around the middle of the next decade at the earliest, and then only if the oil price is at least $80 per barrel. Much better, said Walia, would be for Shell to invest in other projects, for instance in Brazil and Australia and in its new acquisition, BG.

The Chukshi Sea can supply the world’s oil needs for just two months

But Shell remained deaf to all these pleas. CEO Ben van Beurden said Shell was managing the risks of Arctic drilling “down to the levels that we think are acceptable and indeed negligible”, according to the Wall Street Journal. He has no intention to leave the Arctic.

So why does Shell find it necessary to press on in the Arctic region, despite the risks and reputational damage it’s already suffering? Why doesn’t the company simply to decide to put its money elsewhere?

Vital resources

Shell’s Sustainability Report 2012 contains an interview with Marvin Odum, Upstream Americas Director, who is asked this very same question:“Why does Shell want to explore off the coast of Alaska?”.

His answer: “The world’s population is increasing, living standards are rising and economies need energy to grow. Yet in many regions, easy-to-access energy resources are scarce. To meet growing demand we need a mix of strategies, and we must develop all forms of energy, traditional and renewable. To make up for the decline in conventional oil and gas resources, we have to develop resources in new, more challenging locations.”

In Shell’s Sustainability Report 2014, Ann Pickard, Executive Vice President Arctic and Alaska, is also asked this question. She replies: “Exploration of the Arctic is important as future generations may have to depend on it for a significant amount of their energy, especially as the world’s population grows from seven billion to nine billion by 2050. Today, about 10% of the world’s oil and 25% of our natural gas come from Arctic regions. Since 1918 the world has consumed roughly 25 billion barrels of Arctic oil and 550 trillion cubic feet of Arctic gas. As much as a quarter of the world’s remaining energy source remains there.”

Pickard makes a similar point in the 2013 Sustainability Report, where she notes that “Alaska oil and gas represents a potentially enormous and vital energy resource for the world”.

In other words, Shell justifies its Arctic campaign with reference to the world’s growing energy needs. How credible is this?

According to the famous US Geological Survey (USGS) report of 2008 (see also this press release), the Arctic contains an estimated 90 billion barrels of “technically recoverable” oil and 1670 tcf (trillion cubic feet) of technically recoverable natural gas. According to the USGS, this is “13 per cent of the undiscovered oil and 30 per cent of the undiscovered natural gas” in the world (though I have to confess I don’t understand how anyone can claim to know how much “undiscovered” oil and gas there is in the world).

Note that USGS refers to “technically recoverable” oil and gas, which is not the same as economically recoverable. How much oil can be economically recovered depends on many factors, not the least of which is the oil price. If we take a very high recovery rate, say 33%, and we just look at oil, it means that 30 billion barrels of oil could be produced from the Arctic region.

That may sound impressive, but annual world oil consumption currently stands at about 32 billion barrels of oil. Hence, if we assume consumption stays level despite population growth, the Arctic resource is not even enough to supply the world with one year of oil. (For gas the calculations are similar.)

Tthe Alaskan waters where Shell wants to drill are very shallow, just some 150 feet, compared to the 5,000 foot depths in the Gulf of Mexico

This applies to the resources of the entire Arctic region. If we just look at the Alaskan part, this is estimated to contain 27 billion barrels of technically recoverable oil. Slightly more than half of this, some 15 billion barrels, are in the Chukchi Sea, where Shell is going to be active. According to this report from the US Bureau of Ocean Energy Management, at an oil price of $60 per barrel, about a third of these 15 billion barrels could be produced, i.e. 5 billion barrels. Thus, if Shell makes a success of its Arctic campaign, the Chukshi Sea can supply the world’s oil needs for just two months.

In other words, to say, as Ann Pickard does, that “exploration of the Arctic is important as future generations may have to depend on it for a significant amount of their energy”, seems off the mark. The world can do without Arctic oil and gas – indeed, it will have to, because Arctic oil and gas will never be able to supply more than a fraction – or a very short period – of the world’s energy needs.

Heartlands and frontiers

But if the Arctic is a small step for mankind’s energy needs, it is a large step for a company like Shell. The real reason for Shell’s continued interest in the Arctic can be found in the company’s Investor Handbook 2014, on page 16, where this graph is shown:

This graph illustrates Shell’s “conventional exploration” strategy. Shell distinguishes between four types of resources that it wants to exploit in future:

• near-field resources (small profitable plays near Shell’s existing assets)
• heartlands (new plays within Shell’s existing major fields)
• frontier positions (acreage in under-explored areas)
• and – an entirely separate category – “Arctic”, which Shell describes as “growth options for the long to very long term”

What is key here is the “prospect size” of these four types of resources. As can be seen from the graph, the Arctic resources represent by far the greatest prospect size, twice as much as the frontier positions, four times as much as the heartlands, and twenty times as much as the near-field resources.

For a company like Shell, as long as it does not radically change its business model, it is essential to maintain its proved oil and gas reserves. That is what most of the value of the company is based on. In 2014 Shell produced 3.1 million barrels of “oil equivalents” (oil and gas together) per day (2% of global oil production and 3% of gas production), i.e. 1.13 billion barrels per year. The company’s total proved oil and gas reserves at the end of 2014 stood at 13 billion barrels, i.e. good for just 11.5 years of production. This means Shell constantly has to find (or buy) new oil and gas, if it is to stay in business as an oil and gas company. Roughly over 1 billion barrels per year.

The question for Shell is where to find these new resources. It doesn’t have a whole lot of options. Most major oil and gas producing countries, like Brazil, Russia, Saudi Arabia and the like, prefer to retain ownership of their own resources. What is left are politically risky areas such as in Africa or Iraq, or highly competitive regions like the Gulf of Mexico. And then there is of course Alaska: an oil state that is 90% dependent on fossil fuel revenues and lets private companies own resources.

Some have questioned the profitability of oil production in the Arctic. Shell has already spent some $7 billion on preparatory activities (including $2 billion to purchase the licenses in the Chukchi Sea). It will have to spend many billions more before even molecule of oil or gas is produced. But last year Shell invested $37 billion; it does that roughly every year. So the investment is not prohibitive.

“The people who live in the Arctic nations such as Canada, Greenland, Norway, Russia and the USA own these natural resources and it’s their decision alone whether or not they should be developed”

As to production costs, an interesting article in Fortune back in 2012, “Why Shell is betting billions to drill for oil in Alaska”, notes that “some analysts estimate the price of offshore Arctic production at $70 to $80 a barrel”, but adds that “one scientist who has been involved in the Shell project says he expects the cost to be closer to $30”. As Fortune notes, a 2011 report from the US Bureau of Ocean Energy Management (BOEM), referred to above, “appears to support the lower, $30-a barrel assessment. The BOEM estimates the oil ‘hurdle price’ necessary to justify the cost of Arctic drilling at $38 a barrel for Chukchi oil and $29 a barrel for the Beaufort.”

And Shell may know more about the Chukchi sea than we do: the company already drilled wells offshore in Alaska in the 1980s and 1990s. These efforts were abandoned when oil prices collapsed to $20 a barrel.

In addition, although climatic conditions may be daunting in the region, the Alaskan waters where Shell wants to drill are very shallow, just some 150 feet, compared to the 5,000 foot depths in the Gulf of Mexico. This makes operations there much simpler and therefore cheaper.

Not without reason did Ann Pickard state, in Shell’s 2013 Sustainability Report: “We believe that Alaska’s Chukchi and Beaufort Seas are the most promising undeveloped hydrocarbon basins in the United States.”

Next 75 years

It is clear, then, that for Shell the Arctic is not just any other project. Its Arctic campaign lies at the heart of the company’s long-term strategy. Successful development of the region may be another 10 to 15 years away, but as Pete Slaiby, Shell’s Vice-President for Alaska, says in the Fortune article: “Shell is going to be here for the next 50 to 75 years.”

What is interesting is that this implies that Shell’s decisions in the Arctic will demonstrate, like no other activity, the business model the company is committed to. If Shell were to decide to leave the Arctic, that would be a significant step indeed.

But it’s not just Shell that is faced with a choice. Time and again in Shell’s Sustainability Reports, the company’s executives stress that it’s not Shell that is taking the lead in exploiting the Arctic. It’s the Arctic nations themselves that do so. “The nations of the Arctic have taken the decision to open up the region for offshore development and trust companies such as Shell to do it responsibly”, says Pickard in the 2013 Sustainability Report. (Marvin Odum says literally the same in the 2012 Report – they must have talked about it to each other.)

In the 2014 Sustainability Report, Pickard says: “The people who live in the Arctic nations such as Canada, Greenland, Norway, Russia and the USA own these natural resources and it’s their decision alone whether or not they should be developed. These nations have asked Shell and other companies to help explore this vital, long-term source of economic security.”

Van Beurden clearly does not believe that 25 years from now supply and demand of energy will look fundamentally different from today

Leaving aside Pickard’s somewhat dubious assumption that “the people” are identical with their governments, she does have a point. If these nations decide they need or want to get their hands on the oil and gas in the Arctic, they will do so – and then it hardly matters who does the drilling. It might as well be a relatively responsible and competent company like Shell.

In that sense, the activists and shareholders who are demanding that Shell leaves the Arctic, are aiming at the wrong target. They should be targeting the governments of the Arctic countries first of all.

Yet this does not remove the responsibility for Shell to make its own strategic decision about where it wants to go. When asked, in Shell’s 2014 Sustainability Report, “What impact does Arctic drilling have on climate change and the melting sea ice?”, Pickard answers: “The Arctic is especially vulnerable to the effects of global warming. Scientific measurements show that the thickness and extent of summer sea ice in the Arctic have declined over the past 30 years. The loss of sea ice has the potential to accelerate global warming and to change world climate patterns.” And she adds: “Climate change is a key issue for Shell. The scientific evidence shows that the rising CO2 levels in the atmosphere is the main cause of climate change. It is the effect of cumulative emissions around the world, rather than being caused by Arctic drilling.”

If Shell really believes this, isn’t it time that the company should at least start to alter its course? Nothing in the company’s utterances indicates that it is doing so, as critics like John Ashton and Adriaan Kamp have recently pointed out on Energy Post.

At the annual general meeting last Tuesday, defending Shell’s course, CEO Ben van Beurden said: “If there will be no further investments in oil production, the gap between supply and demand could be 70 million barrels per day by 2040 [i.e. we will virtually have no oil production left!]… we will need sustained and substantial investment just to meet the demand to fuel economic growth especially in the developing world.”

Van Beurden clearly does not believe that 25 years from now supply and demand of energy will look fundamentally different from today.