A helicopter ride 130 miles south of New Orleans in the Gulf of Mexico brings you to Royal Dutch Shell’s offshore Olympus platform. The hulking steel structure supports a deepwater drilling rig that can produce the equivalent of 100,000 barrels of oil a day.
For the Anglo-Dutch major, drilling far beneath oceans is essential for raising the funds for investments that will steer it through an uncertain energy transition.
“The responsibility deepwater has is to generate the cash that is going to pay for shales and for renewables,” said Wael Sawan, Shell’s head of deepwater exploration and production.
“From 2020 we start to pay the bills for the organisation,” added Mr Sawan, speaking to the FT on the four-year-old platform.
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The company is banking on this new profit centre — alongside conventional fossil fuels, integrated gas and its refining arm — to cover the dividend, finance debt and pay for the investments that will future-proof Shell.
“Failure is not an option here,” said Mr Sawan. “We are trying to navigate what is an evolving landscape.”
The energy industry is grappling with how to invest in cleaner and more flexible production amid uncertainty about future oil demand growth, when returns cannot match those from traditional fossil fuels.
For Shell, this means turning back to its legacy business to fund its future.
Drilling in water depths greater than 300m was previously plagued by delays, exorbitant costs and questions over safety standards after the fatal 2010 Deepwater Horizon explosion. Despite being capital intensive, today’s projects are cheaper, simpler and smaller.
For the majors a sweetspot has been struck. High-margin new production is starting up as costs — for now — are falling, even as oil prices continue to rise.
“For all big majors, deepwater is a growth element,” said Angus Rodger at oil consultancy Wood Mackenzie. “Deepwater is where all the big discoveries are made . . . But it is only accessible for those with cash reserves and technical capability.”
Shell has both. In July, Shell reported cash generation from operating activities excluding working capital of $11bn, the strongest since 2014 when oil prices were above $100 a barrel.
Its third-quarter financial results on Thursday are expected to reveal higher earnings, with Shell continuing to deleverage its portfolio and a $30bn divestment plan nearing an end. Analysts also see improved profitability from the upstream business.
Shell’s improved financial position is allowing it to spend more than a fifth of its annual total capex budget, $5bn-$6bn, in deepwater compared with $2bn-$3bn for shale projects and $1bn-$2bn on new energies — from electric vehicle charging providers to biofuels and renewable technologies.
Deepwater has a target to generate $6bn-$7bn in organic free cash flow from operations in the 2020s with crude averaging $60 a barrel. However, with the oil price expected to exceed this, cash flow from deepwater could come second only behind its dominant integrated gas business. This would help manoeuvre Shell through what Mr Sawan calls a “time of turbulence”.
Shell also has scale. It is the largest operator by production in the US Gulf of Mexico, pumping out 350,000 barrels of oil equivalent per day — more than 40 per cent of the company’s total deepwater production, which is on track to reach more than 900,000 boe/d by 2020 as new projects come on line.
The division’s centre of gravity remains in the Gulf of Mexico, but it is also in the early stages of expanding its presence in Brazil and Mexico. Nigeria and Malaysia are other deepwater hubs.
“They need to grow the deepwater business now to make it a cash engine of the future,” said Irene Himona at Société Générale. “Conventional oil and gas and the other divisions will continue to generate profits but these are mature businesses.”
Barriers to entry in the deepwater sector are high. About 75 per cent of future spending — $250bn of deepwater projects are in the pipeline — will be made by eight majors, according to Wood Mackenzie.
ExxonMobil of the US is prioritising Guyana, UK’s BP seeks big potential in Mauritania and Senegal, France’s Total is dominant in west Africa and Equinor of Norway is also investing in Brazil.
Executives at these energy majors are acutely aware of the need to produce returns quickly for shareholders who now have little appetite for large-scale costly developments that take years to generate a return.
When oil prices crashed, costs dropped as activity slowed — rates for deepwater rigs have halved since 2014. Companies streamlined by cutting thousands of jobs, utilising existing infrastructure better, negotiating more favourable terms with contractors and increasing drilling efficiency and safety through automation.
Today the industry has clawed its way back to being competitive and the economics of some deepwater projects now challenge US shale fields. Projects are now profitable should prices fall to $35 a barrel rather than the $85 a barrel that was once needed.
Production of oil and gas from deepwater fields in the Gulf of Mexico is expected to reach a record high in 2018 of more than 1.9m boe/d, according to Wood Mackenzie, with global offshore rig demand expected to increase 15 per cent by 2020.
Jeremy Thigpen, chief executive of rig operator Transocean, said last month the ultra-deepwater drilling market was “turning up”.
However, while more than half of new global discoveries are expected to be found in deepwater, the high volumes will not be in the US Gulf of Mexico — forcing Shell to squeeze costs and boost productivity in the region. Those that have limited running room are being sold off — such as the Brutus platform in 2016 — and new ones have been redesigned to reduce spending.
“The resources we are discovering in the Gulf are not as material as some of the resources we are finding in other places, so we have to continue to stretch the imagination to be competitive,” said Rick Tallant, Shell’s Gulf of Mexico chief.
Shell’s rivals are doing the same. Bernard Looney, BP’s head of exploration and production, has said that better data analysis and new seismic imaging technology had enabled it “to see 200m barrels we wouldn’t have been able to otherwise”.
Not helping are Trump administration policies that are hurting the Gulf’s attractiveness. US steel import tariffs could dramatically impact the value of new developments such as Vito, which Shell gave the go-ahead for earlier this year. “Tariffs make any project more expensive,” said Mr Tallant.
“As the rules of the game change sometimes the competitiveness and predictability of your business changes.”
Big energy majors recognise that oil from deepwater fields will be necessary to meet growing consumption in the next few years, despite rising investment into shale oil output.
“Deepwater is going to provide the supply the world is going to need,” said Clay Neff, who heads up exploration and production for Chevron in Africa & Latin America.
But it is unclear how long deepwater projects will remain a priority. Unlike previous cycles, the industry is weighing up a future where oil demand stops growing as the world moves towards cleaner fuels.
Although Mr Sawan said there was no talk yet of “winding down” at Shell there could be a time where all capital expenditure goes into renewables, particularly amid rising shareholder demands that energy companies do more to limit climate change.
“Right now we are continuing to grow,” said Mr Sawan. “It becomes a question of how do I generate even more cash out of our existing businesses to be able to have more cash to invest in renewables.”
The thinking is a glimpse into the dilemma facing major energy companies, all of whom are under pressure to invest in new energies, despite struggling to generate similar kinds of revenues as dirtier fuels.
“The danger is, if you start saying you’re going to stop investing in one in favour of the other, you’re going to be losing your fundamentally advantaged position in favour of something in which you have yet to truly show you are able to create value out of,” Mr Sawan added.
