“The U.S. Arctic Ocean presents almost a perfect storm of risks – a requirement for a long-term capital-intensive investment for uncertain return, a remote and uniquely challenging operating environment, ongoing court challenges, a lack of extraction and spill response infrastructure, and the spotlight of the world’s environmental organizations, the U.S. political community and international media.”

A new report, published by BankTrack members Greenpeace, Platform, and Pacific Environment, along with ShareAction, Oil Change International and Oceana,  examines the risks to shareholder value from Royal Dutch Shell’s Alaskan Arctic drilling program.

The report explores the economic and operational challenges Shell has been forced to deal with by undertaking offshore drilling in the U.S. Arctic. Shell has been forced to abandon its 2012, 2013, and 2014 U.S. Arctic drilling programs based on its inadequacy in dealing with Arctic conditions and both public and legal challenges.

Executive Summary

Royal Dutch Shell stands at a strategic crossroads. Its response to the reserves scandal in 2004 has been a global reserves replacement hunt through a program  of relentless capital expenditure. This search included an investment in US Arctic Ocean leases in the mid-2000s that dwarfed other companies’ spending (see section 1.2). Shell’s U.S. offshore Arctic plans have been a failure despite capital expenditure, to date, in excess of $5bn. Following a 2012 drilling season beset by multiple operational failings and a subsequent ‘pause’ in the company’s Arctic program, Shell announced, on 30 January 2014, a forced reversal of its intention to return to the Chukchi Sea in the summer of 2014.
The main factor cited by Shell for its decision to pause its offshore Arctic drilling program yet again was a decision by the US Court of Appeals for the Ninth Circuit. On 22 January 2014, the court found in favor of Alaska Native and conservation organizations in their challenge to the environmental analysis underlying the US government’s decision to sell leases, including those owned by Shell, in the Chukchi Sea. The plaintiffs have sought to have the leases invalidated. Even if that does not occur, it is likely that the government will be forced to carry out a new environmental analysis, which could delay Shell’s exploration in the Chukchi Sea by several years (see chapter 3).
Investors in IOCs are increasingly questioning allocation of shareholder capital to high cost, high risk projects such as offshore Arctic drilling against an industry backdrop of flat share prices and declining returns on equity even through a period of sustained $100/barrel oil prices. Shell’s January 2014 profit warning –the company’s first in 10 years – was attributed in part to “high exploration costs.” Despite increasingly vocal shareholder calls for greater capital discipline, Shell remains committed, at least publicly, to the high cost, high risk U.S. Arctic Ocean.

Significant concerns remain regarding Shell’s preparedness and capabilities for responding to a major incident. In reviewing the company’s 2014 exploration plan and operating plan, one of the relevant regulatory agencies, the Bureau of Ocean Energy Management (BOEM), raised a number of significant questions. Several of these queries relate to contractor oversight (see section 5.2) – the source of many of the problems that arose in 2012 and an unwelcome echo of the root causes of the Deepwater Horizon disaster. Shell’s response to these questions and its public statements do not evidence serious recognition of the problems in 2012 or a concerted effort to improve.

As Ben Van Beurden, the new CEO of Shell, prepares to deliver his vision for the future of the company and to set its strategic priorities, he and investors must carefully balance any focus on reserves replacement ratio with the potential financial impact of the short and long-term risks inherent in any project. The US Arctic Ocean presents almost a perfect storm of risks – a requirement
for a long-term capital-intensive investment for uncertain return, a remote and uniquely challenging operating environment, ongoing court challenges, a lack of extraction and spill response infrastructure, and the spotlight of the world’s environmental organizations, the US political community and international media.
In this context, investors must scrutinize Shell’s assessment of such risks and the company’s ability to mitigate and manage them in order to determine whether the potential return provides sufficient justification to continue. Questions for investors to ask Shell on these issues are suggested at the end of each chapter and brought together in the conclusion.

ARCTIC OIL AND GAS PROJECTS – THE RISKS FOR SHELL AND ITS SHAREHOLDERS

UNCERTAIN LONG-TERM PROFITABILITY

Shell’s capital investment in 2013 is at a record high, while at the same time, the company has warned investors that its 2013 profits are at a steep drop. In this context, shareholders should question whether Shell’s continued investment in Arctic Ocean drilling is likely to return capital in the long run. Such a return would require finding significant oil reserves at Shell’s prospects and sufficiently high oil prices beyond the 2030s.

Shell’s Chief Financial Officer, Simon Henry, acknowledged that Shell depends on an oil find to make profit from the Chukchi Sea project. However, the U.S. government has estimated the Burger Gas Discovery (Shell’s prospect) to contain 14 trillion cubic feet (tcf) of dry gas and 724 million barrels (mnb) of condensate – no crude oil. The government agency concludes: “Even under a very optimistic set of assumptions, Burger is a marginal development opportunity.”

Analysis from Rystad Energy based on government estimates also suggests Burger is an uneconomical gas play. In fact, with current resource estimates and current projections of North American natural gas prices, the project is estimated to yield a negative cash flow of over $23.5bn (see section 2.3). While proprietary data from Shell’s geological assessment of Burger may encourage the company to drill for oil there, all other sources of information suggest that Burger is a high cost gas play that is unlikely to be commercial.

Even with an oil find, Shell would depend on high oil prices to justify extraction from the Chukchi Sea prospect. These prices would be determined by the oil market in the 2030s, which depends on both highly unpredictable technological changes in transportation efficiency and whether government policies will continue to fail to address global climate change. Effective climate regulation would involve reducing oil demand and result in lower oil prices, thereby making Arctic oil extraction unfeasible. Considering economic analysis by the International Energy Agency (IEA), Shell appears to be gambling on a lack of effective climate regulation, and even the IEA considers that gamble to be highly risky (see section 2.4).

LITIGATION RISK

Corporate and government decisions to move forward with oil and gas activities in the U.S. Arctic Ocean have generated substantial opposition and litigation by conservation organizations, local government and community bodies, and Alaska Native entities. Since 2007, successful federal court challenges have been brought at all relevant stages of the process – Five-Year Leasing Program, lease sale, and exploration.

Most recently, the Ninth Circuit Court of Appeals invalidated the environmental impact statement underlying the government’s decision to hold Lease Sale 193 – the sale in which Shell purchased the leases on which it seeks to drill in the Chukchi Sea. The challenge was filed by Alaska Native and conservation organizations, and the ruling is the second court decision invalidating the government’s 2008 analysis. Petitioners are asking the court to invalidate the leases and, even if that request is not granted, the government will need to remedy the problems identified by the court, which may delay Shell’s drilling by several years, as the previous decision did.

The strong opposition and litigation are almost certain to continue. In another pending case, Alaska Native and conservation organizations are challenging the government approvals of Shell’s oil spill response plans for the Chukchi and Beaufort seas (see chapter 3).

INADEQUATE OIL SPILL RESPONSE

The potential financial impact of a major oil spill in Arctic waters has not yet even been assessed by Shell. In addition to significant financial penalties in the form of clean-up and remediation costs (compounded by the practical challenges involved (see section 4.2)), regulatory fines and prolonged litigation in a variety of courts from a myriad of claimants, Shell would also likely face uncertain impacts on share price and credit ratings, unprecedented reputational damage, and a threat to its ability to do business in the U.S. Almost four years after the Deepwater Horizon disaster, BP is still banned from bidding for government contracts.In order to pay the penalties and address longer lasting financial impacts, BP has sold assets worth $38bn in the past three years.

Since Shell is self-insured to only $1.15bn per event, it is likely that Shell would have to conduct a similar ‘fire sale’ of assets to meet the resulting financial liabilities of a major Arctic spill. At present, it is far from clear that Shell has adequate physical or financial oil spill response plans. In fact, there is no available information about how the company would address the financial implications of a major spill.

The U.S. government estimated that there is a 40% chance of a large spill (over 1000 barrels) during the lifetime of exploration and extraction of oil in the Chukchi Sea.

So far, no analyses have been published quantifying the specific oil spill response impediments in Shell’s lease areas in the Chukchi Sea. But a study commissioned by WWF found that it would not be possible to respond to an oil spill in the Canadian Beaufort Sea for seven to eight months of the year. During the most favorable weather conditions (July–August), a response would only be possible 44–46% of the time, assuming that the infrastructure and workforce were readily available. A response gap analysis needs to be carried out and published to be able to accurately assess the threat that spills pose to Shell’s potential operations.

Even if response efforts can be mounted, the usual techniques for controlling a spill (booms, skimmers, and dispersants) are of questionable efficacy in icy waters. Nonetheless, Shell’s worst case scenario planning is based on the questionable assumption that those types of mechanical recovery equipment would recover 95% of a major spill before it could reach the shoreline—a clean-up rate that has not been achieved for any large spill anywhere to date (see section 4.2). Less than 10% of spilled oil was recovered using these techniques after the Deepwater Horizon and Exxon Valdez spills.

The infrastructure to mount a large-scale response to an oil spill in the Chukchi Sea simply does not exist. The nearest major road system is more than 500 miles away as the crow flies. There are no hotels or other housing capable of accommodating thousands of responders. The nearest Coast Guard station is roughly 1000 miles from the likely drilling sites (see section 4.3).

Essential safety equipment has not been tested in appropriate real-life conditions. A 2012 Freedom of Information Act request revealed that Shell’s capping stack (vital equipment in case of a well blowout) was tested for less than two hours off the coast of Seattle rather than in icy water and was not attached to a simulated wellhead and blowout preventer as would be necessary in real life (see section 4.5).

Shell’s 2014 Chukchi Sea exploration plan suggests that overall spill response capacity may be reduced. The previously approved oil spill response plan depends upon simultaneous operations in the Chukchi and Beaufort Seas allowing both fleets to be mobilized in the event of a spill in one sea. Shell’s operational plans do not explicitly commit to bringing all of the assets proposed for response in the previous plan and do not propose increasing response capacity, despite only intending to operate in the Chukchi Sea (see section 4.4).

MANAGEMENT RISK

In the aftermath of Shell’s numerous operational setbacks in its 2012 U.S. Arctic program, Shell’s failures should also be viewed, in corporate governance terms, as a failure of management and board oversight. In its review of the 2012 season, the US

Department of the Interior found that there were “significant problems with contractors on which Shell relied for critical aspect of its program” (see section 5.1). The review went on to describe the problems with contractor management and oversight as “the most significant shortcomings in Shell’s management systems.” It then recommended that Shell satisfy two conditions prior to being allowed to resume drilling operations in the US Arctic Ocean. While Shell published an integrated operations plan in November 2013 (fulfilling the first condition), it has not yet fulfilled the second condition: “a full third-party audit of its management systems, including but not limited to, its safety and Environmental Management Systems program (SEMS)”. This has resulted in a situation where the integrated operations plan refers repeatedly to management systems such as SEMS which have yet to be audited independently (see section 5.2).

Shell does not specify in its 2014 integrated operations plan what changes have been made in contractor oversight and selection practices since 2012. BOEM also requested more detailed information from Shell regarding contractors, stating that Shell’s documents “must clearly detail how Shell conducts contractor oversight to ensure that its safety and environmental protection policies and standards are implemented by its contractors.”

2012’s operational failures stood in marked contrast to the confident statements of board members about the company’s preparedness for Arctic exploration, suggesting a lack of senior executive oversight of a high risk, heavily scrutinized project. 2014’s most recent development – the finding of the Ninth Circuit Court of Appeals – appears to have blindsided the company. Furthermore, the company’s statements that its “

2012 exploration drilling operations in the Arctic were conducted safely, and with no serious injuries or environmental impact” suggests that the company has chosen to make a surprisingly positive internal assessment of what to an objective observer was a failure (see section 5.5).

REGULATORY UNCERTAINTY

Both ConocoPhillips and Statoil identified uncertain standards as reasons for delaying exploration. In fact, ConocoPhillips announced in a press statement that it was delaying planned exploration “given the uncertainties of evolving federal regulatory requirements and operational permitting standards” (see chapter 6).

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