COMMENT

Leonard Le Blanc

Are we there yet?

The prospect of licensing for oil and gas exploitation in international waters is approaching. The advent of drilling in 10,000-ft water depths will almost assuredly speed the demand for licenses beyond the generally recognized 200-mile territorial boundary.

Already, producers are bumping up against a potential problem in the central and eastern Gulf of Mexico, where the US, Cuba, and Mexico lack clear-cut territorial rights. Some way may be found to partition the remaining acreage. However, the US does not talk to Cuba, so some sectors may remain undrilled until bilateral agreements are worked out.

The Law of the Sea treaty, a quasi-UN formulation, activates the machinery to set up a working international leasing agency. The Treaty will cover all forms of mineral exploitation. Trials of ocean mining operations have taken place in international waters under a temporary UN aegis until the Treaty comes into full force. The central Gulf of Mexico is not the only water body where international hydrocarbon leasing could occur in the future. Others include the: Eastern reaches of the Grand Banks, east of Newfoundland; Atlantic shelf off Argentina; Southwestern edge of the Celtic Sea; Denmark Strait, between Greenland and Iceland; Barents Sea, between the various Russia and Norway holdings; Agulhas Basin, south of South Africa; Wallaby Plateau, west of Western Australia; Tasman Sea shelf, west of New Zealand; South China Sea, although claimed all or in part by six countries; and East Siberian Sea, off northeast Russia.

These areas, certainly not all inclusive, harbor sedimentary basins of various thicknesses. Some areas have large accumulations of gas hydrates, a potentially exploitable hydrocarbon when the recovery technology comes along, as it most surely will. Unless some sort of revolutionary collapse in energy demand takes place in the future, the hydrocarbons in international waters will be just as critical to global supply as offshore production is today.

This is not to ease the significant multilateral disputes in international leasing, the restrictions that could evolve, and the disposition of leasing and production revenues. Certainly, it will test the accommodation abilities of US and other western governments in accepting access restrictions, as well as under-developed nations that look upon the revenues as a deserved windfall. Ironically, the US government, which opposes the regulation of access in the Law of the Sea Treaty provisions, accepts access restrictions readily for its own territorial seabed.

Larger correction due

A recovery of Asian economies is too far off to rescue low oil prices, and Japan and China's struggles are likely to keep oil demand off for several years. An over-arching concern, long-term, is tighter environmental regulation of the industry.

Near-term, the international petroleum industry is replacing crude production at a rate of 135%. Demand will not absorb that growth in supply, and even with a dwindling exploration effort, a falling replacement rate will not impact production for at least two more years. Further, all drilling, servicing, and equipping of wells is being undertaken in a rising cost environment.

In view of the oil supply over-hang, a significant industry correction is due. Most producers have not passed on the full impact of shrinkage in cash flow due to lower oil prices for several reasons:

Long-term drilling contracts are stretching out the impact of drilling softness, but operators already are showing great selectivity in re-leasing. Fortunately, most rig contractors have been willing to meet that softness with lower rig rates.
Drilling success in deepwater also has disguised market softness. As deepwater budgets receive a larger share of shrinking budgets, the shortfall impact is beginning to show up elsewhere.
Sunk costs - completed acquisition of licenses, leases, and geoscience surveys - have caused most producers to do whatever it takes to preserve the value of that investment, especially for good prospects, but it won't continue indefinitely.
Downstream margins have protected upstream spending for integrated companies, but continued supply price competition will take its toll.

While the industry will have to cope with a 1-2 year correction in the short term, the long-term prognosis is that demand will ramp up again as under-developed nations substitute for heavier carbon fuels. Conservation and energy alternatives will cut into demand increases, but global supply and demand should equalize sometime in the 2000-2002 time frame.