From Houston boardrooms to Cajun kitchen tables to Manhattan offices, a fog of uncertainty swirls around the future of the offshore industry. Ripple effects from BP’s tragic Macondo accident in April continue to cast a pall over the Gulf of Mexico.

Operators, service companies, investors and bankers use the same word to describe the outlook: uncertainty. No one doubts that the Gulf continues to hold untold petroleum potential for America, especially in ultra-deepwater plays such as the Lower Tertiary Trend and in ultra-deep wildcats such as the Davy Jones appraisal well now drilling on the Outer Continental Shelf in shallow water.

And, no one doubts Gulf activity will rebound. The question is timing, and how much operators will have to pay to play. There are 284 independents in the Gulf’s shallow water alone, and they account for 73% of the shelf’s production. Some may have to change their strategies and exit.

“I think banks are going to choose more carefully where their exposure is in the Gulf, and they are re-ranking all the operators,” says one chief executive.

Deepwater-oriented stocks may not recover to their pre-spill highs until sometime in 2012, predicts one analyst.

“We had a contract with one customer to drill six to eight wells, but now, we are going to take it on a well-by-well basis,” says a drilling contractor.

Raymond James & Associates’ head of research Marshall Adkins worries the government hasn’t considered the full ramifications of shutting down deepwater drilling in the Gulf. In his pre-spill model, he anticipated 400,000 barrels of oil per day in production growth during 2010 and 2011 from the Gulf.

“Post-spill, if you’re not going to drill, we think you lose a couple hundred thousand each year, so you wind up being down about 400,000 during the period. The net change to what would have been is about an 800,000-barrel-per-day swing in non-OPEC production from what we were modeling six months ago, and that’s a big deal for the global oil equation.”

In the lobby at ATP Oil & Gas Corp.’s Houston headquarters, you can pick up a corporate brochure titled “Patience Transforms.” Investors in the firm had to be patient as the company scrambled to raise enough capital for its many offshore developments in the Gulf and North Sea. At the same time, it has won patents and industry awards for its technical creativity and safety in bringing offshore reserves to production.

Its 70-story Titan, a reusable production and drilling platform, was installed in 4,000 feet of water on Mississippi Canyon 941 last November. It is the first deepwater, dry-tree MinDOC (minimum deepwater operating concept) facility set in the Gulf of Mexico to be built entirely in the U.S.

It forms the basis of ATP’s $1.3-billion Telemark Hub project, which will have four producing wells and more than double the company’s production. The first well is on line—the other three are delayed by the deepwater drilling moratorium.

Chairman and chief executive T. Paul Bulmahn tries to be patient when expressing his frustration about the challenges he and the rest of the industry face since BP’s well blew out April 20. The very day before, ATP had priced a $1.5-billion high-yield offering to advance development. A day later, and the deal likely would have been impossible. As it was, the company received the money April 23, the day after the Deepwater Horizon sank, taking 11 lives with it.

Now, certain projects the company was counting on are delayed by the moratorium, and its production guidance has been revised downward. ATP’s stock, like that of many of the offshore independents, has taken a beating.

What’s more, the spill has affected a wider section of the U.S. economy than first believed. “I discovered that at ATP, we send checks out to 44 of the 50 states, from people we employ to consultants to vendors—even Red Wing Shoes in Minnesota has noticed its revenues have fallen off in the Gulf Coast region,” notes Bulmahn.

“It’s been an interesting summer,” John Schiller, chairman and CEO of Energy XXI, says wryly. “We left the IPAA (investment conference) in April at a 52-week high, and then, boom. I think as a group we are all in this together and we have come together.”

Energy XXI has remained active within its core producing properties and has received permits to perform workovers, recompletions and sidetracks for wells in its Main Pass 61, South Timbalier 21, East Cameron 334 and Eugene Island 275 and 330 fields. To date, none of the company’s production, drilling activities or future plans have been materially affected by the spill.

The company, and Apache Corp., Seahawk Drilling Corp. and others have formed the Shallow Water Energy Security Coalition to educate the government and petition for continued drilling without onerous taxation or liability caps. At press time, some 44 jackups and nearly 5,000 workers had been idled by the slowdown in shallow-water permitting. Only five shallow-water permits have been granted since June.

Because Energy XXI’s fiscal year begins July 1, the company knew what it was facing and was able to adjust its 2011 budget accordingly. “This year we will be doing a lot of recompletions and sidetracks that are not subject to the new NTL-06 (a federal notice to lessees that requires new and stricter regulation of offshore activity). We will drill only one or two new operated wells.”

One big problem is the slow and uncertain pace of drilling permitting, even in shallow water. “You are dealing with four district offices and trying to figure out the new recipe,” Schiller says.

“Permits for sidetracks do not require NTL-06 and are going at more or less the normal pace, but they told us to get used to ‘just-in-time’ delivery, which makes it harder to coordinate getting a rig. Now we have to designate which rig we will use beforehand.”

The company is about to go through its semi-annual bank redetermination procedure, and Schiller expects no problems, partly because Energy XXI deals mostly with foreign banks such as BNP Paribas and Royal Bank of Scotland, “and that’s by design, because they have a different tolerance for risk.”

Meanwhile, Energy XXI is a non-operating partner in the ultradeep wells being drilled by McMoRan Exploration Co. at Davy Jones and Blackbeard East, wells that demonstrate the huge potential of the shallow-water shelf.
All of Seahawk’s 20 jackup rigs are in the shallow water. The new company is a 2009 spin-off from Pride International Inc. After a tough downturn in 2009, it reactivated some rigs that had been stacked; eight were working at the time of the BP blowout. At present, it is experiencing several delays due to the permitting slowdown, says chief executive Randy Stilley.

“It’s had a huge impact on us. It used to take one or two weeks to get a permit, but now it’s been taking six to eight weeks. We have to educate the government that there is a difference between the shallow water and deepwater. This is a known basin, there are not a lot of surprises; there’s lots of offset well data. (Since 1949, some 46,000 wells have been drilled in the shallow-water Gulf.)

“For now we are working on customers’ sidetracks and recompletions that don’t get held up (by the new rules or the moratorium), but we are going to run out of those opportunities over time.”

Seahawk may have some options, though; for example, it has maintained its relationship with Pemex, and available rigs provide leverage to even a marginal recovery in permitting.

Stilley says he doesn’t think he’s ever seen the level of frustration in the industry he’s seeing today. “I have to tell you, we are looking elsewhere. Even places like West Africa look more secure than the U.S., and that is a shock to me. I’d like to be more optimistic, but we have so little visibility on what’s likely to happen in the next six months. If we had a map to when permitting would occur, we could all deal with that.”

Rally for Investment

Along the Louisiana Gulf Coast, political risk when investing in E&P was largely nil until this summer. Although the Louisiana coast has been oiled by the Macondo blowout and other damage remains unknown, residents largely work for the energy industry or thrive by serving those who do.

Their support for drilling was made clear one Wednesday in July when more than 11,000 filled the Cajundome in Lafayette to support drilling.

John Hofmeister, former Shell Oil Co. president and the founder of Citizens for Affordable Energy, elicited dome-raising applause, stomping and fist-pumping. He said President Obama’s drilling moratorium will result in higher gasoline prices—and soon.
“In 2012, when the pump price is $5, Mr. President, your administration and all of your dreams are toast,” he said.
David Welch, president and CEO of Lafayette-based Stone Energy Corp., told Oil and Gas Investor that the Gulf’s profile was a perfect 10 for political stability before the Macondo blowout. It slipped to a 5 when deepwater drilling was stopped, he estimates. He’s confident the ban will be lifted soon, possibly before November 30.
And, investment will continue, he says.
“First, the deepwater Gulf of Mexico just holds incredible reserve potential. It is one of the most economic plays in the world. Companies from all over the world are trying to get into the deepwater Gulf. The reserves are just so compelling. It’s worth staying in the game.”
Founded in 1993 with a Gulf focus, Stone Energy Corp. inherited acreage in the Rockies and began to accumulate acreage in the Marcellus in 2005. But the Gulf remains its reliable revenue-maker to date, with most of its 2009 average daily production of 215 million cubic feet equivalent derived from the shelf.
The company was just beginning a deepwater exploration program. That is shut down for now.

“We’ve spent that past four years building deepwater teams, buying seismic data, buying leases,” Welch says. A first deepwater discovery came in 2009, and Stone was ready to drill three or four more wells this year. It drilled one, a development well, before progress was suspended. Its deepwater Amberjack program can proceed, as the rig is fixed to the platform and not floating, but “we’re seeing a delay of about a year or so of our growth plans in deepwater.

“We were anxious to proceed, but this does give us another year of study before we commit significant dollars for deepwater exploration.”

Stone has redirected its 2010 deepwater and deep-shelf capex budget, totaling some $64 million, to the Marcellus shale where its leasehold has grown to some 60,000 acres.

Once new regulations are outlined and liability costs are clear, a few of Stone’s drilling plans in the Gulf may become marginal opportunities, he forecasts.

“Gulf producers will get back to business, but it will be a new normal. We’re obviously going to see some increased cost.” Punitive legislation may be overwhelming. “I’m guardedly optimistic the Gulf will continue to be one of the best places in the world to do business.”

Redeploying Dollars

Don Briggs, president of the Louisiana Oil & Gas Association, says the independent producers that continue to mine the shelf will be harmed the most by higher operating costs and investor uncertainty.

“There was a change taking place on the shelf already because of higher insurance costs due to recent hurricanes,” Briggs says. “Now, the cost of doing business there has escalated to a degree that makes it very difficult for a small company to operate.”

Securities analysts and shareholders “are starting to say, ‘Hey, you’ve got assets in the Gulf, and we don’t think you should be there.’” The news from Plains Exploration & Production Co. in early August that it has posted its Gulf portfolio for sale is a leading indicator of industry perception of the return-on-investment health of the region, Briggs adds.

Jim Flores, Plains chairman, president and CEO, built his E&P buy-and-build career offshore Louisiana, starting with a $55-million acquisition from Shell Oil Co. in state waters and eventually selling Ocean Energy Inc. some 20 years later to Devon Energy Corp. for $4.3 billion.

Briggs says, “Here’s a guy who started in the Gulf, and he’s going to unload those assets. The reason is just one simple word: uncertainty. Several companies are packing their bags and are going to move their capital onshore.”

If fewer independents operate in the Gulf, the region’s decline rate will accelerate, which is already some 30% to 40% on the shelf and in deepwater, contributing further to the U.S. oil deficit.

Higher per-barrel prices due to reduced supply may offset higher Gulf operating costs, making the region, the shelf in particular, an ongoing, viable investment. But that is theory. Meanwhile, investor returns are expected quarterly.

Are prospective buyers of small, conventional shelf assets even able to assign value to these properties? “Good question,” Briggs says. “There is a lot of interest in Plains’ properties because they are in really good plays, such as in the deep shelf with McMoRan (Exploration Co.), so they will probably be able to sell.

“With the smaller guys on the shelf, it’s a different story. Probably not.”

This is because potential shelf buyers are primarily the fellow wounded—other independents. Major oil companies left the shelf years ago, when discoveries became too small to be meaningful to their huge production-replacement targets.

Stone’s Welch points to advancements in wild-well control as a result of the Macondo blowout that all of the Gulf industry can access now: the containment cap and a deep-sea top-kill procedure. “And, these have been battle tested now, so we know they work.” Both can be deployed in a matter of days, rather than months.

“The amount of oil that would escape would be a very small percentage of the amount of oil that came from the Macondo incident.”

Meanwhile, Washington’s response to the blowout has been an over-reaction, Briggs says. The incident is an anomaly, best practices were simply not followed, and BP was reckless. “Those were almost my words, verbatim, when I was on Wall Street…and when I testified before the Senate. This is not the norm. The independents have drilled 2,500 wells in the Gulf; independents have drilled 1,200 of them in deep water—1,200 of them!—without an accident.”

Effect on Equities

In the wake of the blowout, many investors remain uneasy about the energy sector. Several institutional investors, still smarting from the recent recession, are becoming energy gun-shy all over again. Sell-side analysts for the most part are taking a wait-and-see stance. They like offshore-oriented stocks for the longer term, but don’t see a buying opportunity just yet.

Before the drilling moratorium, the deepwater Gulf boasted a number of positives for investors. There was the quick payback of development costs once a project came online. In general, deepwater players receive premium pricing, royalty rates are lower than for onshore projects and there are no production taxes, says Richard M. Tullis, senior E&P analyst, Capital One Southcoast. His group covers 10 companies with Gulf of Mexico exposure, mainly smaller independents.

“While not drilling wells can have a positive effect on these companies’ short-term cash flow, they’re incurring costs from the demobilization and remobilization of rigs, and standby fees. We may also see an impact on their year-end reserves, which could affect borrowing bases.

“It seems inevitable that capital will start to migrate away from the Gulf to onshore projects and abroad, especially since the oil shales are gaining prominence.”

Even before the accident, mutual funds and hedge funds were moving away from offshore investments in favor of unconventional, shale-driven names, says analyst Neal Dingmann of Wunderlich Securities Inc.

“Since the spill, the risk that has always been a part of offshore projects has been compounded by political risk,” he says. “Add to that the natural-disaster risk from hurricanes and it makes clients very cautious about offshore projects…these stock prices could stay low for several quarters. As an investor you always have some commodity risk. The last thing you want is very high political risk in addition to that.”

Collin Gerry, analyst, Raymond James & Associates, says, “There are some institutional clients willing to look beyond the next two years, but the reality is that a majority of the institutional money is looking at deepwater stocks as a dead space in the near term.”

The exception would be the premium jackup market, notes Marshall Adkins, Raymond James’ head of energy research. Still, he expects the majority of the market to sit on the sidelines until mid-2011. And he doesn’t expect deepwater stock prices to return to their pre-leak highs before 2012.

“There’s a lot of broader market risk in play during the next three to six months,” Adkins says. “This is combined with some overwhelmingly good news in other parts of the service sector, such as pressure pumping and premium land rigs. It’s a lot easier for most investors to go where the good news is, and, unfortunately for the deepwater stocks, there’s not a lot of short-term good news. But we’re still very bullish on the long term.”

Domino effect

The circumstances may also produce a wave of consolidation on the E&P side, notes Allen Brooks, managing director, Parks Paton Hoepfl & Brown. And the pause in activity as companies reassess strategy could confound service companies this year and through 2011, he says.

“Sadly, this event could impact energy companies for decades. There will be more redundant equipment out there, higher operating costs and more required training and certifications, all of which will raise the threshold for the economic viability for even the already discovered fields that haven’t been developed.

“In time, part of the fallout will probably be a renewed focus on mature basins. The Gulf of Mexico stocks will likely become even more volatile and very news-driven.”

Meanwhile, what can E&P and drilling companies do to keep business moving and attract investment dollars? Short term, E&Ps have to redistribute spending and diversify, diversify, diversify. Service companies must cut costs, look into bidding rigs internationally, and preserve existing contracts as they are able, without losing customers.

“For now, E&P companies need to focus on doing well what they can do—activities such as drilling from stationary rigs, completions and workovers,” says Tullis. “Longer term, hopefully companies will be allowed to get back to their core focus areas, but they will need to do it with a new risk-assessment process.”

Adkins expects to see a lot of private-equity investors and longer-term investors come into the offshore space. This situation is a “classic opportunity for people with a longer time horizon to snatch up assets. This should help stabilize companies’ values, at least for a while.”
Ensco remains the favorite offshore drilling pick of Jefferies & Co. offshore analyst Judson Bailey “due to upside from the jackup market in 2011, value creation from the expansion of its ultra-deepwater fleet, and attractive valuation. The stock is also trading well below historical averages at similar points in the cycle…”

Many analysts point out that deepwater names slightly outperformed jackups in August, and that companies with a higher concentration of premium rigs or international contracts outperformed those without.

“Generally speaking, the same names that outperformed in July continued to modestly outperform in August,” said Bailey. These were Rowan (up 1.8%), and Seadrill and Pride International (both down 1.0%).

The one exception in August was Transocean, which bounced back and was the best-performing offshore driller, up 10.1% following its disclosure of the Horizon drilling contract with BP (which revealed a stronger-than-expected indemnity clause).

“Looking forward, with negative sentiment providing a low hurdle to beat expectations, we believe the group could continue to move higher through year-end,” Bailey said in an August research note. “Valuations are still reasonable, the premium jackup market continues to strengthen, and signs point to increasing floater demand in 2011, which may result in dayrates better than the Street’s lowered expectations.”

Insurance Matters

The week before the BP incident, Energy XXI was readying to go to market to renew its offshore liability insurance. Thanks to its December acquisition of assets from Mitsui, the cost rose to cover more assets, but on a barrels-of-oil-equivalent basis, the cost stayed flat. CEO Paul Bulmahn says that ATP actually renewed its insurance recently at a lower rate.

Whether insurance premiums increase for operators in the Gulf will depend on factors including where they operate, what the management team looks like, and what the loss history has been, says John Ludwig, chief executive officer of EnRisk Services Inc. The energy insurance market has lost money over the past number of years, so there is pressure to raise rates across the board.

“If you were good on all those factors, and not in the deepwater, you probably haven’t seen an appreciable increase through 2010 and may have experienced a decrease,” he says. “But if we are looking to 2011, I would surmise, based on current sentiment, that overall we’ll likely see increases in the entire market. My advice would be to budget for an increase of 20% to 25% in 2011—and if there’s a wind event, then Katy bar the door.”

Ludwig thinks that if premiums and availability are strained in the coming years, operators will likely create consortiums and move to captives, such as one called Wildcat, that specifically target the oil and gas industry, to cover some of the liability domestic insurers are unwilling to participate in. “The one balance to all of this is that when premiums increase dramatically, there are always new insurance facilities that come about and help to balance the industry,” he says.

What if Congress does pass reforms to hike or eliminate offshore-liability caps?

“Right now companies buy OPA product that limits liability to $35- to $150 million. These limits are readily available and the market is set up for it,” says Ludwig. “If the limits rise to $300 million, for the larger operators, that’s not a big deal necessarily,” because they have the financial strength and insurance relationships to handle such an increase.

“But when you start talking about the smaller operators and non-operators that have been venturing into deeper water over the last number of years, the market may not have enough capacity or the willingness to extend coverage. In the shallower water, there will be an appetite for the opportunity, but again, it is market dependent. “

Today, underwriters want to come onshore. “There’s a tremendous amount of competition right now in the onshore market. This could lead to flat to reduced rates onshore.”

The biggest lesson of the spill is that no one should underestimate risk, says Matt Gelotti, vice president, Aon. The event has led to re-evaluation of risk all around.

“Companies, under the direction of their boards, are asking us to reevaluate their entire risk portfolios, as well as guidelines and safety handbooks—everything involved in safety, risk, and their insurance program. The good news is that insurance, even for energy companies, is relatively cheap balance-sheet protection. Many companies do not buy enough to protect against more severe events even though higher limits are often available for modest premiums. The key is, don’t wait until after a major incident to review what you have.

“The industry is looking at new ways to find insurance capital, particularly for the smaller companies trying to do business in the deepwater. AON is in the middle of putting together a new facility with a large private-equity firm to allow operators to purchase the necessary limit of liability in the event the government requires higher limits. It would cover small- to mid-size independents all the way up to the larger companies,” says Gelotti.

Gulf Exodus?

Plains Exploration & Production Co.’s move to put its Gulf assets on the block may signal a trend. The Houston-based operator is seeking to rationalize its exposure to drilling in an unclear regulatory environment and to focus capital on fast-growing assets in the Granite Wash, Haynesville shale and California.

“We hope to continue to be in the Gulf of Mexico—just smaller—but right now we think it’s a good time to divest some,” said Plains’ Jim Flores in a conference call.

A report from tax and audit firm Grant Thornton LLP predicts future costs of drilling and operating in the Gulf “will rise considerably” from natural forces such as insurance and capital providers reevaluating risk, and more significantly, from external forces like new regulatory policy, adding layers of costs.

“The repricing of risk in conjunction with proposed regulatory changes will have drastic long-term implications for E&P companies,” the report says. “Smaller independent oil and gas companies without critical mass and strong financial resources will have difficulty absorbing the higher drilling and operating costs in a post-spill environment.”

Jefferies managing director Bill Marko believes the changing cost structure to operate in the Gulf will fracture the transaction food chain there.

“Size will matter,” he says. “Big and capable companies will think about how to high-grade opportunities, and this may be a time for them to go hunting for additional opportunities. The smallest companies need to think seriously about their exposure to the Gulf and if they can manage it. Those in between are going to have some hard decisions to make as to what to do about the Gulf.”

Currently, deal flow for offshore transactions is frozen, stymied by myriad uncertainties. Prior to the spill, the Gulf of Mexico transaction market was seeing an upswing in momentum and valuations after having suffered the effects of several hurricanes and the economic downturn.

BMO Capital Markets reports three Gulf of Mexico deals through the second quarter for a total deal value of $3.2 billion and an implied reserve value of $3.56 per thousand cubic feet equivalent (Mcfe). That compares with two deals for all of 2009, for a total deal value of $315 million and an implied reserve value of $1.83 per thousand cubic feet equivalent.

While deals initiated before the incident have moved to closing or are still progressing, new offerings have been sidelined.

Michael Collier, U.S. leader of the energy M&A practice at PricewaterhouseCoopers, says the question is whether companies operating in the Gulf want to take on the risks and liability associated with developing their positions. “Some will exit because they don’t want it. Some will see an opportunity to come in because they feel they are equipped to deal with that risk and uncertainty.”

Scotia Waterous director Ken Becker concurs that “clarity always helps,” but he foresees more activity moving into the fourth quarter. “There’s energy building for asset sales,” he says, particularly for small and medium-sized packages.

Once regulatory questions are answered, he expects companies will decide to lower their offshore exposure and diversify onshore, but “I don’t see a mad rush to the doors. I do see a rebalancing and a certain amount of caution.”

He adds, “If ever there was an opportunity for contrarian investors, this is it.”

The deepwater will be most impacted by regulatory changes, and will likely result in fewer names focusing on only the highest-potential prospects.

Becker says that by establishing a $1-billion clean-up fund to allay public and government concerns related to drilling in the Gulf, majors ExxonMobil Corp., Chevron Corp., ConocoPhillips and Royal Dutch Shell are sending a signal that they intend to stay and build their positions in the deepwater.

As the moratorium lingers and permits prove hard to come by, drilling contractors are also feeling the stress mount. Collier expects some drillers to monetize their rigs locally in a regional exit and redeploy that capital elsewhere globally or onshore.

Consolidation is also likely between those that stay and play.

Says Collier, “Ultimately, we won’t see too many panicked sale situations—just sound, strategic decisions that will lead to adjustments in portfolios.”

Leslie Haines, Nissa Darbonne, Bertie Taylor, Steve Toon and Susan Klann contributed to this article.