Energy Independence: The Gulf’s Growing Role

New advances in drilling technology have unlocked a virtual ocean of oil and natural gas across the U.S. As new-found reserves and inventories of critical fossil fuels continue to rise, the dream of American energy independence is quickly becoming a reality.

Over the last few weeks, in InvestorPlace‘s series on the quest for U.S. energy self-sufficiency, we’ve identified many opportunities for investors in this unfolding paradigm, from infrastructure and pipelines to massive new liquefied gas export terminals. However, with the exception of the LNG tanker firms like Golar (NASDAQ:GLNG), the bulk of our focus has been the onshore marketplace.

Where Did Warren Buffett Go Wrong?
Where Did Warren Buffett Go Wrong?

That’s understandable, considering that hydraulic fracturing in fields such as the Northeast’s Marcellus and the Dakotas’ Bakken have been the key to unlocking the country’s vast energy reserves. Nonetheless, a historic and decidedly “old school” offshore field continues to be a vital piece of our energy puzzle: Drilling in the Gulf of Mexico is heating up and will continue to play a major role in our road to independence.

And that’s good news for investors.

Back With a Vengeance

Roughly two years ago, deepwater drilling in the Gulf of Mexico hit a huge snag, to say the least. The explosion that rocked BP‘s (NYSE:BP) Deepwater Horizon offshore rig in 2010 not only killed 11 workers and created arguably one of the worst oil spills in history, but seriously set back activity in the region. The resulting moratorium issued by the Obama administration halted drilling activity and issuance of new permits, and for six months the Gulf was fallow. More than 33 deepwater wells were essentially shut off.

Due to the ban, many investors and energy firms saw oil extraction from the Gulf as a lost cause and began to focus on more unconventional sources of supply. However, over the last year, the drilling halt has been lifted, and activity in the region is thriving again. Driven by triple-digit oil prices, deepwater drilling in the Gulf of Mexico is back with a vengeance. The higher price per barrel makes dealing with the various new government regulations and additional costs well worth it for many of the industry’s largest players.

So far, the newly reconfigured Bureau of Ocean Energy Management & Regulatory Enforcement (BOEMRE) has approved roughly 260 deepwater drilling permits since the ban was lifted. That includes 44 permits written this year. Back in December, a block of federal water leases roughly the size of South Carolina, 21 million acres, went up for auction. More than 20 companies bid $337.6 million for 191 available blocks that will eventually lead to more than 400 million of barrels of oil production.

According to oil-service firm Baker Hughes (NYSE:BHI), more than 45 rigs are currently operating in the Gulf, just seven fewer than pre-disaster levels. Analysts estimate that soon the Gulf will have more deepwater rigs (drilling in more than 2,000 feet of water) than before the spill.

At the same time, shallow-water drilling in the region is thriving as well, also thanks to advances in technology. Since January 2011, shallow-water rig contracts have risen by around 32%, and in February BOEMRE issued 10 new drilling permits. Advances in seismic activity and horizontal drilling — the same technology that’s responsible for America’s onshore bounty — have allowed firms to pump out a surprising amount of oil from previously dead or dying wells. For example, small-fry Energy XXI (NASDAQ:EXXI) has had great luck squeezing more oil out of old Exxon (NYSE:XOM) assets it purchased back in 2010.

There certainly is good reason to be bullish on the Gulf of Mexico. It now produces an average of 1.5 million barrels of oil per day. That’s 27% of total U.S. output and about 8% of U.S. demand. However, the potential is there to produce more. The main deepwater portion, where the bulk of new discoveries have been made, is sitting on an undersea bounty. Known as the Lower Tertiary geological formation, it’s estimated to contain around 15 billion barrels of oil.

Beyond hydrocarbons, the region is attractive on other fronts. For one thing, it’s surrounded by politically stable nations, unlike many of the world’s energy hotspots that come with some threat of nationalization or regime change. See Argentina for details. In addition, much of the undersea infrastructure required to bring that oil to shore is already in place. Finally, despite complaints from the energy industry, overall costs including royalties, taxes and regulation requirements are among the lowest in the world.

Betting on the Gulf’s Riches

While drilling activity has resumed, the number of players has shrunk. Firms need deep pockets and experience to navigate the new complexity of the Gulf’s deepwater region. Raymond James analyst Pavel Molchanov said it best when he referred to the majors as “the only companies that can take on the liability risk of having a multibillion-dollar oil spill.”

Luckily, two of my favorites have been ratcheting up their activities in the region. Of the 44 permits issued this year for deepwater drilling, Chevron (NYSE:CVX) snatched up 14 and Royal Dutch Shell (NYSE: RDS-A, RDS-B) has 13.

Chevron has already surpassed its pre-moratorium drilling pace and recently restarted its Moccasin project. The drilling ban put that well on hold for over a year. Overall, this field promises to be a gusher and a cash cow for the integrated energy company.

Meaning “lost” in Spanish, Shell’s Perdido deepwater field could be one of the biggest in a long time. Among the first rigs to tap the Lower Tertiary through its 35 wells, it’ll produce as much as 360 million barrels of oil and 750 billion cubic feet of natural gas. The Perdido find may contain enough oil to satisfy total U.S. demand for two years. Analysts predict that Shell could ultimately generate $39 billion in revenue and around $16 billion in profits.

Finally, for investors who prefer to stay closer to shore, rig operator Hercules Offshore (NASDAQ:HERO) continues to have the largest presence in the shallow-water Gulf. Of the 34 rigs there now, the company operates 18. While the company’s balance sheet is less than sterling, renewed interest in the Gulf has allowed the firm to almost double its day rates. Ultimately, that’ll benefit Hercules’ cash flows as well as investors.

In a nutshell, the Gulf of Mexico continues to be a vital piece of U.S. energy supply, one that will become more attractive for its role in the pursuit of energy independence and for investors searching for energy opportunities.

As of this writing, Aaron Levitt doesn’t own any securities mentioned here.

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