The US Minerals Management Service proposal to expand offshore royalty relief in an effort to increase deep natural gas production in the Gulf of Mexico is "all sizzle, no steak," said a financial analyst with Raymond James & Associates Inc. (RJA), St. Petersburg, Fla.
MMS officials recently proposed to expand royalty-suspension incentives to encourage companies to risk exploration and development of deep gas deposits in shallow-water areas already under lease (OGJ Online, Mar. 26, 2003).
Under that rule, lessees would be eligible for royalty relief on existing leases if they drill for new and deeper prospects more than 15,000 ft below the seabed. MMS estimates as much as 20 tcf of undiscovered gas resources may underlie that "frontier" area. About 2,400 existing leases are expected to qualify for royalty relief under the proposed rule, MMS said.
"On the surface, it appears that the royalty relief program could help lower costs and improve returns to producers and compensate for the higher risks involved with deeper drilling," said Jeffrey L. Mobley, an analyst in RJA's Houston office.
However, he said in a recent report, "As you would expect with a government program, the devil is in the details. All of the industry's leading deep shelf explorers that we talked to viewed the incentives as nice to have but didn't expect the program to change their drilling plans at all."
In his report, Mobley ticked off several reasons why the royalty relief proposal "is not that big of a deal":
- Relief is available only for the first deep or ultradeep well drilled on a lease and is not available if the lease has previously been drilled below 15,000 ft. "In other words, not every well qualifies," Mobley said.
- The proposed relief would not be available in any year that natural gas prices average above $5/Mcf, adjusted for inflation. That means the program "effectively only serves as a downside price hedge," said Mobley. "Therefore, if we're right on the step-change in natural gas prices to $5/Mcf, the proposal is irrelevant."
- Deeper drilling involves substantial risks and high costs, with deep and ultradeep wells costing on average "$10-15 million just to drill, and the more-challenging wells can be double or triple that amount," he said. "Furthermore, deeper wells face a high risk of failure and require the discovery of large accumulations, with high flow rates, to be economic." As a result, Mobley said, "A modest amount of royalty relief is not likely to change (producers') decision process in initiating a deep or ultradeep well."
- Similar programs have not materially changed drilling activity. "In 2000-01, the industry averaged drilling about 78 wells below 15,000 ft (in less than 600 ft of water in the gulf), vs. an average of about 65 over the previous 5 years," Mobley said.
"Even if the new royalty relief program does spawn a modest increase in drilling, it is not likely to meaningfully impact the domestic supply of natural gas," he said.
"We are of the view that domestic natural gas production has probably peaked and that longer-term LNG imports are the only real avenue to meaningfully increase the supply of natural gas to the US market," said Mobley.
"However, increased and improved access on federal lands for producers and the return of Section 29 tax credits for production from unconventional gas reserves could help the supply problem," he said. "Unfortunately, these solutions are really public policy issues."
The National Ocean Industries Association earlier praised the proposal, saying royalty relief would alleviate some of the enormous front-end costs and help to make marginal prospects economically viable.
"At a time when natural gas supplies are tight and prices are high, this kind of exploration incentive is a significant step in the right direction," NOIA said.