Drilling Moratorium: Be Careful What You Wish For

Todd Shriber
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On the surface, the Obama Administration's six-month moratorium on deepwater drilling in the Gulf of Mexico following the April tragedy at the Deepwater Horizon rig was a reasonable reaction to a dour confluence of events. Eleven deaths and the biggest oil spill in U.S. history were not going to go unnoticed by politicians, certainly not in an election year. And let's be honest: Deepwater drilling is risky business and some enhanced safety protocols could wind up benefiting the industry and its employees.

So while some may view the moratorium as a knee-jerk reaction to the Gulf spill, and it probably is on some level, there may be some practical, worthwhile measures that result from halted deepwater drilling. That is the good news because as is usually the case when Washington gets involved in the private sector, there are going to be unintended consequences and those consequences revolve around higher future oil prices.

Yes, oil prices have tumbled mightily in the past month. In early May, NYMEX-traded crude was going for $87.15 a barrel. On Tuesday, crude for July delivery closed at $71.99, representing only a modest rebound from the May low of $67.15. Oil prices may remain weak over the near- to medium-tear as investors eschew riskier assets, but remember oil is a commodity and commodities are often held hostage to supply and demand dynamics. What is the Gulf moratorium going to do? Remove supply from the market.

The Energy Information Administration (EIA) lowered its fourth-quarter production outlook by 26,000 barrels per day and its 2011 outlook by 70,000 barrels. The potential loss of supply is being reflected in long-dated oil futures. On Sunday evening, oil for delivery in December 2018 was trading $22 higher than the July 2010 contract. That is the double the premium before the Deepwater Horizon rig exploded on April 20th.

It also must be noted that the moratorium is not entirely exclusive to the Gulf. There will be no new drilling off the coast of Virginia and Royal Dutch Shell's (RDS-A) plans to initiate new drilling projects in Alaska have been dealt a blow. As a result, Sanford C. Bernstein estimates that a one-year moratorium on drilling would reduce global supply by 500,000 barrels per day by 2013. That is less than 3% of daily U.S. consumption, but it is nearly enough to power Argentina, according to Bloomberg News. Deutsche Bank thinks U.S. production may be cut by 150,000 to 200,000 barrels a day due to the moratorium.

Factor in the EIA's estimate that hurricanes could hinder production this year by 26 million barrels and the specter of $90 oil, while not a legitimate threat over the next month or so, could arrive sooner rather than later with supply being taken off the market. Sure, it will pay to make oil and gas rigs safer. It is just a matter of who is going to absorb the cost and if oil prices move higher as a result of the moratorium consumers will be picking up the tab.