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What drives exploratory drilling?
Examination of North Slope drilling history shows complex interrelationship with oil price, major discoveries and state tax changes Alan Bailey for Petroleum News
The recent havoc in the oil market as a consequence of the COVID-19 pandemic, with the curtailed Alaska exploration drilling program last winter, has prompted interesting questions regarding the long-term impact of the oil price and oil market on exploration drilling on the North Slope. An analysis by Petroleum News of annual drilling levels, the market price of oil and other factors impacting the North Slope oil industry shows the complex interaction of a number of parameters.
Drilling data for this analysis came from the Alaska Oil and Gas Conservation Commission - the AOGCC has complete records of all wells drilled in the state. However, the commission does not distinguish between exploration wells and oil prospect appraisal wells, with both types being categorized as “exploratory.” The graphic accompanying this article shows the total number of exploratory wells drilled on the North Slope annually, since oil exploration started on the Slope in the 1960s. Excluded are gas wells and wells drilled by government agencies such as the U.S. Geological Survey. Since the AOGCC well data does not always include well spud dates, the dates used are the well completion dates - in most cases this corresponds to the year when the well drilling was initiated.
Major discoveries and oil prices An immediate and obvious point of note is the correlation between some relatively high levels of drilling and major oil discoveries. In particular, the discovery of the giant Prudhoe Bay field in early 1968 was followed by a major peak in North Slope exploratory drilling. The Pikka oil discovery in the Nanushuk formation in 2005 also led to a flurry of exploration and appraisal drilling in subsequent years.
Layered on top of these features there appears to be some impact from oil price trends. The oil prices in the graphic come from the Energy Information Administration - they are the inflation-adjusted prices of oil imported into the United States and seem a reasonable proxy for the North Slope oil price. However, it is important to note that, while buoyant oil prices may encourage exploration activity, companies planning exploration must consider oil price expectations several years into the future.
A statistical analysis of the oil price and drilling trends shows that there were periods when there was a correlation between the oil price and the number of wells drilled. However, there were also periods when the drilling rate completely disconnected from any oil price effect, as different factors came into play. Factors influencing the amount of drilling included changes in Alaska oil production tax statutes, the availability of state tax credits for drilling activities, and encouragement from major oil finds. Overall, periods of no oil price impact on drilling cancelled out the oil price correlation observed during other periods: The net effect was zero statistical correlation between the oil price and the number of wells drilled across the entire period since drilling started in the 1960s.
1970s market disruption The Arab oil embargo of 1973 to 1974, followed by market disruption and an energy crisis triggered by the Iranian revolution and the Iran-Iraq war, caused oil prices to climb rapidly. This price climb and spike appear to correlate somewhat with a rise in North Slope drilling activity. The geopolitical events presumably also drove an interest in increased U.S. oil development.
The ending of the market disruption of the 1970s resulted in an oil glut and subsequent tumble in the oil price. The price peaked in 1980 and crashed by the mid-1980s. Alaska’s economy saw a recession, as oil industry activity ground to a halt. And there was a corresponding sharp fall in the amount of exploratory drilling.
Statistically, the entire period from 1972 to 1988 saw quite a strong positive correlation between the annual number of wells drilled and the annual average oil price.
While the oil price remained relatively low for the next few years, it appears that the level of exploratory drilling on the North Slope recovered somewhat. Also, there were a number of appraisal wells drilled in this period, including wells associated with the major Alpine field, discovered in 1994. In the late 1990s there was a brief collapse in the price, as oil supplies exceeded demand. Although North Slope operators cut back on drilling, there appears to have been only a brief dip in exploratory drilling.
The upshot of all of this was a small negative correlation between the annual well count and the average price of oil between 1988 and 1998.
An oil price peak Then, as the global economy grew, with the Chinese economy for example growing rapidly, oil demand started outstripping supply. The price of oil increased steadily, reaching a peak well over $100 before collapsing back in 2014 through 2016. Initially, the pace of North Slope exploratory drilling increased, much in line with the increasing oil price - between 1998 and 2007 there was a modest positive correlation between the well count and the oil price. However, the drilling activity subsequently disconnected from the oil price trend, presumably at least in part because of major changes in the laws governing Alaska oil production taxes.
Production tax changes The oil production tax arrangements in Alaska remained unchanged from the early days of the North Slope industry until early 2005, when then Gov. Frank Murkowski increased the taxes by changing the rules for the “economic limit factor,” or ELF. This change impacted legacy oil fields in the Prudhoe Bay unit and appears to have had little effect on the amount of exploratory drilling.
In 2006 the state Legislature passed then Gov. Sarah Palin’s production profits tax, or PPT, a major rewrite of the tax law, changing the basis of tax assessments from taxing the wellhead value of oil to taxing the profits on oil production. This was later modified into Alaska’s Clear and Equitable Share, or ACES, a tax passed in 2007 that retained the profits based arrangements of PPT while increasing the base tax rate and the tax progressivity at high oil prices.
The oil industry slammed the new tax laws, arguing that a resulting huge tax increase would have a significant negative impact on North Slope investment.
It is perhaps not coincidence that from 2008 to 2011 there was a continuous decline it the number of North Slope exploratory wells drilled, during a period of relatively robust oil prices.
In 2013 the Legislature passed Gov. Sean Parnell’s Senate Bill 21, or SB 21, another major rewrite of the production tax statutes. SB 21 eliminated the progressivity of ACES while combining a flat tax rate with credits to encourage increased production. The industry has been supportive of SB 21.
There was a spike in North Slope drilling in 2012, the year prior to the passage of SB 21 - a peak in oil prices in 2011 and 2012 may have supported exploration enthusiasm.
Pikka discovery Over the next four years exploratory drilling continued at a level of around five wells per year. A number of these wells were drilled in response to the Pikka discovery.
In 2014 the oil price started collapsing, sinking to an average of around $40 per barrel in 2016, as excess production flooded the market with oil. The oil market subsequently came into balance at prices around $60 to $70 per barrel. Until, that is, the COVID-19 pandemic arrived and, with it, the recent oil price disruption.
The winters of 2018 and 2019 saw particularly robust exploration drilling activity, with much focus on discoveries and prospects in the Nanushuk, in a business environment involving reasonable and seemingly stable oil prices.
However, across the entire period from 2007 to 2019 there was approximately zero statistical correlation between the number of wells drilled and the oil price - it appears that other factors such as new discoveries and the production tax situation were at play.
State tax credits Another factor impacting exploratory drilling in Alaska has been the availability of state tax credits. Tax credits have proven a key parameter in the encouragement of new drilling in the Cook Inlet basin and in Alaska’s Interior basins. Credits have also encouraged exploratory drilling on the North Slope.
The first tax credit, a credit for exploration drilling, was introduced by Gov. Murkowski in 2003. That may have impacted the rise in exploratory drilling between then and 2007. The PPT legislation included a capital expenditure credit that could benefit exploration drilling, although this credit was discontinued on the North Slope by the SB 21 legislation. SB 21 replaced the capital expenditure credit with a new oil credit, to encourage the development of new oil.
Companies involved in the exploration that led to the Pikka discovery have indicated that tax credits significantly motivated their drilling projects. That drilling led to further exploration in the Nanushuk play discovered at Pikka. It is also likely that the credits introduced in 2003 encouraged Caelus Alaska’s drilling in Smith Bay in 2016 - those credits sunsetted shortly after that drilling was completed.
On the other hand, Gov. Bill Walker’s veto in 2015, deferring some tax credit payments, also had a negative impact on the amount of new drilling done, in part by undermining confidence in investments in Alaska exploration.
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