On June 3, 1979, workers aboard the Sedco 135-F semisubmersible drilling rig located in Mexico’s Bay of Campeche removed pipe from the Ixtoc-1 well to change the drill-bit.

During this routine process, oil and natural gas under tremendous geologic pressure overcame the weight of the drilling mud and the well blew out. The blowout preventer–a device designed to close the well in the event of a just such an emergency–activated but wasn’t powerful enough to shear through the thick pipe being pulled out of the well.

The result was devastating. Hydrocarbons gushing from the well ignited at the surface, and the 63 rig workers, some injured and burned, were rescued before the rig sank. Gas bubbling from the well continued to burn on the surface long after the rig went down.

In the late 1970s, the Bay of Campeche was still a relatively young hydrocarbon-producing region. The largest oilfield in this area is Cantarell, a giant field discovered in 1976 that produced more than 2 million barrels per day at peak production in 2003-04.

These young fields offered huge production rates because reservoir pressures were still high and oil flowed rather easily into wells. Although that was great news for the Mexican oil industry, it represented a significant problem for Ixtoc-1; the well gushed oil and natural gas into the Gulf of Mexico for some time. 

Petroleos Mexicanos (PEMEX), Mexico’s national oil company, made several attempts to plug the Ixtoc well, including pumping drilling mud, scrap rubber and other debris into the well under high pressure–the infamous top-kill. PEMEX also installed a containment cap over Ixtoc in an effort to collect some of the hydrocarbons flowing from the field.

But all of these efforts failed, and the well continued to spill oil into the Gulf of Mexico until PEMEX completed two relief wells that intersected the blown-out well. At that point the company was able to pump mud and cement into the well to plug it permanently.

The bad news: It took PEMEX nearly 10 months to drill the two relief wells and stop the spill. Over 290 days, the well gushed oil at an uncontrolled rate. The Ixtoc spill is estimated at 3.3 million barrels (138.6 million gallons) of oil. 

The Ixtoc disaster had a significant environmental impact. The oil flowing from the well drifted into US waters, and tar balls washed onto Texas beaches. Mexican beaches also were heavily oiled; the bird population suffered, and commercial fisheries had to be closed for a time after the spill. Studies showed that biomass–the quantity of animal life in the region–fell more than 50 percent for some species in the immediate aftermath.

But most marine biologists who studied the after-effects of the spill were surprised at how quickly the Gulf recovered. In the warm waters of the Gulf, oil degrades at a far faster pace than it does in colder conditions; the basic rule of thumb is that for every 10 degrees Celsius oil degrades at about twice the speed. Accordingly, the oil spilled by the Exxon Valdez in Alaska took much longer to break down than the oil in the Gulf of Mexico.

Oil and gas leaks into the Gulf and have occurred for thousands of years. Oil naturally seeps from subsea reservoirs all over the world; producers even look for natural seeps as an indicator of good regions for further exploration. Although the exact amount of oil seepage is unknown, estimates suggest that 1 to 1.5 million barrels of oil (42 to 63 million gallons) leak into the Gulf of Mexico each year. Here’s a satellite image from NASA dated 2006 that shows several oil seeps in the Gulf.

Source: NASA Earth Observatory

Mother Nature has a way of taking care of herself; the Gulf’s waters contain natural microorganisms that break down oil.  

By most accounts, local fisheries had recovered to more or less normal levels within two to three years after the Ixtoc-1 spill. Some believe that fishing bans in the wake of the spill alleviated overfishing in the region and helped total population.

From Mexico to Macondo

The parallels between Ixtoc and the Macondo spill are clear, from the failure of the blowout preventer to the operator’s hurried, ad hoc attempts to slow or plug the well before the relief wells could be completed.

US media coverage of the Macondo disaster has been almost universally negative and sensationalist. And the Obama administration, admittedly under intense political pressure, has stepped up the rhetoric at BP (NYSE: BP) and CEO Tony Hayward. The political rhetoric has become so extreme that British government officials appear to be asking the US administration to tone down its comments directed at the company.

Don’t forget that roughly 15 percent of total dividends paid to UK pension funds come from BP. Demands by US Congressmen that the company eliminate its payout to shareholders until the spill is cleaned up aren’t falling on sympathetic ears in London. Nor is the fact that so many Stateside insist on calling BP “British Petroleum,” though the firm hasn’t been known by that name in 12 years.

Amid all the bad press, anyone who dares to make a comment that could be construed as vaguely favorable to BP risks being labeled an apologist for the energy industry. Mindful of that risk, I’ll point out a few facts.

Macondo is likely to be a smaller spill than Ixtoc, though the latter was technically a much easier spill to manage because the water was only 160 feet deep and the well could be accessed by divers and from the surface. Nevertheless, it took PEMEX 10 months to drill the relief wells and bring the gusher under control. It’s a testament to the improvements in oilfield technology that relief wells located in 5,000 feet of water take less than half the time to drill as they did in 1979.

And although PEMEX tried unsuccessfully to contain the spill under a dome, BP’s recent efforts to funnel oil to the surface appear to have worked–an impressive feat given that this particular containment system had to be installed remotely by robotic submarines 5,000 feet beneath the surface of the sea.

But the press has made scant mention of Ixtoc. Most prefer to call Macondo the largest spill in US history and compare it to the Exxon Valdez. Although this claim is likely true, the media neglects to mention that BP’s disaster isn’t the largest spill to impact the Gulf of Mexico.

Even assuming only modest success with containment and an August completion of relief wells, the Macondo spill is likely to be far smaller than Ixtoc.

Of course, differences between the two spills might increase the Macondo’s impact. That list includes the leak’s proximity to sensitive coastal wetlands and the fact that microorganisms that break down oil are likely more active in shallower waters.

My point is simple: Macondo is an environmental disaster, but investors must separate pre-election political rhetoric and sensationalist media coverage from reality and history. Odds are that Macondo will turn out to be far less of a disaster than BP’s most vocal critics suggest.

Disaster to Opportunity

Fortunately, emotion, widespread panic and misinformation always create investment opportunities.

If we step back from the political and media circus, there are two clear conclusions: The US reaction to the spill will have larger economic impacts than the spill itself, and crude oil prices are headed much higher over the long haul.

On May 27 the administration extended a drilling moratorium on new offshore well permits by a further six months, canceling two planned lease sales. But many analysts were surprised when the administration announced that wells currently being drilled in water deeper than 500 feet would be halted as soon as it is safe for producers to stop operations. This mandate covers 33 wells currently being drilled and, by extension, 33 deepwater rigs drilling those wells.

The moratorium is strict. The standard definition of deepwater is any well located in water more than 1,000 feet deep; by using a 500-foot standard, the moratorium actually extends to wells traditionally considered shallow-water wells. In other words, the moratorium’s ultimate impact on production will be greater than previously thought.

And although the administration has confirmed that shallow-water wells won’t be affected by the six-month moratorium, new permits will be on hold until new safety regulations and inspection procedures are in place–a process that could take some time.

Insurance premiums for shallow-water drillers likely will spike because of the spill, and the region could become uninsurable if the government substantially increases the cap on liabilities. Producers generally regard the shallow-water Gulf of Mexico as a relatively high-cost region; the economics for natural gas production were already marginal in the current pricing environment.

It appears the government will continue to allow workover operations at existing wells–that is, repairing wells they’ve already drilled. And most important, the ban has no immediate impact on previously drilled deepwater wells that produce oil and natural gas. The moratorium does not mean that all production from the Gulf of Mexico–nearly one third of total US output–will cease immediately.

The ban’s ultimate impact on the energy industry’s profits and production depends on the length of the moratorium and what regulations are put in place once it’s lifted.

The 33 deepwater rigs now idled in the Gulf are primarily booked under long-term contracts to operators like BP or ExxonMobil (NYSE: XOM). But most drilling contracts contain force majeure clauses that are triggered if drilling is interrupted for a certain period.

At that point the day-rates decline slightly for a period, after which the producer can cancel the contract. Many analysts expect the six-month moratorium to extend well into 2011, perhaps lasting a year or more. In that case, the contracts for most of the deepwater rigs operating in the Gulf would be canceled, and many units would seek work in other regions.

Plenty of deepwater projects are underway in deepwater Brazil, offshore West Africa and other areas. But the sudden influx of these new rigs will depress day-rates across the entire industry.

And it’s not just the rigs. Deepwater projects are extremely service-intensive. Companies such as Schlumberger (NYSE: SLB) and Baker Hughes (NYSE: BHI) have sizable workforces stationed in the Gulf–workers experienced in handling all sorts of functions related to drilling technically complex wells. The services firms will likely relocate staff members to other deepwater regions.

This sudden influx of service labor and new rigs may enable Brazil’s national oil company Petrobras (NYSE: PBR) and similar firms to accelerate their drilling plans.

Once all of these assets and talent leave the Gulf, it will take months to reverse the situation; when the government lifts the moratorium, drilling activity would take some time to reach former levels. And new regulations that require major changes to equipment and procedures could delay the restart even further.

Deepwater wells in the Gulf have a high decline rate–as time passes, the underground pressures diminish rapidly and production tails off. The near-term impact on output from the Gulf won’t be enormous because existing wells, many in relatively young fields, will continue producing crude. However, over time the natural decline rate of existing wells will begin to take over and the production decline rate will accelerate. This will prove tough to reverse if much of the deepwater Gulf production infrastructure exits as a direct result of the moratorium.

More broadly, deepwater is the final frontier for the energy industry, one of the only areas where there has been a good shot at actual oil production growth in coming years.

Total US production of oil has declined from7.38 million barrels per day in 1990 to around 5.6 million barrels day in 2010. Onshore production in the lower 48 States plummeted 1.7 million barrels per day, and Alaskan output was down 400,000 barrels per day; only deepwater production has grown, up nearly 1.5 million barrels per day. All estimates for current US and non-OPEC oil production growth will need to be revised lower in the wake of the moratorium. That means more dependence on OPEC oil and higher oil prices to come; I expect oil to hit $100 a barrel by year-end.

In the Media

I regularly visit Clean Skies TV to discuss developments in global energy markets. Here are links to my most recent appearances:

–          CS Sunday: Gulf Oil Spill Implications

–          Gue Talks Drilling Suspension, Its Effect on Market