BP's murky deep-water future

(Fortune) -- Not only did the virtually impossible happen -- a blowout on the Gulf of Mexico seabed a mile down -- it happened to a top-notch oil team. BP's debacle is the U.S. oil industry's most serious setback, undercutting nearly 60 years of incremental progress in offshore drilling, and it could crimp future output from ultra-deep water, the source of an increasing share of America's -- and the world's -- oil production.

"I know all the companies have big egos, and they think they can do best, but when they see something like this happening to this [BP] team, they have to be shaking their heads and wonder what the heck is going on -- this was pretty much an all-star team," says Gary Taylor, a senior writer for Platts Oilgram News, who has four decades of experience covering the industry.

What will happen is a major industry review, both from within, and from the U.S. government.

Output will come at a higher cost as regulations tighten and insurance rates go up, in addition to the significant adjustments the industry will take on its own as the reverberations spread.

The unprecedented oil spill came less than one month after President Obama decided to open up offshore drilling in the Atlantic, from Virginia to mid-Florida and the Gulf of Mexico. But last Thursday, the Department of the Interior halted all permits for any new exploratory drilling in the outer continental shelf, pending the outcome of a 30-day investigation -- a report is due May 28 -- into the cause of the Deepwater Horizon spill.

The U.S. gets more than a third of the oil it produces domestically from the Gulf of Mexico. Already 20% to 25% of this is from ultra-deepwater; and that share is rising as fields in shallower water decline in productivity.

"We have milked the on-shore cow pretty hard in all major oil-producing basins of the world. It is the offshore really where the future is," says John Olson, a former industry analyst who is now managing director of an energy hedge fund, Houston Energy Partners.

How the spill will affect the industry's reputation

Typically, operators over-engineer and build in redundant safety systems that are meant to prepare for a worst-case scenario. But in the real world, three BP (BP) systems designed to shut the well-head off on the Deepwater Horizon rig failed.

The media raised the suspicion that the oil industry has begun to inappropriately cut corners, but insiders say the industry has a frontline stake in maintaining safety standards.

"There is a natural compulsion, that has nothing to do with regulation, to be careful," says Bob Tippee, editor of Oil & Gas Journal. "People in the industry, better than anyone, know the dangers. They are trained to know that; that's what all their education is about. They are putting their lives on the line."

While the jury is out on whether BP was negligent in this case, its reputation seems bound to deteriorate after already being seriously dented by the 16 deaths from its Texas City refinery explosion in 2005 and by the Prudhoe Bay pipeline leak in 2006.

Much rides on how quickly the company can staunch the flow of crude into the Gulf waters and how much damage the released crude does to the fishing and tourism industries. Initial efforts to cap the well failed, but the company continues to try. "My hat's off to them if they can make that work because they are taking a page out of Star Trek there with this thing," says Taylor.

BP, which owns 60% of the Mississippi Canyon 252 lease, initially suggested that blame for the accident lay elsewhere (it is not the operator), but the company has accepted responsibility for claims it acknowledged will exceed the current $75 million cap established by the Oil Pollution Act. On Monday, BP said it has spent $350 million so far on cleanup and other costs associated with the massive spill.

"If BP is successful in the next two weeks, costs could be under $1 billion," says a May 3 research note from Oppenheimer & Co., an investment firm. "If all failed until the relief well is completed in 90 days, costs could be significantly higher." By comparison, the Exxon Valdez accident 20 years ago cost more than $3.5 billion in cleanup and $5 billion in damages.

Others say BP can expect to take a hit of $6 billion or more -- in addition to its share-price loss. On Wednesday, Moody's revised its outlook for the company to negative, noting that "it is too early to exclude scenarios leading to downward pressure on [BP's] Aa1 rating."

How much of a punching bag a Democratic-controlled Congress makes of BP is another unknown variable. And, perhaps more significantly, it is also unclear whether other oil companies will opt to avoid BP as a partner, particularly on U.S. projects.

"We have every oil company and oil services company under the sun engaged with us," says David Nicholas, a spokesperson for BP. Nicholas also noted that whatever is learned from the spill will provide "invaluable lessons for the whole industry."

BP, which pioneered deepwater drilling in the North Sea, has the biggest industry presence in the Gulf in terms of leases, production, reserves, and the overall investment -- and any shift to rebalance its portfolio worldwide would be another expensive consequence of the blow-out. Although the company says it has no plans to do so, if containment and clean-up efforts go badly, brand consultants have even suggested BP may be tempted to change its name.