Why Shell is betting billions to drill for oil in Alaska

In Barrow, Alaska, the northernmost city in the U.S., it’s hard to tell where the land ends and the frozen Arctic Ocean begins. The average temperature stays below freezing for eight months of the year.

FORTUNE — Pete Slaiby is eating breakfast with an Eskimo businessman at a Mexican restaurant across the street from the Arctic Ocean when two Coast Guard admirals happen to walk in. It’s 8 a.m. on a Tuesday in late March. Outside the temperature is an extremity-tingling, -35° F. Look 100 yards north, and it’s not at all clear where the snow-covered land ends and the ice-covered ocean begins. Slaiby, Royal Dutch Shell’s vice president for Alaska, rises to give the Coast Guard brass a warm welcome before they grab a nearby table. “Welcome to Barrow,” he says wryly as he sits back down to his plate of huevos and reindeer sausage.

Indeed, it’s a typical morning at Pepe’s, a hole-in-the-wall eatery in Barrow, Alaska, population 4,300, the northernmost municipality in the United States. Everyone is there for the same reason. And with apologies to Pepe’s colorful longtime proprietor Fran Tate — whose claim to fame is presenting Johnny Carson with an oosik, a walrus penis bone, during a 1984 appearance on The Tonight Show — it’s not the cuisine. They’ve all come to Barrow because some 100 miles offshore, in the Arctic Ocean’s Chukchi and Beaufort seas, lies what U.S. government geologists believe is 27 billion barrels of recoverable oil. Slaiby wants Shell (RDSA) to be the first company to get that oil out of the seabed. The Eskimo is a subcontractor who wants a piece of Shell’s business. And the admirals want to ensure that a drilling accident doesn’t happen in an ocean ecosystem that environmentalists consider to be one of the most unspoiled on the planet.

Alaska’s outer-continental shelf has been off limits to oil companies — despite the fact that Shell paid the U.S. government $2.2 billion for drilling rights back in 2005 and 2008. But that’s about to change. After years of lawsuits, regulatory hitches, and other delays, Shell will finally sink its first exploratory wells in July, making this the first new offshore drilling project approved by the government since the 2010 BP (BP) disaster in the Gulf of Mexico. Come fall, the big news out of Barrow may well be America’s largest offshore oil discovery in a generation. “We can’t know,” says Slaiby, “until we start drilling.”

The stakes are huge — for Shell, for the environment, for the oil industry, and for the oil-addicted U.S. economy. The fact is, oil demand is soaring. Worldwide oil consumption is now running at 89 million barrels a day, according to the International Energy Agency. Not only is that up 6% from the lows of the recession — a big increase given tight supplies — but it’s also above the pre-recession peak of 87 million barrels notched in 2008.

In the U.S. the clearest consequence of surging oil demand has been a sharp increase in the average price of gasoline — from a recession low of $1.87 a gallon in December 2008 to a recent price of $3.75. Unsurprisingly, high gas prices have emerged as a red-hot political issue. President Barack Obama’s supporters argue that domestic oil production is at an eight-year high. Republicans, who want to open up more public land to drilling, counter that most of the production growth has occurred on privately held lands — which means Alaska could become a powerful counterpoint to Republican attacks. “Everybody is being squeezed at the pump,” says Whit Sheard, a senior lawyer for Oceana, one of the environmental groups opposing Shell’s Alaskan plans, “and there’s a perception — a wrong one in my view — that drilling there will reduce prices.”

Looming over the debate are still-fresh memories of the explosion of BP’s Deepwater Horizon drilling rig in 2010. The death of 11 crewmen and the subsequent spilling of 5 million barrels of crude oil into the Gulf of Mexico have raised tough questions about domestic drilling. Can the safety assurances of oil companies be trusted? What risks are we and aren’t we prepared to take in order to quench our thirst for oil? Oil companies are attempting to restore offshore drilling’s reputation while simultaneously seeking access to environmentally sensitive Arctic regions — believed by scientists to hold some 22% of the world’s undiscovered oil and gas. Tyler Priest, senior policy analyst to the President’s National Commission on the BP Deepwater Horizon Oil Spill and Offshore Drilling, says he was surprised how quickly the debate over the BP spill morphed into a referendum on Alaska. “The environmentalists clearly wanted to use Deepwater Horizon as a justification to prevent offshore drilling in Alaska,” says Priest, an oil industry historian and professor at the University of Houston’s Bauer College of Business. “The oil companies wanted to prove that they could drill up there safely.”

That’s why Shell’s performance in Alaska — not only how much oil it finds but also whether drilling can be done with a minimal environmental footprint — will be so closely watched. “The eyes of the world are going to be on the Arctic this summer,” says U.S. Sen. Mark Begich of Alaska, a pro-drilling Democrat who has been one of Shell’s key allies.

Shell finally has all the major permits, which means its drilling ships, specially designed for use in the icy waters of the Arctic, will soon make their way north toward Barrow from their temporary home in Seattle. Even with icebreakers on duty, it’s only possible to operate in Arctic waters during the summer thaw. Before sinking a single well, Shell will have already invested $4.5 billion in its Alaska project — $2.3 billion assembling the necessary equipment and personnel on top of the $2.2 billion for the leases. The wells Shell will begin drilling in July are exploratory, not producing. So assuming Shell does find oil, it would be another seven to 10 years before it’s able to drill producing wells, install permanent platforms, and build the offshore and onshore pipelines required to get Arctic oil to consumers in the lower 48. By then, the up-front investment for Shell, which reported $31 billion in profits for 2011, will probably have topped $7 billion.

Typically, only one out of every two or three exploratory wells drilled strikes oil or natural gas. Such modest success rates make Shell’s Arctic bet appear risky. However, Shell knows there is oil offshore in Alaska because it owned leases and drilled wells in the Chukchi and Beaufort seas in the 1980s and 1990s. It abandoned them only because the $20-a-barrel prices at the time did not justify the expense of further drilling. “They would not have committed so many resources if they didn’t believe this was a sure thing,” says Eric van Oort, a former Shell engineer who is now a professor of petroleum engineering at the University of Texas.

One of Shell’s strategies in recent years has been to deploy capital in politically stable regions where obstacles to oil and gas development are less daunting than in, say, Nigeria. Shell’s Nigerian operations have been hindered by the hijacking of its oil rigs and the all-too-frequent kidnapping of its employees. In Alaska nobody is going to be brandishing guns at Shell workers. Nevertheless, the U.S. permitting process has proved more vexing than anyone at Shell headquarters in The Hague ever anticipated.

It took two years to get the proper permits, and just as Shell seemed on the verge of beginning drilling in 2010, Deepwater Horizon happened and the U.S. Department of Interior issued its moratorium. A year later, Shell’s plans for drilling in 2011 had to be canceled after the Environmental Protection Agency issued an 11th-hour ruling requiring Shell to install $60 million exhaust-filtration systems on its ships — systems Slaiby believed were unnecessary. “It’s ridiculous,” Slaiby says, in a rare flash of frustration. “But I guess it doesn’t matter how good your air is if they don’t like the product that you’re selling.”

Pete Slaiby, Shell’s point man in Alaska

Imagine the prototype front man for an oil company — hard-driving, charming, on-message — and he would look a lot like the 53-yearold Slaiby. Ask the Shell lifer, who grew up outside Hartford, Conn., and studied mechanical engineering at Vanderbilt, whether he’s irritated by the grinding regulatory process, post-BP spill, and he treads carefully: “We’ve never been out there asking for lower standards, only a more streamlined process.” What about the environmental groups that have fought Shell at every step? “For environmentalists there’s a lot of emotional energy tied up in Alaska,” he says. As for the Eskimo population, “Shell is going to be here for the next 50 to 75 years, so it’s important to us the people here believe in what we’re doing.”

Ever since Slaiby arrived in Alaska in 2008 — he took the assignment reluctantly, he says, after much warmer gigs in Brunei and Brazil — his focus has been on winning hearts and minds of the Alaskan North Slopers who hunt and fish for food and who fear a Deepwater Horizon in their backyard. Slaiby has made more than 40 trips to Barrow and attended dozens of community meetings. “Pete has been relentless,” says Begich. Even those wary of Shell’s plans appreciate Slaiby’s efforts to find common ground. “I’m a long ways from putting up a driftwood fire by the beach with him and singing ‘Kumbaya,’ ” says Edward Itta, mayor of the North Slope Borough from 2005 to 2011. “But personally I do like Pete Slaiby.”

From Shell’s perspective, and that of Alaska’s Republican governor, Sean Parnell, the problem with the U.S. regulatory process is that there is no clear finish line. “It’s far too open-ended,” says Slaiby. New legal challenges can seemingly always be filed, and different regulators sometimes make conflicting demands. “The federal government has demonstrated that their permitting process is broken,” adds Parnell. Trying to head off yet another last-minute postponement, Shell went so far this year as to file a preemptive lawsuit against environmental groups that might file a legal challenge to the Shell oil-spill response plan approved by the Department of the Interior in February.

Shell took this unusual legal step to get the court to review the plan now to avoid challenges on the eve of summer drilling. In fact, on May 16, a coalition of environmental and native Alaskan groups did file a different last-minute challenge — to Shell’s EPA air permit — alleging that Shell’s ships “will pump tens of thousands of tons of pollution into pristine Arctic skies.”

The prize that Shell is chasing is worth the ongoing frustration: the estimated 27 billion barrels of recoverable oil held in Alaska’s outer-continental shelf — plus another 130 trillion cubic feet of natural gas. At its peak, offshore oil production in the region could top 1.45 million barrels a day. “Shell is making big bet there, but I think it’s justified based on the geology,” says Oswald Clint, an oil analyst at Sanford C. Bernstein and a geophysicist by training.

Shell says that it expects the 410 Alaskan offshore leases it holds in the Arctic to become the company’s biggest source of crude oil globally within 10 to 20 years. Were it to capture just a 10th of the oil in the Chukchi and Beaufort seas, Shell would, over time, add 2.7 billion barrels to its proven reserves. To put that number into perspective, Shell’s total proven reserves of oil stood at 4.3 billion barrels at the end of 2011. Given Shell’s perpetual need to find new reserves large enough to replace what it pumps, the company must aim high when it comes to exploration, says Clint, the Bernstein analyst. “Adding 200 million barrels in new reserves doesn’t move the needle for an oil company as big as Shell,” Clint says. “They really have no choice but to push into the big, unexplored basins like the Arctic.”

It’s not entirely clear how those new reserves will affect Shell’s profitability, since Shell won’t discuss its production costs in the Arctic. Some analysts estimate the price of offshore Arctic production at $70 to $80 a barrel. However, one scientist who has been involved in the Shell project says he expects the cost to be closer to $30. A November 2011 report by the U.S. Bureau of Ocean Energy Management appears to support the lower, $30-a-barrel assessment. The BOEM estimates the oil “hurdle price” necessary to justify the cost of Arctic drilling at $38 a barrel for Chukchi oil and $29 a barrel for the Beaufort.

Factor in yet-to-be-determined royalty rates, and it’s reasonable to peg Shell’s profit margin on Alaskan crude just a notch or two below the 39% margin Shell reported on total U.S. production back in 2008 — the last time prices were consistently above $100 a barrel. Bottom line: Each 100,000 barrels a day in new production could net Shell $1 billion or more in annual profits depending upon prevailing oil prices. “Let’s just say it’s large enough to have a significant impact,” says Marvin Odum, president of Shell’s U.S. subsidiary.

The math gets a lot more challenging if oil prices fall significantly. Even if they don’t fall, the three-month-a-year drilling window means it will take longer for Shell to earn back its investment. “To me, it looks like a bad decision by an otherwise well-run company,” says an energy analyst at one of Shell’s major mutual fund shareholders.

From an engineering perspective, Slaiby argues that Alaska is a less challenging endeavor than drilling in the Gulf of Mexico. The Alaskan waters where Shell will be drilling generally have depths of 150 feet, vs. the 5,000-foot depths where BP was drilling in the Gulf. “We’ll be drilling in much shallower water with lower gas pressures,” he says.

Intense gas pressures were a contributing factor to Deepwater Horizon. It was the failure of the blowout protector — a $20 million piece of equipment that rests on the ocean floor and prevents natural gas from rushing uncontrollably up the rig and blowing pipes out of the bore hole — that caused the explosion. The blowout protectors Shell will use have an extra cutoff valve just in case the main one fails. In another nod to Deepwater Horizon, Shell will have on standby the same type of capping and containment systems that ultimately stopped the BP blowout. Shell says the equipment can be deployed within hours, even in icy conditions, and will be stored on icebreaker support ships positioned between the Chukchi and Beaufort drilling locations. Of course, conditions in the Arctic are much different from those in the Gulf.

While the water may be much deeper in the Gulf, drillers there don’t have to deal with crushing ice floes, Arctic hurricanes, and total darkness for 70 days a year. “Any oil that’s spilled under ice is almost impossible to deal with,” says Sheard, the Oceana lawyer. “We’re setting ourselves up for a disaster.” Environmentalists are especially concerned that the areas where Shell intends to drill overlap with vital migration routes for whales, walruses, and other marine life. “Depending upon the time of year, an accident could wipe out an entire species, specifically bowhead whales,” says Layla Hughes, senior program officer in Alaska for the World Wildlife Fund.

Even ecologists who have worked with the oil industry in the Gulf have doubts. “Drilling in the Arctic is far riskier than in the Gulf,” says Larry McKinney, executive director at the Harte Research Institute for Gulf of Mexico Studies at Texas A&M in Corpus Christi. “I’m sure they’re going to be cautious, but it would be a technological miracle if something bad doesn’t happen. If there’s a blowout, it could be five months before they’re able to drill a relief well, depending upon the ice and the time of year.”

Slaiby disputes such a scenario, noting that drilling will be suspended by late summer, which means there will be a one- or two-month window for Shell to deal with a spill or blowout before the ocean starts to freeze. He also says Shell is prepared to work under the ice if necessary. Slaiby can’t guarantee an accident-free operation though — no oil company can — and this reality creates a torturous dilemma for the Inupiat Eskimos who live in Barrow and the other communities in Alaska’s North Slope. Nobody exemplifies this dilemma more than Itta, the 66-year-old former mayor of the North Slope Borough.

The Inupiat Eskimos worry that offshore drilling in water they consider sacred could endanger the whale hunting that is central to their culture.

The Inupiat culture, not to mention its diet, revolves around the hunting of walruses, seals, and especially bowhead whales, which is why community leaders in Barrow are so wary of Shell’s plans to drill in waters they consider sacred. On the other hand, the Inupiats’ standard of living has improved dramatically since the inflow of hundreds of millions of tax dollars from the original Alaskan oil boom in nearby Prudhoe Bay, also part of the North Slope Borough.

Prior to 1970, Barrow was literally off the grid, with no electricity system, no water and sewer service, and no high school for local teens. Oil money has transformed life in the city, paying not only for electricity, running water, and a modern high school (with an Olympic-size pool, no less), but also a new airport, hospital, library, community center, roller-skating rink, and community college.

When Itta was first elected mayor, he says his attitude toward offshore drilling was, “Hell no!” and “Over my dead body!” Given the sway of Inupiat and other tribes in Alaskan politics, overwhelming native opposition probably could have killed Shell’s offshore plans. But then the realities of governing sank in. Over 95% of the borough’s tax revenue derives from oil and gas, and production from Prudhoe Bay and other North Slope oilfields has been in steady decline for years — down from 2 million barrels a day in 1988 to 560,000 barrels last year. Not only has that cut into local tax revenue, but continued declines could threaten the viability of the entire North Slope oil industry long before the oil actually runs out.

Alaskan crude oil is transported south via the Trans-Alaska Pipeline, and a 2011 report by the pipeline’s operator, Alyeska Pipeline Service Co., raised doubts about whether the pipeline can operate safely if throughputs continue to decline. The slower the oil moves through the pipeline, the greater the risk that water will separate from the crude and freeze at the bottom of the pipeline during winter, causing corrosion and cracks. This and other risks, according to the Alyeska report, “decrease confidence that the pipeline can be reliably operated at throughputs lower than 350,000 barrels per day.”

“It’s not looking good,” Itta says of the production declines. “And if there’s no oil going through the pipeline, that oil infrastructure becomes worthless, and our tax base goes down.” All of Barrow’s infrastructure was built by oil money, and all of it is now maintained by oil money. “I started realizing,” Itta continues, “that my biggest responsibility was maintaining the economic well-being of the borough, and that largely has to do with maintaining oil in the pipeline.” The low-flow threat to the pipeline is a huge state issue as well, given that over 90% of Alaska’s state revenues come from oil and gas.

Edward Itta, mayor of the North Slope Borough from 2005 to 2011

If Itta had his way, the new oil for the pipeline would come not from offshore drilling but from the Arctic National Wildlife Refuge — better known as ANWR (“An-war”) and believed to hold about 10 billion barrels of recoverable oil. “You can clean up oil so much easier onshore, and the risks are not even comparable,” says Itta. “It’s been befuddling that we have all this potential oil and gas onshore, and yet that seems to be sacred to environmental groups. But it’s the reality we deal with.”

Itta gradually came to accept Shell’s plans — a grudging acceptance but one Slaiby views as crucial. Still, even after wringing several key concessions from Shell — the most important being a promise to cease drilling during whale hunts — Itta still wonders whether his decision to throw his support behind Shell was the right one. He doesn’t trust Shell’s ability to clean up a significant oil spill, especially if oil is trapped beneath ice.

A whaling boat captain himself, Itta emphasizes that Inupiat concerns about the whale hunt are as much about culture as food: “We have a culture that has survived one of the harshest environments on earth for thousands of years, and that culture is really what’s at stake.” The values of the whale hunt are the values of his people, Itta continues. “No one person can catch a whale. It takes a whole community. Because of the whale, we share, we are very close, we come together. Without it, our way of life — what we pass on to our kids and grandkids — would be diminished. The whale is what binds us. So this is my personal battle. Am I going to be the one remembered for my children’s children being able to enjoy the same standard of living I have now? Or will I be remembered as the one who helped destroy our way of life?”

It’s a heavy burden for any man. When pressed on whether he truly wants Shell to find a lot of oil this summer, Itta pauses before answering. “I hope they don’t. Maybe then we can have meaningful discussions about drilling in ANWR.” For Slaiby and Shell, however, the time for talking is finally over. They’re ready to drill.

This story is from the June 11, 2012 issue of Fortune.

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