Profit from the scramble for the Arctic

Millions of miles of barren ice, freezing temperatures and months of continuous darkness make the Arctic Circle one of the most inhospitable places on earth. The landscape is so unforgiving that it was only in the last century that humans reached the North Pole. Indeed, with earlier claims now widely discounted as bogus, historians believe 1926 was probably the first time a modern explorer crossed the Pole.

So while 20th-century trade and population growth created metropolises in the plains of Africa, the deserts of the Middle East and the jungles of Asia, the Arctic remained untouched. Apart from the odd scientific mission or Cold War-era radar base, the sole inhabitants of the Arctic Circle a ring that begins at latitude 66.46 north and covers almost 6% of the world's surface remained native peoples, such as the Inuit, who have lived there for over 1,000 years.

But that's changing fast. One reason for this is our apparently insatiable demand for resources. Prices for most commodities have surged over the past decade. Given time, rising prices encourage explorers to look for more resources and make it profitable enough to justify the high costs involved in setting up in more remote or hostile regions. Even if a slowdown in China ends up hurting commodity prices, at least some of these projects will continue.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

The other reason is that the Arctic looks set to become more accessible: Arctic sea ice is becoming less widespread. As The Economist points out, "that Arctic sea ice is disappearing has been known for decades. The underlying cause is believed by all but a handful of climatologists to be global warming brought about by greenhouse-gas emissions".

It is important to note that Arctic ice cover is always subject to seasonal swings. Every winter the ocean is completely covered with ice, which starts to melt away in spring. By summer, normally half of the ice has melted away. Cloud cover and ocean currents also play an important role in determining the extent of the ice cover.

But within those seasonal changes another trend has emerged. Every year the summer melt has begun to turn more and more ice into water. Records only stretch back to 1979, when US satellites could monitor total ice cover from space, but there is no doubt that sea temperatures are rising and ice cover is falling. Scientists have long noted the trend and the consensus used to be that we would see a totally ice-free summer Arctic in 2100.

That consensus has now fallen to 2050, as the melting has happened more rapidly than expected. Lower down, in the landmasses that reach into the bottom of the Arctic Circle, changes are also visible. Glaciers in Greenland are shrinking at a faster rate, while permafrost the frozen land that dominates the barren Arctic landscape is melting and retreating further north.

Clearly, this is disruptive. It could mean huge changes to the region's ecosystem, which is bad news for the animals that rely on it as a habitat. While melting Arctic sea ice doesn't change sea levels, if the ice on land melts, that would have an impact, particularly on the world's coastal regions.

However, the changes may also bring economic benefits for some parties at least. The rising temperatures and melting ice will make it easier to extract the region's considerable natural resources, while new Arctic shipping routes could also transform trade. In the longer term, the unreliability of climate change models makes it difficult to know exactly how things will pan out. But for now, the greatest opportunities will be found in the Arctic Circle.

So what's up for grabs?

Energy, for starters. The Arctic Circle includes the northern-most parts of Canada, Russia, America, Sweden, Norway, Iceland and Finland. Some of these countries have already explored for oil and gas. To date more than 400 fields have been found with proven reserves of around 240 billion barrels of oil and oil equivalent natural gas (BBOE).

That's about 10% of the world's known conventional hydrocarbon resources. But scientists from the US Geological Survey (USGS) think there is a lot more. "Most of the Arctic, especially offshore, is essentially unexplored with respect to petroleum The extensive Arctic continental shelves may constitute the geographically largest unexplored prospective area for petroleum remaining on Earth."

After studying samples from the region's sedimentary basins and rocks, the USGS estimates there is a further 90 billion barrels (bbs) of oil and a further 1,669 trillion cubic feet (tcf) of natural gas to be found. Around 80% of these new discoveries are likely to be found offshore. If those figures are right, the discoveries would add almost 7% to existing oil reserves and 25% to existing gas reserves. That's not even taking into account the possibility of unconventional deposits.

Russia's truce with Big Oil

Given this massive potential, it's little surprise that energy firms have already begun to search the Arctic for oil and gas. Russia has by far the largest Arctic territory but, up until recently, many Western oil observers had long given up on the country. When the then-president Vladimir Putin came to power, he wrested control of large swathes of the country's vast energy resources from the private sector. The dismantling of Yukos, a huge private Russian oil firm, and the nationalisation of a large chunk of Shell's stake in the Sakhalin Island stood out as clear warnings to foreign energy firms.

But in the last few years, the Russian government has changed tack and encouraged foreign investment in the energy industry. As a result, deals have started to flow. Exxon recently signed a $3.2bn partnership deal with Russian oil producer Rosneft that will give it access to the Arctic Kara Sea. Exxon says its share of the investment is likely to rise to "several tens of billions of dollars".

Unsurprisingly, US rival Chevron is now keen to pen a similar deal and met with the Russian Ministry of Resources in early March. As The New York Times put it: "Once seen as a useless, ice-clogged backwater, the Kara Sea now has the attention of oil companies."

BP, which missed out on a deal with Rosneft when it was sued by Russian partners in its TNK-BP project, recently shelled out for a $10bn pipeline that will allow it to send new Arctic oil to China. In total, TNK-BP plans to spend $45bn on developing Arctic oil and gas during the next ten years. Meanwhile, Norwegian firm Statoil and France's Total are working on an Arctic project with another Russian state-controlled energy company, Gazprom, in the Barents Sea.

So why have Putin and the oil firms learned to be friends again? Because they need each other. Russia's economic resurgence has been based on oil, which it churns out at a dizzying rate. It only' has 5.6% of world oil reserves, but accounts for 13% of global production. The trouble is, at that rate it will run out of oil far more quickly than more cautious producers in the Middle East. Given that oil and gas make up about 25% of its GDP and two-thirds of its export earnings, it can't allow that to happen.

Russia aims to keep producing 10 million barrels a day until 2020, but its traditional fields in the more hospitable parts of Siberia are being rapidly depleted. The Energy Ministry reckons Russia will need investment of $300bn over the next ten years to keep production at those levels. Without any investment, production will drop by 20%, says the Ministry.

Not content with the deals already signed, in February Putin who is returning as president after a spell as prime minister -said that he is considering changing the law to allow foreign firms to develop Arctic assets on their own. "We made a decision that only state-controlled companies may work offshore in the northern seas. This, to my mind, constrains production development. We have to work out what more should be done to increase opportunities."

It's not just foreign investment that Putin is after he also needs international expertise. Constantly changing ice cover, freezing temperatures, months of darkness and a lack of supporting infrastructure make the Arctic the world's most challenging oil province. Moving icebergs could wreck rigs and pipes, while cold temperatures mean that if there is an oil spill, very little of it would evaporate.

Norway's Arctic success story

These challenges have made other countries with potential access to Arctic oil more cautious about exploiting it, but Barack Obama's administration in the US recently signalled that exploration blocks in the Arctic Ocean would be ready for auction by 2015.

It's believed that the Chukchi and Beaufort Seas off the coast of Alaska could hold 26billion barrelsof oil. The US Interior Department has finally granted Royal Dutch Shell conditional approval to drill exploratory wells in the Arctic Ocean off Alaska's coast starting next year.

Canada has also stepped up its Arctic oil and gas programme recently. It had already sold exploration rights to BP and Exxon Mobil, but in December last year the national energy regulator released updated regulations paving the way for offshore Arctic drilling to begin.

Despite their green' image, most of the smaller Scandinavian countries that border the Arctic are just as eager to exploit its resources. Norway has proved to be one of the most successful offshore Arctic explorers. Last year, state-controlled oil firm Statoil found two major offshore fields in Norway's Arctic region.

The discoveries in the Barents Sea are estimated to hold up to 600 million barrels of oil equivalent. In November, the Norwegian government unveiled a 20-year plan to unlock the region's oil and gas and deliver them to foreign markets. "It is the project of a generation," said foreign minister Jonas Gahr Stre. "As the ice melts, new transport routes are opening up, resources are becoming accessible and human activity is drawn to this region."

Denmark has unveiled an Arctic strategy to open up the area to industry and trade. "Previously, the discussion about the Arctic region has focused on the environment, on whether we oughtn't to turn the region into one large, natural preserve. But Denmark, Greenland and the Faroe Islands have agreed that we want to utilise the commercial and economic potential of the area," says Danish foreign minister Lene Espersen in The Wall Street Journal.

Greenland's bid for independence

Danish protectorate Greenland is especially keen to promote Arctic exploration as a means of achieving financial independence from the mainland. Danish subsidies still make up about 40% of Greenland's GDP. Greenland has already issued offshore exploration licences for its west coast, although so far, the only firm to drill there, the UK's Cairn Energy, has generated more negative publicity than oil (see below).

Greenland is also at the forefront of Arctic mineral extraction. It's home to vast amounts of copper, nickel, zinc, gold, diamonds, uranium and platinum. But what's really getting investors excited is its huge deposits of the rare earth' metals needed to make fancy electronic equipment from iPads to fighter planes. More than 90% of Greenland is covered in ice, but as that starts to melt, it is becoming easier for the dozens of international mining companies now active in the country.

The same is true elsewhere in the Arctic. For example, in Arctic Canada, steel conglomerate ArcelorMittal is planning a giant open-pit iron ore mine. "Places like Baffin Island have always held a treasure trove of minerals, but low commodity prices, coupled with the high cost of operating in the Arctic, left many deposits undeveloped," says Paul Waldie in Canadian newspaper The Globe and Mail. But soaring prices have made "mining's last frontier... financially viable."

Melting Arctic sea ice means that "mining in the Arctic has become logistically possible as well, because sea lanes stay open longer due to thinner ice and railways can operate year round". As a result, old mines across the Arctic are being reopened and new ones developed.

A new era for trade

The Arctic investment story isn't just about extracting resources, however. As the area warms up and the ice melts, new trade routes are opening up too. These new routes, shown on the map below, could potentially cut journey times between Asia, Europe and America by around 40%. Russian mining companies are already acting on the opportunity.

(Click on themap for a larger version)

OAO GMK Norilsk Nickel, Russia's largest mining company, plans to spend $370m to double its shipments across the Arctic Ocean by 2016. It will send the goods from Russia's Murmansk port, near Finland, to China and South Korea as melting ice allows the route to rival the journey through the Suez Canal. While the journey still requires the use of icebreakers as escorts, or ice-class transportation vessels, it takes 18 days, compared with about 40 through Suez, justifying the costs.

Meanwhile, Novatek, Russia's second-largest gas producer, has sent tankers loaded with gas condensate through the Northern Sea route. Several Arctic countries are now planning new deep-sea ports while shipping companies worldwide have already built 500 ice-class ships, with more under construction.

The scramble for the Arctic

As a hub of natural resources and shipping, the Arctic will undergo a switch from being a deserted outpost to becoming one of the world's most important strategic areas. As a result, the geopolitical assumptions governing the area are being rapidly re-written. At present each one of the eight Arctic countries controls the sea next to its border, while regional issues are discussed at the Arctic Council. The council is made up of the eight countries found in the Arctic and representatives of indigenous groups, but now other countries, such as China and South Korea, are pushing for greater involvement.

China's interest in the Arctic is both commercial and military. As the world's greatest trading nation, it has a lot to gain from new routes that could make its goods more competitive, and also it likes the idea of having greater access to extra resources to fuel its growth.

The Arctic also has profound military implications for China. Until now, it was thought that in a war with India, its largest Asian rival, the maritime action would centre on an Indian attempt to blockade the Indian Ocean. Now, however, the melting Arctic is undermining half a century of military strategy.

Similar examples apply around the world as the opening of the Arctic changes strategic assumptions. Given the region's new-found importance, it's little surprise that countries around the world are beefing up their Arctic military capabilities. Russia recently sent extra brigades to its northernmost bases while Norway is planning to buy 48 F-35 fighter planes tobolster its Arctic defences.

Canada is also getting in on the act. It recently staged its largest-ever Arctic military manoeuvre and has ordered a new fleet of patrol ships and icebreakers. Even more telling are the actions of non-Arctic powers. China has upgraded its aircraft carrier to be seaworthy in ice, and India is building an icebreaker.

In short, it's clear the region is about to undergo a huge investment boom.

Where to put your money

So far, the nearest thing to an Arctic oil pure play' is British explorer and producer (E&P), Cairn Energy (LSE: CNE). Last year it bought the rights to explore several blocks of Greenland's west coast and ran an extensive drilling campaign. Unfortunately for the firm, the gamble hasn't yet paid off, as none of the wells revealed commercial deposits of oil or gas.

But it's not giving up, and has ploughed some of the profits from the sale of its successful Indian business into funding more exploration in Greenland. It has also partnered with other firms, such as Norway's Statoil, to help with exploration.

Investing in the hope of a discovery is always a risky business but buying in cheap is one way to mitigate some of that risk. And Cairn Energy fits the bill nicely. Last year's bad luck caused the share price to plunge. Its market cap has fallen so far that this week it was demoted from the FTSE 100 a move that will come into effect from 16 March.

As a result, Cairn is now one of Britain's cheapest E&P companies, trading on a forward price/earnings (p/e) ratio of 10.5. Even if it doesn't find anything in the Arctic, US investment bank JP Morgan reckons Cairn's existing assets alone make it worth 455p a share its current share price is 317p. However, it's worth noting that Cairn's drilling programme will likely stretch on into 2014, so this is a long-term investment.

A safer option is Norwegian state-controlled oil producer Statoil (NYSE: STO). We normally steer clear of state-owned firms, as they often do best by government, not private shareholders. Yet the Norwegian government, which owns 67% of the firm, is committed to developing the Arctic's oil resources.

Statoil has a good track record in the Arctic. It found a giant Arctic gas field in 1981, which it later exploited with the world's only Arctic liquid natural gas facility. On its own, or with partners, it has drilled more than 80 wells in Norway's Arctic waters. It also has both offshore and onshore operations in Russia's region of the Arctic and fields in Newfoundland, which although not above the Arctic Circle, pose similar challenges.

Chief executive Helge Lund told Reuters the firm now plans to focus on the Arctic, following a recent discovery. "We believe we now understand [the geology] and have cracked the code in this area. We think we will be able to make additional finds in this licence in the future."

Importantly, the company also has an excellent safety record, which, as the Deep Water Horizon disaster showed, should matter as much to investors as it does to environmentalists. On a forward p/e of 9.5, Statoil looks good value.

There are a host of Arctic miners operating throughout the Arctic Circle. Greenland's reserves make its mining sector particularly exciting. Yet mining is still at early stages of development in Greenland, which means investing in companies operating there is particularly risky.

There's also the risk that a slowdown in China poses to commodity prices in general. So a more established option would be to go for Canadian-listed gold miner Agnico-Eagle (TSX: AEM). Of the four mines the firm operates, two are in the Arctic Circle. Its Kittila mine in Finland is exploiting one of Europe's largest gold deposits, which is expected to last until 2039. Meanwhile, the Meadowbank mine in Nunavut, Canada, is the company's largest mine.

Mining in the Arctic isn't easy, something Agnico investors know more than most. Higher productions costs and lower-grade deposits forced Agnico to write down some of the expected profits from the mine. A rogue wolverine added millions to costs by preventing electricians from making necessary repairs, causing a temporary shutdown of the mine.

As a result, the share price has slumped and the firm now trades on a more acceptable, if still not dirt cheap, forward p/e of 15. The firm is adamant that it has learned from its Meadowbank experiences and is confident that it can keep costs down at its next Arctic mine, due to enter production in 2017.