Analysis - North Sea oil and gas - Platforms for profit

Huge volatility in the world's oil producing nations makes the North Sea an attractive proposition for exploitation. But how far will home-grown expertise be profiting? Matt Warner investigates.

Great excitement accompanied the discovery of the North Sea oil and gas fields over 30 years ago. By the 1980s, Britain was self-sufficient in hydrocarbons and was busy filling super-tankers, rather than emptying them. While successive chancellors rubbed their hands with glee, major oil companies, such as BP, proudly used North Sea activities in their advertising campaigns - this was Britain's oil secured by tough Britons working in a hostile environment so we, the public, could heat our businesses and homes. In doing so, they were also creating employment and pouring cash into the economy, neither of which was in abundance in the early 1980s.

The story in 2004 is rather different. North Sea oil and gas production reached its peak in 1999, at 4.5m barrels of oil-equivalent per day (BOEPD), but the current figure is 12% below that. New fields are more complex to work and typically are only half the size of those found a decade ago, while existing fields are producing 50% of what they did 10 years ago.

The major oil companies in search of billion-barrel reserves are looking elsewhere, such as West Africa, South America and Indonesia.

War and strife

It is impossible to divorce the oil business from politics and the global economy. Events in the wider world are influencing the future of the North Sea basin, none more than the rocketing price of crude. The price of Brent crude (from the North Sea) reached over $50 a barrel in October. 'If assumptions about prices shift from a forward price of $20 to $30, that makes an enormous difference to investment plans and could be key for the development of the North Sea,' says Alec Carstairs, head of oil field services at Ernst & Young.

Many in the business feel the world is experiencing a 'paradigm shift' in oil prices, as Jeff Corray, KPMG partner in European oil and gas, puts it. Global factors are applying relentless pressure. The fashion for gas-guzzling SUV cars in the US market continues, and each state has its own regulations for fuel quality, further complicating the market. In China, demand has increased by 20% in the last year as the economy surges, while political instability is rife in many oil-producing areas.

The situation in Iraq is worsening. Funds earmarked for development of the oil infrastructure are spent on security, and the situation shows no sign of improvement. In neighbouring Saudi Arabia, the murder of westerners by Islamic fundamentalists is causing employees in the oil sector to leave the country. Iran is run by a theocracy implacably opposed to the US, its major market. Venezuela has seen coup attempts and general strikes.

Ethnic tension is widespread in Nigeria, and the Russians have imprisoned the chairman of Yukos, the largest oil company, for non-payment of taxes in what many view as a political manoeuvre by the Kremlin - the business has filed for bankruptcy.

OPEC's recent announcement of a 1m-barrel-a-day production increase made no impact at all. Its members are essentially already producing at full capacity. Knowing all this, speculators are exacerbating the situation.

With global stocks so low, the market is exposed to sudden price rises if supplies are threatened, so as hedge fund speculators bet on the possibility of higher prices, they in turn help push the price up.

Gas is also in huge demand by utilities, which are keen to secure long-term supplies. It is cleaner when burnt, so has better environmental credentials than coal or oil, but is also more flexible than other energy sources.

Gas-fired power stations can be turned up or down more easily, allowing demand to be met when needed. Much will come from the Norwegian sector of the North Sea. With a tiny domestic market, Norway has long geared up its industry for pure export. While generally having a more stable pricing environment than oil, gas is in ever greater demand. The wholesale price in 2005 is expected to be 50% higher than the 2003 price.

Good news for the North Sea

All this chaos augurs well for the North Sea. There is political stability, a well-established infrastructure, a huge market on the doorstep, a well-trained workforce, and the high prices make more marginal fields profitable.

A 'mature basin' it may be, but the UK continental shelf (UKCS) is attracting interest - mainly from outside Britain. 'Make no mistake, this is an American business,' says Corray. US independents have the cash to run operations and mature basin experience gained in the Gulf of Mexico. The Canadians are also heavily involved. The Buzzard field, the last 'elephant' (large find) likely to be found in the North Sea, was discovered by PanCanadian.

This world-class field is operated by EnCana, also from Canada.

However, despite the decline in production and increasing costs, the North Sea is very far from a lame duck. A look at the figures (see box) shows just how important the industry is to the UK. Brent crude was selling at just under $50 a barrel at the time of going to press, and it is estimated there are up to 30bn barrels' worth remaining under the sea, while the demand for natural gas has never been higher. A new group of independent oil companies intends to pump it ashore, actively encouraged by the government.

Home-grown expertise

One such company is Aberdeen-based Dana Petroleum. Its finance director David MacFarlane has no doubt about what is needed. 'Clearly the North Sea is in the second half of its life, but opportunities are there although they need to be worked more aggressively. Unless assets get into the hands of companies that are focused on making the North Sea work, there is a danger of it stagnating.'

MacFarlane sees current actions of the major producers as unhelpful.

'Oil prices are high, so they are harvesting cash from the UKCS but investing it elsewhere. It's almost like a bank to fund global operations.'

This poses a problem: with Brent crude so valuable and the infrastructure in place, there is little incentive for the major producers to divest.

This can stand in the way of smaller businesses that would invest, and investment is vital, as KPMG's Corray explains: 'Further investment is the issue. For the majors, there is still sizeable production left but not huge finds. The returns in these fields are not as exciting as say West Africa. For a company like BP, there are many conflicts - "do we spend a dollar in UKCS or in Africa?" And the simple answer is Africa.

What needs to happen is a change in ownership.'

Change is taking place, and the majors insist they are encouraging that change in the UKCS. 'We don't believe in sitting on opportunities that can't compete in our global portfolio. We have led the industry in introducing new players,' says BP's spokesman. BP did work with American independent Apache, which has taken over the North Sea 'Forties' field, but BP remains the largest producer in the UKCS, and its spokesman describes the North Sea as 'still a significant piece of business'.

The majors may claim to be encouraging players like Apache, but this is commercial common sense and deliberate Department of Trade and Industry (DTI) policy. The government, mindful of the problems experienced in the mature Gulf of Mexico basin, decided the UKCS needed a new approach to offshore operations. The PILOT scheme involves oil businesses, contractors and government departments working together and has a vision of sustaining investment at £3bn a year, and production of 3m barrels a year by 2010. Key to achieving these and other ambitions is the 'Promote' licensing scheme.

Promote is designed to introduce and encourage entrant companies to UKCS.

Lessons from the Gulf of Mexico showed that a rapid turnover of leases stimulates activity and standard legal agreements speed up deal closures.

Red tape continues to be cut - in September, the DTI announced that far fewer businesses would need to apply for gas transporter licences. Hopefully more marginal fields, which are not of interest to the majors, will be exploited by companies whose size, and balance sheet, can make them pay.

Furthermore, fallow fields, which are being held by majors, must be exploited within a set time-limit, or their licences will be removed.

Treasury calls the shots

These efforts at stimulating business have been widely applauded. New investment will only come with new players, but it may prove premature to congratulate the government too much, as MacFarlane explains: 'The Promote licences are helping, but it's the Treasury that is calling the shots fiscally - it is a long-term business, projects might not generate income for years, so you don't want tax-rate changes. Tax is one of the material factors that impacts your economics.'

In 2002, the industry suffered an unexpected blow from the Treasury.

Corporation tax was raised by 10% to 40%, in an initiative called the 'supplementary charge'. 'It was done at the wrong time,' says MacFarlane. 'The industry badly needed to stimulate new investment but it made everybody pause and question the validity of investing in the North Sea.'

Unsurprisingly, the Treasury takes a different view. Its spokesman points out that the '40% rate is still the lowest of any major oil producing nation', and that 100% allowance was introduced for UKCS capital expenditure.

Royalty payments were also abolished. 'The rationale behind the tax rise was to raise a fair share of revenue and encourage investment through a stable fiscal regime,' says the spokesman, adding that there was 'no evidence that the change had affected investment in the North Sea'.

The DTI would not comment on the supplementary charge, but one can only imagine the consternation of those running the Promote licences when they heard the news. Trisha O'Reilly of the UK Offshore Operators Association is critical in her assessment of the tax changes. 'There's no doubt it hit the industry very hard. It had a direct impact on investor confidence.

The slump in exploration activity could be attributed to that tax.'

Oil companies fear that the next time a government initiative needs extra funds, the North Sea piggy bank might be raided again. 'Politically, oil is an easy target,' explains MacFarlane. 'But we need the government to be more creative and take a longer-term view of the future. Much of the thinking has been short-term, with eyes on the next election. The prospect is that we'll be importing an increasingly scarce resource at ever higher prices. We should be saying, "How do we sustain the North Sea for as long as possible?" '

The nationality of those tackling the business of offshore operations may be varied, but they all face the same hostile environment. Huge 50,000-ton production rigs have to be built onshore and then installed offshore in what MacFarlane calls 'a major civil engineering project'.

Any such project carries risks, but they will be deemed worthwhile by independent oil and gas companies looking to exploit estimated reserves of more than 30bn barrels. The fields may be getting smaller, but the price is getting higher - and car bombs are unknown in Aberdeen.


•   In 2003, 4m barrels of oil-equivalent per day (BOEPD) were produced, making the UK the world's fourth largest gas producer and 11th largest oil producer.

•   In 2002 (most recent year available) the value of the UK's oil and gas production was £23bn, or 2.5% of gross value added (GVA) for the economy.

Net exports were worth £5.4bn.

•   £195bn in North Sea taxes has been paid since the mid-1960s. The Treasury received £4.5bn in 2003.

•   Since the mid-1960s the industry has invested £211bn in the development of the UKCS. Investment in 2003 on exploration, development and operating costs reached £8.6bn. The oil and gas industry invests more in the UK than any other single industry.

•   In 2003, the industry provided employment for 260,000 people - operators directly employing 30,000 while 155,000 were employed in the supply chain or as contractors. A further 75,000 jobs were sustained through investment and wages from the industry.

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