Oil’s corroding pipeline

Oil and gas burned furiously through the independence referendum campaign. Quite a lot was said by people on both sides who should have known better.

It’s now the subject of a conspiracy theory suggesting vast reservoirs were being hidden from voters.

Oil and Gas UK, the industry body, has just published its annual economic report, which seeks to do several things. One of them appears to be an attempt to calm things down a bit, with a sober assessment of what’s left and what it will take to extract it.

It’s also very keen to impress on the UK government that more tax breaks will be required if oil and gas are to keep flowing.

No change there, then. The industry is adept at lobbying, particularly on tax. And it’s got quite a strong story to tell about the challenges it faces.

Drilling

The most striking facet of the industry in UK waters is its steeply rising costs.

The story starts with exploratory drilling. The cost of that has shot up from an average £20m per well over most of the past decade to £70m last year. That has quite a lot to do with the shortage of drilling rigs, pushing prices up, while drillers are losing economies of scale by becoming scarcer.

Only 15 exploration wells were drilled through all of last year, down from an average of 35 between 2004 and 2008. So far this year, it’s looking like a further drop.

In 2013, they found only 80m barrels of oil (or its gas equivalent, known as boe), after only 20m were found in a particularly poor preceding year. Only around half of that looks commercially viable.

Yet if the industry is to get to the bottom end of what it hopes to achieve in the coming decades, it needs to find an average of 150m boe each year.

High pressure

Put that together with development costs, and the price of investment per boe has risen from £4 per barrel 10 years ago to £13.50 last year.

That is largely explained by the type of field now being developed – complex brownfield work on older depleting fields, or wells under deep water, some with high temperature and high pressure.

Getting at those fields has given the North Sea a second wind, and a first one to new fields west of Shetland. This remains a bumper time for the industry.

While last year saw a record investment of £14.4bn, that’s expected to be the peak, to be followed by two years of £10bn-plus investments, before declining to £7bn-£8bn.

But the rising cost of investment per barrel is bringing doubt: “Opportunities… are simply becoming unattractive as capital costs continue to rise”.

Chevron and Statoil have both put plans on ice pending a cut in cost inflation.

Alarming figures

What is alarming them more has been declining production. There was a fall in output of 19% in 2011, then 15% in 2012, and a less alarming 9% last year, to 1.44m boe per day.

The indications from Whitehall’s energy boffins are that 2014 is seeing a 1% rise in output – the first annual rise since UK output peaked in 1999. That’s expected to continue through this decade until the long-term decline continues.

Factor in the price of producing that reduced output, and you get to some more alarming figures for the industry.

The total bill for production in UK waters rose 15% to £8.9bn last year, with the expectation it will rise to £9.5bn this year – explained by inflation, ageing equipment and increasing complexity.

With sharply reduced output and a rising bill, the cost per barrel has soared by 62% in only two years, from £10.50 to £17. In 19 fields, it’s more than £30.

Those numbers help explain why 2013 was the first year of the UK industry having no post-tax cash flow since the rock bottom oil prices of 1992.

Crude pricing

So costs are looking at least challenging. But don’t forget price, the most volatile element of all.

Brent crude has been unusually stable through the downturn years, but it has just finished its worst quarter for more than two years, down 14%. In June, it was above $115 per barrel: it ended September with a $3 drop in oil for November delivery, to below $95.

The economics of offshore oil are sensitive to that indicator more than most. And Oil & Gas UK warn that if the price falls to $80 per barrel, a third of developments would be unlikely to proceed. Some older fields would be wound down faster than planned, it says.

Remaining reserves

So that brings us to the question of how much is left. It was this that got the most attention in the referendum campaign, perhaps because it’s the least knowable figure of all.

The main industry body clearly wants to calm things down by explaining how wide the variations are. The risk is that it will excite yet more claims of bonanza or of doom.

The widest spread is from Whitehall’s Department of Energy and Climate Change (DECC), saying there could be only another 4bn barrels to come from UK waters. Or it could be 34.5bn. A more realistic range, it admits, is between 11bn and 24bn.

Oil & Gas UK chooses a range of 15bn to 24bn boe. But with its latest report, it adds an important caveat: “The recent lack of exploration success and slow rate of bringing discovered resources through to maturity demonstrate how difficult it will be to reach the upper end of these ranges”.

It explains that, without further investment, 6.6bn boe should flow. Investment plans currently being considered could bring between 2bn and 5.5bn more.

That leaves up to 12bn barrels “for which there is a significant degree of certainty of recovery”. It depends, however, on successful exploration, the commitment of investment, continued development of technologies, and both production costs and prices remaining attractive.

It may be worth remembering the 15bn-16bn range was the one thought most likely by Sir Ian Wood and Professor Alex Kemp.

Trillions

You’ll probably recall that the 24bn upper limit was repeatedly used by the ‘Yes’ campaign in the referendum.

And if it were all recovered from under the seabed, we were told it could have a wholesale value of £1.5 trillion. That’s £1500bn.

But Oil and Gas UK point out in this, most recent report that the cost of finding, developing and extracting it would be £1 trillion at today’s prices – a factor that was sometimes overlooked.

Contrast that with the 43bn boe extracted so far, for expenditure of £525bn, and you can see the average cost boe is rising. So the taxable profit looks rather less of a windfall for the energy firms, and for HMRC.

And that tax question is why the oil reserves question mattered to the campaign, and would matter again if the independence battle is to be rejoined.

The industry is arguing that the portion of oil and gas being recovered without special tax breaks – known as Field Allowances – is set to fall fast over this decade. So it wants such incentives to be built into the reformed fiscal regime being drawn up by the Treasury for publication this December – the UK government response to Sir Ian Wood’s report on maximising recovery.

The problem for Scottish independence was not, as sometimes portrayed, that oil and gas is somehow a curse, and uniquely so for this country.

The problem was that a generous dollop of tax revenue from offshore production has been necessary to keep the government’s anticipated deficit to a manageable scale.

And the oil industry is trying to tell both the Treasury and anyone else who wants to tax its profits: if we want to maximise the recovery of offshore oil to help the balance of payments and keep the industry employing a lot of people, we’re going to have to pay for it with less tax take.

BBC