19th May 2015
In times of low oil price and rising costs, the North Sea can’t escape the doom and gloom headlines. Drilling activity is grinding to a halt and operators are trimming their waistlines with reduced capital spending and workforce down sizes. In this climate could anyone really argue with the savvy investor looking to invest in other more promising regions around the globe? Yes, the North Sea has problems, but the size of the remaining prize is still considerable. There are 7,100 million barrels of oil plus gas equivalent of reserves and resources currently under production or about to be developed (WoodMac). This is almost 20% of what has already been recovered and doesn’t include the potential development of new discoveries or previously uncommercial accumulations. The question is not whether there is value in the UK North Sea, but rather how can this value be unlocked?
The creation of the new Oil and Gas Authority (OGA) and the significant reductions in Petroleum Revenue Tax (PRT) could not come at a better time. The PRT reduction now means there is additional motivation for operators to drive down costs, as a bigger proportion of cost savings will now be taken as profit after tax rather than lining the pockets of the taxman. It’s also clear that the OGA will have teeth to drive co-operation with the power to enforce fines of up to £5million and intervene when required to sort out commercial agreements between operators to ensure any solution is cost optimised for everyone. However, there are still many challenges that any investor or operator must navigate through to unlock value.
Focus on the operators
Operators will always be the key link in the chain for monetising a hydrocarbon resource. Once licences have been awarded, the burden is on them to make the right technical and commercial decisions to extract maximum value from their acreage.
Unsurprisingly, almost 50% of the yet to be produced 7,109 MMboe reserves and resources are held by only 11 of the majors. The remaining 50% is held by 64 independents and smaller junior operators. It is these small junior operators that will be feeling the pain more than others in the North Sea. The majors and independents have global portfolios to support struggling North Sea assets and can spread the risk in times of high cost and low oil prices. Their capital investments can be slowed down in tough times and ramped up again when conditions improve. Although, majors and many independents can support this approach, the smaller junior operators do not have the financial clout.
Looking closer at the 42 juniors, the majority are exclusively non-operating partners with only 10 of them actually having an operating position. Additionally, very few of these 10 operators have operations outside the UK North Sea. This makes them all the more exposed to the current North Sea conditions. Not only do they lack the financial support available to a large major, but they lack a global portfolio in which to shift investment and hence rebalance risk.
Within the 10 junior operators, it’s clear that some will be feeling the pinch more than others. Figure 2 splits out the reserves and resources of these juniors into two categories. On the x-axis is the reserve volume currently being produced, whereas the y-axis plots the reserves and resources under development or likely to be developed. When this is done, a picture emerges of which operators are holding cash generating reserves under production and which operators are still investing capital to get their new developments onstream.
Those that hold more reserves in producing assets than in new developments are the “harvestors” and are focused on making the most of what they already have without investing in new developments. At the other end of the spectrum are the “investors”, who hold more reserves and resources in new developments than in producing assets. Although the “investors” are the future value creators, many of them are heavily exposed by having large volumes of reserves and resources with only a small proportion of production. This implies large capital investments with low cash flow. As can be seen in Figure 2, the majority of juniors fit into this category and do not have the “harvestor” cash flow, which will further compound their pain.
Despite this bleak picture, there is an upside. Compared to independents and majors, juniors tend to have a much larger equity share in their operating assets. Majors and independents have an average share of 37% and 34% respectively in assets that they operate in the UKCS compared to juniors with 57%. Hence, although juniors don’t have global portfolios on which to balance risk, they do have a high level of equity in their assets that could be farmed out in exchange for capital and/or technical know how to improve the prospects of new developments. In these challenging times, this equity is the key trading tool that juniors have to ease their pain. It also means opportunities for capital lenders and service companies willing to trade in equity.
Rationalise pipeline and facilities infrastructure
In addition to the operators, the second key UK North Sea enabler is the pipeline and facilities infrastructure. From 1975 to 2013, 86% of all crude oil has been exported via pipeline and over two thirds of all oil produced has used one of three pipelines: Forties, Brent or Piper. These highly concentrated export routes are a result of the hub and spoke pipeline structure that has evolved in the North Sea. As new discoveries were made it was cheaper to tie them into existing infrastructure and pay a transit tariff to a hub owner rather than investing in an alternative method. The result is that all North Sea production is hugely dependent on the three hubs serving the Forties, Brent and Piper pipelines.
Figure 3 compares the oil volumes exported from the key hubs and via shuttle tanker in 2014 with 2025 estimates. The 2025 figures were calculated with a simple decline curve analysis by GCA and don’t take into account any new discoveries or recovery factor improvements to existing fields. Like any commercial venture, these export hubs must remain economic. However, this will become increasingly difficult with lower volumes of export oil and hence lower tariff revenues. If these hubs were to be become uneconomic and were closed by their operators, there would be a domino effect of other closures as fields dependent on these hubs for oil export would no longer have an economic export route.
Part of this problem is how current infrastructure ownership is set up in the UK North Sea. Hub owners are running two different types of businesses. On one hand they are operating their upstream oil producing assets and on the other they are operating infrastructure hubs with other upstream operators as the customer. These are two different types of businesses with different and potentially conflicting priorities.
Figure 4 is a Harvestor/Investor plot for the pipeline export hub operators with bubble size proportional to the volume of hydrocarbons exported via the respective hub. A clear pattern has emerged: the operators of the biggest hubs (the big bubbles) are “Harvestors” and not investing in new developments. This raises the question of whether the North Sea would benefit from a split supply chain with upstream operators focusing on exploration and production and other midstream entities managing export hubs.
The recently passed UK Infrastructure Act 2015 has enshrined in law that the UK government must have a strategy to maximise economic recovery of UK petroleum. It also legislates that all license holders must always act to maximise the economic potential of their assets. If economic recovery is to be maximised help must be given to small junior operators to have access to capital and technical know-how. This will give them the best possible chance of keeping their high number of new developments economic. It also means looking at offshore infrastructure afresh and questioning whether it makes sense to have the same companies operating midstream and upstream assets.
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