Shepherd and Wedderburn LLP
  May 21, 2010 - Scotland

The Future of North Sea Oil
  by Kevin McGrory

The UK is a mature oil and gas province, past its peak, competing for investment in a global market. Nevertheless, there are still huge reserves of oil and gas remaining.

Industry association Oil and Gas UK (OGUK) estimates that up to 25 billion barrels of oil equivalent could still be produced from UK waters. To put that in perspective, around 40 billion barrels have been produced to date. OGUK forecasts that with sufficient investment the UK could be producing 1.5 million barrels a day in 2020, which is enough to satisfy around 50% of total forecast energy demand.

 In any oil and gas province the average size of new fields gets smaller over time. The average size in 2009 was 20 million barrels, compared to 500+ in the 1970's. Small fields are not as attractive to large multinationals because their primary goal is to replace reserves and they don't want to spend capital and resources chasing small prizes.

 As a consequence, Government has encouraged smaller independent companies to enter the market with initiatives such as the fallow acreage programme and drill or drop licences. In 2008, 80% of the exploration wells in UK waters were drilled by small independents, but exploration is usually funded by equity capital and the funding disappeared when the financial crisis hit.  This, coupled with a combination of a fall in the price of oil from $140 to $40 per barrel and high costs due to contract lag, led to a significant reduction in the number of wells drilled in 2009.

 Today, the oil price seems to have stabilised at around $80 per barrel and costs have fallen, but funding remains an issue. OGUK has suggested that Government should incentivise exploration drilling by advancing recovery of costs without delaying until the costs can be offset against revenue. Norway did this successfully some years ago.

 Access to infrastructure is another factor fundamental to the future of the industry. Revenues from small fields don't justify the costs of installing a platform and pipeline to shore, so need to use existing infrastructure. Much of this was installed in the 1970's and 1980's and is still largely in the hands of the multinationals. New users provide income which offsets the costs required to maintain the infrastructure, extending its economic life. However, a disparity between the amount the new user offers to pay and that which the owner demands often leads to protracted negotiations.

 One change that Government could consider is the abolition of Petroleum Revenue Tax. PRT was abolished in 1993, but only for new fields. Removal of PRT on older fields would extend their economic life and encourage the owners to accommodate new users.

 Why don't the new users simply buy out the current owners? With their leaner cost base and incentive to extend the life of the old fields they are natural buyers. The biggest obstacle is that under current legislation the seller remains liable for decommissioning the infrastructure in the event the buyer defaults. Sellers naturally require buyers to provide security against that liability, often with a multiplier to cover contingencies. This is calculated on a pre tax basis because Government will not guarantee that the costs will be allowable against tax paid, although that is currently the case. The preferred security is a bank guarantee. For most small independents that is well nigh impossible to provide.

 Industry has lobbied Government unsuccessfully to guarantee the tax relief or to allow a tax effected provision to be built up during the life of the field. If we are to avert the premature demise of the UK as a viable oil and gas province, Government may have to think again.