What's Ahead in 2005

Maturity approaches on the UKCS

Professor Alex Kemp, University of Aberdeen, Aberdeen, Scotland

In some respects, events on the UK Continental Shelf (UKCS) in 2004 have followed earlier predictions. But in others, the outcome has been quite different from what could reasonably have been expected. Oil and gas production is broadly in line with expectations. It should end up at an average of around 3.8 million boed, compared to 4 million boed in 2003. Gas output has kept up better than oil, but the downward trend from 2000's peak production continues.

Total field investment during 2004 could end up at around £3.5 billion ($6.3 billion). A surprise was the relatively low amount of development drilling. For the first six months, well numbers were down when compared to the same period in 2003. In recent weeks, the drilling rig market has revived, with rates for semisubmersibles substantially higher than a year earlier.

Early in the year, the Department of Trade and Industry (DTI), in its annual survey of exploration and appraisal (E&A) intentions, said that 39 E&A wells would be drilled this year (compared to 34 in 2003). Indications are that the forecast will be exceeded.

Field operating expenditures could total at least £4.2 billion ($7.56 billion) in 2004, as the number of producing fields continues to increase to as many as 250 by the end of the year. Operating expenditures have continued at relatively high levels and, in contrast to some years ago, they now exceed field investment.

Large increases in prices have substantially enhanced cash flows to licensees and tax revenues to the Exchequer. This has generated some increased drilling. The number of new field development approvals for 2004 might also be double the 2003 figure of 14. Recent weeks have seen more announcements than usual. It is possible that high, near-term prices, and the ability to make contracts on the forward market at these relatively attractive values, has accelerated development of incremental, short-lived projects.

DTI initiatives. DTI recognizes the need to encourage enhanced activity in light of continued production declines. DTI's recent estimates of remaining potential put cumulative output at around 33 billon boe. Officials' estimate of remaining potential is 24 billion boe, with an upside possibility of 44 billion boe.

This appears very promising, but it conceals the fact that remaining reserves are in prospects where expected sizes are much smaller than those experienced historically. Average new field development size is just over 30 million boe. In the first half of the 1970s, the average new development size was 600 million boe.

Small developments are not always attractive to licensees, especially in non-core UKCS areas. Similar thinking applies to exploration acreage. These issues have led to the fallow/ discovery block initiative. This scheme, agreed to by DTI and operators to enhance activity in such acreage (either by existing licensees or by new ones through asset sales or relinquishment/ re-licensing), is now bearing fruit. More noticeable benefits from this initiative will become apparent over the next couple of years.

DTI has encouraged new players to enter for some time. The fallow discovery/ block initiative can help to make acreage available to such companies. Access to acreage has been a big problem in recent years, as many interesting tracts have already been licensed in previous rounds. In fact, most North Sea blocks put on offer were relinquished in earlier rounds.

New entrants, by definition, do not own UKCS infrastructure. The most economical way to develop a new field is to use existing pipelines, host platforms and terminals. About 90% of new developments utilize these to some extent. Terms of access are very important to third-party users. The tariffs payable can sometimes account for 50% of operating costs.

Code of Practice. DTI has been keen to enhance the offshore infrastructure market's efficiency. Historically, terms have been determined by individual negotiation. This has often been very time-consuming, with the outcome uncertain. In September 2004, a revised Code of Practice was agreed, whereby transparent, non-discriminatory terms will be offered. The parties shall negotiate on specific terms in good faith for up to six months. After that, if agreement has not been reached, DTI will determine the tariff, based on a competitive rate that assesses the risks involved.

Licensing improves. Results of the 22nd Licensing Round were announced in September, with 163 blocks awarded, the highest number since the Fourth Round of 1971 – 1972. This figure is misleading, as the majority was Promote Licenses. These were introduced in 2003, in the 21st Round. Licensees acquire data and work up prospects over a two-year period at very low cost (10% of standard license fees). Plans have to be produced for significant work in the second two-year period. About 60% of licensees are seismic contractors, consultants and small oil companies.

A second feature of the new round is the large number of blocks awarded in the West of Shetland area. Over the last few years, this region's exploration, which earlier had offered bright prospects, has been rather disappointing. A reinterpretation of geological prospects is now likely. The area has had some recent good news, including a discovery (unannounced to date) and Total's successful appraisal of Laggan gas field.

A third interesting feature of the 22nd Round is the substantial number of new players. Of 58 companies awarded licenses, 15 are new entrants, reflecting well on DTI's efforts.

Prior to this year's large price increases, the 2005 outlook indicated a continuing fall in production to around 3.62 million boed, field investment of about £3.2 billion ($5.76 billion) and operating expenditures of roughly £4 billion ($7.2 billion). Higher oil prices, plus expectations of exceeding $30/bbl, may bring forward the execution of incremental projects and possibly accelerate new field developments. Such increases will be fairly modest.

DTI's survey indicated that 37 E&A wells could be drilled in 2005, a number that may be exceeded, thanks to price increases. Further modest gains may be obtained from the fallow discovery/ block initiative and the new Code of Practice agreements.

Tax modifications. In 2003, the government removed Petroleum Revenue Tax (PRT) on tariff income on new contracts, and it came into operation this year. Net economic benefits will be passed on to users. This calculation is quite complicated. It depends not only on removal of the tariff income tax, but on the reduced tax relief received by asset owners in providing the service. In turn, this depends on how costs of providing the service are split between PRT assets and non-PRT assets. For typical assets, the net economic benefit would result in tariff reductions in the 20%-30% range (rather than over 40%).

Next year will also see two government-led initiatives on the UKCS. From January, the European Union Emissions Trading Scheme (EUETS) starts. This applies to UKCS platforms and terminals, but not to stand-alone drilling rigs. Installations have been allocated quotas. Quotas have been reserved for future fields, and some provision is made for changes in output as fields deplete.

There are obvious implications for operating costs and revenues. There will be complications within license groups regarding how allowances are traded. Initial allowance values are expected to be quite low. Another scheme being introduced by DTI is trading of oil in produced water. How this functions, and what its effects will be, remains to be seen.

THE AUTHOR
	Alexander G. Kemp is the Schlumberger professor of petroleum economics at the University of Aberdeen. He was formerly lecturer, senior lecturer and reader. He also previously worked for Shell, the University of Strathclyde and the University of Nairobi. For many years, Professor Kemp has specialized in petroleum economics research, with special emphasis on licensing and taxation. He has published more than 100 books and papers in this field, including Petroleum Rent Collection Around the World, Institute for Research on Public Policy (Canada). He is European editor of the Energy Journal and editorial advisor to other academic/ professional journals. Professor Kemp is director of Aberdeen University Petroleum and Economic Consultants (AUPEC), providing consultancy in petroleum economics.