What's Ahead in 2006

Busy, eventful year in prospect for UK Continental Shelf

Professor Alex Kemp, University of Aberdeen, Aberdeen, Scotland

The year 2005 has seen a transformation in activity levels on the UK Continental Shelf (UKCS). A large price increase has undoubtedly played a major role, but increased activity is also due to fresh interest by both established players, and recent entrants not entirely motivated by high prices.

All indicators are up. Higher activity can be measured by physical and financial indicators. In the first nine months of 2005, there were 174 development wells drilled, compared to 166 for all of 2004. The latter was, admittedly, a particularly low figure, with the average over the last 10 years being 238. However, the upward movement is certainly encouraging. For 2005, around 80 exploration and appraisal wells might be drilled. This compares with 63 in 2004 and an average of 69 over the last decade.

The money spent by the industry have also showed strong upward movement. Thus, field development spending could be around £4.5 billion ($7.74 billion) this year, compared to £3.3 billion in 2004. Field operating costs could exceed £5 billion, compared to £4.7 billion last year. Exploration and appraisal spending might approach £500 million versus under £400 million last year. Taxes paid should be around £10 billion, as opposed to £5.3 billion in 2004. Net cash flows are also strong, but increased expenditures will restrain growth from the £9 billion realized in 2004.

Strong licensing results. Increased interest in the UKCS among investors was manifested in the strong response to the 23rd Licensing Round. The results were appropriately announced at Offshore Europe in September, with the award of 264 blocks. There were 99 applicant companies, of which no less than 24 were new entrants to the UKCS.

A considerable number of blocks were awarded through Promote Licences, whereby the licensees (generally very small companies) are given the chance to assess and promote the prospectivity of the acreage in question over a two-year period without having to overcome the more stringent requirements to become a traditional licensee. There is a 90% discount on the rental fees for the two-year period. This interesting concept permits the entry of tiny companies with interesting ideas into the UKCS.

Another feature of the 23rd Round has been the renewed interest in the West of Scotland region (Atlantic Margin). Results of the considerable exploration effort in this region since the early 1990s have generally been rather disappointing, but Total’s successful appraisal of the Laggan discovery and Chevron’s discovery of Lochnagar/ Rosebank have encouraged a reappraisal of the region.

Thus, a substantial number of blocks have been taken up in the 23rd Round. Interestingly, the new licensees include some smaller companies, such as Faroe Petroleum and Hurricane Exploration. To encourage exploration in this high-cost region, Frontier Licences are available, under which the normal rental fees are discounted by 90% for an initial period.

Yet another interesting feature of the Round is the acquisition of a substantial number of blocks by Esso (in partnership with Shell) in a part of the North Sea that, to date, has not been regarded as very prospective. New geological interpretations have, of course, already led to discoveries in locations that previously had been thought uninteresting. A prime example is Buzzard field in the outer Moray Firth. Current estimates of expected recoverable reserves from this field now exceed 500 million bbls. It was discovered on acreage that had been relinquished more than once.

Some lagging issues. Problems are, of course, being encountered. During 2005, large maintenance and refurbishment programs were undertaken. These inevitably involve production shut-ins. The consequence has been that output of both oil and gas has fallen by a larger amount than anticipated. It is not yet clear to what extent large maintenance and refurbishment programs will be a continuing feature of North Sea activity. For 2005 as a whole, production could average around 3.3 million boepd, compared to 3.6 million boepd in 2004.

At the time of this writing, the industry nervously awaits the Pre-Budget Statement from the Chancellor of the Exchequer. There have been press reports that a tax increase is likely. The present system is generally geared to encouraging new investment, at least by existing players, with corporation tax and Supplementary Charge, together, at a 40% rate, and allowances for all investments on a 100% first-year basis.

On old fields developed by March 1982, Petroleum Revenue Tax applies as well, with a marginal rate of 70%. Thus, new field developments are taxed at lower rates than incremental projects on old fields. When tax was last increased in 2002, the result was a major debate and some loss of confidence in the industry. Since then, the industry and the government, particularly the Department of Trade and Industry, have worked together closely. Various joint incentives on fallow acreage/ discoveries, infrastructure Code of Practice (on access terms), and brown fields (stewardship) have been very fruitful, with the promise of even bigger rewards in the future.

The year, 2006, thus promises to be one where field development and exploration should continue at relatively high expenditure levels. The volume of activity should also continue at a very high level. There may be some divergence between the change in activity measured in money terms, and that in volume terms.

Costs are up, too. Market cost inflation has already been quite considerable. Between 2004 and 2005, the average cost of a field development increased by around 10%. Between 2005 and 2006, such market cost inflation could approach 20%. The major increases in drilling rig rates have been widely documented, and the impact of this will be keenly felt next year. Currently, some development and exploration plans are being held back by a shortage of rigs, and this problem may well persist into 2006. There is a particular shortage of rigs suitable for use in the region, West of Scotland.

Thus, in 2006, investment figures will reflect substantial market cost inflation, and close attention should be paid to physical indicators, such as the number of wells drilled. Expectations are that these could be on a par with those of 2005. It is important that the market cost inflation does not proceed much further. The UKCS remains a high-cost region and has to compete for investment funds with other petroleum provinces. The high oil and gas prices partially mask the problem, but if the price falls, the issue will become more noticeable.

The UK natural gas market has attracted much attention throughout 2005, and 2006 promises to bring the same interest, perhaps intensified in the winter months. The UK is now a net gas importer, due to the decline in output from the peak in 2000 and the continued growth in demand. Gas is now the most important single fuel in the UK, accounting for around 40% of primary energy demand. Further, nearly 40% of electricity generation is from gas. Winter produces a large demand peak, as gas is by far the most common form of domestic heating.

Winter outlook. In the winter of 2004-2005, the market was very tight, with the forward price attaining extremely high levels. Some power stations on interruptible contracts were interrupted, and switched to other fuels, particularly coal. The coming winter will be tighter still, with the decline in UKCS production. Many gas import schemes, both via pipelines and from LNG, are underway. In a couple of years, the UK market will be amply supplied, which could exert downward pressure on gas prices. But these schemes will not be ready in time for the forthcoming winter.

The only new substantial scheme that has been completed is the expansion to the import capacity of the Inter-connector between Bacton and Zeebrugge to 16.5 Bcm/year from 8.5 Bcm/year. This is substantial, given the UK market’s total size, around 100 Bcm/year. But if there is a coincidence of a cold winter in the European continent as well as in the UK, then imports may not flow to the UK, depending on prices in the two markets.

Thus, there is a possibility that, if the winter is severe as currently forecast, interruptions to power stations and other large industrial users with interruptible contracts, will occur. General public, as well as specialized interest in oil and gas matters will thus remain high in the coming year.

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.