Oil and gas: The long road to sustainable recovery

Oil Rig
By Jeremy Cresswell, The CA magazine

17 April 2015

When faced with a crisis like none before, what can the oil and gas industry do? Jeremy Cresswell talks to experts about the challenges and the chances of the sector bouncing back.

"If we cut the costs of this industry in a thousand different ways, we have the chance of being more sustainable."

This is the distillation of a message that Bob Keiller, CEO with leading oil services business Wood Group, has been punching out around the UK offshore oil industry of late.

When I wrote this review 12 months ago, Brent blend oil was $100-plus per barrel; today it is in the $55-60 range. A year ago it looked as if the UK oil and gas industry was enjoying an Indian summer. Today, the North Sea is wracked by problems, many of its own making. It is a crisis like none before.

It would be easy to pin the current state of affairs on the oil price slide that started in the summer and which has been bumping along the bottom since about Christmas. On 19 June, Brent traded around $115; on 13 January it bottomed at $46.67. The longest oil price bull-run in the history of the UK Continental Shelf had been brought to a crashing end.

Rocketing US shale oil production, and OPEC's decision to defend market share rather than price, changed the dynamics of the global market. Saudi Arabia has said enough is enough; it is no longer prepared to be the swing producer or tolerate Washington's unwillingness to curb burgeoning US production.

UK industry concerns

Even before all of this, concerns had been growing for the UK industry. The Wood Review has been tasked with producing recommendations on how to maximise economic recovery, and the Treasury launched its North Sea tax review in mid-July last year at which point Brent was still a comfortable $107 or so. The Treasury reported the outcome of its review in early December, by which point Brent was sub-$70.

Tax matters aside, more than a decade of relative boom had left the sector bloated, with costs out of control. The Treasury contributed to the mess with an ill-judged tax grab in 2011, when the Supplementary Charge was jacked up from 20 per cent to 32 per cent. The subsequent introduction of various targeted field allowances, didn't help much.

The Activity Survey 2015 from industry body Oil & Gas UK (OGUK), published in February, provides what it calls "striking evidence of how rising costs, taxes and inadequate regulation have taken their toll on the UK industry's international competitiveness".

Need for 'sustained investment'

OGUK CEO Malcolm Webb says the survey paints "a bleak picture" yet "demonstrates clear potential for the future", so long as the right actions are taken by the industry, by government and by the newly created quango, the Oil & Gas Authority.

Malcolm warns: "Without sustained investment in new and existing fields, critical infrastructure will disappear, taking with it important North Sea hubs, effectively sterilising areas of the basin and leaving oil and gas in the ground."

The survey reports that 6.3bn barrels of oil equivalent (boe) are sanctioned or under development. There are another 3.7bn boe of potential investment opportunities, although companies indicated at the end of 2014 that less than 2bn boe of those were likely to be developed. It could cost £90bn-£100bn to extract that prize of roughly 10bn barrels.

Meanwhile, operating expenditure rose nearly 8 per cent to £9.6bn last year and, on a unit of production basis, reached a record high of £18.50/boe.

Falling oil prices meant that revenues fell to just over £24bn for the year, the lowest since 1998 (the year before oil output peaked), and this, combined with rising costs, resulted in a negative cash flow of £5.3bn for the basin, the worst since the 1970s.

"Without sustained investment in new and existing fields, critical infrastructure will disappear, taking with it important North Sea hubs, effectively sterilising areas of the basin and leaving oil and gas in the ground"

Malcolm Webb

Annual investment in sanctioned projects alone is forecast to decline rapidly and could collapse to £2.5bn by 2018. Exploration drilling has all but collapsed, with only 14 wells drilled in 2014 out of the expected 25. Fewer than 10 exploration wells could be drilled this year.

Malcolm says: "Even at $110 per barrel, the ability of the industry to realise the full potential of the UK's oil and gas resource was hamstrung by escalating costs, an unsustainably heavy tax burden and inappropriate regulation. At current oil prices, we now see the consequences only too clearly."

"We need to see full delivery of the Wood Review recommendations as well as a permanent reduction in the headline rate of tax, a simplification of the tax allowance structure and stimulus for exploration."

Self-help message

HM Treasury can do only so much to stimulate a revival of fortunes, regardless of the mechanisms devised. The industry must galvanise itself into action, based on a very cautious expectation of where oil prices might be in 12-18 months, with $70 touted as a realistic long-term possibility.

Which is where Bob Keiller comes in. He has been banging out forthright messages via a roadshow designed to highlight both the critical issues and the opportunities.

Bob says: "Oil & Gas UK figures suggest that at $50 oil, two thirds of UK production and 80 per cent of UK assets are still viable. It's certainly not a death knell for the industry. We still have many years ahead of us here in the UK and to do that we're going to need people and we're going to need support and we're going to need to create different headlines."

Bob Keiler's self-help message involves:

  •  Getting the messaging right

  •  Avoiding firing people if at all possible

  •  Sorting out behaviours to achieve joined-up thinking and actions

  •  Beating down costs

He has a message for oil company bosses too: "When I see my customers cutting the base salaries of their senior managers, then I'll know we're beginning to take cost reduction seriously."

Bob warns: "If we put the burden of change on a small number of people in the industry, sure as eggs are eggs, costs will bounce back if conditions recover. This needs to be something that covers every part of the industry."

Rise in distress mergers and acquisitions

Norman Wisely, Aberdeen-based partner at law firm CMS, agrees the situation is serious: "Nearly every service company is being asked by their customers to discount pricing. Some can afford to do that and might try to exchange discount for volume. Some can't afford to cut margin and they will lose turnover to those that can.

"We are also beginning to see a rise in distress M&A activities as companies struggle to remain viable, and there has certainly been a significant increase in disputes... The disputes we are seeing tend to fall between two categories, the first relating to companies not approving budgets and work programmes under operating agreements in order to avoid capital expenditure, or potentially defaulting on those agreements... The second is focused around oil companies looking to terminate long-term contracts with service companies."

Beth Mitchell, an independent analyst, believes one of the critical issues facing the North Sea is financing the future. She says: "Equity and shareholders could not see where the value was going. It is hard to believe that companies could be sitting with $100 oil and not making any money. That's why equity fell out of love with the sector."

Private equity investment

So what about private equity (PE)? New generation companies like Siccar Point and Verus (UK) and Orego (Norway) have been launched with considerable underpinning from that quarter.

Beth says: "One problem with PE is where they want to invest. Typically PEs like production because they want cash flow and they want to see an exit. Traditionally, that exit has been to either sell it to Big Oil or float on the market within three to five years.

"PE investors have found their time horizons lengthen, by circumstance, to more like five to seven years. But they have not traditionally so far invested in early stage appraisal and exploration companies which, in a way, are being let down by the equity markets. What could emerge ... and we haven't seen any signs yet ... would be more of a VC [venture capital] sub-sector of PE which could take on the earlier, higher risk, non-cash flow generating companies, incubate them and then perhaps sell them on to later-stage PE companies and thence into the market."

Graeme Sword of investment house Blue Water Energy – who, some years ago, led the build of 3i's then large oil and gas- related investment portfolio – takes issue with Beth's view.

"We still have many years ahead of us here in the UK and to do that we're going to need people and we're going to need support and we're going to need to create different headlines"

Bob Keiller

He questions how much PE money is really available. He says: "I accept that PE is sitting on a lot of 'dry powder' but how many investors want to commit capital to North Sea E&P? The answer is 'not many'. I suspect less than $1bn is available and that is not significant in an industry spending billions.

"On the UKCS, PE has invested in production to achieve self- sustaining cash flow. In other regions, exploration has been the preferred strategy (Revus, Agora and Spring in Norway, Kosmos and Cobalt further afield). All investors want an exit but more importantly, how does PE build companies?"

Graeme adds: "Timeframe is not an issue. PE funds have 10- year money and three years to exit is not the norm. PE investors typically look at a five-year return and are happy to hold for longer if the company is still growing."

Graeme is also sceptical as to whether VC funding fits the industry's model or its need for a broad portfolio to mitigate risk.

Three key ingredients for recovery

Malcolm Laing, a partner at Aberdeen law firm Ledingham Chalmers, identifies three key ingredients for recovery. "Firstly, there must be an overhaul of the taxation regime to encourage more exploration and production," he says. "Secondly, there needs to be a cross-industry commitment to greater co- operation. And, thirdly, we need to find ways of reducing costs, whether through greater collaboration and information sharing, new technologies or more efficient working practices.

"If we don't achieve these changes, then particularly with the price of oil at around $60 per barrel, we risk the UKCS becoming non-viable and the industry moving overseas to areas with more benign tax regimes and lower costs. This would be a disaster given the importance of the industry."

Speaking ahead of the March Budget, Alan McCrae of PwC believes the industry would be content with a corporation tax plus supplementary charge take of 45-50 per cent. In effect, this would take it back to perhaps a little better than the pre-2011 Budget level.

Focusing on the new regulator, the Oil & Gas Authority, KPMG's Alan Kennedy and Anthony Lobo are both optimistic that Andy Samuel [formerly of BP] and the team he is gathering will be an effective force for positive change, regardless of what the Treasury decides.

"Because he [Samuel] has already taken on people from DECC [Department of Energy and Climate Change] and because he has come from the industry, there really is the opportunity to reset the relationship between the North Sea industry and the Government through DECC and Whitehall," says Anthony.

But how long do they think the OGA team has to make its mark? Anthony says: "It has taken a significant time to get to this stage. We don't think it's going to be three months or six; more likely closer to between one and three years."

Alan adds: "I also think there is the question of momentum. If he can get some quick wins, this will build credibility; particularly operational wins around infrastructure and simplification. We don't need PR successes. We need true operational changes for the better."

The UK's offshore industry clearly faces massive challenges; but it is also hugely resourceful and will doubtless stage a recovery. However, quite what shape that recovery will take is too uncertain to second-guess with any accuracy.

Jeremy Cresswell is Editor of Energy, An Aberdeen Press and Journal publication.


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