Opinion: Will falling oil prices compound activity decline in the UKCS?

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Opinion by Energy Voice

At the time of writing this article, the Brent crude oil price benchmark had fallen to $85 from $115 in June on concerns of abundant global oil supply and weakening demand.

Goldman Sachs, the international investment bank, earlier in the week released a price prediction of $80 for 2015 having reduced this from $100 previously.

Markets are spooked and bearish sentiment is plaguing the energy sector. Concerns are that the cost and operational challenges we have witnessed in 2014 in the UKCS, compounded with commodity price reductions, could spell a difficult time for investment and activity in our home market.

So what is happening? Let’s look at the two key components that determine pricing: supply and demand.

On the demand side the IEA stated in their October report that oil demand for 2014 will be 0.2million barrels per day lower than previous forecast due to “reduced expectations of economic growth and the weak recent trend”.

This is primarily due to concerns over European and Chinese market outlooks; however, we need to keep in context that oil demand has not collapsed. Over the past 12 months, oil demand has actually increased by 1million bpd.

What is driving the market fundamentally is concerns over supply. Growth on the whole has been impressive and exceeded demand by 300,000bpd since January this year. Libya has added 550,000bpd in the past three months and unconventional production in US shales and Canadian oil sands have driven supply growth.

Historically, when supply exceeded demand the world market has looked to Opec and Saudi Arabia particularly to reduce supply and drive prices up. The next meeting of the Opec cartel is due late this month, although initial soundings are that few members will be pushing to constrain supply.

Iran, one of the more aggressive cartel members that push for price increases due to the limitations they have on production are unlikely to seek a reduction.

More importantly, however, are the actions of Saudi Arabia. At present, it looks as though they won’t cut supply and are willing to accept lower pricing in the short term.

This suggests that for the remainder of 2014 there will continue to be downward pressure on oil prices.

This is material as it’s at this time of year that most E&P companies set their project spending or Capex budgets for 2015. The current outlook suggests that budgets will be lower going into 2015 and a number of higher cost, higher risk drilling projects and developments will be shelved.

We can clearly see that even at $100 per barrel a number of E&P firms struggled to be free cash flow positive. In the US most independents were negative at $105. The major firms have struggled to contain Capex and returns at $110. Reductions in capital spending are inevitable.

From an oil supply perspective, however, reductions in investment will halt production growth and markets will ultimately balance. How quickly this could happen is anyone’s guess but it could be relatively quick.

The immediate downside relates to spending. Investment in the market will be reduced and service companies across the world will have a very different outlook with a reduced demand environment for new projects and Capex-related activity particularly.

Simply put then, we have an environment where oil demand is still growing, supply will reduce as a consequence of reduced investment, commodity pricing will recover and we will be back on track again, right? Perhaps.

Greater capital discipline within the oil majors and a focus on returns will not necessarily prompt them into increased spending on the back of better commodity pricing.

Similarly, the independents will be reliant upon the financial markets to fund their development programmes and finance their working capital requirements which may or may not be available.

I would suspect that E&P on the whole will continue to exert capital discipline and concentrate on returns in the medium term, learning from the recent past. Focus will be on progressing high net present value investments which will help control demand for services and associated costs.

Looking to the UKCS there are a number of implications. Like any changing market, there will be winners and losers among the industry stakeholders. Simply put, however, it’s all going to be about cost.

While the province has a number of large and medium scale developments on the horizon we can already see that Capex-related activity will be lower over the next five years relative to what it has witnessed in the previous. Market softness and cost reduction initiatives that have been in place prior to the recent oil price reductions will be more aggressive.

A big part of the market in the UKCS is related to the ongoing maintenance and production activities of existing oil and gas fields. Like the Capex market, operating expenditure or Opex will also be under pressure and the current environment will foster urgency for greater efficiency and cost reduction.

And it will happen. We have seen that a number of the E&P companies in the UK have either completed, or are in the midst of cost and personnel reduction initiatives. With reduced management and decision making capacity, coupled with reduced budgets there will be strict limits to what can actually be progressed in the UKCS.

This comes at a time when many of the service companies have upped capacity and thus my classic economics suggests that lower demand coupled with higher supply will create downward pricing. This in turn will really expedite a rebalance of the market in the UKCS and impact on service firms which will need to be more efficient and cut costs accordingly.

Importantly, however, we need to remember that while oil prices will recover, costs in the longer term have to come down. The UKCS is a mature environment and, quite simply, new operational approaches will have to be implemented.

I don’t think that there is any technological solution out there to prosper UKCS economics. It’s quite the opposite in fact. We need to be less clever.

We need to move from a white collar to blue collar operational model, coupled with engineering, HSE and importantly fiscal evolution to ensure the longevity of the basin.

Those willing to evolve will be winners. Those focused on the classic model will ultimately lose.