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Sense of trepidation as oil and gas industry looks ahead to 2016

Derek Leith
Derek Leith

At the start of the year there was a growing sense of trepidation as to what the next 12 months may hold for the sector due to an acceleration of the downward trajectory of the oil price in the second half of 2014.

As the price continued to fall through successive and psychologically important thresholds the outlook for 2015 moved from anticipation of a difficult year to a sense of incredulity about how far the commodity price had fallen and anxiousness about where it would bottom out.

Of course the warning signs had been there for some time, but 14 successive quarters of $110+ prices implied that the oil price was not subject to the fundamental economic relationship of supply and demand.

The sector was lulled into an over confidence in the medium to long term projection of oil price.

The rude awaking of the price fall, with only a very brief and modest recovery in the second quarter of 2015, to a low of less than$40 a barrel, has had a seismic impact on investor confidence and triggered a slashing of capital budgets by oil companies as capital has retreated from the sector.

However, the ever increasing list of cancelled or deferred projects has made little impact on the oil price as a result of: OPEC has lost any sense of cohesion and offers no prospect of production cuts; the lifting of Iranian sanctions brings more production into the market and falling economic growth in global markets, notably China, has dampened demand.

As we approach the end of 2015, broad sentiment has swung from a bullish view of the medium to long term oil price to the other extreme with forecasts of oil price falling further in the short term and the new medium to long term price resting between $50 to $75.

The ramifications of both a fundamental uncertainty around when the price will start to recover and to what level has caused a complete review of strategy in the oil majors, made the independents focus on reducing debt and securing cash flows, and is likely to cause some of the smaller companies to go out of business.

The swift fall in price has exposed the sector as being inefficient relative to other global industries, and lacking discipline in the control and execution of capital projects.

The paradigm has now changed completely, and as companies cannot influence the oil price they must radically streamline their operating models, introduce leading capital project management and enhance efficiency in every area of operation.

It is only by making such changes they can remain competitive and secure further investment.

The rapidly changing environment has had a significant impact on the UKCS.

Thankfully the Wood Review, the report of the Scottish Government Expert Commission on oil and gas, and the HM Treasury North Sea fiscal review had all occurred before fall in the oil price.

The Wood Review and the Expert Commission had both highlighted the need for radical change if the UK was to continue to successfully exploit its hydrocarbon resource base.

That was largely because of the apparent lack of exploration potential outside of frontier areas, aging infrastructure and falling production efficiency, escalating operating and capital costs, a lack of collaboration amongst the oil companies, and a huge gravitational pull of investment capital into the burgeoning shale oil business in the US.

As a result of these reviews, 2015 saw the establishing of the new regulator, the Oil and Gas Authority (OGA), a comprehensive list of reforms to the oil and gas fiscal regime, and the more intangible emergence of local resolve to secure Aberdeen’s long term future in the oil and gas sector and at the same time introduce more diversity into the economy of Aberdeen and the North East.

The OGA has largely been in the process of staffing up, and trying to identify priorities in the perfect storm of collapsing price, investor confidence and falling competitiveness of the basin. Not an enviable task but one that we can expect to see more progress on in 2016.

The fiscal changes were welcome and primarily aimed at incentivising investment by reducing the headline tax rate and providing a form of investment allowance which will further reduce the tax burden for companies that invest in the UKCS.

Regrettably, a combination of the level of capital investment made in 2012 to 2014, the rising costs of the basin, falling efficiency and the low oil price has left the vast majority of companies in the basin with tax losses.

Clearly tax rate reductions and incentives have no effect on cash flow where companies don’t have taxable profits.

Therein lies part of the problem for the UK Government.

The OBR Fiscal Sustainability report published this year estimates the production taxes from oil and gas exploitation over the next 25 years as only £5bn compared with the £139bn forecast for the same period by the OBR in 2011.

One may argue the latest OBR forecast is deeply pessimistic on oil price and production – but is does indicate that there is little the UK Government can do in terms of further tax cuts to boost the sector.

That’s not to say further fiscal change isn’t required, but it is changes to the regime to remove barriers to commercial activity rather than more fundamental reforms.

That leaves the sector as having to take responsibility for creating its own future and longevity. Local initiatives such as the creation of Opportunity North East and the prospect of securing the City Region Deal are vitally important for Aberdeen.

2015 will be a memorable year with Aberdeen’s over dependency on a single industry exposed and many facing 2016 with greater trepidation than the previous 12 months.

However, the basin wasn’t sustainable without radical change and the low oil price has focused minds on the steps that need to be taken to weather the storm and make the necessary investments for the future.

The year ahead promises more challenges but there are reasons to be optimistic.

The oil industry can make the changes necessary to succeed, we can broaden the North East’s economic base, and the City Region Deal can provide a platform for investment which will be transformational.

Derek Leith is head of tax, Scotland and oil and gas partner at EY

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