Prof Alex Kemp: 2016 to be just as challenging for the UKCS

Professor Alex Kemp
Professor Alex Kemp
Opinion by Energy Voice

The year 2015 has been an annus horribilis for all stakeholders in the UK Continental Shelf (UKCS).

The reinforcement of low oil prices has ensured that the industry will end up with a substantial negative cash flow for the year. The intensity and spread of the effects are more reminiscent of the events of 1986 when $10 prices were recorded, than the experiences of 1988 and 2009 when very sharp price falls were also experienced.

The effects have been particularly pronounced because the price collapse has occurred in a period when investment was in any case due to fall substantially from the remarkably high levels achieved in the period 2011-2014 even if the price had remained in excess of $100. The strong upward pressure on both unit investment and operating costs in this period has meant that the viability of existing operations as well as new projects are under much greater stress following the price collapse to $40 or less. The result is a substantial reduction in new field and project investments.

The year 2015 saw major changes to the tax system applicable to the UKCS. Thus the rate of Supplementary Charge (SC) was reduced from 32% to 20%. A new investment allowance of 62.5% was introduced for SC, to replace the existing complex plethora of field allowances. The rate of Petroleum Revenue Tax (PRT) is being reduced from 50% to 35%. The consequence of all this is that the overall headline rate of tax on new fields is 50%, but the average or effective rate can be as low as 30%. On old fields the headline rate is still high at 67.5%.

Despite these tax concessions, the collapse in oil prices is still holding back new investments. Modelling by the present author and Linda Stephen at the University of Aberdeen indicates that, without cost reductions, many new field developments in North Sea conditions are non-viable before tax. However, if cost reductions in the 20% – 30% across the board can be achieved, many new projects currently on hold can become viable at oil prices in the $55 – $70 range.

Cost reductions have been pursued through 2015 and more can be expected in 2016 as contracts with the supply chain expire and terms are renegotiated. As an example, drilling rig day rates for semi-submersibles, a major cost item in the UKCS, have fallen by some 40% in the first half of 2015.

Modelling by the present author and Linda Stephen at the University of Aberdeen suggests that while field investment will decrease in 2016, by 2017 the decline could be moderated as a consequence of new projects becoming viable following cost reductions of around 20%.

Operational problems in the UKCS have been exacerbated by the major decline in production efficiency over the last decade. Production efficiency is defined as the ratio of actual production to the maximum potential rate.

This was estimated by the Department of Energy (DECC) at 80% in 2004, but falling substantially to 61% in 2012. A major cause of this decrease has been unplanned shutdowns due to corrosion, leaks, and other technical problems. The industry has devoted much effort to this issue and the most recent information is that production efficiency has increased to around 65%. The target of the industry is to obtain an average of 80% over the next few years. This would greatly increase cash flows at a critical financial period, and help to reverse the production decline. There may well be a production increase in 2015 which could be maintained in 2016 if production efficiency continues to improve.

Exploration has been at low levels since before the price collapse, with only 14 wells being spudded in both 2013 and 2014. For 2015 the eventual number may be lower. The industry has asked for further tax reliefs to incentivise exploration activity which is clearly necessary to exploit the remaining physical potential. Again, modelling by the present author and Linda Stephen, suggests that, while tax reliefs can help, cost reductions are necessary. At current oil prices some forms of relief, such as extending the applicability of the investment allowance for SC, may result only in more unused allowances because the investor has insufficient income against which to use them. A refundable tax credit for exploration on the lines of that available in Norway would have a positive but limited effect because, at present oil prices, full cycle returns are very constrained on a pre-tax basis. The West of Shetlands region has high upside exploration potential but very high costs.

The Oil and Gas Authority is now very active. It has recruited much expertise from the industry, and initiatives relating to exploration, infrastructure production efficiency, cost reductions, and collaboration among licensees and with the supply chain, are being pursued. There is a determination to enhance economic recovery. In 2016 there will hopefully be tangible evidence of positive effects on activity from these initiatives. The first indication of this could be an increase in total production.

Professor Alex Kemp of the University of Aberdeen is one of the industry’s most respected academic voices, penning dozens of reports, insights and thought leadership pieces. This year he was inducted into the Press and Journal’s industry hall of fame for his service and dedication to the sector.