Economic Report 2002 Index

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Competitiveness International Dimension In recent years the industry worldwide has invested in previously inaccessible regions and unexplored provinces with notable successes, making large discoveries in deep water provinces such as Angola and the Gulf of Mexico, and new areas such as the Former Soviet Union (FSU). In a global industry, the UK must compete for oil industry investment funds versus these and many other provinces. The competitiveness or economic attractiveness of any province is a function of many factors including: The prospectivity of the province in terms of the probability of finding oil or gas. The likely size of any discovery. The costs of developing and operating a successful discovery. The fiscal regime, including the risk that the host Government may adversely change the regime after investments have been made. The political risk. In February 2002, Wood Mackenzie published a benchmarking study to compare the economic rewards from investing in some 57 areas in 50 countries across the globe.1 Wood Mackenzie used their extensive database to reflect all of the above mentioned factors, except political risk, based on a detailed economic analysis of exploration activity over the period 1991-2000. For the purposes of their analysis the UK was considered in two areas: firstly the "Southern Basin" the shallower water (100 feet) gas prone area off East Anglia, and secondly the remainder of the UKCS. ¹Global Oil and Gas Risks and Rewards., Upstream Economics Benchmarking Study Wood Mackenzie - February 2002 Prospectivity - the Exploration Success Rate Figure 8 illustrates the exploration success experienced by the industry over the last 10 years across the 50 countries covered by the study. Success is classified either as: "Commercial" where the discovery has already led to a commercial development or in Wood Mackenzie's assessment is likely to lead to one in the near future, or "Technical" where commercial development of the discovery does not look imminent in the near to medium term. It will be noted that despite, and to some extent because of, its relative maturity the UK areas do not rank very highly, particularly in terms of the important commercial success rate. Discovery Size Over recent years the average size of discoveries on the UKCS have been in the 25-30 million boe range. Generally, only the larger of these discoveries have proved commercial in the high cost North Sea environment. Figure 9 shows that over recent years, the average size of UK oil discoveries does not rank highly on a global scale. Costs The relative small size of UK discoveries, when combined with the high cost North Sea environment, results in the UK having the second highest unit cost for fields developed since 1995 amongst the 57 areas considered in the Wood Mackenzie study (see Figure 10). Even the shallower water UK Southern Basin ranked tenth highest in terms of unit costs. It should be noted that exploration costs are not included, which for the UKCS represent an additional $4/boe.   Box 3 - Oil Industry Profitability Measures The Economists Approach - Full Cycle Economics Full cycle economics is the most comprehensive approach to the measurement of industry profitability in that it captures all costs and revenues over the full cycle of the project or venture (Insert Diagram -Oil Industry Full Cycle). It captures the cost of exploration, including the cost of dry holes, the chance of a commercial discovery, the cash flow derived from the full spectrum of commercial discoveries including decommissioning costs, and the actual fiscal regime. It is one of the most informative measures of profitability of an oil or gas province, reflecting the timing of cash flows over the full cycle extending 30-40 years. The 'Expected Monetary Value' (EMV) is the statistical expectation of the present value of an exploration program. The 'Full Cycle Return' is the statistical expectation of the Discounted Cash Flow Rate of Return over the full lifecycle. The Wood Mackenzie Benchmarking Study calculated the EMV using a 10% nominal discount rate. The UKCS EMV was close to zero, confirming the conclusions of many other analysts that the UKCS Full Cycle Return for current exploration investment was in the range of 10% nominal or some 7-8% real. The Accountants Approach - Return on Capital Employed or Assets (ROCE) The Full Cycle measure however remains a forecast until the final decommissioning event has occurred. This is inadequate for shareholders and others who require an assessment of the current profitability of a company or industry. To measure the profits in a particular year requires an apportionment of the initial capital costs over their economic life. Because of the unique nature of E&P assets this apportionment or depreciation is normally done on a unit of production basis where the depreciation each year is based on the ratio of production to remaining reserves. Tax relief associated with the capital expenditure are also spread over the life of the field consistent with the capital depreciation through a deferred tax accounting process. The annual profits so derived are then expressed as a percentage of capital employed (or depreciated capital assets) to give the Return on Capital Employed (ROCE).The accounting approach also ignores the impact of inflation over time, which in the case of long term investments ,such as those in the UKCS, further inflates the ROCE. The Office of National Statistics (ONS) publishes quarterly estimates of the ROCE of UK industry, including a separate estimate for the UKCS. The ONS recognises the difficulty of reflecting the uniqueness of E&P assets in their depreciation calculations, and indeed cautions the reader "net rates of return are not a good measure of performance of UKCS companies because of the nature of fixed assets. This leads to distortions in the average capital employed". ONS circumvents the difficulties of calculating tax effects by quoting profits before all taxes. Before any comparison of UKCS profitability versus other UK industries, UKCS profits must be adjusted to reflect the special taxes of Royalty and PRT uniquely paid by the oil industry. Compare and Contrast In summary the Full Cycle Return measures the economic return over the full life cycle of an investment. As used in this Report and the Wood Mackenzie Benchmarking Study it is being used to measure the expected profitability of current exploration investments. Clearly the most relevant measure to a prospective UKCS investor. The ROCE is an attempt to measure the profitability in a specific time period. It is most commonly calculated on an annual basis, and in the case of the oil industry as such it is subject to the same volatility as the oil price. Any realistic assessment of oil industry profitability based on ROCE must be based on a meaningful time period of at least 10 years.   Expected Monetary Value The most important comparison in terms of assessing the relative attractiveness of each area is the Expected Monetary Value (EMV). Wood Mackenzie estimated the cost of a typical exploration programme in each of the areas, and based on actual recent exploration results the probability of a commercial discovery, and the range of costs for those discoveries. Using a common oil price, adjusted for quality and transportation differentials, and the actual fiscal regime prevailing in each country, Wood Mackenzie were able to estimate the EMV to be derived from an exploration programme in each area. Figure 11 compares the EMV for each area expressed as the ratio of the after-tax cost of the exploration programme. It is clearly evident that in terms of exploration attractiveness the UK ranks very low on a global scale (31st for the UKCS and 50th for the Southern Basin). Indeed the analysis stimulated Wood Mackenzie to conclude " ...the low EMV's for the UKCS… reflect the over-riding economics of wildcat exploration in this mature and high cost province - and indicates that the much lower level of exploration drilling in the UK over recent years is justified by the economics. Moreover, the analysis suggests that there is no room for additional fiscal rent to be extracted from upstream companies on an EMV basis" UK Budget Impact The Wood Mackenzie study was published in February 2002 on the basis of the prevailing UK fiscal regime at that time. The pre-Budget regime, when considered in isolation, was widely recognised as having been one of the most attractive in the world and, as the study demonstrated, well attuned to the economic realities of the North Sea. Probably of more significance than the impact of the tax increase announced in April 2002 will be the impact on 'political risk', including an assessment of the UK as a location providing a stable fiscal regime for investments. Over the past 20 years the UK had built up a reputation for providing one of the most stable fiscal environments. Tax changes, indeed increases, have occurred, but almost without exception the changes were accompanied by transition arrangements to protect recent investments. The 2002 changes contained no transition arrangements, and recent investments were the most severely impacted. The already marginal exploration investment identified by Wood Mackenzie received Corporation Tax relief at 30%. Any successful discovery will be taxed at 40%. For explorers who have recently invested in the UK the actual economics are worse than depicted by Figure 11. The impact the 2002 tax increase will have on industry confidence in investing in what is already a high cost marginal activity will emerge over time. Insert Box 4 UKCS Profitability The Government supported its decision to raise UKCS industry taxes in the April 2002 Budget by the selective use of ONS pre-tax ROCE data to demonstrate high profitability (see Box 3). Whilst UKCS returns have risen over the last three years, reflecting high oil prices, UKOOA believes that to construct a more objective assessment of upstream profitability it is necessary to derive post tax returns over a longer time period, and assess how these compare with other successful business sectors in the UK, not just average UK industry performance. Accordingly, UKOOA recently commissioned a study by Oxford Economic Research Associates (OXERA) who have analysed the UK sector profit performance of a range of companies across a range of industries. The analysis concludes that over the period 1990-2001 on a pre Corporation Tax basis, remembering that UKCS companies have paid taxes that other industries did not pay (Royalty and PRT) and are now subject to even higher taxes , returns are amongst those secured by other successful industries.   BOX 4 RBS group has been a major participant in the UK oil and gas industry since its early origins and views it as having an extremely dynamic future. Its importance to the UK economy is much greater than suggested by its share of GDP or contribution to employment. Energy is a basic requirement for all economic activity and access to secure supplies is a pre-condition for stable economic growth. Oil and gas is a major industrial sector where the UK retains key competitive advantage in terms of skills and technological development. UK operators and service companies have operated in one of the world's most challenging environments for the past three decades, which has allowed them to develop expertise and export this to a global industry hungry for skills and knowledge. The RBS group 2002 service sector survey showed that 78% of Scotland's service companies now export to one or more provinces. The internationalisation of the sector's skills and expertise will be key to its long-term sustainability. With production at or near peak and intense competition for investment globally, industry and government require to continue to work closely together to ensure barriers to entry are reduced, costs constrained and the attractiveness of UK as an investment location is maintained and enhanced. Aberdeen's role will evolve with the strong commitment from Government and industry to develop the city as an international energy research centre. We look forward with great anticipation to further decades of industry participation. Tony Wood Group Economics Royal Bank of Scotland   Over this time period OXERA estimated the UKCS rate of return to be around 13%. Two further points about UKCS profitability need to be stressed: These returns are shown before Corporation Tax (CT). The oil and gas sector alone is now subject to the extra 10% Supplementary Charge. As noted above, UKCS returns have been boosted by high returns in recent years resulting from the high oil price. There is little confidence that future prices, on which new investment decisions are made, will remain at these levels. New Entrants Oil and gas companies compete with other industries in debt and equity markets for funds. Rational investors will invest in the oil and gas sector only if returns are commensurate with the risks and match or exceed returns available in other industrial sectors. The difficulties of attracting capital are confirmed by the case study in Figure 13. The poor historic performance of the E & P sector has engendered much higher performance requirements from new investors. As this case study shows, the cost of capital for start-up companies may be in the range 22% to 28%, so new companies need to deliver high returns (above 20% ) on new projects. Unless the Government has a different approach to UKCS sector returns then their ambition to encourage more participants into the UKCS is likely to be thwarted.   BOX 5 "The oil and gas sector contributes immensely to the economy in the North-east of Scotland, generating wealth and employment. We have a long and successful relationship with the many contracting and supply companies, which service the UKCS. Since our first private equity investment in 1986, we have invested over £50 million in oil and gas related companies such as Wood Group, Roll stud, Multiphase, Norton Services and ITS Drilling. "However, the North Sea is now a mature province and to recover the untapped reserves operators are having to change the ways in which they work and make innovative use of new technology. Smaller independent companies are emerging to revitalize old fields. We recently invested £10 million in Tuscan Energy which is an ideal example of an entrepreneurial company finding imaginative yet economic methods of extracting the remaining oil. We believe this is a very significant deal, not only for us but also for the oil and gas industry, prolonging the life of the UKCS." Hugh Little Investment Director Scotland Aberdeen Murray Johnstone Private Equity   Maturity One of the biggest challenges for energy policy makers and the offshore oil and gas industry is to maximise the economic recovery of reserves in a safe and environmentally acceptable manner. For an industry in its mid-life phase it is critical to ensure that all the signals are set to ensure that this happens and that opportunities are not missed to the detriment of future generations. The long term implications of the added cost of introducing regulations such as the Working Time Directive should be carefully considered and minimised. The maturity of the UKCS is manifest in many ways. As the volumes of oil and gas flowing through the legacy of infrastructure of pipelines and platforms declines the unit cost of using them increases. Efforts are continually being made to reduce these costs without risk to safety and the environment. While these facilities are working close to capacity the incremental cost of bringing in new developments is low but, when throughput declines, these costs rise and the economics of exploration and new developments deteriorate. The window of opportunity has been kept open by a series of initiatives, but it behoves policy makers and the industry to keep it open as long as possible by ensuring the economic rent extracted by both government and infrastructure owners permits thorough depletion of the nation's resources. Figure 14 shows how the UKCS infrastructure network and the catchment areas (denoted by blue circles) may change by 2020 as existing fields are decommissioned. Efforts to defer abandonment by, for example, working with Norway to transport their gas through UK infrastructure, may extend the lives of existing fields. By keeping the infrastructure operational, the opportunity to exploit new discoveries in the vicinity will be retained. A stark measure of the maturity of the basin may be seen in the extent of depletion of the largest oil fields as shown in Figure 15. With the exception of Schiehallion, a comparatively recent development, these fields are heavily depleted with remaining reserves well under 10% of the total amount recoverable. Nonetheless... ...opportunities are continually being sought to increase the recovery of hydrocarbons from the older fields by infill drilling and improved technology. Professor Kemp of the University of Aberdeen has demonstrated in a recent statistical study how recovery factors for fields of different sizes and types have increased over time. The opportunity to do so tends to be greater in the larger fields where the expected benefits are greater. But these older fields are currently subject to a marginal tax of 70%, and the question must be asked whether this high tax rate is deterring industry efforts to maximise recovery. An additional legacy of maturity is the wealth of skills and resources among the industry's suppliers and contractors... - both hardware and people are to varying degrees mobile. The UK has become a centre of excellence for many aspects of the industry and there is a growing opportunity to build on the legacy of the UK industry and transfer it to other oil and gas provinces. While these export opportunities are increasing, they must be managed carefully as there is a potential also for 'resource flight' which could damage the remaining economic prospects in the UKCS.   BOX 6 "Ledingham Chalmers is a professional services business which has benefited from and contributed to the development of the economy in the North East of Scotland for over 100 years. We have had a successful relationship with the oil and gas sector since its arrival on our shores. The industry is key to our strategic objectives as an ambitious law firm both in terms of sustaining oil related activity in the United Kingdom and the exporting of expertise developed in our own province. The local economy has benefited greatly from the arrival of the oil industry - many businesses have derived benefit directly and indirectly from its presence. However, the UKCS is now a mature province and all of the wider community must work to ensure that the North Sea remains an attractive investment destination both for UK based and overseas investors." Robert J A Ruddiman Head of Oil & Gas Ledingham Chalmers   Decommissioning Few platforms have been removed from the UKCS and as a consequence significant uncertainty remains regarding the actual scope and cost of specific infrastructure decommissioning. The costs of abandonment will depend on the experience gained on the first programmes to take place and also on the regulatory environment. The DTI will be instrumental in this respect and OSPAR 2003 will be an important milestone in determining the necessary decommissioning requirements. Figure 16 shows the current industry estimates for decommissioning cost from the industry/DTI survey, indicating that cumulative costs have increased by £400 million to £8.8 billion since the 2001 survey. To take note of the experience gained to date it is worth reviewing a recently completed example (the Maureen Field), and also one which is due to commence in 2004 (the Frigg Field) and for which there is a published decommissioning document.   BOX 7 Maureen: Originally discovered in 1973, 163 miles north east of Aberdeen, production began in 1983 and finished in 1999 after having generated 220 million barrels of oil (50% more than first expected). A unique design was used for the platform, combining flotation, ballasting and oil storage. Planning for decommissioning began in 1993 with the potential for reuse high on the agenda. The evaluation process gave particular consideration to selecting one which was technically feasible, safe, cost efficient and respectful of national and international regulations. A marketing campaign for reuse began in 1995. Fifty suggestions for full reuse were evaluated but none fully satisfied the necessary criteria. The Decommissioning Programme was finally approved in December 2000 and the platform was towed away in 2001. Partial reuse was achieved although not within the industry as had been planned. The tanks of the platform base have been cut up to provide a deepwater quay at the AkerKvaerner yard in Norway and the concrete column of the articulated loading column will become a breakwater for a nearby marina. In the end result over 95% of the platform has been reused or re-cycled. The total cost of the decommissioning programme to date has been £184 million. The Scottish Fisherman's Federation in May 2002 provided a certificate of "clear seabed".     BOX 8 Frigg: The Frigg field was originally discovered in 1971 and production began in September 1977 as a natural gas field with associated condensate. The field was developed under the provisions of an agreement (the Frigg Treaty) between the Governments of the United Kingdom and Norway, as it is a transmedian field. Cessation is anticipated early 2004 after having produced an estimated1, 150 boe. Planning for the decommissioning of the Frigg field began in 1998 with a public consultation starting in April 1999. Subsea facilities at North East Frigg have already been removed (1996/7) and reused onshore. The East Frigg and Lille - Frigg subsea production facilities were removed in 2001. Reuse and recycling is a key objective for the removal of the Frigg field itself which includes five fixed installations (three of which are subsea concrete structures) and in field and export pipelines. Completion is not expected until 2012. The total anticipated cost of the Norwegian and UK facilities is currently £226million.