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Deloitte Offers a Cautious North Sea Outlook

Gaurav Sharma 08/07/2010 The latest report on UK's North Sea offshore drilling activity by Deloitte's Petroleum Services Group (PSG) must be greeted with cautious optimism. It suggests that drilling activity has risen by 133 per cent over the second quarter of 2010. Deloitte further notes that whilst Q2 appraisal activity experienced a modest increase of 15 per cent when compared to the same period in 2009, exploration activity has doubled in the second quarter of 2010. The North Sea (southern zone) has seen the highest level of drilling activity, with the region representing 38 per cent of all exploration and appraisal wells dug on the UK Continental Shelf (UKCS) over Q2. The analysis is essentially based on the financial advisory firm's latest North West Europe Review of oil & gas drilling, which documents drilling and licensing in UKCS. It reveals that a total of 28 exploration and appraisal wells were dug in the UK between April and June; 14 apiece for each type. This compares with a total of 12 wells during Q1 2010. However, it would be wise to look beyond the headline data and probe historical data. Positive though the recent figures may be, Graham Sadler, managing director of Deloitte's PSG, also advocates caution. "This seemingly dramatic increase comes off the back of the lowest drilling activity levels that the UKCS had experienced in six years (up to Q1 2010). However, the second quarter drilling figures represent an 86 per cent increase on the same period last year and are therefore reflective of an increasingly stable North Sea operating environment. Furthermore, a record 356 applications for blocks in the 26th (UK) Offshore Licensing Round demonstrates that there is clearly some confidence filtering back into the market," Sadler said. The 26th round offered all of its territorial waters for the first time in 12 years and included tax incentives to explore some areas for natural gas. However, there is a message in the latest round of licensing as well - the North Sea's decline is inevitable but not immediate. Geologists are not yet suggesting the North Sea oil has nearly run out. Both government and private research indicates there is still about 15 to 25 billion barrels of the crude stuff beneath the UKCS. However, all the "easy oil" in the UK has nearly dwindled.

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Deloitte notes that ICE Brent crude oil futures contracts have remained relatively constant throughout H1 2010 averaging US$78 per barrel in the first six months of the year, building from the decline seen in the early part of 2009. Looking ahead, analysts at Société Générale CIB, BofA Merrill Lynch and Credit Suisse are all forecasting a crude oil price in the circa of US$78 to 85 a barrel, while some such as Total CEO Christophe de Margerie believe it may cap the US$90 mark. Deloitte believes market sentiment is furthering activity as a more stable oil price, improving credit conditions and the need for organisations to consider post-recession expansionary plans have created improved conditions within the industry over Q2 2010. However, harder to extract oil requires additional extraction infrastructure investment as production becomes more and more capital intensive. On a visit to Aberdeen in February, I found out that - of late - most new discoveries contain less than 50 million barrels; a minuscule amount by global standards. This may not merit investment by major oil companies. Oil & Gas UK (OGUK) expects investment to fall significantly and fears it could even drop below £3 billion in 2010; investment stood at £4.9 billion in 2007. Furthermore, a fall in value of the pound sterling against the US dollar and relatively smaller discoveries per exploratory project would imply that 2010 would result in extraction infrastructure investment of a comparable level yielding less than one third of the oil it did in 2001. From a project finance standpoint, this tells its own story.

North Sea drilling: Not what it used to be (North Sea Rig Photo © BP) OGUK is not shying away from admitting things are not what they used to be. To its credit, the lobby group meaningfully acknowledges UK's internal "Peak Oil" argument. It believes the

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surge in oil price during 2007 and 2008 masked a steady decline in the competitiveness of UKCS extraction infrastructure. This brings us to the question, just how important is the oil price? I had an interesting discussion with Stephen Craen, Managing Director of Energy Project Finance, at Société Générale CIB. He noted that in the sphere of energy project finance, project economics and project costs seem to have followed oil prices up over the last three years. "However, relatively high oil prices have not actually made, for example, many new LNG projects move forward. Shale gas has been an interesting phenomenon, in that it was ignored because it was thought to be too expensive to develop on a larger scale. Oil & gas prices then rose and wider scale shale development reduced the costs to an extent that it seems to be here to stay," he added. As Craen's remarks suggest, it is not as straight cut a case between oil price and energy infrastructure spending as many would imagine. However, it would be imprudent to ignore the connection - both from a British as well as an international standpoint. Some use the argument to suggest that UKCS' decline is unlikely to be stemmed unless the government provides more tax breaks to bolster North Sea drilling. The latest (26th) round of licensing contains some tax breaks, but ones that are nowhere near levels the industry craves for. Tax breaks for "big oil" are a touchy subject, especially as the oil price touched the dizzy heights of US$147 a barrel not all that long ago. The financial tsunami that followed over 2008-09 and the current precarious state of the UK public purse makes allowance for such tax breaks for North Sea operators unthinkable. In fact, energy economists believe North Sea investment was hit both ways. High oil price masked under-investment and made tax breaks unpalatable for most of 2007-08. Subsequently, a greater decline in activity was an obvious consequence of a lower oil price which fell to US$34 per barrel in December 2008 with no tax break in sight for entirely different reasons. Energy Minister Charles Hendry remains committed enough without committing much from the public purse. In a recent speech, he said, "The North Sea remains an important hub for investment and will continue to be at the heart of the UK's energy security for years to come. There are still plenty of opportunities for developments in UK waters." Unmasking a stark reality, the Office for National Statistics (ONS) data after Q2 2007 frequently suggests the UK is fast becoming a net importer of crude oil for the first time in decades. A serious rethink is required about North Sea infrastructure spending. In the interim, figures such as those published by Deloitte should provide cold comfort.

This feature was first published by Infrastructure Journal on July 7, 2010. An online copy of the feature may be seen here.

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