There is a massive power game going on in the worldwide oil industry, between OPEC and the USA – a nutcracker of a game in which the pressure on the North Sea is no more than collateral damage.
The game is elsewhere.
There’s a ‘What’s going on?’ question. There’s a ‘How long will it last?’ question. There’s a ‘What will it do to the North Sea sector?’ question. There’s a ‘What can government do?’ question.
So what’s going on?
It’s a classic impasse, with two players in a game which, if either pushes it to the limit, one or both will be fatally damaged by it.
The irresistible force is the wealth of shale oil and gas being produced in America, hitting the export market and bringing down the price per barrel. The immovable object is the 12-member Organisation of Petroleum Exporting Countries [OPEC] – seeing America a dominant force in the export market and hitting OPEC where it hurts – in market share. OPEC is continuing to produce – as is its right – causing a glut in the market and forcing the price ever lower. This is high stakes eyeballing.
The shale boom has hurt the economy of Saudi Arabia which is currently ‘taking the fat out of its budget’. It threatens the survival of the OPEC alliance, which has internal divisions that will become apparent if it does not win this standoff fairly quickly. Its member states with smaller reserves want to stop production to drive the price back up more quickly, in order to get the best price for their resources. The members with greater reserves are often the economies now under pressure and needing the cash flow – and it they don’t produce they don’t earn.
One such is Saudi Arabia, which no longer has the reserves it had in the last major oil price war in the glory days of the 1980s. Much of what it now has is heavy crude which the European refineries can’t handle. Its Ghawar field - by far the largest conventional oil field in the world, accounting for over half of the total Saudi oil production – is now past its best.
Ghawar was discovered in 1948, went onstream in 1951, peaked at 5.7 million barrels per day in 1981 -the highest sustained production rate of any single oil field in history. Fields in the south of the Ghawar were discovered later with the overall field estimated to have peaked in 2005. This is denied by the state owners of the field who nevertheless release little other than notably historic data on production from Ghawar. The field is reliably said by industry sources now to be producing in response to how much sea water they pump into it. [Water injection replaces pressure lost in extraction, improves flow and extraction rate and helps to recover remaining oil from old wells.]
So – in response to the market driver of American tight oil, OPEC has, under sustained pressure form Saudi Arabia with Kuwait and the Enirates, fought back to try to recover and retain market share – with the command of the price of oil that position confers.
On 27th November 2014, OPEC had been expected to do what it has traditionally done – drive the price of oil back up by slowing or stopping production and starving the market.
It did the opposite. It decided to hold production at the then current levels of 30 million barrels a day. Moreover, OPEC does not meet again until June 2015, so the world immediately knew that the over-supply which is driving down prices will continue at least until them.
In taking the action it took in November 2014, a former President of OPEC admitted that with the advent of the American shales, it could no longer control the market as it had previously done – and that it was now fighting to get back its market share.
The USA is projected to increase production to 9.5 million barrels a day in 2015. That’s a million a day up from its 2014 rate of 8.5 million. This reflects America’s growing self-reliance in energy:
- In 2014 it was still importing around 1.2 million barrels a day from Saudi – and it’s now producing an additional 1 million a day itself. It’s not hard to see what this means. [Other OPEC members are also losing market share in the States.]
- Last year, 2014, America’s net imports were only 10% of its total consumption across the energy range. This is the lowest percentage in nearly 30 years.
These figures convey a sense of the market impact of shale extraction.
On top of this, America’s statistics provider, the Energy Information Administration [EIA], expects consumption in the States to rise only by 1% in 2015 – so its self sufficiency is in good nick – not good news for the OPEC market position.
The need of some of the OPEC economies for cash flow dictates its strategic options and is part of the driver of its decision to maintain production levels at current prices. For instance, the industry is aware that Saudi Arabia doesn’t want to see its output go below 9.6 million barrels a day, described as ‘a baseline and legitimate level the Saudis will not forgo’.
The impact of OPEC’s action was summed up by Deutsche Bank in 2014, estimating then that if OPEC kept up production at the price levels back in November, 9% of America’s shale production would be uneconomic; but that, if the price fell below $80 a barrel of Brent, that non-viable percentage would rise to 40%. And today we are seeing not just a a price below $80 but one of $50 and falling.
OPEC is fighting for survival as an organisation, keen to avoid the consequences of fragmentation if it cannot hold together. It is therefore being, in competitive terms, strategically sadistic. It is not just interested in driving American shale extractors into liquidation and taking their place in the market. It is aiming also to hit the banks and investors that have fuelled the shale production. The financial sector will be the secondary sufferers when shale companies go down.
This strategy is designed to stop down any recovery in shale production if – on the premise that OPEC wins this standoff – the rising price of oil then tempts some shale producers back into the game. If banks and investors take pain this time around, when the producers come calling for funds next time, lenders and investors will have little incentive to listen.
This is aimed to neutralise the other consequence of the moment OPEC decides to stop production and let the price rise: the higher price for the flow of shale oil and gas would benefit America. It was, of course, the high price of oil – $140 a barrel in the first half of 2008 – which was enough to overcome the negative of the high costs of fracking and see the start to fracking in the North Dakota area of the mighty Bakken shale.
So OPEC is playing a long game, not just focused on winning now but on securing control of the game for some time into the future.
Will it work?
Well, America’s not daft. They know the game and they’ve not been slow in protecting themselves.
The American economy has benefited substantially from the growth of shale oil and gas production. America has reindustralised on the strength of cheap energy and its sectoral exports have been good to its balance of payments.
There is plenty more to come. The Baby Bakken play, for example, with 94,000 acres, looks like being a productive second generation successor to the Bakken itself, which sprawls across North Dakota, Montana and neighbouring states across the border in Canada.
Many of the shale producers have been using the Futures markets to hedge against the falls in oil price. These Futures contracts offer both seller and buyer different forms of protection. A seller hedges against a falling price and a buyer hedges against a rising one. As the expiry date approaches, it is obvious which party is the winner – but the contracts are rarely redeemed. They have tended to be bought back in.
For example, a company that had sold contracts to hedge a part of its 2015 production at $90 a barrel – effectively shorting forward oil prices to protect against a fall – could have bought them back in early January at around $57 – at a profit of about $33 a barrel.
It is now evident that the smaller shale producers have been tending to liquidate their hedges, aware of the position they are likely to find themselves in and lacking the cushions the big producers can summon – for a time. However, larger companies are not monetising their hedges but are using the funds to shield themselves against a further slip in market price by buying contracts and options pegged closer to current price levels.
While there is now a bearish market in oil futures [Brent crude futures have dropped about 35% since OPEC unexpectedly maintained its production targets in November 2014], it is pretty certain from hedging activity in the States – up from 15 million barrels in August 2014 to over 77 million barrels at the start of 2015 – a rise of 513% in four months – that many shale producers have revamped their hedging. This is likely to see them resistant to the falling prices driven by OPEC’s production rate not only until the OPEC June meeting – but probably until the end of the year.
The question is whether OPEC factored into their combative calculations the impact of the degree of shelter of the hedging employed by the American shale producers.
This situation means that the answer to the ‘How long will the low price of oil last?’ question is ‘At least until the end of this year’.
It is worth noting here that BP sees a price of $50 -$60 lasting for 2-3 years – because it expects Saudi, Kuwait and the Emirates to keep on producing to recapture market share by burning off the high cost American frackers against prices held low. And Saudi Arabia has just said that it can produce at this level at these prices for eight years if it tightens its belt – which it is now having to do.
This is the most naked statement of intent to date. So could they really stand an eight year war of attrition or are they bluffing? It’s that sort of game.
What’s this game doing to the North Sea sector?
The OPEC game is to drive and sustain a low price oil market to see if it can make America the first to find the pain unbearable. But this affects countries beyond the two principals.
On the positive side of the consequences for others, China is experiencing the relief of seeing the massive re-engineering of its economy -currently going through a bumpy phase – fuelled by cheap imported energy. And the North Sea?
The North Sea is taking real damage and will sustain potentially profound damage if this stand off is not resolved quickly – which looks unlikely.
The bald fact is that the North Sea companies cannot possibly continue to produce – in a basin where production costs are high – when production in powerfully uneconomic. They would be spending to lose money. Their shareholders would bail.
Geoff Gillies, Head of Europe Upstream Research for Wood Mackenzie, describes the situation succinctly, saying that the North sea was: ‘…already in difficult times before US $50 oil. Costs were unsustainably high, exploration performance was desperately poor, and production only recently stabilised from steep decline. Although investment was strong from 2010 to 2014, even by global standards, there are far fewer projects in the pipeline now – and investment could be half of 2014 levels by 2017.
‘The key question now is: will oil prices stay low? If the price recovers within a year, then the challenges remain the same as this time last year. Clearly spend would still be cut but companies will not shut-in vast amounts of production in the short term.
‘If low prices are sustained for more than a year – then current problems will be exacerbated and we are in danger of a hastened decline. Production is at risk when revenue does not cover ongoing costs.’
Financial analysts, Company Watch, estimate that 70% of UK exploration and production companies are making losses – amounting collectively to about £2 billion at the moment.
They see the situation for the smaller companies as being even worse, with total collective losses of over £12 billion.
Robert Plummer, research analyst at North Sea specialist Wood Mackenzie, says that at $50 a barrel the UK is amongst seventeen countries ‘producing cash negatives’ – meaning operating at an overall loss.
Alistair Winter, chief economist at the global investment bank, Daniel Stewart & Co, predicts a price fall to the low $40 – and possibly as low as $20.
Marginal fields operated by smaller companies need $60 to be viable – and the North Sea operation is now peopled by a lot of small companies.
Robert Plummer estimates that at $40 or lower there would be production shutdowns in the North Sea. This would be the finish of old and ending North Sea fields which are currently in production at a modest loss – in preference to getting into high cost decommissioning running to hundreds of millions of pounds. BP has said that it will now shelve plans to extend the life of older fields as extraction from them is too expensive.
As of yesterday, 20th January 2015, Talisman Sinopec’s announcement that it is cutting 10% of its North Sea workforce – a total of 300 jobs going, [100 staff and 200 contractors] brings the total number of North Sea job losses to 2,015, made up of: .
- 225 – from Chevron
- 250 – from Royal Dutch Shell
- 350 – from ConocoPhillips
- 250 – from Apache
- 300 – from BP
- 100 – from Schlumberger
- 130 – from Talisman Energy [100 offshore, 30 onshore]
- 100 – from Baker Hughes Inteq [employs 417, with 25% to go]
- 300 – from Talisman Sinopec -100 staff and 200 contractors]
In terms of North Sea activity, BP has said it will postpone investment in new capacity that has not yet started. Alex Kemp, Professor pf Petroleum Economics at Aberdeen University says that planned new projects will be stalled; and exploration budgets will be cut. North Sea exploration is already at a very low level.
As reported above, BP has also said it will shelve plans to extend the productive life of older fields as extraction from them is now wholly uneconomic, Robert Peston has said that those hardest hit will be companies, often the smaller ones, with stakes in these older fields – and faced already by rising production costs. The profitable life of such fields will be markedly shortened unless the oil price comes back up in short order.
All of these add up to a long impact on the North Sea, running well into the period after the price of Brent crude rises again. We expect the shape of the North Sea operation to be slimmer and more rationally purposive after this face-off.
The positive news for the North Sea
On 16th January 2015, Total confirmed a £500 Million investment in the start up on Phase 2 to extract 40,000 barrels a day from its West Franklin field to the Elgin Franklin hub. West Franklin has reserves of up to 85 million barrels.
Total is also to start producing from its £3 Billion investment in the Laggan-Tormore gas fields west of Shetland, more in the North Atlantic than the North Sea.
Then, as part of the achievements of the trade delegation accompanying the Prime Minister David Cameron, on his recent visit to America, Carlyle International Energy Partners – a member of the Carlyle Group, one of the world’s biggest alternative asset managers – is looking to invest £660 million in the North Sea - the detai of which has not yet been announced or perhaps has not yet been decided.
So there are also positives for the North Sea – to add to the good new and still productive fields already there and to contribute to the nature of the reformed sectoral operations later.
What can government do?
The UK Government’s needs in a situation not of its making and beyond its control, are to respond in ways that:
- smooth out, if they cannot stem, the tide of jobs lost;
- retain the high level skills base to support recovery later;
- support future production in the North Sea wells that still have a decent future;
- keep companies active in the North Sea that have the capacity to expand operations again when the time is right;
- retain as much tax revenue as is compatible with the above .
This is a time for hard decisions looking to the future. Rather than let the North Sea muddle on, as they would undoubtedly have done, the government is now likely to see constructive strategic decisions forced upon it.
Old and uneconomic wells will go out of production and many of these will shut down for good. The positive here is that this ought to jump start the next industry to benefit the North Sea sector – decommissioning
As we said in our last situation analysis, Why North Sea is crisis for UK, this is an industry that is certain to develop, that will require new technologies and new types of infrastructure to enable the complexity of what it will have to do – all of which has a commercial value to be sold on. This is an industry that may not be as profitable as the oil industry in the good old days, but will last for around 40 years, be relatively stable and have progressively marketable expertise and skills – and construction.
The cost of developing the new technologies and the new kit is such that this potential industry has been holding fire on gearing up until return on investment is guaranteed by enough certain decommissioning work coming into the pipeline.
The UK government, rather than incentivise continuing uneconomic production, might be wiser to incentivise the development of decommissioning – and take a lead in that powerful and lucrative market, a lead that would secure the future in several directions.
So far Chancellor George Osborne has done the right thing in giving public assurances that the March budget will make changes to ameliorate the oil and gas sector’s tax obligations – but that he will take time to make sure that these will be of generative as opposed to passive support. There is no need to press for premature decisions. Reliable assurances of easement are all that is necessary since between now and March, nothing predictable is going to make any difference to what is happening to the price of oil.
The North Sea tax regime is profits driven, so when the producing companies are making less or no profit, the Treasury gets less or no tax revenue. The UK government takes 81% of profits in taxes, with the controversial Supplementary Corporation Tax on this industry no more than a second hefty bite at the same cherry.
It would cost the government nothing in the foreseeable future to cut the top levels of the profits-based corporation tax. The production companies will not be making profits at that level but, since this is an industry with a long planning timeline, the security of a more supportive coming tax regime has a decent chance of keeping some of the major players involved in the North Sea.
For now, where the price of Brent makes expensive North Sea production profoundly uneconomic, there will be no alternative to production shutdowns, with no profit and no tax revenues coming from the shutdown fields.
As the price 0f oil remains low or continues to fall, there will inevitably be more job losses. This produces problems for government in dealing with sudden increases in unemployment levels. The Scottish Government response has been to set up a Task Force to address the situation with North Sea jobs.
There is then the issue of losses of highly skilled jobs, with those employable and mobile workers heading off to burgeoning fields in other parts of the world. This means that when the price rises and planned new North Sea projects are taken out of mothballs, the necessary skills base is unlikely to be available here.
The issue of energy security is one of which the UK government is acutely aware. Russia’s Gazprom has, not too long ago, demonstrated its willingness simply to turn the taps off [as a political aide memoire] – and the UK has been a major importer.
This sort of aggressive market behaviour, often politically driven, is one of the situations that can threaten our energy security. Another is war. Neither are predictable. There is a need to ensure that in eventualities like these, the UK will not be starved of adequate energy sources.
Continuing North Sea activity at a sustainable level is a major part of this security. There has to be uncertainty now as to what that security will look like when we reach endgame in the OPEC poker game.
It may be that we will now see an accelerated licensing of exploration and production from our own onshore shales, fuelled by the issue of energy security needs.
Interesting times indeed.
Note: The price of Brent crude at close of play today, 21 January 2015, was $48.41.
