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High costs and high risks in the North Sea

In a period of weaker oil prices, can the UK’s offshore cope with Brexit too?

IT IS the double-whammy for the North Sea - weak oil prices and Brexit.

As one of the most expensive exploration areas in the world, the North Sea has been harder-hit than most fields by the collapse in oil prices in the past two years. Half of its operators have been running at a loss this year, according to a study by Company Watch, a consultancy monitoring corporate financial risk.

These companies already faced a stark choice - that of hanging on for better days or starting a decommissioning programme with unpredictable costs. But the shock of Brexit may have brought that decision closer as falling share prices highlight the disparity between hefty debt levels and low market capitalisations.

"Everything's out of kilter," says Colin Welsh, head of international energy investment banking at Simmons & Company, an investment bank. He's also worried about the contagion risk posed by the spider's web of partnerships that are typical of many of the North Sea installations. "If one goes bust, it goes right down the line."

As if this wasn't enough, on 23 June came UK voters' decision to leave the EU - "obviously Brexit has added to that risk", says Welsh.

Maintaining integrity

With the days of easy money over, operating efficiencies have become an urgent priority as companies try to reduce costs. Even old installations have had makeovers. Erskine, for example, a 35-year-old gas condensate field in the central North Sea jointly owned by Chevron, BG Group (Shell) and Serica Energy, has undergone maintenance improvements, including the "pigging" of a 30km pipeline, to boost efficiency to more than 90%. At around 27,000 barrels of oil equivalent a day, production jumped to its highest level in two years after the programme.

The rush to efficiency has gone straight to the bottom line. According to Oil & Gas UK, by the end of 2016 average operating costs per boe are forecast to drop to £15 a barrel ($20/b), down from £17.80/b in 2014, as the industry targets what the trade body describes as "asset integrity". Collectively, the savings in the sector should hit around £2bn by the end of the year, equivalent to a 22% decline in costs.

In this tougher operating environment, the future belongs to small, low-cost, low-debt operators that can turn a profit at $50

Although cost reductions give the industry some breathing space, the looming problem is capital expenditure. In a climate of low or negligible returns, where will it come from? As Oil & Gas UK chief executive Deirdre Michie pointed out in the trade body's latest assessment of the state of play: "Exploration for new resources has fallen to its lowest level since the 1970s." By the organisation's own estimates, capital investment will drop by £2bn a year during this year and next. At that rate total capex will collapse to around £8bn or lower compared with 2014's £14.8bn.

For Simmons & Company's Welsh, capex is a burning issue. "How do (operators) fund it and how do they get a decent return?" he asks. "The big companies aren't going to spend any money at these prices and even the smaller operators, such as (Houston-based) Apache Corporation and (UK-based independent) EnQuest, will have to shrink their balance sheets."

Although the government has stepped in with a kinder tax regime for the sector and is paying for seismic surveys that may identify new areas for exploration, this may not be enough. The industry is lobbying for more tax cuts - a thorny matter, given the likely fiscal squeeze the post-Brexit UK faces.

In this tougher operating environment, the future belongs to small, low-cost, low-debt operators that can turn a profit at $50, believe many in the sector. One of these is Faroe Petroleum, a London-listed specialist in the Norwegian North Sea, which announced in June the discovery of low-cost oil and gas reserves off the coast of Norway. The cash-rich operator is looking for other opportunities including acquisitions.

"There's a lot of life left in the North Sea," insists chief executive Graham Stewart. "Some of it will be decommissioned but I think there are some green shoots coming out of the downturn. I would not give up on the North Sea."

Indeed, some firms might be able to cope at much lower prices. "The more nimble operators could even survive at $30/b," suggests Welsh. "There's uncertainty but fundamentally the system isn't broken."

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