This post focuses on the importance of getting oil and gas assets into the ‘right hands’, and suggests why this natural process is currently being inhibited in the UK.

Briefing:

There are two important characteristics for the production profile of an oil and gas basin; the peak – after which point oil and gas reserves decline, and the tail – which describes how long the basin continues to produce for. Maintaining domestic production is good for government tax receipts, security of energy supply and jobs, amongst other things.

The production peak is principally determined by geological factors, but the size and length of the tail rests in human hands; developing enhanced recovery technologies and sustaining a high aggregate investment are crucial factors if a basin’s production tail is to wag. Sustained investment is itself a factor of a stable fiscal regime and the attractiveness of projects.

Attractiveness of projects:

‘Attractive’ is a relative concept. An asset that is attractive to one operator does not make it universally so – some operators such as Centrica have a gas focus, Statoil have a penchant for heavy oil. Given limited capital, companies need to prioritise available projects. This is done by ranking all available options by their net present values (NPV); only those above the company threshold get sanctioned. Obviously, these thresholds are different for each company; a field no longer material to Shell could still be very valuable to a smaller company.

Companies continuously ‘streamline’ their global portfolios to avoid project overreach; hiving off distracting assets and focussing on the ones that best align with company strategy. Majors typically strive for large volumes of oil and gas, so with time even a big field will struggle to clear the internal barrier needed to justify further investment. However, the reserves stranded in this field may still be significant to other, smaller, operators. Should the field be traded, the new owners will look to plough additional investment in to keep production going, which translates to an extension of field life.   

Basin evolution – the “Russian doll” model:

The pattern, then, is for an increasing number of ever smaller companies to enter a maturing basin by way of asset trade.

New plays are usually first tapped by majors or large National Oil Companies. These ‘frontier’ areas are therefore characterised by the presence of a small number of very large companies (e.g. deepwater Gulf of Mexico). As the average discovery size falls, large independents move into the basin (e.g. Norwegian continental shelf). At the end of the spectrum, mature basins see a large number of very small companies chasing smaller profits (e.g. the “mom and pop” model seen in shallow water Gulf of Mexico).

Government policy must therefore be to facilitate this “Russian doll” evolution of operators.

The current UK situation:

The importance of asset deals in the UK is made clear by studying the fate of the 16 assets that changed operatorship between 2005 and 2011:

• Cessation of production was extended, on average, by c.10 years. All the other assets that were not traded in this time had an extension of c. 4 years (likely due to the high oil price in this period)
• When the forecast investment from the old and new operators going into these 16 fields is compared, there is increased capital investment of £2.1 billion
• The benefits of this are twofold; extra production and a deferment of the planned decommissioning date

The deferment of decommissioning date is important not only because leaving infrastructure in place improves the economicsof small, marginal fields nearby, but because in money of the day terms, it makes the cost of decommissioning cheaper. This is important for both industry and government because the current provision in the UK is for each to pay half.

The key issue inhibiting asset trades

The government’s contribution to decommissioning comes via tax relief from the Supplementary Charge Tax (SCT) levied on the industry. Whilst this is not straight from the public purse, the opportunity cost to the government of ‘forsaking’ this money is still high: given the current state of the UK economy, the government is under considerable financial stress and is looking to save and generate money where it can. In the 2011 Budget, the government not only raised the SCT rate from 20% - 32%, it also capped the amount of decommissioning relief that the industry could claim from SCT at 20%, this simple decoupling is estimated to have saved the government £3 billion in the short term. However, the long term economic ripples of this action are likely to end up far outweighing the amount saved...  

The industry is now wary that government might do this again (as changes to these tax rate rules require no consultation or notice). For this reason, when a large company trades an asset to a smaller one, the large company wants to make sure that the new owner can fulfil 150% of the estimated cost of decommissioning the facility: i.e. the buyer has to be prepared to receive no relief from the government. Were the seller not to ask for this, then under Sections 29 and 34 of the Petroleum Act, the worst case scenario could see DECC allocating some (or all) of the decommissioning bill back to them (to protect the tax payer). This means that the smaller buyer has to try to find something in the order of several hundred million pounds to cover the decommissioning liability – typically with a letter of credit. This sum of money, which could otherwise be used for capital investment and drilling campaigns, is tied-up; serving only to reassure the seller. The opportunity cost of this situation, brought about by the uncertainty surrounding decommissioning relief, is very high. In reality, the disincentive is often too great for the smaller operator to complete the sale, and UK asset trades have withered as a result.  

Conclusion:

As a basin matures, there should be a progressive increase in the number of smaller operators coming into the basin by asset trade. In the UK, there is currently a roadblock to this evolution because of uncertainty surrounding the government’s provision of future decommissioning relief.

Whilst deals have trickled in, if the government were to provide, say, contractual evidence to guarantee the nature of their involvement, a great deal more asset trades would be done. This would land old assets in the right hands and give them a new lease of life.