North Sea oil: The history and future of a troubled industry

For petroleum is now – especially in Scotland – a political embarrassment. Following the 70% crash in the price of crude in 2014-15, the ruling SNP is loath to mention oil revenues. The party’s Growth Commission report, authored by Andrew Wilson, simply decided to ignore a half-century of promising “It’s Scotland’s Oil”. A deadpan Wilson explained: “We’ll assume for the purposes of our projections that oil is producing zero revenues.”

Yet oil prices and profits are back on the rise. And with new gas finds such as last week’s, never mind major developments in the Atlantic west of Shetland, surely it’s time for our politicians to remember there is a stonking great energy industry sitting on Scotland’s doorstep. One with a woeful history of profligacy, economic mismanagement and foreign interference in Scotland’s affairs. Lesson: Big Oil is not going away any time soon.

For instance, only this November, BP started pumping oil from its giant Clair Ridge development west of Shetland. The Clair field was discovered 40 years ago but deemed too deep and too fractured to access commercially. But times (and technology) change. Clair Ridge is now key to doubling BP’s output in UK waters to around 200,000 barrels of oil equivalent a day, by 2020. More to the point, with prices back up to $60 (after a summer dip), Clair will make a tidy fortune for BP and its partners, Royal Dutch Shell and the US Chevron. At $60 pb, Clair Ridge will generate circa $4.5 billion revenue per year.

Leave aside for the moment the question of whether we should keep hydrocarbons in the ground. Global thirst for oil and gas is still increasing, thanks to demand in China and India. Currently, global petroleum demand is growing at circa 1.3 million barrels per day (mb/d). Total global demand is forecast by the intergovernmental International Energy Agency (IEA) to rise to 105 mb/d by 2040, up from 93.9 mb/d in 2016. At the same time, each year the world needs to replace 3 mb/d of supply lost from mature fields. That’s the equivalent of replacing one North Sea every 12 months.

GREEN critics rightly accuse the IEA of being conservative when it comes to grasping the potential of renewables as a replacement to hydrocarbons. The world added 100 gigawatts (GW) of solar energy last year and 50GW of wind power. The IEA is very definitely underestimating the transformative impact of electric vehicles.

However, there’s no mistaking the global thirst for plastics and other products made from hydrocarbons, including food preservatives, fertilisers, furnishings, paints and lubricants. The main market for such products is the burgeoning Asian middle class. As a result, petrochemicals will account for more than a third of global oil demand growth by 2030, and nearly half of demand growth by 2050.

Which means the North Sea and Atlantic shelf will remain in play. According to the latest estimate by the UK Oil & Gas Authority: “The UK’s petroleum reserves remain at a significant level which could sustain production for at least the next 20 years and beyond if additional undeveloped resources can be matured.” For “can be matured” read “if capital investment is sufficient”. Here lies the nub of what happens next.

The North Sea oil industry has made a good recovery from the 2014 crash. But this recovery has all the hallmarks of being temporary. Oil and gas production grew by a solid 5% in 2018, but low levels of drilling mean the outlook for future years is “much more uncertain”, according to the trade industry body, Oil and Gas UK. Its latest Business Outlook report carried a pessimistic tone: “The lack of new project approvals, and the recent low level of development drilling in the last few years, means it is likely that the UK Continental Shelf will return to a position of production decline during the early 2020s.”

Despite the long-run rise in demand, the UK oil industry is ill-prepared to take advantage, because of its perennial short-termism. One reason, bizarrely, is lack of skilled labour. The UK oil industry was brutally hollowed out by the 2014 price slump. Total employment, including those supported indirectly onshore, crashed from a peak of 500,000 to barely 300,000 by 2017. Now activity has revived, there is a predictable shortage of skilled workers, because so many have left the industry or sought employment abroad.

Oil is a cyclical business. It does not take a lot of imagination for the public and industry agencies to have foreseen the inevitable upturn and preserved a sufficient cadre of workers for the future. Fortunately, the 2014 crisis led to the creation of the public UK Oil and Gas Agency (OGA), with a mission to “regulate, influence and promote the UK oil and gas industry in order to maximise the economic recovery of the UK’s oil and gas resources”.

The OGA is meant to bang industry heads together and ensure a longer-term approach. But there’s an obvious problem with the effectiveness of the OGA, apart from the fact it was created half a century too late. The fact is that the private management of North Sea oil business is deeply flawed and always has been. UK oil has a mismanaged heritage which needs to be addressed at source.

We are used to thinking of the North Sea oil industry as uber efficient. Nothing could be further from the truth. The degree of financial waste over the years is staggering. Some 40 billion barrels of oil equivalent were milked from the North Sea between the 1960s and the opening decades of the 21st century. The oil majors were awash with cash – and grossly inefficient in how they spent it.

Efficiency is measured in unit operating costs, which means total costs divided by the barrels of oil equivalent produced. At the time of the 2014 price crash, average unit operating cost in the North Sea was around £18 a barrel. By 2018, this had been slashed to £12, a third less. This improvement was the result of a massive productivity increase driven by the collapse in petroleum prices. Tony Durrant (below), boss of Premier Oil, summed it up: “The drop in the oil price forced everyone to focus. If you roll back to 2012-2013, then the North Sea had a shocking record of about 65% efficiency.”

An industry operating at 65% efficiency? And nobody got fired? Had big oil companies such as Shell and BP been pumping at 2018 levels of efficiency in earlier decades, the surplus revenues available either as taxation or for productive investment elsewhere would have been vastly greater. Forget the dramatic images of oil workers braving the elements on storm-lashed platforms. The North Sea oil industry spells waste, waste, waste.

Surely the 2014 crisis was a wake-up call to the oil majors? Their first reaction was to do what giant monopolies always do – protect their shareholders. The 2014 price crash triggered losses for the major producers. In the third quarter of 2015, Royal Dutch Shell reported a loss of £4bn for the three months. Nevertheless, Shell’s board decided to maintain its dividend to shareholders. Bosses who don’t deliver dividends cease to be bosses.

Shell was not alone. The Big Four global oil companies – ExxonMobil, BP, Shell and Chevron – paid dividends in 2015 that represented more than 100% of their falling profits. In 2016, ExxonMobil ponied up a whopping $3.1bn in dividends for the second quarter alone, against a net income of only $1.7bn. The gap was filled by taking on debt and flogging assets. Greed and short-termism prevailed. But it also had dire consequences for the North Sea.

Desperate for cash, the major oil companies in the North Sea decided to sell off lucrative, secure assets – because it was easy. In 2017, Shell sold half its North Sea assets (for £2.9bn) to oil exploration firm Chrysaor. Initially, these moves looked positive, because they brought new, entrepreneurial blood into the industry. This has led to a partial recovery in output and some new discoveries. But it is only a partial recovery. For the smaller independents entering the North Sea sector lack the scale or capital to keep the industry growing. Result: a looming crisis in the mid-2020s.

Where is fresh North Sea investment going to come from? The recent gas find off Aberdeen was the work of a consortium led by the French company Total, helped by a major cash injection from China’s state-owned CNOOC – an enterprise with a rather dubious human rights record. Chinese money could fill the gap left by the majors. But Western economic and security worries about Chinese energy investments are already bubbling. CNOOC was blocked from buying the US Unocal oil company in 2005. Chinese money comes with political strings, while Brexit poses even more questions regarding future European involvement.

Nor are we likely to see the oil majors return to the sector. To understand why, we need to look at another aspect of the perverted economics of Big Oil.

For most of the period since the Second World War, the oil majors funded their heavy investment programmes from internal cash flow – admittedly, underpinned by generous tax allowances provided by naïve governments and corrupt politicians. But all that changed with the global financial crisis of 2008, when central banks introduced quantitative easing to push interest rates low. Suddenly the oil majors could borrow at near zero cost.

BIG Oil behaved like kids in a sweetie shop, ratcheting up debt like there was no tomorrow. The net corporate debt of the Big Four more than doubled in two years. Investments were made that lacked any commercial sense. This, incidentally, was the real reason the 2014 price drop was so calamitous. In truth, the immediate mismatch between oil demand and supply was tiny. But the oil majors suddenly found themselves over-extended just as cheap fracked oil hit the market in a big way. Prices stayed down longer than was expected and the newly debt-ridden majors panicked, taking the market with them.

Now, with global interest rates on the rise, the oil majors are focused on investing in areas with the highest marginal return – which is not the North Sea. BP, having recovered from the Deepwater Horizon debacle of 2010, is more interested in shale fracking these days. Its commitment to the expensive Clair field west of Shetland – Europe’s biggest – is piecemeal, and more about retaining a tradeable asset on the books to keep its credit rating up.

In 2009, the first SNP government published a report entitled An Oil Fund For Scotland: Taking Forward Our National Conversation. The document demanded that “devolving control of North Sea taxation and production to the Scottish Parliament would allow Scotland to control its own natural resources and ensure that they provided a lasting benefit for the country”. Westminster duly ignored the report.

The subsequent decade has provided proof enough that the free market approach to running the oil industry is a barren experience. Certainly, the world must move quickly to decarbonise energy production. But that still leaves the need for oil as an industrial feedstock, at least for the lifetime of the North Sea fields. Experience suggests this is best done under more direct public control, as in Norway. And the only sure way of securely financing the industry is via state involvement.

Such a shift in direction requires political change on a grand scale. Till then, the North Sea sector remains a commercial jungle. And, as Macbeth discovered, it does not pay to ignore the ghost at your table.