THE U.K. ENERGY SECTOR: A SPECIAL REPORT FROM OIL AND GAS INVESTOR AND GLOBAL BUSINESS REPORTS A Renaissance Its future seemed bleak but recent discoveries, higher commodity prices and a new tax regime are pushing hopes for U.K. North Sea production higher.

ive years ago, what was once Europe’s leading oil and gas Field, in the . Today, 45 onshore fields are pro- producer was in deep disarray. With alarming outlooks on ducing 32 million barrels of oil per year and around 23 billion Flevels of extraction and rig counts and a globally depressed cubic feet (Bcf) of gas. oil and gas industry, the U.K. sector was looking at its future Despite more than 80 years of activity, significant discover- with an eye on retirement schemes. Half a decade later, the ies are still being made, the coalbed-methane industry is still in outlook seems radically changed, with the sector buzzing with its infancy and there is much room for innovative thinking in news of fresh deals and renewed activity and oil and gas indus- the basin to expand the onshore production life-cycle. trialists adopting a much more optimistic stance, both at home Yet, the U.K.’s real potential, and base for its oil-producing and abroad. status, comes from its offshore hydrocarbon reserves, out of Oil was first discovered in the U.K. in the early 1910s on- which 31 billion barrels have been extracted, with an estimated shore. In 1919, the first oil was produced from the Hardstoft 24- to 32 billion barrels of extractable reserves remaining.

Going offshore In 1959 the massive Groningen onshore gas field was discovered in the . Geologists esti- mated that the same rock formations might be found beneath the southern

BP’s Northwest Hutton platform north of the Islands in the U.K. North Sea is among older platforms that are being decommissioned as production has declined below what is economic. (Photo by Lowell Georgia.)

This special report was prepared by -based Global Business Reports after meeting with some of the industry’s leaders and upcoming players. It highlights some of the elements leading the U.K. oil and gas industry into its rebirth. Authors are Gilles Valentin, oil and gas reporter, Global Business Reports ([email protected]); Carsten Gueber, financial reporter, Global Business Reports; and Naomi Sutorius-Lavoie, project and marketing coordinator, Global Business Reports.

UK-1 North Sea basin in U.K. waters. the basin could, beyond any doubt, They were right, and gas was dis- be further extended. That find, covered off the U.K.’s East Coast which is currently in development, in the 1960s. With gusts of up to 120 will be in production in late 2006, Clues discovered around the with peak output of 180,000 to coast of Greenland gave geolo- miles per hour, cold waters and 190,000 barrels per day expected in gists the idea that there may be 2007. oil and gas around Scottish wa- building-size waves, the The discovery triggered a wave of ters. There had been onshore oil challenge…[is not] an easy one.” extra interest and pushed the U.K. wells in Europe since the 1920s, Department of Trade and Industry but it wasn’t until the 1960s that into an even more aggressive promo- exploration in the North Sea re- tion of the opportunities to be found ally begun, without encounter- in the U.K., both offshore and on- ing much success in the early years. or onshore Russia, the U.K. fell into shore. The 21st offshore licensing round he first commercial oil was finally decay, with levels of exploration falling held alongside the 11th onshore round, struck in 1969 in Amoco’s Ar- and the country looking nostalgically as which was open to applications from Tbroath Field and discoveries suc- its oil-producing status slipped. February to May 2003, witnessed a record ceeded one another from then on. The number of new entrants willing to grab ex- first oil shock accelerated U.K. offshore A large discovery ploration licenses from all across the basin development and efforts to put hydrocar- A steep rise in oil prices, however, at and the complete range of asset profiles. bons onstream. In 1975, Hamilton’s Ar- the end of the 1990s, doubled with a for- Sixty-two E&P companies, from vet- gyll oil field started production, bringing ward-thinking government policy, re- erans to minnows and total newcomers, the first U.K. offshore oil to market in sulted in the outlook suddenly looking successfully participated, winning li- June that year. By 1978 U.K. North Sea less bleak. New exploration campaigns censes in what became the most success- production topped 1 million barrels of oil went under way and new players entered ful licensing round in the U.K. oil and per day for the first time. The first major the fray. gas industry’s history. The wave of opti- discovery of gas, now in production at In June 2001, Canadian independent mism triggered by these rounds and the the West Sole Field, was in 1965. EnCana sent the signal that the industry great level of new interest cannot be Following these early stages, a major had been seeking during the past decade: measured. It holds a great number of offshore exploration campaign opened the Buzzard discovery, estimated at more promises for the local support industries, the North Sea backed by the resource than 400 million recoverable barrels, which were looking at declining produc- base for the industry in the U.K. and proved that there was still major potential tion rates with some trepidation, and has . By 1991, 100 fields were in pro- held on the U.K. Continental Shelf signaled the beginning of a new era for duction in the U.K., with majors like BP (UKCS) and that the life expectancy of the U.K.’s oil and gas industry. and Shell leading the way, build- With many more en- ing their offshore know-how and trepreneurial, fast-moving and lat- facing the challenging task of op- eral-thinking organizations erating assets from offshore infras- N coming to the fore, the problem of tructures in some of the harshest Faroe decline has taken on a whole new Islands Northwest maritime conditions possible. Hutton dimension and the U.K. can look With gusts of up to 120 miles Oil field ahead with confidence. The next per hour, cold waters and build- Gas field 10 years will be innovative and ing-size waves, the challenge of Shetland productive, and the U.K. will realizing such successful opera- Islands surely remain a considerable oil tions out of such an unforgiving NORWAY and gas producer. basin cannot be considered an It is now time to assess if the ef- easy one. It was excellently tack- SW forts put together by the existing led nevertheless, and for more players, the newcomers and their than 30 years, the North Sea was NORTH SEA supporting partners from the fi- the bread and butter of a national nancial sector, the service industry industry that was built up bench- DEN. and the public authorities will be marking itself against the most good enough to slow the decline stringent of environments. and meet the U.K.’s rising gas A buoyant service industry consumption as well as its oil-ex- sprung in the wake of this oil UNITED port commitments with its ailing boom and developed as an inter- KINGDOM production. The future of Britain’s nationally active and recognized security of supply and its status as NETH. subsector. Yet, with 30 billion a producing nation is at stake. barrels extracted and now consid- A large part of the country’s in- ered a mature province, the fron- BELGIUM dustrial and technological devel- tier is no longer hidden in the opment achieved in the wake of harsh seas of the North Sea or in- the oil and gas boom also needs to deed onshore U.K. With most of FRANCE rethink its positioning. This report the majors concentrated on hunt- is addressing these issues at a cru- Oil and gas fields in the North Sea have been prolific ing elephants off the coasts of producers of revenues for companies and governments cial time in the basin’s history, West Africa, in the throughout the area. both offshore and onshore. Ⅺ UK-2 oilandgasinvestor.com ▪ February 2004 THE U.K. ENERGY SECTOR: THE INDEPENDENTS Majors, Move Over Opportunities onshore and offshore the U.K. are increasingly falling into the hands of non- majors.

he U.K. is going through a historical phase as a hydrocar- Eventually 27 new entrants were awarded licenses out of the bon-producing country. After having relied on small en- 62 distributed in total. Alongside this offshore round, the 11th Ttrepreneurs for the development of its onshore onshore licensing round was held, where eight licenses were underground oil and gas wealth, it let the state-owned and pri- awarded. vate majors take care of the major risks and the colossal invest- Total inland production cannot rival in any way the off- ments required for the exploration and development of its shore figures. Onshore fields have yielded more than 25 million offshore resources. tons between 1975 and 1995, when a steep decline in yearly BP, the chief explorer and producer, expanded its reserve production set in. Production in 1996 was 5 million tons; in base, financial wealth and experience enormously thanks to its 2002, it was 2.6 million. This was from 24 fields. 35 years of active presence in the basin. As a state-controlled During the same period, the offshore U.K. was producing 1.8 organization, BP contributed greatly to the U.K.’s economic billion tons; in 2002, it yielded 105 million. growth and its global stance as an oil and gas producer during In the 1980s, a tax scheme allowed oil companies to offset these three decades while the company grew to become the their onshore exploration costs against their offshore costs. A second-largest oil and gas operator in the world. robust inland exploration campaign followed, driven by the Meanwhile, Shell also expanded its activities throughout majors, which struck some interesting discoveries like the the U.K. offshore oil and gas development, alongside many of mega-field Whytch Farm, thought to contain 350- to 500 mil- the largest European E&P operators, who, at different stages of lion recoverable barrels, and today still yields more than 2 mil- their lives, moved into the U.K. Continental Shelf (UKCS) to lion tons of crude per year. grab the rewards, and the thrill of the North Sea. With the withdrawal of tax relief however, the larger com- Today, BP, still the key major operator of the basin, ac- counts for more than 15% of the drilling activity (comprised of exploration, appraisal and production wells) and more than 15% of the U.K. North Sea total investment. The super-major reckons that it continues to have 4.5 billion barrels of oil and gas to extract from the North Sea. BP has also redeployed its activities on a number of other core areas, dubbed “strategic profit centers,” in Angola, Azer- baijan, the deepwater , Trinidad and Asia-Pa- cific LNG. BP is also looking at strengthening its global position by working on major projects including in Russia, through the TNK joint venture. But despite such major strategic redeploy- ments, the U.K. North Sea still accounts for around 20% of its oil and gas production and is expected to remain a major part of its business even when the new areas go into production in the years ahead.

New entrants inland The North Sea has recently offered the opportunity of ad- venture to a number of smaller producers. Although the ticket to enter the U.K. offshore is expensive, the last decade has been particularly fruitful for the smaller player, as industry con- solidation has released a lot of human resources very willing to use their skills, experiences and networks to join the fray. Former BP, Shell, Exxon and personnel have joined forces and started a number of oil and gas minnows that are now at the forefront of the British independent sector. These early movers are now mostly in the production stage and their success has been emulated. The recent 21st offshore li- censing round is in itself a testimony to that, as 36 out of the 75 applicants were total newcomers to the U.K. offshore, and were comprised mainly of business ventures set up to join the inde- pendent sector or new entrants with previous experience in Winds of 50 miles per hour or more in the North Sea make for sea action other basins. on platform risers. (Photo by Lowell Georgia.) February 2004 ▪ oilandgasinvestor.com UK-3 Putting the energy back into oil exploration

Tullow Oil plc is an international Oil & Gas Exploration, Development and Production company with interests in Europe, Africa and South Asia. We focus on exploration and production opportunities in established hydrocarbon basins. We aim to be a partner of choice for Governments and coventurers in our core areas. As a dynamic player in the international oil and gas industry, we have a well-balanced portfolio comprising strong and sustainable production assets, nearfield and satellite exploration upside and high-impact international exploration. A responsible approach to health and safety, environmental and social issues is a core element of our strategy. Tullow has offices in the , , Pakistan, India, Bangladesh and Gabon.

Contact: www.tullowoil.com Tel: +44 20 7333 6800 Email: [email protected]

TULLOW OIL PLC. 5th Floor, 30 Old Burlington Street, London W1S 3AR, United Kingdom. Tel: +44 20 7333 6800, Fax: +44 20 7333 6830. panies made room for their smaller U.S. round in February 2003, are among the small companies, as virtually no major or and U.K. counterparts. Though unable critical reasons for the round’s success. even medium-size companies are present to maintain the previous levels of pro- They grant developers two successive in this area, and the costs are low.” duction, these assets nevertheless still of- two-year periods, the first dedicated to Andrew Hindle, second joint manag- fered some room for much more exploration, followed by two years for de- ing director, adds, “The main problem entrepreneurial types of ventures. velopment. faced by companies like ours onshore is The U.K. onshore activities offer During the first two years, the com- that there isn’t the level of drilling activ- much less risk than their offshore pany exploring the license will pay re- ity that would drive the prices down for cousins, and the rewards can be great. duced rental fees for the acreage, and at oilfield services and make the onshore There have been 46 onshore discoveries the end of this period will decide whether U.K. really attractive.” since 1983, most of them generated by to drill the prospect, or to drop it. the tax incentive. Midmar Energy grabbed an offshore li- Independents offshore ecently, the good news has been cense under these terms with venture For some independents, onshore oper- provided by the smaller indepen- partner Providence Resources. This foray ations provide a springboard to offshore Rdents. In August 2003, Pentex Oil offshore the U.K. builds on the develop- ambitions, where levels of production UK announced a discovery of more than ment of the company’s onshore portfolio. and reward can dwarf inland operations. 100 million barrels of oil equivalent on Besides its rewarded participation in Since the beginning of the offshore rush, farmland at Avington, near Winchester, the 21st offshore licensing round, Mid- 294 fields have been approved for pro- Hampshire. The privately owned com- mar is planning to drill a very promising duction, out of which 275 were approved pany, which also has interests in the Bal- offshore prospect in 2004 with its partner after January 1976. Today, there are 151 moral Field in the North Sea and and license operator, Providence. Black offshore oil fields in production, yielding operates wells in Hampshire and the East Rock is in the Celtic Sea, offshore Ire- between 5,000 and 5.3 million tons per Midlands, says the find is at least 30% land, and “could be our jewel in the year (like the Schiehallion Field operated larger than its biggest existing U.K. re- crown,” says Midmar chairman P.J. Red- by BP). serve, 15 miles away. man. Besides the majors, a few indepen- Pentex claims to be the U.K.’s third- Several other onshore players are em- dents are making a name, leading the largest onshore supplier of oil, behind ulating these examples. Odiham, Hamp- pack and opening the way. and market leader BP, and Venture Production, an independent, its find, thought to be the largest onshore was successful in acquiring assets from Britain discovery in the last two decades, Shell and Conoco. It is focusing on has triggered renewed interest in the in- brown-field investments, in securing land basins. cash flow-generating producing assets, A number of very interesting opera- The U.K. onshore and exploring the fringes to reduce risk. tors emerge from the onshore operating activities offer much less The company is looking at releasing new picture. Star Energy, today the second- volumes and reserves through the drillbit largest inland producer after BP, has de- risk than their offshore and has been investing heavily in the veloped a unique model of oil and gas cousins, and the rewards last years, capitalizing on these brown- production and independent energy gen- field opportunities. eration, acquiring four gas turbines gener- can be great. Venture Production managing direc- ating 25 megawatts from gas that was tor Bruce Dingwall, who is also president previously flared. of the U.K. Offshore Operators Associa- The company is now exploring possi- tion (UKOOA), says, “It has taken a bilities for new business developments. while for big companies to start rational- With the company’s oil fields moving shire-based Egdon Resources is, for izing their portfolios. Promote licenses, a into depletion and the expected future instance, technology-driven, looking at very welcomed novelty, are a joint initia- growth in demand for gas storage, Star applying PC-based software tools and ap- tive of industry and the Department of Energy is currently developing gas-stor- plying workstation technology to repro- Trade and Industry (DTI). age projects in its declining oil fields. It is cess seismic data. The company is “Today is a time when more appropri- also working on a wind farm, comprised looking at assets that weren’t correctly ate operators are moving in the U.K. of 14 wind generators in four locations, tested or drilled and aiming to realize basin because of the materiality of assets epitomizing the birth and rise of home- their value at lower costs. It is also a 20% to be found in the U.K. Continental grown multi-activity energy organiza- partner in Pentex’s major Avington find Shelf. We are, for instance, quite happy tions. and this should provide it with a wel- to drill 10- to 20-million--of-oil- Other small operators are looking at come line of cash flow. equivalent prospects, while big compa- such examples of success with a mix of And there is more potential ahead. nies cannot do it, as it doesn’t impact envy and confidence. Midmar Energy, a With the rather brutal stop in explo- their bottom line.” dynamic operator with experience on- ration activity following recent tax After the acquisition of the Kittiwake shore, is looking towards the company’s changes, a lot of “half-done” work is assets and infrastructure from Shell, the next leap forward. Already working to re- available. company signed a duty-holding agree- develop five mature onshore assets in dif- “One of the opportunities in onshore ment with service provider and facilities ferent parts of the U.K., the company has U.K. is the fact that data is very widely management operator . This recently benefited from the government’s available, through the U.K. onshore geo- partnership with service operators builds push to help the U.K. offshore get a sec- physical library and reprocessing the data on a strong tradition of cooperation ond wind. is largely facilitated,” says Mark Abbott, among oil companies to work cost-effi- The “promote” licenses, first offered Egdon Resources joint managing direc- ciently in the basin. It was started when to the industry during the 21st licensing tor. “The U.K. onshore industry attracts Shell and Exxon teamed in the 1980s. February 2004 ▪ oilandgasinvestor.com UK-5 director. Xcite Energy Resources, on its side, is Above, a slug-catcher at Tullow Oil’s gas terminal in Bacton. At right, Tullow Oil chief executive looking at appraising a reservoir also ac- Aidan Heavey, who says there used to be a “big company” approach to the U.K. North Sea— quired under the promote initiative dur- usually expensive and slow—but that has been changing. ing the 21st round and taking it through development. Its license covers an asset The North Sea partnership approach “There is also a very cooperative ap- in the northern North Sea that has been is unique, often featuring groups of up to proach between smaller players, trying to proven to contain huge volumes of oil— 10 partners, all of them equity partici- share costs and cut overheads by putting around 650- to 700 million barrels, ac- pants in an asset, and nevertheless in common facilities, sharing transporta- cording to DTI estimates. achieving, in most cases, great levels of tion costs, and such. The industry is The main question mark concerns the efficiency. This may create some sort of changing, and after watching the majors quality of the oil, which has never been cultural shock for North American com- gobble up independents during the past fully tested. Here again, a group of en- panies willing to enter the basin, says five years, we can now see the majors trepreneurs is teaming to generate value Nick Hooke, executive director of asset- breaking up into small independents, as on a proven, but untested, field, and are management consultancy Challenge En- the sizes of projects are much more suit- now looking at finding the most suitable ergy Ltd. able for smaller operators.” approach to test the block with a strong “Most North Sea ventures are multi- any opportunities are opening up view to developing it, most probably company partnerships and therefore de- for total newcomers, especially with partners. cision-making is taken by a group of Mon the more marginal side of the Another interesting innovation is companies, each with their own business business. Promote licensee Corsair epitomized by Tuscan Energy, also a agenda and processes. Most American , without linkage to its North newcomer to the basin. Looking at E&Ps are used to owning 100% of a li- American cousin, is for instance looking brown-field opportunities, Tuscan was cense and are consequently not used to at developing an asset thought to con- awarded a license for an abandoned field. anyone interfering with their decision- tain heavy oil, therefore calling for differ- The main novelty in this case is the fact making.” ent expertise than in most of the rest of that, highlighting the DTI’s commit- Opportunities abound for medium- the basin. ment to lateral thinking and innovation, size companies like Venture, Palladin But the partners behind the venture it awarded Tuscan an operator license Resources and Tullow Oil. Dingwall says, are very confident that their combined without it having any previous experi- “It is a great time to invest here, but very experiences across the scope of offshore ence. few people actually are. We aren’t oppor- petroleum exploration and production Tuscan’s Dave Workman says, “But tunity-strained in the basin.” will turn Corsair into a successful com- that also implied a lot of work on our Tullow Oil chief executive Aidan pany, should its licensed asset hold its side to present a good field-development Heavey adds, “In our case, as well as in a promises and the quest for partners bring plan contained directly in our license ap- few others, our experience abroad has to the company a successful combination plication. We are now working on rede- been very helpful in defining new ap- of expertise and financing. veloping the field and will go on with proaches in the North Sea. There used to “Looking at the Gulf of Mexico, you drilling throughout 2004, drilling high- be a ‘big company’ approach to the sec- can see a lot of small companies develop- angle wells at 60 to 70 degrees instead of tor, usually synonymous with expensive ing assets and developing value that the the original vertical wells.” and rather slow. majors might not even see. One of our The company’s model seems to hold a “In the old days, fields were being shut advantages here is that we are home- brilliant future, as the first well drilled down for a month for maintenance while grown and therefore know about the pit- and commissioned started flowing at rates it is now an ongoing process achieved falls of the U.K. sector,” says Simon of up to 20,000 barrels of oil per day, without any shutdown. Gorringe, Corsair Petroleum managing proving the worth of the business plan. UK-6 oilandgasinvestor.com ▪ February 2004 About this project, Stephen Timms, duction of 45,100 barrels of oil per day energy minister, says, “This is excellent and net proven reserves of 147.6 million news for the North Sea. Government barrels. and industry have worked closely to en- This deal should underline the fact For some sure that the UKCS is still an attractive that with more reasonable prices per place for exploration and development. barrel, the deal flow could increase con- independents, onshore The revival of this once dead field shows siderably in the months and years ahead, operations provide a this collaboration is working.” notably featuring more asset deals be- tween smaller companies. springboard to offshore Challenges ahead The acquisition also epitomizes one ambitions…. Yet, despite such successful examples of the issues highlighted by some UKCS and innovative approaches, difficulties players that may help to explain the remain. With high oil prices and the ma- sluggish pace of investment from inde- jors looking at maximizing the value of pendents. From the sale of Forties, BP re- delays in putting a deal together. their assets when they farm out their in- tained ownership over the pipeline However, the DTI has taken into ac- terests, acreage doesn’t go for a bargain. infrastructure tied to the field’s produc- count some of the concerns of the indus- Apache Corp.’s recent acquisition of BP’s tion. This decision makes perfect busi- try and has worked closely with some of 96.14% interest in the Forties Field ex- ness sense, as it is an economically viable its representatives to put together an in- emplifies that. infrastructure with a potential for tie- frastructure access code, formalizing rela- Described as a win-win for the North backs into the pipeline from operations tionships and conditions of access Sea by the energy minister at the time, in the vicinity in the years ahead. between infrastructure owners and pro- the sale triggered a lot of interest from With most of the pipeline infrastruc- ducers. the U.S. and was well received by the fi- ture in the hands of the majors, smaller The issue of decommissioning of nancial markets. players are very prompt to denounce the played-out fields has also been presented Discovered by BP in 1970, the Forties big companies’ abuses of their dominant as a potential headache in the basin, as Field is the largest ever found in the U.K. position, or indeed monopolistic posture some of the infrastructure in place is sector of the North Sea, and still ranks and their lack of understanding in defin- more than 20 years old. The cost of aban- eighth in production and reserves after ing win-win access tariffs positions. donment could be a potent deterrent for having produced approximately 2.5 bil- When looked at closely, the situation new entrants who might not have the fi- lion barrels to date. Apache’s acquisition isn’t so dramatic and most of the prob- nancial shoulders to bear it. economics estimate average 2003 pro- lems encountered are actually down to A number of innovative approaches

February 2004 ▪ oilandgasinvestor.com UK-7 have been adopted to tackle the de- commissioning problem. In some cases, majors like BP and Shell have “We are…quite happy to drill 10- to 20-million- transferred their assets and infrastruc- tures to U.K. minnows while agreeing barrel-of-oil-equivalent prospects, while big companies to retain the cost of abandonment. cannot do it, as it doesn’t impact their bottom line.” Obviously, the majors have made pro- visions to take abandonment into ac- Bruce Dingwall, Venture Production count, but are also expecting that the transfer of ownership will delay the end of a field’s life and the associated to give the basin more room for growth. aversion to oil production. costs of decommissioning for as long as These issues are being tackled effi- Offshore, the picture is even more ex- possible. ciently and the North Sea picture is be- citing. After years of disillusionment, the inally, the major hindrance to the coming rosier by the day. U.K. U.K. North Sea is addressing the chal- successful second wave of develop- independents have interesting, and re- lenge of production decline in a whole- Fment of the U.K. oil and gas indus- warding days, months and years ahead. hearted manner. try, and most notably of its offshore Onshore, the picture is filled by Great ideas are coming to life, new- dimension, is the release by the majors of small entrepreneur-driven companies, comers are showing enthusiastic interest fallow acreage, exploration blocks, some of them already with very sizeable and the U.K. government has proven its proven discoveries, brown fields and operations. The innovative approach will to sustain the momentum and ex- other assets lying undeveloped and wait- preferred by most of them has been tend the basin’s life term by increasingly ing for the right combination of risk-tak- proven successful in many cases and knocking down barriers to entry. ing and innovative thinking. one can expect more in the years It is now the turn of the operators to Here again, things are moving in the ahead. It may be fuelled by increased demonstrate their commitment to a se- right direction, as the industry and the levels of cooperation among U.K. and cure, yet costly, area of operation. With DTI are cooperating in the so-called “fal- North American companies, and ap- the application of technology and the low field initiative,” to release more plied to the problem of mature onshore coming together of experiences from the acreage and opportunities for smaller oil and gas production. North Sea and other mature basins like players to enter the fray. The ball is now This could in turn fuel even more Canada or the Gulf of Mexico, the in the camp of the majors, who retain deregulation, liberating a sector that is North Sea should retain its status as a rights on most fallow acreage and are still kept under by local regulatory major producer for at least a decade to widely expected to move ahead speedily framework and the local population’s come. Ⅺ

UK-8 oilandgasinvestor.com ▪ February 2004 THE U.K. ENERGY SECTOR: THE SERVICE SECTOR Bracing for a Sea Change Innovation among service-company offerings in the U.K. North Sea is allowing many operators to continue production cost-efficiently.

rom the outset, the U.K.’s oil and gas industry was able to Union) brought union fisheries under a common set of strin- build a large part of its development on the back of the gent norms and fishing limitations. The oil boom reverted the Fcountry’s long-established and well-developed industrial gloom and turned the city into the offshore petroleum center of base. Providing capable engineers, technicians and a solid sup- the U.K., and indeed Europe, with the Norwegian city of ply chain, the British industrial sector was able to sustain its Stavenger playing a similar role on the eastern fringes of the overall growth, which went some of the way in reversing the basin. steep decline of traditional heavy industry in the second part of Aberdeen witnessed a flow of oil and gas workers and indus- the last century. trial operators coming and settling down in its region, creating A direct inheritance from the Victorian industrial revolu- jobs and lifting the local economy and spirits alongside the pro- tion, the textile, mining and metallurgical industries plum- duction levels off its shores. meted from the post-war years onwards, but some engineering Today, the city is using these 30 years of development and firms were able to grab the benefits of the birth and rise of a accumulated experience to claim the title of “Energy Capital of new sector of activity—the offshore oil industry. Europe,” notably putting together incentives to attract and pro- While the onshore exploration and production industry was mote technology-intensive industries linked to the oil and gas marginal in fuelling the development of a service industry, the sector and to the development of alternative renewable energy vigorous development of offshore production activity following sources. A number of ambitious wind-farm projects are in the the first oil shock gave a very welcomed breath of life to two pipeline along the northeastern Scottish coast. areas in particular. The other region that saw its economy regenerated by the Aberdeen, a city on ’s eastern coast, was looking at birth and rise of the U.K.’s oil and gas industry is northeast its traditional fishing activity with an increased sense of doom, . Traditionally known for its heavy metallurgical indus- as the European Economic Community (now the European try and ship-building, the region had been declining since the early 1960s. The development of offshore exploration activities allowed shipyards to use their docks to manufacture platforms, manufacturers to work on topsides, and steel foundries to turn to pipe-making. Cities like Newcastle benefited strongly from this second in- dustrial revolution which helped to offset the decay of their in- dustrial facilities. Today, the level of activity cannot be compared to what was the case in the late 1970s through the mid-1980s, but some fabrication yards have been catching the wind of change and have started developing competencies in pressure vessels, FPSOs or equipment, managing to con- serve the strong industrial tradition of the region.

The service providers Today, U.K.-based service operators range from engineering firms to fully integrated service companies. One of the major engineering, procurement and construction (EPC) operators is Wood Group, based in Aberdeen, which grew from a family owned fishing business to the rank of No. 1 service company in the U.K. It has become a market leader in engineering design and project management-services, providing “life-of-field” en- gineering, from green-field to infield engineering, production enhancement and maintenance management, to decommis- sioning of platforms. Employing 12,000 people worldwide, the group demon- strates the strength of the U.K. service sector. Ian Wood, chair- man, says, “Out of the U.K.-based companies, we are probably the one that has the biggest impact on the U.K. oil and gas ser- vice sector.” Clearly, the role of such an organization is expanding be- yond its direct scope of business, as Wood adds. “We have a very significant role in the supply chain by the sheer size of our A tugboat brings a ship into Aberdeen’s historic harbor. (Photo by Lowell operations. But we also take a direct approach by running semi- Georgia.) nars for local SMEs (small- and medium-size enterprises), help- February 2004 ▪ oilandgasinvestor.com UK-9 ing them to integrate themselves into the supply chain and expanding ways on how they can cooperate amongst themselves and with us. As we move internationally, we also try when possible to take those who can offer potential services to our foreign customers.” Competition is lining up from the likes of Group. Employing more than 2,000 people worldwide, it has be- come an innovative leader in oilfield technology aligned with the needs of its customers. In addition to its presence in the U.K., Expro Group has a corporate office in Houston and facilities in Brous- sard, Louisiana. Chief executive officer Graeme Coutts says, “Expro is a top-tier player in the global service industry. As such we require state-of-the-art facilities to support our ac- tivities and our growth aspirations. The Gulf of Mexico, and both the deep and shallow U.K. Continental Shelf (UKCS), remain very important to the strength in future development of Expro. But we be- lieve that the U.S. market will underpin the strategic growth plans for years to come.”

depth. “Exit strategy from the North Sea? No way.” Ian Wood, From innovative Early Production Facilities in the North Sea, through deep- Wood Group water subsea solutions offshore Angola, to cost saving perforating techniques in Alaska, the Expro Group has been delivering proven client focused solu- Amec Plc, an international provider of tions for 30 years. specialized services and engineering solu- tions for clients in manufacturing, com- mercial, infrastructure and process Supported by a global operational network and technological expertise, industries, is another key operator in the U.K. basin. It is also headquartered in the integrated with a dynamic and responsive approach to customer service, the U.K. and although oil and gas isn’t its main field of business, it has made a name Expro Group provides the oil and gas industry with value adding services on this front too, playing a major role in and products to deliver well solutions and enhanced production. the development of the North Sea off- shore infrastructure.

Our strength lies in continuing to deliver tailored solutions Internationalization With the maturing of the industry, and developing cutting edge technology to meet the evolving needs of our some service companies have developed major international dimensions, to the clients. extent that foreign operations now repre- sent the major part of their activity. Internationalization works both ways, however, through acquisitions abroad (like Wood’s purchase of Houston-based Mustang Engineering in August 2000) and through the entrance of foreign ser- vice operators into the U.K., bringing strengthindepth.com with them their expertise and pragmatic approach to development at a time when it is largely required. “U.K. offshore engineering service oilandgasinvestor.com ▪ February 2004 Email: [email protected] companies had a strong tendency to ‘over-engineer.’ We dropped this ap- proach when we internationalized that environment in the 1980s and 1990s and opened up to the use of fit-to-purpose equipment, notably with U.S.-made top- sides and platforms. Now, we have learned to combine the two approaches, thanks to this influx of foreign exper- tise,” says Wood. n aggressive acquisition campaign and successful internationalization Aof the U.K. upstream sector helped to fuel the global development of the local service sector and put it in a po- sition to become a serious contender for major projects in the Caspian, West Africa and the former Soviet Union. The British service sector has also made its way in the Gulf of Mexico in recent years, but the North Sea is still very Offshore personnel return to land via North Sea helicopter transportation. (Photo by Lowell much a core area for most of them and Georgia.) isn’t considered to be abandoned. ganizations like RGIT Montrose have integrated services for a seven-year con- “Exit strategy from the North Sea? No had to address the challenges of change, tract on behalf of Shell Expro worth an way,” says Wood. “We see it as a mature notably providing their customers with estimated 750 million pounds to operate area with many more years of productiv- the possibility of totally outsourcing their in the U.K sector of the North Sea for ity. The basin still has got a huge number health, safety and environmental (HSE) Shell, Esso and other co-venturers. of brown-field opportunities and a large training. “Sigma 3 is a very pragmatic ap- number of fallow fields that will offer The safety culture, force-fed into the proach. We have skills that our competi- much work for the service industry in the sector following the tragedy, tors don’t have and they have skills that U.K.” is now widely exported. “The culture of we don’t have. So we put all our skills to- safety is spreading across the industry, gether to serve Shell and also managed to Increasing safety and we can bring the North Sea ap- develop a cooperative approach on the The service industry has also been proach and experience to the world, and cost front,” says Wood. building on the basin characteristics, build on the most stringent set of norms,” Expanding on this cooperative ap- which are unforgiving in many cases and says Murray Strachan, RGIT Montrose proach, Bill Murray, chief executive of necessitate a particular approach to group managing director. the Offshore Contractors’ Association safety, health and environment. When Similarly, marine operations have de- (OCA), points to the role played by the tragedy struck in July 1988, the basin was veloped, notably through the security re- OCA in developing the spirit of coopera- changed forever. On July 6, a fire broke quirements for safety standby and supply tion among companies. out aboard a production platform oper- vessels being moored to offshore facilities “This cooperative approach would not ated by , followed at all times. Local fishing companies have happened to the same extent had by an explosion and, in what became the struck by the crisis in the 1960s managed not the association published codes of worst accident in the offshore industry to develop and expand their role in this good practice for a number of years to worldwide, 167 men died. area of operations, later on expanding which our members have signed up,” The Piper Alpha disaster was a turn- into mooring, towing, transportation, Murray says. ing point in the U.K. offshore industry cable- and pipe-laying, offshore catering “As an example, all the workforces on and marked the low point of safety in the and a wide range of necessary operations the Sigma 3 project should be paid basin. From then on, the number of acci- to sustain E&P operations offshore. roughly the same, as we negotiated, on dents has decreased dramatically as more behalf of the member companies with stringent rules and regulations were im- Cooperation the trade unions and we produced base- posed and observed. With the maturing of the U.K. off- line terms and conditions. Similarly, we Some organizations were able to build shore basin also came the need to rein- took care of good contracting practices on this necessary threshold and devel- vent the market approach for the service for transfer of workforces and in matters oped their own products to answer the sector. Based on the traditions of high- of standard contracts. All these have needs of the industry. RGIT, an offshore level cooperation between oil companies contributed to the ability to nail these survival and safety training company, in the basin, a number of innovative ap- contractual agreements together and we merged with Montrose, an organizer of proaches stand out, notably based on the believe this is a great contribution from fire-fighting courses, in May 2000 and is spread of cooperation between service our side. The overall lesson from these today dispensing compulsory safety and operators. operations is that companies can cooper- survival courses to offshore workers from The Sigma 3 project epitomizes this ate together for better business.” the British and Norwegian sectors of the cooperative approach. Set up in April by North Sea. Amec, Wood Group Engineering and BP’s MAST initiative With the change in the shape of busi- KBR, a business of , to sup- Another initiative that attracted at- ness of the majors and the increasing port Shell U.K. Exploration and Produc- tention before Sigma 3 was the Mast Ex- number of new entrants in the basin, or- tion (Shell Expro), Sigma 3 provides perience, brought to life in 1998 by BP. February 2004 ▪ oilandgasinvestor.com UK-11 Having recognized in the early 1990s that a different approach was required for the management of its mature fields, BP brought together the Beatrice, Buchan, Clyde and Thistle fields, along with their respective satellites, to form a single asset named MAST. The net result was a big success in- volving the coming together of an al- liance of various contractors that together managed to increase the value of BP’s assets. The four fields were con- suming 17% of overheads, yet contribut- ing 4% of production. hese fields were each at an advanced stage of maturity, but did not share Tmany other characteristics. Beatrice, with its series of platforms, is in the envi- ronmentally sensitive Moray Firth. Buchan was one of the very earliest float- ing production facilities, with subsea wells tied back to the platform. Thistle, in the northern North Sea, was one of the first-generation platforms with many wells, so the estimated abandonment costs were high. Clyde was much more modern and in the central North Sea. BP’s goal was to improve cash flow, extend field life and defer abandonment by increasing reserves, improving produc- tion profiles and lowering costs. The super-major wanted to focus on core skills and looked to the marketplace to provide the expertise and operational ex- perience required for those activities per- ceived as noncore. This was a bold move at the time as some of these activities, like reservoir management, were being outsourced for the first time in the North Sea. An oper- ating alliance of different contractors was formed to manage the fields, and mem- bers were given challenging targets and incentives for extraordinary delivery. The seven alliance companies were given various responsibilities, for the top- sides, the well-management, subsurface operations and other tasks. Teamwork was a key contributor to the success of the group, featuring interesting innova- tions like board meetings held on the platforms. During the first year of MAST opera- tions, operating expenditures were re- duced by about 20% across the board for the four fields. Significant savings were achieved in logistics, marine helicopters, and other areas. Headcount cuts occurred everywhere too, helped by cross-training onshore and offshore personnel. Production profiles were improved by additional water-injection capacity gen- erated by rerouting some of the topsides systems, and additional reserves were re- alized through infill drilling and satellite development. UK-12 oilandgasinvestor.com ▪ February 2004 The most tangible result was that This service is, in any case, widely abandonment was deferred by a number welcomed in a basin that is eager to find of years. Before MAST, the four fields “The operatorship is a cost savings, but also for companies that would have reached the end of their lives key issue in the North as new entrants, may not benefit from between 1995 and 1999. This deadline any offshore production experience, was pushed to beyond 2000 in all cases Sea….” while their financial lifeline resides in and the assets are still producing today. the fast and steady flow of oil or gas from Aidan J. Heavey, their assets. Field management Tullow Oil Plc Besides which, Petrofac’s readiness to Besides this and other innovative ap- become a direct stakeholder through eq- proaches, some of the local service opera- uity participation in the management tors have built their competitive edge on gas-producing installations (three un- deals is a guarantee for the client that the a radical rethinking of their client needs manned, the others connected to a cen- service operator will seek an aligned and a remodeling of their businesses. tral complex) as well as the operation of common interest in the production suc- Founded in Texas in 1981 and today the Bacton onshore gas terminal in East cess of an asset while also guaranteeing a based in London and Aberdeen, Petrofac Anglia. fair service fee. is a name that has stood out during the It was the first time in the U.K. that a Such a scheme was organized in Alge- last decade. service operator was given responsibility ria’s Ohanet gas project, where Petrofac Now with more than $700 million in for an onshore gas terminal, demonstrat- is co-venturer, alongside eight partners revenues per year, the company has ex- ing again the change in business approach including , in a risk-service panded its presence in the Middle East, that has been filtering through the sector. contract. The U.K. service operator, be- the Caspian region and the former Soviet Aidan J. Heavey, chief executive of sides being associated 50/50 with ABB Union and has added facilities support Tullow Oil Plc, says, “The operatorship is Lummus Global in the EPC for a gas-pro- and operational management to its EPC a key issue in the North Sea, as the com- cessing facility, is also receiving a share of activity, notably through the acquisition, panies who operate have to have very the liquids production over a target in December 2002, of Aberdeen-based specialized staff and very strict HSE de- eight- to 12-year period. PGS Production Service. The company partments and policies in place. To take has announced its ambition to become a over the operatorship, you have to obtain Future contracts world-leading, fully integrated EPC and the approval of the Department of Trade This kind of agreement promises a facilities management company. and Industry. great future in a mature basin like the he dimension of its activity that “What has changed, is that a lot of U.K. offshore, where operating costs are may make the difference with the the duty-holding activities, basically the the biggest headache in the face of de- Tcompetition in the years ahead is people on the rig doing the day-to-day clining production levels and where new Petrofac’s capacity to provide financing work, is passed on to contractors, but the entrants might be willing to go for inno- and take equity participation in selected actual operatorship is still maintained by vative approaches for asset management. projects. Unlike other attempts at con- the companies. So companies like our- The success of facilities management, tract-to-produce experiments in the selves would have a very specialized oper- and the announced will of other U.K. 1990s, Petrofac co-invests as a minority ating group and we subcontract the service operators to move into such duty- for alignments, only where it can drive duty-holding job to someone else, like in holding schemes, is a clear indication value for customers through application our case in Bacton and Hewett.” that the U.K. service sector is looking at of its enginering, construction or opera- In the case of Venture Production, the future with confidence. tional services. Petrofac remains strongly Petrofac Facilities Management took Its successes abroad and the second service-led. over operation of Kittiwake, a production breath of the North Sea are reasons for Petrofac also recently struck facilities- platform and oil-loading facility previ- optimism. But the keen interest from management deals (not including equity ously owned by Shell. The deal included North American operators in the recent participation) with Paladin Expro, Tul- the Mallard oil field, a subsea develop- licensing rounds is also expected to trig- low Oil and Venture Production. All ment tied back to Kittiwake, as well as ger a wave of interest from North Ameri- three companies are amongst the most the Goosander, Grouse and Gadwall oil can service players in the years ahead. prominent of U.K. independents. These fields, which have yet to be developed. Most North Sea players are keen to deals were following on five years of suc- Rob Pinchbeck, Petrofac Facilities draw parallels between the history and cessful management for ChevronTex- Management managing director, says profiles of offshore development in the aco’s Galley Field. “Our aim in this business has long been Gulf of Mexico and the UKCS. It is also In the case of Paladin, Petrofac Facili- to develop as a turnkey operator, because clear that service companies from the ties Management took over responsibility we saw many more companies coming to U.S. and Canada have developed strong for their Montrose, Arbroath and Ark- the North Sea, notably much smaller competitive edges in mature basin opera- wright assets in May 2003. The deal with companies that did not necessarily have tions, end-of life and remedial field work Tullow Oil came as a blessing for this the capacity or the interest to develop and tailor-made, cost-cutting solutions company, as it was struck straight after operating capability. to meet customers’ exact requirements. Tullow had purchased the entire Cono- “The logic was that the oil company This possible increase in the competi- coPhillips interest in the Hewett assets in would do the reservoir management and tion levels could bring even more inter- the southern North Sea sector of the investment management, and the service est in the U.K. offshore’s renewed lease UKCS. company would do the production man- of life. At a time when decommissioning That allowed the oil company to agement. If you look through the inde- and the future cost of abandonment is a manage a smooth transition, using the pendent oil sector, they tend to be worry to some operators, it allows the service operator’s experience to success- mostly exploration-driven rather than basin to refocus on some of its more im- fully take onboard the management of six production-driven.” mediately optimistic prospects. Ⅺ February 2004 ▪ oilandgasinvestor.com UK-13 The exploration and production company took a risk searching for oil. The contractors took a risk drilling for oil. The pipeline company took a risk transporting oil. The refinery took a risk manufacturing gasoline from oil. And thanks to Marsh solving these risks, full service means a crew of experts and thousands of cheering fans.

www.marsh.com

Marsh is the risk and insurance unit of Marsh & McLennan Companies THE U.K. ENERGY SECTOR: FINDING CAPITAL Financial Kingdom Long experienced in large capital structures, the U.K.’s financiers are developing capital-provider programs that more closely fit the needs of smaller energy-sector players.

he U.K. has a long-established position as a world finan- nearly $800 million, and has other well-advanced deals in the cial center. Just as the country’s maritime and industrial pipeline. Ttraditions fuelled the growth of banks in the 19th century, Gerald Kenny, head of natural resources, oil and gas development from the 1970s onwards has also says HBOS aims to remain the leading arranger of loans to in- driven the growth of financial services. Today, the U.K. oil and dependents in the U.K. “Our business is expanding in size, gas industry’s second breath of life and the arrival of smaller in- product range and geographical coverage and we believe we dependent players demand new financial tools and ample sup- can provide a second-to-none service to the industry. plies of capital from the major banks. “There are exciting opportunities for the independent sector Compared with North America, Britain’s financial institu- in the North Sea and there is no bank better placed to assist tions are relatively unfamiliar with the requirements of mid-tier those companies that wish to invest there. However we recog- and small independents. The U.S. and Canada have a wealth nize that this is very much a global industry and we are happy of “boutique” investment banks and financial institutions to provide financing solutions for our clients operating in many specifically dedicated to the oil and gas business. Meanwhile, regions around the world.” the U.K. has only major banking institutions and is lacking the Its rival to predominance in the British industry is the Royal smaller operators that can offer finely tailored financial engi- Bank of Scotland (RBS). Fighting hard to quell the reputation neering to fit different phases of a project, and even small ones. for conservatism attached to the U.K. banking sector, RBS was But things are shaping up, and with the changes in the sec- involved in the North Sea since the beginning and a strong tor during the last decade, financial institutions are rethinking player in the U.S. through its Houston office. It has been a key their approach to the industry, no longer characterized by an accumulation of mega-projects with financial needs passing the $1-billion mark. The first sign is the strengthening of the presence of venture capital and private equity funds in the industry. Leading British venture capitalist firm 3i, has, for instance, invested heavily in both the upstream and the service sector, with more than 30 capital and equity participations in the industry. In the U.K., it invested in the small Venture Production, helping the com- pany finance its growth and become the largest holder of acreage amongst the independents. 3i also invested $40 million in service and facilities-manage- ment firm Petrofac, helping fuel the development of its North Sea and international businesses. Meanwhile, oil and gas investment banks like Houston- based Simmons & Co. International have moved in, with of- fices in Aberdeen and London. They have been busy scouting for technology-intensive companies in need of financial engi- neering, while being closely associated in other deals with E&P operators and service providers. Besides such cut-to-fit solution providers, the largest bank- ing institutions have also been working hard to develop offers. A key operator is the Halifax Bank of Scotland (HBOS), which in the 1970s was the first British bank to establish a spe- cialized oil and gas financing unit. For more than 10 years, the bank has been the top senior debt provider to the U.K. man- agement buy-out market and one of the pillars of the oil and gas industry. Since participating in the development of the Forties Field, the bank has deepened and expanded its knowledge of the U.K. North Sea to become the recognized industry leader in fi- nancing the oil and gas sector in the U.K. and with interests ranging worldwide. In 2003 it was involved in arranging oil and gas deals worth more than $1.3 billion and participated in deals worth $1.4 bil- Castle Dunnottar perches on the rugged coastal cliffs of the North Sea lion. It currently has mandates to arrange further loans worth near Stonehaven, Scotland. (Photo by Lowell Georgia.) February 2004 ▪ oilandgasinvestor.com UK-15 Tailored to the same high standards. Every time.

Intrepid Energy Ramco Seven Heads (North Sea) Ltd Ltd Refinancing Development and oil field of Seven Heads development, gas field, Irish Sea UK North Sea £60m US$600m April 2003 June 2003

Venture Production Burrup Fertilisers plc plc Ltd Refinancing and oil field Refinancing, oil field Construction of ammonia acquisition, acquisition & plant, Burrup Peninsula, UK North Sea development costs, UK Western Australia US$75m North Sea US$270m & Trinidad June 2002 US$175m December 2002

March 2003

Lundin Petroleum AWE Petroleum Pty AB Ltd Acquisition of Development of Yolla Gas Coparex Field, offshore Victoria, International, Australia France A$80m and US$172m US$37m

June 2002 April 2002

Bank of Scotland Corporate Banking continues to deliver an impeccable level of service. Our experienced Project Finance team provide a comprehensive range of flexible and innovative finance solutions for the Oil and Gas sector. So whatever the deal, you’ll be assured of an individually crafted solution that suits your style and is tailored to the same professional standard, time and time again.

For details of our funding solutions for the Oil and Gas sector, including the UK North Sea, please contact Gerald Kenny, Head of Natural Resources on +44 131 659 0503.

Bank of Scotland Corporate Banking is part of the HBOS Group. Registered Office: The Mound, Edinburgh, EH1 1YZ. Our specialist teams deliver innovative funding solutions from 33 locations worldwide. www.bankofscotland.co.uk/corporate experience the difference “The lack of mezzanine here is simply due to the fact that there hasn’t been the demand for it up to now.” Peter Buchanan, Royal Bank of Scotland

nity on both sides, the companies and timate cost of decommissioning may ours.” eventually prohibit their ability to attract The influence of the North American capital,” says John J. Lapsley, chairman of financial sector is very noticeable, with the Marsh marine and energy practice, U.K. oil and gas attracting equity and headquartered in London. now mezzanine from the big banking op- “Our product is a way of paying for de- Insurance leader Marsh has developed an instrument for containing the risks of erators. But a wider spread of innovative commissioning now, in a very efficient fi- decommissioning costs, says John J. Lapsley, products and attitudes is required to nancial transaction. This product is chairman of the Marsh marine and energy make sure local players don’t turn sys- unique to the North Sea and has been practice. tematically to the U.S. or Canada for the well received by the sector.” financing of their North Sea activity, All those operators are working hard partner for some new entrants and small through equity, debt or private finance. to adapt their services to the existing and independents as well as big E&P projects Already, a number of new entrants are upcoming challenges presented by the undertaken by the majors. indicating they strongly believe they will U.K. oil and gas industry. In a maturing For RBS, the North Sea is a core area. find more receptive ears and understand- basin, with smaller entrants and an in- “We have been slightly more innovative ing for their project financing and part- crease in new deal flows, a strong, inno- than our competitors, notably investing nership quests on the western side of the vative and lateral-thinking financial equity in a few start-up companies, which Atlantic. community is a must. was a big step for a commercial bank,” Other financial operators are also Looking at the way the sector is struc- says Peter Buchanan, director of the oil working on tackling specific North Sea tured in the U.S. and Canada, a number and gas division at RBS. issues. With decommissioning luring on of local E&P operators wish the U.K. “The thing that makes us different is most of the early North Sea infrastruc- were offering the same facilities. But with that we are a truly oil and gas bank, with ture, risk insurance leader Marsh has de- the increased interest in the basin by a long experience in the North Sea, in- veloped a financial product to address North American operators, and the cluding throughout the downward cycle.” the issue in a cost-efficient way. larger presence of U.K. financial institu- The conservatism of the banking sec- “This issue is certainly a matter of tions in the oil and gas industry in the tor is an element sometimes presented by concern for big companies although they U.S. and Canada, one may expect a great E&P players as hampering the full devel- can absorb it in their balance sheets, but deal of cross-fertilization to occur in the opment of the oil and gas sector because for smaller companies that may have a years ahead, for the benefit of the indus- of a lack of significant underwriting capa- nonoperating interest in an asset, the ul- try, in the U.K. and beyond. Ⅺ bility and debt products. The limited availability of mezzanine debt is espe- cially resented. “The lack of mezza- nine here is simply due to the fact that there hasn’t been the demand for it up to now. In the U.S., with thousands of oil companies against a handful here, the demand is much more important and filled by specialist providers of mezzanine. Over here, you see a much more traditional capital structure. Never- theless, a number of smaller companies are now starting to get more interested in using the leverage to increase the equity return and this is now seen as an opportu- A view of Scotland’s spectacular Highlands. (Photo by Lowell Georgia.) February 2004 ▪ oilandgasinvestor.com UK-17

THE U.K. ENERGY SECTOR: BUSINESS COSTS Taxation Recent U.K. tax law changes were shocking to some existing players’ field economics but may prove to be a boon to new players.

espite its seeming fiscal steadiness, the on certain mature assets, some of the larger U.K. oil and gas tax regime has wit- operators have yet to divest other assets that Dnessed a number of changes throughout have not seen any development for years. its development, especially during the last In 2004 the government will need to have few years. The change that has had the most a good strategy in place as to how it will be impact on the industry was the 10% corpo- able to encourage brown-field development rate tax increase introduced in 2002. where only larger independents or the majors It came as a surprise to the industry, as it will be able to play a leading role. This will was believed that stable, low oil prices in the very probably be a point of friction between late 1990s had removed the threat of increased the industry and the government. taxes. The Treasury argued that the changes Investors from the U.S. and elsewhere were brought in to ensure that companies paid looking to invest in North Sea projects will be their fair share of taxes as well as to encourage concerned as to what the tax regime is likely “long-term investment” in the sector. to be for the whole of their expected invest- Foreign investors in particular have been Tax law changes have been designed ment period. Given past changes, it is unlikely put off by this change, as they believe the to, in part, provide incentives to investors will ever feel comfortable that there U.K. in general is a good but expensive place specific areas of the industry that will not be further major changes to the have been perceived as weak, says to do business, making it an even larger in- Stephen Timms, energy minister. regime in the future. vestment for them. Investors need stability when committing money to long- Abandonment issues term investments. However, even after the initial changes, new The abandonment issue is one of real concern as some of the ones have occurred about once every nine to 10 years. Al- sector’s major fields near the end of their economic life. To though there may be no more giant fields to be found in the date, only a number of small fields have been abandoned and North Sea, one would expect many development projects to most of these have used floating production facilities or have last for more than 10 years, and the tax regime at the end of a been linked by a subsea tie-back to another field. project life can still have a strong influence over the project’s Where existing infrastructure has been removed, the facili- economics. ties have been on Southern Basin gas fields. The facilities Having said this, despite the 10% corporate tax increase, have been removed by a simple crane lift operation. marginal tax rates for new oil and gas fields remain at 40%, and Historically, tax relief for abandonment expenditure was avail- are still some of the lowest in the world. able as a normal disposal of plant and machinery or under the Overall, these measures have been revenue-raising for the abandonment allowance regime, which gave a 100% immediate government and driven by political factors, but there have also deduction for the costs of demolition of plants and machinery for been beneficial developments. According to U.K. Energy Min- the purpose of closing an oil and gas field. ister Stephen Timms, the government has been focusing on The Inland Revenue’s interpretation of this legislation was providing incentives to specific areas of the industry that have strict, and the cost of “mothballing” assets for possible future been perceived as weak. These include: use or of preparing an asset for reuse was not allowed. One con- • Changes to the capital allowances regime giving 100% sequence was that the assets could be more economic to sell first-year allowances for the majority of U.K. upstream capital than preserving or attempting to reuse them. expenditure. To address this, in 2001 the 100% immediate deduction was • Abolition of royalty from January 2003. extended to all expenditure incurred in decommissioning a • PRT exemption for tariff income arising from new busi- field provided: ness from January 2004, in order to promote further use of ex- • Expenditure incurred on decommissioning (explicitly de- isting North Sea infrastructure. fined to include mothballing and reuse costs) U.K. offshore in- To anticipate future changes in the tax regime one needs to frastructure; take into account the declining North Sea reserves and re- • Decommissioning complies with an approved abandon- duced exploration. The larger operating companies are focusing ment program; and their activities in Africa and Russia while smaller players are • Plants and machinery are not to be replaced. coming into the market to develop mature assets. The govern- Where a company has discontinued its ring-fence activities ment’s strategy to extend the life of the North Sea and maxi- (that is, has ceased oil and gas production) and incurs aban- mize recovery is intended to encourage exploration and to donment costs within three years of the cessation, the company further the use of infrastructure. can claim a 100% capital allowance for the spending in its final The Fallow Fields Initiative is intended to persuade the ma- trading period. jors to divest their portfolio of assets that do not fit their strate- While this enables businesses to receive a 100% balancing gic review, but this has been a very slow-moving process. allowance for the final period of the company’s trading period, While some smaller developers have been successful working the three-year time limit may be inadequate to guarantee effec- February 2004 ▪ oilandgasinvestor.com UK-19 tive relief, particularly if the field has a common transport or terminal facility, in Key Corporate Tax Allowances for Capital Costs which case full abandonment cannot Stage Nature of Costs Tax Allowance proceed until the last-user field ceases Concession acquisition Geological and geophysical Research and development production. surveys Where a participator in a field meets Cost of license Mineral extraction another participant’s abandonment costs Exploration Drilling costs Research and development under the term of an abandonment guar- Appraisal Drilling and associated costs Research and development antee, that expenditure will generally Development Development wells Mineral extraction/first year qualify for relief as though the original allowance participator had incurred it. Production facilities Plant and machinery/ Where the company has ceased to including platforms first-year allowance trade, losses resulting from abandonment Pipelines and onshore Plant and machinery/ can be set off against profits of the trade facilities first-year allowance in the preceding three years. Many in the Production Additional facilities Plant and machine/ industry have concerns that this period is first-year allowance inadequate, particularly as fields tend to Abandonment Demolition and production Demolition and abandonment be less profitable toward the end of their facilities allowances life and thus the losses available for carry-back can outweigh the profits sively being made available for use by tructure and the owners of third-party available to be relief. third parties on payment of a tariff. Field- fields seeking access to that infrastructure. dedicated lines are economically viable The scope for tension between non-pro- Access to infrastructure when fields are relatively large but be- liferation of infrastructure offshore and The investment required to build the come less viable as fields get smaller. competition creates a need for regulation. infrastructure needed to transport oil and here is scope for gains for all parties The Secretary of State has the power, gas from offshore fields is characterized if the development of small fields is under the Petroleum Act 1998, to im- by significant costs and irreversibility. Tmade viable by the owners allowing pose a solution to problems involving This can lead to conflict between the ef- access to their existing infrastructure, pipeline-sizing, connections or tariffs. ficient use of resources and the wish for thus gaining additional revenue from the These powers have, however, so far greater competition. new users. Some of these gains would be never been exercised. The efficient use of resources requires lost if monopolistic behavior were to no unnecessary duplication of infrastruc- deter the development of new small Changing dynamics ture while greater competition requires fields. For many the recent tax increase con- alternative pipeline systems to be avail- The more mature areas of the south- tributed to a change in strategy, with able to producers. Effective regulatory ac- ern North Sea, with large amounts of larger operating companies starting to tion can prevent the exploitation of local part-empty infrastructure, offer good op- scale back their North Sea operations to monopoly positions where competing portunities for pipe-on-pipe competition. focus on other regions. In response, the pipelines do not exist. In the central North Sea, there is less government and the industry are work- The evolution of offshore infrastruc- spare capacity and the additional compli- ing on initiatives to prolong the life of ture on the U.K. Continental Shelf cation of relatively small gas volumes as- the North Sea, notably by encouraging (UKCS) has been characterized by com- sociated with oil production. exploration and further use of infrastruc- panies developing pipelines for their sole There is more potential for commer- ture. Insiders expect that the recent use, followed by spare capacity progres- cial tension between the owners of infras- changes to North Sea taxation may not be the last, with future policy being driven by three potentially contradictory Main Elements of the Current Tax Regime factors: Royalty Tax, which is paid, as a condition of each oil production license, at 12% of the • The government’s formal policy of landed value of petroleum “won and saved,” less an allowance for the cost of bringing the being “guided not by short-term factors petroleum ashore and treating it. but by the need for a regime that raises a Royalty is not payable for any field approved after March 31, 1982, and may be waived fair share of revenue and promotes long- on production from older fields if it can be shown to be impeding activity. The Treasury term investment in the North Sea;” has committed to a consultation of royalty with a view to abolishing it in the near future. • Declining revenues which may see (PRT), which was introduced by the Oil Taxation Act 1975. PRT is a tax on profits related to separate geological and technically determined fields, the gradual withdrawal of major global charged on the difference between income and expenditure with allowances designed to players and their replacement by smaller, ensure it bites only on the larger, more profitable fields. leaner but less-capitalized businesses un- A significant reform of PRT was introduced in the 1993 Finance Act to encourage fur- able to maintain the existing level of ther investment by allowing oil companies to keep more of their income. The rate of PRT North Sea infrastructure; charged on existing fields was reduced from 75% to 50% in July 1993 and PRT was abol- • The U.K.’s economic position, and ished for fields approved after March 15, 1993. that of the global energy markets. Corporation Tax (CT), which is charged on the profits of oil and gas companies, in In 2004, the and gas much the same way as any other industry. In the case of new fields, this is now the only sector remains a vibrant but evolving tax on profits. sector, which remains critical to the The main rate of CT is currently, at 30%, one of the lowest company tax rates in the world. Both royalty and PRT taxes are deductible in computing profits for CT purposes. U.K.’s economic and taxation policies. Profits from upstream activities are ring-fenced so they cannot be reduced for CT purposes As the North Sea oil and gas fields move by any losses or relief arising from any other activity, including downstream operations. into the later stages of their lives, tax changes remain likely. Ⅺ UK-20 oilandgasinvestor.com ▪ February 2004