Monday, June 6, 2016

The North Sea Dries Up

The pressure on the oil and gas sectors around the world has not been restricted to the major players in the United States and the Middle East. In fact, suppliers with major stakes in the North Sea are feeling even more pain as declining operations coincide with the region's diminishing financial viability. Oil and gas companies are generating lower reserve replacement ratios. A Financial Times article reported that North Sea decommissioning rates are projected to increase then peak by the 2020's. In fact, a UK oil and gas group predicts that £16.9 billion will be spent on unwinding assets from 2015 to 2024. In that time, oil and gas production in the continental shelf is projected by the UK's Oil and Gas Authority to go from 85 million tonnes to just 57 million tonnes. As one might imagine, the energy sectors in European countries are in danger of falling into financial crisis.

From Crystol Energy
Norway and the United Kingdom are two homes of oil and gas firms with large stakes in the North Sea play. Production from both of these countries appears to have peaked at the turn of the century as they now face a flattening trend in the early parts of the 2010's. At the peak, Norway and the UK supplied 9 percent of the world's oil. In 2014, their share dropped to just 3 percent. In Crystol Energy's assessment of the North Sea's viability, it said, "the North Sea is unlikely to relive its heyday of the 1990s." Because improvements in efficiency are unlikely in mature fields like the North Sea, low oil prices will discourage expansion there. Capital expenditures and operating costs from these firms have dropped to all-time lows as the Brent spot price dipped to its own lows. Unless Brent approaches its 2014 highs, the conditions could signal the death of many firms that rely on the continental shelf region for a majority of its production. The Bank of Scotland recently published their annual analysis of the oil and gas sector in the UK. The reports reveal the firms' thought processes as the deflation in oil prices begins to give way to a recovery. The survey of 141 decision makers in the industry found that "the short-term outlook is understandably gloomy" even though their barrels of oil will soon be selling for $50 a barrel (over 25 percent increase from the beginning of the year).

Only 38 percent of the firms surveyed think that prices will return to $75-$80 a barrel between 2020 and 2022. The low rates of optimism in the industry are relatively unprecedented as "nine
out of ten companies planned expansion" when a recovery to $70 a barrel was predicted last year. This "psychological correction" means that UK energy companies will be adjusting their strategies in the upcoming years with new plans for exploration and production a necessary ingredient for the survival in the new markets. Going into the new year, the survey found that 48 percent would be looking for ways to cut operating costs and increase efficiency, both of which are hard to do in a weak oil play like the North Sea. As a result, most of these firms will hope to be able to place their bets abroad in regions like West Africa and Asia where reserves are more bountiful. According to the report, none of the large companies surveyed said they had plans for expansion in the North Sea. The lack of interest in local drilling could be very detrimental to the UK's energy sector which has already seen employment go down as a result of low realization. So far, 51 percent of oil and gas companies were forced to cut jobs. However, the worst may not be over; 24 percent of the largest firms expecting that "headcount will decrease" over the next 12 months. As operating capital quickly transitions into decommissioning expenses, the weakness in North Sea production could hinder growth in the UK and Norway.

What's next? Firms committed to the production in the continental shift are focused on cutting costs as Brent attempts a recovery. Of the larger firms that plan to stay, 72 percent intend to focus on "efficiency measures," well above the 25 percent hoping to achieve "growth." Still, major energy players feel that sticking with the typical incessant drilling is not enough to conquer the dangers posed by another deflationary crash in commodity prices. In fact, 71 percent of the largest claimed "there is still more to do" to "survive the downturn." Exactly half of he smallest, though, answered, "Yes, we feel we have done all we can/enough to survive the downturn." But as the contrarian might say in the face of a crisis, opportunities abound at the bottom, and too much optimism at this point in time could translate to a naive approach to recovery. The smallest firms had the largest percentage of no's when asked the question, "Has the current business climate presented new opportunities for your business in the UK?" Large- and mid-sized firms answered "yes" the most. Like every good businessman responding to risk, the companies in the survey said that diversification was a new opportunity 51 percent of the time, more frequent than the other five options. If the probabilities hold, the energy sector in the United Kingdom could experience one of the first pushes to renewable energy sources as their major source of oil begins to fade into the background. Only 22 percent of firms said that investment in research and development was an opportunity while 57 percent of big companies said decommissioning as an opportunity. Many of the responders who answered bearishly on local petroleum opportunities may be looking towards a new horizon. 38 percent of large-sized companies, 46 percent of mid-sized companies, and 37 percent of small-sized companies answered, "Are you interested in diversifying into work involving renewables?" with, "high interest." Watch out investors. The energy sector in the United Kingdom could come out of the glut green, sleek, and renewable.

So how does one trade on a report like this? First of all, investors must identify the unique position in which the UK oil and gas industry finds itself after global crash of energy spot prices. While shale producers in the United States revitalized their domestic energy sector with expansion in production, modest growth in demand, and increasing exports, their peers in the UK were forced to grapple with declining production, contracting demand, and increasing import dependency. Between the two regions, an extreme makeover in energy is more likely (and more in demand) in the UK. Second, investors must realize that companies that continue to pour money into production in the North Sea are misusing their capital. Investments in their stocks should be avoided unless they exhibit the desire to diversify and unwind uneconomic plays in the jaded oil field. Lastly, investors must watch for the transformation of the energy firms who saw the opportunity to migrate into renewables. It is only a matter of time until green becomes viable and, eventually, more economical than black. If European companies find that petroleum demand continues to fall, they will have a robust incentive and an incredible opportunity to burst onto the mainstream green energy scene before the rest of the world.

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