Much has been written and promised about the benefits of North Sea oil to an independent Scotland. The reality is that North Sea oil production is in dramatic decline and the deepwater services business is peaking. Thus, oil is a declining benefit to Scotland, and Aberdeen is about to become a liability.
As an American, I have friends in both England and Scotland, with great regard for all of them. I wish all the best no matter how the independence vote turns out. But Scots should be under no illusions about their oil prospects.
Oil production from a given area will tend to decline once it has peaked, regardless of oil prices. This is no less true for the UK North Sea. Production the UK North Sea peaked at 4.8 mmboe /d (million barrels of oil equivalent, including natural gas, per day). It has since declined by nearly three-quarters to 1.5 mmboe / day in 2013. Recent decline rates have proved brutal, averaging more than 12% annually since 2011.
Where does it go from here?
UK North Sea Oil and Gas Output
Source: DECC, via UK Office of Budget Responsibility, “Fiscal Sustainability Report 2014”, EIA, Prienga (author’s) estimates
The UK’s Department of Energy and Climate Change (DECC) sees a plateau at recent production levels, followed by renewed decline after 2020. This is pure nonsense. DECC made this same prediction in 2013; DECC now expects 2014 output 11% lower than its prediction last year, and 25% below its forecast of 2011.
Despite DECC’s hopes for the future, there has never been a plateau in North Sea oil production even remotely resembling DECC’s forecast, and there is no reason to believe we will see one now. Indeed, if recent trends continue, UK oil production could fall from an anticipated 1.5 mmboe / day in 2014 to 1 mmboe / day by 2016, and below 500 kbpd by 2022. That is, on current trends, UK oil production could fall by a third in the next 2-3 years, and by two-thirds in the next eight or nine.
How likely is this bleak scenario? Consider: The great Prudhoe Bay field in Alaska is declining by 6% per year, despite ministrations to maintain production there. On the other hand, the decline rates for mature offshore platforms in the US Gulf of Mexico and Brazilian offshore are typically in the 12% range. Thus, UK production is declining at the rate of a mature offshore field with no significant production additions. It doesn’t get much worse than that. Norway, by contrast, has seen an average decline rate of 3.6% since 2010, albeit with perhaps better prospects than those of UK waters. Given that Norway's oil company, Statoil, is cutting capex and focusing its incremental efforts outside Norway, we might expect declines there to accelerate.
Thus, the UK North Sea might expect to see a decline rate between that of Prudhoe Bay and a mature offshore field, perhaps 8-9%. Using 8%, UK oil production would fall be 1 mmboe / day in 2019, and below 500 kboe / day in 2027, as the graph above shows.
What are the economic implications?
Oil and gas receipts to the UK are a function principally of three factors: oil and gas production; oil and gas prices; and the costs of extraction for the oil companies. Having considered the oil and gas production outlook, let us consider prices. The UK’s Brent oil price stood at $111 / barrel in 2011 and 2012. It has plummeted to $96 / barrel in the last few days, and the futures markets expects it to stay there through the end of the decade. Thus, oil prices have declined and are not expected—at least by the futures market—to recover.
At the same time, revenues to oil companies—and the cost of exploration and production—have been rising at the pace of 8% per annum in the North Sea over the last decade or so. Operating costs increased by 15.5% in 2013 alone, according to UK trade group, Oil and Gas UK. If an 8% pace continues, and the futures price holds, then government take, oil and gas revenues to the government, would fall to effectively zero by 2018. Of course, some receipts will flow in. While there is production, the government should see revenues. However, to maintain production, the government in the UK (as elsewhere) will find itself forced to progressively offer increasingly generous incentives to producers, and within a very few years, will effectively be willing to accept nothing as long as production, and related jobs, are maintained.
Oil prices may well come in above the futures curve. To an extent, rising costs should be mitigated by rising oil prices. North American unconventional production growth has been spectacular and is now sufficient to depress global oil prices. Notwithstanding, about one-third of the world oil supply is subject to cost and price pressures similar to that seen in the UK. Therefore, within the finite future, at recent prices, we will begin to see significant deterioration in the conventional oil supply. This will affect supply growth and ultimately lift Brent prices, despite formidable shale oil production. North Sea production economics will benefit. On the other hand, oil prices are unlikely to exceed the global carrying capacity, currently calculated at around $115 Brent on a sustained basis in the near term. Although there is upside in the oil price, it is by no means unlimited.
Therefore, a better case forecast sees Brent oil prices edging back to those seen in the last few years, around $106 / barrel, and gradually increasing to $120 / barrel in 2020, and $175 / barrel in 2030. Meanwhile, operator costs are anticipated to rise at their recent rate of 8.9%. If we combine all these in a single forecast, UK government take for 2017 would come in at £2.3 bn, 1/3 below the most recent projections of the Office for Budget Responsibility (OBR). Government take would be half the OBR's forecast level by 2020 and converge with zero after 2025.
UK Government North Sea Fiscal Receipts
Source: DECC, UK Office for Budget Responsibility, “Fiscal Sustainability Report 2014”, Prienga (author’s) estimates
This is the scenario which I would recommend to a voter in Scotland as most likely. The North Sea will continue to decline at an elevated, but not draconian, pace. Oil prices will increase. But as seen in the last decade, cost increases will outpace revenue increases, for the reason that consumers’ willingness to pay more for oil, beyond the carrying capacity value of $115 / barrel, will be limited to GDP growth and efficiency gains. That is, the pace at which North Sea geology is deteriorating is likely to remain greater than the growth rate of global purchasing power. As a result, North Sea economics will deteriorate. In the worst case, fiscal receipts all but dry up by 2020; in the better case, they dwindle to insignificance by 2025.
The oil business in Scotland is more than just the UK North Sea fiscal receipts. It is, even more importantly, the oil field services business, centered around Aberdeen. How will Aberdeen fare in the coming years?
Aberdeen supplies more than just the UK offshore oil sector. It also delivers the highest quality and most sophisticated oil technologies and services around the globe.
About half of supply chain sales in Aberdeen are to the UK North Sea, and another 10% or so are to Norway. These will decline in line with oil production in these two regions, although revenues to an extent will be supported by North Sea decommissioning and on-going maintenance activities. Still, this side of the business will see declines on average.
Non-Norwegian exports constitute the other half of the market, and this portion should remain in somewhat better shape. The principal export regions are Europe, Africa and the Middle East. UK firms would expect to win work in deepwater Mediterranean gas fields off the coasts of Israel or Cyprus, for example. In Russia, UK firms might provide material support to Arctic projects. In Africa, Angola is the key market, with as yet unknown pre-salt potential there. Nigeria could be a strong market if politics become more tractable there, and LNG in Mozambique is likely to bring work to Aberdeen. In the Middle East, the Red Sea is the new frontier. Its deepwater potential is not yet well understood, but should that region develop, UK firms would be first in line and Aberdeen would profit.
Having said that, deepwater has not really lived up to its potential. Angola’s output has hardly budged; Nigeria’s offshore production has declined. The US Gulf of Mexico is seeing production gains, but Brazil is likely to be adversely affected by the re-election of Dilma Rousseff as President of Brazil. Ukraine has compromised Russia's Arctic offshore development. All of these have a greater or lesser negative effect on the UK oil field services supply chain.
Furthermore, the major oil companies are cutting capital expenditures (capex), which are meaningfully the revenue stream to Aberdeen’s oil services sector. As the oil majors rely heavily on deepwater projects, vendors should anticipate that deepwater projects will also be—frankly, already are—on the chopping block. This trend will continue, with upstream spend falling around 20% this year for the likes of Shell and Exxon, and similar amounts for others over time. Further cuts may be expected from 2015. Overall, exports sales from Aberdeen might remain range bound for 5-10 years, followed by a decline thereafter as deepwater plays are progressively exhausted.
Take it all together, and 2013 or 2014 will likely come to represent the peak year for Aberdeen. While the Granite City will continue to play an important role in deepwater and other complex oil and gas projects, its best days are likely already behind it.
Indeed, Aberdeen could become a liability. Until recently, shale oil production had not materially dented global oil prices. However, North American production growth, rising at a pace of 2 mmb/day per year, has become sufficient to make an impact, and Brent has been plummeting as a result. The above-mentioned capex cuts by the oil majors were initiated when Brent stood at $110 / barrel. At $95 / barrel Brent, these cuts will be accelerated and operators like Shell and Statoil will become reluctant to approve high cost capital projects of the sort in which Aberdeen specializes. Thus, two or three more months of Brent at depressed prices will lead operators to materially curtail their orders from Aberdeen. It may well put the city into a recession, and may do so soon.
The decision to seek independence or remain in Great Britain is ultimately one of many facets, of which oil revenues and the oil services business are just two. But as far as oil prospects are concerned, voters should not be complacent. The inability of oil companies to produce more oil after 2005 created Aberdeen’s fortunes, as consumers paid more and more to suppliers of exotic technologies to find them oil, any oil, anywhere. Aberdeen, with its expertise in deepwater, provided the knowhow to access the world’s most remote resources. But after 2011, oil prices had risen to a point at which the marginal consumer was willing to do with less. Look at Europe: its oil consumption continues to fall at a 2% pace. But costs have pushed on remorselessly, and operators are harder and harder pressed to find fields in which Aberdeen’s technology can be economically employed. As a result, they are being forced to cut spending, and this will directly affect Aberdeen’s fortunes. This process, which brought riches to Aberdeen on the way up, will grind it down from here on out.
Oil will not save Scotland. Whatever voters may decide, they should keep that in mind.