Oil & Gas - Maximising Recovery Programme (formerly SHARP) IOR Views

Investment Behaviour

The effects of the increase in oil and gas prices on activity in the UK Continental Shelf (UKCS) generally depend on (a) the size of the increase and (b) the perception of how permanent or temporary the increase may be.  It can be argued that the larger the increase the more attractive will become investment in (a) exploration, (b) field developments and (c) incremental projects.  Projects under all these three headings which were previously uneconomic become viable after the price increase.  A further effect of the price increase is to augment cash flows from current operations thus facilitating the readier financing of new projects.

But there are several other relevant considerations.  As noted above the expectations regarding the duration of the price increase influence long-term investment decisions.  Investors have keen memories of the major fluctuations in oil prices and tend not to be mesmerised by any level which might turn out to be short-lived.

Thus for some time investors have been very cautious and indeed conservative in their choice of oil prices to screen long-term investment projects.  Currently values of $25 or perhaps $30 at the most are being employed.  With gas, long-term investment decisions have to be based not only on the current very high price levels but on what might happen in a few years when the large planned new import capacity becomes operational.  The further uncertainties regarding how much of the import capacity will actually be employed have also to be considered.

Effect of Oil Price on Production

The present author recently undertook a detailed analysis of the potential effects using financial simulation modelling including the use of the Monte Carlo technique for analysing exploration and its possible consequences!  The study employed 3 price scenarios namely $20 per barrel and 18 pence per therm, $30 and 28 pence and $40 and 36 pence.  The underlying assumption was that investment decisions were made at the 3 prices.  They are all at real, 2005 prices.

Figure 1: Potential hydrocarbon production at $20/bbl and 18p/therm with 10% hurdle rate.

The results in terms of total hydrocarbon production are shown in Figures 1 to 3.  It is seen that in the short-term the effects of the price variations are very small.  This is because in the next few years production is generally determined by past and current field investments.  In the medium and longer terms, however, the price sensitivity is seen to be much greater.  In 2015, for example, production is 2.25 mmboe/d under the $20, 18 pence scenario, 2.65 mmboe/d under the $30, 28 pence case and as much as 2.95 mmboe/d under the $40, 36 pence case.

Figure 2: Potential hydrocarbon production at $30/bbl and 28p/therm with 10% hurdle rate.

The substantial increase in production in 2015 from the price change from $20 to $30 is explained by the finding that many fields in the technical reserve category were non-viable at the $20 price but became acceptable at the $30 price.  A further increase from $30 to $40 did not have such a strong effect because most of the fields classified as technical reserves were already viable.  Further, the higher exploration effort at $40 was associated with a lower success rate than under the 2 lower prices, and the extra discoveries reflected diminishing returns to the further exploration effort.

Figure 3: Potential hydrocarbon production at $40/bbl and 36p/therm with 10% hurdle rate.

Major Fluctuations Unhealthy

Major fluctuations in oil prices are generally in nobody’s interests.  From the viewpoint of the upstream sector it leads to short-term booms and busts which are unsettling for all, but particularly for the contracting sector.  An obvious manifestation of the unhealthy effect is the prevalence of large numbers of stacked drilling rigs with very low hiring rates followed only two years later by a doubling or even trebling of these rates and the enforced postponement of drilling activity due to the non-availability of rigs.

The dramatic increase in rig rates is only one element, albeit an important one, in the current market cost inflation.  For an average field development this may have amounted to 10% or so between 2004 and 2005 but might be as much as 20% between 2005 and 2006.  It is currently unclear what will happen thereafter.  Again, relatively sudden and large cost escalation is unhealthy from the viewpoint of facilitating long-term investment.  The current problem has been exacerbated by the reduction in some of the producing capacity over the past few years when oil prices have sometimes been very low.  The problem applies to personnel as well as equipment.  When investment activity was relatively low perceived long-term employment opportunities were also perceived by some to be less than exciting.  Currently the industry has to overcome this perception and persuade young graduates that the long-term prospects remain attractive.

The current strong cash flows do give an opportunity to experiment and consider riskier investments than could be contemplated under a low price situation.  An example is exploration West of Shetland.  One or two substantial successes there could produce a critical mass for the exploitation of gas fields which is currently quite challenging.