North Sea Oil—The Economic Implications

The United Kingdom was late in arriving among the ranks of the world's oil and gas producers--and this was principally due to international politics, not to the technology. The massive gas field at Groningen in North Holland, probably the largest under commercial development in the world, had been discovered in 1959; but the industry could not extend its search out into the adjacent and relatively shallow waters of the southern North Sea as there were at that time no offshore national boundaries. Until that hurdle had been cleared, no company could operate and no government could give out concessions.

We had to wait patiently until June, 1964 when the United Nations Convention relating to the exploitation of the Continental Shelf was at long last promulgated, and the boundaries in the North Sea between the United Kingdom, Norway, Denmark, Germany and Holland were defined.

Thereafter events moved very rapidly indeed.

The United Kingdom gave out its first offshore concessions in the southern part of the North Sea in that same year, 1964, and the first gas was discovered in 1965. Development was very rapid as new finds were made, and it was relatively simple technically in view of the shallow water. It has been a great success story, and reserves of around 30 trillion* cubic feet were established. These are currently producing about 4 billion+ cubic feet per day, all of which is consumed in the United Kingdom--a figure, incidentally, which is almost identical to Canada's internal consumption. The British figure represents 18 % of its total energy requirements--which, again coincidentally, is identical to your own gas utilization as the percentage of total energy used.

But there was no oil at all in that southern part of the North Sea. For Britain, that didn't come until 1970 in much deeper waters further north, in concessions given out in 1969. And it was not until 1972 that the first discoveries were announced in what has subsequently turned out to be the most prolific area -the extreme north, east of the Shetlands and up towards the 62nd parallel.

That far-north oil taxed the industry's technical ingenuity to its utmost, and moreover taxed its financial resources in a manner that it had never even considered before anywhere in the world.

I'm not going to dwell on that technology, but let me just tell you this about what we were up against.

The water depths ran over 600 feet, way beyond any previous experience, and in these northern latitudes approximately the same as South Baffin Island--weather conditions are extreme. As a consequence, any fixed structure or anchored floating equipment that goes into these fields has to be designed to withstand waves 100 feet high and wind speeds of 120 miles per hour, gusting up to 160 miles per hour. Now 100-foot waves may not sound so bad when I say it quickly, but you get a better impression if you visualize waves the height of an eight- or nine-storey building. Furthermore, the fields are over a hundred miles away from a land base, and in periods of sustained bad weather--which really means right through the winter--there are major problems in getting supplies out to the rigs and platforms.

In the little over four years since the first discoveries were announced east of the Shetlands, extraordinary advances in the technology have been made--laying 36-inch pipelines on the bottom in 500 feet of water, at a cost of about $2 million a mile; towing out and placing concrete platforms over 600 feet high and weighing 200,000 tons; working dives to over 900 feet, where a diver works 12 minutes on the bottom and needs more than six days to decompress--constantly pushing the technology and techniques further and further ahead.

But, unfortunately, costs have also shot ahead. We were well aware that it would be an extremely high-cost operation; but we had certainly not appreciated that in the brief space of about three years our estimates of capital cost for specific development projects would have to be multiplied by a factor of two--and in some extreme cases, three. This was partly due to inflation, increased steel and fuel cost, but it was also due to the fact that we were climbing a very steep learning curve. Nothing ever turned out to be easier than we expected; it was always more complex. The engineer's constant demand for more money to cope with capital overruns finally led one exasperated financial administrator in the industry to propound somewhat bitterly a new law of economics. The law runs: "In any North Sea project, regardless of the state of completion, the estimate of future capital expenditure yet to be met to finish the job will always exceed the original total cost estimate." He was not entirely joking.

It is a cold, hard fact that investment in the northern North Sea oilfields now requires something like $6,000 to $9,000 for every daily barrel of peak producing capacity. By comparison, historical development in the bulk of the existing world reserves would lie between a paltry $200 and $400 per daily barrel.

To put this a little more clearly, if one was to develop a 60,000 barrel a day onshore oil field under, say, typical Middle East conditions in the early 1970s, this would have cost something in the order of $20 million. To develop a comparable oil field in the northern North Sea now could cost over $500 million.

Obviously the total calls on capital are enormous. For instance, the Shell/Esso consortium will have invested the staggering total of nearly $9 billion by the end of 1980 to develop its existing British North Sea discoveries, and will probably have invested over half as much again by 1985. But there is another aspect to this capital investment. It is not just enormous, it is also very heavily "front-end loaded" in the cash flow sense, in that most of the capital has to go into a project before any income is generated. The "cash flow sink" the degree of commitment to what is essentially a high risk venture gets very deep before climbing back towards break-even. We estimate that Shell/Esso in the British North Sea venture will be in the hole to the tune of about $3 billion before starting the climb out, as the annual cash flow at last turns positive. We have our necks well and truly stuck out--a tremendous commitment to the skill and abilities of our engineers.

Now the point that I would like you to consider is not that the North Sea should be regarded as something unique, but that instead it should be regarded as the shape of things to come in overall energy cost terms. The North Sea development is only worth taking on at these vast costs because there is no alternative cheaper energy currently available.

It is exactly the same story in Canada. The sources of additional hydrocarbon energy are here, but the cheap sources--the existing oil and gas fields, for instance are not repeatable in quantity. The vast majority of the technologically simple and, by definition, cheap developments have already been located and are in production. The development of the enormous indigenous energy sources that you undoubtedly have--whether it be in the shape of oil and gas in the Arctic, or offshore in northern latitudes, or in the tar sands where the reserves are vast, or in coal--all of these are going to require the same order of massive capital investment as we are experiencing under North Sea conditions, or possibly considerably greater. The capital requirements for future hydrocarbon extraction throughout the free world are going to be of a completely different dimension to those that we have been used to in the past.

I would like to move on now to the other aspect of North Sea development that I referred to earlier--the national economics and the British attitudes towards pricing, taxation control and participation.

The first question, of course, is how great is this national resource? Not just a question of how much oil has been discovered already, but also the more difficult question of how much is likely to be discovered in the future? Not easy to answer in the current state of development, and the definitive answer is unlikely to become clear for another ten years as development proceeds. These circumstances inevitably encourage a variety of experts, and non-experts, to propagate their views!

In my own company's opinion, the figure for commercially recoverable oil from United Kingdom waters is around 3 billion tons (say, 20-25 billion barrels) from the currently known oil provinces. Of this total, approximately two-thirds has, we consider, already been discovered, and the remaining one-third is our estimate of future discoveries that will be made. This figure is at the lower end of the spectrum of available forecasts, but I believe justifiably so. However, that 3 billion ton figure represents a total worth as crude in present-day terms of around $300 billion.

Putting this reserve figure in terms of the United Kingdom's internal demand, it is approximately equal to 30 to 35 years' consumption at current rates. Self-sufficiency levels should certainly be reached by 1980. This does not mean, of course, that self-sufficiency levels can be maintained for thirty years or more. Oil fields unfortunately decline steadily in output as the pressure in the reservoir reduces; and there is the additional complication that a government decision has to be made on overall levels of offtake, particularly the extent to which it is deemed necessary to produce quantities in excess of self-sufficiency levels in the 1980s, in order to improve the general national economic situation by crude export earnings. The higher the production levels in the short term, the shorter will be the self-sufficiency period.

But clearly the oil in the North Sea is a formidable national asset however you qualify it; and this has been recognized by government in the form of the British taxation and legislation that has evolved over the last few years.

Taxation was probably the most fundamental question. Both government and industry appreciated that the pre1974 rules would have to be changed as a result of the oil price rise--the concessions were originally given out on a basis of 121/ % royalty plus corporation tax, now at 52%. The new tax structure had to recognize both the massive increase in crude prices and also the massive front-end loaded capital cost of extraction.

The result was an additional special petroleum revenue tax introduced in the 1975 Act, which was levied prior to corporation tax and applied strictly to production activities--that is, "ring fenced" on a field-by-field basis--so that it was effectively isolated from all complications of the refining or marketing business. It thus ensured that a highly desirable transparency entered into production taxation. Moreover, and most important to the operators, it was set up as a cash flow tax: it is not levied until all allowable capital expenditure, plus an allowance compensating for interest charges, have been recovered. The net effect of the new tax, coupled with royalty and corporation tax, amounts to an overall government take of between 70-75 % of taxable income; but the cash flow provisions mean for the industry a reasonably rapid approach to break-even. (Even so, it is becoming more and more apparent that insufficient provision has been made to permit development of the smaller accumulations.) In view of the high front-end loaded cost now implied in most energy resource development, I am sure that we will see wider worldwide application of some form of cash flow tax.

Another interesting point was that, in adopting the new petroleum revenue tax, the government abandoned any concept of protective pricing mechanism. Oil would be priced at going competitive world market prices both for home consumption and export--a sensible step surely. In a new age, when the need for conservation is imposed on us all by the precariousness of the world's energy balance, it makes no sense to protect the consumer from economic reality. But for Britain it was a major break with past practice, as a directly contrary line had been pursued with North Sea gas.

North Sea gas was a pre-energy crisis development dating from 1965, as I explained earlier. It was pegged at a landed price which is now equivalent to only about 20% of alternative fuel value. It is a policy that is probably politically impossible to unscramble; but its continuation has meant that the southern gas fields had to be declared exempt from petroleum revenue tax. Even so, however, the price obtained by the producers is insufficient to make further exploration and development viable. But this is a situation in relation to gas that many other countries are familiar with, and one that has brought similar problems of disincentive to conserve, coupled with disincentive to explore and produce. It is a legacy from the old world of stable, low-priced energy which we left in 1974.

I could give you many other examples of how the new regulations and legislation have been constructed to cope with high cost/high-priced oil. But time is short, and perhaps I'd better just touch on one last point, one that has generated so much feeling in Britain--the issue of government participation in the oil fields and the role of the new British National Oil Corporation (BNOC).

The question of participation first arose in 1974, when the increasing number of discoveries and increasingly optimistic forecasts of reserves induced the government to seek a majority holding--not in the concessions, but in all the commercial oil fields. It apparently wanted a "voluntary" 51 % stake, which it was prepared to acquire by a contribution process that was never, to my knowledge, defined.

The oil companies immediately, and I believe justifiably, screamed "foul". We felt very strongly that participation on this retroactive basis, after the discoveries had been made, was rather like approaching a man who has just won a lottery and offering to buy a half-share of the prize for half the price of the ticket.

In the debate that followed, it became clear that the government's aim was not increased take; that was dealt with by the petroleum revenue tax in 1975. Nor did it appear to be a basic question of regulation and control, for the most comprehensive set of control regulations was embodied in our Petroleum and Submarine Pipelines Bill, which was introduced in 1975 with the aim of defining very precisely the full extent of government control.

A great deal of confusion resulted and the participation debate dragged on, until in 1976 the government changed tack. They dropped the so-called "contributory" participation aim and substituted what became known as the "option route" to participation. In essence, this implied that an operator on an existing licence who discovers oil and is in process of development would agree to give an option to buy, at going market prices, 51 % of the output to the government via the agency of the newly-formed BNOC. This was a more acceptable route for the industry, but there were long and complicated arguments regarding the producer's buy-back rights to the option crude before there was general agreement. The basic philosophy was apparently that the option route, if universally applied, would give the BNOC control over the destination of the majority of the total crude produced in U.K. waters--a percentage that, including royalty oil taken in kind, could amount to 57% of the total production.

What apparently lies behind this philosophy is an awareness that the world can well be facing another energy crisis in the years ahead--not necessarily a politically generated emergency, but a shortage due to the growth in demand for oil worldwide outstepping availability, before either additional sources of oil (such as tar sands, shale or deep offshore) or alternative energy sources (such as coal or nuclear power) are available in sufficient quantity and by environmentally acceptable means to take their place.

That danger, I believe, is real. It is now over three years since the oil crisis gave the developed countries such a jolt, but depressingly little has been achieved towards the development of alternative energy supplies. Assuming that world economies recover from the recent general decline, the demand for oil could well outstrip availability despite the North Sea and Alaskan developments. The likely growth of United States, European and Japanese import requirements is a frightening prospect when viewed against OPEC's anticipated total capacity.

In the circumstances, the acquisition of North Sea crude by BNOC via the option route participation is understandable. But to my mind, the problem of energy shortage will not be solved by isolated government action; nor can individual governments effectively isolate their economies from those of their neighbours. If another energy crisis comes, it will be a worldwide affair and one that we can only be sure of avoiding by worldwide awareness and concerted action now on the conservation and alternative energy fronts.

The participation row, which has now been amicably resolved by the option route, involved the principle of retroactive imposition of new terms on existing concessions. On future concessions, the present government intends to take up a full 51 % participation on a contributory, equity basis right from the beginning--sharing the risks right from the initial exploration expenses. This is, of course, very different from a retroactive buy-in to the established successes, and the industry can have no complaints provided, of course, BNOC proves itself to be an efficient and capable partner.

Hopefully now, most of the legislative and fiscal problem areas regarding North Sea oil development are behind us, and the ground rules are now clear enough to ensure steady progress. There has been throughout a constructive dialogue between government and industry--not always smooth, but perhaps made easier by the realization that both parties are feeling their way into this new environment of high-price/high-cost oil. We in the industry are grateful for it, and I believe that Britain's experience in this new area will be of real value elsewhere in the world.

One final word. It is very difficult to answer the question "just what will the North Sea mean to Britain's future?" It is of course a question for the politician, not the oilman; but we can attempt some quantification, particularly in respect of the effect on the overall balance of payments, which is clearly very substantial. The net current account benefit derived from North Sea oil activity should be around £ 1 billion in 1977, rising to over £5 billion in 1980. If you take the value of North Sea gas into account as well, the 1980 figure should show a benefit of over £ 8 billion. Assuming the price of oil maintains its value in real terms, that figure should more than double by 1985, based on an offtake of approximately 50% above self-sufficiency levels.

The figures cannot be more than approximations, depending as they do on crude oil price and exchange rate fluctuations, but the significance for the British balance of payments is obviously major.

This is really where oil industry comment should cease. Thereafter there is a major government choice: the short term temptation of using the additional revenues to raise consumption levels in Britain, to raise real wages regardless of productivity; or to attempt to use the resources to help develop an efficient industrial structure for the long term, and to develop alternative long-term energy supplies. It is to be hoped that the latter is the major priority.

I'm afraid the engineers can do little more than say to the politicians, "For Heaven's sake, use the oil revenues as a springboard and not as a mattress--and always remember that it won't last for ever."

The appreciation of the audience was expressed by Major-General B. J. Legge, C.St.J., E.D., C.D., Q.C., a Past President of The Empire Club of Canada.

*trillion--million million

+billion thousand million