Europe in crisis?

The industry will emerge from its current crisis, but the next chapter in the oil and gas industry may look very different. Hannon Westwood’s Andrew Vinall gives his view.

Northwest Europe 2016 exploration and appraisal wells

It’s a complex picture for Northwest Europe due to falling commodity prices, high development and operating costs, lack of commercial exploration success, funding shortfalls, stalled commercial activity, pending flights of capital to onshore and renewables with private equity poised to invest. Making matter worse the Brexit vote in late June sent markets into turmoil, and then, there’s the threat of strike in the UK and Norway for higher offshore wages.

Over the past year activity that was not already commissioned has largely stalled, while projects that were planned, or at the point of sanction, have either been deferred or sent back to the drawing board for redesign and cost reduction.

Despite Brent’s recent recovery from its January low, there is still a nervousness in the sector over oil prices given continuing global oversupply concerns. In the medium term, Brent may stabilize around US$60, which approximates to the average cost of production on the UK Continental Shelf and is also the point at which shale oil in the US begins to be seen as viable. This could lead to the creation of a self-regulating pricing system, but one effect could be that there will be a number of high opex fields in Northwest Europe that could be considered for early cessation of production. Until we have a period of price stability and sustained reduction in costs to give headroom for profits, we will not see reinvestment by oil and gas companies in exploration.

Exploration activity levels are a good check of a sector’s health. This is nowhere better reflected than in the UK over the past few years and more recently in Norway, the two areas where activity levels are higher than the rest of Northwest Europe.

Figures as of end June 2016. Data from Hannon Westwood.

Until the last couple of years, the issues facing the UK have been different from those in Norway, where the direct government rebate for exploration has ensured that activity levels are maintained even as success rates have fallen. But, even Norway is not immune from the downturn and this is reflected by recent figures. The hope is that reduced activity levels will lead to smarter exploration and a relative increase in success and while that may be true, there could also be a short-term hangover. Some higher risk wells will be drilled due to outstanding commitments that were made in more optimistic times and we will have to wait a while longer for the better prospects to come through.

So where do we stand? Since 2012, exploration and appraisal activity in the UK has been in continuous decline, although for the past three years it has been appraisal drilling that has shown the greatest decline, while exploration drilling remains at a relatively steady, if historically low, level.

Compare this with Norway on the other hand and we can see that, apart from 2012, when appraisal drilling pushed the activity in the UK above that of Norway, Norway has been consistently outperforming the UK in terms of overall drilling activity.

The comparison of the number of exploration and appraisal wells between the UK and Norway is notable. The UK has consistently shown a greater weighting towards appraisal than Norway. This can be attributed to several factors: the maturity of the UK; the complex, commercial uncertainty of a greater number of undeveloped discoveries than in Norway; and the desire to explore for new material reserves in Norway against a backdrop of effective government subsidy for exploration drilling, something that is not, and probably will never be, available again in the UK, other than for those few companies that can offset exploration expenditure against tax.

As a consequence of government incentives, Norway has continued to explore at a relatively high level through the start of the downturn and throughout 2015; however, fiscal prudency resulting from the key factors of high sector costs, lower profitability and restrictions on access to new capital has led to lower global exploration budgets and a consequent decrease in exploration drilling. Poor recent exploration performance in Norway is also considered to be a factor; the UK discovered more resources with significantly fewer wells in 2015, with all but one discovery being considered potentially commercial.

In 2016, it appears that Norway will be harder hit than the UK and although activity in the UK is expected to reach an all-time low with only 10 exploration and four appraisal wells likely to be drilled, this really represents only a marginal decrease from 2015 levels.

At the start of the year it was thought that the number of wells in Norway would be severely curtailed and we predicted around 29 exploration wells would be drilled over the course of 2016. Drilling over the first six months of the year showed activity levels were way below those of 2012 and consequently the predictions have been downgraded accordingly, with an expectation that now only 24 wells will be drilled, 21 of which will be exploration. Worryingly for Norway, this represents a near 50% decrease on 2015. This figure does not include Lundin’s re-entry of Neiden in the Barents Sea, which was commenced and suspended in 2015.

The UK and Norway have been the most active European provinces for a long time, with the Netherlands the third most active.

In 2015 there were 12 wells drilled in the Netherlands; nine exploration and three appraisal, though 2016 levels are already significantly below this with only two wells, one exploration, one appraisal (both offshore) drilled in the first six months. Denmark remains at very low levels with only two exploration wells drilled in 2015 and none drilled in the first six months of 2016. We expect one or two wells to be drilled in each of the Netherlands and Denmark in 2H 2016, and no wells are anticipated in the Northwest Europe provinces of Faroes, France, offshore Germany, Greenland, Iceland or Ireland.

Merger and acquisitions activity was expected to pick up in 2016 following a lull in 2015, while stresses in the system were absorbed and the industry waited for distressed companies to be revealed. While there were a large number of assets, from production through to exploration on the market in Northwest Europe in 2015 the differential expectations of value between buyer and seller were such that many assets in which there was acquisition interest could not secure sufficient sale prices to meet hold values and therefore sales did not proceed and assets were removed from the market.

Notably, there was Shell’s acquisition of BG Group that dominated global M&A, which has precipitated a $30 billion divestment program from the combined portfolio, much of which is expected to come from European assets. The acquisition by private equity group Sequa, via its Norwegian subsidiary Tellus, of a number of production and development assets from Wintershall and Total collapsed in the late stages most likely due to funding issues resulting from the fall in oil price. Company collapses in the NW Europe arena related to debt were First Oil (UK), Atlantic Petroleum (Norway, Ireland UK), Noreco (Norway, UK), PA Resources (UK, Denmark), Iona (UK). In each case, these collapses brought about divestments of various types with all but First Oil restructuring in some way that will allow the companies to continue in some form going forwards, though Atlantic Petroleum and PA Resources are no longer active in NW Europe.

The industry is waiting for prices to stabilize at or above $60/bbl, at which point investment for all but the asset poor private equity buyers, who are continuing to look for bargains in the current market, will start investing again, though it is expected that the multinationals will continue to concentrate their medium-term investment on areas that offer the highest margins and these might not include Europe. As with previous deep downturns the industry emerges fresher, leaner and potentially stronger with some changing of the old guard. There is a feeling that this time is different with long-term oversupply, the rehabilitation of Iran and the potential that US shale will act as the new swing producer and that these will moderate the future landscape so that a return to $100/bbl oil will be a long way off. But, emerge it will and a new chapter in the oil and gas industry will begin. The question is, how much of it will be in Europe?

Andrew Vinall is technical director at Hannon Westwood. He is a senior geoscientist with expertise in geological and geophysical interpretation. Vinall has extensive career experience spanning production, development, exploration and commercial aspects of the UKCS. He co-founded Hi-Grade in 2003, which was purchased by Hannon Westwood in 2005.