Over the past five years, the wealth creation in the Scottish north-east has been conspicuous. This said, the UK is facing a crisis due to reduced production and major cost increases which is simply killing the industry.
During 2013, the cost of producing a barrel was an incredible 30% higher than the previous year. While cost increase has been nothing new, in the past the increase in commodity price has helped to offset the pain and maintain economics.
This time, however, it’s unlikely that material and more importantly sustainable oil price increases will occur to better economics. Political troubles in Iraq and wider Middle East uncertainties may put some upward pressure on short-term pricing, however the fundamentals don’t really support higher pricing from current levels.
Anyone arriving into Aberdeen Airport and travelling into the town centre for the first time in a couple of years will be instantly struck by the number of new hotels and industrial space that surrounds the immediate area.
The commercial landscape of Aberdeen and its shire has changed quite markedly of late, witness the huge number of new office complexes in Westhill, the town centre and other districts, coupled with significant hotel room additions.
Shortages of commercial space due to the current North Sea and global boom has put significant pressure on local infrastructure.
Recent additions seem to be well balanced with demand for now as both hotel and commercial property rates are still among the highest in the UK.
The activity increases and economic impact has been noticeable across the jobs market and residential housing as well.
Average salaries in the energy sector are roughly twice that of other industries for comparable roles and unemployment stands at only 1.5% in the city – arguably the natural level. The north-east has seen house price increases 120% in the past 10 years, the highest in the UK, including London.
Underpinning this impressive economic development is the activity and spending growth in the oil and gas sector. Globally, it has grown significantly, with some £14.4billion spent on the UK North Sea last year, supporting 240,000 direct and 100,000 indirect jobs, of which around 45% are in Scotland . . . with most in the north-east.
The question, however, is, has the Aberdeen City & Shire economy peaked?
Sadly, I think it has.
The next two to three years will see a huge readjustment in the economic fortunes of the area as significant reductions in investment materially impact demand for jobs, housing, commercial space and services at a time when additional capacity has come to the market.
Pricing will need to adjust and will come down, to what extent I don’t know but it could be material.
According to Oil & Gas UK, each £1billion spent in Britain has a direct influence on 15,000 to 20,000 jobs. Run some simple numbers and take the forecast of a potential reduction of £7.4billion in investment in the next three years then the direct impact is a potential 49,000 jobs across the UK. While specific demographics are unknown it is estimated that around 45% of roles are in Scotland and the majority of these are in the Aberdeen area.
This equates to around £3.2billion on wages and salaries which have the potential to be wiped from the economy, not considering the impact on indirect workers in support services that rely on the oil and gas sector.
What is fuelling much of the current dynamism is a small number of very large projects on the UKCS. But the capacity additions are happening at a time when demand is set to drop.
Large projects like Quad 204 and Laggan-Tormore are uncommon and, last year, about 25% of all expenditure could be linked to just four fields.
When we look to the pipeline of sanctioned projects and future potential opportunities, it is hard to see the multibillion-pound investments needed to support current prices supply infrastructure and capacity.
But surely exploration will continue and we will find more large projects to invest in? Not so, as the latest DECC UK Energy Sector Statistical report indicates.
Q1 exploration activity this year was materially lower than the historical average and there is little sign of this reversing. The majors that dominate production and own many of the licences in the UKCS are focused either on cutting investment to return more capital to shareholders, or actually looking to exit the UK region by selling on assets to other companies.
Indeed the mergers and acquisitions market for UK exploration and production assets is at its highest ever.
Of course, potential transfer of ownership could have a beneficial impact as smaller, or more focused companies come into the market and seek to invest in newly acquired assets as we have seen in the past.
Reality is that there are far more sellers than buyers in today’s market.
Many older assets, though producing still carry significant liabilities in way of decommissioning exposure. The net effect is that numerous offshore fields have limited net values and potential financial risk when operational, cost and production uncertainties are considered.
So where does this leave us? Simply put, it means that we are entering a period of reduced investment coupled with cost reduction.
This has started. Wood Group PSN recently announced a 10% reduction in contractor fees and Shell has revealed that a reorganisation is imminent.
And similar reviews are under way at many of the operating and large service companies in the UK, with cost and headcount reductions in the pipeline.
Of course, the industry is its own worst enemy. Most firms have known about the skills shortage across the sector for a while but, as opposed to investing in training and development of new blood, many chose to attract staff from competitors, offering higher wages and fatter packages. This only led to hyper-inflation.
Allied to this is the contractor model that seems to dominate engineering employment. As opposed to hiring individuals as staff many firms choose to hire them as contractors.
This in turn makes the “dayrate” the primary motivator which in a buoyant market leads to cost inflation and lack of continuity of knowledge as personnel move from contract to contract.
While the Wood Report provides focused guidance on the interventions required for the UKCS to fully prosper, one can’t help but notice that there are only two stakeholders that need to change – the Government and the E&P community.
The missing group is the oil service and engineering contractors whose business model and practices have in part created operational inefficiency, cost increases and contributed to the deteriorating economics and prospectively of the basin.
As we enter a period of reduced investment, I don’t think this is a bad thing. However, the sector and the region really need to rebalance and curtail inflation and inefficiency to prosper in the longer term.
Even with some of the material adjustments that are coming, the UK will still have a significant oil and gas industry and therefore investment opportunity. We just need to recognise that the unsustainable boom that Aberdeen City and the Shire has experienced is fast coming to an end.
Andrew Reid is the Aberdeen-based managing director of energy consultant Douglas-Westwood
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