Smaller Oil Companies Fuel UK's North Sea Revival

LONDON Sep 25, 2007 (From The Wall Street Journal via Dow Jones Newswires)

Tax changes and investment incentives are transforming the landscape of Britain's North Sea -- reinvigorating Europe's second-largest oil basin after Norway and raising hopes that its long decline may slow.

The revival has taken many in the industry by surprise, because when the government in 2005 announced it would raise taxes on oil production, big international companies warned the move would discourage investments.

Two years later, the biggest oil companies are reducing their presence, but a clutch of smaller companies have moved in to fill the void. The shift in ownership suggests the government may be able to capture more revenue from high oil prices while limiting risks to its energy security needs.

This year, Royal Dutch Shell PLC, Chevron Corp. and Exxon Mobil Corp. started to offload a sizable number of their North Sea fields, much as BP PLC and ConocoPhillips did last year. As they reduced their exposure, small, independent companies such as Fairfield Energy Ltd., Oilexco Inc., Venture Production PLC and Perenco SA seized what they saw as a good opportunity. These smaller companies have leaner cost structures that make them better suited to the mature, high-tax basin, energy analysts say.

The North Sea is to the United Kingdom what the Gulf of Mexico is to the U.S. -- a province that pipes oil and gas straight into one of the world's largest economies, reducing its dependence on tight international energy markets.

The future of the basin, which in 2006 produced 2.9 million barrels of oil equivalent a day, is crucial to global energy supply. But ever since a peak in 1999, production has been in decline -- falling 10% in 2006 -- as fields slowly deplete.

Large companies have warned higher taxes could accelerate that trend and are speeding up asset-divestments programs. In August, Chevron said it was selling its interests in the Mariner and Bressay fields to Norway's Norsk Hydro ASA for a sum not disclosed, pending regulatory approval. In June, Shell and Exxon Mobil unit Esso put a string of North Sea assets up for sale and entered exclusive negotiations to offload their Dunlin fields to Fairfield Energy of the U.K.

The major oil producers aren't abandoning the North Sea altogether. The assets Shell put up for sale in June represent just 8% of its North Sea production. But Shell has said it will reduce its U.K. North Sea investment in the coming years. Like other companies, it has moved to new areas such as Norway, Qatar, West Africa or Russia to find better value.

Oil companies raised a clamor last year when the British government raised tax on oil-production profits by 10 percentage points, bringing the tax rate to 50%. The Labor government also said it wouldn't rule out further tax increases if it wins the next elections, due no later than 2010. The tax increase worsened what is already "a very high cost environment," says Tom Botts, Shell's head of exploration and production for Europe.

Smaller companies, though, see the majors' pain as an opportunity. U.K. midsize company Venture Production, which bought a smaller peer for 224 million euros ($315.5 million) last year, has said it is looking into buying the Shell and Esso assets.

The U.K. fiscal system is "the best deal in the world," says Arthur Millholland, chief executive of Oilexco, a Canadian company that is moving aggressively into the North Sea.

He pointed out that the U.K. rewards companies investing in drilling wells with a 100% tax deduction on such investment compared with 25% to 30% in the U.S. This incentive, introduced in 2002, has been gradually expanded. The 100% tax deduction was deferred from 2005 to 2006, and new investment can be used to offset part of the tax for as many as six years.

Meanwhile, a measure put into place in 2002 -- the so-called Fallow Initiative -- is also helping. The measure forces companies to divest themselves of undeveloped acreage, and has been one of the factors pushing the major oil companies to monetize some of their licenses, the consultancy Hannon Westwood notes.

The newcomers are now playing a big role in investment. According to Hannon Westwood, recent entrants, none of which are major producers, accounted for more than 50% of all drilling in search of oil or natural gas in 2006, a proportion it expects will rise this year. The consultancy said drilling in 2005 and 2006 reached its highest level since 1998, with 116 wells.

Oilexco drilled about a quarter of the wells in all of the U.K. North Sea during 2006, more than BP, Shell, Total SA, Chevron and ConocoPhillips put together, according to figures from Wood Mackenzie, an energy-consulting company. Oilexco has expanded by acquiring stakes in North Sea fields that were left undeveloped by Chevron, Italy's Eni SpA or ConocoPhillips.

The smaller companies benefit from their leaner cost structure. In particular, says Oilexco's Mr. Millholland, they employ fewer staff. "We are as professional as big oil," he says. "What we do not have is corporate bureaucracy."

A spokeswoman for Oil and Gas U.K., a British oil-industry association, disagrees that smaller companies can take better advantage of U.K. tax rules than bigger ones. "A number of factors such as rising costs, fiscal uncertainty and lower production levels is having an impact on [U.K. North Sea] competitiveness and these will affect the business decisions taken by companies no matter their size," she says.

Hannon Westwood says the ownership change will have a positive impact on oil production as acreage where no exploration is taking place is being acquired by more active players. It points out that exploration drilling in 2005 and 2006 discovered an estimated 1.2 billion barrels of oil equivalent.

Mr. Millholland says he agrees with the U.K. government's view that the incentives will help slow the rate of decline of North Sea production.

Copyright (c) 2007 Dow Jones & Company, Inc.

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