Flagship UK North Sea Gas Project in Doubt Over Costs

LONDON Apr 18, 2007 (Dow Jones News)

The U.K. government's flagship project for the development of remaining offshore energy resources is in doubt because of rising costs, high taxes and low gas prices, senior industry figures said.

Without action to address these issues, the oil and gas resources West of Shetland, thought to be a sixth of the U.K.'s remaining reserves, may remain untapped. As oil and gas production declines elsewhere in the North Sea, this could have profound consequences for energy security in the U.K. and the rest of Europe.

In 2006, the U.K. produced around 77.4 billion cubic meters of gas, equivalent to 16% of total consumption in the European Union. But production from existing fields is declining rapidly. The country could be 80% dependent on imported gas by 2020, most of which would come from areas of "substantial political risks", said the U.K.'s Secretary of State for Trade and Industry, Alistair Darling at a recent oil and gas conference in Aberdeen, Scotland.

"We need to get the most out of resources, which are still substantial, in the North Sea," Darling said. "The West of Shetland area is of great potential, possibly three to four billion barrels of oil equivalent, 17% of remaining reserves."

The untapped resources West of Shetland are primarily gas. "If it all came onstream by 2010-2011, by 2014 we could supply 6% of U.K. gas demand from West of Shetland," said David Mendelson, Business Development Director at French oil and gas company Total SA (TOT), which owns Laggan, the largest gas field West of Shetland.

West of Shetland is a deep water region in northern Scotland. British energy giant BP PLC (BP), U.S oil majors Chevron Corp. (CVX) and ExxonMobil Corp. (XOM), Denmark's DONG AS (DONG.YY) and Total own the rights to resources discovered there.

Many of the fields were discovered more than twenty years ago, but the remoteness of the area and the challenging conditions have so far proved too great an obstacle for development.

BP started producing oil from the Loyal-Schiehallion field in 1998 and from Clair in 2005, which have total estimated recoverable reserves of 600 million to 700 million barrels. West of Shetland's four trillion cubic feet of potential gas reserves remain completely untapped.

"Strong winds, high waves, make it very difficult to put any sort of facility in place," Mendelson said. Simply drilling wells out there is hard, he added. Most of the fields are also in 400 to 1000 meters of water, much deeper than most existing North Sea fields.

"The biggest challenge is there is no infrastructure," Mendelson said. New gas developments in the central or southern North Sea can tap into existing platforms and pipelines. West of Shetland, this will all have to be built from scratch, he said.

Given that most of the West of Shetland fields are medium-sized, it is questionable as to whether it would be economic to build new infrastructure for a single development.

Companies operating in the region, along with the U.K. Department of Trade and Industry, formed a task force last year to develop a shared solution to infrastructure developments West of Shetland. It is expected to give a preliminary report to the government in May.

Preliminary government estimates for the development of 30 production wells, around 800 kilometers of new gas pipeline and an onshore or offshore gas processing hub have a price tag of at least GBP4 billion.

But the technical challenges, coupled with high taxes, rising costs and current low gas prices may pre-empt the task force's decision.

"People have to think very much harder because there is much more uncertainty on gas prices in the next four to five years," said Mike Tholen, Economics and Commercial Director for industry group the U.K. Offshore Operators' Association, or UKOOA.

An influx of gas through new pipelines and new liquefied natural gas terminals have more than halved U.K. gas prices since the beginning of winter 2006, down to around $18 per barrel of oil equivalent.

Most industry analysts put the average cost of recovery for remaining U.K. oil and gas reserves at around $22-25 per barrel of oil equivalent and rising. Oil prices, still above $60 per barrel, have little economic relevance to an area rich in gas, not crude, industry experts said.

The cost of finding and exploiting resources has risen dramatically. The oil and gas services sector is tight on equipment and skilled labor. Rental rates for drilling rigs in the North Sea have increased up to 600% in the last three years and other costs are rising just as fast.

"Very high service costs and today's low gas prices, combined with the problem of size makes the economics of the (Laggan) project very challenging," said Mendelson.

The outlook is not entirely bleak. Geoff Gillies, a senior analyst for Europe at oil and gas industry consultancy Wood Mackenzie forecasts the U.K. gas price to be around $35 per barrel of oil equivalent from 2010 to 2015, when most of the West of Shetland projects could be coming onstream.

"Our analysis shows Laggan is currently economic at those levels," Gillies said, although it remains marginal if it cannot share infrastructure costs with other projects.

But it is unclear if smaller fields West of Shetland would work, even at higher prices, without some help from the government.

"The government may have to consider, has it got it right on the tax side?" said UKOOA's Tholen.

"I believe tax incentives should be part of the equation," said Mendelson. He would like to see the government playing a role in the development of gas infrastructure in the area by giving tax relief on the heavy upfront investment. "Effectively the government would be investing in the project by giving a tax incentive," he said.

Companies producing oil and gas from new fields on the U.K. Continental Shelf pay a tax rate of 50%, compared to a standard corporation tax of 28%.

There is a strong argument for cutting this rate, Tholen said, if that is indeed the deciding factor in whether the region is developed or not. "Getting 40% of a lot of money is better than getting 50% of damn all," he added.

Darling of the Department of Trade and Industry said: "We are very conscious of the fact that as the North Sea becomes more mature, as we go into more difficult areas like West of Shetland...we've got to make sure the tax regime is appropriate.

"We are prepared to sit down and work with the industry to make sure we have the right fiscal regime to get the most out of the North Sea," he added.

DTI spokesman Richard Shrubb said it is too early to say if tax relief will be part of the development plan for West of Shetland.

The initial development may just be the key that unlocks yet to be discovered resources in this region, Mendelson said. "If there's infrastructure in place, that will encourage more exploration. If smaller discoveries are made, that will mean there is already a route to bring it to market," he said.

"There is still a lot of oil and gas out there," said Darling.

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

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