Select Committee on Trade and Industry Written Evidence


APPENDIX 30

Supplementary memorandum by the UK Offshore Operators Association

  This supplementary information from UK Offshore Operators Association (UKOOA) responds to requests and comments made by the Trade and Industry Committee during the recent hearing held at the House of Commons. It addresses the following:

    —    market competitiveness;

    —    oil price movements over the last decade;

    —    the relationship between oil and gas prices; and

    —    the likely impact of a windfall tax.

COMPETITIVENESS OF THE UK WHOLESALE GAS MARKET

    —    Over the course of the inquiry, the competitiveness of the UK gas market has been questioned by various parties. UKOOA's members are responsible for the exploration for and production of gas offshore and its delivery to Transco's National Transmission System for wholesale in the markets. UKOOA's remit does not extend into the downstream aspects of the gas supply market.

    —    UKOOA has 31 member companies and there are more than 20 non-operators who share ownership in offshore production. Typically, gas (and oil) fields in the UKCS are jointly owned by several companies. Whilst one company is responsible for operating the field, each company sells its share of gas (and oil) production separately, via individual sales contracts.

    —    Over the last five years there has been a steady increase in the number of new operators in the UKCS who are gradually acquiring producing assets from many of the traditional operators. These new entrants include Tullow, Caledonia, Gaz de France, Apache, Nexen, Paladin, RWE Dea and Perenco. This transfer of assets to new operators will continue to promote a yet more commercially competitive environment in both gas and oil.

    —    At UKOOA's request, ILEX has made an independent assessment of the competitiveness of gas production in the UK by calculating the Hirschmann-Herfindahl Index (HHI), a commonly used measure of the degree of concentration in any sector or industry.

    —    ILEX concluded that 15 offshore producers in 2003 accounted for 92% of total UK gas production, with the top five accounting for 58%. They calculated an HHI for the sector in 2003 of 866, indicating a highly competitive market. [46]ILEX also noted that this had improved slightly compared with 2002, when the HHI was 950. These figures compare, for example, with those for mobile phone networks and power generation of 759 and 936 respectively (using the most recent figures we could identify for these two industries).

    —    UKOOA expects that the supply of gas will become even more competitive as new imports of LNG and pipeline gas begin to feed the market alongside indigenous gas, thereby enhancing both the diversity and security of supply. This new and expanded infrastructure will increase the connectivity between the UK, European and world gas markets, expanding the size and liquidity of the overall market.

RELATIONSHIP BETWEEN GAS PRICES AND OIL PRICES

    —    In its previous written submission, UKOOA agreed with Ofgem and ILEX that the fundamental driver behind increasing gas prices had been the increase in oil price, because of the linkage to the oil-indexed continental gas market from the time when the Interconnector was commissioned in late 1998.

    —    On top of that underlying effect, there were uncertainties about the UK's supply-demand balance during this winter and next, and market sentiment was reflecting that.

    —    It has been questioned whether gas prices demonstrate a stronger linkage to prices of crude oil or oil products (Gasoil and Low Sulphur Fuel Oil (LSFO)). As a result, UKOOA has asked ILEX to examine the correlations between the various prices.

    —    ILEX has reviewed data between 1997 and 2004 to establish trends. They have found that oil product prices in Europe follow crude oil prices very closely: for Gasoil the correlation is 0.98 and for LSFO 0.91, although the link between crude oil and LSFO weakened in 2004, perhaps as a result of tighter environmental regulations reducing demand for LSFO. [47]

    —    Changes in gas prices tend to lag behind changes in oil prices by a few months owing to the way in which long-term continental gas contracts are indexed, typically to 50% Gasoil + 50% LSFO. Allowing for the time lag, ILEX has found that gas prices measured in US$ have shown a correlation to 50% Gasoil + 50% LSFO, between Q1 1997 and Q3 2004, of:

      —  0.91 in Europe (a very high correlation); and

      —  0.77 in UK (a high correlation).

    —    Over the same period, UK and European gas prices measured in Euros have shown a correlation to one another of 0.82 (still high), even though this includes summers when the Interconnector was flowing at maximum export capacity, thus reducing the correlation. [48]

    —    Over the same period, the UK gas price in sterling terms continues to show a correlation of 0.77 to 50% Gasoil + 50% LSFO (in US$) and of 0.80 to European gas (in Euros), again high figures.

OIL PRICE MOVEMENT OVER THE PAST DECADE



    —    The two graphs show oil price movements since 1990 in $/barrel and £/barrel and the $:£ exchange rate, prices in the left hand graph being in money of the day and in the right hand graph in 2004 money, ie adjusted to take account of inflation.

    —    US Dollar and Sterling oil prices have been volatile over the period, reflecting a pattern of uncertainty that has been acknowledged since the early 1970s. When the impact of inflation is allowed for (right hand graph), the change in oil prices since the mid-1990s is much less pronounced. This is even more the case when considering the Sterling price of oil which has remained fairly constant over this period, particularly when inflation is taken into account.

    —    Exchange rate fluctuations have, therefore, had a significant impact. This has been demonstrated most recently in 2004 with the Sterling price of oil rising 30% less than its Dollar equivalent. In this context, it should be noted that UKCS costs are mainly (approximately 80%) in Sterling.

UPDATED EUROPEAN GAS PRICES

    —    We have updated the chart of gas prices in various countries in Europe which we included with our original, written evidence. It now includes January 2005 prices and continues to show that for small, medium and large industrial and commercial users the UK remains among the lowest cost countries for gas in the EU. One point of interest, for which we do not have an explanation, is that Germany is the most expensive country for small and medium users, but the cheapest for large users. This updated chart is attached at the end.

GAS PRICE MOVEMENTS

    —    Producers totally refute any allegations of collusion or market manipulation which is both illegal and subject to severe penalties. No evidence of such behaviour has ever been found in various enquiries, investigations and a public consultation over the past four years by Ofgem, the European Commission (regarding the Interconnector) and the DTI.

    —    In recent evidence to the European Parliament, RWE Npower's director of UK markets was reported as stating that "Liberalised markets will have high volatility" and that predictions of a cold winter and potential shortages had caused suppliers to buy enough to ensure that their customers would not be affected (a comment which is consistent with ILEX's analysis). He added that he had not detected any collusion on the part of upstream producers: "As a gas buyer, I have found them falling over themselves to compete to sell me gas—and that doesn't sound like collusion." (Ref UK Gas Report, 7 February 2005).

    —    UKOOA remains convinced that the forward price of gas for this winter, during the summer and early autumn of 2004, was driven by three main factors:

      —  the price of oil, through indexation of gas prices in continental Europe;

      —  concerns about the supply-demand balance in the UK; and

      —  market sentiment.

  In this, we are in agreement with Ofgem and ILEX. However, the out-turn this winter has been benign, because of very mild weather and a good supply—spot prices have been around 30 p/therm.

    —     Nonetheless, it should not be forgotten that last winter two events showed the significance of a tight supply-demand balance and market sentiment:

      —  in late January 2004, the Rough storage field suffered a technical failure at a time when very cold weather was forecast, with the result that the spot price of gas jumped to 80-100 p/therm within a day;

      —  the Interconnector flowed at full import capacity (ie gas flowing into Britain) for several consecutive weeks which had never happened before (when it is full, or shut, the link between the two markets ceases and prices will move apart); it seems to UKOOA, as we stated in paragraph 31 of our original submission, that the market was expecting the same to happen again this winter—a reasonable assumption given a slow decline in UKCS supply and none of the new import projects being onstream—and, therefore, forward prices were pushed upwards above continental ones, in significant part because of a capacity constraint imposed by a full Interconnector; this significant point about the role of the Interconnector seems to UKOOA to have been missed by many who have commented on the market's behaviour.

    —    There are a number of new projects in hand which will bring large quantities of gas supplies to the UK within the next few years. Indeed, the earliest of these will be complete by the end of 2005 which should help next winter's supply. We have updated the table (attached) which was with our original submission, with some corrections and revised timings. Overall volumes of gas remain the same, though.

    —    While UKOOA believes that the market has generally been working and evolving well, it is worth considering whether it has signalled the need for these new projects in as timely a manner as is required to meet the UK's needs, given the long lead times inevitably involved. If, for example, one or two of the earlier projects had been 12-18 months ahead of their current timings, it is much less likely that we would have seen the type of prices which occurred in the forward markets during the summer and early autumn of 2004.

CORRECTION: "DRY" GAS V "ASSOCIATED" GAS

    —    With regard to our oral evidence, at the top of page 63, and our letter of 7 February, we must apologise for creating confusion regarding the proportion of gas which is "dry", or is "associated" with oil or natural gas liquids. We have now done a thorough check and the correct figures are 45% dry and 55% associated (the error in our letter arose because the 30% given only took account of dry gas in the southern North Sea).

IMPACT OF ANY WINDFALL TAX ON INVESTMENT

    —    UKOOA would like to close by reflecting on the very public discussion regarding the potential imposition of a windfall tax on the industry. Recent experience has shown that the increase in taxation in 2002, with a 10% supplementary charge on Corporation Tax (SCT), did much to damage investors' confidence.

    —    It is also clear that the industry and Government have benefited from higher revenues during this past year, just as both suffered in 1998-99. We believe that our industry's role is to run profitable, efficient, long term businesses that can attract investment capital from around the world, ensuring the production of secure and reliable sources of energy for the nation, providing the infrastructure to facilitate imports of energy as that becomes necessary and creating wealth for society and our members' shareholders which include many people's pension funds.

    —    The UKCS is a mature oil and gas province, struggling to remain competitive in the face of rising costs and declining reserves. Most, if not all, of the large discoveries have been made; the average size of each new field has fallen from several hundred million barrels of oil (and/or its gas equivalent) to around 25 million.

    —    From the late 1990s, the number of development wells drilled had been falling steadily, with exploration and appraisal (E&A) drilling exhibiting similar trends; neither of these was improved by the imposition of SCT. By the end of 2003, the number of drilling rigs stacked and reduced activity within the supply chain demonstrated the size of the challenge which the industry was facing.

    —    Through the combined efforts of industry and Government, investors' confidence is now gradually returning to the UKCS and positive results are beginning to be seen. The most recent activity survey by UKOOA confirms, for the first time in four years, an improvement in the production outlook, accompanying a trend of rising investment which is estimated to increase by 10% to £3.8 billion in 2005. Furthermore, a 30% increase in E&A expenditure, rising to £0.6 billion, is anticipated this year.

    —    Our capital expenditure makes us the largest industrial investor in the UK. In recent years, the industry has consistently accounted for 17-20% of total industrial investment per annum.

    —    Set against all of this, global competitiveness remains the over-riding issue. Operating costs are up by over £0.5 billion per year, equivalent to an increase of 15% per barrel of production, and are on a rising trend. Research by energy consultants, Wood Mackenzie, has shown the difficulties for the UK in remaining competitive in new E&A opportunities when compared with other oil and gas provinces worldwide, where the potential rewards are much larger.

    —    Investors already face substantial geological and technical risks in the UKCS, not to mention the many regulatory requirements imposed in recent years. Most of the new entrants are much more mobile than traditional oil and gas companies. A windfall tax would further raise the risk of doing business, reduce investment and recovery of reserves, hasten import dependency, cost thousands of jobs and, ultimately, diminish the Treasury's revenue.

UKOOA

February 2005


New Import Projects
Name of Project Target Date(s)Capacity (bcm/year)
Langeled Pipeline
(Ormen Lange)
2006 and 200723
Bacton Interconnector*
Upgrading
Phase 1 2005-06 Phase 2 2006-07   8   8
BBL Pipeline
2006-07 10-15    
Isle of Grain LNGPhase 1 2005
Phase 2 2008
  4 10
Qatar Petroleum/ExxonMobil LNG (Milford Haven) Phase 1 2007-08
Phase 2 2009-10
10 10
Petroplus LNG
(Milford Haven)
Phase 1 2007
Phase 2 2010-12
  6   6
Totals61-100**  
*  Existing import capacity of Interconnector = 8.5 bcm/year.
**  Current demand in the UK is 100+ bcm/year.
Revised February 2005—amendments underlined in red.










46   The Hirschmann-Herfindahl Index (HHI) is a commonly used index to measure the degree of concentration in any sector or industry. An HH Index below 1,000 is generally taken as an indication that a market is relatively un-concentrated (very competitive). An HHI between 1,000 and 1,800 is considered moderately concentrated, while and index greater than 1,800 is generally considered highly concentrated. Back

47   A correlation of 1 implies a perfect relationship between variables and a value of zero indicates no relationship. Back

48   European and UK gas prices will diverge from one another when the Interconnector is either full or shut. "Exports" through the Interconnector are from UK to Europe and "imports" vice versaBack


 
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