Examination of Witnesses (Question Numbers
100-119)
PROFESSOR ALEXANDER
KEMP
19 MARCH 2009
Q100 Sir Robert Smith: The independents
who were giving evidence to us last week were highlighting that
there may still be concerns amongst some of the new entrants and
smaller players that the terms of that negotiation are actually
quite difficult. Do you detect whether the Government should be
doing any more to make it easier for those negotiations to come
to a speedy conclusion?
Professor Kemp: There was a major
review of this a few years ago and, if my memory is right, in
2004 a new Code of Practice was brought in which was designed
to speed up the negotiation process and to give guidance on what
might be achievable. In terms of the economics, a key element
in that substantial document was to say the two parties shall
negotiate in good faith for six months and if they cannot agree
after that and if one of the parties wants to get the government
to intervene then the government would intervene and could set
a tariff and other conditions taking into account the risks and
costs of the infrastructure, and after having taken that into
account would set the tariff which could prevail in a competitive
market. That is the present arrangement. I do not think there
has been any formal intervention to date. Whether that means it
is all going very well I am not quite so sure, but clearly it
is an issue that deserves to be made efficient because it can
hold up new developments quite a lot.
Q101 Mr Weir: Just to follow that
up. One of the things the independents were suggesting is there
should be a common carrier system and they suggested the one in
the United States, particularly in the Gulf of Mexico, that was
put in place by the US Government because they feared that perhaps
the Secretary of State would not want to intervene in these negotiations.
Is that something that has been looked at that would speed up
the access to infrastructure for smaller fields?
Professor Kemp: The history in
the UK has been that it should be by negotiation between the parties
and the government would intervene as a last resort. Clearly there
are other models. For example, in Norway there is a regulated
tariff that is known to everybody and that is that. The Government
here has not wanted to go down that route. Common carrier would
be quite a major change. The present system does have flexibility
because in different parts of the UKCS there could be different
conditions, different requirements and so on, so the flexibility
is quite good. To develop a common carrier system would be extremely
complicated because we do not have an easy basis for that. We
have it onshore, of course, for the national transmission system
but that is because it is already there and established on that
basis. To do it offshore would involve a lot of complications
and whether that would be the right way to proceed I am not so
sure. My thought when in 2004 the revised Code of Practice came
out was that if the government showed that it really was willing
to intervene, and did do so when called upon, then that would
reasonably solve the problem.
Q102 Mr Anderson: Professor Kemp,
my understanding is that originally there were six or seven companies
operating in the North Sea and now there are something like 60
or 70. Has that made things more difficult or easier in terms
of regulating these companies and making sure they do the right
things?
Professor Kemp: The number of
companies certainly has grown and I think there are a lot more
than that altogether if you include the small licensees and the
Promote licences. The advantage of large numbers is that you do
have diversity because not everybody sees prospects in the same
way and there are different ideas. We do have trading of assets
because companies have different ideas of what to do with an existing
asset or a block that has not been properly explored. My view
is that larger numbers are fine because there will be more players,
large ones, medium-sized ones and small ones. At the moment with
a lot of small fields the very large players may not find some
of them very attractive because the materiality of the expected
return in relation to their size would not be very interesting,
whereas for a small company it could be perfectly interesting.
I think the large number of companies and diversity is good because
it is one factor that can help to maximise the economic recovery.
It does, of course, mean that the Department of Energy and Climate
Change has more work to do in their talking, watching and regulating
all of these companies, but that would seem to me to be very much
worthwhile doing.
Chairman: Thank you. If we can just look
at the current market conditions next. Professor, it is not easy
for anyone at the moment with the global credit crunch, downturn,
a fall in oil prices, so there are clearly implications for the
industry there and, Judy, I know you wanted to come in on this.
Q103 Judy Mallaber: Yes, if we could
explore that in some more detail. In some of your very early comments
you mentioned about the price of oil. Is the low price of oil
the single most important factor in the current market conditions
facing UKCS companies? Is that the critical factor?
Professor Kemp: The present position
is a very difficult one in the UK Continental Shelf. The price
of oil, as you will know, collapsed from $140-odd to just over
$40. What was not so well discussed was that the gas price at
the wholesale level has also come right down as well. The wholesale
price was just over 30 pence per therm this morning. That accounts
for 45% of total production. That is a big concern as well. Over
the last four or five years the costs have pretty well doubled,
or maybe more, so the cost per barrel is now very, very high and
there is a kind of pincer movement between the price coming down
and the cost per barrel going up. On top of that we have the financial
sector problems which make it very difficult for the small and
medium-sized companies to get external finance, whether debt or
equity. This has come very, very quickly but, of course, the companies
have done their budgets—they do them late in the year—so
$40 for oil is not a good outlook looking ahead and into next
year because it does not look to me as if the price is going to
come up much in the next couple of years.
Q104 Judy Mallaber: I think when
you were talking earlier you indicated that there would be a relationship
between the price of oil and the amount that would be taken out.
Does your research confirm that lower oil prices will lead to
lower rates of oil production from the Continental Shelf? I understand
you are saying that there is a link between the rising costs of
development and the price, but what prospects are there for the
long-term price of oil and how significant will it be for the
industry and how much exploitation will we get?
Professor Kemp: On the first point,
the amount of investment will certainly be linked to the price,
so if a relatively low price continues we will certainly get a
significant reduction in investment and that in turn would mean
that the economic recovery would be put in jeopardy because some
of the infrastructure that we have already mentioned might not
become sufficiently used and might have to be decommissioned.
Our modelling shows with $80 and more then in the long-term we
could recover over 22 or 23 billion barrels, but if it stays at
$60 then a fair bit less and at $40 certainly much less. There
is a link with long-term price sensitivity. My own view on the
oil price is that I fear it may stay relatively low for a while
because the world recession and reduction in world demand has
been the driver in bringing the price down and that could easily
remain the case for the next couple of years. Although eventually
it will come up, I fear it may be sometime in the future and that
is what has led me to say in my memorandum that for maximising
economic recovery from the North Sea then intervention by the
Government in the form of a tax stimulus is very appropriate now.
Q105 Judy Mallaber: What is the timeframe
between investment decisions and prices? How sensitive are investment
decisions, how long does it take for there to be a change in production
either up or down depending on the prices?
Professor Kemp: Broadly speaking,
oil companies are quite cautious in the prices they use for screening
investments. I am quite sure that none of them would have used
$100 or $140 to screen a long-term investment because we are talking
about an investment which would last, depending on how big the
field is, 20 or 25 years if it is a reasonably sized field and
ten years if it is a very small one. That is why a cautious view
is taken given the history of big fluctuations. The time between
the investment decision and getting production if it is a very
small field could be quite quick, it could be one or two years
if it is a very small one, but if it is a big one you and you
have to have a big platform constructed then we are talking about
several years.
Q106 Judy Mallaber: You mentioned
the problem about getting finance for companies in the current
credit crunch. Is there a real distinction between the impact
on large and small companies? You also indicated you thought that
the Government needed to assist. What kind of assistance would
you look for? Is that to all types of companies? What responsibility
do you think there is on the Government to give assistance to
get extra finance in for investment and exploration?
Professor Kemp: Oil companies
are affected by the knock-on effects of the financial squeeze
because that has helped to bring the oil price down so, therefore,
all companies' cash flows have come right down. The major oil
companies, despite the fall in their cash flows, will still have
funds available and could get external funds more readily than
small ones but, nevertheless, as we say, they will be rationing
their capital as well. The problem with the North Sea is with
the new projects being 20 million barrels or less, when it comes
to capital rationing they may not stand up too well against offshore
Angola, for example. For the medium and smaller companies, their
capital rationing problems will be more acute because their cash
flows are down and the financial institutions, whether debt or
equity providers, are not very enthusiastic. Their problems will
be more acute.
Q107 Judy Mallaber: So should the
Government be helping smaller companies or larger companies?
Professor Kemp: In my memorandum
I said there was a very strong case. The Treasury put out a consultation
document at the time of the Pre-Budget Report and it raised a
particular incentive for new developers called the value allowance
that would be an allowance for the supplementary charge. For new
field developments we have the corporation tax, which is 30%,
and then the supplementary charge on top of that of 20%, so the
total for a new development is 50%. They said value allowance
is on the table and my thinking is it is very important that a
reasonably sized value allowance should be implemented in the
Budget this April. If it is of a reasonable size it could make
a material difference to investment. I do not think it would stop
investment falling a bit over the next two years, but it could
certainly mitigate that and incentivise and bring forward some
projects which would be of great help not only to the oil companies
themselves but to the supply chain which is now beginning to suffer
from lack of orders and unemployment. You mentioned exploration.
Exploration will actually fall this year because a lot of that
does come out of the cash flows, nearly all of it actually, and
they are right down because of the low prices. The explorers in
the UKCS who have been most active in the last few years have
been the medium and smaller players and they are quite hard-hit.
In my memorandum I said that for those explorers who are not yet
in a tax paying position there are advantages in giving them the
same sort of reliefs as would be available to a company that was
in a tax paying position. A few years ago Norway instituted a
system like that to put the non-taxpayers on a level playing field
with existing taxpayers and in effect the government, after expenditure
on approved wells and exploration had been undertaken, would pay
a share of that cost equal to the tax rate.
Q108 Judy Mallaber: I think we are
going to come on to the tax regime in a bit more detail. On that
last point, is that why the Bank of Scotland invested in the Norwegian
Shelf recently when companies are telling us they are getting
problems in getting them to invest in companies here, or was there
another reason why they went for the Norwegian investment?
Professor Kemp: It certainly is
the case that when the Norwegians a few years ago introduced their
incentive for new players to come to the Norwegian Continental
Shelf there were small companies based here who went to Norway
and they could never have done it without that relief.
Q109 Mr Weir: Just to pick up one
point about the value allowance. You mentioned it for new fields
but it has been suggested to me that something similar is required
to help with the older fields that are coming towards the end
of their lives to make them economic to ensure the last drop of
oil, so to speak, is taken out of these fields. Is that something
you feel the Government should look at?
Professor Kemp: Yes. We did a
study two or three months ago on the mature fields that are still
subject to petroleum revenue tax. That means incremental investments
in these fields are faced with a tax take of 75% and now that
the oil price has come right down that is very high, but it is
also discriminatory. It is also clear from our studies that looking
ahead the economic recovery that we could get from the remaining
reserves to a large extent is from existing sanctioned fields
as well as from new ones. All the excitement is on the new ones,
but to increase the recovery rate from the old ones, from 45 to
50 or 50 to 55%, something like that, is a lot although it does
not get the main attention in the media because that is not as
glamorous as developing new fields. We said in our paper that
there was a case, and we modelled the potential incremental projects,
for removing the PRT altogether from these. There is a scheme
in existence where under rather special conditions the PRT could
be removed from such projects, but only where the incremental
project is clearly separated from the main field, like a satellite,
for example, of a main field. We think economically that does
not make too much sense based on the physical separation and there
is a case for applying it to all incremental investments.
Q110 Sir Robert Smith: That goes
back to the earlier point about the future in the North Sea being
small fields requiring the existing infrastructure to stay there,
so is there not quite a strong incentive and a national interest
for the Government to see ways of making those older fields more
exciting to continue in production? Surely some kind of incentive
is a bit easier than just stepping out into a new well and being
able to build incrementally on that platform? Would that kind
of tax incentive not be a double-win because it would not only
encourage extra production on the platform but would keep the
platform there as a hub?
Professor Kemp: Yes. The importance
of the infrastructure of pipelines, big processing platforms and
terminals for maximising recovery at lower cost is very clearly
a major point. The infrastructure is getting old in a lot of cases
and it has to be maintained and fit for purpose over the longer
term and, therefore, will require very considerable investment.
The best way to incentivise that is to get as much ongoing business
as possible for these pipelines, and incremental projects would
play a major role here. We did a study on that a year or two ago
which showed initially it would be the big processing platforms
that would be coming up to the end of their lives and, of course,
the host field would be near the end of its life. If you have
got a lot of small incremental projects all tied in, satellites
tied in, you could extend the life of that platform and also it
would enable investment in the pipeline to be enhanced as well.
That was a point I mentioned earlier on, namely the way to maximise
economic recovery from the North Sea is to get a very steady stream
of investment going. My worry at the moment is if it falls down
for two or more years then we could be on a slippery slope and
there will not be enough incentive to maintain the infrastructure
and then it will be too late.
Q111 Sir Robert Smith: We should
not be complacent either because of past lessons. In the past
when the price dropped there was still the attractiveness of reasonable
finds to keep that infrastructure in place, but this time around,
unless we get an incentive in there, we will not be around when
the recovery comes.
Professor Kemp: The need for incentive
is obviously stronger when the remaining fields and projects are
all relatively small. In my memorandum I did show a lot of new
fields could be brought on-stream with the value allowance even.
Q112 Sir Robert Smith: What sort
of figure do you think the value allowance should be pitched at
that achieves the double-win of maximising investment and minimising,
I suppose, the Treasury's risk-taking?
Professor Kemp: That is a difficult
one and I was a little coy coming up with one figure. What we
did was to test a range of value allowances ranging from a small
one of 12.5 million per field value allowance all the way up to
100 and for some difficult situations, like west of Shetland,
to 250 million. We found as the size of the allowance went up
then you did get more fields brought on-stream. Those fields I
termed were contributing to economic production because they were
still paying corporation tax at 30%, they were not being subsidised
or getting it tax-free. We found the numbers of fields incentivised
went all the way up and we stopped at 250. It is a difficult judgment
because clearly the Treasury has to look at what happens to its
tax revenues. On the tax revenues we found that the evidence was
a bit mixed, that sometimes the Treasury would be better off,
that it gained more than it lost, although sometimes it was the
other way around.
Q113 Sir Robert Smith: Just one final
thing I would like to look at is how the UK regime compares with
others. Obviously as a north-east MP I have had fairly strong
representations over the years that one of the downsides of the
UK regime has been constant change and uncertainty so investors
have never quite known how to do long-term planning. How in other
ways does the UK regime compare with other provinces fighting
for investment?
Professor Kemp: Around the world
we are not the toughest because the toughest ones tend to be in
countries with gigantic fields. I think the way to look at is
to relate the tax regime we have to the reserves and prospectivity
and cost per barrel. We must remember that we now are a relatively
mature province with the average size of field of 20 million barrels
of oil equivalent. Norway is a bit tougher, but their average
size of a new development is probably about 60 million barrels
of oil equivalent and they also have a number of very big ones.
They are in a rather different position. I would say that the
profitability of operations at the moment is not all that high.
Of course, it changes if you go to $100 and artificially it looks
very high for a short time and that comes out in the ONS data.
I think that is extremely misleading and does not affect the longer
term potential.
Chairman: Thank you very much. Linking
with the issues of investment and financial regime is this issue
of how you develop new fields and a lot of the industry and, indeed,
the Government are looking to the west of Shetland. There is a
wide range of issues there, not least some environmental sensitivities
and, Dave, you want to come in on this one.
Q114 Mr Anderson: Thank you, Chairman.
Professor, what exactly have we got out at the west of Shetland?
What reserves are there?
Professor Kemp: What we have at
the moment is in production we have got three substantial fields,
Foinaven, Schiehallion and Clair. We have got some others that
look promising. There have been some worthwhile discoveries on
the gas side. We have two or three significant gas discoveries,
quite large ones, and then a whole lot of small ones, over 20
altogether. The problem is to make these gas fields commercially
viable has been very, very difficult because of the very high
costs. The development costs per barrel of oil equivalent could
be 20 or way up there. There is the problem of the infrastructure.
If we want to get all these gas fields developed we do need another
substantial pipeline and that is very expensive as well. In terms
of the economics, that has been a big problem that has been studied
for quite some time. In terms of reserves to make a scheme viable,
things are looking a bit more promising there but the gas price,
the oil price, has come right down. It is a very difficult environment.
That was why we thought there was a case for giving a bigger value
allowance for projects west of Shetland because all the modelling
we have done over the last few years indicates it is extremely
difficult with present costs and prices, and even higher prices,
and the present tax regime to get a viable cluster development,
which is ideally what we would like.
Q115 Mr Anderson: What is the volume
of the reserves out there? Is it possible to estimate that?
Professor Kemp: Within a very
big range. The Department of Energy and Climate Change has some
big numbers but they are yet-to-find and quite speculative. I
do not have them in my head but they are quite big. It is acknowledged
that they are yet-to-find.
Q116 Mr Anderson: If the development
costs are $20 a barrel, what does that equate to what you pay
in the North Sea, for example?
Professor Kemp: Again, there is
a range depending on where you are based in the central North
Sea. In the southern North Sea it could be $12 or $15 per barrel
development costs and operating costs on top of that.
Q117 Mr Anderson: At the moment I
understand the oil that is being pumped out of the three fields
is going into tankers. Why could that not be continued if you
had the field further out rather than putting the pipeline in?
Professor Kemp: For the gas you
do need a new big pipeline, that is the problem, and tht is very
expensive.
Q118 Mr Anderson: What sort of pipeline
length?
Professor Kemp: Eventually the
gas will have to come to market. The kinds of schemes that are
being looked at would initially take the gas to Sullom Voe where
it would be treated, the liquid separated and then you could have
a dry gas pipeline coming down to St Fergus. That is one of the
schemes that is being looked at but, as you can imagine, that
is very expensive.
Q119 Mr Anderson: In terms of supporting
the Government, do you think that the Treasury's proposed value
allowance would help with this?
Professor Kemp: If we consider
that what is on the table at the moment is this value allowance
for the supplementary charge then if it was quite a big one for
west of Shetland, given the special difficulties and very high
costs there, it certainly could make a difference, yes. It is
a little complicated because one of the big factors which differentiate
the west of Shetland is the need for a very big joint pipeline
and the value allowance is not directly geared to that, it is
geared to the fields.
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