2 The UK Oil and Gas Sector
- Since 1970, approximately 40 billion barrels of oil equivalent (boe) of oil and gas have been extracted from the UK Continental Shelf ( UKCS). Production has fallen since 2000 but between 15.5 billion and 25.0 billion boe have still to be extracted.
- Rising prices mean that the value of the remaining reserves on the UKCS has increased significantly. The US Energy Information Administration forecast that oil prices will average $105 a barrel over the next twenty years. This compares to an average price of $41 a barrel over the previous 20 years.
- Under the current constitutional settlement, tax revenues from oil and gas production on the UKCS are reserved to the UK Government. Analysis by leading academics at the University of Aberdeen estimates that around 90 per cent of total tax revenue generated in the North Sea since 1980 has occurred in Scottish waters.
- Based on current trends for production, prices and profitability, with the correct incentives there remains significant revenue to be generated from further exploration and development of the North Sea. This would suggest that there is scope for the establishment of an oil fund for Scotland.
2.1. Since the discovery of oil and gas reserves in the North Sea in the 1960s, the industry has become an important part of the Scottish and UK economies. In 2008, oil and gas was the largest single sector in the FTSE 100 Index of leading companies, and a sector where UK firms are leading global players 15. The oil and gas industry has been highly profitable and therefore generates considerable tax revenue. The majority of North Sea oil and gas production is from areas that could be classified as comprising Scotland's geographical share of the UK Continental Shelf ( UKCS).
2.2. The development of the oil and gas industry is always subject to uncertainty; for example future reserves and discoveries, future prices and costs. Notwithstanding those uncertainties, it can be said with some assurance that the sector will remain a vital part of the Scottish economy over the coming decades and will continue to make a large contribution to the public finances.
2.3. This chapter examines important aspects of the economics of the oil and gas sector including:
- oil and gas production in the North Sea, including Scotland's estimated share of UK production;
- estimated reserves of North Sea oil and gas;
- the development of world oil and gas prices;
- capital and operating costs in the oil and gas industry; and
- government revenues from oil and gas production.
Oil and Gas Production in the North Sea
2.4. Since 1970, it is estimated that approximately 40 billion boe of oil and gas have been extracted from the UKCS16. Oil production peaked at just over 1 billion boe in 1999 with gas production peaking a year later at just under 750 million boe. In 2008, oil production was 542 million boe (47 per cent lower than in 1999) while gas production was 478 boe (36 per cent below the 2000 peak). The UK is currently the nineteenth largest oil producer and the eleventh largest producer of natural gas in the world 17.
Determining Scotland's share of North Sea oil and gas
2.5. There has been considerable debate over the share of UK oil and gas production allocated to Scotland. In the UK national accounts, activities from the North Sea are allocated to a separate 'region' distinct from mainland UK referred to as 'extra-regio'.
2.6. Professor Alex Kemp and Linda Stephen from the University of Aberdeen have estimated Scotland's geographical share of oil and gas production using the principle of the median line, that is, that all points on the dividing line are the same distance from the Scottish and rest of the UK ( RUK) coastline 18. This division is consistent with the approach taken in 1999 to determine the boundary between Scotland and the rest of the UK for fishery demarcation purposes. A range of alternative methods of demarcation are possible.
2.7. Scotland's estimated geographical share of the North Sea sector according to the median line is highlighted by the dark shaded area in Figure 1.
Figure 1: UK Continental Shelf and Scottish Boundary
Source: Scottish Government Marine Directorate
2.8. Using this method of demarcation, Scotland's share of UK oil production has generally exceeded 90 per cent. In the early 1980's, when oil prices peaked, the share is estimated to have exceeded 98 per cent 19. Gas production has typically been of lower relative importance in Scottish waters, and throughout the 1980s and 1990s, the Scottish share of total gas production was estimated to be less than 50 per cent. However, Scotland's share of total UKCS gas production has increased in recent years, rising from 49 per cent in 2000 to approximately 61 per cent in 2007 20. It may also increase further in the future with the development of new gas fields in the North Sea to the west of Shetland.
2.9. For 2008, Kemp and Stephen estimate that Scotland's share of total UK oil and gas production was 95 per cent and 61 per cent respectively 21. Figure 2 illustrates the level of production in 'Scottish' oil and gas fields using the shares reported in Kemp and Stephen (2008). As illustrated, oil production in 'Scottish' fields is estimated to have fallen from almost 900 million boe in 2000 to approximately 520 million boe in 2007, a decline of around 42 per cent. Gas production has been more stable over this period with production falling from just under 370 million boe in 2000 to approximately 300 million boe in 2007, a fall of 20 per cent.
Figure 2: Scottish Geographical Share of Oil and Gas Production 2000 to 2008
Source: DECC - Oil and Gas Production and Kemp & Stephen (2008)
Estimated Reserves of North Sea Oil and Gas
2.10. As Figure 2 highlights, oil and gas production in the UKCS has declined in recent years from peak levels. However, it is estimated that significant reserves remain in the UKCS. The precise quantity of extractable reserves is subject to variation given difficulties in accurately measuring the amount of known recoverable reserves, forecasting future discoveries and assessing future economic viability. Table 1 summarises the estimates of remaining reserves in the UKCS made by Oil and Gas UK. They estimate total remaining oil and gas reserves of between 15.5 billion and 25 billion boe. This suggests that between 30-40 per cent of total UKCS oil and gas reserves (by volume) have still yet to be recovered.
2.11. Given the volatility in both commodity prices and exchange rates there is uncertainty over the long-term value of these reserves. However, based on the average price of oil and gas forecast by the US Energy Information Administration, between 2009 and 2030 these remaining reserves may have a wholesale value of between £650 billion and £1.1 trillion 22. Therefore, while the stock of remaining reserves is declining, the value is likely to increase with the possibility that the associated economic benefit may not have peaked.
Table 1: UK Continental Shelf Projected Reserves (Billion boe)
Exploration (Yet to Find)
Total Projected Reserves
Source: Oil and Gas UK (2009) - 2009 Economic Report. Results may not sum due to rounding
2.12. The UK Government Department for Energy and Climate Change ( DECC) also estimate the level of oil and gas reserves remaining in the UKCS. Their most recent estimates, published in September 2008, suggest that there is 21 billion boe remaining in UK waters with a lower and upper estimate, of 11 billion and 37 billion boe respectively 24.
2.13. It is clear, that with the correct incentive structure, there remain considerable opportunities in the North Sea. The sector will thus remain an important part of the Scottish economy over the coming decades.
Estimating Scotland's share of future reserves
2.14. Figure 3 forecasts Scotland's estimated share of UK oil and gas production between 2009 and 2013, as estimated in Kemp and Stephen (2008). Over this period, Scotland's geographical share of oil production is estimated to remain relatively fixed at approximately 96 per cent of the UKCS total, while the share of gas production is estimated to rise from 63 per cent to 67 per cent. This increase in Scotland's share of UK gas production reflects the fact that the largest decline in gas production over the coming years is expected to occur in the southern portion (i.e. non-Scottish waters) of the North Sea and the Irish Sea.
Figure 3: Scottish Estimated Geographical Share of Oil and Gas Production 2009 to 2013
Source: Kemp & Stephen (2008)
Operating Costs in the Oil and Gas Industry
2.15. In recent years, capital and operating costs per barrel of oil equivalent in the North Sea have increased and most industry experts predict this trend to continue. This is in part due to production focussing on more marginal fields where exploration is technically more difficult. It also reflects cost inflation in the oil and gas industry more widely due to increased demand for exploration equipment and a shortage of skilled labour in key areas of the industry.
2.16. Oil and Gas UK estimate that unit operating costs rose by between 10-15 per cent in 2008 to reach around $13.5 per barrel. The unit technical cost (i.e. the cost of developing and producing a single boe) for new developments in the North Sea stood at $29 per barrel in 2008, an increase of 12 per cent on the previous year 25. Higher operating costs in the North Sea are also reflected in falling levels of investment. Oil and Gas UK report that capital investment in the industry is expected to fall from £4.8 - £5 billion in 2008 to between £3.5 - £4.5 billion in 2009, emphasising the need for continued incentives to encourage investment and exploration.
2.17. Furthermore, as the North Sea industry matures operators will face costs from decommissioning existing platforms and operations in exhausted fields. Decommissioning is regulated under the 1998 Petroleum Act which makes operators and owners of North Sea facilities responsible for decommissioning disused installations. Such processes are highly complex and require significant investment. Research commissioned by Scottish Enterprise in 2008 suggests that expenditure on decommissioning in the North Sea will rise from $200 million USD in 2003-2007 to over $1.1 billion USD over the period 2008-2012 26. Kemp and Stephen (2008) estimate that decommissioning expenditures will rise to £2.2 billion in 2016 with cumulative decommissioning costs under high and low price scenarios reaching £24.6 billion and £26.5 billion respectively by 2035 (at 2008 prices) 27.
World Oil and Gas Prices
2.18. Whilst oil and gas production has declined over the past six years and costs have increased, this has been offset by an upward trend in oil and gas prices as outlined in Figures 4 and 6. Higher prices boost revenues by increasing the profitability of production.
Figure 4: Oil Prices 1977 - 2009 ( GBP and USD Per Barrel) (2008 Prices)
Source: Reuters Ecowin. Oil, Light Crude Spot ( WTI), Nymex , deflated using the OECDUKGDP Deflator
2.19. Figure 4 illustrates the price of oil since 1976 in constant 2008 prices in US Dollars and Sterling 28. Between 2001 and mid 2008, the Dollar denominated oil price followed a steep and sustained upward trend peaking at over $140 a barrel in July 2008. This upward trend in prices has been ascribed to rising demand, particularly in Asia, declining surplus capacity and geopolitical uncertainty 29. Following the onset of the global economic slowdown in the second half of 2008, oil prices fell sharply and reached a low of $33 per barrel in December 2008. Since the start of 2009 oil prices have recovered, as illustrated in Figure 5. In June 2009, prices averaged $69 a barrel, significantly above the long-term real average over the last twenty years of $41 a barrel. The depreciation of Sterling against the US Dollar has also meant that the Sterling denominated price of oil has not fallen as sharply since its peak in 2008. North Sea production is worth nearly 20 per cent more at June 2009 exchange rates than it would have been if exchange rates remained at their peak of almost $2 to the pound during the summer of 2008. As the global economy recovers prices are also expected to increase significantly. The International Energy Authority forecast that prices will average approximately $100 a barrel in real terms between 2008 and 2015 30.
Figure 5: Oil Prices 2009 ( GBP and USD Per Barrel) (2008 Prices)
Source: Reuters Ecowin. Oil, Light Crude Spot ( WTI), Nymex , deflated using the OECDUKGDP Deflator
2.20. Gas prices have followed a broadly similar trend to the price of oil - Figure 6. Gas prices remained relatively stable during the 1980s and 1990s. However since 2000 they have exhibited significant volatility especially during winter months. In December 2005, prices reached a record high of £9.50 ($16.70) per MMBTU31. Prices also increased sharply in the first half of 2008 before declining in the second half of the year. Despite these falls the Sterling denominated price in the first six months of 2009 has remained close to its long run average.
Figure 6: Gas Prices 1977 - 2009 ( GBP and USD Per MMBTU) (2008 Prices)
Source: Reuters Ecowin. Henry Hub, Spot, End of Period, deflated using the OECDUKGDP Deflator
Future oil and gas prices
2.21. Forecasting long-term oil prices is difficult due to the uncertainty of future supplies, production capacity and potential demand. This leads to a wide range of competing forecasts. Figure 7 summarises the estimates for oil prices in 2009 as a whole made by the independent forecasters tracked by HM Treasury. The estimates provided range from $47 to $74 a barrel, with most forecasts around $60.
Figure 7: Forecasts of Future Oil Prices 2009
Source: HM Treasury (2009) - Forecasts for the UK Economy, July 2009
2.22. The variability in estimates is even more pronounced when forecasting oil prices over the medium to long-term. In the industry, a frequently cited forecast is produced by the US Government's Energy Information Administration ( EIA). Their most recent forecasts, published March 2009, are shown in Figure 8. 32
Figure 8: World Oil Prices (1980 to 2030) (2007 Dollars per Barrel)
Source: EIA (2009) - Annual Energy Outlook 2009
2.23. The EIA reference case forecasts that oil prices will recover in the coming years with prices returning to $80 a barrel in real terms by 2010 and increasing to over $100 from 2013. These forecasts are based on the assumption that strong demand for oil in non OECD countries combined with constraints on the supply of low cost oil will continue to exert upward pressure on oil prices over the long-term. However, in recognition of how uncertain future oil prices are the EIA high and low price scenarios encompass a very broad range of prices as illustrated in the chart above.
2.24. The UK Government's most recent energy price forecasts were published in spring 2009. The central DECC forecast is for oil to average approximately $80 a barrel in 2008 prices over the next twenty years, this compares to a long run average price of approximately $41 a barrel over the last twenty years. Their 'high' and 'high high' cases are for average oil prices of approximately $109 and $139 a barrel respectively 33. DECC's central forecast is for natural gas prices to average 66p per therm between 2010 and 2030 with 'high' forecasts of between 89p and 110p per therm.
Government Revenues from Oil and Gas
2.25. Under the current constitutional and fiscal settlement, tax revenues from oil and gas production in the UKCS are reserved to the UK Government. The North Sea fiscal regime currently comprises of three primary elements, petroleum revenue tax ( PRT), corporation tax ( CT) and a supplementary corporation tax charge. There have been numerous changes over the years to the tax system, including the introduction and subsequent abolition of Supplementary Petroleum Duty and royalty payments. The marginal tax rate on fields approved prior to March 1993 is currently 75 per cent whilst fields approved after this date have a marginal tax rate of 50 per cent.
2.26. Since 1976-77, the UK Government has raised approximately £155 billion in direct tax revenue from oil and gas production. Adjusted for inflation, this is equivalent to over £269 billion (2008 prices). Such revenues have been used to fund UK Government expenditures and/or lower taxation. This has arguably allowed for greater public sector investment and a more competitive tax environment than would otherwise have been the case.
2.27. Figure 9 plots the level of revenue collected for the UK as a whole from the North Sea since 1980-81 in 2008-09 prices. UK Government revenue peaked in real terms at £29 billion in 1984-85 before declining in the early 1990s - largely as a result of a substantial fall in world oil prices at that time. However in recent years, tax revenues have followed an upward trend. For 2008-09, HM Treasury report that that the North Sea generated £12.9 billion in tax revenues, 70 per cent higher than in the previous year.
2.28. Using the data provided in Kemp and Stephen (1999 and 2008) it is possible to obtain an estimate of the value of North Sea revenues raised from Scotland's estimated geographical share of the UKCS - highlighted by the red line in Figure 9. It is estimated that since 1980, approximately 90 per cent of North Sea revenues are estimated to have been raised from 'Scottish fields', equivalent to approximately £230 billion in 2008 prices 34.
Figure 9: North Sea Revenues 1980-81 to 2008-09 (2008 Prices)
Source: HM Treasury & OECDUKGDP Deflators
2.29. Going forward, HM Treasury estimate that North Sea revenues will be between 0.3 per cent and 0.5 per cent of GDP per annum between 2009-10 and 2013-14 35. This is equivalent to a tax take of approximately £32 billion over the period.
2.30. Based on current trends for production, prices and profitability, it is clear that there remains significant revenue to be generated from further exploration and development of the North Sea. This Government believes that some of this windfall should be used to establish an oil fund for Scotland.