Oil & Gas UK Economic Report 2015

Lower Prices in Investment Appraisal The behaviour of long-dated oil futures prices provides an indication of how the recent spot price volatility has affected price expectations and how it may influence future upstream investment. Between mid-2014 and the summer of 2015, the price of Brent futures for delivery in 2018 fell from $100/bbl to $62/bbl (see Figure 3 overleaf) and the futures curve moved from backwardation to contango, where prices for forward delivery are above current spot prices. While there is a tension between near-term price falls and anticipation of a higher price in the longer term, it is undoubtedly the case that investments are being screened against much lower oil prices than have been seen for a decade or more. Over the same period, wholesale gas prices at the UK National Balancing Point (NBP) for 2018 delivery have also declined, from 59 pence/therm (p/th) (or $10/million BTU (m BTU)) to 44 p/th ($7.30/m BTU), broadly in line with the shift in forward oil-indexed term contract prices in continental Europe. Stronger Dollar Eases Impact of Lower Prices on the UK Continental Shelf TheUKContinental Shelf (UKCS), as part of the international upstream industry, is largely a US dollar-based industry. All oil revenues are dollar-denominated and gas revenues also reflect the influence of continental oil-indexed contract prices, even if the NBP-related revenues are denominated in sterling. Revenues from oil account for about 70 per cent of total UKCS operating revenues. The operating cost base also combines both dollar-denominated and local sterling-denominated elements. As so often in the past, the recent sharp decline in dollar oil prices was accompanied by a strengthening of the US dollar against other traded currencies. This mitigated the impact of lower oil prices on the terms of trade for both oil-importing and oil-exporting countries. The relative strength of the US recovery and anticipation of a tightening of monetary policy and rise in US interest rates in 2015 reinforced the rise in the dollar. Against sterling, the dollar strengthened from 1.70 in mid-2014 to 1.50 in March/April 2015 (see Figure 4 overleaf). The chronic Eurozone crisis and the anticipation of a possible exit by Greece from the Eurozone accentuated the appreciation of the US dollar against the Euro. The effect of this dollar appreciation on UKCS producers was to slightly alleviate the severe squeeze on cash flow and margins arising from the fall in oil prices. At the time of writing, the $/£ exchange rate had reverted to 1.55, within the post-recession range of 1.50-1.70.

Saudi Arabia’s crude oil production in June was reported to have reached a new record of 10.6 mb/d. Its renunciation of any role as swing supplier to the oil market has resulted in the steady build-up of inventories for six consecutive quarters in 2014 and 2015 and a diminished ability of the supply chain to continue to absorb current production. There is little doubt that Saudi Arabia will have seen the signs of a reversal of US tight oil output, the recovery in its market share in Asia and the sharp cut in upstream capital expenditure in 2015 as the first indications of the success of its new strategy. However, the impetus to cut capital and operating costs among non-OPEC producers and the incentive for other OPEC producers to maintain export volumes may ensure that the battle for market share is protracted and painful for high-cost producers. By mid-2015, Iraqi production had risen to 3.9 mb/d, the highest since 1979 and is believed to be capable of further expansion. Furthermore, in July, the conclusion of years of international negotiations over Iran’s nuclear capability is expected to lead to the partial lifting of sanctions after three years of restraint. This raises the prospect of a gradual recovery in Iranian production and exports in late 2015 and 2016 and further downward pressure on international crude prices. Demand Responds Slowly to Lower Prices The collapse in oil prices acted as a welcome stimulus to economic activity in oil-importing countries, including the UK. By dampening inflationary expectations and inducing a brief period of consumer price deflation in early 2015 in some developed economies, the fall in oil prices offered support to consumer expenditure and postponed further the long-expected tightening of US and UK monetary policy. The collapse in crude oil prices did not feed through to end-users uniformly because product prices were slower to decline and, in many parts of the world, the link between international prices and end-user prices is muted by high taxes, exchange-rate movements or government consumer subsidies. Nonetheless, a demand-side response is now emerging in the US, Europe and non-OECD Asia. After recording demand growth of 0.7 mb/d in 2014, the International Energy Agency (IEA) is now projecting an increase of 1.6 mb/d this year and 1.4 mb/d in 2016. This represents above-trend growth over the last 15 years but is still not sufficiently rapid to eliminate quickly the current stock surplus.

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ECONOMIC REPORT 2015