Trade and Industry Committee Inquiry into Fuel Prices November Submission by UK Offshore Operators Association

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1 Trade and Industry Committee Inquiry into Fuel Prices November 2004 Submission by UK Offshore Operators Association Introduction 1. UK Offshore Operators Association (UKOOA) represents operating companies who are licensed by government to explore for and produce oil and gas from the United Kingdom continental shelf (UKCS). Its members are responsible for over 95% of UKCS oil and gas production. 2. The response to the inquiry addresses member companies activities as gas producers and the transport of gas from offshore to the point of entry into the National Transmission System (NTS, the high pressure pipeline system which is operated by NGT). UKOOA s remit does not encompass the role of the shippers (wholesalers) of gas within the UK gas market who manage the demand for gas within the NTS, before its delivery to customers. Similarly, whilst it is able to comment on wholesale price trends, UKOOA does not have the expertise to address movements in domestic gas prices. 3. In July 2004, UKOOA commissioned a report from ILEX, a well known, independent energy consultancy to address recent changes in wholesale gas prices. It was published in October and has been supplied previously to the Trade and Industry Committee. It is also available on UKOOA s web-site: Summary 4. The following summarises UKOOA s response to the Trade and Industry Committee; further detail is provided in subsequent sections of this report which also address issues specifically raised by the inquiry. Evolving gas market The UK gas market is the most liberal in Europe. It is continuing to evolve in response to changes in supply and the forthcoming rise in imports to meet overall demand for gas Gas production from the UKCS has met the country s needs for many years and the UK has been a net exporter of gas since the mid-1990s, during which period there has been an abundant supply of gas. This gas surplus has gone and the UK is expected to become a net importer of gas again in 2005/6 Offshore production is in response to shippers nominations which are driven by market requirements to meet demand. 1

2 Current Prices UKOOA agrees with Ofgem and ILEX that three factors are driving wholesale and traded gas prices: o Linkage to the European market which provides a floor for gas prices in the UK, through oil price indexation o Uncertainty in the supply-demand balance o Market sentiment. Gas prices in the forward markets have been affected by all three factors. However, winter prices have declined sharply over the last two months after peaking in late September / early October. It is expected that long term gas prices will decline as new imports reach the UK market in about two years time, but always subject to the future price of oil and the timely completion of the import projects. Security of Supply The market has already committed investment of circa $20 billion in new production, pipelines, and Liquefied Natural Gas (LNG) to meet the longer term needs of the UK, with a further similar amount anticipated in the next few years. UK producers have routinely provided a wide range of information to National Grid Transco (NGT) to aid both long-term security of supply planning and short term management of supply and demand. This has been both enhanced and made more formal in the past 12 months Further information is also being made available to the wider market, via an agreement reached between DTI, Ofgem, NGT and UKOOA. Business Climate The industry continues to invest around 4 billion pa to develop new UK oil and gas production which will still meet the bulk of the UK s needs for the remainder of this decade. The UKCS is a mature oil and gas province; new oil and gas discoveries have halved in size and the number of fields in production has doubled over the last ten years. Much of the UK s offshore infrastructure is now over 25 years old and operating costs continue to rise in order to maintain its long-term integrity. The UK has to compete globally to attract investment to the UKCS. Investors confidence fell sharply as a result of the tax increase in 2002 and has only returned more recently on the back of higher oil prices. Against this backdrop, continued fiscal and regulatory stability are a prerequisite to sustain current rates of investment. 50% of UKCS gas production comes from joint oil and gas fields, with the economics of oil tending to dominate. Both have to be produced together to maximise oil recovery. 2

3 Evolving Gas Market - UK market most liberal in Europe and evolving quickly in response to new imports - UKCS provided for needs of the country for many years - Domestic gas surplus has gone 5. UK Gas Production: Production of gas from the UKCS began over 35 years ago (and of oil nearly 30 years ago). In 2003, approximately 100 billion m 3 of gas and 800 million barrels of oil were produced. In annual terms, the UK is a net exporter of gas (but it is an importer during the winter) and this is forecast to be the case until 2005 or 2006 when it will become a net importer again. However, on current projections, the UK is still expected to meet over 60% of its total gas requirements from indigenous production in About half of UKCS gas production comes from dry gas fields, predominantly located in the southern North Sea, and requires limited processing to meet sales specification. The term dry means that the gas exists in the reservoir without the presence of liquids (oil, condensate or gas liquids). The flow rates from these fields may be varied over the year to accommodate changes in demand, depending on the commercial terms under which the gas is sold. 7. The other half of UKCS gas production comes from oil fields in the central and northern North Sea and is mostly wet gas. Here the gas is produced together with liquids (oil, condensate or gas liquids) and requires substantial processing to meet sales specification. These are much more complicated reservoirs to operate and manage and the economics are usually dictated by the liquids. Such reservoirs prefer to be operated in constant flow conditions; this aids overall recovery of the oil and gas. 8. UK Gas Sales: It is estimated that some 75% of the gas produced is sold to wholesale buyers (known as shippers) at beach-head terminals under long term contracts, with the balance being sold under short term arrangements. Some gas sold under long and short term contracts is also traded by the buyers/shippers in the market. Certain shippers are affiliates of producers and the internal transfer pricing is subject to close scrutiny by the requirements of the tax authorities. 9. Shippers in turn sell gas to power stations, large industrial and commercial users and to suppliers who retail the gas to smaller users shops, offices, households etc. There are also traders in the wholesale markets who may be affiliates of producers or shippers / suppliers or wholly independent. 10. Contracts between a producer and a shipper will typically specify a minimum and a maximum quantity of gas which may be nominated, i.e. called for delivery, by the shipper day by day. It is the producer s responsibility to deliver the nominated quantity at the beach-head. Nominations take place ahead of delivery, being confirmed on the day before, although as demand is not exactly predictable in advance re-nomination is allowed during each day. This 3

4 nominations system is, therefore, crucial to the response of producers to variations in demand. 11. All shippers are required to balance their inputs to and outputs from the NTS over the course of a day. In case of variations in overall inputs and outputs, NGT has a role as the residual balancer of the NTS so as to maintain operating pressures within safe limits. Shippers may also be able to draw from gas which they have in store to meet their requirements. This is an essential element required to meet very high demand or in the event of a supply difficulty. 12. Gas arriving by pipeline at the beach from offshore is usually a cocktail from various different fields and is under multiple ownership. By the time it has passed through a beach-head processing terminal, the flows from several offshore pipelines will have been combined to provide an even more multioriginating and multi-owned cocktail of gas. However, in a small number of cases, flows along particular pipelines come from only a few offshore fields. Current Prices - Three factors driving wholesale and traded gas prices (as seen both by Ofgem and ILEX) Linkage to European, oil indexed markets Supply-demand balance Market sentiment - Traded prices peaked in late September / early October and have declined sharply since - Expectations are that prices will decline as new infrastructure / sources of supply come on-stream, but always subject to the price of oil and timely completion of import projects What has been the main cause behind the recent price changes? 13. In its report, ILEX identifies that the main driver behind the increase in gas prices has been the increase in oil prices. The figure below shows how UK gas prices have followed oil prices (but with seasonal variations), due to the linkage to the continental gas market, from the time the Interconnector was commissioned in late When oil prices increased from $15/barrel to $25/barrel in early 2000, a similar shift occurred in the gas market, as prices moved from below 15p/therm to 22p/therm. Recently oil prices have moved from $30/barrel to over $40/barrel, following high demand from countries such as China, combined with worries about security of supply. 4

5 Monthly Brent crude prices compared to UK gas prices Significant changes in oil price feed through to UK gas price with a 9 month lag Unlike oil prices, UK gas prices show seasonality driven by significant consumption in the winter Brent crude ($/bbl nominal) Jan-95 May-95 Brent crude (IPE month-ahead) UK NBP gas (Heren month-ahead) Sep-95 Jan-96 May-96 Sep-96 Jan-97 May-97 Sep-97 Jan-98 May-98 Sep-98 Jan-99 May-99 Sep-99 Jan-00 May-00 Sep-00 Jan-01 May-01 Sep-01 Jan-02 May-02 Sep-02 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep ILEX has identified other reasons which have affected gas prices in the UK. One is that the gas trading market has been worried that there might not be enough gas to supply the UK in the coming winter. The issue of market sentiment has often been given as the reason that prices move unexpectedly in markets. ILEX does not believe that the market is over-reacting to the risk of supply failure or excessive demand from a cold winter. Rather, the combination of high oil prices and supply concerns have meant that traders are worried about being caught short if prices increase further particularly if there is a cold winter. This could be a significant factor in explaining the rise in prices in Quarter 1, 2005 which in early October traded on the IPE at over 60 p/therm NBP gas (p/therm nominal) 15. However, forward prices have fallen sharply since then, as shown in the graph below, probably reflecting a re-assessment by the market of the likely outcome this winter. 5

6 Gas Prices in UK - May to November 2004 source: Heren NBP Within Day "Spot" Price Forward Price Qtr Forward Price Jan p/therm /05/ /05/ /05/ /05/ /06/ /06/ /06/ /06/ /06/ /07/ /07/ /07/ /07/ /08/ /08/ /08/ /08/ /08/ /09/ /09/ /09/ /09/ /10/ /10/ /10/ /10/ /11/ /11/ /11/ /11/ In the first attachment at the end of this response, there is a comparison of commercial gas prices across various markets in Europe, as recently published, showing that prices here are similar to the rest of western Europe. 17. It should also be noted that the market price of gas in energy terms is only about 2/3rds of that of oil. Security of Supply - Large, new investments in pipelines, LNG and infrastructure in hand - Helping the market work more efficiently - provision of routine information to NGT (and now wider market) 18. Security of Supply: It is estimated that the market has already committed some $20 billion in new capital to supply the future needs of the UK, with a further similar amount expected in the next few years. This investment is in the provision of new gas production and processing facilities, international pipelines and LNG plant, ships and terminals (please refer to the second attachment for a list of new import projects). This investment is important, especially when it is remembered that gas is the largest source of primary energy in the economy and fuels the generation of nearly 40% of Britain s electricity. 19. UKOOA members play a pivotal role in ensuring the UK s security of gas supply. The industry continues to invest several billions of pounds per year ( 4 billion in 2003, with the same anticipated in 2004) bringing new UKCS oil and gas reserves into production and it spends a further 4.5 billion per annum in 6

7 operations and maintenance. The rate at which additional reserves can be brought to market depends upon the available opportunities, market conditions and the stability and competitiveness of the investment climate, relative to those which apply elsewhere in the world. 20. Helping make the market work better: In the past year, through discussions facilitated by DTI and Ofgem, a number of agreements have been reached to improve the supply and timeliness of information to improve security of supply and enable the market to work better. Firstly, in November 2003, UKOOA s members agreed to standardise the information provided via the terminal operators to NGT on available gas supplies from offshore fields and on planned and unplanned maintenance shutdowns. 21. Then in March 2004, UKOOA agreed to provide NGT once again with further operational and planning information to help with its Transporting Britain s Energy (TBE) 10 year planning process. This information, which contains market sensitive data, used to be provided by our members informally, but a change to NGT s gas transporter s licence in April 2002 meant that NGT might have been forced to publish it and so participation by producers fell sharply. Now it has been restored, under agreed confidentiality arrangements, which helps NGT and benefits security of supply. 22. Furthermore, UKOOA s members also agreed with DTI and Ofgem in March that NGT should provide four categories of information about flows into the NTS to the wider market in an aggregated form. Category 1: physical flows, close to real time Category 2: forecast flows, ahead of and hourly through the day Category 3: deliverability of gas, reflecting planned maintenance Category 4: sub-terminal after-the-day flows. 23. Categories 3 and 4 are now available on NGT s website and NGT anticipates that categories 1 and 2 will become available in third and first quarters of 2005, respectively. UKOOA is keen to see the timely completion of the work required to publish all the information outlined above. This will improve the supply of information for all market participants. 7

8 Business Climate new developments much smaller as the UKCS matures, but still new opportunities to be had continued fiscal and regulatory stability needed to sustain investment infrastructure is ageing, so needs to be exploited before being decommissioned drive to maximise production, the more so given that half UK gas production comes from oil related fields 24. The Business Climate: The development of Britain s oil and gas reserves has reached a mature phase, production of oil having peaked in 1999 and of gas in Unit costs of production are rising in what is already one of the most expensive oil and gas provinces in the world (ref. Wood Mackenzie). Investors confidence is crucial to the successful exploitation of the remaining reserves and the industry looks to government to provide fiscal and regulatory stability to underpin its investment intentions which amount to some 4 billion in Allied to this is the need to exploit the existing infrastructure of platforms, pipelines and terminals, before they are decommissioned. After that, the opportunity for development of today s small fields will be much reduced. 25. Following the unexpected tax increase which occurred in 2002, investors confidence is now returning on the back of higher oil prices; there is more activity on the UKCS generally and, in particular, there is more drilling a key indicator with fewer rigs laid up and rising rates for the hire of drilling rigs. 26. On the regulatory front, though, the pressure is relentless: EU Emissions Trading Scheme, new Chemicals Regulations (UK and EU), Oil in Produced Water (OSPAR), Large Combustion Plant Directive (EU) and the Working Time Directive (EU), to name some topical current or recent ones. Implementation of all of these is not without its cost and resource implications. 27. UKOOA firmly believes that it is not only in its members interests, but also in the UK s, if new investment is encouraged so that: maximum recovery of oil and gas reserves is achieved new technology is thereby developed and supported in the UK the increase in exports of oil and gas goods and services is sustained more jobs are created than would otherwise be the case tax revenues flow as a result of all of the above balance of payments continues to benefit. These are, in essence, many of the objectives of PILOT, the government - oil and gas industry forum. 8

9 Additional Questions raised by the Committee (where not answered above) 1. Does UKOOA have any comments on either Ofgem s or ILEX s reports regarding: i) the accuracy of the data? ii) strengths and weaknesses of the messages? i) The Accuracy of Data. 28. To the best of our knowledge, we believe that the data in both reports are sound. We do not, though, have ready access to some of the detailed information presented and so have to rely on the expertise of both Ofgem and ILEX. On one point, however, we are unable to agree fully with Ofgem; this concerns some legacy contracts. In the press release accompanying its report, Ofgem has said with regard to these contracts that. at times of high prices, around five per cent of UK gas supplies were physically available, but did not reach the market. whereas, on page 19 of its report, figure 2.1a shows that only one per cent was contractually unavailable. We suggest that this discrepancy requires some explanation. ii) Strengths and Weaknesses of the Messages. 29. Both reports agreed that the historic linking of gas and oil prices in continental Europe is a major factor, together with supply-demand considerations particularly during the coming two winters. Market sentiment then adds to these two underlying causes of high prices. Neither report any found evidence of market manipulation. 30. It seems to us that an important element of ILEX s analysis has not been fully appreciated. Quoting from the summary of the report: The [European] oil indexed gas contract prices set the floor for UK gas prices assuming that the Interconnector is not full. The seasonal variation in UK supply-demand will then influence the oil indexed price in winter prices may be much higher as we see in the forward curve. Q1 05 prices are now over 50 p/therm. The ILEX model suggests that gas prices for Q1 05 should be around 45 p/therm. It is the significance of the words about the Interconnector which may have been overlooked, because when the Interconnector is full (or shut) prices in the two markets, Europe and UK, will diverge see sections 2.9 to 2.12 and figures 11, 12 and 13 of ILEX s report. 31. Given that last winter, for the first time ever, the Interconnector flowed in maximum import mode for several weeks, it would appear that the market is assuming that the same will happen again during the coming two winters, in which case supply-demand considerations and associated market sentiment are tending to push UK forward prices above continental ones, in significant part because of an expected capacity constraint imposed by a full Interconnector. 32. On a separate matter, Ofgem and ILEX seem to disagree, namely whether liberalisation of markets in Europe will break the oil-gas price link. Ofgem thinks that it should, whereas ILEX is doubtful whether it actually will, citing evidence 9

10 from the USA. UKOOA is not sure one way or the other; however, we do think that oil is likely to remain the most powerful energy price indicator worldwide for several decades to come. 33. ILEX comments interestingly on the lack of a truly speculative trader willing to go short and exert downward pressure on prices. It suggests that traders have been worried about being caught short if prices were to rise further, particularly if there is a cold winter. 34. Since both reports were published, the forward market has fallen from its heights in early October, as noted above in the section titled Current Prices. 2. From UKOOA s viewpoint, what are the issues surrounding reserves i) How much is there out there ii) How easy to bring on stream faster iii) Are reserves / production market driven i) How much is there out there 35. The UK remains a world class oil and gas province; it currently ranks as the fourth largest producer of gas and the eleventh largest producer of oil. 36. At the beginning of 2004, the UK had produced 1800 billion m 3 of gas from the continental shelf and had remaining proven and probable gas reserves of around 900 billion m 3. When exploration potential is included, the remaining opportunity is projected to rise to over 1250 billion m 3 of gas which is the equivalent of 12 years of production at current rates. 37. Much of the UK s future gas production will continue to come from joint oil and gas fields. As previously noted, the UKCS is a mature oil and gas province; new discoveries have halved in size and the number of fields in production has doubled over the last ten years. Substantial parts of the UK s offshore infrastructure are over 25 years old and operating costs continue to rise, in part reflecting the need to maintain the infrastructure s long-term integrity. 38. Continued exploration for new fields is extremely important in order to maximise recovery of the UK s hydrocarbon resources. Exploration remains a high risk activity in the UKCS; new finds are typically million barrels in size and technically difficult to develop. Typically, only 1 in 4 exploration wells is successful and most new finds need further appraisal drilling before they can be developed. 39. In 2001 the UK s offshore oil and gas industry drilled 60 exploration and appraisal wells. Following the introduction of the supplementary charge to Corporation Tax, which added 33% to the industry s Corporation Tax rate, 2002 saw the number of wells fall to 42, a drop of 30%. This occurred during a period when the oil and gas industry had the opportunity to invest in previously inaccessible regions of the world, regions that were beginning to reveal large discoveries of oil and gas at much lower costs than those pertaining to the UK. 10

11 40. The uncertainty and instability of 2002 continued into 2003 and activity reflected budgets which were created during and soon after the events of Budgets for 2004 were made in a more positive environment. The shocks of 2002 were 18 months in the past, relationships with government, and Treasury in particular, were more positive and focused on the future, whilst the oil price continued to remain strong. Against this backdrop, exploration and appraisal drilling activity has recovered in 2004 to where it was in 2001, some 30% above 2003, and early indications for 2005 are that a further increase is possible. ii) How easy is it to bring new developments on stream faster? 41. The industry is continuing to work with Government to maximise recovery of UKCS reserves and to create a business environment which encourages new investment in the UK rather than in other oil and gas provinces. 42. Production from existing oil and gas fields is declining at about 15% per annum. By sustaining investment of 4 billion per annum in exploration and new developments, the industry is reducing the rate of decline to about 7% per annum. It should also be remembered that investment is not driven by short term oil prices, as new developments take 2-5 years to bring on stream and will be in production for, typically, a further 10 or 20 years. These rates of decline are to be expected in a mature oil and gas province and have been evident for several years in UKOOA s annual projections. 43. As the basin matures, it is becoming harder to maintain the current investment rate, let alone increase the pace of developments. However, there are some signs of an increase in activity in the UKCS. Hire rates for drilling rigs, a key indicator, have doubled over the last two years and the availability of drilling rigs is becoming an issue. This year five drilling rigs have been brought back into service and rigs that had left are returning to work in the basin. 44. Ready access to offshore infrastructure to bring the gas ashore is also fundamental to developing many of the new fields in the UKCS, otherwise they are not economic. This year saw the launch of a new Code of Practice to ensure equitable and timely access to infrastructure, particularly for new entrants. It was launched on 15 September and is ground breaking in the sense that it provides for greater transparency and speed, encourages good commercial behaviour and should help extend life of the UKCS. All UKOOA members have signed the new CoP and non-operators are rapidly doing so. iii) Are reserves / production market driven 45. This question addresses two separate issues, firstly what drives the development of new fields/reserves and secondly what drives production from fields once they have been developed. As outlined above, the development of new fields is a long-term process and depends on a long-term view of gas (and oil) prices. Fiscal and regulatory stability encourage investors to take a positive, long term view. 11

12 46. The rate of development of new fields will also depend on other market factors than just gas price. There are a finite number of new fields in the UKCS and new developments need to be initiated at a rate which ensures a long term and sustainable future for the industry. In considerable part, this will be determined not only by budgetary requirements, but by resource restraints, both human and equipment. 47. The rate of gas production depends in part on the type of oil or gas reservoir. Where oil and gas are produced together from the one reservoir, reservoir management and the economics of oil production encourage constant rates of production. Where the reservoir only contains gas, without any oil or other liquid hydrocarbons, production is more able to be varied to accommodate changes in demand. In all cases, gas production has to be nominated by the shipper to enter the NTS. 48. Production is ultimately dictated by market demand and the specific commercial arrangements which will vary for each of the co-venturers in any field. The UK market is both large enough and liquid enough to accommodate the various patterns of production from both wet and dry gas reservoirs. UKOOA November 2004 Attachments: 1. Gas Prices in Europe, July and October New Import Projects bringing gas to the UK 12

13 Gas Prices in Europe Ref: European Gas markets (Heren), 16th November SmallFirm Medium Firm Large Firm Small Interruptible Medium Firm Large Interruptible Small Medium Large Small Medium Large Small Medium Large Small Medium Large Small Firm Medium Firm Large Firm Small Firm Medium Firm Large Firm Small Medium Large Source: Energy Advice Small = 1 million m3 / year Medium = 10 million m3 / year Large = 50 million m3 / year July 04 Oct 04 Austria Belgium Denmark France Germany Great Britain Italy Netherlands Spain Gas price ceur/kwh and exclude taxes

14 TOTALS Name of Project Langeled Pipeline (Ormen Lange - Easington) Bacton Interconnector* Upgrading BBL Pipeline (Netherlands Bacton) Isle of Grain LNG Qatar Petroleum / ExxonMobil LNG (Milford Haven) Petroplus LNG (Milford Haven) New Import Projects Target Date(s) 2006 & 2007 Phase Phase Phase Phase Phase Phase Phase Phase Phase Capacity (bcm/year) ** * Existing import capacity of Interconnector = 8.5 bcm/year ** Current demand in the UK is 100+ bcm/year 14

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