If you thought it was all over for North Sea oil, it’s time to think again. Profits will flow soon for smart investors, says James McKeigue. Here, he reveals the best shares to buy now.
At 9.40am on 2 March this year, the oil platform’s alarm sounded. Soon helicopters were being scrambled to airlift workers to safety. For the second time this year, an oil leak at the ageing Cormorant Alpha platform in the North Sea was causing havoc. Eventually, the problem was contained, but the damage had been done.
It was a big blow for Taqa, the Abu Dhabi energy firm that owns the platform. Another leak meant lost production and lots of difficult questions about its safety procedures. But it wasn’t the only loser. The platform is also an important pumping station for the giant Brent pipeline system, so when it shut down it stopped oil from other platforms getting to shore.
In total, around 10% of Britain’s oil and gas production was knocked offline by the leak. That hits both Britain’s terms of trade – as more energy has to be imported to make up the shortfall – and government tax revenue, neither of which are particularly robust at the moment.
The leak was also bad for North Sea energy production in general. Indeed, on the face of it, it seems like another sign of its irreversible decline. Much of its oil and gas infrastructure was built in the 1970s and is now starting to show its age. Many of the North Sea’s major fields are also past their best too. After yielding billions of barrels of oil in the 1980s and 1990s, production is now in freefall as reservoirs dry up.
The sense of decline is backed up by the statistics. Britain went from exporting to importing gas in 2004 and oil in 2005. Combined production has fallen from four million barrels of oil equivalent per day (MMboe/d) in 1999 to 1.55 MMboe/d in 2012. Moreover, the fall has accelerated in recent years, with the sector contracting by 30% in the last three years alone.
Given all of the above, investors would be forgiven for ignoring the North Sea and looking for companies active in more exciting oil regions. But that would be a mistake, as there are signs that the North Sea is starting to enjoy a revival.
Last year, investment in the British part of the North Sea reached a generational high of £11bn. That looks set to be topped in 2013, with a record £13bn of investments on the cards.
It’s estimated that these extra projects will help lift production back up to two MMboe/d by 2017. That would provide a welcome boost to the British economy and throw up interesting opportunities for investors.
New opportunities in the North Sea
The first misconception to correct is the notion that Britain is running out of oil and gas. It’s believed that with current oil prices and technology, the UK continental shelf (UKCS), which covers all of Britain’s offshore, including the North Sea, could have up to 24 billion boe, according to the the government’s Department of Energy & Climate Change. Given that so far the UKCS has yielded 30 billion boe, that’s a sizeable amount.
However, there’s no doubt that the type of opportunities available have changed. In the early years oil firms understandably went for the large deposits of easily available high-quality oil.
As a result, the North Sea is now left with depleted large fields (as a reservoir empties it becomes more difficult to extract the oil), or small fields, which are less profitable because they incur some of the same fixed costs as a large field but yield less oil.
For the biggest oil companies, which produce millions of barrels of oil a day, the challenges of producing oil from depleted or small fields are an unnecessary headache. But for medium-sized and smaller companies, this type of maturing oil region is rich in opportunities. In recent years such firms have flocked to the North Sea and started to invest.
One type of firm much more common in the North Sea nowadays is the mid-sized ‘independent’. These firms specialise in taking on depleted elephants and ageing reservoirs and applying a range of new technologies to increase production.
For example, when BP sold the famous Forties oil field to Apache in 2003, it was producing 40,000 barrels of oil a day. Since then Apache has used 4D seismic techniques and advanced reservoir engineering data to find small, stranded pockets of oil close to the main reservoir and increase production.
It’s not been cheap – the firm says it’s spent $4.3bn on repairs and upgrades in the last ten years – but it has increased production to 70,000 bo/d. It’s also extended the life of the field. It had been thought that Forties would stop producing in 2012, but now it looks likely to go on until 2030.
“Apache originally purchased 144 MMboe of proved reserves within the Forties field at a cost of $667m,” says Jim House, Apache’s UK North Sea region vice-president. But now it has “produced nearly 190 MMboe and still has 130 MMboe of proven reserves yet to deliver”.
The field is a good example of how the received wisdom about the North Sea is being proved wrong. And that example is being acted out in several other parts of the oil province.
Indeed, several mid-sized oil companies have gone on something of a North Sea shopping spree in the last year. Dana Petroleum has inked a £1bn deal in the Harris and Barra fields. Canadian firm Talisman Energy and Aim-listed Xcite Energy have also got plans for projects worth £1bn and £600m respectively.
There has also been a marked increase in interest from Asian and Middle Eastern energy firms. For example, Chinese state-controlled oil group Sinopec and Kuwait’s state oil company, Kuwait National Petroleum, recently bought into UKCS oil and gas. The Kuwaiti deal involves applying new technology to release 29 million barrels from an abandoned well.
A boon for minnows
Of course, not everyone has billions of pounds to invest in upgrades and fancy new technology. But the North Sea also has interesting opportunities for companies further down the food chain.
The North Sea’s infrastructure may be old, but it’s also very extensive. There’s more than 10,000 km of laid pipeline linking wells to the shore. That makes it economically viable for smaller companies to find and exploit smaller deposits and link them to the existing infrastructure network.
Of course, the majors and bigger independents don’t bother with this. Finding a few million barrels would barely budge their share price. Instead, a brigade of tiny, lean explorers are busy scouring the North Sea for pockets of oil or gas that their larger peers may have missed.
As the independents and smaller firms look for opportunities in the North Sea, the majors are turning their attention to Britain’s last remaining ‘giant fields’ in the northern-most tip of its seas. Norway’s state-controlled oil firm, Statoil, recently committed $7bn to developing the largest offshore oil and gas project in British waters for more than a decade.
The Mariner field, which is southeast of the Shetland Islands, is believed to hold more than 250 million barrels of oil. Mariner is not a new find, in fact it was discovered more than 30 years ago, but oil firms have been put off by its heavy oil – which is less valuable than light oil – and a technically challenging reservoir.
Now, however, the combination of improved technology and higher prices means it is economically viable. Statoil is now turning its attention to another, long forgotten giant on its books, the Bressay heavy oil field.
A helping hand from government
The government is also going out of its way to boost UKCS production. In 2011 George Osborne launched an unexpected, and desperate, tax raid on North Sea oil producers. While it’s understandable why a cash-strapped chancellor would be keen to exploit high oil prices, Osborne’s move made Britain look less appealing for new investment.
However, the particularly severe drops in production since then – which had more to do with leaks and repairs than with tax – have prompted a U-turn. Indeed, Osborne seems to have realised that upping oil and gas production is perhaps the only concrete way he can improve Britain’s trade deficit and increase the government’s tax take.
As a result, the Treasury redrafted the offshore tax rules in 2012 to make the UKCS more appealing for the small- and medium-sized companies that are best suited to maximise production in mature fields.
The government also clarified the tax-relief available for firms paying for the eventual decommissioning of the North Sea infrastructure. This removed a major uncertainty that was threatening future investments. This type of government support is another plus for North Sea operators, compared to those in other oil regions.
The combination of fiscal incentives and genuine exploration potential helps explain why last year’s UKCS licensing round was so successful. A total of 224 applications covering 418 blocks were lodged – the most ever received in one round.
That licensing round and the deals listed above show that industry insiders are optimistic about Britain’s oil and gas prospects, even if everyone else isn’t. We look at ways to play these prospects below.
The three stocks to buy now
One firm that believes in the North Sea is Ithaca Energy (Aim: IAE), a small explorer and producer. Ithaca has just made a £200m bid for fellow North Sea minnow Valiant Petroleum. If the deal goes through it would double Ithaca’s production to around 15,000 boe/d and boost reserves of oil that are more likely than not to be recoverable (the industry term for which is 2P) by 35% to 74 million boe.
Ithaca’s share price tanked on the news, falling 10% as investors feared it was overpaying. But the market seems to have overreacted. The deal is a natural fit for Ithaca and gives it new fields and exploration rights. Analysts at Casimir Capital expect the new group to be producing 26,000 boe/d by 2014.
Casimir also notes that the deal “more than doubles UK tax allowances” and creates scope for a lot of general and administrative savings. It thinks the deal will create a larger, more profitable firm. As a result, Casimir estimates that Ithaca is trading on a 2014 price-to-earnings (p/e) ratio of 1.5, far less than its current p/e of six.
Martin Waller in The Times notes that the new group could soon become a takeover target itself. Given the recent market sell-off, now would seem an opportune moment to buy.
Further up the food chain is EnQuest (Aim: ENQ), with a market capitalisation of £1.2bn. The firm was formed when oil-services firm Petrofac and Swedish independent Lundin demerged their North Sea assets and formed a new company. EnQuest’s oil services background puts it at the forefront when it comes to using new technology to get the most out of depleting oil stocks.
Even more encouraging is that its latest operational update – released in February – shows that the strategy is going to plan. In 2012, production yielded almost 23,000 barrels – above forecasts – while a successful drilling campaign increased 2P reserves to 34 million barrels.
Like all North Sea producers, most of EnQuest’s costs are in sterling, which looks likely to get weaker, while its product is priced in strengthening US dollars. Of course, British inflation will erode some of that advantage, but JP Morgan analyst James Thompson believes that EnQuest is in a stronger position than many of its North Sea rivals. “EnQuest’s strong cash-generation profile and production base ought to help it deal with cost inflation better than non-producing peers.”
Another way to play the coming boom is to go for a service provider. Indeed, because of the technical challenges posed by depleted reservoirs and marginal fields, service firms should see their share of the North Sea rise in the coming years. Our favourite option is Norway’s Subsea 7 (NO: SUBC; US: SUBCY).
Known in the industry as a seabed-to-service-engineering contractor, Subsea 7 helps its clients install platforms and extract oil. The firm cut its teeth operating off the Norwegian continental shelf, but has since expanded into the British North Sea.
Orders on both sides of the British/Norway North Sea divide accounted for 71% of Subsea 7’s announced orders during 2012. So far this year the figure is at around 50%. Subsea 7’s other main interests are in west Africa and Brazil. Its key role on both sides of the North Sea was highlighted by a brace of deals signed this year.
It was awarded a $285m contract by Talisman Sinopec Energy UK for the development of a complex of pipelines linked to the joint venture’s redevelopment project in the North Sea. It also won a $380m contract from Statoil to supply the development of the Aasta Hansteen gasfield in the northern Norwegian Sea.
As investment in the North Sea increases, Subsea 7 looks a likely beneficiary. On a forward p/e of 16 it’s not cheap, but the price is justified by the likely growth prospects. Moreover, other North Sea-focused service firms, such James Fisher, trade on higher ratings.
Back Britain’s would-be frackers
Regular MoneyWeek readers will be familiar with the story of how hydraulic fracturing, or ‘fracking’, for unconventional gas has revolutionised America’s energy production. But a lot less is known about Britain’s attempts to follow suit.
No one really knows how much recoverable shale gas Britain has, with previous reports ranging from 20 trillion cubic feet (tcf) to 170 tcf. Either way it’s a lot less than America, which has around 862 tcf, but enough to help Britain’s 3.3 tcf of annual gas demand, 55% of which is currently met by imports.
Until recently, Britain’s would-be frackers were held back by environmental concerns and legal uncertainty. However, much like the North Sea scenario, the government has recently decided that it needs to do all it can to boost production.
In December, it lifted a ban on shale gas fracking and in the recent Budget, George Osborne unveiled several incentives. Accountancy firm Deloitte estimates that the new measures will give firms 60% tax relief on well development costs and lower the effective tax rate of production to 30% from 60%. The government has also just created the Office for Unconventional Oil and Gas to help develop the industry in Britain.
Even with all this help, other barriers remain. A lot of the legal framework needs to be ironed out, while there is a lack of specialist shale equipment and know-how. So far no other country, including those with far more shale reserves than Britain, has managed to replicate America’s success.
Nevertheless, if you want to get in early on in what is admittedly a very speculative story, there are several options for British investors. The biggest player, and the only one to have drilled a well so far, is Lancashire-based Cuadrilla Resources.
It’s a private firm but investors can gain access through AJ Lucas Group (ASX: AJL), an Australian engineering group that has a 42% stake in Cuadrilla. IGas Energy (Aim: IGAS) recently raised £23m to start a drilling appraisal programme. If results come in better than expected, the share price should rocket.