In the current climate of uncertainty that surrounds the global Oil industry, there is one thing that you can be sure of – the price of oil WILL recover. When? And by how much, is another story and the subject of a lot of conjecture and speculation. What we do understand is that the current depression in price is likely to last a while longer...
Why are cuts needed?
This is as simple as it is obvious. Global demand for oil has dipped due to a slow down in growth for some of the world’s largest economies. Oil provides more than a third of the energy we use every day and is the single largest source of global energy. A lack of demand for a commodity is known as under consumption, which in turn leads to a drop in price. The drop in the value of a barrel of oil has been so dramatic and so rapid that in some parts of the world, like the North Sea, the cost of producing a barrel of oil is actually more expensive than the price it trades for. This is due to the enormous increase in production costs over the last 10 years or so – it is estimated that the cost to produce a barrel of North Sea oil is five times more than in 2002! The solution – cut costs. But how far?
The danger of cutting too deep
Headlines in the North Sea are dominated by one major concern at the moment - job losses. When it comes to cost base reviews; rate decreases, contractor layoffs and staff redundancies seem to always be viewed as the easy answer. On the face of it, this would seem to make sense – these are costs which are quickly and easily removed. The resources are less likely to be missed from a business perspective, given the lower workload due to reduced CAPEX budgets. However, the danger of reducing costs by reducing headcount is related to the one thing that (as already mentioned) we can be sure of – the oil price bouncing back as demand increases. The increase in demand will cause an increase in competition for skilled workers, increasing salaries and rates required within the industry.
This throws the industry back into chaos and back to the start of the long cycle which sees rates and salaries swell, costs increase and the exposure to future oil price volatility return (something which seems increasingly likely given the ever-evolving geopolitics affecting the oil price). With investor confidence levels being so low throughout this downturn, surely a future price crash would expose the North Sea to even more scepticism and therefore increase the pressure for investor capital to be focused on more stable regions, potentially spelling the end for North Sea production.
Why tax breaks alone aren’t the answer?
Whilst there is a lot of pressure being put on the UK government to introduce tax breaks, this alone is not the answer. Tax is paid against profit made; therefore a project must be generating positive cash flow before a tax break provides a benefit. Whilst it will free more cash from profitable projects allowing cash negative projects to continue, the responsibility falls upon the industry to bring costs to a manageable level. Where the government can have a positive impact is by stimulating exploration drilling activities and ensuring that marginal projects are given the best chance of development to enable the industry to pull through these uncertain times.
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