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Did the banks kill the North Sea?

The North Sea oil and gas industry is a mere shadow of its former self.  Once the cash cow for successive UK governments, the industry is now a basket case that requires government grants and tax breaks just to keep it operating.  Even with these props, the industry predicts a further 120,000 job losses by the end of 2016.

For most commentators, low oil prices are the reason for this sorry state of affairs.  Before June 2014, with prices above $100 per barrel, the North Sea’s future looked assured.  But within months, falling demand and over-supply forced prices down below $50 (and eventually sinking as low as $30 earlier this year).  Even today, with prices rallying once more, the North Sea cannot break even.  But the reason for this is all too easily overlooked.

For Jillian Ambrose in the Telegraph the underlying cause is clear enough:

“City bankers are just as much to blame for the UK oil and gas crisis as the precipitous fall in global oil market prices… by focusing on growth, rather than the sector’s dwindling returns, banks continued to allow small oil and gas companies to swell their debt piles to unsustainable levels even before the oil market crash took a heavy toll on the sector.”

In this, Ambrose is half right.  Certainly the financialisation of the energy industry is responsible for oil companies’ lack of resilience in the face of falling prices.  But it hides an even deeper problem.

Financialisation of an industry occurs when there is more money to be made from issuing debt and then selling securities and derivatives based on that debt; than from the product of the industry itself.  The most obvious example being the fortunes that bankers make out of the housing market compared to the relatively modest returns made by house builders.

Prior to the 2005 global peak in conventional crude oil production, the oil industry had been immune to financialisation.  However, the huge oil price spike that many believe to have triggered the 2008 financial crash left oil companies reeling as demand crashed even as the cost of extracting (largely unconventional) oil went through the roof.  As the world emerged from the crisis, access to massive borrowing on the back of quantitative easing and low interest rates resulted in a drilling spree – most obviously seen in the US shale patch, where expensive fracking operations helped create the myth of Saudi America.  Less obviously, other expensive oil patches around the world – including the North Sea – were also boosted by loans that (apparently) allowed them to begin work on recovering the harder to extract oil that remains in the smaller fields.

The question nobody in the mainstream media wants to ask is whether any of the additional drilling that took place after 2008 would have happened without massive debt.  North Sea oil and gas are not cheap to recover.  The biggest and easiest North Sea fields were depleted long ago.  What is left is in smaller and harder to develop fields.  In this, they are similar to the now stalled attempts at deep sea and Arctic drilling, and the rapidly collapsing shale patch.  Without the influx of massive amounts of credit, few of these new projects would have been possible.  But the downside of debt – as every mortgage and credit card holder knows – is that it increases your monthly outgoings.  For the North Sea (and the energy industry in general) debt has served to significantly raise the break-even point – the point at which the price of a barrel of oil covers a company’s costs.

As with the run up to the 2008 crash, the banks have been doubling down – turning a large volume of the energy sector’s debt into the equivalent of an interest-only mortgage.  So long as companies can service the interest on the debt, they have been allowed to roll it over in the hope that the industry might one day become profitable.  But there are two ways of paying off a debt.  The most fruitful is to increase your earnings – something the energy companies cannot now do without prices rising to an economy-crushing $100 per barrel or more.  The other way is the George Osborne approach – cut, cut and cut again in order to minimise monthly expenditure.   This, of course, is exactly what the energy industry has been doing – scrapping exploration projects, writing off capital, mothballing rigs and laying off the workforce.  In the US shale patch this may work to some extent, since shale drilling is relatively easy to start up again as prices rise – at least for companies with access to the remaining sweet spots.

The North Sea is less easy to develop than even unconventional land based fields.  Projects that are being shut down today are unlikely ever to attract the new capital required to restart them.  And following the experience of the two year plummet in oil prices, it will take more than a temporary price spike above $100 to persuade investors back into oil.  So it is likely that we are seeing the very worst of all worlds – oil companies failing, debts going bad (with banks and investors eating the losses), government losing tax revenues, and taxpayers facing the cost of cleaning up the mess.

We could blame the banks for this state of affairs.  But the underlying truth is that the cost of extracting the oil that our economy depends upon is becoming too expensive… and the consequences of that really are catastrophic.

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