THE DIRE FUTURE OF THE OIL

INDUSTRY IN THE NORTH SEA

Assessing the economic viability of the UK offshore oil
industry using an alternative approach on the Hotelling rule

Name student: Job Last

Student number: 2033879
Date: October 2015
Type of study: Master thesis
Master program: Earth Sciences and Economics
University: VU University Amsterdam
Supervisor: Dr. Steven Poelhekke
Second assessor: Prof. Dr. Cees Withagen

Acknowledgements
First of all, I would like to thank Tom Beving, who works at the consultancy firm Royal
HaskoningDHV, for helping me starting up and for guiding me through this study. Without his help
the study would not have turned out the way it has. Secondly, I would like to thank Dr. Steven
Poelhekke from the Faculty of Economics and Business Administration at VU University, for his
supervision and positive criticism during meetings. I also give my gratitude to Prof. Dr. Cees
Withagen from the same faculty for being willing to function as second assessor.
During the research several interviews with experts in the field were conducted. I am therefore very
much thankful for the cooperation of Ronald de Vries, Director Advisory Group Process and Chemical
Industry at Royal HaskoningDHV, and Neil van Ham, oil and gas technical consultant at Royal
HaskoningDHV. Speaking with them has led me to gain much more insight in the UK offshore oil
industry. Then, I cannot thank Ryan Kellogg enough, one of the authors of the article this study is
based upon, for meeting me when he was visiting the Netherlands. His support and his help with
some very specific questions was extremely important. Another person helping me, especially in
starting up the study, is Chris Grieve, vice president of the commercial intelligence firm Wood
Mackenzie. I thank him for our e-mail correspondence and giving me his expert judgement. Finally, I
would like to thank my father, Wilmar Last, working for Royal HaskoningDHV during the study, for his
knowledge on the topic and for answering many of my questions.

Job Last

Cover page figure: a North Sea oil rig in stormy weather (oilandgaspeople.com, 2015)

Abstract
The Brent crude oil price has from June 2014 on collapsed from $110 to below $50. One of the
industries affected most by this collapse is the UK offshore oil industry because of its mature oil
fields. The UK offshore has been producing oil since 1975 and it is nowadays dealing with relatively
high operating costs, making it one of the least competitive places on earth to produce oil.
This study assesses the future of the industry by making use of Hotellings (1931) classic model of
exhaustible resource extraction, based upon the article by Anderson et al. (2014). Hotelling states
that depletable resources optimally need to be extracted at the rate of interest; the Hotelling rule.
However, limited empirical evidence has led Anderson et al. to study Texas oil production reacting to
oil price shocks to see whether production indeed rises at the rate of interest. The authors show that
production does not respond to price incentives, while drilling activity does. To explain these facts
they modify Hotellings model by imposing a production constraint due to reservoir pressure, and
letting producers choose when to drill, instead of when to produce.
Following the approach by Anderson et al., an UK specific model is created which is able to forecast
the optimal path of drilling activity and oil production. Running this model leads to the conclusion
that the future of the UK offshore oil industry is viable, since oil production increases for every oil
price scenario. However, investment is needed for the optimal path.

Table of Contents
Acknowledgements ................................................................................................................................. 2
Abstract ................................................................................................................................................... 3
1 Introduction .......................................................................................................................................... 6
2 Methodology: basics of the Hotelling rule and its applicability to the UK offshore ............................ 8
2.1 The basics of Hotelling................................................................................................................... 8
2.2 Empirical applicability and extensions .......................................................................................... 9
2.2.1 Technological progress and resource accessibility............................................................... 10
2.2.2 Exploration ........................................................................................................................... 10
2.2.3 Effects of risk ........................................................................................................................ 10
2.2.4 Changes in demand .............................................................................................................. 11
2.2.5 Capacity constraint ............................................................................................................... 11
2.2.6 Conclusion ............................................................................................................................ 12
2.3 Hotelling under pressure by Anderson et al. (2014) .................................................................... 12
3 Data: oil production, drilling activity, geology and economics on the UK Continental Shelf............. 17
3.1 Data for empirical analyses ......................................................................................................... 17
3.2 Geological background ................................................................................................................ 19
3.2.1 The North Sea Oil Province................................................................................................... 19
3.2.2 Atlantic Margin ..................................................................................................................... 21
3.2.3 The Irish Sea ......................................................................................................................... 22
3.2.4 Oil potential of the UKCS ...................................................................................................... 22
3.2.5 The role of reservoir pressure .............................................................................................. 25
3.2.6 Conclusion ............................................................................................................................ 27
3.3 Economic background ................................................................................................................. 27
3.3.1 Industry performance and trends ........................................................................................ 27
3.3.2 Costs and benefits ................................................................................................................ 28
3.3.3 Effect low oil price ................................................................................................................ 31
3.3.4 Conclusion ............................................................................................................................ 32
4 Empirical analyses: impact price incentives on oil production and drilling activity ........................... 33
4.1 Impact price incentives on oil production ................................................................................... 33
4.2 Impact price incentives on drilling activity and costs .................................................................. 36
4.3 Similarities and differences in industry cost structure between Texas and the UK offshore ..... 38
4.4 Conclusion ................................................................................................................................... 40
5 The model: optimal UKCS specific drilling activity and oil production............................................... 41
5.1 Details of the model .................................................................................................................... 41
5.2 Optimal price paths in different oil price scenarios ................................................................... 43
4

5.2.1 Drilling activity ...................................................................................................................... 43

5.2.2 Oil production....................................................................................................................... 45
5.2.3 Conclusion ............................................................................................................................ 47
5.3 The dynamics and sensitivity of the model ................................................................................. 48
5.3.1 Reserves................................................................................................................................ 48
5.3.2 Costs ..................................................................................................................................... 50
5.3.3 Discount rate ........................................................................................................................ 52
5.3.4 Conclusion ............................................................................................................................ 54
Conclusion ............................................................................................................................................. 55
Discussion .............................................................................................................................................. 56
References ............................................................................................................................................. 57
Appendix A: Statistical analysis ............................................................................................................. 60

1 Introduction
From June 2014 on the Brent crude oil price has fallen from $110 a barrel to below $50 a barrel in
January 2015. The United Kingdom offshore oil industry is one of the oil producing industries affected
most by the oil price collapse. The operating area of this industry, the UK Continental Shelf (UKCS), is
characterized by the presence of many mature oil fields, with relative high operating costs. These
costs are only increasing, making the UKCS one of the least competitive places on earth to operate.
The industry body Oil & Gas UK states in their Activity Survey 2015 its cost base is unsustainable and
that exploration activity on the UKCS has collapsed. Without getting the balance between investment
and cost control right, areas of the basin will be effectively sterilised for further oil and gas
production. Therefore a significant regulatory and fiscal reform is needed according to the industry
lobby (Oil & Gas UK, 2015a).
Although necessary, effective cost control is not able to sustain UK offshore oil production at current
oil prices. A 20% cost reduction would have the same effect as only a $10 increase in oil price,
keeping in mind operating costs increase as fields are depleted (Oil & Gas UK, 2015a). Higher oil
prices seem to be essential for the industry to recover, yet forecasting oil prices is nearly impossible.
Those who are involved in the UK offshore oil industry are likely to be interested in the future of the
industry, especially considering todays low oil price. It would be valuable to know how much oil can
be expected to be produced and when and where new wells should be drilled. In order to assess the
future of the UK offshore oil industry, this study forecasts the optimal drilling activity and oil
production considering several oil price scenarios. Taking both economic and geological aspects into
account, this approach would help understand the situation the UK offshore oil industry is currently
dealing with, and it would provide insights to depict a strategy for optimizing its economic viability.
The foundation of this research consists of the article by Anderson et al. (2014). In their study, they
are able to explain the behaviour of oil production and drilling activity of the Texas oil industry. They
show that oil production barely reacts to oil price shocks while drilling activity and costs strongly
react to prices. These observations are mainly related to the fact that oil production is constrained by
reservoir pressure, which decays as oil is extracted. Producers cannot increase the production of a
well that is at its constraint, but they do not decrease a wells production either. The empirical
findings are in contrast to the conceptual model of Hotelling, in which resource owners try to
maximize wealth by trading off extraction today versus extraction in the future. The rate at which
extraction increases over time equals the rate of interest; this is known as Hotellings rule. In order to
understand this contrasting behaviour, Anderson et al. reformulate Hotellings rule: resource
extraction is treated as a drilling problem instead of a production problem. By explaining observed
patterns, they show a Hotelling-style model can give predictions that are empirically valid, as further
explained in the literature review section.
The use of the article by Anderson et al. (2014) as foundation for this study is motivated by two main
arguments. First, the role of reservoir pressure in the model of Anderson et al. is a crucial one and it
contributes to the Hotelling literature, being one of the few to incorporate this geological feature
supported by empirical evidence. Since reservoir pressure is believed to be of major importance to
the UKCS, containing many mature fields, the approach of Anderson et al. holds the potential to
explain UK offshore oil industry behaviour as well. Second, applying the approach to the UK offshore
oil industry is interesting due to the fact that the cost structures of Texas onshore and UK offshore
differ. An onshore well in Texas might cost $10 to $14 million to drill; 40% of this is for drilling, 40%
for completion and 20% for other costs. Wells in the UK can easily cost $30 to $50 million depending
on water depth and complexity (Grieve, 2015). Substantial higher operating and capital costs are
6

believed to show attenuated reactions to prices, but drilling activity and costs reacting to prices are
nevertheless hypothesized. In that case, the modified Hotelling model by Anderson et al. is likely to
be applicable to the UKCS as well.
Following the approach by Anderson et al., this study will try to answer the following research
question:
Using a reformulated model of Hotellings classic model, what is the future economic viability of the
UK offshore oil industry in the context of oil price and geology?
To help answering this research question, a range of subquestions has been formulated. Related to
the methodology of the study, the following three questions have been framed:
-

What is the Hotelling rule, and how is it related to the UK offshore oil industry?
To what extent is Hotellings rule empirically applicable, especially to the case of the UK
offshore?
What is the Hotelling-based approach of Anderson et al. (2014) and how could it be applied
to the case of the UK offshore?

Considering the data used for the empirical analyses and building the UK offshore model, these three
questions are formulated as follows:
-

What data is used for the empirical analyses determining the effect of the oil price?
How do geological settings and reservoir pressure in the UK offshore affect current and
future oil production, to gain insight in the data needed?
How is the UK offshore oil industry currently situated in terms of operators and economics,
and how does the low oil price affect this situation and price scenarios, to gain insight in the
data needed?

Conducting the empirical analyses is guided through the subquestion:

-

What is the effect of changes in the oil price and expected price increase rate on respectively
oil production, drilling activity and drilling costs, and do these results match with the results
in Anderson et al. (2014)? With other words, can the approach by Anderson et al. empirically
justified be applied to the case of the UK offshore oil industry?.

Finally, when building the UK offshore specific model, these two questions will help answering the
research question:
-

What are the optimal drilling activity and oil production paths for the UK offshore oil
industry, and how does the oil price have an impact on these paths?
What are the dynamics of the model, i.e. how do the different parameters affect the optimal
paths?

The structure of the report will be as follows. In Chapter 2 the methodology will be described, by first
explaining the basics and empirical applicability of the Hotelling model. Then the article by Anderson
et al. (2014) and how its approach may be applied to the UK is analysed. In Chapter 3, the study takes
a look at the data needed for the empirical analyses and the UK offshore specific model. Chapter 4
will analyse the impact of oil prices on the oil production, drilling activity and costs of the UK offshore
oil industry compared to the results of Anderson et al. In Chapter 5, the model by Anderson et al. will
be modified and applied to the UK offshore oil industry.

2 Methodology: basics of the Hotelling rule and its applicability to the

UK offshore
This study tries to assess the future of the UK offshore oil industry using an alternative approach on
the Hotelling rule. This rule is mentioned in Chapter 1 as the equality between the rate at which
extraction increases over time and the rate of interest. Since this is a very brief description, which
may be hard to understand, this chapter will at first focus on the basics of the theory. Subsequently,
its empirical applicability is examined through the possible extensions of the theory and its results.
The third section will solely concentrate on the empirical article by Anderson et al., which functions
as the foundation for this study, discussing its approach toward Hotelling and its results. Last but not
least, it is explained how the approach by Anderson et al. may be applied to the case of the UK
offshore.

2.1 The basics of Hotelling

Before the approach by Anderson et al. and its applicability to the case of the UK offshore is
explained, the answer to the following question needs to be found:
-

What is the Hotelling rule, and how is it related to the UK offshore oil industry?

All of mainstream economic theory relies crucially on the assumption that actors are focussing on
maximizing some measure of economic returns. The standard model simply deals with competitive
producers taking prices as given and lacking any market power, trying to maximize their profit.
Maximizing profit in such a perfect competition is done when the market price of one extra unit of
production equals the incremental cost of this particular unit (Krautkraemer & Toman, 2003).
However, as Hotelling (1931) made clear, when producing a depletable natural resource the measure
of economic returns translates into a present value of current and future net revenues. This is
because most natural resources have fixed stocks and once produced they cannot be renewed.
Optimizing depletable natural resource extraction can therefore be referred to as a cake-eating
problem; the problem of distributing the cake, or stock, in such a way that maximizes utility, or the
present net returns. This can only be when the equi-marginal principle is satisfied, which requires
that the marginal net return is the same for every period. Therefore, the current value of the
marginal net profit in future periods needs to be increasing at the rate of discount. Satisfying the
principle implies two conditions. First, the marginal gain of additional extraction in any time needs to
equal the full opportunity cost, which includes the present value of future losses due to extracting
now, as well as the incremental production costs. Second, the rate of return of holding an unit of
natural resource, needs to equal the rate of discount since revenues could be invested at a rate of
interest. These two conditions are known as the Hotelling rule and it implies that the rate of
extraction equals the rate of interest (Krautkraemer & Toman, 2003).
Mathematically, the Hotelling rule can be explained by first showing the equi-marginal principle. Let
() be the price of the depletable natural resource at time , ( ) the marginal cost of extracting
units at time , and the discount rate.
(0 ) (0 ) =

(1 ) (1 )
(2 ) (2 ) () ( )
=
=
= = 0
(1 + )1
(1 + )2
(1 + )

(1)

where 0 is the present value of marginal net profit. This number can interpreted as the shadow
value of the resource stock since it reflects the increase in present value if one extra unit of natural
resource was added. In this equation, the marginal net return is the same for every period.
8

Thus, at any point in time:

() = ( ) + (1 + ) 0

(2)

reflecting the first condition, in which the marginal gain of additional extraction in any time, needs to
equal the full opportunity cost, which includes the present value of future losses due to extracting
now, as well as the incremental production costs.
And, in any successive time periods:
(11 ) (11 )
() ( )
=
(1 + )1
(1 + )

() ( ) = (1 + )[1 (1 )]

(3)

implying the second condition, in which the rate of return of holding an unit of natural resource,
needs to equal the rate of discount, since revenues could be invested at a rate of interest.
Returning to the question What is the Hotelling rule, and how is it related to the UK offshore oil
industry?, it could be said the Hotelling rule states that the rate of extraction equals the rate of
interest. Moreover, Hotellings rule relates to the UK offshore oil industry in the way that the
industry is a depletable natural resource industry and thus should follow the rule like any other
depletable resource industry.

2.2 Empirical applicability and extensions

Intuitively, the conceptual model of Hotelling seems to make sense. Nevertheless, as with any
economic theory its empirical applicability has been extensively researched. In this section, the
following question will be answered.
-

To what extent is Hotellings rule empirically applicable, especially to the case of the UK
offshore?

Despite its intuitive concept, Hotellings empirical applicability is not proven in the literature. For
example, Gaudet (2007) has observed the changes in U.S. price data of ten different natural
resources since 1870. Hotelling would suggest a positive trend in the change of prices, i.e. at the rate
of interest. However, Gaudet finds that in none of the ten cases the mean rate of change is
significantly different from zero (Gaudet, 2007). Alongside Gaudet, several other authors of
qualitative reviews on the Hotelling literature find that trends in natural resource prices cannot
confirm the basic Hotelling model of increasing prices at the rate of interest. Kronenberg (2008)
shows in his literature review that the paths of four major industrial resources fall more often than
they rise, while adjusted for inflation. He backs this result up with the conclusion of the econometric
analysis paper by Ocampo and Parra (2003) that relative raw materials prices deteriorated markedly
in the course of the twentieth century. Slade and Thille (2009) find mixed evidence for rising real
resource prices reviewing empirical literature. In their paper comes forward that resource prices may
be U-shaped. An initial drop would be the result from large initial discoveries, but due to extraction
the price trend would turn positive. Moreover, in trying to confirm the validity of Hotellings basic
model, Gaugler (2015) finds in his very recent review that drawing a generally valid conclusion on
price trends seems not possible. He and the other reviewing authors come to the conclusion that
other drivers are impacting resource prices and thus that the model needs to be extended.
The lack of empirical evidence is not surprising, considering the shaky assumptions the model of
Hotelling is built upon. It assumes non-changing extraction technologies over time, a known stock of
homogeneous quality and no risk averse behaviour of actors. Moreover, the model does not deal
with changes in demand for finite resources (Gaugler, 2015). However, since the model holds great
9

conceptual potential, authors have developed extensions to the model to improve empirical results.
Several of these extensions, relevant to the case of the UK offshore, will be briefly discussed in the
sections to follow.

2.2.1 Technological progress and resource accessibility

When trying to make the model more realistic by extending it, one of the first factors that come to
mind is technological progress and its effect on extraction costs. Gaudet (2007) mentions that the
average extraction cost for almost every natural resource has been following a negative trend in the
past century. Moreover, Gaugler (2015) shows in his review that multiple empirical studies have
found significant reduced extraction costs due to technological progress. But resource accessibility is,
on the other hand, of importance. Since resource stocks are not homogeneous as Hotelling assumes,
extraction costs should rise over time since the best accessible resources are extracted first (Gaudet,
2007). Resource quality degradation over time is strongly correlated to this phenomenon. Due to the
fact that technological progress and resource accessibility are opposing drivers, the dominating one
would steer extraction costs. Mixed empirical evidence leads to the conclusion that both drivers do
influence extraction costs and resource prices, but a dominating driver is not confirmed (Gaugler,
2015).

2.2.2 Exploration
Hotelling assumes the resource stock to be finite and known with certainty. This is not realistic since
new discoveries of natural resources are made every day. When extending the model with
exploration and by assuming there are stock effects, marginal extraction costs will be impacted. A
period of successful exploration would lower marginal costs, and thus the resource price. However,
since discoveries are limited, the intuition of Hotelling will hold in the long run and it will cause
resource prices to rise. On the other hand, as actors know exploration opportunities exist, their
expectations will change. They would consider their resource stock as the remaining expected
reserves and no longer as the remaining proven reserves; thus the intuition would still apply. An
exploration extension could improve a Hotelling model, but it is unlikely to be crucial (Kronenberg,
2008).

2.2.3 Effects of risk

The equi-marginal principle leads producers to be indifferent to extract an extra unit of natural
resource now or in the future. However, there is uncertainty regarding many important future
influences, such as resource price, extraction costs, technological progress, exploration activities and
the possibility of a future competitive energy source (Krautkraemer & Toman, 2003). Whereas
Hotelling assumes producers to be risk-neutral, it is more realistic to consider an actors behaviour as
risk-averse due to future uncertainties. In other words, an actor would prefer to produce an extra
unit now, rather than in the future. The basic model of Hotelling could be extended with risk by
simply adding a positive risk premium to the interest rate. This would result in a steeper price path as
a long-term effect. Moreover, the increase of interest rates leads to an increase in producers capital
cost due to the steeper price path. This would result in the dropping out of firms not having a
positive net present value after the increase of interest rates. Consequently, in the beginning of the
period there is a small price jump (Gaugler, 2015). Empirical Hotelling literature which takes into
account the possibility of risk diversification provides contradicting conclusions, although it tends to
support the view that it is an important element in explaining resource prices (Gaudet, 2007;
Gaugler, 2015).

10

2.2.4 Changes in demand

The above considered extensions are all supply-side drivers. Changes in demand are not accounted
for in the basic model, nor through these extensions. Yet. demand for natural resources has been,
and is still, facing a huge growth due to the growing world population and increasing global welfare.
To gain insight in the development and dynamics of demand, and its relation to the price and
depletion path, a four-quadrant model can be used (see Figure 1). The solid line in the north-west
quadrant shows the original demand function while the dashed line shows the increased demand
function. The solid and dashed lines in the north-east quadrant show the corresponding optimal price
paths whereas the solid line represents Hotellings original optimal price path. The south-east
quadrants 45 degree line is plotted only to establish a connection with the south-west quadrant, in
which the depletion path is shown. This path is again corresponding with the demand function. At
time T, the resource is depleted. The figure shows that an increasing demand leads directly to an
upward shifting price path. The positive relation between demand and prices is backed up by
numerous empirical studies in which the evolution of resources and commodities is investigated. This
leads to believe the demand side to be an important extension of the Hotelling model (Gaugler,
2015).
Figure 1: A four-quadrant model showing the relation between an increase in demand and the optimal price path, extending
Hotelling's basic model (Gaugler, 2015)

2.2.5 Capacity constraint

Extractive industries are usually capital intensive, something that is not captured in the basic
Hotelling model. In the model, an actor would try to reduce its capital input over time when it is
expected extraction will decrease. However, capital in extractive industries is mostly non-malleable;
11

i.e. it cannot easily be converted to another industrys capital. The extractor anticipates by lowering
its initial capital investment. In turn, the extractive capacity is likely to be constrained since it would
be profitable in the short-term to produce more. Consequently, it leads to an inelastic supply-curve,
which explains the empirical view of resource prices being volatile. To see this, suppose demand for a
natural resource increases and so does the price. Due to the capital intensive characteristic of the
industry, it invests slowly in response. Supply cannot follow demand closely, causing prices to be
relatively volatile (Krautkraemer & Toman, 2003).
The capital intensity of extraction industries and its constraining effect on production can be applied
to the model of Hotelling by imposing a production constraint. This constraint would decay by
cumulative extraction. This extension is especially relevant to the oil industry, in which wells are
drilled into the ground facing a decreasing maximum productivity. This decreasing maximum
productivity is directly related to the reservoir pressure in the oil reserve; i.e. the reservoir decays
proportionally with the remaining reserves (see Section 3.1.5). This extension is therefore consistent
with the petroleum geology and engineering, but its power is also recognized through empirical
findings. The modified models by Okullo et al. (2012), Mason and Van 't Veld (2013) and Anderson et
al. (2014) are not only capable of explaining resource prices volatility as they also explain the
empirical finding that production barely reacts to prices. This finding is also mentioned by Thompson
(2001).

2.2.6 Conclusion
Lets recall the question To what extent is Hotellings rule empirically applicable, especially to the
case of the UK offshore?. Despite the lack of literature proving the theory, a range of extensions has
been put forward by authors. Intuitively, each of the discussed extensions is relevant to the case of
the UK offshore in its own way. However, considering the relative capital intensive aspect of the UK
offshore oil industry and the important role of reservoir pressure (as discussed in the introduction)
the capacity constraint extension in Section 2.2.5 is in particularly interesting. The article by
Anderson et al. (2014), which approach is used in this study, is thereby especially relevant thanks to
its strong empirical results. The next section will go extensively into the approach and results by
Anderson et al. (2014).

2.3 Hotelling under pressure by Anderson et al. (2014)

The study is based on the article by Anderson et al. (2014), Hotelling under pressure, which has been
briefly summarized in the introduction. Their main contribution to the literature is that a Hotellingstyle model is indeed capable of replicating empirically proven oil price, extraction and drilling
activity behaviour whilst the literature has mostly failed to deliver empirically. By dealing with the
Hotelling model as a keg-tapping problem rather than a cake-eating problem (in which firms choose
when to drill rather than when to produce), they show that implementing reservoir pressure is
crucial to an effective Hotelling model.
This section gives an answer to the subquestion:
-

What is the Hotelling-based approach of Anderson et al. (2014) and how could it be applied
to the case of the UK offshore?

The approach arises from the empirical evidence Anderson et al. found studying oil production and
drilling activity in Texas. The plotting of oil production of existing wells against current and expected
future oil prices shows that production barely responds to price shocks. Figure 2 visualizes that the
total production of existing wells evolves as a long-run downward trend with only minor response to
prices. This trend is backed up by regression results, in which no statistical significant correlation
12

between the crude oil price and oil production is found. This empirical fact strongly contrasts the
standard Hotelling model, in which production should react negatively on decreasing oil prices and
positively on increasing oil prices.
Figure 2: Crude oil prices and production from existing wells in Texas (Anderson et al., 2014)

However, there seems to appear a positive correlation when drilling activity is regressed against
prices, as is shown in Figure 3a. The statistical results indicate that the elasticity between the
monthly drilling rate and the crude oil price within two months is statistically significant, about 0.60.
Following this result, a positive covariance between drilling costs and the oil price is expected (Figure
3b), which indeed turns out to be 0.79 and statistically significant. Thus, an increased oil price results
in more wells being drilled, and therefore results in higher marginal costs.
Figure 3: Texas drilling activity and drilling costs versus crude oil prices (Anderson et al., 2014)

Anderson et al. argue that these empirically proven facts are reflected in the Texas oil industry cost
structure in which: 1) production is physically constrained, declining asymptotically toward zero due
to a decreasing reservoir pressure, 2) marginal production costs below capacity and transportation
costs are very small to observed oil prices, 3) fixed operating costs are non-zero and possible costs
13

for restarting shut-in wells are not too large to be overcome, and 4) drilling rigs being a fixed
resource, an upward sloping supply curve of drilling rigs for rent is present. The capacity constraint
and the relatively low marginal production cost partly explain the observation of a slightly curved
downward oil production trend, being unresponsive to price shocks. On the other hand, production is
unlikely to affect oil prices since Texas is a small oil producing region on a global level. Therefore
firms are price-taking and the industry exhibits perfect competition.
Both the empirical results and standard petroleum geology and engineering indicate a capacity
constraint. Therefore, Anderson et al. developed a theory following the cost structure characteristics
closely, including a flow capacity constraint which depends on the decline in reservoir pressure per
well over time. The model uses continuous time and there are infinitesimally small wells to be drilled.
Moreover, marginal extraction costs are assumed to be trivially low and fixed costs are ignored.
One of the important necessary conditions of the model is the ability of explaining why production
does not decrease when the oil price is low and prices are expected to rise faster than the interest
rate. Since marginal production costs below capacity are very small compared to oil prices, deferring
production could seem to be optimal. Yet, Anderson et al. are able to explain that any production
that is deferred today cannot completely be recovered at the instant it is most valuable due to the
production constraint. Instead, it must be recovered over the full remaining life of the well, including
time periods in which the oil price is lower. Only if the time period in which the oil price is rising
faster than the interest rate is large enough, decreasing production at time t is value-maximizing.
However, they show for their sample at no time during the sample period this is the case.
Then, they can empirically justified focus on the case in which production is constrained during
drilling, manipulating the conditions to yield:
( + )(()) (()) ()
0
(()) [

]=

(4)

where (()) is the marginal utility gained from deriving a unit of oil flow, which in a market
context is equivalent to the oil price, is the discount rate, is the decline rate of oil flow, (()) is
the derivative of the total drilling cost of drilling wells, () reflects the marginal rate at which new
wells are drilled and is the maximum flow of a newly drilled well. The term 0 can be interpreted as
the shadow value of the marginal undrilled well at time = 0. The shadow value is the marginal
utility gained by relaxing the capacity constraint with one well.
Equation 4 can be interpreted as the modified Hotelling rule. The right hand side can be seen as the
per-barrel shadow value of oil in untapped wells. On the left hand side is the marginal utility of oil
minus the costs in brackets, in which the first term represents the marginal drilling costs. By now, the
equation is equal to the Hotelling rule. This can be seen by contrasting Equation (4) to Equation (2),
where (()) is the same as (), the first term in brackets equals ( ) and the right hand side
is no different from the discounted shadow value 0 . Both equations are the same, except for the
second term in brackets in Equation (4), which captures the opportunity cost of drilling now versus
waiting. To put it more simply, the left hand side gives the present value of extracting one unit of oil
flow, whereas the right hand side gives to value of leaving the unit in the ground. Since these values
need to be equal in equilibrium, and the right hand side is rising at the rate of interest, Hotellings
rule is still satisfied.
To describe the dynamics implied by the optimal solution, Anderson et al. model oil production and
drilling activity in the case of exogenous oil prices. The exogenous price model studies the optimal oil
14

production, and drilling activity paths for a constant high and low oil price and a fixed stock of wells.
This model is especially relevant for a relatively small and local region like Texas, where price are
taken as given. The authors find that a high oil price has an initially high rate of drilling and causes the
stock of wells to be drilled more quickly. This translates in a sooner occurring and higher peak
production. These findings are both visualized in respectively Figure 4a and Figure 4b.
Figure 4: Optimal drilling activity and oil production in a local region (Anderson et al., 2014)

The arbitrage condition for the rate of drilling (Figure 4a) is given by Equation (5):
(()) =

0
+

where the costs (a()) need to equal the discounted revenues

(5)

minus the shadow value of the

untapped well 0 rising at the interest rate . In this condition, 0 is uniquely determined for every
set of parameters, causes total drilling on the optimal path to equal the number of wells available to
be drilled. Now, if 0 > 0, it indicates drilling for oil is profitable and thus that drilling costs need to
decline over time so that drilling is equally attractive for every time . The rate of drilling a()
therefore also declines over time, when the oil price and other parameters are constant. The higher
the oil price, and thus the revenues, the higher the initial drilling activity and the steeper the slope,
as is visualized in Figure 4a.
Oil production follows drilling activity in such a way that production increases from newly drilled
wells and decreases due to the declining reservoir pressure, as given by:
(1 ) = (0 ) + (0 )

(6)

where () represents the oil flow, beginning at zero, quickly increasing as new wells are drilled and
eventually declining asymptotically toward zero. Figure 4b visualizes these dynamics as a humpshaped production profile, as is a well-known feature of oil production in fields all over the world.
Obviously, this model is an intentional oversimplification of reality, but will function great as base
model for the UK specific model in Chapter 5.
However, first the Hotelling approach by Anderson et al. needs to be empirically justified for the case
of the UK offshore oil industry as well. To do this, data of the UK offshore needs to be analysed and
needs to show the same kind of trends as shown in Figure 2, 3a and 3b. The same type of data needs
to be assembled, which is considered difficult since publicly available data on oil industries is scarce.
15

Then the same empirical analyses need to be performed, including the statistical analyses1. If the
results match, the base model by Anderson et al. as visualized in Figure 4 can be empirically justified
applied to the UK offshore oil industry. However, in order to make the UK specific model realistic and
credible, UK specific parameters and different oil price scenarios need to be implemented.
When applying the approach to the UK offshore, it is crucial that the results of the empirical analyses
of Texas and the UK offshore match. Theoretically the results of Texas in Anderson et al. (2014)
should match the results in the case of the UK offshore. However, this is not self-evident considering
the huge differences between the Texas onshore oil industry on the one hand and the UK offshore oil
industry on the other. Without going too much into detail, the Texas oil industry is characterized by
relatively low costs per well, low production per well and a high drilling activity. Compared to Texas,
the UK offshore oil industry is characterized by very high costs per well, very high production per well
and a very low drilling activity.
The subquestion mentioned earlier in this section is What is the Hotelling-based approach of
Anderson et al. (2014) and how could it be applied to the case of the UK offshore?. The approach of
Anderson et al. is an extension of the Hotelling model with a production constraint and a well-by-well
instead of a barrel-by-barrel approach. Since this approach is empirically justified for the case of the
Texas onshore oil industry, matching results for the case of the UK offshore oil industry are necessary
and crucial. Then, by implementing UK specific parameters and several oil price scenarios, the base
model by Anderson et al. could be successfully applied to the case of the UK offshore in a realistic
and credible way.

The methodology and results on the statistical analysis on the empirical analyses can be found in Appendix A.

16

3 Data: oil production, drilling activity, geology and economics on the

UK Continental Shelf
This chapter focusses on the data needed for the empirical analyses on the one hand and the UK
specific model on the other. Describing the data (sources) for the empirical analyses is rather straight
forward. Data is described, it is explained why it is necessary and where it is found. However, the
data used as input for the UK specific model and accompanying scenarios is discussed in a story
context. To get a feeling about the size and dynamics of the UK offshore oil industry, which is
necessary for understanding the input and results of the model, both a geological and economic
background are included in this chapter.

3.1 Data for empirical analyses

Two main empirical analyses need to be carried out in order to empirically justify the approach of
Anderson et al. on the UK offshore oil industry. First, an analysis of the effect of the oil price on oil
production, and second an analysis on the effect of the oil price on drilling activity. To support the
results on drilling activity, Anderson et al. also performed an analysis on the effect of the oil price on
drilling costs. Based on the following subquestion, this section gives an overview of all data used for
the empirical analyses:
-

What data is used for the empirical analyses determining the effect of the oil price?

Due to limited availability, data has not been found to fit one specific time period. However, there is
no reason to believe that the potential impact of price incentives would vary over time. This is due to
the fact that the analysis takes external shocks, affecting crude oil prices differently per shock, into
account.
Well-level crude oil production data come from the disbanded Department for Business Enterprise
and Regulatory Reform (BERR), a United Kingdom government department. Through the UK
Petroleum Production Reporting System, UK offshore production operators provided monthly
production data on well-level. The data is available through the Well Data Release Index Page of the
Department of Energy and Climate Change (DECC). Data have been provided since 1975, while the
DECC has stopped receiving data since 1999. For a total of 2,204 wells, monthly production has been
recorded (DECC, 2015).
Data to measure drilling activity originates from Oil & Gas UK. Through the web site
UKOilandGasData.com, information on 95% of oil and gas wells in the UK offshore is to be found,
including the spud date2 and well intent3. Data is provided for the full length of drilling activity in the
UK offshore (from 1967 up to 2015), for a total amount of 11,811 wells (Oil & Gas UK, 2015b).
The oil price data come from the New York Mercantile Exchange (NYMEX) and it measures up to
2008 prices for West Texas Intermediate (WTI) crude oil, which is the oldest and well-known
benchmark for global oil prices up to 2008. However, from 2009 on, European prices have begun to
differ due to intercontinental changes in oil supply. In order to reflect North Sea oil prices, from that
year on NYMEX Brent crude oil prices are measured. These prices reflect spot prices4 and they are
averaged per month. The data have been gathered through Thomson Reuters Datastream
Professional software. All prices are converted to December 2014 dollars using the All Urban, All
2

This is the date on which the ground was first penetrated for the purposes of drilling the well.
The original operators purpose in drilling the wellbore, as agreed with DECC (Exploration, Appraisal or
Development).
4
The spot price is the current price at which a barrel of oil can be bought or sold.
3

17

Goods Consumers Price Index (CPI) of the Bureau of Labor Statistics (BLS, 2015). The NYMEX WTIBrent oil price is visualized in Figure 5 as the solid black line.
Figure 5: Crude oil spot prices and futures curves (own figure, based on data from Thomson Reuters (2015))

Note: the black solid line refers to the WTI and Brent oil price in real December 2014 dollars. The coloured solid lines are
futures contracts in January per year, corrected for inflation and in real December 2014 dollars.

To measure production firms price expectations, prices for longer-term futures contracts are used5.
Since these contracts are traded at the horizon by deep-pocketed risk-neutral traders, this proxy for
price expectations is considered more consistent than no-change forecasts. These data have also
been assembled by the use of Thomson Reuters Datastream Professional and are converted to real
December 2014 dollars. Moreover, the contracts are corrected for inflation using the average
inflation rate between April 1983 (at which futures trading started) and December 2014 of 4.21%.
Figure 5 shows January contracts as coloured lines.
The figure shows the future market for crude oil is almost always backwardated: the futures price is
lower than the spot price. This is partly due to the relative high inflation rate for futures contracts,
but even without corrected for inflation backwardation is most prominent. Contango, which means
the futures price is higher than the spot price, is only revealed in the small periods of ultimate low oil
prices.
Finally, data for renting drilling rigs in the UK offshore have been obtained for the time period 20052015. These data originate from the Oil & Gas UKs Activity Survey 2015 and includes monthly
average rig day-rates for jack-ups and semi-submersibles (Oil & Gas UK, 2015a). Considering the
different time period and relatively rough data, both due to a lack of availability on cost data, these
5

A futures contract is a legally binding agreement to buy or sell a commodity or financial instrument in a
designated future month at a price agreed upon at the initiation of the contract by the buyer and seller
(Nasdaq, 2011).

18

data will only be used to support the drilling activity results. This is because drilling activity and rig
day-rates are believed to be linked since rig rentals are typically the largest expense in the overall
cost of a well, as discussed in Section 3.3.2.

3.2 Geological background

The UK Continental Shelf (UKCS) is characterized by mature oil fields, but also holds a range of lightly
explored and frontier sedimentary basins. The offshore part of the UKCS currently contains 186 oil
fields which have not been decommissioned, together producing 241 million barrels of oil in 2014
(DECC, 2015). Thanks to the geological setting of the North Sea Oil Province, the UK offshore is
established as one of the worlds major oil-producing regions. This section will go into current oil
production and oil potential according the following subquestion:
-

How do geological settings and reservoir pressure in the UK offshore affect current and
future oil production, to gain insight in the data needed?

There can be three different oil provinces distinguished in the UK offshore: the North Sea Oil
Province, the Irish Sea and the Atlantic Margin (Figure 6). For each of the three provinces the
geological settings will be explained and its production and oil potential will be described. Later on,
the role of reservoir pressure will be highlighted and put into context.
In order to understand the occurrence of hydrocarbons in the North Sea, a brief introduction to
petroleum systems is necessary. The accumulation of oil and gas in the subsurface requires four
essential ingredients. First, organic-rich source rocks generate oil and gas with burial and heating.
Buoyancy forces the oil and gas to migrate upward. Second, reservoir rocks, porous rocks which are
capable of containing the migrated petroleum in the pore space between the grains. Third, seal
rocks, impermeable rocks preventing the petroleum to migrate any further toward the surface. And
fourth, a trap, which is a structure or geometry in the subsurface in which the petroleum can
accumulate, creating an oil or gas field or both (Allen & Allen, 2005). Needless to say, this is a very
simplistic view on the mechanics behind petroleum systems, but it suits the scope of this study.

3.2.1 The North Sea Oil Province

Of the three provinces, the North Sea Oil Province is by far the greatest in production and the
number of oil fields (Figure 6). The geological history of the province is dominated by a period of
crustal extension, or rifting, in which the filling of basins with organic-rich sediments was accelerated.
This period let to the formation of the Viking Graben, Central Graben and Moray Firth rift systems,
which are basically depressed blocks of land bordered by faults. Organic-rich sediments matured to
source rocks and thus most of the oil fields lie close to these basins (Brooks et al., 2001). The
moment in time sediments were deposited is of importance and distinguishes the origin and age of
oil fields. Broadly, three different types of oil fields can be divided: pre-rift, syn-rift and post-rift. Prerift oil fields have source rocks that were deposited before rifting took place, syn-rift source rocks are
deposited during rifting and post-rift after rifting.

19

Figure 6: Location of UK hydrocarbon provinces and basins (DECC, 2013)

20

The most productive petroleum systems in the past on the UKCS, the Brent and Ninian systems, are
located up north the Viking Graben, close to the UK Norwegian border. They have pre-rift source
rocks and sandstone reservoirs, deposited in a deltaic environment. The seal rocks are mudstones
and traps are formed by tilted fault-block structures (Brooks et al., 2001). The fields in these systems
were one of the first to be discovered thanks to their size. They started production in respectively
November 1976 and December 1978. The oil production of the Brent field peaked in March 1984
with close to 16 million barrels that month, whereas the Ninian field peaked in January 1982 with
almost 10 million barrels. However, production today is only marginal, with in January 2015 Ninian
producing 0.4 million barrels and Brent just 0.02 million barrels (DECC, 2015). More details on the
production decline curve and the related reservoir pressure are described in Section 3.2.5.
Syn-rift oil fields, mostly located in the South Viking Graben and the Moray Firth, are currently the
most active in the North Sea. Thanks to their wide-spread high-quality reservoir sandstones, closely
associated mature source rock and wide-spread mudstones functioning as topseals, interest in these
kind of fields is high. Especially since the discovery of the Buzzard field in the Moray Firth formation
in 2001 (DECC, 2013). Ever since production started in 2007, it has been UKs most producing field to
the present day. Thanks to the drilling of new wells, the field has since 2007 been able to maintain a
monthly production of around 6 million barrels (DECC, 2015).
Sediments that have been deposited from the cessation of rifting to date have formed oil fields
mostly in the Central Graben, but also where the three formations come together. The reservoirs of
these fields are located in a succession of up to fifteen slightly dipping depositional layers6. Only
where a reservoir sandstone and a sealing mudstone are deposited in sequence, a successful
petroleum system may occur. Ever since the first North Sea oil discovery in 1969, the exploration of
these sequences has led to the discovery of 31 petroleum fields in the year 2001 (Brooks et al.,
2001). The oldest and one of the highest producing post-rift oil field is the Forties field. Starting
production in December 1975, it peaked in December 1978 with over 17 million barrels. Today its
production is still substantial with a steady 1.5 million barrels in January 2015 (DECC, 2015).

3.2.2 Atlantic Margin

The Atlantic Margin oil province includes the Faroe-Shetland Basin, north of Scotland, and the
relatively unexplored Rockall Basin, Hatton Basin and Hatton Continental Marginal, all north-west of
Britain (see Figure 6). These areas are characterized by water depths exceeding two kilometres,
which is considered deep compared to the North Sea. Moreover, the Atlantic Margin is different
from the North Sea oil province due to its basaltic volcanism. During the opening of the North
Atlantic between Greenland and North-West Europe, magma found its way through the Earth crust.
At places where it did, lavas and basalts are present, severely attenuating the seismic signal7. The
geologic history of the Atlantic Margin is therefore hard to construct, causing oil fields to be hard to
find. It might not come as a surprise that oil production in the Atlantic Margin area is relatively low,
although undiscovered reserves may be substantial (DECC, 2013).
Practically all of current production in the Atlantic Margin originates from the Faroe-Shetland Basin.
Oil was found as early as 1972, but economically viable reserves only in 1992. Current production
fields are utilised with floating drilling rigs, as there is no existing infrastructure. Today four active

Layers of homogenous depositional materials are rarely horizontal, they often have a dip toward a direction.
The dip is the direction and angle in degrees between a horizontal plane and the inclined layer (Skinner et al.,
2004).
7
Seismic is data that is acquired by reflecting sound from underground strata and is processed to yield a
picture of the sub-surface geology of an area in order to find oil or gas (PremierOil, 2015).

21

fields are present, of which the Clair and Foinaven fields are producing and the Loyal and Schiehallion
fields are temporarily suspended due to redevelopment (BP, 2015). In 2014, both the Clair and the
Foinaven field produced around 6 million barrels each. However, it has to be noted the Clair field
usually produces more and holds more reserves (DECC, 2015).
The Foinaven, Loyal and Schiehallion fields and most of the significant discoveries originate from
post-rift source rocks. This is mainly due to the fact that pre-rift and syn-rift prospects are difficult to
image, because of the basaltic volcanism mentioned earlier. Post-rift mudstones, known as the
Kimmeridge Clay Formation, are the source rocks while reservoirs are formed through basin-floor
fans8. This petroleum system is located in the west of the Faroe-Shetland Basin. The Clair field was
discovered later, which finds its origin in pre-rift source rocks with a reservoir provided by fractured
rocks. The field sits on a ridge and thus is located higher, causing it to be economically viable (DECC,
2013). In Figure 6 the Clair field can be found in the south-west of the Faroe-Shetland Basin.
The Rockall Basin, Hatton Basin and Hatton Continental Margin are the last truly frontier areas in the
UK designated waters. Only a minor part of the area has been licensed, back in 1997. Consequently,
only twelve wells have been drilled, which is practically nothing compared to the thousands of wells
drilled in the North Sea Oil Province. Although none of the wells drilled proven source rocks, two gas
shows9 have confirmed working petroleum systems are present at least locally in the Rockall Basin.
The forming of the basin was initiated by a period of crustal extension, but this period did not
continue into the next phase, leading the Rockall Basin to be considered a failed rift system. In this
case, the moment in time rifting was initiated is crucial. Due to the lack of geological knowledge
about this particular basin, it is not completely certain if it was initiated until Cretaceous times10. If
not, there is no potential for mature source rocks, which is crucial for a working petroleum system.
The Hatton Basin and Hatton Continental Margin are even less explored, with very sparse seismic
data coverage. Therefore, the geological history remains highly speculative, yet multiple studies
show possibilities for hydrocarbon reserves (DECC, 2013).

3.2.3 The Irish Sea

Located in between Ireland and Britain is the Irish Sea. In the UK designated waters can be
distinguished three basins; the East Irish Sea Basin, the Caernarfon Bay Basin and the Cardigan Bay
Basin. Of the three, the East Irish Sea Basin has the longest exploration history and it is the only one
commercially producing oil. In 2014, 1.8 million barrels were produced, mostly from the Douglas
fields (DECC, 2015). In the East Irish Sea Basin all production comes from fault-bounded traps, with
basinal mudstone source rocks, Aeolian sandstone reservoirs and top-sealed by mudstones and
evaporites (DECC, 2013).
The other two basins are currently being explored. They have proven to contain mature source rocks,
but mostly for gas production. Apart from some oil shows in exploration wells, no oil reserves have
been found in these basins (DECC, 2013).

3.2.4 Oil potential of the UKCS

The Department of Energy and Climate Change is constantly carrying out studies trying to establish
the oil potential of the offshore UKCS. These studies are not only based on exploration and appraisal
activities, but also on understanding of the geological subsurface. This section will shortly describe

A basin-floor fan is a reservoir formed by sediments that moved through incised valleys toward the basin and
was deposited on the basin floor (Allen & Allen, 2005)
9
An oil or gas show is defined as any indication of oil or gas observed while drilling (Allen & Allen, 2005)
10
The Cretaceous is a geological time period 145 to 66 million years ago (Allen & Allen, 2005)

22

the geological characteristics of the most promising oil potential areas. Subsequently, the potential
will be translated into actual numerical predictions of the remaining UK offshore oil reserves.
The North Sea Oil Province pre-rift petroleum potential in structures similar to the Brent and Ninian
systems, is believed to be limited since virtually every footwall closure has already been tested
(Brooks et al., 2001). However, the pre-rift source rocks of the oldest Moray Firth oil field Beatrice
are now believed to be widespread beneath the northern half of the oil province, extending far
beyond the graben margins. Moreover, the syn-rift reservoir rocks in the Moray Firth similar to those
of the Buzzard field are believed to be underexplored. This petroleum system is currently one of the
most explored and it is believed that is will continue to be an attractive exploration target. Finally,
the post-rift sequences in the Central Graben may hold undiscovered recoverable resources (DECC,
2013).
In contrast to the North Sea Oil Province, it is difficult to establish the oil potential of the Atlantic
Margin due to the lack and quality of seismic data. However, the DECC (2013, p. 32) expects the
Atlantic Margin to may have the greatest potential to replace existing UK hydrocarbon production by
the discovery of major new oil and gas fields. While the North Sea Oil Province most certainly holds
no major new fields, underexploration of the Atlantic Margin makes the yet to come discovery of
these major fields possible. The Faroe-Shetland Basin has already proven to be an oil-producing
province, with opportunities remaining for further oil discoveries. These discoveries can be found in
the known petroleum system of the Foinaven, Loyal and Schiehallion fields, but also in to be found
petroleum systems at the margins of the basin from pre-rift and syn-rift source rocks. The other
Atlantic Margin basins, north-west of Britain (i.e. the Rockall Basin, the Hatton Basin and the Hatton
Continental Margin), have no proven commercially producible reserves yet. The Rockall Basin holds
one proven viable petroleum system, based on oil and gas shows in exploration wells, but more
exploration is needed to find reserves. In the Hatton areas, potentially attractive geological
structures have been found, but the presence and maturity of significant source rocks remain to be
proved (DECC, 2013).
Most oil potential in the Irish Sea can be found in the East Irish Sea Basin, were oil production is
existing today. Future exploration will concentrate of extending this petroleum system. There are
other known widespread sandstone reservoirs in the basin, however for oil production local
mudstone topseals have yet to be found. The two other basins in the Irish Sea, i.e. the Caernarfon
Bay Basin and the Cardigan Bay Basin, have mostly gas potential. The Cardigan Bay Basin has some oil
potential, but it is not considered significant (DECC, 2013).
In order to quantify the oil potential of the UK offshore, it is necessary to distinguish between the
different types of oil potential. The DECC (2015) distinguishes:
-

Reserves, which are discovered, remaining reserves that are recoverable and commercial.
These reserves can be either proven, virtually certain to be producible, probable, a better
than 50% chance to be producible, or possible, a significant but less than 50% chance of
being producible.
Potential additional resources, being discovered resources that are not currently technically
or commercially producible.
Undiscovered resources, being undiscovered but potentially recoverable resources, based
on exploration activities and geological understanding.

The distinguished terms can be considered to be respectively descending in success factor.

23

Figure 7 shows the estimates for the reserves, potential additional resources and undiscovered
resources per region. Proven and probable reserves are summed up because both types of reserves
are expected to be produced in the near future. The North Sea Oil Province is divided into the
Northern North Sea and the Central North Sea. Moreover, the Atlantic Margin is split into the FaroeShetland Basin and the other basins north-west of Britain. The numbers are in million barrels of oil.
Figure 7: Offshore UKCS reserves growth and undiscovered resources per region (own figure based on data from DECC
(2015))

Note: the error bars for undiscovered resources show the lower and upper estimate

The undiscovered resources are rough estimates. For this reason, the lower and upper estimates are
visualized through error bars. However, each of the values for undiscovered resources still have to be
treated with caution. Many of the possible petroleum systems used to generate these estimates
have a high geological risk. To control this factor, the DECC has left out the prospects with a
geological chance of success of 5% and lower. However, with this action they assume that the
geological understanding and technology will improve. When considering a reasonable estimate
based on current knowledge, the prospects with a 10% and lower chance of success have to be
ignored, resulting in 65% of the undiscovered resources to be left. Finally, when basing the estimate
on recent drilling activity, the prospects with 20% and less should be left out, leaving only 20% of the
24

undiscovered resources. Estimates for undiscovered resources are therefore not only most uncertain,
they also heavily depend on improvements in geological understanding and technology toward the
far future11.
From the figure becomes clear that the North Sea Oil Province dominates the oil potential on the
offshore UKCS. However, the Atlantic Margin is expected to be an important region as well. The Irish
Sea is expected to contribute marginally to future oil production, mostly because it is considered a
gas province. Moreover, the Irish Sea is in a mature exploration phase, therefore only the upper
estimate expects undiscovered resources. The Atlantic Margin shows less oil potential than the North
Sea Oil Province since the basins are much smaller and less accessible. The estimates of undiscovered
resources are more uncertain, but on the other hand there is the possibility of finding new major oil
fields.
When it comes down to one number that gives the total amount of barrels of oil that could be
produced from the offshore UKCS from 2015 on it would be 15.5 billion, according to the DECC.
However, when assessing the likelihood of that number by each type of reserve (Figure 8), only 34%
is fairly certain to be produced. The 17% of the possible reserves currently have a significant but less
than 50% chance of being produced. The remaining 49% is considered to have even a lower average
chance.
Figure 8: The distribution into types of reserves of the future oil production of the offshore UKCS (own figure based on data
from DECC (2015))

3.2.5 The role of reservoir pressure

Reservoir pressure on the oil that is trapped inside reservoir rocks causes the oil to flow through the
pores of the rocks into the well. This energy either comes from fluid expansion, rock expansion
and/or gravity; the reservoir drives. The type of reservoir drive determines the production
characteristics of a reservoir and thus of the wells that are drilled into it (Hyne, 2012).
Four types of reservoir drives can be distinguished. There is the dissolved-gas drive: gas is dissolved in
the oil and expands when a well is drilled in the reservoir. The well decreases the initial high pressure
11

For more information on the methodology of estimating undiscovered resources, visit

https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/441087/Estimates_of_UK_U
ndiscovered_Resources_2015.pdf

25

on the oil, causing gas bubbles to push the oil through the pores into the well. A dissolved-gas oil
reservoir faces an exponential decline rate in reservoir pressure and thus in oil production; a rapid
decline early on, after which it approaches a steady but low rate of production (Hyne, 2012).
The gas-cap drive is somewhat comparable to a dissolved-gas drive, however this time the gas is not
dissolved in oil, but it is floating on top of it. When oil and gas are trapped in the same reservoir, gas
is above oil. Drilling a well in the bottom of the reservoir causes the gas to decrease in pressure and
expand, forcing the oil to flow into the well. A gas-cap drive shows a moderate, somewhat linear
decline in both reservoir pressure and production (Hyne, 2012).
A more obvious type of drive mechanism is the gravity drive, which is present in all oil reservoirs
since the weight of the column of oil pushes oil down into the well. However, this type is almost only
observed when a reservoir has depleted its original drive. The gravity drive characterized by a low oil
production rate, which can however stretch out over a long time (Hyne, 2012).
Last but not least is the water drive, where pressure originates from a water body adjacent or below
the reservoir. An active water drive provides an almost constant reservoir pressure and production
rate (Hyne, 2012). This type of drive is also often artificially applied by producers, by pumping water
from the surface into the reservoir, pushing the oil toward the well. This process is called
waterflooding (Jayasekera & Goodyear, 2002).
The majority of the worlds oil reservoirs is driven by the dissolved-gas mechanism while roughly
one-third have natural water drives. The dissolved gas-drive can only provide up to 20% of the
original oil in place and is therefore normally supplemented early in reservoir life by improved oil
recovery (IOR), such as waterflooding or gas injection. It is technically impossible to produce 100% of
the original oil in the reservoir, in fact recovery rates above 60% are rare. Using IOR, a range of 4550% is normal. At the end of the IOR processes, enhanced oil recovery (EOR) can be applied to
recover an additional 7 to 15% of the original oil in place. This type of recovery consists of thermal
and chemical processes, pumping steam, gasses or fluids into the reservoir to increase pressure
(Sandrea & Sandrea, 2007).
Waterflooding has also been applied to most of the UK offshore oil fields, from early in field life. Of
the EOR processes, the ones that have subsequently been implemented at full field scale in the UK
offshore are hydrocarbon water-alternating-gas (WAG) projects and post-waterflood reservoir
depressurisation. WAG projects aim on residual oil to mix with both water and gas to form one
solution, which flows into the well. Depressurisation is mostly implemented in fields with a high oil to
gas ratio after waterflooding. By depressurizing the reservoir, gas expands and is produced, along
with residual oil. Including fields with EOR projects, in 2002 the average recovery rate of fields in the
Central and Northern North Sea was estimated to be 45% (Jayasekera & Goodyear, 2002).
The role of reservoir pressure on the dynamics of oil production is substantial. The type of reservoir
drive determines the shape of the decline curve of a well or an entire field. When a well is drilled into
a reservoir, the initial production will be the highest due to the high reservoir pressure. As reservoir
pressure declines as production continues over time, production will decay toward zero. However, at
some time production will reach a point where production costs will equal net production revenue;
the economic limit. It depends on the depth of the well and the production characteristics. When the
limit is reached, the well is either shut-in and eventually abandoned or EOR processes will be
commenced (Hyne, 2012).
Applying the theory to the case of the UK offshore, well production profiles are hypothesized to
decline exponentially. However, they should be more stretched out over time due to the fact that
26

most UKCS fields are waterflooded from early in life on. Zooming out, looking at the oil production of
the entire UK offshore, a basically linear, slowly declining profile is expected due to the matureness
of the area. As wells are decaying toward their economic limit, fewer and fewer wells are drilled in
new reservoirs.

3.2.6 Conclusion
This section reflects on the subquestion asked earlier: How do geological settings and reservoir
pressure in the UK offshore affect current and future oil production, to gain insight in the data
needed?. With most fields being mature, current oil production follows a negative trend. However,
with high field lifetimes, reservoir pressure only decreases slowly. Despite the long history of oil
production on the UKCS, it is believed there could still be 15.5 billion barrels of oil be left of which
roughly one third is fairly certain to be produced.

3.3 Economic background

This section is included to provide a global overview of the economic size and dynamics of the UK
offshore oil industry. Moreover, it will go into the production firms costs as far as possible given the
publicly available cost data. Last but not least, the effect of the low oil price on each aspect will be
analysed. All of these aspects are included in the following subquestion:
-

How is the UK offshore oil industry currently situated in terms of operators and economics,
and how does the low oil price affect this situation and price scenarios, to gain insight in the
data needed?

3.3.1 Industry performance and trends

In the early 1970s the UK government commenced oil production, leading the UK to become the
second largest hydrocarbon producer in the EU (see Figure 9). Oil production peaked in 1999 with
over 900 million barrels, however it has subsequently declined by circa 7% a year (Deutsche Bank,
2013). Yet, in 2014 the hydrocarbon production decline was reduced to only 1.1% and it is expected
that in 2015 the UKCS should see its first increase in 15 years. Thanks to the expected start-up of new
fields, which should be greater than the 12% decline in production of existing fields (Oil & Gas UK,
2015a). It is likely though that this improved production will last for just a few years and is set to
move back to a declining trend. The UKCS is after all a mature oil province with a majority of fields
being in their last production phase (Deutsche Bank, 2013).
Over time, the UKCS has become a complex area, as is visualized in Figure 9. When oil production
was first commenced, it was dominated by a small number of large fields. Today, production is made
up of hundreds of much smaller fields. This has increased inter-dependency between the field and its
operators and has made UKCS production vulnerable. While in the early years fields had their own
infrastructure system, such as Brent, Ninian and Forties, there is a potential knock-on effect today.
When an important infrastructure piece is shut-in, planned or unplanned, it affects many fields (Oil &
Gas UK, 2015a).

27

Figure 9: UK offshore oil production by oil field since 1975 (Oil & Gas UK, 2015a)

Note: in this figure each field is characterized by a different colour. The thickness of the lines reflect the amount of oil
production.

Moreover, the increase in fields has led to an increase in operators, almost 50 in total (DECC, 2015).
Differences between these operators are great. There are the (super)majors on the one hand, but
also relatively small-sized companies specializing in for instance EOR processes for mature fields. The
diversity of UK offshore oil operators supports the claim that the UK offshore oil industry exhibits
perfect competition. Looking at the size of the industry at a global level (0.9% of world oil production
(BP, 2015)), the assumption that the industry is price-taking is also likely (Van Ham & De Vries, 2015).
Following the approach of Anderson et al. (2014) it is important for these aspects of the industry to
be true.
Assessing the UK offshore oil industrys performance and trends, another important aspect to look at
is exploration activities. On the UKCS, the number of exploration activities has collapsed in recent
years. In 2014, just fourteen exploration wells for both oil and gas were drilled, which was the lowest
rate of drilling since 1965. In 2015 eight to thirteen wells are anticipated. This trend is worrying, but
seems not to be driven by a lack of petroleum potential. Oil & Gas UK believes post-tax revenues on
exploration drilling are just not competitive. The collapse of drilling is therefore likely to be
correlated with the fiscal regime and the oil price (Oil & Gas UK, 2015a). The assessment of the
relation between the oil price and drilling activity will be performed in Chapter 4.

3.3.2 Costs and benefits

The history of costs and benefits on the UKCS is visualized in Figure 10. In the early years, benefits
consisted solely of funds from shareholders. However when production was commenced, the UKCS
started to raise revenues and re-invested them in the area, explaining the negative cash flow. Ever
since 1979 the cash flow has remained positive up until 2014. Increasing costs and decreasing

28

production have led to a negative cash flow today and is likely to restrain the near-term rate of
investment (Oil & Gas UK, 2015a).
Figure 10: Revenues and cash flows on the UK Continental Shelf (Oil & Gas UK, 2015a)

Taking a closer look at the costs (see Figure 11), four different types of costs can be distinguished:
operating costs, development costs, exploration and appraisal costs and decommissioning costs. The
trend of operating costs, or operating expenditures (OPEX), is striking in the sense that they are
almost ever increasing while production has been declining since 2000. Most of the expensive fields
are located in the Northern North Sea oil province, which consists of the Viking Graben. This area has
been developed for oil production early and saw its peak production in 1985. Many of the assets are
large steel structures, and although its production nowadays is just one sixth of its peak production,
operating costs have barely declined. On an unit basis, the Northern North Sea is therefore the most
expensive region, with an average unit operating cost of 27 pounds per barrel of oil equivalent. It is
no surprise the industry is trying to implement reductions on operating costs, even before the oil
price collapsed. To stay competitive in the current oil price environment, the average unit operation
cost should decline with 40% according to Oil & Gas UK. Realizing this would require a combination
of cost reduction, production efficiency and more investment in new production. However, with a
20% cost reduction having the same effect as a $10 increase in oil price, it is important for the UKCS
to see the oil price rise again (Oil & Gas UK, 2015a).

29

Figure 11: Total expenditure on the UK Continental Shelf (Oil & Gas UK, 2015a)

Looking at development costs, or capital costs (CAPEX), there is a significant increase from 2010
onward. Between 2010 and 2013 the stable high oil price and new discoveries made it attractive to
develop a handful new fields. In 2014 no new activities were sanctioned, but cost over-runs on the
other developments resulted in a record breaking capital investment. On the one hand, these fields
are expected to start producing in the nearby future and development costs will decrease. On the
other hand, since new investment is not likely to be sanctioned up to 2018, the further development
of the UKCS is in danger (Oil & Gas UK, 2015a).
Ignoring the role of exploration and appraisal costs, the last point of attention is decommissioning
costs: the costs of shutting down and removing production equipment from depleted oil fields. These
costs were absent until 2003. Starting small, decommissioning costs have reached one billion pounds
in 2014, 4% of the total costs. However, these costs are expected to double in five years and for 2040
Oil & Gas UK expects the costs to be 46 billion pounds (Oil & Gas UK, 2015a).
To provide more tangible cost values on field-level, it is useful to look at the North Sea rig market.
Anderson et al. (2014) mention that for an operator to rent a drilling rig from a rig contractor is
usually the highest cost in the life of a well. This is also confirmed by Chris Grieve, vice-president of
Wood Mackenzie, a global leader in commercial intelligence (Grieve, 2015). Drilling rigs can be
divided into jack-ups and semi-submersible rigs. Both types of drilling rigs are mobile offshore drilling
platforms. Jack-ups have retractable legs, on which the platform rests. Semi-submersibles contain
floats or pontoon submerged to give stability, kept in position by anchors (PremierOil, 2015).
Operators usually sign a single- or multi-year contract with the contractor in which a fixed rig dayrate is included. Drilling a well takes a few weeks or months, so in order to cover an entire field the
contract usually needs to last at least one year. The rig can be used for exploration, appraisal and
development drilling and for decommissioning. Contracts in the last five years have produced an
average day-rate for jack-ups of $100,000 to $170,000 and for semi-submersible rigs $250,000 to
$400,000. Note, these values are costs per day in order to drill a single well (Oil & Gas UK, 2015a). Rig
day-rates are hypothesized to vary with the oil price, however the analysis in Chapter 4 will go
further into that.
30

3.3.3 Effect low oil price

The Brent oil price was unusually stable for three years (2011-2014) with a price of $100 to $115 a
barrel. However, in June 2014 Brent prices started to collapse to below $50 a barrel in January 2015.
In the months to come the Brent oil price slightly recovered up to $65 in May, only to fall below $50
again in the first week of August. The combination of a slowdown in demand growth in developing
countries and continuing expansion of supply, especially in North America, led to the collapse. An
acceleration in the decline may be attributed to the announcement of the Organisation of Oil
Exporting Countries (OPEC) to cut its output (Oil & Gas UK, 2015a). A nice survey on understanding
the decline of the oil price since June 2014 has been carried out by Baumeister and Kilian (2015).
According to Oil & Gas UK the effects of the low oil price are mainly noticeable in the lack of
investments, accelerated measures of cost efficiency, less exploration activities and changes in the
rig market. As mentioned before, the UK offshore oil industry was already taking initiatives to reduce
operating costs, but the low oil price has only accelerated these macro-level measures. Moreover,
new capital investments are unlikely to be undertaken in the near future as firms compete for capital
globally. This lack of investment can also be seen in recent developments and expectations for
exploration activity. Already in 2014 a total of seventeen exploration wells were postponed and four
were cancelled, mostly related to financial constraints. The low oil price will probably be the cause of
more cancellations, and the lack of investment offers little hope for a lot of new exploration activity
(Oil & Gas UK, 2015a). This lack of investment is already noticeable in the rig market. The North Sea
Reporter, an established publication providing in-depth news and analysis of the North Sea rig
market, foresees problems as the number of idle rigs rises. In July 2015, fifteen of the circa hundred
rigs in the North Sea are stacked, rising to twenty in the next few months. This is directly associated
with operators expenditure reduction programmes in response to the low oil price. Moreover, firm
evidence has emerged that shows rig day-rates have dropped by 30 to 40% (North Sea Reporter,
2015b). Rig over-supply and dropping rig rates can therefore be seen as direct effects of the collapse
of the Brent oil price since the rig market is believed to exhibit perfect competition (Van Ham & De
Vries, 2015). The relation between the oil price and rig day-rates is further analysed in Chapter 4.
What does the future hold for crude oil prices? The EIA forecasts the future Brent crude oil price in
their Annual Energy Outlook 2015 considering four scenarios: a reference scenario, a high oil and gas
resources scenario, a high oil price scenario and a low oil price scenario. All cases account for market
conditions in 2014, with an average Brent oil price of $97 per barrel. However, only the reference
scenario and the high oil and gas resources scenario reflect market events through the end of 2014
with the oil price dropping to $56 in 2015, see Figure 12 (EIA, 2015b).

31

Figure 12: Brent crude oil spot prices in four scenarios, 2005-2040, real $2013 per barrel (EIA, 2015b)

The EIA considers multiple factors related to the uncertainty of future crude oil prices including
worldwide demand, crude oil production and supplies of other petroleum liquids. For the reference
scenario, there is downward price pressure due to increasing US oil production on the one hand and
upward price pressure due to increasing demand from non-OECD12 countries on the other. These two
aspects result in a steadily increasing Brent oil price, but which will be still below $80 in 2020. After
2020 US oil production will decline, yet increasing production from non-OECD and OPEC countries
still limit the oil price to $141 in 2040. The high oil and gas resources scenario follows the reference
scenario the first few years, then putting more downward pressure on prices due to higher crude oil
production resulting in $129 per barrel in 2040. However, different assumptions on demand,
production and supply in the high and low oil price scenarios show significant price variation (EIA,
2015b).

3.3.4 Conclusion
In Section 3.3 has been tried to answer the following subquestion: How is the UK offshore oil
industry currently situated in terms of operators and economics, and how does the low oil price affect
this situation and price scenarios, to gain insight in the data needed?. Already before the oil price
collapse, some worrying trends characterized the UK offshore oil industry. A diversity of operators
and fields cause operating costs to be increasing, while production is decreasing. The low oil price
only attenuates these trends and is expected to take some years to recover to $80 per barrel.

12

The Organisation for Economic Cooperation and Development (OECD) is an organisation trying to improve
the economic and social well-being of people around the world. Countries member of this organisation are
considered as developed countries, while the non-OECD countries are considered as developing countries
(OECD, 2015).

32

4 Empirical analyses: impact price incentives on oil production and

drilling activity
As discussed in Chapter 2, Anderson et al. (2014) find that oil production in Texas barely responds to
price incentives whereas drilling activity responds strongly. Moreover, the oil price and futures prices
have an impact on the costs of renting drilling rigs. Anderson et al. (2014) provide empirical and
statistically significant evidence for these findings, and therefore justify their modification to the
Hotelling rule. By imposing a constraint on oil production per well, induced by reservoir pressure,
they approach the Hotelling rule as a keg-tapping problem rather than a cake-eating problem.
Extraction decisions are therefore made well-by-well, instead of barrel-by-barrel.
This chapter will show to what extent UK offshore data on well production, drilling activity and
drilling costs can provide empirical evidence matching the results in Anderson et al. (2014), following
the question:
-

What is the effect of changes in the oil price and expected price increase rate on respectively
oil production, drilling activity and drilling costs, and do these results match with the results
in Anderson et al. (2014)? With other words, can the approach by Anderson et al. empirically
justified be applied to the case of the UK offshore oil industry?.

It is important to keep in mind that the industry cost structure of Texas on the one hand and the UK
offshore on the other have observed differences, further elaborated in Section 4.3. For this reason,
whenever there are differences in empirical results, explanations should first be linked to the
different cost structures.
The structure of this chapter is as follows. First, the impact of price incentives on oil production is
studied. In Section 4.2, the same type of analysis is carried out on drilling activity and costs. The last
section will elaborate on the differences and similarities between the cost structures of Texas and
the UK offshore.

4.1 Impact price incentives on oil production

The aim of the analysis on production data is to find out whether oil production in the UK offshore is
irresponsive to price incentives, similar to the results for Texas in Anderson et al. (2014), visualized in
Figure 2. By adjusting the flow rates or pumping rates of wells, production operators could respond
to oil price shocks. The sample consists of existing wells in 1990, with monthly production data up to
1999. It is of importance not to allow new wells to enter the sample, refraining them from having an
impact on oil production. The analysis is performed on a total of 702 wells, for which production data
are not missing for any month, whereas production is non-zero for at least one month. The wells in
the sample produce at average 50,335 barrels of oil per month (bbl/m), with a standard deviation of
99,415 bbl/m.
The green line in Figure 13 shows the average production per month, except for 1990, which is
ignored because in that year new wells were able to enter the sample. The black line shows the
monthly crude oil spot prices. The dashed red line represents the expected price increase in
percentages, i.e. the percentage change between the spot price and the 12-month future price for
every month. This line thus reflects the expected increase or decrease of the oil price for every
month.

33

Figure 13: Crude oil prices and production from existing wells in the UK offshore (own figure, based on data from DECC
(2015) and Thomson Reuters (2015))

Note: the black solid line refers to the WTI and Brent oil price in real December 2014 dollars on the right axis. The green solid
line shows average oil production in barrels per month on the left axis. The red dashed line represents the expected price
increase in percentages on the right axis.

At first glance, oil production follows a slightly curved downward trend, similar to the oil production
curve in Anderson et al. (2014). However, due to far less observations and higher production rates,
standard errors are higher leading to higher volatility. Taking a closer look at the curve, one could
argue the dramatic decrease of spot prices from October 1990 to April 1991 had an impact on oil
production, which fell from an average of 93,912 bbl/m to 69,956 bbl/m between March 1991 and
June 1991. The same could be said for the decrease in production in June 1995. Yet, there are several
reasons to believe the oil price has a minor impact on oil production.
First, the oil price depths which may had an impact on production are not the lowest depths in the
sample. In January 1994 the oil price fell to 23.39 real 2014 dollars, while the lowest spot price of
$15.94 was reached in December 1998. Since these prices reflect real 2014 dollars, it is not likely it
was the oil price that impacted production in 1991 and 1995, since it did neither in 1994 and 1998.
Second, an article in Oil & Gas Journal Volume 90 reported in January 1992 the conclusions from a
review of the UK North Sea oil industry in 1991 from County Natwest Woodmac13. It stated 1991 was
a weak or even negative year for many UK oil producers due to higher capital investment, costs
overruns, pressure on operating budgets, and lower than expected oil production. A large number of
new fields at an advanced stage of development and renovation of the infrastructure led to higher
capital outlays. Moreover, the implementation of the new safety recommendations, following the
Piper-Alpha disaster in 1988 which got 167 men killed, caused higher operating costs. Despite the

13

Today, this company is called Wood Mackenzie, a global leader in commercial intelligence.

34

quickly decreasing oil price early 1991, the article does not make any reference to oil prices related
to oil production (O&G Journal, 1992).
To provide formal proof of a lack of impact of price incentives on oil production, a statistical analysis
has been run. The methodology and results of this statistical analysis are described in Appendix A.
For the case of oil production has been concluded there is practically no statistically significant
response of oil production on the spot price or expected increase rate, regardless the type of lag
used.
Although the evidence for a lack of impact of price incentives on oil production seems convincing, it
is relevant to investigate the origin of the decreased oil production depths, especially the one in June
1991.
In Figure 14, existing wells in 1990 are again analysed. Although the wells are existing, they still can
have zero production in one or more months. This is because wells may have been depleted before
1990, but not yet abandoned because future technology might be able to make these wells
profitable again. Another option is that wells have been depleted during the sample period, and may
or may not have been abandoned. Also, wells can have zero production for just a few months and
then return to regular production, due to maintenance or redevelopment.
Figure 14: Number of shut-in wells in the UK offshore (own figure, based on data from DECC (2015))

Note: the green dashed line represents wells in 1990, in which wells were still allowed to enter the sample

Apart from the spike, an upward trend is observed, caused by the increasing number of depleted
wells. The number of shut-in wells may seem high at the start of the time period. This can be
explained by wells that have been producing, but were already depleted before 1990, however have
not yet been abandoned. These wells have (tried to) start up production somewhere in the sample
period.

35

Attention has been drawn to the spike, which appeared in April 1991 and is most likely responsible
for the decline in oil production. Compared to March 1991, 128 more wells were shut in in April
1991. The data show this increase was almost solely caused by four out of 40 oil fields: Cormorant,
Dunlin, Hutton and Thistle. These fields are all part of the Brent System (ExxonMobil, 2015), which
was shut down entirely for six weeks up from April 1991 due to the installation of emergency
shutdown valves (IEA, 1991). This maintenance related shut-down was followed by a three week
shutdown of the other constituent stream of the traded Brent Blend, the Ninian System (IEA, 1991).
These shutdowns fully explain the peak in shut-in wells and the depth in oil production in the period
April 1991 to June 1991, proving once more the inelasticity of oil production toward price incentives.
This conclusion contrasts with results from standard Hotelling models, in which production should
have been shut down in periods where the spot price is lower than expected futures prices. Thereby,
production should have responded to both positive and negative price shocks. Both responses were
not observed in the production of in 1990 existing wells.
The results and conclusion match very well with the results on oil production by Anderson et al.
(2014) despite huge differences in average oil production, the number of existing wells and the
different time period. Both the results show oil production as a slightly exponential, downward
trend, barely reacting to oil price shocks.

4.2 Impact price incentives on drilling activity and costs

Following on Section 4.1 in which oil production was examined, this section analyses drilling activity.
Drilling activity is hypothesized to be correlated with the oil price, as is visualized in Figure 3b.
Figure 15 shows the drilling of new wells, together with crude oil prices. This analysis focuses on
exploration and appraisal wells rather than developing wells14 since it is believed exploration and
appraisal wells are more prone to price incentives. After all, developing wells are only drilled when
exploration and appraisal wells have been successful, practically regardless the oil price. The analysis
is run on a total of 3,439 drilled wells with an average of slightly over ten wells drilled per month. The
time period runs from April 1983, when futures trading started, to June 2011, when the original well
intent of newly drilled wells stopped being reported consequently.

14

An exploration well is usually drilled to look for the existence of hydrocarbons. An appraisal well is drilled
after the discovery of hydrocarbons, to establish the limits of the reservoir. A developing well is drilled in order
to start production (PremierOil, 2015).

36

Figure 15: Crude oil prices and drilling of new exploration and appraisal wells in the UK offshore (own figure, based on data
from Oil & Gas UK (2015b) and Thomson Reuters (2015))

When comparing Figure 15 to the similar figure in Anderson et al. (2014), Figure 3a, the relationship
between crude oil prices and drilling activity seems to be much stronger for the Texas region.
Nonetheless, drilling activity in the UK offshore seems to follow spot prices to some level, looking at
the peaks in 1990 and 2008, whereas drilling activity decreases following price depths in for example
1986 and 2009.
In order to prove the existence of a relationship between drilling activity and crude oil prices, a
analysis has to come up with statistically significant results. This statistical analysis has been carried
out in Appendix A and indicated that the elasticity of the monthly drilling rate with respect to the
crude oil price is circa 0.95, four to six months later in time, and significant to the 1% level. For
details, again see Appendix A.
A positive correlation between crude oil prices and drilling activity, with a lag of four to six months,
should lead to an increase in the utilization rate of drilling rigs15. This should lead to higher rig dayrates, which indicate higher production costs. Therefore, a relationship between crude oil prices and
costs should exist, when considering a greater lag than four to six months. Due to very limited
availability of the industry cost data, only monthly averaged rig day-rates for jack-up and semisubmersible rigs for the period 2005-2015 have been used. In Figure 16 these data are visualized,
together with crude oil prices.

15

The utilization rate of drilling rigs is the percentage of rigs used with respect to the total available rigs in a
region.

37

Figure 16: Crude oil prices and jack-up and semi-submersible rig day-rates in the UK offshore (own figure, based on data
from Oil & Gas UK (2015a) and Thomson Reuters (2015))

The figure shows an evident relation between crude oil prices and rig day-rates with a lag of at least a
few months. The statistical analysis in Appendix A comes up with significant results for the lag of
seven to nine months up to the lag of thirteen to fifteen months. For jack-up rigs, the elasticity with
respect to the oil price is about 0.75 with a lag of seven to twelve months, significant to the 1% level.
For semi-submersible rigs the elasticity equals circa 0.81 with a lag of seven to fifteen months,
significant to the 1% level.
Thus, as the crude oil price increases, production does not respond. However, drilling activity
strongly responds four to six months later, causing rig day-rates to increase. The conclusion that rig
day-rates react to prices with a lag of at least seven months is strengthened by Section 3.2.3 in which
the effects of the oil price are described. It stated that in July 2015 the North Sea Reporter (2015b)
have noticed rig day-rates dropped 30 to 40% in June 2015, while the collapse of the oil price started
in June 2014. Due to the fact that the analysis was completed before the North Sea Reporter did this
discovery, it seems like the real life events back up the theory.
Drilling activity and consequently costs reacting to oil price incentives, matches the result by
Anderson et al. (2014). The only difference is that the lags are greater for the UK offshore, but that is
only considered logical, looking at the differences in cost structures as will be discussed in the next
section.

4.3 Similarities and differences in industry cost structure between Texas and the UK
offshore
The analysis of Anderson et al. (2014) on Texas oil production and drilling activity, let them to
document two empirical facts: First, production from drilled wells is almost completely
unresponsive to changes in spot or expected future oil prices and Second, drilling of new wells
38

responds strongly to oil price changes, and rig day-rates respond commensurately (Anderson et al.,
2014, p. 12).
Despite differences in production, drilling and cost numbers, the analysis on the UK offshore
performed in this study documents the same empirical facts. Statistical analyses have proven
production to be unresponsive and drilling activity and costs to respond to oil prices. The only
difference being the time in which the response occurred. Where in Texas drilling activity responds
within two months to oil prices, drilling activity in the UK offshore reacts after four to six months.
This difference is not surprising when taking into account the differences in drilling rig costs.
Anderson et al. deal with an average Texas rig day-rate of $8,008, while UK offshore rigs have a dayrate of $151,238 for jack-ups and $326,413 for semi-submersibles (see Table 1). It is therefore likely
oil companies in the UK offshore do not take their decisions as quickly and impulsive as Texas
companies might. The numbers in Table 1 for oil production and drilling activity moreover indicate
the UK offshore oil industry to be more rigid than the Texas onshore oil industry.
Table 1: Differences in production, drilling activity and costs between Texas onshore and UK offshore (Anderson et al., 2014;
DECC, 2015)

Average oil production per

well
Average number of wells
drilled per month
Average drilling rig rent rate
per day

Texas onshore
108 barrels

UK offshore
50,502 barrels

728 wells

10 wells

$8,008

$151,238 - $326,413

Anderson et al. argue that the empirical facts derived can be explained by an industry cost structure
with four relevant characteristics, mentioned briefly in Section 2.3. This section explains how these
characteristics can explain the price responses and whether or not the UK offshore possesses these
characteristics as well. Citations come from Anderson et al. (2014, p. 12).
1) The rate of production from a well is physically constrained, and this constraint declines
asymptotically toward zero as a function of cumulative production. The existence of a
maximum oil flow due to reservoir pressure is explained in Section 3.2.5 and applies to Texas
as well as the UK offshore.
2) The marginal cost of production below a given wells capacity constraint, [], is very small
relative to observed oil prices. Together with the capacity constraint, the low marginal
production cost explains the unresponsiveness of production toward oil prices. Whenever
the oil price is low, firms will not reduce their well production to save on costs. Whenever
the oil price is high, firms cannot increase their well production because of the constraint.
Finally, the reason why firms do not reduce their well production when oil prices are
expected to rise faster than the interest rate, is because deferred production cannot be fully
recovered when it is most valuable, as explained in Section 2.3.
When comparing the marginal cost of production of Texas to the UK offshore, there are
some differences. Anderson et al. argue that Texas marginal costs consist of energy to the
pump (if there is one) and transportation costs. For the UK offshore it is believed the costs of
improved or enhanced oil recovery processes (if there are any) and possibly transportation
costs are the most important costs. Concerning the recovery processes, waterflooding is the
most common one. However, the application of waterflooding is needed to make projects in
the UK offshore economically attractive (Jayasekera & Goodyear, 2002). It is therefore
unlikely these costs are large relative to oil prices, otherwise they would not make project
39

economically attractive. Concerning the transportation costs, almost all of the North Sea oil
fields are connected to existing infrastructure, making marginal transportation costs minimal.
Therefore, this characteristic is likely to suit Texas as well as the UK offshore.
3) The fixed costs of operating a producing well are non-zero. There may also be costs for
restarting a shut-in well, but they are not too large to be overcome. This characteristic
reflects the shut-in of some relatively low-volume wells in Texas when the oil price was low
in 1998, according to Anderson et al. Suggesting fixed operating costs are present,
production could have been no longer sufficient to cover these costs. Since many of these
wells restarted, it is moreover argued start-up costs can be overcome.
Although this study did not clearly encounter this type of shut-in, it is likely the UK offshore
cost structure has this characteristic as well. For example, in an interview with two offshore
oil industry experts came forward that if the oil price would be too low for a specific well, it
can be easily shut in and restarted at a later time (Van Ham & De Vries, 2015).
4) Drilling rigs and crews are a relatively fixed resource, at least in the short run. Higher rental
prices are required to attract more rigs into active use, leading to an upward-sloping supply
curve of drilling rigs for rent. This explains the response of Texas rig day-rates toward oil
prices and looking at the results, it should be no different for the UK offshore.

4.4 Conclusion
This section focussed on empirically justifying the application of the approach of Anderson et al. to
the case of the UK offshore, following the question: What is the effect of changes in the oil price and
expected price increase rate on respectively oil production, drilling activity and drilling costs, and do
these results match with the results in Anderson et al. (2014)? With other words, can the approach by
Anderson et al. empirically justified be applied to the case of the UK offshore oil industry?.
Anderson et al. found for the case of Texas that the oil price barely has any effect on oil production
per well. The average production shows a slightly curved declining trend and statistics prove there is
no correlation. For the case of the UK offshore, the same trend is observed and statistics back this up.
Thus, there is no effect of changes in oil price on oil production and this matches with Anderson et al.
When drilling activity is concerned, Anderson et al. observe a strong correlation between the oil price
and drilling activity, backed up by statistical significant results. The visualized correlation for the UK
offshore is less obvious, but statistics prove drilling activity reacts to changes in the oil price four to
six months later. This conclusion also applies to the effect of oil prices on drilling costs.
Any differences in the (visualized) results can be explained by the differences in production per well,
amount of drilling activity and the costs per well. However, since the four points that characterizes
the industry cost structure apply to both industries, it can be concluded that the approach by
Anderson et al. can be empirically justified be applied to the case of the UK offshore oil industry as
well.

40

5 The model: optimal UKCS specific drilling activity and oil production
Keeping the goal of assessing the future of the UK offshore oil industry in mind, the approach by
Anderson et al. (2014) will be used to find the UK offshore specific optimal extraction path. Anderson
et al. briefly describe the dynamics of their approach by modelling drilling activity and oil production
in the case of exogenous oil prices, as discussed in Section 2.3. They model for a single hypothetical
region, in which the industry takes prices as given. A constant high and a constant low oil price is
used, whereas for the other parameters general values are filled in, i.e. these values are not
considered to be realistic. The dynamics prescribed by Equation (5) and (6) are visualized in Figure 4a
and Figure 4b.
Since this study focusses specifically on the UK offshore region, the parameter values in the UK
specific model are as realistic as possible. Moreover, since forecasting a constant oil price is not
considered realistic, several oil price scenarios will be modelled in the UK specific model. To make
the model even more realistic, the UK offshore region is subdivided into four oil provinces, with each
their own reserve base. This way the following two subquestions will be answered:
-

What are the optimal drilling activity and oil production paths for the UK offshore oil
industry, and how does the oil price have an impact on these paths?
What are the dynamics of the model, i.e. how do the different parameters affect the optimal
paths?

The structure of this chapter consists of three sections. In the first section, the structure and
parameters of the model are discussed, together with the values given. Then in Section 5.2, the
optimal drilling activity and oil production paths for the UK offshore are given for different oil price
scenarios. In the last section the dynamics of the model are even further explored by looking at the
impact of changing the reserve, cost and discount rate parameters.

5.1 Details of the model

This section refers on the one hand back to the methodology of Anderson et al., as discussed in
Chapter 2, and on the other to the geological and economic background for giving values to the
parameters, as discussed in Chapter 3.
Before discussing the parameters themselves, some details concerning the structure of the model
are given. The model computes the optimal extraction paths for four different regions: the Northern
North Sea, Central North Sea, Irish Sea and Atlantic Margin (see Figure 6). Moreover, the optimal
extraction paths are different for each oil price scenario, as discussed in Section 3.3.3 (see Figure 12).
The model first calculates the optimal drilling activity () as prescribed in Equation (5), uniquely
determined by 0 as explained in Section 2.3. Then, the oil production () is calculated based on
the value of () for each time period, as prescribed by Equation (6). The model calculates both
drilling activity and oil production for every quarter from the year 2015 up to 2100.
The parameters are given by Equation (5) and (6) and are listed in Table 2.

41

Table 2: Overview of the parameters and their values used in the UK specific model

Symbol
(())

( )

Description
Costs in mln $ of drilling wells at time
. Consists of a cost intercept, which is
spend before drilling any wells, and a
cost slope, the cost of drilling a single
well.
Oil price. Constant in the Texas model,
varies in the UK specific model.

Value Texas
1 + 5

Value UK offshore
5 + 40

$50 and $100

Reserves per region. Are based upon the

possible reserves.

50 mln bbl

Reserves per well.

Initial well stock. Varies per region.

0.5 mln bbl

100 wells

Capacity rate, i.e. the maximum flow

from a newly drilled well. Equals the
decline rate times the reserves per well.
Discount rate. Constant over time.
Decline rate. Exponentially declines
toward zero.
Shadow value of the undrilled well.
Uniquely determined for every set of
parameters.
Initial oil production at time = 0.
Equals production over 2014, varies per
region.

0.05

Up to $75.52 (low),
$141.28 (reference),
$252.05 (high)
NNS = 870 mln bbl
CNS = 1245 mln bbl
AM = 427.5 mln bbl
IS = 15 mln bbl
10 mln bbl
NNS = 87 wells
CNS = 125 wells
AM = 43 wells
IS = 2 wells
1.92

0.1

0.1

e-0.1

e-0.192

Varies

Varies

0 mln bbl/year

NNS = 71.61 mln bbl/year

CNS = 155.84 mln bbl/year
AM = 11.94 mln bbl/year
IS = 1.85 mln bbl/year

The cost function is a guesstimate derived from correspondence with Chris Grieve, the vice-president
of Wood Mackenzie, a commercial intelligence company. It should be noted this function is not
based on actual data, but based on expert judgement. Oil price scenarios are derived from the
Energy Information Administration (EIA, see Section 3.3.3). The well stocks are based on the possible
reserves per region (see Figure 7) and an average reserve per well, empirically derived from the oil
production data in Section 3.1.
As mentioned earlier in Chapter 3 there could be 15.5 billion barrels left in the ground, yet the
possible reserves of only 2 billion barrels are considered as reserve base. The reason for this
assumption is twofold. First, the proven and probable reserves are considered to be included in the
initial oil production, i.e. existing wells will produce these reserves. Second, being aware a share of
the possible reserves are not likely to be produced, it is assumed this share is compensated by
producing some of the potential additional resources and undiscovered resources. The capacity rate
comes from the reserves per well times the decline rate, again empirically derived from the oil
production data. The discount rate is set at 0.1, as is usual in forecasting studies (Breaking into

42

Wallstreet, 2015). Finally, the initial production sums up to 241 million barrels as is described in
Chapter 3.

5.2 Optimal price paths in different oil price scenarios

This section tries to give an answer on the subquestion What are the optimal drilling activity and oil
production paths for the UK offshore oil industry, and how does the oil price have an impact on these
paths?. Making use of three oil price scenarios (a reference scenario, high oil price scenario and low
oil price scenario), the optimal paths are found and the impact of the oil price is assessed.

5.2.1 Drilling activity

First, the optimal drilling activity path for the reference scenario is modelled, with the values given in
Table 2. The result is visualized in Figure 17, where the grey columns and the dashed black line
represent the historical drilling activity and oil price per quarter over the period 2010-2014. The
coloured columns show the optimal drilling activity for every region as modelled, while the solid
black line reflects the oil price in the reference scenario.
Figure 17: Optimal drilling activity in the UK offshore considering the reference scenario

Note: this figure includes a lag of two quarters in accordance with the statistical results from Appendix A, i.e. drilling activity
only reacts to changes in the oil price after six months.

The optimal path modelled in Figure 17 is different from the result by Anderson et al., as shown in
Figure 4a. Not only do the absolute values on the axes differ, but also the course of the path.
Whereas the Texas model shows ever decreasing drilling activity, the UK offshore model computes
quickly increasing drilling activity for the first five quarters. Total drilling then levels out at around
thirteen wells per quarter for another five quarters, to decrease rapidly to zero in the year 2025.
The course of the path is directly correlated to the course of the oil price in relation to the discount
rate. This is where the Hotelling logic kicks in; the extraction rate (i.e. the rate of drilling activity)
43

needs to equal the rate of interest (i.e. the discount rate) over the full time of extraction. The
reference scenario expects the oil price to rise relatively quickly from $55 to $71 in five quarters.
Since this increase rate is higher than the rate of interest, drilling activity is therefore partly pushed
forward. After five quarters the oil price increase rate lowers to a rate similar to the rate of interest,
creating a plateau peak in drilling activity for another five quarters. Since the rate of increase
consequently lowers even further, drilling activity declines toward zero.
Since the model does not take into account historical drilling activity numbers, the optimal path
numbers need to be put into perspective. The grey columns show the drilling activity of development
wells in recent years, since this kind of well is drilled for the purpose of producing. However,
comparing the grey columns with the coloured ones is not straightforward since the actual drilled
wells are not likely to produce on average ten million barrels16. Still, it could be stated the peak can
be considered as an increase in drilling activity compared to historical drilling. Assuming the
modelled wells to be more productive, the increase could even be described as substantial. The
different types of wells may also well explain the seemingly lack of response of historical wells to the
oil price back then.
Looking at the differences between the four regions, no striking aspects are evident. One could say
the Atlantic Margin is not modelled to be as important as might expected, recalling the DECCs
statement the Atlantic Margin could replace existing hydrocarbon production. However, the model
assumes possible reserves as reserve base, whilst most reserves in the Atlantic Margin are
considered undiscovered. The impact of producing currently undiscovered reserves is modelled in an
self-contained scenario in the next section.
In order to assess the impact of the oil price on the optimal drilling activity paths, the model has been
run on a high oil price scenario and a low oil price scenario, as well as the reference scenario. These
paths are showed in Figure 18.

16

A development well can be defined as a well drilled within the proved area of an oil or gas reservoir to the
depth of a stratigraphic horizon known to be productive (PremierOil, 2015). Therefore, not every well will
necessarily be a fully productive well, while the model assumes all wells to produce ten million barrels of oil.

44

Figure 18: Optimal drilling activity in the UK offshore considering three oil price scenarios

Note: this figure includes a lag of two quarters in accordance with the statistical results from Appendix A, i.e. drilling activity
only reacts to changes in the oil price after six months.

The relation between the optimal path and the oil price increase rate has been established, but what
is the exact impact of the high and low oil price scenario on the optimal paths? Taking a look at the
green line, the optimal drilling activity in the low oil price scenario, there is a resemblance with the
result by Anderson et al. in Figure 4a. Both paths are ever decreasing toward zero, holding the same
remote cause. Since in the low oil price scenario the rate of oil price increase never exceeds the rate
of interest, the peak of drilling activity is at time = 0.
From Figure 18 becomes clear that not only the rate of oil price increase impacts the optimal path,
but also the absolute height of the oil price does. Looking at the red line, reflecting the high oil price
scenario, there is a peak after five quarters like in the reference scenario. However, the peak is much
higher, and total drilling ceases earlier. This is related to the discounted revenues which are higher,
causing more wells to be drilled.

5.2.2 Oil production

The optimal path for oil production follows directly from the optimal drilling activity per quarter and
the exponential decline rate related to reservoir pressure. The path starts at the given level of initial
oil production, equalling the average actual production per quarter over 2014. This level, together
with the rate of drilling activity, determines whether oil production is to increase, or decrease for
ever. The optimal oil production path considering the reference scenario is visualized in Figure 19. In
this figure the wide grey columns represent actual yearly production for the years 2010-2014, while
the small coloured columns show the optimal path per quarter.

45

Figure 19: Optimal oil production in the UK offshore considering the reference scenario

Note: this figure includes a lag of two quarters in accordance with the statistical results from Appendix A, i.e. drilling activity
only reacts to changes in the oil price after six months.

The grey columns once again show the decrease in oil production in recent years, a trend present
since 1999. However, the rate of decrease seems to lower as investments in new oil fields during the
years of a high and relatively stable oil price pay out. It is expected that the level of production will be
maintained or will slightly increase in 2015 and 2016 (Oil & Gas UK, 2015a).
However, the modelled optimal production path shows an strong increase in the years to come up to
2020, when production peaks at a level close to the level in 2010. Thanks to the high rate of drilling
activity early, the added oil flow by newly drilled wells is substantially higher than the exponential
decrease of initial production due to declining reservoir pressure. As drilling activity lowers to cease
in 2025, production consequently decays toward zero.
Comparing the different scenarios is visualized in Figure 20. The result is very much alike to the result
by Anderson et al. as visualized in Figure 4b; i.e. a high oil price scenario results in an early and high
peak whereas the low oil price scenario has a later and lower peak.

46

Figure 20: Optimal oil production in the UK offshore considering three oil price scenarios

Note: this figure includes a lag of two quarters in accordance with the statistical results from Chapter 4, i.e. drilling activity
only reacts to changes in the oil price after six months.

5.2.3 Conclusion
Assessing the four figures answers the question What are the optimal drilling activity and oil
production paths for the UK offshore oil industry, and how does the oil price have an impact on these
paths?. The optimal drilling activity and oil production paths show early peaks for each of the
scenarios. The oil price has an impact in such a way that it impacts the exact moment and height of
peaking. However, in either scenario, production in the UK offshore shows an increase in the shortterm. It is thus optimal to invest in drilling to the extent that drilling activity peaks early. The
Hotelling logic tells that the longer the peak is postponed, the less profitable the path will be since
revenues will never completely recover at the instant it is most valuable.
It is important to realize that these results and conclusion are derived from the specific set of
parameters and its accompanying values are given in Table 2. Changes in the value of any parameter
will result in a (slightly) different optimal path. Some alternative scenarios will be introduced in the
next section in order to assess the dynamics and sensitivity of the model,.

47

5.3 The dynamics and sensitivity of the model

The optimal paths and the impact of the oil price are known, but these observations are all based on
one set of parameters with specific values. Answering the question What are the dynamics of the
model, i.e. how do the different parameters affect the optimal paths? will give insights in the
dynamics and sensitivity of the model and therefore its credibility.
Judging from Table 2 it could be stated the most arbitrary, unreliable or unknown values for
parameters are the values for the reserves, the costs and the discount rate. By changing these values
and consequently modelling the optimal paths, the impact and sensitivity of the parameters is
discovered.

5.3.1 Reserves
The proven and probable reserves (see Figure 7 and Figure 8) are assumed to be produced by
existing wells; i.e. initial oil production will produce these reserves with the exponential decline rate
. The reserves shown in Table 2 () are therefore based upon possible reserves. Figure 8 indicates
the previous section assumed a total reserve base of proven, probable and possible reserves of
slightly more than half of the oil that could still be in the ground, i.e. 51%.
So what if all of the 15.5 billion barrels of oil will be produced, for instance because of quickly
improved technology? It is not hard to change these values for the reserves, but to keep the scenario
of producing all reserves somewhat realistic some measures have been taken. The oil price forecast
used is the High oil and gas resource scenario (see Figure 12). This forecast assumes an improved
technology, causing more oil and gas worldwide to be produced and thus expects lower prices. The
Potential Additional Resources (PAR) from Figure 8 are summed up with the possible reserves and
can be produced from the start. However, since the undiscovered resources still have to be
discovered, it is unrealistic they can be produced from the start as well. Therefore the undiscovered
resources are able to be produced from a fixed date on; that is the first quarter of 2025. Yet,
producers are unknown of the fact undiscovered reserves can be produced by then, causing the
optimal path to 2025 to be unaffected. The production of all undiscovered resources at once is
unrealistic, but will show the effect of the addition of new reserves.
In Figure 21 the scenario described above is modelled for drilling activity, in which the blue line
reflects the reference scenario as modelled in the previous section, whereas the black line represents
the high resources scenario. From the figure is clear that adding reserves to the initial reserve base
simply makes the optimal path to shift upward. Then in 2025, when the undiscovered reserves are
made possible to be produced, a huge peak in drilling activity occurs which immediately starts to
decrease to zero. The fact that the new peak is not postponed as showed by the initial peak is due to
the oil price, which is not rising faster than the interest rate from 2025 onward.

48

Figure 21: The optimal path for drilling activity in the UK offshore for the high resources scenario compared to the reference
scenario

Figure 22 shows the high resources scenario again, but for oil production subdivided in regions. Two
observations can be derived from the figure. First, the new peak in drilling activity leads also to a new
peak in oil production in 2030 of close to 150 million barrels of oil per quarter. This production
translates to 600 million barrels a year, which is about the same level as was produced in 2005.
Second, the Atlantic Margin seems to become somewhat more important than was modelled in the
reference scenario, but it cannot be stated the Atlantic Margin to have the greatest potential to
replace existing UK hydrocarbon production (DECC, 2013, p. 12).

49

Figure 22: The optimal path for oil production for the different regions in the UK offshore for the high resources scenario
compared to the reference scenario

Concluding, the amount of reserves has an impact on the height of the optimal path, but not on its
course. Moreover, any undiscovered reserves made possible to be produced in the future lead
drilling activity to peak again at the very instant, but then it decreases immediately to zero. If these
undiscovered reserves are great enough, they are able of making oil production peak higher than
initially.

5.3.2 Costs
In the model costs are denoted as a simple cost function consisting of a intercept and a slope. The
intercept can be seen as capital costs; costs that are made every time period irrespective the amount
of wells drilled. The cost slope gives the costs that are made for every well drilled. Since these values
are very hard to determine, especially the cost intercept, this section will look at the impact of
changing these values.
First, the cost intercept is multiplied by a factor ten (from $5 million to $50 million) and its effect is
visualized in Figure 23, where the reference scenario again is showed through the blue line. Despite
multiplying the cost intercept by no less than ten times, the impact on the optimal path is marginal.
There are two reasons explaining this observation. First, the cost intercept is relatively small
compared to the cost slope and the amount of wells drilled each time period. Second, the well stock
is fixed and all of the wells have to be drilled before drilling ceases. Combined, this leads to an impact
similar to a slightly lower oil price. Since drilling is a bit less profitable, the peak will be somewhat
lower and ceases a bit later.

50

Figure 23: The optimal path for drilling activity in the UK offshore with an increased cost intercept compared to the
reference scenario

For the cost slope, the value is doubled from $40 million to $80 million per well. Its effect is visualized
in Figure 24. Doubling the costs for drilling a well has a rather severe impact on the course of the
optimal path, especially compared to the impact of the cost intercept. The effect can be explained by
looking at Equation (5), where costs need to be equal to revenues. If not, all drilling would occur at
the instant it is most profitable; i.e. the moment the oil price start to rise slower than the rate of
interest. Since that is not possible, drilling activity is spread out. The higher the costs of drilling, the
more it needs to be spread out. This is what comes forward from Figure 24: a lower peak and a later
moment of ceasing drilling activity.

51

Figure 24: The optimal path for drilling activity in the UK offshore with an increased cost slope compared to the reference
scenario

Since all wells will be drilled no matter the profitability, it is important to know at what values for the
cost intercept and slope drilling is no longer profitable. Since 0 > 0 for drilling to be profitable, as
prescribed by Equation (5), this parameter can be set to 0 and the fixed amount of wells can be
modelled by changing either the intercept or the slope for each region. The results are listed in Table
3.
Table 3: Values for either cost intercept or cost slope for drilling to be profitable, or 0 > 0.

Region
Northern North Sea
Central North Sea
Atlantic Margin
Irish Sea

Intercept value ($ million)

< 913.13
< 906.27
< 921.12
< 928.60

Slope value ($ million/well)

< 3,076.96
< 2,140.87
< 6,223.46
< 133,802.98

Note: these values only apply according to the assumption that every drilled well produces 10 million barrels of oil in its
lifetime, and considering the reference oil price scenario

The results are reassuring to such extent that no matter the values for the costs, as long as they are
somewhat realistic, drilling is profitable and the optimal paths are credible.

5.3.3 Discount rate

The discount rate, or the rate of interest, is extremely important. Yet, it is impossible to be sure to set
the right discount rate for the future for any study. The discount rate is related to ethical aspects:
how much does an oil producer value producing in the future? If he values it low, he will produce
more in the short-term future. If he values it high, he will produce more in the long-term future.
Anderson et al. (2014) set their discount rate to 0.1 as it is consistent with a survey of oil producers
during their sample period. Moreover, in the oil and gas industry the standard discount rate is also
considered as 10%, known as the PV10 value, an acronym for present value at 10% (Breaking into
52

Wallstreet, 2015). Modelling the optimal paths for the UK offshore, 0.1 as the discount rate is also
used.
Yet, changing the discount rate can have reaching consequences. For example, 1000 dollars are
discounted at the rates 0.01, 0.05, 0.1 and 0.2 fifty years into the future. The net present value at
each of the interest rates vary substantially, see Table 4.
Table 4: Net present values of 1000 dollars discounted fifty years into the future at varying rates

Discount rate
Net present value

0.01
608.0388

0.05
87.2037

0.1
8.5186

0.2
0.1099

To see the effect of the discount rate on the optimal path of drilling activity, the model has been run
on each of these rates. The result is shown in Figure 25.
Figure 25: The optimal path for drilling activity in the UK offshore with varying discount rates compared to the reference
scenario:

From the figure becomes clear that the impact of the discount rate on the optimal path is substantial.
The most striking aspect of the figure is the dotted line, which shows the optimal path at a discount
rate of 0.01. However, its path is easy to explain. The oil price is forecasted to increase at all times
faster than a discount rate of 0.01 up to the year 2040 where it stops forecasting. From 2040 on, the
oil price is assumed to be constant and therefore lower than the discount rate. Thus, the 0.01
discount rate path peaks in 2040, but this rate is not considered realistic. From the other paths
becomes clear that the higher the discount rate, the higher the peak and the earlier drilling ceases.
The height of the discount rate is food for discussion. The so-called PV10 value tends to overvalue
reserve types as they grow more uncertain (ValueScope, 2015). Since the model uses uncertain

53

reserves as input, a discount rate of 0.15 or 0.2 could be considered more realistic than a discount
rate of 0.05 or 0.01.

5.3.4 Conclusion
This section tried to answer the question What are the dynamics of the model, i.e. how do the
different parameters affect the optimal paths? by assessing the impact of varying reserves, costs
and discount rates. Reserves impact the height of the optimal drilling activity path, but principally not
the course. The cost intercept has a marginal effect on the optimal path, which is comforting since
this is one of the most arbitrary parameters. The cost slope impacts the peak and the moment of
ceasing, but is considered less arbitrary. Finally, the discount rate can severely affect the course, the
peak and the moment of ceasing of the optimal path. However, for the credibility of the study this is
no great issue since any forecasting study deals with this problem and the standard discount rate for
the oil and gas industry is considered to be 0.1. Yet, a higher discount rate could result in an
improvement of the model whereas a lower discount rate is unlikely to be realistic.

54

Conclusion
This study is carried out guided by the following research question:
-

Using a reformulated model of Hotellings classic model, what is the future economic
viability of the UK offshore oil industry in the context of oil price and geology?

It can be concluded that the future of the industry is economically viable. This is due to the fact that
the optimal path for oil production in the UK offshore increases for every oil price scenario, despite
the exponential decrease in production due to declining reservoir pressure. The UK offshore reserve
base is great enough to increase production through an optimal peak in drilling activity within a few
years.
However, to follow the optimal drilling activity and oil production path, the UK offshore oil industry
needs to invest greatly in drilling development wells in order to realize a peak in drilling activity in a
few years. The exact moment of peaking is at that point in time when the interest rate exceeds the
oil price increase rate. Assumingly, this is at the moment the oil price is recovered to about $80 per
barrel. Postponing drilling, for instance due to a lack of investment because of the current low oil
price, will result in a path that will never be able to completely recover at the instant it is expected to
be most valuable. Instead, it must be recovered at oil prices lower in present value.
In the introduction of this report it is mentioned the UK offshore oil industry body Oil & Gas UK states
that the industrys cost base is unsustainable and that exploration activity on the UKCS has collapsed.
For further oil and gas production both a regulatory and fiscal reform are required. First, a resourced,
independent and expert regulator should be established, whos task it is to maximise the realised
value of the UKCS reserves with facilitating collaborative behaviour. Secondly, Oil and Gas UK states
that a wide-ranging fiscal reform to the regime is necessary to regain international competitiveness,
reflecting a mature and high-cost offshore environment (Oil & Gas UK, 2015a).
Comparing these two propositions to the results of the research indicate that there are some
similarities. A regulatory reform carried out through an independent and expert regulator would
bring firms in the industry together, sharing information and depicting a strategy to maximize the
value of the reserves. This approach is more likely to result in an early drilling activity peak than a
business-as-usual scenario since information on reserves and incentives to invest are key to maximize
value. Therefore, a regulatory reform is in compliance with the results of this study as the reform is
likely to further approach the optimal path.
Reforming the fiscal regime is according to this study not absolutely necessary taking into account
the profitability of the UK offshore oil industry. If a lower tax would be required, cost values for
drilling to be profitable should come close to actual drilling costs in the UK offshore. Table 3 in
Section 5.3.2 shows these values are very high and cannot be close to actual values. Therefore a
lower tax is not necessary for the UK offshore oil industry to be profitable. On the other hand, a
lower tax would encourage firms to invest in the UKCS since firms are at the moment scared to invest
due to the low oil price. A lower tax would provide more security for firms to invest.

55

Discussion
I would first like to touch upon the issue of the input data used in this study. Whereas the input data
for the empirical analyses in Chapter 4 is fairly solid with lots of observations on both well production
as drilling activity, the input data for the UK specific model in Chapter 5 is rather arbitrary. Although
the dynamics analyses in Section 5.3 show that the course of the path does not change dramatically
when adjusting the values of the parameters, the fact remains that some of the values are nothing
more than guesstimates. The reason for the relative low quality of the model input data is the scarce
public availability on reserves and especially on costs.
Thereby, this model is as any other model an simplification of reality. I realize that accomplishing an
almost instant peak in drilling activity is practically impossible, especially when taking into account
the matureness of the UK Continental Shelf. I therefore like to emphasize the conclusion should be
interpreted in such a way that approaching the optimal path should be based on relatively high
drilling activity in the near future.
By no means I state that the set of parameters and their accompanying values used in this study is
right or the best. Moreover, as I tried to answer the research question by modelling the optimal
paths, I intended this study to show the mechanics, dynamics and possibilities of the model of
forecasting the optimal path.
The possibilities of the model are basically endless. To give some examples, a complex cost function
could be built in, different kinds of reserves could be accounted for, as well as different kinds of
reservoir pressures. In fact, the whole model could be extended to a field-level or firm-level model in
which every field or firm would have their own geologic and/or economic characteristics. Since the
model is very flexible, really only two things are needed to extend it: time and data. This study has
tried to stretch its boundaries on both aspects, but oil production firms or other types of firms
related to the oil industry should be able of extending the model to some level.
A possible follow-up study should therefore focus on making the model as realistic as possible by
extending the model and by making it more complex. I believe extending the model to field-level
with specific and credible data is crucial for creating a realistic model.
As far as I know, this kind of Hotelling approach is not used by any firm or industry to measure its
optimal path on drilling activity or oil production. Yet, I most definitely believe the approach by
Anderson et al. (2014) and this study should be considered as a view on the industry worth looking
into. This theoretical view is different from the standard cost-benefit analysis used in the industry,
not necessarily better, but not necessarily worse as well. Hence, the possibilities to extend the model
could make the approach a very powerful tool for the industry to calculate the optimal path for
drilling activity and oil production.

56

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Appendix A: Statistical analysis

In order to provide proof of the inelasticity of oil production, and the elasticity of drilling activity and
costs with respect to oil prices and the expected increase rate of futures prices, a regression analysis
is carried out in this appendix.
For oil production, the log of monthly production of wells existing in 1990 is taken. For drilling
activity, the log of new exploration and appraisal wells drilled per month is taken. For costs, the
logarithm of monthly averaged rig day-rates is taken. All are regressed against the logged spot price,
and the expected annual increase rate of futures prices in percentages. The analysis is performed in
first differences, reflecting changes rather than absolute values. This approach makes sure results are
triggered by changes in one or more variables, instead of some trend over time.
Since it is expected responses are observed after some time, multiple lagged differences are
included. The lagged differences are expressed as moving averages of changes over three months.
The first lag of the spot price equals the average change in spot price for month 1 up to
month 3. The number of lags for each dependent variable is determined by minimizing the AIC
criterion.
The regression for oil production could be formulated by the following equation:
( )
= + 0 ( ) + 1 (1 ) + + ( )
+ 0 ( ) + 1 ( 1 ) +
+ 2 ( ) + +
(7)
The regression contains a time trend , which is included to account for the possibility the
decline curve is hyperbolic rather than exponential. Finally, the regression is carried out calculating
Newey-West standard errors, which improves the regression in such the way that it corrects for the
effects of correlation in the error terms applied to time series data.
In Table 5 the estimates of the regression are displayed for all four dependent variables, with bold
coefficients representing significant estimates. In column (1) the estimates for oil production are
showed including the time trend, while column (2) excludes the time trend. None of the price and
increase rate variables are significant to any level, apart from the first increase rate lag, which is
weakly significant. However, this seems to be a lucky shot. The insignificance of the variables proves
the inelasticity of oil production toward price incentives.
When looking at column (3) and (4), the estimates for drilling activity, significant coefficients are
present in the second lag of both price and increase rate. For price the coefficients are strongly
significant, to the 1% level, and represent an elasticity of about 0.95. So for every 1% increase in the
spot price, drilling activity increases by 0.95%. Since increase rate is measured in percentages, every
1% increase in expected futures prices reflect about 0.72% increase in drilling activity.
For the cost regressions in columns (5) to (8), strong significant results are present from the third lag
on. Jack-up rig day-rates seem to respond to a 1% increase in spot prices seven to 12 months later
with a 0.75% increase (with a standard error of 0.1992), significant to the 1% level. The weakly
significant coefficient in column (6) for the pricet variable could may be explained by jack-up
operators who directly adjust their day-rates, whenever a price shock takes place, not waiting for the
rig utilization rate to respond.
Semi-submersible rig day-rates respond seven to fifteen months later with a 0.81% increase (with a
standard error of 0.1993), again significant to the 1% level. The added lag could be explained by the
60

magnitude of the semi-submersible rig day-rate, which is roughly twice as high as the jack-up rig dayrate. Responses to price incentives could therefore be a bit slower.
All results together could be well-explained: whenever the spot price of expected price increase
changes, oil production does not react. However, drilling activity does, with a lag of four up to six
months. An increase in drilling activity most likely reflects an increase in the regional rig utilization
rate. This phenomena induces rig operators to boost their prices seven to fifteen months after the
original spot price or expected futures price increase.

61

Table 5: First-differenced regressions of UK offshore oil production (January 1991 December 1999), drilling activity
(January 1991 December 2010) and rig day-rates (April 2005 January 2015) on oil prices.
LOG (PRODUCTION)
VARIABLES

(1)

(2)

LOG (DRILLING
ACTIVITY)
(3)
(4)

LOG (JACK-UP
DAYRATE)
(5)
(6)

LOG (SEMI-SUB
DAYRATE)
(7)
(8)

LOG PRICE
T(0 TO T+2)

-0.2607
(0.1872)

-0.2124
(0.1831)

0.1022
(0.5087)

0.0690
(0.5000)

0.1605
(0.1256)

0.1657*
(0.0958)

-0.0855
(0.0892)

0.0156
(0.0831)

LOG PRICE
T-1 TO T-3

0.1907
(0.1386)

0.2001
(0.1383)

-0.3233
(0.3740)

-0.3356
(0.3757)

-0.0206
(0.0999)

-0.0181
(0.1108)

0.0253
(0.0763)

0.0715
(0.0776)

LOG PRICE
T-4 TO T-6

-0.0353
(0.1641)

-0.0291
(0.1587)

0.9684***
(0.3635)

0.9443***
(0.3457)

0.0866
(0.0985)

0.0885
(0.0898)

0.0920
(0.1347)

0.1262
(0.1378)

LOG PRICE
T-7 TO T-9

-0.2010
(0.1383)

-0.2388
(0.1458)

-0.5827
(0.3925)

-0.5676
(0.3804)

0.3515**
(0.1449)

0.3545***
(0.1290)

0.3310**
(0.1563)

0.3916***
(0.1350)

LOG PRICE
T-10 TO T-12

0.0307
(0.1862)

-0.0027
(0.1694)

0.4913
(0.3819)

0.5183
(0.3752)

0.3950***
(0.1084)

0.3973***
(0.0972)

0.1361
(0.1157)

0.1761*
(0.0981)

0.2641**
(0.1043)

0.2413**
(0.1130)

LOG PRICE
T-13 TO T-15
INCREASE RATE
T

-0.0008
(0.0011)

-0.0005
(0.0012)

-0.0056
(0.0048)

-0.0056
(0.0048)

0.0013
(0.0011)

0.0014
(0.0009)

-0.0011
(0.0013)

-0.0001
(0.0015)

INCREASE RATE
T-1 TO T-3

0.0015
(0.0011)

0.0018*
(0.0010)

-0.0025
(0.0035)

-0.0028
(0.0034)

-0.0010
(0.0012)

-0.0010
(0.0013)

-0.0010
(0.0013)

-0.0005
(0.0012)

INCREASE RATE
T-4 TO T-6

0.0001
(0.0013)

0.0003
(0.0012)

0.0074**
(0.0035)

0.0069**
(0.0033)

-0.0013
(0.0009)

-0.0013
(0.0009)

-0.0021
(0.0014)

-0.0016
(0.0013)

INCREASE RATE
T-7 TO T-9

-0.0013
(0.0012)

-0.0015
(0.0012)

-0.0045
(0.0030)

-0.0044
(0.0030)

0.0027
(0.0018)

0.0027*
(0.0016)

0.0026
(0.0018)

0.0035**
(0.0015)

INCREASE RATE
T-10 TO T-12

0.0004
(0.0016)

0.0002
(0.0015)

0.0000
(0.0036)

0.0002
(0.0036)

0.0040***
(0.0013)

0.0041***
(0.0010)

0.0010
(0.0016)

0.0018
(0.0013)

0.0020*
(0.0012)

0.0017
(0.0013)

INCREASE RATE
T-13 TO T-15
TIME_TREND

-0.0254
(0.0202)

0.0775
(0.0952)

0.0047
(0.0321)

0.0848***
(0.0306)

CONSTANT

-0.0141***
(0.0025)

-0.0155***
(0.0024)

-0.0090
(0.0102)

-0.0070
(0.0095)

-0.0033
(0.0050)

-0.0032
(0.0051)

-0.0055
(0.0051)

-0.0036
(0.0052)

108

108

240

240

118

118

118

118

0.0940

0.0886

0.0703

0.0792

0.4376

0.4375

0.4631

0.4256

Note: Data are monthly, but lags are moving averages over three months. The expected rate of price increase is measured
as a percentage. Standard errors in parentheses are Newey-West with 6 lags. Coefficients with * are significant to the 10%
level, with ** to the 5% and with *** to the 1% level, all in bold.

62