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Interview with Jim Hannon, Hannon Westwood

03 October 2008

Jim Hannon has got some mixed news about the future of the North Sea oil and gas industry. On the upside, there are more resources still hidden beneath the seafloor than most people would ever believe. On the downside, without a huge injection of outside capital and a move to consolidate among small-cap explorers, it could all be down there for a very long time.

Hannon should know. The ex-BP geoscientist has spent most of his career devoted to oil and gas exploration and production in the North Sea. Along with business partner Charles Westwood, he now runs respected consultancy firm Hannon Westwood, advising E&P companies on how and where to boost their chances of oil and gas success.

He says the regeneration of the North Sea industry that started back in the 1990s is now reaching a critical point. With heady oil prices, surging interest and improving technology, small-cap companies have got a grip on the potential still left in the North Sea. But turning a discovery into cashflow doesn’t come cheap, and with a funding gap that runs into billions of dollars, Hannon is uncertain about how or when that potential can be tapped.

Major legacy

Offshore UK oil and gas production really took hold back in the 1960s, when the markets were opened up and the big majors arrived with their know-how, will and financial base to work the North Sea. While it had its advantages at the time, Hannon says the legacy those majors left behind means that the North Sea is now is now much more suited to small-cap companies.

According to Hannon, around six years ago the UK Government seized the initiative to resuscitate the ailing industry by putting in place a series of regulations. Among other things, those rules encouraged oil majors to recycle unloved or unwanted acreage by returning it to the market. At the same time, the DTI – as it was known then – arranged a series of cheap new licensing rounds, recognising that a lot of the staff that had been laid off in the 1990s were capable of reforming themselves into smaller companies.

“They put recycled acreage together with cheap licenses alongside a willing and maturing group of people who saw the opportunity,” Hannon says. “It created a real buzz – they actually recreated exploration in the North Sea.

“People tend to think the North Sea is on its knees. While 34bn barrels of oil and gas has already come out of the ground, we estimate that there is nearly 27bn barrels left to go.”

Of that number, 9bn is certain, about 3bn to 6bn is in line and another 12bn is potential – in other words, proven, probable and possible. Right now, 9bn barrels is in production and owned mostly by the oil majors. But while some of those oil giants have clung on to milk their licenses for all they are worth, Hannon says a new group of smaller companies has emerged and begun looking at ways to get at the acreage.

As he explains: “A 20m barrel prospect is neither here nor there to an oil major - if you’ve got 1bn barrels in your portfolio it’s 2% of your business. You naturally need to chase 100m – 500m barrels. But if you’re small, with nothing, 20m barrels at $100 a barrel is worth $2bn of sales. Now what would you give for $2bn of sales in any business? Your right arm. That’s why small-caps have an environment in which they are excited and wish to thrive.

“For five years the environment has been favourable and the consequence of that is where we had 75 companies five years ago we’ve now got 173 all working in the North Sea. It’s an amazing array of companies to exploit what’s out there.”

But while Hannon says the Government has done well to create the environment for an oil and gas renaissance in the North Sea, he says the smaller companies that are now leading the way face new constraints.

“Where is the money coming from?” he says “Back in 1965 the money came from the deep pockets of the seven sisters, but now there is no deep pocket. These small companies have to go to the banks, private investors or wherever they can and there is a whole range of funding being sought by them to try and muddle through for a year or two.

“But if you’re drilling a $25m-$30m well these days – and the odds are that it will be a dry well to start with – you’re asking someone to put money in to back your judgment. There maybe three dry holes and maybe a fourth that’s successful. It’s a heck of a take.

“If banks and shareholders fund 150 companies I personally think about 50 would be successful and 100 could fail. So as the stakeholder, you could be backing the wrong horse.”

The funding issue has been exacerbated in recent years by soaring costs that have seen the average cost of a well shoot from $10m-$15m to $20m-$30m. But despite the eye-watering numbers involved, statistics show that there has been an equally huge jump in profits coming out of the North Sea.

“In Aberdeen, for instance, the contractors have bathed in the light of rising oil prices and rigs have trebled or quadrupled in price,” Hannon says. “And I don’t think those prices will come down - we’ve got enough information to show that the North Sea has a queue of about three years of wells to come. The rig industry has a full order book for as long as the eye can see.”

Small-cap opportunity

On Hannon’s numbers, there are around 100 companies in the North Sea that don’t have any production – and around 50 that do. He says the success rate of those smaller players is no worse than the majors and in some instances better because they can be more focused.

“Small companies are technically capable overall,” he says. “In the early days the acreage they were given was called “promote” acreage, and the quality was dubious – it was the first attempt to recycle something that nobody wanted. But since then, as they have gained a foothold they have been able to negotiate, spot things, farm in to other people’s acreage, work together, and I think the consequence of that is that they have improved their finding rate and they have improved their commercial ability.”

Hannon says the small-cap contingent has also benefited from more than 400 discoveries that were made by oil majors down the years but left fallow, often because of their small size. But despite their size, these fallow discoveries have proved a big draw for small companies not least because they have a larger appeal for investors.

Hannon says the role of the small-caps should now be to do what has been identified for nearly 20 years – to get after the small oil and gas pools which are material for them but not for the majors.

“I can see the market starting to work in their favour,” he says. “The question now is who wants to invest the time and patience? Many investors will have been tinkering with the market for three or four years and still not had any return. So time is running out for the small-cap. He has to try to bring a discovery on stream quickly with limited people resources. Lots of contractors will help him these days but even so it’s a struggle to go from nothing to production in two or three years.

“The big problem is that while the industry has found the money for drilling wells – typically $1-2bn a year for the last three years – that’s nothing compared to developing 400 discoveries. With 3bn barrels queuing up right now for development, each barrel requires about $25 to develop – that’s $75bn needed to bring on stream the current array of oil and gas properties.”

He believes part of the answer to this material funding gap is the introduction of new players – Korean, Chinese, Japanese, Far East, Middle East companies. “We see signs from these companies,” he says. “Taqa Bratani is a good example, a Middle East company that seems to have almost endless funds to get in to the UK, Europe and North America. It has a massive budget, far beyond anything we’re normally used to.

“There is a great opportunity for small-caps to wire in funds to speed up development if they can excite the right market. The problem is that the amount of funding needed is so huge that if you need an extra $30bn or $40bn for the next two years, where do you go for that sort of money? There is a very restricted number of banks in the UK and some limited private shareholdings. There is also very little involvement from North America or the Far East or Middle East because I don’t think they fully understand it yet. If they did, I think there could be a tremendous opportunity for them.”

According to the statistics, somewhere between 60-90 wells are being drilled in the North Sea every year – up from around 20 wells five years ago. Hannon expects that level to continue for another three years before the need for extra cash to fund field development gets critical.

“If we don’t find the money, all this oil and gas could sit there for a long time undeveloped,” he says. “The small-cap model may not be adequate to get at all this resource. One of the big questions is where does all this money come from in a timely manner and how many small-caps will fall over waiting? There will probably have to be big consolidation among these 100 or so companies to compress them in to something that is better funded. You wonder why it hasn’t happened more quickly.”

www.hannonwestwood.com

Ben Hobson, SmallCapNews.co.uk