The recent divergence between global crude oil and UK natural gas prices could threaten investment in dry gas fields in the UK, offshore association Oil & Gas UK told Platts in a briefing. There is a risk that reserves in the southern gas basin and new gas finds West of Shetland could be left stranded, the trade body said.

Surplus gas supply has resulted in the collapse of prices in the UK," gas and commercial issues manager David Odling said. "The UK continental shelf is a high cost, highly taxed province and all of this is affecting investment in new gas reserves." The southern gas basin and West of Shetland regions were the "most exposed," economics and commercial director Mike Tholen said.

The big problem is that operating costs are being driven up by the high oil price.

The incentive to produce more oil worldwide drives up costs including skilled offshore labor and drilling rig rates for rigs which can explore for either oil or gas. North Sea oil fields can afford to pay these higher costs, because they sell their oil at high international prices. But UK gas prices are now unusually low.

Since the opening of the new Norway/UK Langeled and Dutch/UK BBL lines in late 2006, the UK has been enjoying a brief period of surplus import capacity. UK gas prices - recently around 20 pence/therm day ahead - are now lower than other gas markets around the world (US Nymex gas for July has been trading around $8/mmBtu or 40 p/th).

And UK gas prices are also much lower in relation to oil than they used to be.

Oxford-based energy consultants Poyry have produced a new study of the UK gas market for Oil & Gas UK, covering past and future price development and investment drivers.

The report says that in gas investments 60% of the costs are directly linked to oil investment and 40% are unrelated - such as the cost of a gas-only drilling rig.

"As a result, high oil prices on their own have significantly increased the cost of searching for and producing gas in the UK continental shelf," says Poyry. "The biggest threat to UKCS investment would be a slump in gas price unaccompanied by a drop in oil prices."

Situation for gas 'uncomfortable'

The situation for gas was now looking a little "uncomfortable," Tholen told Platts, noting that there had been no newcomers in the last year to the southern basin. In the current environment "another 10 p/th on the gas price would lead to a different picture," he said, but future gas price development is uncertain.

Action was needed on costs and taxation, Tholen said. Industry had to do its part to drive down the costs of exploiting the UK's remaining gas reserves, which could be in the range of 800 to 900 billion cubic meters, including exploration potential. Innovation had a part to play here. Meanwhile, he said, government had to look again at tax.

The North Sea tax rate is now around 50% (30% basic corporate tax plus 20% in extra charges for the North Sea, 10% introduced in 2002 and another 10% in 2006). "The government must focus on what it is doing by taxing at a rate a lot higher than it was the last time we saw this range of gas prices," Tholen said.

The Treasury has an ongoing consultation underway into the North Sea tax regime. Ideas outlined in a discussion paper published earlier this year include even the possibility of different tax rates for oil and gas, although gas market observers have said that could be difficult to work in practice. The consultation ends in September.

Other work underway aimed at supporting gas production in the UK includes the West of Shetland task force, a joint body between government and industry studying options for transporting gas from the area to shore.

But Tholen said while a lot of effort was being put into this problem, it was clear from the relative silence on the issue in the May 23 energy white paper that government and industry had not come up with any easy answers yet.

Future price development uncertain

Although oil prices are now high and gas prices low, there might be less cause for concern about investment levels if producers were confident gas prices would rise a little in the future.

But a key finding of the Poyry report, Oil & Gas UK's Odling said, is just how uncertain future price development is, in large part due to uncertainty about future gas demand. This uncertainty about future prospects is another obstacle in the way of new investment.

"Gas prices will depend largely on the growth of gas demand," Odling said, "this is highly uncertain because it will depend on decisions in the electricity generation sector on what types of new generation capacity are built as older power stations are phased out."

The UK needs to replace some 30 to 35 GW of generation capacity in the next 20 years or so, equivalent to some 30 large power plants. These are mostly coal and nuclear and might be replaced mostly by gas, but the UK could opt for a new nuclear program.

According to Poyry's report, annual gas demand in the UK could be anything from 75 to 150 billion cubic meters/year by 2025, compared with around 100 Bcm/year now. Future gas demand depends not just on generation, but also future energy efficiency programs.

"There are also uncertainties for the industrial & commercial and domestic/residential sectors, such as the effects of prices, building regulations and insulation, warmer winters and improvements in boiler efficiency, to name a few," says Poyry. Gas demand growth could rise or fall by up to one percent a year, Poyry estimates.

The report studies the past development of the UK gas market and looks at potential future development. The UK moved from an "oversupplied liberalized island" during the 1990s to "interconnection and an increasing oil price" during 1998 to 2003, Poyry says.

From 2004 to 2006 the market suffered a squeeze, until the opening of Langeled brought the start of "capacity excess" and much lower prices. Poyry sees four alternative future worlds.

In the "oil-indexed" world the UK gas market would return to the pattern of 1998 to 2003, being driven by oil-linked gas prices on the European continent. In the "pipeline-delink" world the UK sees so much excess import capacity that it loses its link to continental European gas prices, and future UK gas prices turn out lower.

A third world is "collapse," in which gas is in plentiful supply, perhaps caused by a continuation of warm winters, and prices might return back to 1990s levels.

A new pipeline, locked into the UK, could help to bring about this world. A more expensive alternative is the "LNG wars" world, in which the UK must compete in the global market for marginal supplies of LNG to meet its demand.

Such a scenario could see the highest UK gas prices of all, Poyry's report indicates, and thus might be the most favorable to continuing investment in UK gas.

Investments in UK production, Poyry says, tend not to be large enough to impact UK gas prices themselves. A new Norway/UK pipeline such as the proposed Troll gas line might flood the UK market with new gas for a brief period, but new UKCS production is unlikely to do so.

Poyry sees oil-indexation the most likely future path, but says the chance of prices turning out lower than that are greater than they were in the past.

"Continued price uncertainty makes the UK less attractive to investors," said Tholen. "For UK gas production to meet as much of [future] demand as possible, the industry needs to combat the challenge of price uncertainty by making other aspects of the business environment, like the tax and regulatory regime, more attractive."