The well hasn't run dry: deal makers set sail for North Sea

These fields of dreams offer soaring costs, bad publicity and high taxes. James Moore explains why oil's M&A men are coming
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It was dubbed the "Hallowe'en massacre". But Canada's decision to impose swingeing new taxes on its oil and gas trusts could see millions of dollars heading towards the North Sea.

The profits of Canada's energy income trusts are not taxed at the corporate level as long as a high percentage of profits are paid as dividends to investors. Canada's finance minister, Jim Flaherty, has proposed changing this with a new tax scheduled for 2011 that will remove many of their advantages.

But crucially, investments in overseas assets will not be affected, giving the trusts a huge incentive to look for new investment opportunities abroad. And the North Sea is right in their sights.

Jim Kinnear, president and chief executive of Pengrowth, one of the biggest trusts, says his industry is fighting the tax change. But he admits: "Certainly it [the proposal] gives us an incentive to invest overseas. We are a low-risk operation so we would look for assets in politically stable areas with relatively stable taxation regimes, such as Europe, Australasia. It seems crazy that we are incentivised to invest overseas but that is what the new tax does."

Mr Kinnear says he would like to do "two or three" billion-dollar deals in the run-up to the new tax's introduction – if "the right opportunities come along". Should his industry's lobbying efforts prove fruitless, the ultimate aim would be to have half of Pengrowth's assets overseas, in effect, cutting the impact of the new tax in half. As its current assets are valued at around C$5bn (£2.5bn), that could mean a lot of activity. And Pengrowth is just one trust among several.

Analysts believe that the North Sea is ripe for a mergers and acquisitions boom. In recent times, there has been a perception that Britain's oil and gas reserves are all but used up. Certainly the big, easy-to-extract superfields are nearing the end of their productive lives. But Toby Pierce, director of institutional research at Tristone Capital, the energy-specialist investment bank, points out that while billions of barrels have been taken from the UK's North Sea fields, almost as much remains.

And while he admits it is "debatable" how much of this can actually be extracted, there is still an awful lot of oil (and gas) to shoot for. Currently around 160 companies are hunting down those remaining reserves.

Mr Pierce says: "The elephant fields are all gone but there are probably still some 20 to 50 million barrel fields out there that are relatively easy to develop. The majors are not doing a huge amount of further exploration; they are working their existing portfolios, shedding some less important assets. But there are a lot of smaller companies, ranging from $10m to $250m in market capitalisation, that are."

The trouble is, life is getting tougher for these companies. With the oil price pushing $130 a barrel and no one expecting it to fall any time soon, the perception is that the industry is riding the crest of a wave, pocketing billions at the expense of consumers. Populist commentators from left and right have taken to railing against "big oil" as ordinary people feel the effects of the high oil price in their pockets, in the form of soaring electricity bills and high prices at the pumps.

Bad publicity isn't the only problem, as Joe Magner, an analyst at Tristone, points out. "There are real challenges out there – to not only find and produce oil and gas but to do it in an efficient manner; to meet equipment and technical challenges. It is not getting any easier. The type of oil resource that is being found today is more challenging to access. It is found in deep water or riskier areas."

Governments, too, are demanding bigger pieces of the pie, be it through the imposition of higher taxes or even what amounts to enforced nationalisation of assets. Just ask Shell about its experience working on Russia's Sakhalin Island: it ultimately had no choice but to sell to state-controlled Gazprom amid increasing demands from environmental regulators. Few believed that conditions for the local flora and fauna were at the heart of those demands.

Many analysts would argue that benefiting as much as the companies from the high oil price are the various treasuries of countries fortunate enough to be sitting on big reserves of black gold. And looking at the prestige developments, skyscrapers, stadiums and even artificial islands in the oil-producing hub that is the Persian Gulf, it is hard to disagree. The desire of governments to milk their oil reserves has filtered through to the North Sea.

The Texan oilmen who founded Endeavour, the London-listed oil independent, came to the North Sea because they saw in it a far more attractive opportunity than they could find in the US, where competition for the remaining oil-producing assets is cut-throat.

Chief executive Bill Transier says: "We could have started anywhere but we saw an environment in the North Sea where all the countries that had a production base – the Netherlands, Norway, the UK, Denmark – were trying to encourage exploration and production. We saw tax regimes and geopolitical risk as pretty nice by world standards, and, importantly, we were able to get seismic data.

Since then, things have changed, he says. "You'd expect me to complain about tax, of course, but the UK raised energy tax on us a few years back and we were excluded from the recent 2 per cent cut in corporation tax. Tax revenues from exploration and production in the UK North Sea have gone down dramatically even with the high oil price, and it's not hard to see why.

"You have to incentivise exploration because, if you get to the stage where infrastructure such as pipelines is being removed, you'll never get it back."

He adds: "We are lucky enough to have producing assets now. Companies that don't are finding it tough."

The consequence, thinks Mr Pierce, is that companies will have to start talking deals sooner rather than later. The gap between buyers and sellers is currently huge, with the former wanting to purchase based on a $75-a-barrel oil price and the latter looking at $100-plus to sell up.

But one factor can bring companies closer together: the risk of running out of money.

The International Energy Agency reckons there is around 30 to 40 years of oil supply left in the world. The black stuff is a scarce resource. But with the credit crunch continuing to bite, capital is even more scarce, and Mr Transier says it is not as if costs have been kept down. "The price of equipment just keeps getting higher. It has probably quadrupled in the past few years."

So the conditions are in place for a rash of deals. And with the potential of large chunks of capital looking for a way to avoid a punishing new tax regime in Canada, the North Sea has not been this exciting since oil first started to flow.