Break the fall – taxing times for the UK oil industry

9 May 2016

Will Scargill of market analyst GlobalData explains that, despite the relief measures offered in the chancellor’s latest budget, challenging economic conditions remain a threat to the effectiveness of the latest UK oil tax cut.

The headline tax rate on the UK oil and gas sector will be cut from 50.0%, or 67.5% for older fields, to 40.0%. This could result in a value increase of up to 20.0% for new developments and up to 70.0% for mature fields. However, with many fields already not taxable due to the low oil price anyway, the effects will vary significantly across different companies' portfolios.

Significant reductions in the headline tax rates facing upstream oil and gas producers were included in the 2016 UK budget, delivered on 16 March by Chancellor George Osborne. The reductions, larger than anticipated, reduced the level of state take on all UK projects, although they were biased towards older existing assets.

The petroleum revenue tax (PRT), applicable only to projects given development consent before March 1993, was permanently reduced to 0%; this tax was zeroed expressly to benefit older fields and infrastructure. As platforms and other offshore infrastructure age and require maintenance, the government is keen to optimise their use before they are mothballed and effectively strand otherwise-recoverable offshore reserves. Additionally, all fields will benefit from the halving of the supplementary charge (SC) from 20 to 10%, for which existing capital expenditure allowances for this tax remain unchanged. Both tax changes are effective retroactively from 1 January 2016.

Financial imperative

Other fiscal incentives in the budget include measures that attempt to contribute to maximising economic recovery (MER) of offshore oil and gas reserves, a key policy goal of the Department of Energy and Climate Change (DECC) and the government following the 2013 'Wood Review'.

The government intends to include tariff income in the 'relevant income', which activates the 'investment and cluster area allowances' for the SC. Previously, only achieving first production activated these allowances; by allowing tariff income to activate the 62.5% capex uplifts to the SC, firms with operable infrastructure in fields that have yet to reach first production can realise immediate revenue, from which capex costs can be deducted in paying the SC. This will help optimise the usage of existing infrastructure for the recovery of nearby reserves.

The UK Government’s draft MER strategy contains broad provisions that could improve economic recovery and reduce costs.

The government also made clear that firms retaining the decommissioning liabilities for assets would receive tax relief on these costs. The budget's notification that Her Majesty's Revenue and Customs will follow up with a technical note on the interpretation of the cost relief under current legislation can be seen as the government's effort to encourage firms seeking to offload assets to buyers to proceed with deals. Decommissioning liabilities have hindered some North Sea asset sales in the depressed price environment, and the government is offering further potential tax relief on decommissioning costs as it is keen for assets to change hands to the operators most likely to develop them.

Competitive edge

The tax reductions outlined in the budget will reduce the UK's headline tax rate to 40.0%, substantially lower than its previous range of 50.0-67.5%. This headline rate results in a significantly lower level of state take compared with other North Sea producers (see figure, above), and positions the UK as one of the most competitive regimes globally.

Failure of UK producers to earn profits in a prolonged low-price environment could lead to further reductions in tax, possibly to the 30% headline rate requested by industry body Oil & Gas UK, although the effect that further tax cuts can have on project economics is limited at the current oil price.

Overall tax revenues from the North Sea turned negative in the first half of the 2015 financial year, and the Office for Budget Responsibility is forecasting negative revenues for the next five years. Despite reductions in UK offshore project costs since the downturn, further cost cuts will be required to improve project economics and producer profits on the UK Continental Shelf (UKCS), and in turn, generate government tax revenue.

Tangible measures focused on MER, resulting in cost reduction, could be necessary to spur profit growth. While the government's commitment in the 2016 budget to spend £20 million on seismic surveys supports UKCS exploration activity, it does little to address relatively high offshore exploration costs in a mature basin. By way of contrast, Norway's reimbursement of the tax value of exploration costs, for example, incentivises exploration by reducing firms' costs compared with the UK, whose uplifts on capex only benefit discovered assets.

Regarding MER of existing marginal assets, other North Sea producers have supported numerous initiatives with industry to catalyse the development and use of enhanced recovery techniques.

In its 2016 budget, Norway contributed almost $19 million to the Demo2000 cost-reduction initiative with industry, while the Netherlands and Denmark operate smaller R&D initiatives with industry to apply innovative recovery techniques to depleted assets.

The UK Government's draft MER strategy, formalised in April, contains broad provisions that, if enforced through specific regulations and initiatives, could improve economic recovery and reduce costs. The Energy Bill will establish the Oil and Gas Authority as a government company with enforcement powers to assure operators' compliance with efforts to maximise recovery. However, for further action to have a significant impact on project economics in the UKCS, it will have to focus on cost reduction.

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