In a surprise move, UK tax officials applied the "stick" to offshore producers with an immediate new 10% supplemental tax on North Sea oil and gas profits, while hinting at a future "carrot" through possible abolishment of the 12.5% overriding royalty for older fields.
The new supplementary tax outlined in the new UK budget presented Apr. 17 effectively raises the corporate tax rate to 40% from 30% previously, said officials at Deutsche Bank AG in London. Financing costs are not deductible from the supplementary tax and, like the corporate tax, there is a "ring fence" to prevent the reduction of taxable upstream profits by losses from other activities.
In an Apr. 23 appearance before the House of Commons All Party Offshore Oil and Gas Industry Group, BP PLC Chief Executive John Browne warned that the new UK tax regime will strip £600 million/year ($869 million) out of the North Sea industry, likely triggering layoffs and a drop in oil and gas production.
Browne said, "Those funds are either lost to investment or they have to be made up by gains in productivity–which means jobs." Cutting back the returns to investors would likely reduce investment and hasten a decline in production, he said.
‘Minimal’ impact?
However, officials at UBS Warburg, a business group of UBS AG in New York, said, "While…changes to upstream taxation [are] unwelcome for those companies with UK operations, we believe its financial impact to be minimal."
UBS estimated that Amerada Hess Corp., Murphy Oil Co., Conoco Inc., and Phillips Petroleum Co. have the highest exposure to the tax changes, with possible earnings reductions of 5-7%.
Deutsche Bank analysts reported, "Those companies that are reinvesting a significant portion of their North Sea cash flow into the UK will be least impacted by the tax changes, as the government has also increased capital allowances against the corporate tax and the new supplementary tax."
As part of the UK government’s program to encourage continued investment in North Sea operations, 100% of most first-year North Sea upstream capital expenditures will be allowable for both the corporate tax and the supplementary tax for the year incurred, compared with 25% currently.
"Therefore, those companies that are involved in material development programs could significantly reduce their near-term tax payments, aimed at stimulating new, marginal developments," Deutsche Bank analysts reported.
Royalty burden
In addition to the new tax, Browne said, the new budget leaves in place a regressive tax in the form of a 12% overriding royalty paid on older fields. Although the government said it is considering abolishing that royalty, Browne said that, as it now stands, the new budget creates an uncertain economic environment for producers and does not provide adjustments for a possible fall in oil and gas prices.
"Until royalty is abolished, older fields will have to endure a fiscal take in excess of 70%. In our opinion, the companies will push hard to get royalty abolished as quickly as possible–especially the owners of older fields," said Deutsche Bank analysts. Such owners include BP, Royal Dutch/Shell Group, ExxonMobil Corp., and Talisman Energy Inc., they said.
Royalty was abolished in the 1980s for UK North Sea oil and gas fields that received development consents on or after Apr. 1, 1982.
In addition to the corporate tax and the new supplementary tax, many offshore producers also pay a special field-based petroleum revenue tax, currently at 50%, designed to give the UK government a proportion of "super profits" from offshore oil and gas production. Fields given development consents on or after Mar. 16, 1993, are exempted from that tax.
Hardest hit
The tax change "should result in an average 1.3% reduction in the 2002 net earnings of the UK"s largest producers. BP, the largest producer in the UK [accounting for 20% of UK oil production and 16% of gas production] is likely to be hardest hit," said Deutsche Bank analysts.
"Based on our initial analysis, we expect BP to pay around £160 million in additional taxes that would lead to a 2.4% reduction in its 2002 net income," they said. "ENI SPA"s and BG PLC"s 2002 earnings are expected by us to be reduced by around 1%, and the other companies, less than 1%. Enterprise Oil PLC benefits in 2002 from the higher capital allowance.
"Looking further ahead, the impact of the tax change will depend on the level of capital spending; however, reductions in corporate earnings of 1-2% seem typical."
Deutsche Bank officials said the new tax also will impact UK independents such as Tullow Oil PLC, Dana Petroleum PLC, Paladin Resources PLC, and Venture Production Co. Ltd., since it "inevitably reduces" the value of recently acquired assets in the UK sector. However, such companies "should be able to take full benefit of the capital allowance changes, as they are investing heavily in the UK," said analysts.
"With the maturity of the UK Continental Shelf as an exploration province, most US integrated oil majors are utilizing their [UK offshore] operations for cash generation to fund other international upstream expansion," said UBS Warburg officials. "Consequently, for most US companies the impact of the higher taxation diminishes over time."
However, Deutsche Bank analysts said, "We believe those companies that are using the UK Continental Shelf to fund international expansion will be penalized." That, they said, could "catalyze the larger players" to invest in new developments, to consolidate, or to exit that sector.
Browne: seek alternatives
If changes to the UK tax system have to be made, government officials should explore alternatives that would not threaten the competitiveness of North Sea operators, Browne said. He appealed to the "common interest" of government and industry "in getting this right."
"I don"t think any other country in the world has increased production taxes in this way over the last 10 years–with two exceptions, Venezuela and Argentina," Browne said.
"Last week’s changes were wrong," he said. The former tax system "wasn’t perfect, but it was effective," said Browne.