Mike Tholen
Oil & Gas UK
London
The UK oil and gas industry supports hundreds of thousands of jobs across the UK, invests more than any other sector of British industry, and supplies the majority of the nation's energy needs. Yet it has found its prospects marred by a surprise tax increase.
In the midst of a renaissance, earlier this year the UK Treasury announced a new top tax rate of 81% and a new lower limit of 62% on UK oil and gas production and capped companies' ability to claim tax relief for decommissioning at the old tax rates.
These moves have damaged investor confidence and reduced the attractiveness of the province as a destination for capital, jeopardizing new activity, job creation, and tax revenues over the long-term.
It is imperative that the industry and government work together to lessen the negative effects of the tax change and find a way to cure the chronic fiscal instability that the sector faces.
Former renewed optimism
Oil & Gas UK forecast early in 2011 that its oil and gas company members had a new and growing confidence in the stability of the UK regime and as a result were investing £8 billion this year and had plans to invest £40 billion or more over the next 5 years in order to develop more of the UK's oil and gas reserves—despite the UK province being a mature and relatively costly place to operate.
One impact of this sustained, higher investment was to be a slowing of the production decline rate over the next 5 years. This was significant because at a time of uncertainty over energy supply and economic difficulty, higher UK oil and gas production would have meant less reliance on energy imports and greater tax revenues for the government.
It was also important because the oil and gas sector's role as the country's biggest industrial investor, largest corporate taxpayer, and most significant source of energy security was seemingly assured. At a time of high and rising unemployment, tens of thousands of new jobs were due to be created in an industry that was helping lead the UK out of recession.
Shattering the renaissance
However, just as the renaissance was gathering pace, in March the government shocked the industry by announcing a new top tax rate of 81% and a new lower limit of 62% on UK oil and gas production.
These higher rates of tax apply to oil and gas production for so long as the international price of oil is above $75/bbl. In fact almost half of the UK's production is gas, which is currently fetching a price equivalent to $58/bbl and which has been trading within a range equivalent to $55-60/bbl for some time.
The government also announced that from 2012, companies' ability to claim tax relief for decommissioning would be capped at the old tax rates.
Investors are exposed to oil price volatility equally in all territories, but successive and unexpected negative changes in the UK tax regime reduce the attractiveness of the UK and put it at a competitive disadvantage relative to other provinces.
Coming so soon after assurances that the government understood the industry's need for a stable fiscal regime, this, the third major tax increase in 9 years, has severely shaken investor confidence. We now fear that this has fundamentally jeopardized the sustainable future of the UK continental shelf (UKCS).
Fallout from the changes
Companies are contractually and commercially committed to many projects and will continue with these.
However, unless mitigating measures are soon put in place, Oil & Gas UK's recent survey shows that the budget had rendered marginal at least 25 projects with their associated £12 billion investment and around 15,000 new jobs. In the next 10 years alone, the investment earmarked for projects considered likely to go ahead had fallen by 30% to £23 billion from £33 billion.
Lower capital investment in developing oil and gas reserves inevitably leads to lower production. Over the next 10 years, the survey showed that the rate at which production declines was likely to be 1.5%/year higher than had been anticipated.
The 25 marginalized projects account for more than 1 billion bbl of oil and gas equivalent, which equates to over a year's domestic supply. To fill that gap, energy imports worth £50 billion would be required, increasing the cost of energy to the UK consumer, damaging the nation's security of energy supply, and widening the trade gap.
The damage to projects' economic viability is not confined to new fields, either. Worryingly, the survey found that the tax change may well shorten the lives of at least 20 producing fields by up to 5 years; the continued operation of these older fields, which are often located at infrastructure hubs, can be crucial as their removal can result in oil and gas nearby being left undeveloped.
Shoring up public finances
While we fully appreciate the financial difficulties which the government faces, reserves left in the ground will not generate any tax revenue and ironically, the public finances that needed boosting in the 2011 budget are likely to lose out in the long-term.
The newly marginalized projects could result in £15-20 billion of tax receipts being foregone.
The negative impacts on the wider economy mean it is vital that the government and industry move ahead swiftly to find ways to rebuild investor confidence and to mitigate the effects of the unexpected tax change on future investment.
While the extension to the ring fence expenditure supplement announced in July is constructive and will help a limited number of new investors who are otherwise disadvantaged compared to more established players, it will not redress the damage caused by the tax increase to the wider investor community.
In order to facilitate engagement with the Treasury on ways to reduce damage to investment and on the operation of the mechanism which triggers the higher tax rates, Oil & Gas UK has established a task group of senior industry executives, reporting to the board of Oil & Gas UK.
The group is overseeing work to develop an evidence-based business case demonstrating marginalized investment both in existing and new fields, the impact on gas, and the broader impact on our supply chain. The Treasury has actively signaled it wants to engage on these matters while working within the confines of the existing regime, and we are similarly committed to do so.
In addition, a task group on decommissioning has also been set up to produce proposals to resolve the current uncertainty on access to decommissioning tax relief and address the impact of the cap on decommissioning tax relief that was announced in the 2011 budget. The intention is to complete the bulk of this work before the summer recess and submit proposals thereafter for ministers' consideration.
We believe it is imperative that the industry and government now work together to achieve certainty on access to tax relief on decommissioning and find a way to cure the chronic fiscal instability with which the sector is faced.
Consultation before initiating any future changes to the fiscal regime must surely be in everyone's interest. The UK is seen by the international energy community to have a highly unstable oil and gas tax regime and undoubtedly pays a penalty in its ability to attract investment.
We are committed to engaging on the future of our industry and know the government wishes to do the same. The loss to the UK's economy of not acting now is too great to consider.
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