The looming U.K. tax hike

The oil and gas industry and U.K. government are treading carefully on the subject of taxes related to oil and gas from the North Sea.

The Labor government declared in March that a review under way since last July found that "certain aspects of the current fiscal regime are unsatisfactory." This is the type of thing governments say just before they raise taxes. With crude oil prices slumping, however, the March budget didn't include North Sea tax changes. The government instead described two options and requested further consultation, aiming for legislation at the time of its autumn budget.

Mixed blessing

For producers, the delay is a mixed blessing. It does postpone a tax increase and give the industry time to try to limit damage. Yet it prolongs a period of uncertainty during which action on North Sea projects will surely suffer.

That the government is considering two options compounds the confusion. One option is a supplement to the U.K.'s 30% corporate tax on profits, applied field by field in the North Sea. The other involves expansion of the petroleum revenue tax (PRT), a 50% levy on profits from oil and gas produced in fields approved for development before Mar. 16, 1993. Under either option, the government would abolish the 12.5% royalty on production from fields that received development approval before Apr. 1, 1982.

The changes would not affect all companies the same way. The PRT option would extend the levy to new fields now unaffected by it. It also would cut in half a per-field, volumetric exemption from the tax.

Which option a producer prefers thus depends on the extent to which its output comes from fields now excluded from PRT. A heavy weighting of output from new fields would incline a producer toward the supplementary corporate tax. For a company producing mainly from old fields and therefore paying PRT, elimination of the royalty might be enough to offset partial loss of the PRT volumetric exemption.

The mixed effects make it unlikely that the North Sea producing industry can unite behind a clear choice between the options. Of the two, the corporate tax offers the more even distribution of burden. Its main disadvantage is the relative ease with which the government might at some future date raise the rate again.

What can unify the industry is the question of why the government should want to raise North Sea taxes in the first place. The obvious answer is that it simply wants more money. Companies have done well in the North Sea. Until the price slump, profits of most producers active in the region were rising. The government naturally wants its share.

But raising money for official treasuries is never as easy as raising tax rates and expanding tax bases. Governments seldom want to acknowledge the incentive effects of taxes, but they are real.

Over time, the U.K. government has performed better than most at accommodating its fiscal policy to changes that come with maturation-declining output from old giant fields and shrinking average size of discoveries. U.K. fiscal terms rank among the world's most attractive.

But fiscal terms aren't everything. As an operating environment, the North Sea ranks among the world's most difficult and costly. Exploration is increasingly tricky. If favorable fiscal terms don't offset those disadvantages, companies invest elsewhere.

Investment allure

The U.K. government needs to factor North Sea investment allure fully into its thinking about revenue. Tax changes that detracted from that allure would quickly shrink revenues, by discouraging investment, even as rates climbed. Oil and gas companies nowadays have many places in which to spend and make money.

The potential is high for a tax rate hike to do more harm than good to North Sea operations and therefore to U.K. tax revenues. Extension of the tax consultation period will be worth the uncertainty if it becomes the period in which the U.K. government fully ponders its risks.