One of the roles of government is to make decisions that are in the widest interests of the country, rather than those which are simply popular with the electorate.
That is particularly true when the issues at stake include the medium to long-term health of an industry which is of vital strategic importance to the security of the UK energy supply; which provides employment to approximately half a million skilled workers; which accounts for more than a third of capital investment in the UK, and which provides a platform for an oil field services industry to expand overseas and make a significant contribution to UK exports.
Regrettably, the latest national Budget, as far as it relates to oil & gas, had all the hallmarks of short term political expediency. The government, faced with mounting pressure from the public on prices at the pumps, decided that it had to abandon the fuel duty escalator in order to offer some measure of relief to motorists.
Of course, the direct consequence of that decision was what appears to be a scramble to identify a replacement source of revenue, hence the increase in supplementary charge.
An obvious question to ask is: didn’t industry see this coming?
The answer is probably no, and there is a clear reason for that.
Only nine months ago, after the first Budget, the coalition government said: “The government recognises the importance of a stable and fair UK oil & gas tax regime that provides certainty for businesses. It will take forward discussions with the industry to ensure the regime encourages continuing investment and the exploitation of remaining resources.”
These discussions were in fact a continuation of talks the oil & gas industry were having with the Labour government. They had given rise to a number of changes to the oil & gas tax regime, including measures aimed at assisting marginal developments (the Field Allowance), and measures to encourage the movement of assets among the many companies active in the North Sea, so that the assets would end up in the hands of those companies able to invest in them (the Reinvestment Exemption). They had created a measure of goodwill between government and the industry, damaged by the tax increases of 2006.
In recent months, discussions with the coalition have centred on measures to encourage incremental investment in old Petroleum Revenue Tax (PRT) paying fields, and most recently on the issue of decommissioning security arrangements.
The ongoing dialogue with Treasury officials and, from time-to-time, government ministers, had led industry to believe that a joint understanding and appreciation of the complex issues facing industry in a mature basin like the UK Continental Shelf was being developed.
Therefore, many companies and advisers were blindsided by the changes announced last week.
The North Sea fiscal regime is relatively complex. Larger fields developed prior to March 1993 pay PRT at a rate of 50%.
The participants in these fields also pay ring-fenced corporation tax at 30% (not the normal rate of corporation tax which is soon to be 26% and will eventually be 23%), as well as supplementary charge.
Supplementary charge was introduced in 2002 at a rate of 10%, increased in 2006 to a rate of 20%, and as of midnight last Wednesday, is at a rate of 32%. The combination of these various taxes creates a rate of 81% for PRT paying fields, and a rate of 62% for those fields not suffering PRT.
The position is further exacerbated as financing costs – the borrowing costs that all businesses incur in order to invest and expand their businesses – are not relievable against supplementary charge and, therefore, the effective marginal tax rate is something more than 81% and 62%, respectively. Before the Budget the rates were 75% and 50% respectively.
No industrial sector can simply continue on a “business as normal” footing when it is faced with the overnight imposition of additional taxes which reduce its profits by almost 25%. The oil industry in particular is an industry which has very high capital requirements and investment decisions which carry a high degree of risk, and is dependent on international commodity prices which it cannot control.
Consequently, rigorous appraisals are made before capital is invested and, given the long-term life cycle of an oil or gas development, fiscal stability is a critical feature.
The planned tax increase has come at a time of returning confidence in the North Sea.
The Oil & Gas UK activity survey was forecasting a high level of investment and, most importantly, a number of packages of assets were up for sale by the super majors.
These asset sales are of particular importance, as they signal a further development in the process of the super majors withdrawing from some of the more mature assets, and passing these assets on to the companies with a greater appetite to invest and enhance hydrocarbon recoveries.
Any buyer of assets who has signed a sale and purchase agreement prior to the Budget will be very anxious about the impact of the tax change, and may be nervous that the terms of any bank finance will now be changed.
For others who are still in the negotiation phase, the change may prove fatal to the deal as the seller may not be willing to accept the reduction in price for the asset. Obviously from a buyer’s perspective the new tax rate can be factored in, but the buyer can have less confidence in the sustainability of the commodity price.
So the immediate impact is likely to be stalled deals and assets remaining, at least for a time, in the hands of the current owners, so halting anticipated incremental investment.
While much of the capital and revenue expenditure for this year may go ahead, it is also likely that expenditure next year will be reduced, and the 10-year forecast may be significantly affected.
None of this is good news for the sector. However, special mention must be made to the difficulties caused for gas producers who have not seen the same level of uplift in commodity price as oil producers, but nevertheless have had to suffer the same level of tax.
The papers from the Treasury issued after the Budget suggest that there may be some relief afforded in relation to marginal gas developments by the introduction of a further category of field allowance, but we will have to wait and see.
The indication that the level of tax may decrease if a lower oil price applies for a sustainable period of time doesn’t sound like something to rely on.
The trigger price for such a reduction is to be determined after consultation with the oil industry and motoring groups, two parties unlikely to be aligned, and any consequent tax reduction only granted to the extent it is affordable.
Last week’s announcement has provided further evidence that the UK’s oil & gas industry remains vulnerable to fiscal change.
The sector must work hard to try to get into a position of greater influence so such surprises become a thing of the past.
Derek Leith is head of tax at Ernst & Young in Scotland