Budget 2014 and the future of the UKCS

Alex Kemp, professor of petroleum economics at Aberdeen University.
Alex Kemp, professor of petroleum economics at Aberdeen University.
Opinion by Energy Voice

For Britain’s oil and gas sector the most far-reaching announcements in Budget 2014 were those indicating the launch of a full tax review for the UK Continental Shelf and confirmation of the Government’s acceptance of the Wood Review recommendations.

The speedy implementation of the Wood Review proposals indicates not only acceptance of the view that more effective regulation is needed to maximise economic recovery but that this should start in the very near future. Delays in the implementation of policy changes could result in the sub-optimal long-term depletion of at least some of the oil and gas resources.

The simultaneous announcement of a full tax review indicates recognition that the tax system requires modifications if the objective of maximum economic recovery is to be achieved.

In his report, Sir Ian Wood highlighted subject areas requiring serious attention, particularly:

  • The recent and current low levels of exploration;
  • The substantial deterioration in production efficiency;
  • The steep fall in overall production;
  • The difficulties experienced with regard to third party access to hub platforms and pipelines;
  • The need for enhanced oil recovery schemes (including CO2 EOR).

A full-scale tax review provides the opportunity for serious consideration to be given by the Government as to how tax incentives can be targeted on these problem areas. Expectations have been aroused and well-argued cases will be carefully considered.

Budget 2014 announced for consultation a new allowance against Supplementary Charge (SC) for ultra-high pressure/high temperature fields.

The intention is that this allowance will be based on a percentage of the relevant capital expenditure, with 62.5% being suggested as a possible rate. It is based on a very relevant economic element of the factors which determine whether a project is commercially viable or not.

The proposed scheme is thus conceptually superior to existing new field allowances which are based on physical characteristics of the projects, such as size, water depth, distance from infrastructure, temperature, pressure, and API gravity.

These physical features are really proxies for costs which may not accurately reflect the economic realities of particular projects.

The proposed allowance is superior to these based on physical features because it automatically accommodates variations in investment costs in the appropriate manner.

Cost inflation has been a dominant feature of the operating environment in the UKCS over the past few years and has caused the postponement of some new developments.

A clear, known formula based on investment costs should reduce this problem and enable investors to plan ahead with more certainty. Currently they may well not even know whether a potential new field development is likely to satisfy the eligibility criteria for a field allowance.

It is understood that the proposed new allowance will be available not only for development expenditure but for exploration (including unsuccessful exploration) in the surrounding areas of a development and could thus be defined as a cluster allowance.

This should incentivise more exploration and encourage cluster developments which are a feature of the Wood Review recommendations.

The proposed new allowance will only apply to new ultra-high pressure/high temperature greenfield developments.

But it is arguable that its merits are such that its coverage should be more widespread.

The tax review gives an opportunity for the case to be made for this. There would, of course, be a need to consider any transitional issues in relation to the existing set of field allowances with possible grandfathering arrangements.

Budget 2014 also announced that the proposed bareboat chartering tax measure will go ahead, although restricted to drilling rigs and accommodation vessels with the promise of a review of its impact after one year of its implementation.

Whatever the merits and demerits of the measure from a tax fairness viewpoint the likelihood that a result will be higher day rates for the hiring of drilling rigs is unfortunate.

It comes at a time when these rates are extremely high, especially for semi-submersibles, and cost inflation is rampant in the UKCS. Even with oil prices in excess of $100 the costs of some prospective new developments are such that final investment decisions have been postponed.

Capital expenditure reduction plans have already been announced by several major companies. In an environment of capital rationing reductions in exploration drilling are much more likely to be pursued than curtailment of development drilling, as the latter brings the promise of more likely returns.

As is widely acknowledged the current levels of exploration are inadequate for the regeneration of the reserves base in relation to the ultimate potential as seen in the estimates of DECC and OGUK. Continuing low levels of exploration will increase the production decline rate and accelerate the timing of the non-viability of the infrastructure.

In sum Budget 2014 offers an opportunity for the harmonisation of the North Sea tax system with the aspirations and regulatory changes embedded in the Wood Review. It is to be hoped that this opportunity will be grasped by all involved.

World renowned petroleum economist Professor Alex Kemp is at Aberdeen University