Analysis: UK 2011 Budget Creates Uncertainty for North Sea O&G Investment

The UK government's announcement Wednesday that it would increase the Supplementary Charge (SC) on North Sea oil and gas production to 32 percent effective midnight March 23 has effectively made the UK regime one of the most unstable regimes globally, according to analysis by UK-based consulting and economic planning firm Palantir Solutions.

"The decision complicates investment decision-making and increases uncertainty as most investors had actually been expecting Budget 2011 to introduce improvements for new fields and assets with marginal economics," Palantir said. The UK government said it was increasing the SC in light of higher oil prices, saying it would reduce the SC back towards 20 percent on a staged and affordable basis if oil prices falls below a set trigger price.

The budget's economic impact effectively increases the tax burden by 24 percent for non-petroleum revenue tax (PRT) (62 percent versus the original 50 percent) and by 8 percent for PRT (81 percent vs. 75 percent) assets. For the majority of North Sea assets, this will eliminate at least 15 percent from their values, and the impact is already showing in the share price of companies whose portfolios are heavily weighted towards the UK, such as EnQuest and Premier Oil.

The UK government has sought to increase the SC rate to help the government financially in the near-term; however, Palantir said the move would definitely hurt in the long run as capital would be gradually relocated to more attractive oil & gas provinces – perhaps with a higher government take, but with "cheaper" resources and more stable fiscal environments.

The increase in SC would induce greater risk-taking in exploration among companies who have sufficient profits from other upstream oil & gas activities in the UK to shelter such exploration expenditures, since the government will be effectively paying 62% of dry hole costs for these players versus the original 50%. "However, there is little value added for small pure exploration companies because they will have to bear the full cost of exploration in the absence of profits elsewhere," Palantir said.

While the total effective tax rate has risen now to 62% for non-PRT and 81% for PRT assets, the decommissioning relief will attract only 20% SC deduction. The budget claims that this is to "avoid incentivising accelerated decommissioning". In reality, in the majority of cases decisions on cessation of production timing are based on the cumulative before tax cash flow, and SC rate changes have limited impact on them. However, the increased tax rate will reduce the amount of money available to operators for maintenance and brown-field modifications/incremental investment opportunities, which might actually accelerate decommissioning dates.

"On the other hand, this sets a potentially good precedent for PRT fields for a scenario where PRT gets abolished in the future. While positive on the surface, the biggest uncertainty associated with the potential abolishment of PRT in the future is in the simultaneous loss of PRT decommissioning relief. So the fact that the government recognises that decommissioning relief should be assessed in line with the tax burden over the full field life can be seen as a positive (though minor in the whole scheme of things) news," Palantir said.

The UK government decision to increase the SC because of high oil prices isn't convincing, Palantir said as the increase in price between 2006 and now hasn't resulted in a proportionate increase in corporate profits because the cost base has increased substantially as well. "In addition, when the government refers to unexpected windfall profits in excess of what's been assumed at the time of investment decision it fails to acknowledge the fact that very few companies take their decisions based on the current prices."

While the oil price has gone from $66/bbl to $115/bbl since the last increase in SC rate in 2006, NBP [national balancing point] gas price (at which the majority of the UK gas production is sold) have actually fallen. So the existing and future gas producers in the Southern North Sea, Central North Sea and West of Shetland basins will be worst hit by the SC rate increase. The Budget document also doesn't mention what will happen if the gas prices remain depressed, and is entirely concentrated on oil price threshold of $75/bbl.

Palantir noted that the government will most likely end up in a situation where it will be forced to provide tax incentives on an ad hoc basis to various fields and projects that will simply not meet investment criteria at the new SC rate. An alternative would be to scrap the SC and associated allowances altogether and introduce a special tax ring-fenced at field level and linked to the rate of return (similar to the Danish Hydrocarbon Tax). "This seems to be a more efficient solution, which will please the industry, and allow the government to collect higher taxes on windfall profits without jeopardising the stability of the regime," Palantir said.

Malcolm Webb, Oil & Gas UK's chief executive, said on Wednesday: "In its first Budget nine months ago, the Government recognised the importance of a 'stable' UK oil and gas tax regime which provided 'certainty for investors'. Given that assurance, the industry is shocked to now be hit by a tax increase that raises the tax rate to at least 62 per cent, with some of the most mature and therefore vulnerable fields now paying up to 81 per cent."

"At a time when we could see investment recovering following the last period of fiscal instability, this further shock will only damage investor confidence and make many question whether the UK is an appropriate destination for their investment. Many of our members will now be reappraising their investment decisions."