North Sea Drilling Down As Tax Hike Bites

by Robert Lee, Tax-News.com, London

18 July 2011

North Sea offshore drilling activity fell dramatically over the last quarter, with the unstable fiscal environment partially blamed in new figures released by Deloitte's Petroleum Services Group.

The North West Europe Review, which documents drilling and licensing in the UK Continental Shelf (UKCS) shows that activity in the second quarter of 2011 fell by 52% compared to the same period last year. In addition, there was a 43% drop recorded over the first six months of this year compared to 2010.

In comparison with the same period last year, when 35 exploration and appraisal wells were commenced in the UK sector, from January 1 to June 30, 2011, only 20 saw initial drilling made. There was, however, a 19% increase in wells drilled between the first and the second quarters of 2011, but the mid-year total is in fact at its lowest rate since 2002. Moreover, Deloitte said that, while it was important to stress the small numbers of wells involved, activity was lower than would be expected during a time when the oil price averaged above USD100 per barrel.

Speaking on the results, Graham Sadler, managing director of Deloitte’s Petroleum Services Group, said: “The reduction in activity is concerning, and is likely to be attributable to a combination of issues including a lack of business confidence in the market generally, over recent months, as well as a possible initial reaction to the UK’s shifting fiscal regime. Although it is difficult to pinpoint how quickly companies would have been able to change drilling plans, as a result of the tax changes announced in this year’s Budget, it’s quite likely that the UK fiscal regime is now being viewed as unstable and, therefore, a less attractive place to invest. While there have been some positive announcements during Q2, such as the increased ring fence expenditure supplement, we would not expect to see the full impact of these tax changes for at least another six to 18 months."

In order to fund a GBP0.01 cut in fuel duty at the pumps, Chancellor George Osborne increased the supplementary charge levied on North Sea activity by 12%, from 20% to 32%. This led to fears that the hike could result in a fall in the UK's competitiveness, with both industry firms and bodies criticising Osborne for a decision they believe will damage the sector. Centrica, the British Gas operator, mothballed its South Morecambe field, citing fears over its profitability. However, BP recently announced that it is to pump GBP3bn into its North Sea investments, bucking the trend somewhat.

The increased ring fence expenditure supplement (RFES) referred to by Sadler was introduced at the beginning of July. The RFES regime, first introduced in 2006, originally allowed companies to elect to increase the value of losses carried forward from one period to the next, by 6% for a maximum of six years, not necessarily consecutively. Under the new rules, the annual limit has been increased from 6% to 10%. Fields which qualify for the allowance are small fields, ultra-heavy oil fields, ultra-high-pressure/high-temperature fields, and remote deep water gas fields. Initial government estimates put the costs of the change at GBP50m a year by 2015-16.

Sadler did, however, qualify the findings somewhat. He said: “Considering the relative stability in drilling on the UKCS in 2009 and 2010 it would be prudent to wait until the end of the year before drawing any hard conclusions about the effect that the current economic and fiscal conditions have had. What is clear, however, is that it will take a lot of activity in the next two quarters to get close to the drilling levels we previously experienced.”

Turning to corporate deal-making, Deloitte's findings show that levels continued to be flat with only one deal going ahead in the UK in the second quarter of 2011, compared to one transaction announced during the first quarter of 2011 and three new deals announced during the second quarter of 2010. This too, can be partially explained with reference to Osborne's tax changes said Graham Hollis, energy partner at Deloitte.

“While two deals were announced, the proposed re-organization of EnCore did not go ahead with the company stating that the decision to cancel was made in light of the market conditions which have been exacerbated by the uncertain investment climate created following the recent tax changes in the UK," he said.

Hollis concluded: “The high level of farm-in activity continues the trend from the first quarter of the year with 13 deals announced in the last three months. This type of deal allows companies to increase the size of their reserves portfolio whilst sharing their exposure to risk with other parties, making it a much more popular option in the current climate. What it does demonstrate is a continued appetite for UKCS activity, albeit in a more cautious manner.”

Commenting on the findings, Mike Tholen, economics director of the industry body Oil & Gas UK’s, said: “The drop in UK exploration and appraisal activity compared to other sectors of the North Sea since the Budget is a worrying reflection of the negative impact of the surprise tax increase on investor confidence in the UKCS. Oil & Gas UK’s latest business confidence survey which showed a twenty percent drop in confidence across the exploration, production and supply chain sectors is now backed up by the hard news of a drop in exploration."

“While companies are contractually and commercially committed to many development projects that will go ahead, it is the exploration and future investment activity that investors now perceive as riskier than before and therefore think twice about pursuing. The relatively small average discovery size and resulting lower margin to be made in the UKCS only reinforces that reluctance to invest. The UK’s oil and gas resource still offers huge potential for exploration and production but to maximize economic recovery in the long-term for the benefit of the UK economy, energy supply and tax revenues, it is not only the very attractive projects that must go ahead. It is imperative that the economics of less attractive projects are quickly aided by changes to the tax regime which lessen the impact of the tax hike and that exploration for new reserves is encouraged”, Tholen added.

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