* UK government review into North Sea oil out this month
* Production down 40 percent since 2010
* UK seen taking bigger role to recover hard-to-extract oil
By Stephen Eisenhammer and Claire Milhench
LONDON, Feb 14 (Reuters) - Britain is likely to have to ditch its hands-off approach to the oil industry for a mix of regulation, tax breaks and investment if it is to reap the benefits of the billions of barrels of hard-to-extract oil remaining under the North Sea.
Changing the way an industry has worked for decades will be no easy feat. It could involve costly legal disputes over existing contracts, and a long-term commitment from a government focused on the short-term goal of cutting its deficit.
But with many North Sea oil platforms and pipelines coming to the end of their working lives, time is running out to get at the oil, putting pressure on a government review of the industry - due to be published this month - to deliver a plan of action.
"This is urgent. It's not a problem we can see happening in the next decade, it's a problem now," said David Bamford, a former head of exploration at oil firm BP, who now runs his own consultancy and sits on the board of Tullow Oil.
Production from UK waters fell by about 40 percent between 2010 and 2013 to the lowest level since the 1970s, according to industry group Oil and Gas UK. Exploration has also tapered off, with consultancy Deloitte reporting last month that only 47 test wells were drilled last year - the lowest level since 2003.
That is bad news for a cash-strapped government which in fiscal 2012-13 still relied on the oil industry for over 15 percent of all corporate taxes.
It's not that North Sea oil is running out.
An interim report from the government's review - chaired by industry veteran Ian Wood - estimated as much as 24 billion barrels of oil could still be produced, worth about $2.6 trillion at current prices.
But the oil is getting harder and more expensive to recover. And many of the firms with the skills to do so complain they can't get access to the infrastructure they need because it is owned by major oil companies that are focused elsewhere in the world and see little benefit from helping competitors.
High costs, including wages and taxes, are also making oil firms think twice about the North Sea. In November, for example, Chevron cast doubt over its Rosebank project in the region, estimated to have cost $8 billion, saying it did not currently offer "economic value".
There is also political uncertainty, with BP warning this month that the industry could face extra costs if Scotland votes for independence in a referendum in September.
The interim report from the Wood Review in November suggested the government should set up a stronger regulator for the industry to ensure companies work together in a way that "maximises economic recovery" of oil in British waters.
That could follow the model of Norway, where the NPD regulator is mandated both to drive cooperation between oil firms and to impose Norwegian law - which requires that resources are developed optimally.
The NPD, however, has been operating for around forty years and employs about 200 highly-skilled people with an in-depth knowledge of the North Sea, something which industry watchers say will not be easy to replicate in a short space of time.
"Decent, experienced people in the oil industry can earn a fortune," said Judith Aldersey-Williams, partner at law firm CMS. "They will be difficult to recruit and it's going to be expensive."
The regulation itself could also be deeply contentious, particularly if the government tries to change existing contracts in order to enforce cooperation between companies - something that may be needed given the ageing infrastructure.
"The government can change the terms of licences going forwards, but changing the terms of licences which already exist is tricky without primary legislation," Aldersey-Williams said.
Major oil companies such as BP and Shell have welcomed the Wood Review, saying they support moves to maximise production from the North Sea.
But some in the industry think they will put up a fight if the government tries to force them to maintain expensive infrastructure for longer than they had planned - particularly if they are also asked to help fund the cost of a new regulator.
If major oil firms are to be won over, they are likely to want tax breaks - something outside the Wood Review's remit.
Other parties may also be reluctant to cooperate.
"We need to collaborate more, but my contention is that if you try and tell your kids to play nicely together they look at you and it's like 'Why should I?'," said Paul Griffin, managing director for the UK at Dana Petroleum, which produces 70 percent of its oil from the North Sea.
For ex-BP man Bamford, the government may need to consider more radical solutions with regards to North Sea infrastructure.
"I don't know if it's that you do something like the railways with the infrastructure," he said, referring to the split in Britain between a state-owned railway network operator and mostly privately-owned train companies.
"I hate the idea of it being nationalised, but control of the infrastructure in the North Sea is key."
For Dana's Griffin, a better solution would be the emergence of independent infrastructure owners.
Such companies have grown up in the U.S. Gulf of Mexico. But it is unclear whether infrastructure investors would be prepared to put their money in ageing North Sea assets, or whether the existing owners would be prepared to sell.
The government might have to act as a broker in any such deals, possibly taking stakes in the resulting businesses. That would be a big bet given the price of oil has fluctuated from as low as $10 to as high as $147 a barrel over the past 20 years.