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COLUMN-Falling output, old fields spur North Sea tax fight: Kemp
July 24, 2012 / 4:20 PM / 5 years ago

COLUMN-Falling output, old fields spur North Sea tax fight: Kemp

LONDON, July 24 (Reuters) - UK government revenues from oil and gas production will almost halve over the next four years, as falling output as well as investment in new fields and the cost of decommissioning old ones cut into tax receipts.

Shrinking revenues highlight the rapid depletion of North Sea oil fields, but also the growing costs of plugging and abandoning old wells that are no longer productive as the province becomes more mature.

They have also triggered a bitter conflict between the industry and the government over the tax regime and relief for decommissioning costs.

PLUNGING REVENUE

According to Britain’s tax authority, tax revenues from oil and gas production peaked at almost 13 billion pounds in the fiscal year which started on April 6, 2008 (though in real terms they were much higher in the early and mid 1980s when booming North Sea oil output coincided with high oil prices supported by the Iranian revolution and OPEC).

By fiscal 2011, revenues had shrunk to 11.25 billion pounds. But in its latest fiscal outlook, released to accompany the budget, the government’s independent Office for Budget Responsibility (OBR) forecast revenues would tumble to only 5.3 billion pounds by fiscal 2016, the lowest level in real terms since the 1990s, even though crude oil and gas prices are now much higher (“Economic and Fiscal Outlook” March 2012).

Projected revenues are highly sensitive to anticipated oil and gas prices. Forecasts exhibit significant swings in response to price changes. Moreover, because OBR bases its projections on prices for futures contracts, they are biased downwards at present owing to the backwardation in the Brent forward curve.

However, price effects explain only a small part of the expected decline in tax revenues. Far more important is the anticipated decline in production.

OBR forecasts oil output will drop 14 percent from 51.9 million tonnes (400 million barrels) in fiscal 2011 and 48.3 million tonnes in fiscal 2012 to just 44.7 million tonnes by fiscal 2016. Gas is predicted to decline 7 percent from 16.1 billion therms in fiscal 2011 and fiscal 2012 to just 14.9 billion by 2016.

Some OBR projections and assumptions are set out in the attached table: link.reuters.com/dew59s

But by far the biggest downward revisions to the OBR’s revenue projections stem from increased spending on the development of new oil and gas fields, and the expense of decommissioning depleted old ones, which the industry can offset against tax.

DECOMMISSIONING COST

The UK Continental Shelf contains 470 installations, 10,000 km of pipeline and 5,000 wells, all of which will eventually have to be decommissioned, according to Oil and Gas UK, the offshore industry’s trade association.

Higher oil and gas prices have encouraged operators to extend the life of some wells that would previously have been decommissioned. Nonetheless, as fields age, the number of wells scheduled for plugging and abandonment is rising.

Oil and Gas UK estimates the industry will spend 3.3 billion pounds on decommissioning between 2012 and 2016, and eventually a total of 28.7 billion pounds (at current prices) from 2012 onwards decommissioning all the current wells and infrastructure.

Projected costs have tripled since 2005, reflecting the extra decommissioning cost of new projects launched in response to high prices, as well as the general uptrend in costs across the industry, including for production and development (“Economic Report 2012” UK Oil and Gas).

In a separate piece of research, oilfield services firm Schlumberger estimated that 500 structures with about 3,000 wells are slated for permanent abandonment in the UK sector in the near future.

It is part of a wider phenomenon in maturing oil regions. “By some estimates, as many as 12,000 wells are no longer producing in the Gulf of Mexico, qualifying them as plugging and abandonment candidates. In the Norwegian sector of the North Sea, more than 350 platforms and more than 3,700 wells eventually must be abandoned,” according to Schlumberger (“Offshore Permanent Well Abandonment” Schlumberger Oilfield Review, Spring 2012).

Schlumberger put the cost of plugging and abandoning a well in the UK North Sea at between $1-2 million at the low end and $5-6 million at the high one -- depending on whether the abandonment is from a fixed platform or requires the use of a semisubmersible drilling rig or support vessel with dynamic positioning technology.

Decommissioning in Norway is even more expensive, owing to the country’s more stringent industry standards and government regulations.

Decommissioning will become an ever more significant cost for oil and gas producers as offshore fields which began producing in the 1970s, 1980s and 1990s reach the end of their productive lives. While some costs are incurred earlier, most of the costs of decommissioning (and tax relief) tend to be incurred at the end of a field’s life, according to the UK tax authority.

MAXIMUM SQUEEZE

UK taxation of offshore oil and gas is a complex combination of ring fenced corporation tax (levied at 30 percent), a supplementary charge on profits (levied at 32 percent) and, on fields permissioned before March 1993, petroleum revenue tax (PRT) (50 percent). In total, the marginal rate of tax is either 62 percent or 81 percent depending on whether or not the field is subject to PRT.

The regime is significantly tougher than for companies in other sectors. The rate of corporation tax is specially ring fenced to prevent taxable profits from oil and gas extraction being reduced by losses from other activities or by excessive interest payments (hence “ring fenced corporation tax”).

Offshore petroleum producers have specifically been excluded from gradual cuts in the main corporation tax rate announced in recent budgets. Instead the government has bumped up the supplementary charge from 20 percent to 32 percent in 2011, basically to capture some of the windfall from higher prices.

In a bitter blow, which has left producers fuming, while the supplement has been raised to 32 percent, tax relief for expenditures (including decommissioning) has been capped at the old rate of 20 percent -- introducing a highly unusual asymmetry between the rates at which profits are taxed and the rates at which legitimate expenses can be offset against tax.

The industry complains UK taxation is not competitive. While Norway has a higher headline tax rate, the industry claims discoveries there are more competitive because the fields tend to be larger and there are more generous allowances for capital and drilling costs. In the Netherlands, the tax rate is a flat 50 percent, far below Britain’s 62 and 81 percent rates.

But what appears to have really incensed the industry is the tax regime’s instability. UK Oil and Gas lists more than 16 separate changes to the tax rules since 2002.

Fiscal instability, complains the association, “has blighted the UK Continental Shelf during the past ten years as the result of three separate tax increases since 2002 and a multitude of other tax changes. Fiscal instability creates uncertainty in investment decisions and makes the UK more costly by increasing the fiscal risk premium, especially given the long-term nature of most oil and gas projects”.

The decision to cap tax relief from the supplementary charge at the old rate of 20 percent led to widespread fears the relief might be scaled back even further in future. Following intense pressure, the government agreed in the 2012 budget to enter into contractual commitments with operators from 2013 to guarantee the future rate of relief.

The combination of near-record oil prices, falling production, and looming decommissioning costs has triggered a fierce fight between operators and the tax authorities to secure their share of a shrinking resource and revenue base, as everyone tries to avert the inevitable.

But even the government’s fierce squeeze on the industry, attempting to maximise its share of the remaining “rent”, cannot forestall the imminent reduction in revenues as output sinks and aging fields incur more and more non-productive costs for plugging and abandonment. (Editing by Anthony Barker)

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