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The New North Sea – Part 3: Top 10 “MER UK” issues for exploration activities

Exploration is undoubtedly a key area of focus for the bodies responsible for achieving MER UK. In its Corporate Plan, the OGA lists “revitalising exploration” as one of its priorities. It also sets out a proposed pathway for reaching its target of 50 E&A wells drilled per annum by Q1 2021. In addition, an ‘exploration sector strategy’ is awaited which will hopefully set out in more detail how the OGA intends to apply the MER UK Strategy to exploration operations. Our third post in this series sets out our top 10 key “MER UK” changes which may have a bearing on exploration operations in the North Sea.

1. All exploration activities must comply with the central obligation of achieving MER: All offshore petroleum licensees must comply with the MER UK Strategy (pursuant to the changes to the Petroleum Act 1998, brought in by the Infrastructure Act 2015). The MER UK Strategy was developed by the Secretary of State and sets out the proposed strategy for achieving the principal objective – “the objective of maximising the economic recovery of UK petroleum” (see also our previous post on the MER UK Strategy). It is binding upon relevant persons operating in the UKCS, specifically holders of offshore petroleum licences and operators of petroleum licences.

The MER UK Strategy expressly requires licensees under an offshore licence to plan, fund and undertake exploration activities within the licence area, in a manner that is “optimal for maximising the value of economically recoverable reserves” within the licence area. The MER UK Strategy contains more detail as to how “relevant persons” should act. Some of these are discussed in more detail below, but the key requirement is to carry out all functions in a manner compliant with MER.

2. Failure to comply with MER: Failure to comply with the MER UK Strategy may lead to sanctions. The Energy Act 2016 grants the OGA powers to impose sanctions on offshore petroleum licensees for failing to comply with the MER UK Strategy, or for failing to comply with a term or condition of the offshore licence. The possible sanctions range from enforcement notices and fines to, ultimately, the removal of the operator of a petroleum licence and/or revocation of the licence.

3. No relinquishment until firm commitment carried out: The MER UK Strategy provides that, except where the licensee would not make a “satisfactory expected commercial return” (as defined in the MER UK Strategy), a licensee cannot relinquish a licence until it has completed any work programme, to which it made a firm commitment in the licence.

4. Regional exploration plans: The OGA may produce plans setting out its view of how it expects obligations in the MER UK Strategy to be met. The plans may cover exploration activities carried out within specific regions of the North Sea, for example West of Shetland.

As far as we are aware, the OGA has not yet developed any exploration plans. If the OGA wishes to produce a plan under the MER UK Strategy, it must first consult with those persons it thinks may be affected by the plan. As the plans are binding, we recommend you engage with the OGA on any proposed plan that may affect your exploration activities (and potentially future activities down the line, including development and decommissioning).

If you intend to carry out activities in a manner inconsistent with any plan published by the OGA, you will need to first consult with the OGA.

5. Collaboration and competition law issues: The MER UK Strategy requires licensees to consider whether collaboration or cooperation with other licensees or service providers could reduce costs and/or increase the recovery of economically recoverable petroleum, and to give due consideration to such possibilities.

At the same time, the MER UK Strategy states that no obligation imposed by the Strategy permits conduct which would otherwise be prohibited under legislation, including competition law. There appears to be an inherent conflict between these requirements. It is your responsibility to ensure that you do not infringe competition laws whilst complying with MER.

6. New technologies: According to the MER UK Strategy, licensees must ensure that, in carrying out their activities, new and emerging technologies are deployed to their optimum effect. This may also be the subject of an OGA plan, which you may be required to comply with.

7. OGA attendance at meetings: Under the Energy Act 2016, the OGA will have powers to attend meetings between licensees and other relevant persons discussing matters relevant to achieving MER. This includes formal meetings such as Opcom meetings, as well as meetings conducted through electronic means (e.g. telephone calls). The organiser of the meeting has to provide notice to the OGA of any such meetings (14 days’ notice, unless it is not practicable to do so) and provide any papers relating to the MER UK issue, which are distributed to the attendees to the OGA. If an OGA representative does not attend, the organiser must provide a summary of the discussion to the OGA.

In practical terms, employees organising meetings need to be aware of what “MER” issues are, in order to know when the OGA should be given notice and what papers to provide. Waivers of confidentiality from other persons may be required. In addition, papers given to the OGA should only cover those issues relevant to the OGA and not commercially sensitive information.

Whilst these new powers appear to be fairly onerous, they may be useful, if there is an issue that you want the OGA to be involved in.

8. Information and samples: There are new provisions in the Energy Act that give the Secretary of State the power to create regulations to require licensees, operators and owners of petroleum infrastructure to retain specified petroleum related information and samples. Notably, the regulations can require a party to keep information and samples even where it is no longer a licensee (as a result of transfer, surrender, expiry or revocation).

Procedures will need to be put in place to ensure the data and samples are retained. In addition, each licensee is required to have an information and samples coordinator within the organisation to supervise data retention and correspondence with the OGA.

If a licence is transferred, surrendered, revoked or expires, then the OGA can request that the licensee informs it of what is to happen with information and samples (in an information and samples plan). The plan must provide for the party to either: (i) retain the information and samples, (ii) transfer to a new licensee or (iii) secure appropriate storage. So on a transfer of a licence, the licensee has the choice of potentially incurring costs to retain or store the data and samples, or handing over its intellectual property to another licensee.

9. MER UK disputes: Relevant persons, including offshore petroleum licensees and owners of upstream infrastructure, may refer disputes relating to fulfilment of the MER, or relating to activities carried out under an offshore petroleum licence, to the OGA for a non-binding recommendation on how to resolve the dispute. It should be noted that the OGA also has the power to decide on its own initiative to consider a dispute involving such issues.

As there is already a separate procedure for disputes relating to third party access, the new powers do not apply to such disputes relating to third party access.

10. Satisfactory expected commercial return: The general principle behind the MER UK Strategy is that investment made in the UKCS should be made such that the maximum value of economically recoverable petroleum is recovered, and that assets should be in the hands of those who are willing to make such investment.  So the MER UK Strategy contains a safeguard that no licensee or owner of infrastructure is required to invest or fund activity if it would not make a satisfactory expected commercial return. The definition is fairly vague, but prescribes that a satisfactory expected commercial return is not necessarily a return in line with corporate policy.  If a licensee feels that it would not make a satisfactory return, but a “satisfactory expected commercial return” could be made, the licensee could ultimately be required to sell the asset.

 

 

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The New North Sea – Part 3: Top 10 “MER UK” issues for exploration activities

The New North Sea – Part 1: the revolution begins here

How much of a difference will the recent reforms of UK offshore oil and gas regulation make to the industry and its stakeholders? It may be too early to say whether the creation of the Oil and Gas Authority (OGA), the articulation of the “MER UK Strategy” and the other changes introduced by the Infrastructure Act 2015 and the Energy Act 2016 will facilitate solutions to all the significant problems faced by North Sea operators, but in our view it is already clear that the changes of the last two years will have a profound impact on the industry.

Government intervention in the UK’s offshore oil and gas industry is nothing new. It has taken different forms at different times, and has included, as well as numerous changes in taxation, Government participation (or at least the ability of Government to participate) in decision-making at the individual asset level through rights granted to state-owned entities.

More specifically, for almost 20 years, Government has been aware of, and has been taking action to address, the particular set of problems that the UK Continental Shelf (UKCS) faces as a mature basin.  Between 1999 and 2004, the Department of Trade and Industry and its successors took a series of steps to foster investment and innovation in the industry and improve its efficiency: a joint Government / industry report (A Template for Change) was published in 1999; task forces were appointed; changes were made to the administration of the licensing regime; new types of licence were introduced.

PILOT and small-scale regulatory changes, 1999-2004
1999

 

 

Brent at $9/barrel – a record low – in February, but recovers to $25 by December.

Oil & Gas Industry Task Force report (September) set a vision for the UKCS in 2010, aimed at increasing investment and employment, and prolonging UK self-sufficiency in oil and gas.

2000 PILOT established to take over the work of the Task Force and give effect to its recommendations
2002 PILOT “Progressing Partnership” Work Group launched to address behavioural and supply chain barriers. Initiatives include transferring “fallow” assets to those best placed to exploit them.
2003 “Promote” licences offered for the first time to attract new small players.
2004 22nd offshore licensing round: largest number of blocks since 1965.   “Frontier” licences first offered.
   

However, by the time that Ed Davey, as Secretary of State for Energy and Climate Change, commissioned Sir Ian Wood to carry out a review of the industry in 2013 and the Wood Review’s final report was issued early in 2014, it had become clear that all the good work done after the 1999 report had not resolved or prevented some fundamental problems, and that the “vision for 2010” which it articulated had not been fully realised.   Average production efficiency declined from 81% in 2004 to 60% in 2012.  There had been a downward trend in numbers of exploration wells drilled since 2008 (with about 70% fewer being drilled in 2013 than were drilled five years before).  Perhaps worst of all, costs of production per barrel had risen fivefold in ten years.  And all that was before global oil prices began a period of sharp decline which has seen them fall to levels at which most North Sea fields are said to be uneconomic, with no certainty of a rapid or sustained recovery.

A false sense of security? North Sea licensing events highlighted in Government reports, 2005-2012
2005 24 new companies enter the North Sea as part of a record offering of 151 licences.
2006 UK a net importer of gas in value terms for the first time since the early 1980s.
2007 Legislation to allow storage of natural gas under the seabed / unloading of LNG at sea announced.
2008 Brent crude tops $100 / barrel for the first time, rising to over $140 / barrel in June and July.
2010 Largest number of blocks applied for since the first licensing round in 1964.
2011 Brent crude tops $100 / barrel for the first time since 2008.
2012 Demand for offshore licences again breaks all records (applications covering 418 blocks).
   

Many of the concerns that were articulated in the 1999 report and addressed in the initiatives that followed from are echoed in the Wood Report. Both reports are in favour of such things as “collaboration in place of competition”, “improving relationships between licensees” and encouraging innovation, for example.  But the final results of Wood’s work are very different from those of the earlier report and its follow-up.  Where the 1999 report tends to talk about “deregulation”, the Wood Report has led to the creation of a new, more powerful and better resourced body to regulate the industry.  In the words of the Wood report itself: “In the early days with large fields to be found by major operators, the free market model worked well with a light touch Regulator…However, over time, the number of fields has increased, now to over 300, new discoveries are much smaller, many fields are marginal and very inter dependent, and there is competition for ageing infrastructure. Alongside this, the…Regulator has halved in size in 20 years and…is clearly struggling to perform a more demanding stewardship role.

There has been general agreement with Wood’s conclusion that “a stronger Regulator with broader skills and capabilities able to significantly enhance the level of co-ordination and collaboration” would “largely resolve” the problems that his review identified.  It is rare for an industry to be so apparently united in its desire for stronger regulation – even if it was clear from the first that a regulator based on Wood’s prescription would be different from many sector regulatory bodies in terms of its remit, composition, and its interactions with industry.  It has probably helped that the fall in oil prices has made the problems identified by Wood more acute, increasing the demand for a powerful independent regulator to get to work on solving them.  This, together with the compelling nature of Wood’s analysis and strong political support, has enabled the necessary legislative changes to be put in place rapidly.

The Wood Review and its implementation, 2013-2016
2013 Government commissions the Wood Review of offshore oil and gas recovery (June)

The interim report of the Wood Review is published (November)

2014 Final report of the Wood Review published   (February)

Sharp fall in oil price begins (June)

Government response to the Wood Review published (July)

Clauses on MER UK (to amend the Petroleum Act 1998) inserted into Infrastructure Bill (October)

Appointment of Andy Samuel as CEO of OGA (November)

2015 Andy Samuel asked to lead urgent study of key risks to North Sea oil and gas industry (January)

Infrastructure Act 2015, including revised provisions on MER UK receives Royal Assent (February)

OGA issues “call to action” document in response to DECC’s request to Andy Samuel (February)

OGA launched as an Executive Agency of DECC, carrying out DECC regulatory functions (April)

Energy Bill, dominated by provisions on the OGA, introduced into Parliament (July)

Oil & Gas UK launches efficiency task force (September)

OGA reports: call to action 6 months on (September)

OGA publishes draft corporate plan (November)

DECC launches consultation on MER UK strategy (November)

2016 Brent crude falls below $30 / barrel (January)

Government support package for UK offshore oil and gas (January)

Draft MER UK strategy laid before Parliament (January)

OGA publishes Corporate Plan 2016-2021 (March)

MER UK strategy finalised and comes into force (March)

Energy Bill receives Royal Assent, Energy Act 2016 published (May)

Why do we think that North Sea regulation from now on (or at least from the date on which the relevant provisions of the Energy Act 2016 come into force and the Regulator’s staff complement is up to full strength) will be radically different from what operators have been accustomed to? There are six main reasons.

For the first time, the UK offshore regulatory regime (excluding its environmental and health and safety aspects) has a single governing principle articulated on a statutory basis – the objective of maximising the economic recovery of UK petroleum (MER UK).

Although MER UK is defined in general terms in a strategy promulgated by DECC under the Infrastructure Act 2015, its specific meaning and impact in any given situation will in large measure be determined by the Oil and Gas Authority (OGA).

The obligation to act in accordance with MER UK, as so defined and interpreted, applies – or could be said to apply – to at least one person involved in the taking of almost any commercially important decision in the offshore industry.

Under the new regime, the OGA and DECC will potentially have access to vastly more information about North Sea assets and infrastructure, the commercial intentions of those with interests in them, and the relations between them, than DECC has had to date.

The OGA does genuinely appear to be a new kind of regulator, in terms of its composition, capabilities, culture and combination of functions. It is also likely to take a more proactive approach than its predecessors.

The terms of the MER UK strategy and the robustness of the enforcement tools at the OGA’s disposal suggest that it will enjoy unparalleled leverage over licence holders and others to ensure that collaboration “for the greater good” really does happen.

In future posts in this series, we will explain in more detail how the relevant provisions of the Infrastructure Act 2015, the Energy Act 2016 and the MER UK strategy achieve these results and how we think the application of the new rules by industry parties, DECC and the OGA will affect key moments in the life of North Sea infrastructure and assets.

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The New North Sea – Part 1: the revolution begins here

UK Government initiatives for UK oil and gas : forging links with Mozambique

Last week, the UK Government had a busy week on the oil and gas front – publishing the Draft MER UK Strategy and announcing new measures to encourage investment in the sector and a new City Deal for Aberdeen.

Last Thursday (28 January), the Government laid its new strategy for implementing the plan for maximising economic recovery (the Strategy) before Parliament. The document presented before Parliament is the product of consultation on various drafts since November 2014. Not much has changed from the previous version issued for consultation in October 2015 (see our earlier blog post on the consultation). The Strategy is legally binding upon the Secretary of State, the Oil and Gas Authority (OGA) and players in UKCS upstream operations. The new obligations are intended to help fulfil the aims of MER UK, according to the Strategy without cutting across existing legislation including model clauses…

In case the Strategy wasn’t enough information to absorb in one day, on his visit to Aberdeen on Thursday, David Cameron proudly announced new initiatives intended to demonstrate the UK Government’s ongoing commitment to the UK’s oil and gas industry –

  • 250m investment for Aberdeen as part of a City Deal – the Scottish government has committed a further £254m for infrastructure in Aberdeen and the surrounding region
  • £20 million for funding a second round of new seismic surveys on the UKCS – data from these surveys will be made publicly available
  • £1.5 million available through Innovate UK for innovators outside of the energy sector to develop solutions and disruptive technologies to meet challenges of the energy industry
  • OGA publication of a UKCS Decommissioning plan by early summer (one of the plans to fall out of the Draft MER UK Strategy)
  • Appointment of an Oil and Gas Ambassador to promote the North Sea overseas to boost inward investment, but also to develop links with overseas markets to provide UK oil abd gas companies with best possible access

Of course, an even more powerful display of UK Government support to the industry, might comprise some form of tax relief for faltering producers. We wait to see what happens in the March budget.

Due south to Mozambique

David Cameron’s announcement comes as The Secretary of State for Scotland, David Mundell, prepares to travel to the port town of Pemba in Mozambique, to promote relations with Mozambique’s oil and gas industry. This trip is in conjunction with Aberdeen City Council’s Pemba Initiative which aims to support Pemba’s development as an oil and gas hub.

(A place in the sun - Northern Mozambique) (source: tedchang)

(A place in the sun – Northern Mozambique) (source: tedchang)

The level of oil and gas activity in Mozambique is set to increase dramatically in the next decade. Mozambique has hit the headlines in the last few years, due to huge discoveries of gas in the Rovuma Basin, offshore Northern Mozambique. More than 150tcf of gas discoveries have been made since 2010. Operators, Anadarko and Eni, are both pressing ahead with LNG projects – an initial 12mtpa onshore facility for Anadarko from the Golfinho reservoir in Area 1 and a 2.5mtpa FLNG facility for Eni for the Coral reservoir in Area 4.

A flurry of exploration activity is also expected in the next few years. INP announced the results of the fifth licensing round in October last year, inviting six consortia (including relative veterans Eni, Statoil and Sasol, as well as newcomers ExxonMobil) to enter into negotiations for exploration and concession contracts for six new blocks.

It seems that opportunities abound for Aberdeen and the UK to develop partnerships with and provide support to Mozambique’s relatively young petroleum industry. Although anyone wishing to engage in petroleum operations in Mozambique will need to get to grips with the recently revised petroleum laws, new petroleum regulations and other local laws – including the local content rules.

Mozambique does not have a general local content law, instead provisions for local content are to be found in the 2014 Petroleum Law, and for the Rovuma Basin LNG projects, in the 2014 project-specific Decree-Law. The two laws contain rules about the level of Mozambican nationals participating in the workforce, in addition to, requiring those engaged in petroleum operations to give preference to Mozambican companies and partnerships and joint ventures between foreign and local companies and individuals in the context of procurement of goods and services.

If you would like to discuss any of the issues raised above, please do not hesitate to get in touch with the author or any of your other regular contacts in the Dentons oil and gas team.

Dentons has experience going back over 20 years in advising on energy projects in Mozambique and is heavily involved in the current LNG projects in Mozambique.

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UK Government initiatives for UK oil and gas : forging links with Mozambique

Published at last – a winning strategy for the UK Continental Shelf?

Finally, we have the missing piece of the jigsaw.  The current reforms to the UK’s regulatory regime for the offshore oil and gas industry were recommended by the Wood Review in 2014.  They began to be implemented with the creation of the Oil and Gas Authority (OGA) and the amendments made to the Petroleum Act 1998 (the 1998 Act) by the Infrastructure Act 2015; they are continuing with the current Energy Bill (now half way in its passage through Parliament).  But it is perhaps only with the publication of a draft of the strategy for maximising the economic recovery of UK petroleum on 18 November 2015 that we start to get a full sense of how the new regime may work in practice.

What is the draft strategy, and why does it matter?

The legislation describes the strategy as “enabling” the “principal objective” of “maximising the economic recovery of UK petroleum” (MER UK) to be met.*  The principal objective and the strategy occupy a central position in the revised regulatory scheme.

To begin with the regulators.  In one way or another, the OGA is taking over most of the Secretary of State’s statutory functions under the Petroleum Act 1998 and Chapter 3 of Part 2 of the Energy Act 2011.  The OGA is also to acquire a raft of new functions under Part 2 of the Energy Bill.  In exercising all these functions (including any of its powers under a petroleum licence), the OGA will be obliged to “act in accordance” with the strategy.  The Secretary of State will be similarly obliged to act in accordance with the strategy when exercising her functions under the Part 4 of the 1998 Act “to the extent that they concern reduction of the costs of abandonment”.

At the same time, the strategy will be binding on holders of, and operators under, petroleum licences, when planning and carrying out their activities as such; persons planning or carrying out the commissioning of upstream petroleum infrastructure (broadly defined); and (subject to the Energy Bill) owners (broadly defined) of offshore installations and upstream petroleum infrastructure, when carrying out their activities as owners of such installations or infrastructure, or decommissioning it.  Such persons and (in so far as they can affect the fulfilment of the principal objective) activities are referred to in the draft strategy as “relevant persons” and “relevant functions” respectively.

The Energy Bill provides that if a business which is a relevant person fails to act in accordance with the strategy, the OGA can impose sanctions including financial penalties of up to £1 million (and potentially up to £5 million if the Secretary of State raises the penalty cap by regulations) and revocation of the business’s status as a holder of, or operator under, a petroleum licence.

Although the strategy will become more important as and when the Energy Bill completes its passage through Parliament and becomes an Act, many of the provisions establishing the importance of the principal objective and the strategy are already embodied in the amendments made to the 1998 Act by the Infrastructure Act 2015.  So it is noteworthy that reform of the offshore oil and gas regulatory regime has gone so far without public consultation on a full draft of the strategy.

What the draft strategy says

The Wood Review pointed out, and subsequent OGA papers have elaborated on, the fact that the inter-dependence of different installations and infrastructure in the UK upstream oil and gas industry is such that if each relevant person only seeks to optimise its own financial position, the performance of the industry as a whole is likely to be sub-optimal.  So the key question for the draft strategy to answer is how (and how far) businesses are to be induced to compromise their interests for the greater good.

To look at how the draft strategy answers this question, it is best to start with two of its key definitions.

  • “economically recoverable petroleum” means “those resources which could be recovered at an expected (pre-tax) market value greater than the expected (pre-tax) resource cost of their extraction, where costs include capital and operating costs but exclude sunk costs and costs (like interest charges) which do not reflect current use of resources.  In bringing costs to a common point for comparative purposes a 10% real discount rate will be used“.
  • “satisfactory expected commercial return” means “a reasonable post-tax return having regard to the risk and nature of the investment“.

These two definitions underpin what are perhaps the draft strategy’s two most important provisions:

  • The Central Obligation applies to relevant persons in the exercise of their relevant functions, and obliges them to “take all steps necessary to secure that the maximum value of economically recoverable petroleum is recovered from the strata beneath UK waters“.  (Emphasis added: as a recital to the draft strategy puts it: “all stakeholders should be obliged to maximise the expected net value of petroleum produced from relevant UK waters, not the volume expected to be produced”.  The focus on value (undefined) rather than quantity contrasts with the similar but different words about “securing the maximum ultimate recovery of petroleum” in the petroleum licence model clauses on unitisation, which represent perhaps the greatest degree of intervention by the licensing authority under the existing regulatory regime.)
  • Paragraph 27 provides that if relevant persons “decide not to ensure the recovery of the maximum value of economically recoverable petroleum from their licences or infrastructure (including because that does not achieve a satisfactory commercial return, in accordance with paragraph 3) they must relinquish or divest themselves of such licences or assets“.

The “paragraph 3” referred to here is one of the draft strategy’s Safeguards: “No obligation imposed by or under this Strategy requires any person to make an investment or fund activity where they will not make a satisfactory expected commercial return on that investment or activity.”.

It is hard to quarrel with any of this in the abstract, but applying these principles in any given case will not necessarily be easy.  For example, how do you assess “expected pre-tax market value” in the context of massive uncertainty over future oil and gas prices?  DECC’s own most recent fossil fuel price projections suggest that the average oil price for the next 10 years could be anything from $46.8 to $140.4 a barrel (depending on whether you take the “low” or “high” scenario).

What does this mean in practice?

The consultation document spells out where all this leads.  If you are the owner or operator of an asset or infrastructure and take the view that you cannot make a satisfactory commercial return from its continued operation, you may be obliged to divest it to somebody who takes a different view of what constitutes a satisfactory return or what is economically recoverable.

Paragraph 27 is one of a number of “supporting obligations” and “required actions and behaviours” listed in the draft strategy in respect of exploration, development, asset stewardship, deployment of new technology and decommissioning.  So, for example, owners and operators of infrastructure must plan, commission and construct it in a way that meets the optimum configuration for MER UK, and must allow access to it on fair and reasonable terms.  If the infrastructure is not able to cope with demand for its use, they must prioritise “access which maximises the value of petroleum recovered”.  Meanwhile, the OGA may produce plans addressed to “a single or small group of relevant persons” setting out its view of how the obligations of the strategy may be met in their particular circumstances”.  According to the consultation document: “A plan might target a particular or small range of circumstances, or might be broader and more strategic in nature, for example setting out how the OGA thinks a region should be developed or decommissioned.”.

The new regime

In the words of the consultation document: “How the OGA uses and acts on the Strategy is…of great importance – it will set the tone for the basin and will be a key factor determining its attractiveness to industry and investors.”.

One could perhaps sum up the spirit of the strategy by mangling a famous line from John F. Kennedy: “Ask not what the strategy can do for you, but what you can do to maximise the economic recovery of UK petroleum.”; or perhaps quoting Karl Marx, without modification: “From each according to his ability, to each according to his needs”.

But enough flippancy.  The consultation document goes out of its way to emphasise that the OGA will not be unduly interventionist: “whilst enforcement measures are a necessary backstop, the OGA is expected to act primarily as a convenor and facilitator, working together with industry to deliver increased value from the UKCS for both industry and the UK as a whole”.  If it is “occasionally…the case that the OGA [finds] that a relevant person’s contractual provisions place that person…in breach of the Strategy”, or if the OGA finds that it needs “to assert its right as a regulator to use its sanctions where a relevant person fails to avoid a breach of its MER responsibilities through continued reliance on contractual provisions which conflict with the Strategy…. it will always be for the relevant person to decide for itself how to deal with that in terms of its contracts.”.

Perhaps a useful point of comparison here is the UK power market.  It has become commonplace to note that the UK’s various schemes for subsidising new low carbon electricity production, and the Capacity Market which subsidises old nuclear and fossil fuelled generating stations, have turned the liberalised GB power generation market into something closer to a “planned economy”.  Where the fulfilment of the principal objective is at stake, the Energy Bill requires that the OGA be allowed to participate in meetings between relevant persons, and recommend ways of resolving disputes between them.  Reading such provisions side by side with the draft strategy, it is clear that in the oil and gas industry too, future commercial decision-making may be much more strongly directed by the state than before.

Then again, perhaps one should compare oil and gas production not so much with the power generation market, which is supposed to be characterized by free competition, but with the monopoly markets of transmission and distribution, where it is accepted that it is only economic for one operator to build and operate infrastructure in any given location – just as petroleum licence holders enjoy exclusive rights in their licensed areas and many oil and gas infrastructure owners are de facto monopoly service providers.  In the power sector, to avoid any abuse of monopoly, the returns which network operators can earn on their investment are regulated.  The strategy does not go (quite) that far.

In the end, the strategy highlights the two risks that the OGA will need to guard against particularly carefully in administering the reformed regulatory regime.  The first is highlighted in a letter of 3 December 2015 from the UK Competition and Markets Authority, using for the first time its new powers to make and publish recommendations to Ministers about proposed new legislation: the OGA and those it regulates could collaborate so closely that beneficial competitive pressures, which are important to reduce costs and support the principal objective, could be dampened, so that, for example, the regulatory process ends up facilitating the anti-competitive exchange of information between competitors.  The second and opposite risk is that a less co-operative attitude amongst industry players prompts the OGA to start using its enforcement and other formal powers to an extent that in turn stimulates the kind of “over-zealous commercial and legal behaviour” on the part of the industry that Wood wanted to make a thing of the past.

So perhaps what matters most is not the strategy itself, but the tactics of those who must follow it – both the OGA and industry players.

* Note: The definition given above of the “principal objective” reflects the current text of section 9A of the 1998 Act.  If clause 8 of the Energy Bill (introduced by an Opposition amendment) survives, it will become instead “maximising the economic return of UK petroleum, while retaining oversight of the decommissioning of oil and gas infrastructure, and securing its re-use for transportation and storage of greenhouse gases” – although how much difference some of those additional words will make now the Government has abandoned its CCS commercialisation programme is debatable.

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Published at last – a winning strategy for the UK Continental Shelf?

Oil Price Crash (1): Options for North Sea oil and gas: shut-ins and taxation relief

Companies involved in oil and gas activities globally are tightening their belts. The decline in the price of Brent crude oil (spot sales) from $115 in June 2014 to less than $50 per barrel in just over six months represents a loss in value of over 60%, leading to a reduction in profits (and for some, no profit at all). Regardless of the macroeconomic effects for GDPs, the economics presently look stark.

Some recent headlines demonstrating the devastating effect of the rapid oil price decline:

  • mega mergers and redundancies in the oilfield service sector;
  • the announcements by BP, Talisman and ConocoPhillips of job losses in their North Sea workforces and other operators looking to change the typical “2 weeks on, 3 weeks off” rotation pattern;
  • projects put on hold in Qatar and the Canadian oil sands, (Russia’s Shtokman project and US shale developments are also feeling the pinch);
  • Shell announced last week it will curtail $15bn of investment over the next three years; and
  • across the board rate cuts for North Sea contractors have been implemented since January.

Difficult times for the North Sea

All this comes at what was already a difficult time for the North Sea industry. It is worth noting that some companies were exiting the UK Continental Shelf (UKCS) even before the price crash and that much of the investment, and growth in the UKCS is expected to be in more expensive “frontier” areas. But now, according to a survey of forecasters conducted by The Independent, the oil price is almost at a point that every barrel produced in the North Sea would be unprofitable. There have been calls for a 50% drop in taxes applicable to the North Sea, as 100 (out of around 300) fields were said to be in danger of being shut in.

Weathering a storm

A North Sea platform weathering a storm

Faced with such a drop in the price of their product, operators of producing fields have four choices: (i) sit tight and hope prices bounce back quickly and sharply, (ii) cut costs and/or investment, (iii) shut in production or (iv) lobby the Government to boost their net revenue by changing the fiscal position. We’ve seen some examples of option (ii) already, as noted above. Companies opting for option (i) may wish to consider overlifting or underlifting their share, within the confines of joint venture arrangements, to ease immediate cashflow worries (and see our previous article for issues to consider dealing companies potentially in distress), or gambling on a return to higher prices, respectively. Here we consider options (iii) and (iv) in more detail.

Shutting up shop

Operators of producing fields might consider shutting in production (i.e. stopping production and shutting wells), either for a temporary period until the oil price rises back to a profitable level or permanently with a view to beginning decommissioning. Below, we take a look at some of the practical and legal consequences.

Recommissioning facilities after a temporary shut-in can be a costly and lengthy process. This can be prohibitive, leading to remaining reserves being left in the ground. According to reports it took BP’s Rhum field (temporarily shut in between November 2010 and October 2014) a year to recommence production due to technical delays after receiving approval from DECC.

Those who choose to shut in production with a view to decommissioning must undertake decommissioning activities in accordance with pre-approved programmes. Early field decommissioning can also result in the premature decommissioning of ageing infrastructure which could otherwise be used by newer fields.

Decommissioning in operation

But before an operator can take steps to shut-in production, it must follow a process and obtain certain approvals (which may or may not be forthcoming). Prior to engaging with Government, the operator must obtain approval from its other joint venture parties in accordance with the voting arrangements in the relevant joint operating agreement.  If the green light is given, the operator will need to seek approval in accordance with the law and licence conditions.

Secretary of State blessing

DECC regulates producers operating in the UKCS through the Petroleum Act 1998, as well as the licence conditions in offshore exploration and production licences granted to companies wishing to explore and produce oil or gas in the UKCS. These conditions are drawn from “model clauses” set out in secondary legislation. The model clauses used vary depending on when a licence is granted. But a general principle applying across model clauses for all licences (regardless of when the licence was granted) is that the Secretary of State for  Energy and Climate Change’s (the Secretary of State) consent or approval is required for certain key steps. Under the licence conditions, a licensee cannot abandon any well, nor may it decommission any assets, without the Secretary of State’s consent. Therefore any decision to shut-in a well governed by a UKCS licence requires the Secretary of State’s blessing.

The Secretary of State has the power to revoke a licence (in respect of one or all licensees) on a failure to comply with licence conditions and may direct at the time of revocation that any well drilled is left in good order and fit for further working; thus providing the possibility of future production.

MER UK

The results of prematurely shutting in production seem diametrically opposed to the Government’s aims of maximising economic recovery from the North Sea resource (MER UK) (in line with the proposals set out in the Wood Review). Prior to the coming into force of the Infrastructure Bill, there is no legal requirement for the Government to take MER UK into account when exercising its licensing and decommissioning functions. It is bound to be a factor in decision-making on any request for Secretary of State consent. The Infrastructure Bill, when in force, will also place obligations on producers (see our previous blog) to act in accordance with the Government’s MER UK strategies. 

Death and taxes

There may be nothing more certain than death and taxes, but taxes applying to the UKCS have been far from certain. The surprise increase in the Supplementary Charge from 20% to 32% in 2011 (due to the high oil price) serves as a reminder to the industry of the temptation to shock (but without awe).  Analysts and industry experts believe that what is needed is (i) a quick fix reduction on tax rates to show UK plc supports the North Sea industry (and help those still making a profit) and (ii) a comprehensive review of the tax system in place to reduce complexity.

Head of Oil and Gas UK (OGUK), Malcolm Webb, would like to see “30% as the top tax rate”, whilst “some companies are paying 80% as the highest rate on fields in the North Sea.” How is it that some companies are paying 80% in tax? The Government currently operates three oil and gas tax regimes, which overlap with each other, as follows:

First steps for improving fiscal competitiveness

The Government did respond to the oil price change in December 2014 announcing various reliefs, including cutting the Supplementary Charge from 32% to 30%, extending the ring-fence expenditure supplement for offshore oil and gas activities for four more years as well as plans for new “cluster” allowances. The industry commended these steps, but they were felt not to go far enough. In addition, these reliefs may be more helpful for those engaging in exploration in newer frontier areas than for those producing from the older fields with marginal economics. With the oil price dropping lower (and the potential for sub-$40 Brent crude), in mid-January, Sir Ian Wood, whose Review recommended a wholesale review of the tax structure to encourage investment in the interests of “MER UK”, advocated lowering the Supplementary Charge within the next few weeks by at least 10%, i.e. back to 20%.  Malcolm Webb’s view is that the December “measures can only be seen as the first steps towards improving the overall fiscal competitiveness of the UK North Sea. We will certainly need further reductions in the overall rate of tax to ensure the long-term future of the industry”.

Budget

What else does the 2015 Budget have in store?

Part of the problem is that the UK operates a licensing regime for exploration and development activities, and the Government obtains revenues from the UK’s natural resources through imposing taxes. As a result every response from the Government to market conditions, or attempt to stimulate activity, takes the form of legislation that applies to everyone and tends to hang around. Other jurisdictions, which operate production sharing regimes, have the luxury of adapting production sharing formulas (often set out in contract) to reflect the level of exploration risk for a particular concession or block, with regard to factors such as geographical location and drilling depth, by allowing the parties’ shares to increase or decrease as aggregate production increases. Those operating in such regimes may also benefit from stabilised taxation for a certain period of time (contributing to the attractiveness of a jurisdiction for investment).

OGA to the rescue?

Whilst the UK has tried to import some mechanisms into the tax system to allow for the recognition of risk in exploration, some commentators feel the UK now fields a convoluted and newcomer-unfriendly fiscal system. As the competition hots up between countries to provide home for petrodollar investments, this provides an opportune time to review the tax system for the North Sea. It seems that the new Oil and Gas Authority is getting cracking undertaking a review of measures which could be taken to relieve the existing crisis.

 

 

 

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Oil Price Crash (1): Options for North Sea oil and gas: shut-ins and taxation relief

A strategy for the UK North Sea oil and gas industry: work in progress

Following the recommendations of the Wood Review of the UK’s offshore oil and gas industry, and an initial debate in the House of Lords, clauses have been inserted into the Infrastructure Bill currently before Parliament to legislate for the key principle in Sir Ian Wood’s report, that of “maximising economic recovery of oil and gas for the UK” (MER UK). So far, though, the legislative provisions that have been put forward leave a number of questions unanswered about the new world of regulation according to the principle of MER UK.

Central to Wood’s vision (discussed in an earlier post on this Blog) was the recommendation that a new regulator with a duty to promote MER UK should replace the Department of Energy and Climate Change (DECC) as the body responsible for administering the licensing of petroleum extraction on the UK Continental Shelf. In its response to Wood, the Government has announced that such a body will be created, and indeed the Oil and Gas Authority (OGA) is already in the process of being established in Aberdeen.

The OGA is to be “an independent arm’s-length body, accountable to the DECC Secretary of State, working within a strategic policy and operating framework set by him…to deliver objectives established by him”. It is to use its powers to require licensed operators to act in accordance with MER UK principles and to “instil a new culture of partnership and challenge that will pervade the delivery of MER UK”.

However, there is no mention of the OGA in the Infrastructure Bill. It is said that there is not time to establish the OGA in its final form in the current Parliament, so it is to begin its life as an Executive Agency of the Department of Energy and Climate Change. Reading the new clauses, therefore,  one needs to be aware that some of the provisions that refer to the Secretary of State (those relating to licensing functions) will in due course presumably be amended to refer to the OGA, whilst others (those that refer to the establishment of the strategies) will not.

The Government’s response to Wood states that the OGA should be “operational” in “shadow” form in autumn 2014 and sets a target date of early 2016 for it to be “vested with the necessary powers, duties and functions”. Delivering this obviously depends on the will of a new Government and Parliament. In the meantime, what do the clauses in the Infrastructure Bill tell us?

The concept of MER UK is referred to in the new legislation as “the principal objective”. It is, however, not defined, on the grounds that the Government thinks that it is “something that itself is likely to change over time”.

The principal objective is stated to involve, in particular, the development, construction, deployment and use of upstream petroleum infrastructure, as well as collaboration among holders of and operators under Petroleum Act licences, the owners of upstream petroleum infrastructure and persons planning and carrying out the commissioning of such infrastructure. The Secretary of State is obliged to produce one or more strategies for enabling that the principal objective is met. (Wood recommended six strategies in all, covering exploration, asset stewardship, regional development, infrastructure, technology and decommissioning.) The strategies are to be produced within a year of the relevant provisions of the Infrastructure Bill coming into force, which fits with the “early 2016” target date for the OGA to be fully established. Strategies are to be consulted on in draft and are subject to Parliamentary control by negative resolution. They must be reviewed every four years.

These strategies are to have significant legal implications. The Secretary of State is to act in accordance with them when exercising licensing, decommissioning and third party access functions. Holders of and operators under Petroleum Act licences must carry out their respective activities and make related commercial arrangements in accordance with the strategies. Similar obligations are imposed on owners of upstream petroleum infrastructure and those planning and carrying out commissioning of such infrastructure. However, it is not immediately clear how such obligations will be enforced.

Whilst the focus of the Wood Review was on the recovery of oil and gas from the UK Continental Shelf, the Government’s response states that it “agrees that the [OGA’s] remit should extend to onshore (as well as to [licensing of offshore] Natural Gas Storage and Unloading and Carbon Dioxide Storage)”. The response also states that the Government “believes that the MER UK philosophy established by Sir Ian’s Review should be applied to all oil and gas recovery whether offshore in the UKCS or onshore”. The new regulatory framework being put in place here, then, is not just for the UKCS oil and gas industry, but DECC’s thinking about its wider application seems to be at a relatively early stage. The Government notes, for example, that the application of MER UK principles “may need to be quite different onshore”, and that further consultation is required on this subject, which “should not detract from the focus that is needed on developing MER UK strategies for the UKCS”. At present, the most recent model clauses for onshore licences further embed the concept of maximising economic recovery from the licensed area, rather than MER UK.

A number of Opposition amendments to the new clauses have been proposed, but have not found favour with the Government. These included requirements for the regulator to attend operating and technical committee meetings (a matter “on which the Government intend to work closely with industry to pursue further before deciding what additional powers might be needed”) and provision for the concept of MER UK explicitly to embrace enhanced oil recovery (“intrinsic” to MER UK and so no reference to it is needed in the legislation) as well as the linked technology of carbon capture and storage (“discussion with industry…is needed before we can say with certainty how the MER UK principle should apply to [this area]”).

One of Wood’s key conclusions was that, as the Petroleum Act regulator, DECC was insufficiently resourced, particularly as compared to its peers in other North Sea countries. The Infrastructure Bill therefore provides for a levy under which licence holders will contribute towards the costs of the Secretary of State / OGA where these are not already recovered through specific fees under other legislation. Initially, levy receipts are likely to fund policy work in developing the MER UK strategies, but the levy provisions effectively expire after three years, “to ensure that an effective and efficient cost recovery mechanism is developed in consultation with industry during this time”.

The Government’s response to consultation is clear on the need for further legislative work. Amongst the points potentially requiring further legislation, it highlights the possible need for the OGA to have dispute resolution powers to deal with “overzealous legal and commercial behaviour between operators”. It notes the need for the OGA to be equipped with a more graduated sanctions and incentives regime for enforcement purposes (at present the main available sanction, that of revocation, is arguably too much of a blunt instrument for most purposes). It notes the Government’s commitment to increasing the transparency of and access to data. It notes the potential need for further powers to encourage e.g. joint development plans, area unitisation and “appropriate access to infrastructure without contravening competition law or weakening market incentives”.

Overall, then, the clauses in the Infrastructure Bill are a good start, but much remains to be done in a relatively short time-frame if the detail of Wood’s ambitious vision is to be fully realised. It also remains to be seen whether the regulatory aspects of MER UK will later be supported by any further measures to increase the attractiveness of the UKCS as against other parts of the North Sea (for example, fiscal incentives beyond those announced in Budget 2014 and discussed in an earlier post on this Blog).

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A strategy for the UK North Sea oil and gas industry: work in progress