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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