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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 New UK Oil and Gas Regulator by 2015?

Summary

The title given to Sir Ian Wood’s “UKCS Maximising Recovery Review: Final Report” (published on 24 February 2014), should ensure that his name is immortalised as the abbreviation most will use, the “Wood Review”, and rightly so. This former chairman of oil field services company Wood Group has become a figure-head for reform and has set a CEO-style vision, in addition to his Government remit to make recommendations to: “enhance economic recovery of oil and gas reserves in the future”.

With this in mind, the Wood Review is not overly compromised with detail. The central proposal is for a new, independent, and much more proactive regulator to maximise economic recovery (MER).  This could be criticised as fragmenting current regulation, but Sir Ian’s pragmatic rationale is clear: “a new body…to focus solely on MER will give a clear signal. The Review believes that simply increasing the resource…within DECC is likely to be perceived as a re-badging with little material change.”

Context

The imperative for MER is production apparently falling by 38 per cent between 2010 and 2013 and a sharp decline in exploration and discovery.

Given the right “stewardship,” the UK is said to have the potential to recover an additional 3-4 billion barrels of North Sea oil over the next 20 years, with a resultant £200 billion boost to the UK’s economy.

The final Wood Review is consistent with and builds upon its Interim Report, published in November 2013.

Obstacles to overcome

The Wood Review identifies outdated “light touch” regulation as a key hindrance to the exploitation of hydrocarbons in the North Sea. A regulatory regime designed for an era of large fields and large operators has apparently not evolved to adapt to the new reality of a basin with over 300 fields, much smaller new discoveries, many marginal fields and far greater interdependence in exploration, development and production.

Specific obstacles to growth highlighted in the Review include fiscal instability, insufficient collaboration between industry players in respect of third party use of infrastructure, a lack of sharing of geophysical information, excess time spent on commercial and legal negotiations and inadequate use of technology (including Improved and Enhanced Oil Recovery (EOR)). Floating Production Storage and Offloading vessels are for example noted to have higher operating costs and poorer field recovery than using existing infrastructure where available. Over 20 instances in 3 years of “operators” failing to agree terms for access to processing and transport infrastructure, has led to more expensive / lower recovery developments.

Key recommendations of the Wood Review

The Review advocates a tri-partite strategy involving HM Treasury, industry and the proposed MER regulator. Whilst collaboration may be implicit, it is notable that the involvement of existing regulatory bodies is not emphasised. Some re-alignment of regulatory responsibility is suggested with the new MER regulator perhaps being given responsibility for carbon capture and storage, and with a potential on-shore remit. The Review also recommends new sector strategies be developed for: exploration; asset stewardship; regional development; infrastructure; technology and decommissioning.

The Review envisages that the proposed new MER regulator would be encouraged to make more robust use of existing enforcement powers and may be given new powers or access to licensees, both in the practical sense (for example by being able to attend operational and technical meetings; make recommendations; have greater data access; and to implement a “non-binding” dispute resolution function), and by way of potential new licence terms (relating to maximising economic recovery, achieving acceptable production efficiency and agreeing collaboration on cluster developments). It is further suggested that consideration of past MER performance, should be specifically taken into account for future licence applications. Formal sanctions to encourage MER compliance may include a system of issuing private and public warnings, before removal of operatorship or suspension or termination licences. Interestingly, it is said that the MER regulator should have the right to apply sanctions to the whole consortium or just those who are deemed to be failing to meet licence obligations, or indeed, MER requirements. Whilst it appears there is significant detail to be ironed out here, the collective responsibility intention is notable.

Flexibility

There is also a recognition of a need for flexibility where necessary. The four year exploration and four year development terms in Traditional Seaward Production Licences are noted as appropriate for mature areas, but the Review suggests that six year periods are more suitable for frontiers like the West of Shetland, where the drilling season is short, and in High Pressure High Temperature plays. It is said that licensees shouldn’t be compelled to drill commitment wells where new information suggests they would be unviable. The flexibility theme is also discussed in the context of the almost exclusively gas producing Southern North Sea, which is in danger of apparently premature decommissioning, given the lower market value of gas.

Competitive disadvantages of the UKCS versus the Netherlands are another interesting theme and is, in part, attributed to the Dutch Government’s active ownership of infrastructure. Differences in commercial models are also noted whereby, for example, NOGAT BV (whose business model is solely to operate pipelines and processing facilities) actively seeks to attract new transport business, versus the apparent reluctance of UKCS operators to facilitate third party infrastructure use business as an adjunct to their core production business.

Fiscal incentives

Such issues are intended to be bolstered by HM Treasury’s better use of: “fiscal levers to incentivise MER”, perhaps including: extension of field allowances to incentivise EOR; or incentives for seismic and the drilling of exploration or less prospective wells by operators who currently lack production. In addition, a need for commitment to a simpler and more stable fiscal regime is acknowledged (although tax is beyond the specific remit of the Wood Review).

What is next?

Government and industry appear to publically welcome the initiative, which is to be industry-funded. Indeed, Ed Davey (Secretary of State for Energy) has announced that legislation to implement the new body, will be introduced in the fourth parliamentary session (ie. autumn 2014) but it would be expected to become law in 2015, and may be dragged out by a need for secondary legislation. Ed Davey has hinted at an informal “shadow” arrangement in the meantime. Such break-neck speed perhaps seeks to capitalise on the Review’s current good will, and will hope to minimise potentially significant industry delay in making new investments, pending uncertainty as to the new regulations.  It may also reflect the UK Government’s desire to show oil and gas policy leadership before September’s referendum on Scottish independence, and the spring 2014 publication of detailed Scottish oil and gas proposals for maximising economic recovery, which also intends to consider the Wood Review. Time will tell whether all remain so keen, once detailed provisions take effect, particularly given the Review’s criticism of some current areas of apparent self interest which are to be targeted.  As currently proposed, reforms may touch all areas of the UK oil industry from operators down, both on and off-shore.

 

 

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A New UK Oil and Gas Regulator by 2015?