Production or taxation: the future of North Sea oil and gas

Oil rigs moored in Cromarty Firth. Invergordon, Scotland, UK. Photo: WikiCommons
Oil rigs moored in Cromarty Firth. Invergordon, Scotland, UK. Photo: WikiCommons
Oil rigs moored in Cromarty Firth. Invergordon, Scotland, UK. Photo: WikiCommons

We all know it’s there. We have all heard it’s running out. It’s synonymous with money, power, prosperity and well… Aberdeen. But just why has the future of the North Sea (UK Continental Shelf or UKCS for those who are partial to acronyms) featured so heavily in the independence debate? The SNP will gladly inform you that it is “your oil and your money” being siphoned off by Westminster – a prodigal Scottish maiden being philandered by the English – yours to reclaim should you vote ‘Yes’! Patriotism aside, the situation is far less romantic. The independence debate (regardless of strata – oil, currency etc.) is characterised by one feature: bias.

I will not seek to hide my political affiliation – I am a ‘No’ voter. However, I am not a “Better Together and will pummel you into submission with scare stories” ‘No’ voter.  After much research into the topic and arguments with ardent nationalists, I cannot help but feel annoyed at the level of inaccuracy and factuality on both sides of the debate. I am a numbers guy – apart from the introduction, you will not find too much overblown emotional hyperbole here. This article is not intended to change your voting decision, it is intended to make a you a more informed and curious citizen (assuming you are Scottish and that is unlikely in St Andrews!). The implications for reduced UKCS tax revenue are manifest in the SNP’s own figures. There is a very real possibility (and note I used “possibility” there) that an independent Scotland would need to reduce welfare spending or raise taxation – neither are palatable. Without further ado, let’s delve into the numbers.

In November last year, the SNP published their much-feted white paper – the blueprint for independence. Inside this 670-page tome resided one set of forecasts (on page 75) for Scotland’s fiscal position in 2016/17. This would be the first entire financial year since 1707 that Scotland was completely independent of the United Kingdom. 2014-16 is an intermediary ‘handover’ period.

2016/17 expenditures (nominal £billions)
Public expenditures 63.7
Public sector debt interest 3.9-5.5
Onshore receipts 56.9
Offshore receipts 6.8-7.9
Budget deficit -5.5 to -2.8
As % of GDP -3.3% to -1.7%
Approximate GDP assumption (implicit) 168.75

The key number here is budget deficit to GDP. Deficits are not good after all, but large deficits relative to the size of your economy are particularly bad. While beyond the scope of this article, an independent Scotland would not have the borrowing capacity of the United Kingdom. Standard and Poor’s (the credit rating agency) have stated that “kilt-edged bonds” wouldn’t be risky per se but would likely command a higher interest rate than UK gilts. Conventional (and empirical) wisdom dictates that even if Scotland’s budget was a fiscal frolic from the get-go, the international bond markets may not reciprocate too kindly at sovereign debt auctions. In short: it is a very risky proposition for a newly minted small country to operate with substantial deficits – Scotland needs to balance the books.

Our attention returns to the deficit to GDP number. Let’s fiddle with the ‘Offshore receipts’ line a little bit. What happens when we change the assumptions for oil and gas tax revenues?

2016/17 expenditures (nominal £billions)
Public expenditures 63.7
Public sector debt interest 3.9-5.5
Onshore receipts 56.9
Offshore receipts 2.0-4.0
Budget deficit -10.3 to -6.7
As % of GDP -6.1% to -4.0%
Approximate GDP assumption (implicit) 168.75

A big change, no? You probably think I am being excessive here with more than 50 per cent cut in the midpoint of the range. The Office of Budget Responsibility, the independent UK government spending watchdog, does not think so. If you check their December 2013 forecasts (page 101), they have estimated that total offshore receipts will be around £3.5bn. I think even that number is a bit Panglossian (OBR have overestimated revenues in recent years).

If you are ever having trouble sleeping at night, forget counting sheep. Head over to HMRC’s (the British taxman) website and give the “Oil Taxation Manual” a read. You will be asleep before you know it. Taxation of oil and gas revenue in the UK is devilishly complex but to understand UKCS it is a necessary evil and the keystone to the North Sea’s future. But first let’s tackle the economic obstacles for the North Sea.  There are three fundamental issues in play here:

  1. The number and size of UKCS operators (i.e. oil companies)
  2. The required investment to develop an offshore platform and associated oil field size
  3. The age and quality of support infrastructure in the North Sea

Firm size matters. Imagine you are a wildcat oil driller. You need a few things to make your millions: an oil prospect, finance to pay for start-up costs and a means of transporting the resource back to shore. UKCS has all those things – for a price. The ‘majors’ such as BP/Shell with billions at their disposal have resisted further investment in the region (12 per cent of exploration and appraisal activity was conducted by majors in 2013 – Oil and Gas UK) and concentrated on larger, more profitable projects (think America). This has opened the field to smaller firms – the number of operators in UKCS has increased by 50 per cent since 2003 (Wood Review) – the business model is changing. But smaller firms often do not have other productive assets from which to fund investment, and rig hire (for exploration and drilling) is measured in $100,000s per day, with rig owners requiring payment up-front. But small firms struggle to obtain financing – this is a risky business after all. So the net result has been a sustained reduction in exploration and appraisal activity. Companies just are not drilling enough wells.

E&A 1

E&A 2Still with me? So we’ve established the nature of your typical North Sea operator and kind of problems they face. Let’s talk money. As any Nationalist will gladly brandish, UKCS investment reached an all-time high last year of £14.4bn – a staggeringly large sum by any measure. But taking the figure at face value ignores a crucially important issue. Back to our wildcatter: what is my ‘bang per buck’ when investing in the North Sea (the techie word is ‘capital efficiency’)? UKCS capital efficiency has fallen by 81 per cent since 2002, i.e. it is on average approximately 425 per cent more expensive to extract one barrel of oil from the North Sea. And do not have any doubt here: these numbers are from Oil and Gas UK – the industry body. So when deflated, 2013’s record investment is actually worth £3.2bn in 2003 “money” (actual 2003 investment was £3.6bn). 

Cap EffWhy has it become so expensive? The answer lies in some basic economics. A business in any industry faces two types of cost: fixed and variable. Fixed costs do not change as revenue increases or decreases. Conversely, variable costs do change with revenue. Why does this matter? An oil drilling platform has a predominantly fixed cost base. Let’s put this in context with our wildcatter: before they’ve pumped any oil, exploration and appraisal has to take place, the pumping rig has to be purchased/hired, employees have to be recruited and trained, the rig has to be towed out to sea, the rig has to be connected to pumping infrastructure (e.g. a pipeline)… you catch my drift here. And once the rig actually starts pumping oil, only incremental increases in personnel are required. They want to have 24 hour operation from the beginning after all.  Let’s take the second piece of the puzzle: field size. This refers to the projected size of an oil/gas field in terms of the recoverable resource. The average field size since 2003 has been 25m boe (barrel of oil equivalent – the industry standard metric) and most importantly, it has declined substantially over time. When activity began in 1966, the average field size over the next ten years was 248m boe. Most importantly, this trend displays no sign of abatement – Oil and Gas UK’s 2014 Activity Survey has the majority of new discoveries being estimated at below 50m boe.

So the wildcatter has got their platform out and they are pumping oil. Black gold rush, right? Wrong. Next challenge: get the oil back to shore – the wildcatter needs a pipeline – they need infrastructure. And it is not just transport pipeline they need. I cannot use the image due to copyright, but for the curious, the Wood Review (pdf readily available through Google) has a brilliant diagram on page 44 illustrating the myriad complexity of oil platform infrastructure over a small area. The individual platforms are part of an interconnected web of pipelines forming transport, refining, export and electricity linkages. Does it make economic sense for a small operator to build their own infrastructure for small field drilling? Absolutely not, even if they could find the financial backing. The existing infrastructure was built predominantly by the majors for large fields during the 1970s and 1980s, and it’s still owned by the majors despite their dwindling presence.

A great example of this is the Forties field – it’s the largest field in the North Sea. First discovered in 1970 and entering production in 1975 under BP’s stewardship, the Forties field was sold in 2003 to Apache. Despite BP offloading its 96 per cent stake, it retained ownership of the infrastructure. It is no coincidence that large fields often have an ample number of orbital small fields within close proximity to existing pipelines. Not only did BP recoup their investment on infrastructure through oil production, they continue to receive substantial incomes from infrastructure without taking any exploration risk whatsoever. This change in business model is reflected across UKCS: majors have continued to operate legacy assets (both old fields and infrastructure), but largely resisted further investment into newer assets. But the older infrastructure frequently requires reinvestment to preserve its integrity. Who pays for this? Small operators through hikes in tariff charges. Until recently, as legacy field production winds down, majors were decommissioning infrastructure altogether while they still had other productive assets in UKCS to provide the cash for it (decommissioning is projected to cost between £30-£50bn+ over the next 30 years). Just to recap: my diatribe about the life of a wildcatter was about explaining the economic challenges that firms operating in UKCS must surmount. These are beyond government control – they are necessitated by the geology of the basin and by market forces.

The final part of the puzzle: the government and tax regime. The marginal rate of tax (without any reliefs applied) is 62 per cent%. To put that in perspective: a millionaire banker in the City faces a marginal tax rate of 45 per cent. Marginal corporation tax for non-oily businesses is 21 per cent. But that is not the entire story. There are a multitude of tax reliefs available. There are three of particular note: the small field allowance (SFA), the brownfield allowance and decommissioning deeds. These do not affect the marginal rate but they do affect what the Exchequer actually receives in tax revenue. So just how important are the field allowances? In 2012 (when SFA was introduced), 21 per cent of total investment was in receipt of a field allowance. Just one year later, 48 per cent of total investment was in receipt. That is 129 per cent proportional increase in one year. And remember: the average field size is still falling.

This is reflected in the tax revenue figures. There are three tax streams levied by the Exchequer: Petroleum Revenue Tax (PRT), ring-fenced corporation tax (RCT) and the supplementary charge (SC). Civil servants love acronyms. PRT was abolished for fields given consent after 1993. However, last year it still accounted for 27 per cent of all UKCS tax revenues. You read that right. Fields older than the average age of The Saint’s readership constitute a little short of a third of all oil and gas tax revenues. These fields are also taxed at 81 per cent with no tax breaks in contrast to newer fields. As Denis Healey famously said, they are being taxed until “the pips squeak”. However, the most interesting statistic regarding tax is the change in SC revenues. These reliefs are applied to the SC levied on individual fields. As the name suggests, RCT is not subject to any tax breaks. In the fiscal year after SFA was introduced, SC tax revenues fell by 43 per cent. Extraneous to this, general decreases in production and profitability (the sterling oil price has fallen annually since 2011 but operating costs have risen by 62 per cent in the period) generated a fall in overall UKCS tax revenue from £11.3bn to £6.5bn from FY2011 to FY2012. The SFA is only one aspect. The far greater spectre concerning tax revenue is decommissioning. The UK government is independently forecasted to subsidise around 60 per cent of the £30-50bn plus of decommissioning expenses over the next 30 years. The actual reliefs are confidential.

Tax RevThe North Sea is not running out of oil. It is harder and more expensive to extract but it is still there. The business landscape has fundamentally shifted and the government has reacted by reducing the cost of doing business substantially at the expense of tax revenue. The SNP assumption that UKCS revenues will comfortably pad their budget is completely flawed. It’s production versus taxation – your choice, Alex.

All charts and graphs: Jamie Lewis, using data from the UK Oil and Gas Annual Survey


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