TRANSACTIONAL: Corporate/London: Investment in the UK North Sea: A tax cut designed to increase revenue

by King & Spalding

[author: Susanna Marshall]

Since the first oil produced in 1967, the UK North Sea has been a cash cow for the UK Government and petroleum companies alike. Around 40 billion barrels of oil equivalent (bnboe) have been produced to date. Each year North Sea petroleum production, currently averaging around 4 million bnboe per month, returns £8 billion to UK Treasury coffers and a further £12 billion is spent by the industry in the UK. However, production in the North Sea has been declining each year since peak oil in 1999. With the Treasury’s 2011 Budget shocking the sector with a 12 percent increase in the tax rate on UK North Sea production profits combined with uncertainty surrounding the tax treatment of decommissioning expenditures and ever-increasing operating costs, the UK North Sea might seem like an unattractive prospect for investment.

So, what is the current investment environment?

The UK’s Department of Energy and Climate Change (DECC) anticipates that approximately 20 bnboe remains to be produced, whilst some analysts predict that as much as 36 bnboe could remain in the ground. Good news for E&P companies, but the 2011 Budget still lingers in the industry’s memory and it may be some time before the Government re-establishes the trust of the sector. Earlier this year the Treasury revealed that the effect of the 2011 tax hikes was an 18 percent cut in production to a 30-year low, representing a £2.3 billion drop in tax revenue and provoking a Treasury U-turn.

The 2012 Budget, delivered in March this year, went some way to reassure investors, introducing tax allowances for the development of smaller, deeper, or more complex fields and measures to permit oil companies to enter into contracts with the Government that will provide certainty over tax relief for decommissioning costs incurred in the event of another party’s default. In July, the Treasury announced a new tax relief for shallow water gas fields and shortly afterwards announced that developers of mature “brown-field” production sites could shield up to £250 million of production profits from taxation.

These measures by the Treasury were designed to:

  • temper the impact of the 2011 tax hikes;
  • encourage new investment;
  • promote optimisation of mature fields; and
  • reinvigorate the market for North Sea assets.

But are they working?

DECC’s recent 27th Offshore Licensing Round certainly received unprecedented interest, with 224 licence applications, across the traditional, frontier and “promote” licence types, for 418 North Sea blocks. This record number of applications represents a 20 percent increase on the previous 26th Licensing Round in 2010. Applications for frontier licences, a variation on the traditional licence designed to encourage exploration in remote and challenging environments, doubled on the previous round indicating, perhaps, that the favourable tax allowances for the development of difficult fields, such in the West of Shetland area, are already encouraging investment. A drop in applications for promote licences was seen. Promote licences allow small and start-up E&P companies to enter the market and seek financial and technical capacity at a later date. This drop was countered by an increase in traditional applications, indicating that the appetite of large oil companies remains vigorous, despite concerns that sophisticated IOCs were losing interest since peak oil was reached.

2012 has also seen a significant increase in deal activity, both for asset and corporate acquisitions, whilst farm-in activity dropped. This enthusiasm for acquisitions over farm-in arrangements indicates that oil companies are gaining confidence to acquire assets outright, despite the global economic environment, to obtain the maximum possible benefit from the current high oil price.

New discoveries continue to be made and although the UK North Sea is a mature geological environment, technological advances together with the recent fiscal allowances by the Treasury mean that frontier blocks with a complex exploration and drilling situation are becoming increasingly accessible and attractive for development.

The increased production and deal activity through 2012 shows that the UK North Sea remains an attractive and competitive investment environment. The stark industry warning to the Government during 2011 that it will curtail investment and production under an excessive or volatile tax regime should encourage a measured approach by the Treasury designed to promote, and not punish, investment in the UK North Sea.

  Susanna Marshall
  +44 20 7551 7576

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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