Decommissioning has been big news in the oil and gas sector over the last year – the potential cost to the taxpayer, the risk of early decommissioning in response to the oil price crash and as a result of associated corporate insolvencies, and the dangers of decommissioned assets causing environmental harm have all made the headlines. It’s clear that as the UKCS matures, decommissioning will be moving increasingly up the agenda for operators and regulators, and will form a growing area of business for the industry’s contractors. With this in mind, we have brought together the expertise of a number of colleagues to create a task force to support our clients in dealing with the legal issues arising out of decommissioning. In this series of articles, we will address some of the challenges facing the sector.

For at least a decade, the potential cost of decommissioning has loomed over the industry and has been a significant factor in upstream oil and gas M&A. Sellers have sought to ensure a clean break and to insulate themselves against the risk of being made liable for the ultimate costs of decommissioning by seeking security for the estimated costs of decommissioning from buyers. Co-venturers, faced with new partners who lack the financial muscle of traditional players, have sought similar protection against the threat of joint and several liability for decommissioning. Security has been provided largely in the form of letters of credit, requiring both an annual fee and, for many companies, the provision of collateral to the issuing bank, or, where collateral is not available, a commensurate reduction in their borrowing base. This requirement has been a significant barrier to moving assets into the right hands – particularly to smaller, leaner companies able and willing to exploit these late-life assets.

The industry has taken steps to address the cost of security - the industry standard field-wide DSA (Decommissioning Security Agreement) has alleviated the requirement for a buyer to provide duplicate security to both the vendor and co-venturers. Additionally, the advent in 2013 of contracts between government and industry (decommissioning relief deeds), assuring availability of tax relief on decommissioning expenditure, has allowed buyers to move away from provision of security on a ‘pre-tax’ to a ‘post-tax’ basis, reducing security required by between 50 and 75%.

However, with the growing maturity of North Sea assets, and particularly given the recent fall in the oil price, the net revenue remaining in many fields might be less than or only marginally exceed anticipated decommissioning costs, even on a post-tax basis. Potential buyers do not want to take on liability for decommissioning where there is little if any profit to be made, a situation which has resulted in a number of planned sales falling through. However, where a new owner is prepared to invest in projects such as upgraded production facilities, infill drilling or tie-backs of satellite fields, which did not meet the seller’s investment hurdles, but which will extend field life, then there is value to both buyer and seller in finding a solution to the decommissioning conundrum.

Even where the sale price is small or negative there is benefit to a seller in the ‘time value of money’ that is gained by delaying its decommissioning spend and reallocating its resources elsewhere in the meantime. There is also a hope that the decommissioning industry will be more developed at the time the decommissioning takes place, resulting in costs savings from the application of new technology and greater economies of scale. Meanwhile, the buyer is incentivised to extend field life in order to receive revenues from on-going production for as long as possible, knowing that it will not be responsible for costs of decommissioning at the end of field life.

Sellers and buyers therefore need to find ever more innovative ways to address liability for decommissioning and decommissioning security in order to allow deals to get done. On the sellers’ part, while a sale for positive consideration and a clean-break is still the most desirable outcome, we have been involved in several recent sales of assets where elements of decommissioning or decommissioning liabilities have been retained by the seller in order to get deals ‘across the line’.

There are a variety of approaches which we have recently explored and used:

  • A sale/lease of the asset and re-transfer to the seller at the point of decommissioning. This is simplest for assets where the sellers hold a 100% interest (as otherwise existing co-venturer consent would be required) but the extensive continuing administration required on the part of the seller removes one of the key reasons for selling in the first place, namely the overheads and time dedicated to the relevant asset in its portfolio.
  • The seller being liable for its (transferred) percentage share of the cost of decommissioning of the assets but simply paying the cost at end of field life rather than requiring an asset-re-transfer. While this is the simplest approach, the seller will lose control over decommissioning spend unless it caps its liability or seeks contractual control over decommissioning activities. A split of such liabilities has found favour in recent deals. While a better commercial result for a seller would be to pay for a buyer to take an asset off its hands and for that payment to account for the buyer taking on decommissioning costs, this does not work from a tax perspective (for which see below).
  • The seller transferring decommissioning liability to the buyer but providing security at a field/co-venturer level and obtaining back to back security from the buyer where the buyer cannot meet the co-venturers’ security requirements. Here the seller would take the credit risk of the buyer’s back-to-back security being weaker than its own, knowing that it may be at risk of being liable to co-venturers for the buyer’s share in any default.

However, one further area remains an obstacle to these transactions and this is tax capacity. Oil companies pay tax at much higher rates than most businesses but in return are entitled to some reliefs and allowances which are not generally available and, in particular, tax relief for decommissioning costs. Where the company is no longer generating sufficient profits to enable it to set off costs against its current tax liability, it is able to carry costs back and obtain a repayment of tax paid in previous years. It has been estimated that tax relief will account for 50 to 60% of the overall cost of decommissioning. A clean break is unlikely to be possible if the party buying the asset will not generate sufficient tax capacity during its ownership to be able to offset the costs of decommissioning. In this case, it will almost certainly be necessary for the seller to retain some or all of the decommissioning liability. The Treasury is currently informally consulting on whether it might be possible to allow the seller to transfer some of its tax capacity to the buyer to enable a clean break. This might allow an entirely new business model in the UKCS of companies specialising in buying assets at cessation of production in order to efficiently decommission them – the seller would pay the buyer a fee based on its expected costs of decommissioning, achieving cost certainty and a clean break, and the buyer would seek to make a profit by employing economies of scale and lean methods to decommissioning more efficiently. (This model would only work if all owners were prepared to sell at the same time to the same buyer.)

A number of players are considering this type of business model, including oil and gas advisory firm, Petromall. Graham Scotton, an original founder of Petromall, explains the risk management approach to decommissioning:

“The players in decommissioning have a tendency to see the problem through a single lens. Operators tend to concentrate on overall liabilities, tax and transfer of tax reliefs. Would-be participants offer specific service lines, such as engineering, well abandonment technology, lift vessels and so on. Petromall is attempting to integrate all of this into a single business model that provides advantages from all perspectives - enabling operators to see a coherent way forward in dealing with all aspects of the decommissioning project including cost estimates, project planning, engineering and the contracting strategy for removal.”

This avoids the risk that a ‘cold’ asset sits in the sea for years while internal debate rages on timing and financial capacity for ultimate removal. By taking on the late-life obligation of licensees/co-venturers, the approach taken above has the potential to allow:

  • Maximisation of hydrocarbon recovery, in the national interest;
  • Reduction of the burden of decommissioning provision on owners, which stymies their profitability, borrowing capacity and growth potential;
  • Cash availability ‘on the day’ - when the bills come in for abandonment;
  • Insurance that covers cost overruns, accidents and post-decommissioning environmental liability;
  • Minimisation of cost, and hence taxpayer refund, again in the national interest.

This is the first Foresight article in our Decommissioning series. Discussing various issues from regulation to contracting and insurance, our sector experts, together with colleagues from the industry, offer their commercial opinions on the future for this growing part of the sector.