On 18 November we reported that DECC had published on 18 November its draft strategy (the Strategy) for maximising economic recovery of United Kingdom petroleum (MER UK). 

There is real time pressure on DECC to produce a final version of the Strategy.  Pursuant to section 9A of the Petroleum Act 1998, the Strategy is now open for consultation on its suitability for achieving MER UK. The consultation period closes on 8 January 20161. The Secretary of State must produce the first strategy and have it approved by both Houses of Parliament before 12 April 2016. In this respect, it is worth noting that the Strategy does not yet take account of the more recent amendments to the Energy Bill in the House of Lords, particularly some of those relating to CCS2. The Government has indicated its intention to reverse those changes in the Commons.

In this Law-Now we highlight some key aspects of the Strategy and comment on some issues that we expect will generate strong industry opinion. 

Principles

One of the more eye-catching statements in the Strategy is found in the opening section, which sets out principles to which the OGA will have regard when applying the Strategy. This states that compliance with the Strategy “may oblige individual companies to reallocate value between them, matching risk to reward. However, while the net result should deliver greater value overall, it will not be the case that all companies will always be individually better off3.” It is not currently clear whether this might require a company to give up value to which it is currently entitled or only to accept a lower value than it might have anticipated for some new project. We understand that the latter is the intention, and we anticipate that the final version will clarify that.

The principles also include the statement that the Strategy “is intended to lead to investment and operational activities that, on an expected basis, add net value overall to the UK4”. It is not clear what is meant by “net value overall” but this may be a nod to the concept of “total value added” developed by the Oil & Gas Expert Commission in their July 2014 report “Scotland’s Independent Expert Commission on Oil and Gas: Maximising the Total Value Added”.   This stressed the need to look at the overall impact of the offshore sector in terms of employment, GDP and revenue-raising – however, the measures used in the Strategy itself seem to be focussed only on the direct economic value of petroleum rather than requiring industry players to measure those more indirect impacts.

Key requirements – Central and Supporting Obligations

Much of the Wood Review implementation process is treading new ground and the Strategy is no exception.  Anyone familiar with strategy documents will find this one rather unusual.  It is not so much a strategy as a series of obligations which it is intended will be imposed on those subject to the duty to achieve MER UK (the Principal Objective). 

Although the Strategy binds both DECC and the OGA, those principally likely to be subject to its obligations are currently holders of offshore petroleum licences, operators appointed under those licences, owners of upstream petroleum infrastructure, and persons planning and carrying out the commissioning of upstream petroleum infrastructure5. However, the current Energy Bill will add to that list owners of relevant offshore installations (largely but not entirely caught already by the licensee and operator categories) and extend the activities covered by the Principal Objective to the decommissioning of upstream petroleum infrastructure and installations6.

The Strategy converts the Principal Objective into a Central Obligation that “relevant persons7 must, in the exercise of their relevant functions, take all steps necessary to secure that the maximum value of economically recoverable petroleum is recovered from the strata beneath relevant UK waters8”.

In order to secure the effective delivery of the Central Obligation, the Strategy also sets out Supporting Obligations which are intended to clarify how the Central Obligation applies in areas such as exploration, development, asset stewardship, technology and decommissioning.  These include:

  • Development: relevant persons must plan, commission and construct infrastructure in a way that meets the optimum configuration (including the sort of infrastructure used and its geographical placement) for maximising the value of economically recoverable petroleum that can be recovered from the region in which the infrastructure is to be located.  It seems likely this will require a licence holder to take account of petroleum that could be recovered beyond the boundaries of its licence.  It is not yet clear how a licence holder is expected to be able to take that into account, although this may be an area where the OGA will choose to make use of its powers to gather information and samples as set out in the Energy Bill9 and to use this information in the production of regional development plans. Any sharing of information must take account of competition law constraints – these are not yet expressly mentioned in the Strategy but given the industry’s current focus on this issue, may be included in the final version;
  • Asset stewardship: operators and owners of infrastructure must ensure that it is operated in a way that facilitates the recovery of the maximum value of economically recoverable petroleum from the region in which it is situated and the regions in which others for whose benefit it is used are situated10. This includes, where the infrastructure is not able to cope with demand for its use, prioritising access which maximises the value of petroleum recovered11. This may mean that the owner of infrastructure might have to give priority to third party production over its own where that maximises the value of petroleum recovered, although we would expect that any party whose production has been backed out would be compensated for this in the terms agreed with the third party.  In this respect it is also worth noting that the concept of “economically recoverable” as defined in the draft Strategy excludes “sunk costs and costs (like interest charges) which do not reflect current use of resources12”. This approach to charging for access to infrastructure is similar to the approach under the Infrastructure Code of Practice, where access charges would usually be based on the marginal cost of allowing access to infrastructure that was not necessarily built for third party use.  However, the Strategy suggests that relevant persons may sometimes be required to design and build infrastructure so as to allow for third party access from the outset.  It seems that excluding that person’s sunk costs from the “economically recoverable” definition may restrict it to charging for third party access on a marginal cost basis, even though a certain amount of the infrastructure was built solely for third party access.  DECC has acknowledged that the concept of economic recoverability merits further examination13. We expect that the operator or owner will require compensation over and above the marginal cost of third party access in these cases.
  • Decommissioning: Where the OGA produces a plan on the decommissioning of any infrastructure in relevant UK waters, it may identify particular pieces of infrastructure the decommissioning of which would prejudice the maximising of the recovery of economically recoverable petroleum in a region14. This suggests that the OGA could produce a plan relating to decommissioning that recommends that certain hubs or other infrastructure cannot be decommissioned as to do so would not be MER UK-compliant.  If this is the case there will clearly be questions as to who is responsible for maintaining (and paying for maintaining) the infrastructure that would otherwise have been decommissioned.

Required Actions and Behaviours

There are also Required Actions and Behaviours which will be binding and apply to relevant persons when carrying out the Central and Supporting Obligations.  These relate to issues such as timing, collaboration and cost-reduction, and seek to underline the changes in commercial behaviours identified as essential in the Wood Review. 

Those on relinquishing assets perhaps deserve particular mention. The draft Strategy provides that where relevant persons decide “not to ensure the recovery of the maximum value of economically recoverable petroleum from their licences or infrastructure” they must relinquish or divest themselves of such assets15. Where the OGA considers that petroleum is economically recoverable but the relevant person does not consider that the project to recover that petroleum offers a satisfactory expected commercial return and is therefore minded not to undertake that project, the OGA will discuss that with the relevant person and may ultimately require them to transfer their interest in the licence or asset to a person that is minded to undertake the project16 or to relinquish it.  We understand that OGA’s intention is that the assessment of “satisfactory expected commercial return” is to be effectively a subjective decision for the relevant person to make (see further below under Safeguards) and it is to be hoped that the final version of the Strategy will make that clear. 

Another requirement on relinquishing assets is that where a relevant person is seeking to divest, they must seek to do so without demanding compensation in excess of a “fair market value” or unreasonable terms and conditions, in order that other persons who are able to recover economically recoverable petroleum may do so17. This is likely to be one of the hardest issues raised by the Strategy.  Notwithstanding the uncertainty of what a fair market value would be, we expect that in a situation where a relevant person is effectively made to sell its interest in a licence or asset, the forced sale is likely to result in bids at a discount to what might be fair market value in other circumstances.  It is not clear what the OGA will do if it disagrees with the relevant person as to what constitutes fair market value or if the asset is not saleable at any price.  It may not be reasonable to require divestment if, for instance, the project in question is an incremental project to existing infrastructure rather than something which can be separated out.  Separately, it is expected that the OGA will consider it reasonable for a vendor to require decommissioning security when divesting. 

Safeguards

The language of the Strategy is broad and general in its scope, presumably to take account of the vast range of circumstances in which the Strategy will need to be applied.  Of course, a high level approach and the uncharted territory which the industry is now entering leaves scope for uncertainty as to what the implementation of the Strategy, once finalised, will mean on a day to day basis.  In that regard, industry may, however, take some comfort from the Strategy’s safeguards, which effectively qualify its obligations.  These include the following:

  • No obligation imposed by or under the Strategy permits or requires any conduct which would otherwise be prohibited by or under legislation, including legislation relating to health, safety or environmental protection18. As noted above, a reference to competition law here may be reassuring for the industry.
  • No obligation imposed by or under the Strategy requires any person to make an investment or fund activity where they will not make a “satisfactory expected commercial return” on that investment or activity19. This is defined as “a reasonable post-tax return having regard to the risk and nature of the investment20”, which is stated to be a deliberately flexible definition. “The OGA recognises that there are many factors that are considered and weighed before deciding whether to invest in a project. Matters like the risk associated with the project, the resources thought to be recoverable, the (future) oil price, the cost of capital for that company, and the complexity of the project and shareholder expectation will all play a part. It is therefore not realistic to set a single, clear figure on what a satisfactory expected commercial return would be21”. However, the Strategy also notes “A satisfactory return does not necessarily mean a return commensurate with the overall corporate return on their portfolio of investment, e.g. a low risk investment could give low returns22”.
  • While the very general nature of the obligations may be a cause for concern, the Strategy explicitly acknowledges that the application of the powers will need to be tempered with expediency.  No obligation imposed by or under the Strategy requires any conduct (including investment or other expenditure) where the benefits to the UK deriving from that conduct are outweighed by the damage to the long term confidence of investors in oil and gas exploration and production projects in relevant UK waters23. While it may be difficult to enforce this safeguard in legal terms (who will decide what the effect on investor confidence will be?), the plain fact is that over-zealous application of the rules by the OGA will potentially kill the proverbial goose that lays the golden egg and the OGA appears to be very well aware of that.
  • Another issue which is addressed in the consultation paper but not in the Strategy itself is the role of the OGA in relation to existing contracts – on this issue the paper states: “Neither this Strategy, nor any other legal instrument, confers powers on the OGA which would allow it to intervene directly in private contracts. It may occasionally be the case that the OGA will find that a relevant person’s contractual provisions place that person, or could place that person, in breach of the Strategy. In these cases, the OGA will explore the matter further with the persons concerned in the manner described above. It may be that, occasionally, the OGA will need to assert its right as a regulator to use its sanctions where a relevant person fails to avoid a breach of its MER responsibilities through continued reliance on contractual provisions which conflict with the Strategy. However, it will always be for the relevant person to decide for itself how to deal with that in terms of its contracts24”. In other words, although the OGA cannot alter the terms of a contract it would ultimately have the power to fine, revoke a licence or remove an operator if the objectionable terms were not changed.  It is possible that a relevant person may find itself with the harsh choice of whether to act in accordance with MER UK and breach an existing contract, or act in accordance with the existing contract and breach MER UK.  However, this conflict could perhaps be avoided if the Strategy made clear that the only requirement is not to enforce rights which would infringe MER but that obligations may be respected.

Conclusion

Given the high level wording of the Strategy and the considerable discretion that the OGA is granted, it seems that much will in fact depend upon the approach that the OGA decides to take in practice.  Concerns that this makes for an unpredictable regulatory environment may be tempered by the OGA’s own obligation to achieve compliance with MER UK (including to comply with the Strategy) and the Strategy’s express reference to maintaining the long term confidence of investors.  The OGA appears to recognise that it may face some difficult decisions in balancing that overall aim with the commercial reality of individual arrangements facing challenging economic conditions.  The draft Strategy refers to the need for communication between the OGA and a relevant person before certain significant decisions are taken and, as the draft Strategy is developed and finalised, it seems that ongoing communication between DECC, OGA and the industry will remain key in determining the framework for successfully achieving the aims of MER UK.