Oil and gas production from the UK section of the North Sea has been in decline since its peak in 1999. Nevertheless, an estimated 24 billion barrels of recoverable oil and gas (boe) remain undeveloped. The UK Government is dependent on continued investment from oil companies to ensure that production from these remaining reserves is realised. However in its 2011 Budget the government imposed an unexpected tax increase on North Sea production that resulted in a £2 billion tax increase on North Sea production. This tax hike is likely to affect future investment in the UK North Sea.

Brief Overview of UK North Sea Taxation

The government has historically looked to the North Sea's reserves as a means to boost public funds through a ring fencing tax on profits from oil extraction activities and levying a higher than standard corporate tax rate on companies operating in the region. A Petroleum Revenue Tax (“PRT”) was introduced at 45% in 1975, and subsequently increased to a peak of 75% in 1983, before being abolished for new fields in 1993.

Then in 2002 the government levied a surcharge of 10% (above the standard corporate tax rate of 30%) payable on profits from oil production. This figure was increased to 20% in 2006, which meant that the effective tax rate on oil-related profits became 50% for non-PRT paying fields and 75% for PRT paying fields.

On 23 March 2011 the government unexpectedly increased the surcharge by a further 12%, so that the minimum tax rate levied on North Sea oil production increased from 50% to 62%, although oilfields which also still pay the old PRT are taxed by as much as 81%. The government explained the hike was in response to high oil prices over recent years which have resulted in increased profits for oil companies.

Impact of Tax Hike on Investment in the UK North Sea

The initial response from the industry has been one of fury and shock. Several oil companies have already expressed their opinion that the charge may affect their commitment to ongoing investment in the region. Chevron announced that the tax may deter future investment in the region, and the French oil giant Total, the North Sea’s third-largest operator, announced it is reviewing its annual £170 million spending on exploration in the UK sector of the North Sea as a direct result of the changes.

The impact of the tax hike is likely to be greater for small and medium size producers whose North Sea operations compose a large part of their overall revenue. Much of the investment in the region over recent years has come from smaller players who have been attracted by incentives from the government. These producers typically look either to purchase existing fields with the aim of extracting product from a well near the end of its useful life through the use of enhanced recovery techniques, develop smaller fields that were not economically viable for the majors because of their size, or acquire fields in which production may have ceased but where substantial deposits of oil may remain and are, for the time being, economically viable to recover.

For some majors, the North Sea represents a very small fraction of their global business portfolio and, as a result, the additional tax would have a less significant impact on earnings. The government also conceded that if the price of oil falls below US$75 a barrel the supplementary tax will be scaled back to 20%. That said, the government’s unilateral action may re-ignite a previous trend of major oil companies looking to exit the North Sea.

The initial message from the oil and gas industry is that the tax increase will have an adverse impact on investment in the UK North Sea. The recent hike has already or is estimated to have the following tangible influences on investment and production in the North Sea:

  • Statoil has announced that it is postponing the development of the Mariner and Bressay heavy oil fields in the North Sea located approximately 150 kilometres east of the Shetlands. The two projects are worth more than $10 billion;
  • Valiant Petroleum has announced that it has decided not to drill a £93m exploration well;
  • An analysis by Wood Mackenzie, the consultancy, reveals the tax change has reduced the value of companies’ UK exploration and production portfolios by an average of 21 per cent. BP, for example, has seen the value of its North Sea portfolio drop $3.67bn (although the fall is relatively small in a global context, accounting for 2 per cent of its global upstream value). By comparison, EnQuest, a North Sea-focused oil explorer, has seen the value of its UK portfolio drop $0.26bn which represents 19.5 per cent of its total portfolio. Nexen has seen its portfolio drop $1.7bn, equivalent to 8 per cent of the company’s global upstream value; and
  • A study from Aberdeen University shows that the tax increase announced in the Budget could reduce UK oil and gas investment by up to £30bn and production by up to a quarter over the next three decades.