Monday 2 March 2015 8:17 pm

The North Sea is drowning in tax: Only radical action will salvage UK oil now

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Following his comments at the recent opening of the OECD’s Economic Survey, it is to be hoped that the chancellor gives North Sea oil companies, their shareholders, and their employees enough reason to cheer when he announces the Budget on 18 March. He recognised that the oil and gas industry is a vital national asset and asserted that the government has a plan to back it.

The future of the North Sea Basin is hanging in the balance after the slide in the oil price on top of years of heavy taxation, rising costs, and the inexorable decline in oil and gas production. According to a recent survey of the industry, UK offshore oil and gas spent £5.3bn more than it earned last year, the cost of extraction per barrel rose to a new high of £18.50, and the overall cash drain was the biggest since the 1970s.

The stakes are high, both socially and financially. The North Sea employs 450,000 people and contributes the equivalent of 4p in the pound of UK income tax. It is a vital contributor to the Scottish economy in particular, and this is why it is an election issue. Yet many oil and gas companies face the real possibility of financial distress, because they are highly leveraged, banks are unwilling to lend more money, and working capital is running out fast.

Spending on new oil field developments is projected to fall as low as £9.5bn this year, down from £14.8bn in 2014. Investment in developing projects that have already been approved could trickle to just £2.5bn by 2018. That’s on top of the projected drop in exploration as a result of years of unsuccessful drilling, and high development costs for what has been discovered. Exploration is the source of future production, future tax revenues, and future jobs.

It is vital that present and future governments take decisive and far-reaching action to arrest or reverse these trends, no matter what kind of administration we end up with come 7 May. The Budget should be the starting point for measures aimed at improving the competitiveness of UK oil, and at safeguarding its long-term future. After all, politicians did not help the current situation by hiking the supplementary charge on firms’ profits by 12 per cent four years ago – so it’s not unreasonable to expect them to step in and help the industry in its struggles now.

The chancellor needs to go further than he did in his Autumn Statement to keep oil pumping in UK waters.

The cut in the supplementary charge from 32 per cent to 30 per cent, announced in December, was a starting point, but it still means that headline taxation is running at twice UK corporation tax rates. Up to a third of North Sea oil fields are estimated to be loss-making on a cash basis, which means that many of them, operated by smaller producers, are not paying tax to the government anyway. Without leniency from their bank lenders, they may not survive to pay tax in the future. Subsequently, if operators start failing, the early decommissioning of North Sea fields becomes a real risk, stranding millions of barrels of oil under the sea and denying the Treasury billions in tax revenue.

Deep tax cuts are the way to go. Nothing less than a double digit cut or the elimination of the supplementary charge will achieve the necessary level of impact. The Basin needs help now, or much of it could disappear if the oil price stays at these levels for a number of years.

The government should also incentivise exploration with the introduction of an investment allowance. There cannot be a true recovery or resurgence in the North Sea without this measure. But this allowance should be more daring than the simple financial incentive that has been debated. Rather, it should be tradable between companies, so that those with little or no production can realise gains regardless.

And if policymakers want to be really radical, there is always the option of introducing production sharing contracts for North Sea exploration. The UK is out of step with many other oil producing countries, where these arrangements are a standard alternative to our tax and royalty system. In essence, these contracts between governments and extraction companies guarantee a minimum and maximum return on capital, giving companies more financial certainty and governments more tax revenues.

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