The recent level of exploration activity in the UKCS is of concern, and the relatively small amount of recoverable reserves discovered offers little encouragement to those who hope to see the basin properly exploited. Thus, it is perfectly reasonable to question whether the current oil and gas tax regime is effectively encouraging exploration.
It is tempting to look across the North Sea to the Norwegian sector, see the activity levels there and the reserves discovered, and conclude that the Norwegian tax regime has successfully incentivised exploration. However, that may be too simplistic an analysis.
Currently, the UKCS provides for tax relief at 62% on exploration costs and, dependent on the size of discovery, offers a reduction in the 62% rate for production from the field through the Small Field Allowance. At first blush that doesn’t look too bad a deal.
Norway offers a greater level of relief at 78% and also provides incentives (a capital uplift) that may result in a reduction in the 78% rate for production from the field when it is developed.
Furthermore, the Norwegian system also provides that where exploration expenditure has resulted in a loss the company can claim a tax refund of 78% of that loss. The prospect of an almost instant recovery of 78% of the costs incurred is the most attractive feature of the Norwegian regime.
An investor in a UK explorer knows that the company can only hope to realise tax relief on its exploration spend when, and importantly if, it actually becomes profitable. The same investor in a Norwegian explorer can see his money go almost four times as far as a result of the tax repayment. Crucially, the company also has the opportunity to access the banking sector by borrowing up to 75% of the exploration spend against a pledge of the subsequent tax refund.
There is an attempt to mitigate the time value of money cost in the UK through the Ring Fence Expenditure Supplement, which provides 10% uplift in the value of losses for a maximum of six years, but that doesn’t help the cash flow of the company.
Moreover, changes in the Finance Act in 2013 mean that it is now not possible to monetise the value of the latent tax relief on a sale of the company as the buyer is caught by anti-avoidance provisions if he seeks to crystallise and use the loss by transferring a profitable oil or gas asset into the company he has purchased.
So the case for a move to the Norwegian tax refund system may look fairly compelling. Regrettably that is not the whole story.
Historically, the UKCS has enjoyed higher levels of tax relief for exploration costs (towards 90% in the mid-80s for groups paying Petroleum Revenue Tax), and much lower levels of relief (30% in the period 1993 to early 2002).
A review of wells drilled in these periods offers support for the proposition that higher levels of tax relief incentives drilling – but as many have pointed out, higher activity levels don’t necessarily correlate with an increase in successful wells.
Therefore, achieving an increase in well count alone is the wrong objective, and it would be inappropriate to promote a change to the tax regime as the key issue to be addressed.
The other factors that require attention include:
– The sharing of seismic data to build a more accurate picture of the underlying geology:
– The creation of a forum to discuss success and failure so experience can be shared;
– The altering of perception on the prospectivity in the UKCS; and
– The resourcing of a regulator who is better placed to manage the state’s investment (via the tax regime) in exploration.
Efforts are already under way to try and address these issues. Oil & Gas UK has done a significant amount of work through the Exploration Task Force to try and overcome historical problems with sharing data and to bring about a more collaborative approach which will benefit all parties.
Norway currently enjoys a significant advantage through having a dominant player in the form of Statoil, as they can gain a much better picture of the overall geology of the NCS.
The large number of players we have in the UKCS has tended to result in individual companies gaining detailed knowledge over discrete areas, without the same overall picture being built up.
The recent “Pitfalls in Exploration” conference may be another step forward in sharing exploration experience across the UKCS. Perhaps the government also needs to be persuaded to fund some seismic activity in a similar manner to Norway, and then re-coup the cost when licensing the underlying area.
So where does that leave tax incentives? The tax system has an impact on activity levels in the UKCS generally and perhaps most noticeably in the area of exploration. However, it would be a very significant step for HMT to move to a tax refund regime similar to Norway.
Such a move is only likely to happen if the current downward trend in exploration drilling continues or accelerates and perhaps if the new, better resourced regulator suggested in the interim Wood report is established.
If a new breed of explorers are going to share the risk of exploration on a ratio of 1:2 with the Exchequer then the regulator needs to be sufficiently equipped to ensure that the best prospects are drilled and all the necessary preparatory analysis has been undertaken.
Creating greater incentives for exploration is an important factor in addressing the current decline in exploration activity, but only one of a number of matters that needs to be addressed. Watch this space.
Derek Leith is EY Aberdeen office managing partner and the firm’s head of oil and gas taxation
