Why the Treasury got it wrong on North Sea Oil

Below are extracts of the minutes of a Treasury Select Committee meeting on 13 December 2006 where Michael Fallon MP (Conservative, Sevenoaks) asks the Chancellor about his the shortfall in North Sea Oil receipts.

Mr Fallon: "But your own forecast was that you would receive over £13 billion in receipts from North Sea oil and now you are adjusting that to just over £10 billion, £2.8 billion out, which is a 21% forecasting error."

Mr Brown: "Mr Fallon, I think we have been round this course long enough to know that, if production falls in the North Sea that is not the fault of the Treasury."

Are windfall taxes to blame for falling oil receipts?

Or is it? Just before Gordon Brown's December 2005 pre- budget report we warned that if he imposed a windfall tax on North Sea oil companies, it was a sure fire way of making sure that investment in the North Sea eventually dries up at a time when a severe energy shortage loomed. If post-tax returns are not there the oil and gas would stay in the ground. Indeed exploration virtually ceased in 2002 when the Chancellor raised the profit tax on North Sea companies from 30% to 40%. It was only higher oil prices that restored investment levels in the North Sea.

How to profit from the coming oil crisis: Falling North Sea oil and gas production may be a problem for the government, but it's also an opportunity for investors. We reveal the four oil and energy sectors set to soar -and the hottest share picks in each. Click here to find out more.

At the time we reckoned the Chancellor would opt for short-term fiscal expediency by fleecing the oil companies rather than adopting a stable tax regime that enables oil companies to plan ahead and ensure the sustainability of long term energy supplies. And so it proved. The Chancellor doubled the supplementary corporation tax rate to 20%. This was the third significant tax move in three years and resulted in the UK oil and gas industry being by far the highest taxed sector in the UK economy.

After the 2006 Budget, the average tax paid by oil and gas companies operating in the UK was 57%, with all those companies paying corporation tax at a "special" rate of 50% while around 140 of the UK's older offshore fields were subject to a further tax, Petroleum Revenue Tax (PRT), at 75%.

North Sea oil and gas production predictions

The UK Offshore Operators Association published the2006 Activity Survey Report last week. It summarises the exploration, investment and production plans of North Sea oil and gas operating companies over the next three years. And it is grim reading for the Chancellor.

Oil and gas production in the North Sea is expected to be about 10% lower over the next few years than previously thought. This is bad news for British energy security as it increases the country's dependence on imports and bad news for the Treasury which stands to lose £1bn a year based on constant oil prices.

Last year high oil prices led to a surge in investment in the North Sea, most of it from smaller oil companies who had committed to projects before the latest tax hit. Indeed 2006 was the best year for new finds for five years. There is still an estimated 16 to 25bn barrels of oil equivalent (boe) in oil and gas left to be extracted. However the large old wells are running dry and the new wells are characteristically small, casting an ominous shadow over North Sea energy prospects. Last year output from the North Sea was down 9% at 2.9m boe a day. This was the lowest level since 1992 and represented a steep drop from the peak of 4.5m boe/d in 1999. Production is expected to be down a further 10% by the end of the decade. 

Oil companies hit by higher maintenance costs

The older wells are not yielding as much as previously envisaged and increasing amounts of resources are being diverted to maintenance of the ageing North Sea infrastructure some of which dates back to the 1970's. Moreover although investment last year was high, much of the increase reflected higher maintenance costs rather than increased activity. Indeed a combination of poor yields and higher taxes is expected to bring about a 20% fall in investment this year. 

The Chancellor's opportunist tax hike was ill-conceived because it only focused on rising energy prices at the time. In fact industry costs were rising too. Demand for equipment and skilled labour has sent costs soaring worldwide. The cost of developing and operating a North Sea project rose by a thumping 45% last year.

How to profit from the coming oil crisis: Falling North Sea oil and gas production may be a problem for the government, but it's also an opportunity for investors. We reveal the four oil and energy sectors set to soar -and the hottest share picks in each. Click here to find out more.

Oil companies, like any other business, need planning security and would prefer to operate in a stable environment. The repeated regulatory and tax policy changes implemented by the Treasury have not helped. Windfall taxes on oil companies may seem a clever wheeze at the time when the Chancellor is scrambling for revenue (and votes), but in the long run they undermine the credibility of the Chancellor who risks killing the goose that lays the golden eggs.

By Brian Durrant for The Daily Reckoning. You can read more from Brian and many others at www.dailyreckoning.co.uk

Brian Durrant is editor of the Fleet Street Letter