Rishi Sunak‘s decision to introduce a windfall tax on North Sea oil producers has divided opinion. Some are pleased to see the government re-distributing the “excess” profits of these companies to the poorest in society. Others have complained that it will result in reduced investment in the sector over time.
The new tax has certainly muddied the waters for investors and companies. It is bound to create winners and losers, and due to the complexities of the new regime, it’s not entirely clear who will benefit and who will struggle.
The North Sea tax regime was already fiendishly complex before the new windfall tax was introduced. The sector has to contend with a 40% corporation tax rate, and a 10 percentage point supplementary charge. There is also a zero-rated petroleum revenue tax and multiple other investment and capital allowances.
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The new tax introduces a 25% levy on the “extraordinary profits” of oil and gas companies, but also brings in an 80% allowance on capital spending, allowing companies to save 91p for every £1 they invest. The new windfall tax is supposed to be temporary, although a 2025 sunset clause suggests it might be more permanent than the government is willing to admit.
A quirk of the new tax is that companies cannot use prior losses or decommissioning spending to offset qualifying profits. This looks like it is intended to draw more money out of Shell (LSE: SHEL) and BP (LSE: BP). These Big Oil producers are already “tax negative” in the UK, according to analysts at Citigroup, because of spending on decommissioning of aged-out infrastructure.
That said, these businesses have already laid out multi-billion pound capital spending programmes over the next couple of decades, and are better positioned to bring future projects forward to capitalise on the investment deduction. Bringing spending forward could mitigate additional tax charges.
The cost of the windfall tax for companies
Considering all of the above, I think it’s probably sensible for investors to take any projections or estimates about the effect of the levy on company earnings with a pinch of salt. With so many moving parts, these estimates are almost certainly going to be incorrect.
Still, the initial numbers emerging from the City do give us some guide as to where the windfall tax will fall the hardest:
Estimated figures. Source: Jefferies
As the table shows, the large integrated producers, Total, BP and ENI, are unlikely to see much of a dent in their earnings due to the windfall tax. Total (part of TotalEnergies) is currently expected to book the largest charge in 2023 with a cost of $900m. The tax only applies from 26 May, which is why takings are expected to be far higher next year.
The levy will have a bigger effect on smaller North Sea producers. Serica Energy is particularly exposed. Stifel analyst Chris Wheaton notes that the company has a low proportion of capital expenditure compared to earnings before interest, depreciation, amortisation, and exploration.
EnQuest, which specialises in squeezing oil and gas out of mature fields is also exposed. The company also has over $3bn of tax losses, which cannot be used to offset the new tax.
At the other end of the spectrum, Harbour Energy and Aim-listed Deltic (LSE: DELT) (not in the table above) are expected to escape rather lightly as both have plans to make large investments in the next few years. Later this year Deltic will start drilling with its partner Shell on the Pensacola North Sea prospect, a major potential natural gas resource.
The windfall tax will create winners and losers
The windfall tax is an unwelcome development for North Sea oil and gas producers and as the table above shows, some businesses will be able to mitigate its effects better than others.
Rather than trying to pick winners and losers, investors should focus their efforts on companies that are well positioned to navigate the uncertainties of the commodity sector and the energy translation. Indeed, the UK’s new levy will not affect the global shift towards renewable energy, we could even see more carbon taxes introduced as countries including the UK try to drive capital away from fossil fuels.
That’s why I’d focus on the Big Oil companies. Not only are they better positioned to manage the changing tax environment, but they also have more capital to invest in green energy projects.
And I should also acknowledge that hydrocarbon prices may not stay at current levels forever. It was only two years ago that the price of oil traded below zero. That might not happen again any time soon, but investors should consider all eventualities. Diversified Big Oil companies are always going to have the edge over smaller producers in navigating these environments.
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