Earlier this year, Alistair Darling, the UK Chancellor of the Exchequer, announced changes to the UK North Sea tax regime, the most important of which aims to encourage the development of new fields. The incentives targeted small fields, heavy oil fields, and those at the extreme highs of temperature and pressure. The incentives on heavy oil fields are likely to have the biggest impact in encouraging development and could be enough for operators to sanction a number of such fields.

The incentives for high-pressure/ high-temperature (HP/HT) fields are likely to have less of an impact. This is not because the level of incentive is set too low — it does materially change the economics— but rather because the definition precludes the vast majority of HP/HT fields and prospects.

The small fields represent by far the largest category targeted, with over 260 existing discoveries potentially qualifying. Analysis shows, however, that the incentives announced will have a limited impact on economics. In short, this fiscal change will not be enough to drive the majority of these types of projects forward.

Although the incentives are welcomed by operators, the continued uncertainty in oil and gas prices, the high costs, and in particular, a lack of funding remain the overriding issues as companies plan future projects. For well-funded organizations, the allowance will certainly help move projects up their ranking of global opportunities. However, for those that are more cash-constrained, the difficulty in accessing capital will remain a barrier.

The value allowance
In 2007, the UK government started a consultation with various stakeholders in the UK oil and gas industry. The aim was to investigate fiscal changes that would help alleviate some of the structural issues the industry was facing, namely the expected decline in oil and gas production and investment.

These issues were further exacerbated throughout the second half of 2008 with the increased levels of costs, the collapse of the oil price from record highs, and the freezing of the credit markets — removing access to sources of finance for smaller, cash-constrained companies looking to develop fields.

The result of the consultation period was the introduction of a value allowance in the April budget. This essentially allows an amount of profit to be excluded from supplementary charge on qualifying fields (Table 1). Fields that qualify would normally be subject to a full 20% supplementary charge in addition to the corporate tax rate.

The allowances are not cumulative, but should a field qualify in more than one category, the higher of the value allowances will be applied. The annual allowance is the lower of either the maximum annual allowance or the field revenue.

Field economics
Although on an absolute basis the net present value (NPV) of each of the small field examples does not increase significantly with the addition of a value allowance, on a relative basis the NPV improves by between 6% and 22% (Table 2).

The P/I ratio (NPV (cash flow + capital expenditure)/capital expenditure) is often used by investors to give an indication of both the profitability of the investment and the investor’s required rate of return. Given that the value allowance has a negligible impact on the P/I ratio in the models, it may not be material enough to affect the investment decisions to develop those fields.

Unsurprisingly, the heavy oil and HP/HT value allowances have a more significant impact due to the larger amount that can be offset, increasing the post-tax NPV by between 17% and 55%. For the small number of fields that qualify under the HP/HT and heavy oil criteria, the allowance has the potential to encourage project sanction for field development.

Positive move forward
Although the value allowance is not likely to have a huge impact in driving forward new developments, it is nonetheless a step in the right direction in terms of the government engaging with industry.

In light of the current economic environment facing the UK electorate, the government would likely have met opposition if it had given a much larger tax break to stimulate investment. It was also mindful to avoid giving incentives to fields that would be developed anyway.

Although coming from different angles, both the oil and gas industry and the UK government aim to maximize reserves recovery, and therefore revenue, from the UK Continental Shelf. The constructive outcome of the consultation process is a positive move toward achieving this objective for both parties.

Economic input
The following criteria were used in the economic analysis:
• A Brent oil in nominal terms of US
$50.00/bbl in 2009, $62.25/bbl in 2010, $69.00/bbl in 2011, $75.38/bbl in 2012, escalating at 2.5% per year from the beginning of 2013 on.
• A UK uncontracted gas price of $7.85/mcf in 2009, $6.12/mcf in 2010, $5.88/mcf in 2011, $7.75/mcf in 2012, and $8.18/mcf in 2013, escalating at 2.5% per year from the beginning of 2014 on.
• A US dollar to British pound exchange rate of 1.5 in 2009, 1.6 in 2010 and constant thereafter.
• An inflation rate of 2.5% per year from 2010 on.
• A discount date of Jan. 1, 2009, and a discount rate of 10% nominal.
• The implied tax rate is based on undiscounted value.