UK: Published At Last – A Winning Strategy For The UK Continental Shelf?

Last Updated: 11 December 2015
Article by Adam Brown

Finally, we have the missing piece of the jigsaw.  The current reforms to the UK's regulatory regime for the offshore oil and gas industry were recommended by the Wood Review in 2014.  They began to be implemented with the creation of the Oil and Gas Authority (OGA) and the amendments made to the Petroleum Act 1998 (the 1998 Act) by the Infrastructure Act 2015; they are continuing with the current Energy Bill (now half way in its passage through Parliament).  But it is perhaps only with the publication of a draft of the strategy for maximising the economic recovery of UK petroleum on 18 November 2015 that we start to get a full sense of how the new regime may work in practice.

What is the draft strategy, and why does it matter?

The legislation describes the strategy as "enabling" the "principal objective" of "maximising the economic recovery of UK petroleum" (MER UK) to be met.*  The principal objective and the strategy occupy a central position in the revised regulatory scheme.

To begin with the regulators.  In one way or another, the OGA is taking over most of the Secretary of State's statutory functions under the Petroleum Act 1998 and Chapter 3 of Part 2 of the Energy Act 2011.  The OGA is also to acquire a raft of new functions under Part 2 of the Energy Bill.  In exercising all these functions (including any of its powers under a petroleum licence), the OGA will be obliged to "act in accordance" with the strategy.  The Secretary of State will be similarly obliged to act in accordance with the strategy when exercising her functions under the Part 4 of the 1998 Act "to the extent that they concern reduction of the costs of abandonment".

At the same time, the strategy will be binding on holders of, and operators under, petroleum licences, when planning and carrying out their activities as such; persons planning or carrying out the commissioning of upstream petroleum infrastructure (broadly defined); and (subject to the Energy Bill) owners (broadly defined) of offshore installations and upstream petroleum infrastructure, when carrying out their activities as owners of such installations or infrastructure, or decommissioning it.  Such persons and (in so far as they can affect the fulfilment of the principal objective) activities are referred to in the draft strategy as "relevant persons" and "relevant functions" respectively.

The Energy Bill provides that if a business which is a relevant person fails to act in accordance with the strategy, the OGA can impose sanctions including financial penalties of up to £1 million (and potentially up to £5 million if the Secretary of State raises the penalty cap by regulations) and revocation of the business's status as a holder of, or operator under, a petroleum licence.

Although the strategy will become more important as and when the Energy Bill completes its passage through Parliament and becomes an Act, many of the provisions establishing the importance of the principal objective and the strategy are already embodied in the amendments made to the 1998 Act by the Infrastructure Act 2015.  So it is noteworthy that reform of the offshore oil and gas regulatory regime has gone so far without public consultation on a full draft of the strategy.

What the draft strategy says

The Wood Review pointed out, and subsequent OGA papers have elaborated on, the fact that the inter-dependence of different installations and infrastructure in the UK upstream oil and gas industry is such that if each relevant person only seeks to optimise its own financial position, the performance of the industry as a whole is likely to be sub-optimal.  So the key question for the draft strategy to answer is how (and how far) businesses are to be induced to compromise their interests for the greater good.

To look at how the draft strategy answers this question, it is best to start with two of its key definitions.

  • "economically recoverable petroleum" means "those resources which could be recovered at an expected (pre-tax) market value greater than the expected (pre-tax) resource cost of their extraction, where costs include capital and operating costs but exclude sunk costs and costs (like interest charges) which do not reflect current use of resources.  In bringing costs to a common point for comparative purposes a 10% real discount rate will be used".
  • "satisfactory expected commercial return" means "a reasonable post-tax return having regard to the risk and nature of the investment".

These two definitions underpin what are perhaps the draft strategy's two most important provisions:

  • The Central Obligation applies to relevant persons in the exercise of their relevant functions, and obliges them to "take all steps necessary to secure that the maximum value of economically recoverable petroleum is recovered from the strata beneath UK waters".  (Emphasis added: as a recital to the draft strategy puts it: "all stakeholders should be obliged to maximise the expected net value of petroleum produced from relevant UK waters, not the volume expected to be produced".  The focus on value (undefined) rather than quantity contrasts with the similar but different words about "securing the maximum ultimate recovery of petroleum" in the petroleum licence model clauses on unitisation, which represent perhaps the greatest degree of intervention by the licensing authority under the existing regulatory regime.)
  • Paragraph 27 provides that if relevant persons "decide not to ensure the recovery of the maximum value of economically recoverable petroleum from their licences or infrastructure (including because that does not achieve a satisfactory commercial return, in accordance with paragraph 3) they must relinquish or divest themselves of such licences or assets".

The "paragraph 3" referred to here is one of the draft strategy's Safeguards: "No obligation imposed by or under this Strategy requires any person to make an investment or fund activity where they will not make a satisfactory expected commercial return on that investment or activity.".

It is hard to quarrel with any of this in the abstract, but applying these principles in any given case will not necessarily be easy.  For example, how do you assess "expected pre-tax market value" in the context of massive uncertainty over future oil and gas prices?  DECC's own most recent fossil fuel price projections suggest that the average oil price for the next 10 years could be anything from $46.8 to $140.4 a barrel (depending on whether you take the "low" or "high" scenario).

What does this mean in practice?

The consultation document spells out where all this leads.  If you are the owner or operator of an asset or infrastructure and take the view that you cannot make a satisfactory commercial return from its continued operation, you may be obliged to divest it to somebody who takes a different view of what constitutes a satisfactory return or what is economically recoverable.

Paragraph 27 is one of a number of "supporting obligations" and "required actions and behaviours" listed in the draft strategy in respect of exploration, development, asset stewardship, deployment of new technology and decommissioning.  So, for example, owners and operators of infrastructure must plan, commission and construct it in a way that meets the optimum configuration for MER UK, and must allow access to it on fair and reasonable terms.  If the infrastructure is not able to cope with demand for its use, they must prioritise "access which maximises the value of petroleum recovered".  Meanwhile, the OGA may produce plans addressed to "a single or small group of relevant persons" setting out its view of how the obligations of the strategy may be met in their particular circumstances".  According to the consultation document: "A plan might target a particular or small range of circumstances, or might be broader and more strategic in nature, for example setting out how the OGA thinks a region should be developed or decommissioned.".

The new regime

In the words of the consultation document: "How the OGA uses and acts on the Strategy is...of great importance – it will set the tone for the basin and will be a key factor determining its attractiveness to industry and investors.".

One could perhaps sum up the spirit of the strategy by mangling a famous line from John F. Kennedy: "Ask not what the strategy can do for you, but what you can do to maximise the economic recovery of UK petroleum."; or perhaps quoting Karl Marx, without modification: "From each according to his ability, to each according to his needs".

But enough flippancy. The consultation document goes out of its way to emphasise that the OGA will not be unduly interventionist: "whilst enforcement measures are a necessary backstop, the OGA is expected to act primarily as a convenor and facilitator, working together with industry to deliver increased value from the UKCS for both industry and the UK as a whole".  If it is "occasionally...the case that the OGA [finds] that a relevant person's contractual provisions place that person...in breach of the Strategy", or if the OGA finds that it needs "to assert its right as a regulator to use its sanctions where a relevant person fails to avoid a breach of its MER responsibilities through continued reliance on contractual provisions which conflict with the Strategy.... it will always be for the relevant person to decide for itself how to deal with that in terms of its contracts.".

Perhaps a useful point of comparison here is the UK power market.  It has become commonplace to note that the UK's various schemes for subsidising new low carbon electricity production, and the Capacity Market which subsidises old nuclear and fossil fuelled generating stations, have turned the liberalised GB power generation market into something closer to a "planned economy".  Where the fulfilment of the principal objective is at stake, the Energy Bill requires that the OGA be allowed to participate in meetings between relevant persons, and recommend ways of resolving disputes between them.  Reading such provisions side by side with the draft strategy, it is clear that in the oil and gas industry too, future commercial decision-making may be much more strongly directed by the state than before.

Then again, perhaps one should compare oil and gas production not so much with the power generation market, which is supposed to be characterized by free competition, but with the monopoly markets of transmission and distribution, where it is accepted that it is only economic for one operator to build and operate infrastructure in any given location – just as petroleum licence holders enjoy exclusive rights in their licensed areas and many oil and gas infrastructure owners are de facto monopoly service providers.  In the power sector, to avoid any abuse of monopoly, the returns which network operators can earn on their investment are regulated.  The strategy does not go (quite) that far.

In the end, the strategy highlights the two risks that the OGA will need to guard against particularly carefully in administering the reformed regulatory regime. The first is highlighted in a  letter of 3 December 2015 from the UK Competition and Markets Authority, using for the first time its new powers to make and publish recommendations to Ministers about proposed new legislation: the OGA and those it regulates could collaborate so closely that beneficial competitive pressures, which are important to reduce costs and support the principal objective, could be dampened, so that, for example, the regulatory process ends up facilitating the anti-competitive exchange of information between competitors.  The second and opposite risk is that a less co-operative attitude amongst industry players prompts the OGA to start using its enforcement and other formal powers to an extent that in turn stimulates the kind of "over-zealous commercial and legal behaviour" on the part of the industry that Wood wanted to make a thing of the past.

So perhaps what matters most is not the strategy itself, but the tactics of those who must follow it – both the OGA and industry players.

* Note: The definition given above of the "principal objective" reflects the current text of section 9A of the 1998 Act.  If clause 8 of the Energy Bill (introduced by an Opposition amendment) survives, it will become instead "maximising the economic return of UK petroleum, while retaining oversight of the decommissioning of oil and gas infrastructure, and securing its re-use for transportation and storage of greenhouse gases" – although how much difference some of those additional words will make now the Government has abandoned its CCS commercialisation programme is debatable.

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