United States: The Scottish Vote – Implications For The UK Oil And Gas Industry

After years of speculation and months of debate and promises, the Scots have finally chosen to retain their 307-year union with the rest of the United Kingdom. The official line is that the debate has been settled for a generation... or for a while anyway. With the clear cut, but not overwhelming, result of 55% no versus 45% yes, the result has arguably raised more questions than it has answered.

Devo Max – where will it lead?

The new status of Scotland within the United Kingdom remains highly uncertain. This uncertainty was compounded at the last minute by the frantic yet ambiguous offer of increased devolution by the leaders of the three main Westminster parties. One thing is clear - the Westminster parties and the proponents of Scottish independence concluded their campaigns with very different ideas regarding what the last-minute pledge of increased devolution actually meant. How this uncertainty gets resolved will have an impact on the oil and gas industry. The three main UK parties have each set out separate proposals for further devolution including the transfer of income tax, capital gains and inheritance tax, air passenger duty and some welfare benefits. Taxation of the oil industry is notably absent from their lists, but this could be a battleground in the demand for greater devolution. Thankfully, the announcement of Lord Smith of Kelvin's appointment to deliver a draft Scotland Bill by January 2015 means that we will not have to wait for long to find out.

An underperforming but pivotal industry

The health (or lack thereof) of the UK offshore oil and gas industry was widely debated in the run-up to the referendum and undoubtedly had an effect on the result. While disagreeing on the ramifications for Scotland's independence, both sides of the debate recognized that there were fundamental challenges to the future of the industry that needed to be resolved, including:

  • Rising operating costs – The UK continental shelf is a mature basin with many facilities operating beyond their original design life. As a consequence, there is a constant need to inspect, monitor and repair topsides and subsea pipelines and equipment. Achieving this at a tolerable cost is difficult. Oil and Gas UK, the leading representative body for the UK offshore oil and gas industry, highlighted in its 2014 annual survey that in 2013, despite an 8% fall in production, operating expenditure rose by 15.5%. The average cost of extracting a barrel of oil was up by 27% in only a year, reaching £17. The number of fields with a cost per barrel of above £30 has doubled in the last 12 months.
  • Exploration activity – In 2013, 53 exploration and appraisal wells were spudded, in comparison, only 19 exploration wells have been spudded to date in 2014. Volumes discovered have also been disappointing with less than 330 mmboe of reserves discovered since the beginning of 2011, compared to around 2,540 mmboe which has been produced over the same period.
  • Fragile levels of investment – In 2013, the offshore oil and gas industry experienced its highest rate of investment for more than three decades, primarily due to a stream of new field allowances. More than half of all investment in 2014 is in receipt of a field allowance, demonstrating the effectiveness of allowances. However, low levels of discovered reserves and high operating cost means that investment is scheduled to fall by nearly half within the next three years.
  • Decommissioning – It is now 50 years since the first UK offshore licensing round in 1964 and many of the biggest oil fields of the central and northern North Sea are facing massive decommissioning costs. The companies involved with decommissioning currently benefit from guaranteed tax relief through the Decommissioning Relief Deeds that exist between licence holders and the UK Government. Total decommissioning expenditure is expected to reach £40.6 million by 2040.
  • Third-party infrastructure – In recent years, the average offshore discovery has been relatively small and the majority of such discoveries need to be tied into existing infrastructure to be commercially viable. The North Sea has well-developed offshore production infrastructure, but gaining access to such infrastructure, which is usually owned by other licensees, is time consuming, difficult and expensive. 
  • Taxation – In March 2011, George Osborne, the Chancellor of the Exchequer, delivered a budget that contained an increase in taxes on North Sea oil and gas production. Rates for pre-budget fields went up from 75% to 81%, and for newer fields from 50% to 62%. This increase, which was pitched as a "windfall" tax flayed an industry already burdened by the tax increases imposed by the previous Labour government.

The Wood Review, commissioned by the Department of Energy and Climate Change (DECC) was an attempt by the UK Government to identify solutions to some of the issues that plague the offshore oil and gas industry. In July 2014 the Scottish Government's Independent Expert Commission on Oil & Gas came out with its detailed report entitled "Maximising the Total Value Added" ("Scotland 2") which endorsed and indeed amplified the proposals of the Wood Review.

However, it was this very reliance placed by the nationalist on Scotland's oil wealth that allowed the unionists to argue that an independent Scotland would not be able to fund high Scandinavian levels of spending on the back of its oil reserves. 

What now?

Now that the question of Scottish referendum has been put to bed, the UK Government needs to work with the Scottish Government in order to implement the proposals of the Wood Review. Oil & Gas UK, in its statement following the Scottish referendum result issued a rallying cry for the UK Government to press swiftly ahead with fiscal reform and the implementation of Sir Ian Wood's recommendations to maximise the economic recovery of the UK's oil and gas resources. 

One of the most important recommendations put forward by the Wood Review is the proposal to create an entirely new upstream regulator with wide-ranging powers to facilitate and maximise the economic recovery of remaining petroleum resources. This new regulator will be called the "Oil and Gas Authority" and is intended to fulfil the upstream regulatory function which is currently undertaken by DECC. With Scotland now remaining a part of the UK, the UK Government is likely to proceed with its plans to have the Oil and Gas Authority headquartered in Aberdeen.

The new regulator is expected to adopt a much more interventionist style, signaling the end of the days of light touch, self-prescriptive regulation. In particular, the new regulator could have the power to intervene to resolve disputes between industry participants, could attend JOA operating and technical committee meetings as an observer in order to access operational data directly and could apply various sanctions in order to compel proper licensee performance (including suspension or even termination of the licence). 

The Wood Review has recommended that the new regulator be independent of the UK Government and be funded by a levy on industry participants, rather than centrally funded by the UK Government (as is presently the case for DECC). Unlike the under-resourced DECC, the new regulator is expected to recruit sufficient top quality personnel and not be bound by civil service pay scales. The UK Government has appointed a recruitment agency to lead the search for the head of the new regulator.

The Wood Review also introduced a new acronym, MER (Maximising Economic Recovery). The concept of MER is not defined in detail in the Review but is widely interpreted as representing a broad, coordinated approach to the business of petroleum exploration, development and production – and one which could be expressed as a new obligation of offshore licensees.

The UK offshore regime for the offshore oil and gas industry is increasingly seen to be overly complex, burdensome and uncompetitive. Although taxation of the oil and gas industry was not part of the remit of the Wood Review, Sir Ian called for a rethink of the tax regime to encourage investment in the UK offshore oil and gas industry. Any future regime should prioritise the need to provide tax incentives in order to achieve this.

Without taking a position on whether an independent Scotland is better or worse for the Scots, it is a reality that the no vote has avoided years of uncertainty and change for Scotland and the rest of the United Kingdom. However the decision of Scotland to remain in the union, is not a vote in favour of maintaining status quo in the oil and gas industry. Things need to change if this industry is to continue to be the engine for growth that it has been over the last decades for this (slightly more fragile) union of nations.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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