ALEXANDER G. KEMP, Professor of Petroleum Economics, University of Aberdeen

The UK continental shelf (UKCS) saw great drama during 2011, with a series of noteworthy and sometimes unexpected events. The year began with the industry in an optimistic mood. An activity survey published by the trade association Oil and Gas UK predicted high and increasing levels of field investment over the next few years, with a prospective moderation to the production decline rate in the medium term.

The mood changed dramatically in March with the announcement of sharp increases in the taxation of production income, with immediate effect. Specifically, the Supplementary Charge (SC) was increased to 32% from 20%, increasing the total tax rate on new fields to 62% from 50%. On mature fields subject to the Petroleum Revenue Tax, the total tax rate was increased to 81% from 75%. Furthermore, tax relief for decommissioning costs was to be restricted to the old SC rate, despite the obvious facts that decommissioning costs are legitimate business costs and the SC is a profits tax.

In a straightforward case, the effect is to reduce net cash flows from a project by 24%. (This ignores the complications from the field allowances and the reduced rate of relief for decommissioning.) The budget announcement stated that a handful of new developments could be deterred by the tax increase and indicated that some relief could be made available for such situations. It also stated that, if the oil price fell below $75/bbl, the tax rate could be reduced.

The surprising announcement has clearly shaken industry confidence. Many prospective new developments were reassessed, and Statoil indicated that it was putting work on hold in relation to two major heavy oil developments, Mariner and Bressay. In July the government announced that the Ring Fence Expenditure Supplement, which is available where the investor’s income is insufficient to cover all the tax allowances, would be increased to 10% from 6%. This was sufficient reassurance for Statoil to resume preparatory work on Mariner field.

Despite these problems, activity has remained high in 2011, with field investment likely to be about £6 billion—about £1 billion above the 2009 level. Next year should see a further increase to about £8 billion, largely related to projects already committed. Some of the forecast spending relates to large new developments that have only recently been approved in spite of the tax increases. The most noteworthy was BP’s decision to go ahead with four field developments involving the expenditure of £10 billion over five years. At the largest of these, Clair Ridge, expenditure of £4.5 billion is planned in order to produce 640 million bbl cumulatively. The second largest investment will be the redevelopment of Schiehallion field. The overall consequence will be a substantial increase in oil production from the West of Shetlands region, which may help reverse the decline in UKCS oil output for a few years.

A noteworthy feature of these two planned developments is the use of tertiary recovery technologies. In Clair Ridge field, low-salinity waterflood will be employed, while polymer injection is planned for Schiehallion. To date, enhanced oil recovery schemes have not been widely employed in the UKCS, and, with overall oil recovery rates currently at 38%, there is clear scope for their use.

Another substantial new development at Nexen’s Golden Eagle field, projected to cost $3.2 billion, has also recently obtained government approval. Recoverable reserves are estimated at 140 million bbl.

Other news has been less positive. Decline rates for both oil and gas were notably high in 2011, exacerbated by a particularly high rate of downtime. About one-third of all the platforms on the UKCS are over 30 years old, and the incidence of problems resulting in downtime has been high. Much attention has been paid in recent years to enhancing asset integrity to improve health and safety. Investment geared to reducing downtime could also produce worthwhile rewards.

Exploration and appraisal drilling fell substantially this year. At the time of writing, the number of wells drilled was down by 40% compared with 2009, in spite of the Brent oil price continuing to exceed $100. This cannot be ascribed to the tax increases in the March budget, as drilling contracts would have been signed for the year prior to that date. But the omens are not so good for 2012, when reduced cash flows will be felt more fully.

The government is expected to announce the 27th licensing round early in 2012. A large number of blocks (possibly exceeding 2,000) may be put on offer. The response of the industry will be a good indicator of post-budget investment confidence in the UKCS. This could certainly be enhanced if the next budget, expected in March, provides new allowance to facilitate the development of the many small, high-cost fields that remain undeveloped.

Asset transactions involving mature fields have diminished greatly over the last year—the exception being Apache’s purchase of some of ExxonMobil’s mature fields. A main problem is the uncertainty regarding the tax relief available for decommissioning. The industry is hoping that a scheme can be agreed upon that will remove or at least reduce this problem. The result would be a substantial increase in sales of assets to companies interested in enhancing recovery in mature fields.