Commodity price volatility and political uncertainties dominate UKCS outlook for 2023
The year 2022 has been a turbulent one for the oil and gas sector worldwide. The UK Continental Shelf (UKCS) is no exception to this. Oil and natural gas prices rose dramatically following the Russian invasion of Ukraine. In August, UK gas prices peaked at 600 pence per therm (equivalent to around $452 per boe). At the time of writing, natural gas prices are at 291 pence per therm ($205 per boe). To provide perspective, for some years prior to 2022, UK gas prices were typically in the 30 pence to 40 pence per therm range.
Policy considerations. The dramatic increase in 2022 has led to a reassessment of UK energy policy priorities. The requirements of energy transition to Net Zero by 2050 are well-established, but the traditional policy trilemma to include security of supply and fuel poverty have been given additional prominence.
Currently, the UK has to import over 50% of its natural gas requirements on an annual basis. Over 80% of houses in the UK are heated by natural gas, and around 40% of electricity is generated from gas over a 12-month period. Well over 30% of UK net oil requirements are also met from imports.
Projections by the independent Climate Change Committee on future UK consumption and the production projections made by the upstream regulator, the North Sea Transition Authority, indicate that substantial net imports to 2050, consistent with the achievements of Net Zero by that date, will be required.
Accordingly, the case for allowing the development of further existing discoveries and for holding new exploration license rounds has become the policy of the current UK government. Field development consents have to pass environmental hurdles, particularly the need to reduce CO2 emissions from production operations. In practice, this means reducing the use of diesel and fuel gas for power generation and hopefully the introduction of electricity from renewable sources as sources of power.
Investment situation. The industry has welcomed the possibility of more oil and gas developments (Fig. 1), which have been at a much-reduced level during the Covid lockdown years, and the low oil prices prior to the OPEC agreement in April 2020. But the investment environment has been negatively affected by the introduction of a windfall tax (termed the Energy Profits Levy) on 26th of May plus the promise of an increase from January 2023. This will involve a headline Levy rate of 35%, making the overall rate on income 75%. The augmented Levy will last until end of 2028.
The Levy is complex, because it also involves very large investment allowances. Thus, for all eligible new investments, an expenditure of $100 can lead to tax savings of 91.4 cents. But attainment of this rate of relief is available only to an investor, who has income from another field against which he can utilise the investment allowances. An investor in this position could also benefit from a significant part of his income being taxed after 2028, when the overall rate on income becomes 40%, rather than 75%.
But not all investors are in this position. Many relatively new players in the UKCS do not have substantial current income against which to set the investment allowances. Other companies have no current significant investment plans. They are, thus, fully exposed to the headline rate of 75% on their income. As a consequence of the recently announced increase in the tax rate, many companies are reassessing their investment plans.
There are other complications. Decommissioning costs are not allowed as a deduction for the Energy Profits Levy. This is controversial, given that these are generally legitimate costs for profits-based taxes. Given the reduction in cash flows to the end of 2028 and the consequent capital rationing, decommissioning activities may be postponed until after that date.
The UK government has stated that the Levy will last to the end of 2028. While this provides some certainty to investors, they are likely to be concerned that the relatively high oil and gas prices may not prevail until that date. Gas prices have fallen recently on the news that the gas storage facilities in the European Continent are now full, to the extent of 90%. While this may ensure that the current peak winter demand can be met, great uncertainty remains over gas supplies from the summer of 2023 onwards.
While supplies from Russia to Western Europe will very likely be greatly reduced, the extent to which supplies from other sources (such as USA and Qatar) can fully replace Russian supplies obtained over the past year is highly uncertain. New LNG regasification facilities are being developed in the EU, and the Rough field storage facility is being reopened, but the availability of new imported LNG supplies on sufficient scale is highly uncertain.
The UK and Europe have to compete with other main gas importers. In that context, it is noteworthy that China has recently signed a 27-year gas supply contract with Qatar.
Putting all the above factors together points to the possibility of some increase in investment activity on the UKCS from the depressed levels of recent years. But investors, who are not in a position to benefit from the current large investment tax allowances, may find the current environment quite challenging. WO
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