Alexander G. Kemp, Professor, University of Aberdeen, UK
Professor Alexander Kemp, Professor of Petroleum Economics and Director of Aberdeen Centre for Research in Energy Economics and Finance at the University of Aberdeen, discusses taxation within the UKCS, asking questions like “is the current system appropriate for a mature province like the North Sea? Does it encourage maximization of economic recovery and exploration? Does it deal with the looming problem of decommissioning in a sensible way?”
How is the Aberdeen University currently positioned as partner to the O&G industry?
Currently, the University of Aberdeen has four research themes that our senior management has asked us to pursue. The University itself has put more resources into the energy area across disciplines. I study economics, but the University also has energy-related research in the fields of law, petroleum geology, petroleum engineering, and safety, including in the department of psychology. The research has been given an impetus since energy is one of the University’s key research priorities.
John Scrimgeour has just been appointed Director of our Institute of Energy, whose function is to bring together the expertise of all the disciplines and in particular to promote interdisciplinary research and links with the energy sector, governments, private sector, and universities in other parts of the world. We are developing more links with foreign universities and other institutes in Africa and the Far East on quite a big scale.
The University offers many courses in energy economics, energy issues in engineering and geology. The students overwhelmingly come from overseas, so when they go home we continue our links with them. Although the focus of my own work is in the North Sea, Aberdeen University as a whole is increasingly looking at the world, both in terms of research and teaching.
We have collaborative relations not only with universities, but also with the business community. In my own case, my research effort over many years has been done in association with sponsoring oil companies. Although I keep very close contacts with policy makers, both the British government in London and the Scottish government in Edinburgh, I develop close links with the industry itself. This enables me to prosecute research that is of direct relevance to the problems that are emerging in the North Sea.
I spend a lot of time looking at questions related to the tax system for example. Is the current system appropriate for a mature province like the North Sea? Does it encourage maximization of economic recovery and exploration? Does it deal with the looming problem of decommissioning in a sensible way? I have contributed many papers on these subjects.
As the acknowledged authority on North Sea economics, what are your biggest concerns for an independent Scotland?
The implications of possible constitutional change for the North Sea oil industry are a relatively new issue. We have completed primary research on this subject and highlighted several points.
Firstly, the tax revenues, which have been in the news often, will be significant, but they will also be very volatile since they depend on oil & gas prices, production levels, and on the level of investment expenditure since the allowances for investment expenditure are deductions against income and therefore reduce the tax base. There has been very much volatility in oil prices, production, and investment over the years.
We used our model, which forecasts activity levels over the next thirty years, to predict what share of the oil and gas production might be in the Scottish sector if the median line were used to divide the UK sector between a Scottish sector and the remaining UK sector. We produced projections of what share of the oil and gas could accrue to the Scottish sector in this scenario. The great majority of the oil, more than 90 percent, would be in the Scottish sector, whereas a large portion of the gas would be in the Southern basin and the Irish Sea. Nevertheless, over the coming years, over 50 percent of the gas would also be in the Scottish sector.
Our research has also focused on investment and constitution change since investors would like to have assurances on the taxation regime and the licensing and regulatory regime to which they would have to adhere. Above all, they need clarity on what these regimes would be, even at a relatively detailed level. At the moment, the government’s tax experts and licensing people are all with the London government. The Scottish government would have to build up expertise in all of these matters to become an efficient licensor and tax authority.
From the point of view of the investor, there is thus some uncertainty and some political risk. Although all oil companies prefer a climate of certainty for their investments, they are used to political risk around the world, including constitutional debates and changes. For example, in Canada some years back there was a big debate about whether the provinces should be in charge of taxation or whether the federal government should have a share. Currently, the Zanzibar government and the Tanzanian government are debating about who should have what share of taxes from gas discoveries off the coast.
In terms of decommissioning activities, do you agree that the major challenge is understanding what is required by legislation and correctly interpreting these rules and regulations? When do you see this balance changing?
The legislative environment in which decommissioning is and will be undertaken has changed in the past years. In recent years, a big problem and surprise resulted from the 2011 tax changes when the Supplementary Charge was increased from 20 percent to 32 percent. However, the government also decided that, as relief for decommissioning, it would remain at 20 percent. This caused a big surprise because the decommissioning costs are a legitimate cost of doing business and the Supplementary Charge is a profits tax, and you expect all legitimate costs to be deductible.
The decommissioning liability over the long term will be very large, more than 30-35 billion pounds in today’s money over the next 30 years according to our estimates. Investors thus want to be reassured that they could receive tax relief for these huge costs. A big debate thus took place between the government and industry. Rather surprisingly, the government, perhaps realizing that they had done something rather untoward in 2011, has agreed to provide a contractual framework whereby the companies could receive certainty over the decommissioning tax relief that they will receive. This is a big reassurance and offers other positive side effects.
How would you recommend ensuring that the current high levels of investment lead to more fruitful exploration and production levels?
The level of field investment has been extremely high; 13.5 billion pounds in 2013, and 2014 should also be very high. This can give a misleading signal regarding what exactly is going on in the North Sea.
Firstly, there are a few extremely expensive fields being developed, including phase two of the Clair field, the redevelopment of Schiehallion, and the development of the Mariner field.
The North Sea has also been suffering from very severe cost inflation, and the huge level of investment reflects cost inflation to quite an extent. As evidence of this cost inflation, the operators of both the Bressay heavy oil field and the Rosebank field west of Shetland decided to put these fields on hold and reassess them.
Alongside huge investments in very big fields, many other fields probably do not have high profitability, even substantial ones like Rosebank and Bressay. This issue has to be recognized, as well as the very low levels of exploration, with only 15 exploration wells drilled last year. The small number of discoveries are a consequence of the small number of exploration wells. In 2013, there were only four significant discoveries, and in 2012, only three.
The Department of Energy believes that there is a long term potential of 22 billion barrels of oil equivalent, with a large part of this figure resulting from the fruits of new exploration. Encouraging exploration is also important before the infrastructure becomes so little used that it becomes uneconomic.
A lot of the exploration is also undertaken by small and medium companies who are maybe not in a tax paying position at all. Currently, if they do not have tax shelter for their costs, they can carry forward these allowances for six accounting periods. However, exploration, appraisal, and development activity could last longer than six years. In the Autumn Statement, the British government agreed to allow that for shale gas and onshore in general, the carry forward of allowances for ten accounting periods. This policy could be applied in the North Sea as well. It would give a better full cycle of return and would not cost the Treasury all that much.
How would you go about maximizing economic recovery?
With respect to maximizing economic recovery, there is now a brownfield allowance now geared to the investment costs of the project. This allowance works wells for a number of projects, but some enhanced recovery schemes, such as polymer flood or CO2 injection, have high operating costs as well. With polymer flood you may have to buy the polymers for five or six years, which creates high operating costs. There is thus some virtue in proposing an extension of the allowance to operating costs as well as investment costs for incremental projects, particularly of the tertiary recovery type. Such an allowance would be trickier to implement because it is more difficult to estimate operating costs than capital costs.
In the UKCS, there has been a proliferation of allowances for small fields, high pressure/high temperature, heavy oil fields, stranded gas fields far away from infrastructure, stranded oil fields in deep water, and the like. These allowances are really proxies for costs. I think we should move to a system where the allowances are related to expenditures, which would give a more effective economic relief. Such a system would also avoid a common situation now whereby a company that has a difficult field but does not qualify for high pressure/high temperature, asks for a new allowance for this field.
What is your vision for the O&G industry for the UK in the next decade? What is the role the university will play?
The University will undertake substantial research in the North Sea relating to enhancing oil recovery and exploration, including non-conventional exploration such as shale gas and tight gas. We will work on the economics of these issues. The North Sea is a mature province, so research and innovation will be necessary to enhance recovery. Currently in the UK, the recovery factor is about 45 percent. Increasing the recovery factor to above 50 percent will be a big effort requiring not only tax incentives, but also cost-reducing, productivity enhancing R&D as well. The University of Aberdeen certainly has plenty of expertise to contribute to such an effort.