Scotland's Independent Expert Commission on Oil and Gas: report

2. The UKCS Investment Climate

Key messages:

• Investment in UKCS field development is at record levels
• Exploration activity and production levels are at a record low
• Challenges remain to ensure long-term and sustained investment at all levels in support of the achievement of MER and maximum TVA
• It is critical that Government and industry recognise and adapt quickly to the market forces currently prevailing in the UKCS and the global oil and gas sector

Changing Dynamics of the UKCS

A Maturing Basin

1. The first oil and gas licences were granted almost 50 years ago.

2. Since production began the oil and gas industry has made a substantial contribution in the form of tax receipts to the UK Exchequer, paying more in corporation tax than any other industry. It is the largest industrial sector of the economy, in terms of its contribution to GDP and industrial investment.

3. The industry's impact is further reflected by the significant contribution it has made and continues to make to the UK balance of payments and the employment it generates. Oil and Gas UK estimates that the sector now supports 450,000 jobs across the UK, with half of those in Scotland.

4. The presence of the oil and gas industry in the UK has led to the creation of a sophisticated supply chain to service the offshore industry. There is now a cluster of world class companies headquartered in Scotland and the UK with key strengths in areas such as facilities and project management, subsea technologies, well-management and training services.

5. The sector has an on-going role to play in ensuring security of supply, and in support of the transition to a low carbon economy. In 2012, the oil and gas industry produced 67% of UK oil demand and 53% of gas demand, and it is predicted that in 2030, oil and gas will still provide 70% of the UK's primary energy requirements. ^[11]

6. Initially the very largest international oil companies were attracted by the scale of the prospects. It required their financial and technical capability to develop and exploit the resources in fields such as Forties and Brent.

7. These fields required infrastructure to export production to market. This integral infrastructure underpins current and future production, and requires continued investment to ensure it remains fit for purpose.

8. Through the adoption of new techniques and technologies, the industry has continued to evolve, pushing the boundaries of possibility within the UKCS. This has enabled higher levels of recovery of proven resources, extended field life and increased estimates for total recovery in the basin.

9. One particular example is the Forties field:

Box 2 : Field Life Extension - Forties Field

• The Forties field, discovered by BP in 1970, contained an estimated 4.2 to 5.0 billion barrels of oil, with production peaking at over 500,000 barrels per day (boe/d).
• When Apache purchased the field in 2003 it was estimated to have 144 million boe of proven reserves remaining and production was expected to cease in 2012.
• However, as a result of the transfer of ownership and a new innovative approach to enhancing production efficiency, the field has produced nearly 200 million boe since 2003, with 114 million boe of proven reserves remaining ^[12] .

10. As a mature province, the UKCS now faces a new set of challenges, but these must be seen within the context of the huge potential that still exists through the extension of brownfield recovery and through exploration and exploitation of frontier areas such as West of Shetland.

11. In light of the substantial opportunities that continue to emerge, investment in UKCS field development is currently reported to be at record levels. In its 2014 Activity Survey, Oil and Gas UK confirmed that in 2013, the UKCS experienced the highest rate of capital investment for more than three decades at £14.4 billion with investment more than double 2010 levels. ^[13]

12. The corporate profile of the basin has changed considerably and the fiscal and regulatory regimes have evolved on an incremental basis to keep up with the transformation that is underway. The changing and varied nature of investment in the UKCS reflects the changing and varied nature of the opportunities.

13. All of these factors have an influence on the current investment outlook and underpin the opportunities and barriers that the sector currently faces.

14. There is now growing competition internationally from many new and growing offshore regions. Government must recognise the need for a fundamental change in approach, from one which sought to control access to a sought after resource, to one which seeks proactively to attract investment through creating the right fiscal and regulatory conditions.

Regulatory Regime

15. The changing dynamics of the basin are contributing to a more complex commercial environment. This by its nature requires a more proactive stewardship model in order to realise the full potential of the UKCS. The Wood Review highlighted that the current model of stewardship is not adequately resourced or empowered to perform this role and advocates for the creation of a new arm's length Regulator to rise to this challenge.

16. The Commission recommends that the new Regulator must have enhanced resources and powers to encourage, and, if necessary, enforce the necessary collaboration between operators and with the supply chain, to overcome the challenges facing the UKCS. The emphasis of future regulation should be low on bureaucracy and high on quality, proactive stewardship.

17. The new Regulator will not have responsibility for Health, Safety or Environmental Regulation - which has been established in the UKCS as a robust, world-leading regime. However, it should be noted in this context that effective policy implementation and compliance in Health, Safety and Environmental Regulation has the potential to contribute greatly towards the achievement of MER and TVA through enabling, not impeding, activity and investment, and building on the aim of making the UKCS the safest place to explore for and produce oil and gas worldwide.

Fiscal Regime

18. The offshore fiscal regime applying to the UKCS should set a stable and internationally competitive investment environment, allowing maximum long-term value to be achieved.

19. Stability, predictability and international competitiveness should be the key principles underpinning the fiscal regime, facilitating the delivery of long-term investment to Maximise Economic Recovery and maximise the generation of TVA over the life of the province.

20. Alongside this, the key objectives must be to collect a fair share of the economic rents for the state, while encouraging investment in exploration, development and production. However, the current system has become very complex in the way that it targets these twin objectives.

21. Since the turn of the century, a relatively short period in the life of a major petroleum province, the UKCS has witnessed three major tax increases. All of these took the industry by surprise and were followed by the gradual introduction of several field allowances for the Supplementary Charge and a range of other changes. Investors are as a result very conscious of the instability and unpredictability of the regime.

22. The various field allowances are designed to encourage investment in new fields and have made a significant positive contribution. However, at the time when investors are appraising projects, it is often unclear whether a field allowance will be available for a specific project. Negotiations with Government often take place on a case by case basis and have uncertain outcomes. This does not facilitate swift decision-making or adequate transparency for investors.

23. The result is a highly complex offshore tax system. For mature fields developed prior to March 1993 the headline tax rate is 81%, with Petroleum Revenue Tax ( PRT) being charged at 50% on those fields. For fields developed after 1993, the headline rate is 62%, with Corporation Tax ( CT) at 30%, and Supplementary Charge ( SC) at 32%.

24. Effective rates are often significantly lower because of the application of field allowances. However, it tends to be the headline rates which attract greatest attention from potential investors.

25. Oil prices have increased substantially over the last decade and there has been rapid cost inflation in the sector. With the average size of discovery declining and a prevalence of costly HP/HT, heavy oil, and tight gas fields the investment environment has become more challenging.

26. Against this background, there is a clear need to align the taxation system to the current and emerging environment. This requires a scheme which ensures, not only that projects which are economic before tax remain commercially acceptable after tax, but that licensees contemplating long-term investments can be confident that their tax liabilities will be reasonably predictable.

27. The system should incorporate an inherent and appropriate flexibility in response to external factors, particularly oil and gas price fluctuations and cost changes. This requires the system of allowances to be responsive to such changes.

28. In designing the structure for the longer term it may also be appropriate for the relationship between headline tax rates and allowances to be reconsidered. In this context it is important to recognise that the great majority of future fields are likely to receive a field allowance, albeit that this cannot be predicted with certainty. This prompts the suggestion that lower tax rates with modified allowances could incentivise new developments whilst producing a simpler system.

Requirement for Sustained Investment

29. In order to unlock the full potential of the UKCS and maximise TVA, it is critical that Government and industry recognise the market forces currently prevailing in both the regional and global oil and gas environment.

30. The remainder of this chapter therefore considers the key areas of UKCS activity that require sustained investment and highlights the key challenges now facing the sector, which are having or are likely to have an impact on future levels of investment.

Exploration and Appraisal

31. The number of exploration wells being drilled across the UKCS has fallen to critically low levels and this is damaging the potential for future new field development. Exploration over the past three years has been at its lowest since 1965. OGUK cite the shortage of rigs and access to finance as the two key reasons for this current low level of activity.

32. Exploration and appraisal drilling decreased from 53 wells in 2012 to 44 in 2013. The decline is due mainly to a drop in exploration drilling from 22 wells in 2012 to only 15 in 2013 and expenditure fell by £0.1 billion to £1.6 billion ^[14] .

33. Commenting on the decline in exploration in the UKCS, the latest Oil and Gas UK Activity Survey stated: "Exploration drilling has been on a downward trend since it first fell sharply in 2009 due to the collapse in oil price and the financial crisis which impacted the exploration and production sector. There was a further sharp fall in 2011 coinciding with the increase in the Supplementary Charge." ^[15]

34. Alongside low levels of activity, exploration success has also been low, with less than 150 mboe of new resources being discovered in the past two years. This is well below the potential level of resources still believed to be recoverable.

35. A number of reasons for this have been identified, including;

• Prospective discoveries are considered too small to satisfy the materiality requirements of large operators;
• Smaller operators have encountered difficulty raising capital for exploration;
• Lack of availability and high cost of drilling rigs;
• Lack of appropriate targeted fiscal incentives for exploration;
• Difficulties relating to the availability, sharing and quality of seismic and other subsurface data;
• Concerns over fiscal stability and predictability; and
• Poor resource management ( e.g. not pooling rig requirements).

Field Development

36. Against the backdrop of record levels of investment it is important to recognise that recent high levels of investment expenditure are concealing the significant challenges the industry currently faces at the field development phase.

37. The number of wells drilled for development/production purposes has declined significantly since the early years of this century. In 2001 as many as 286 development wells were drilled, but in the period 2009-2013 the annual rate has been in the range of 120 to 131 ^[16] .

38. According to OGUK field investment is likely to fall sharply over the next few years ^[17] . It is important to develop a clear understanding of the reasons for this prospective reduced investment, which are varied depending on the investor's perspective, and the specific issues that need to be addressed in undertaking a project.

39. This prospective underinvestment demonstrates to some extent investors' perception of the future of the UKCS, and its competitiveness in global terms.

40. The Commission is of the view that the barriers to investment in this area can and should be overcome. Enhancing the level of exploration, appraisal and development activity and the success rates achieved will be key factors in the overall longevity of the basin.

41. Factors impacting upon reduced investment in field development include:

• Access to finance;
• Uncertainty over tax allowances;
• Access to infrastructure;
• Global competition for investment;
• Smaller less commercially viable fields; and
• Escalating costs.

Production and Efficiency

42. In 2013 production averaged 1.43 million boe per day but many operators expect it to rise in 2014. Oil and Gas UK's central case assumes that production will rise gradually to around 1.7 mboe per day in 2018 ^[18] due to new field start-ups and fields coming back on stream.

43. However, production on the UKCS has fallen by 38% over the past three years, amounting to 500 mboe per day. It is believed that around 360 mboe of this decline was lost due to decreased "production efficiency" ^[19] , which has fallen to record lows. This is costing industry and Government billions of pounds in lost revenue and jeopardising the long-term sustainability of the basin.

44. DECC estimate that production efficiency on the UKCS has fallen from 81% in 2004 to just 60% in 2012. This trend is supported by McKinsey analysis, which shows that over the past decade, asset production efficiency has declined by over 1 percentage point a year across the North Sea and is now at record lows in both the UK and Norway. ^[20] There are only four live Enhanced Oil Recovery ( EOR) schemes being employed currently in the UKCS, which suggests that the basin is under performing in this area.

45. The industry has started to respond through initiatives now underway by joint government-industry bodies like PILOT and its Production Efficiency Task Force. The value generated through tackling the production efficiency challenge in the UKCS would be considerable. This is true not just of the associated increase in current production and revenue, but also in extending field life across the UKCS.

46. Production efficiency rates are expected to rise going forward, contributing to the more optimistic outlook for production rates. However, significant new investment and attention is now needed to be paid by the operators and by the new Regulator, in order to improve production efficiency to the required levels.

47. Factors contributing to the decline in production and production efficiency levels include:

• Inadequate stewardship by the regulator;
• Lack of investment in new infrastructure and in maintaining existing infrastructure;
• Inadequate investment in inspection, maintenance and repairs by operators;
• Lack of development and use of EOR and other technologies for improving recovery rates;
• Insufficient oversight of development plans and their impact on overall UKCS production, such as access to infrastructure issues negatively impacting on development decisions; and
• Low levels of collaboration between operators.

Specific Barriers to Investment

48. Despite record levels of investment by the industry, there are a number of specific investment challenges and opportunities that must be considered. The key issues impacting on the sustainability of UKCS investment are considered in turn below.

Escalation of costs

49. A prominent issue for industry is the underlying escalation of costs in the basin. The UKCS is a mature province, therefore remaining oil and gas resources are likely to be in smaller accumulations, in more expensive frontier areas such as West of Shetland, or characterised as HP/HT, heavy oil, or tight gas. New developments will face increased complexity and higher cost. Much of the straightforward oil and gas resources have been developed, and the future fiscal and regulatory framework needs to recognise these factors.

50. The large increase in capital expenditure in recent years is therefore due in part to the relatively high costs of several large projects, which include field extensions and redevelopments as well as incremental recovery projects.

51. It is estimated that the development cost per barrel has risen fivefold in the last decade ^[21] reflecting falls in the average size of new fields and significant cost inflation. Operating expenditure in 2013 rose by 15.5% to an all-time record of £8.9 billion, ^[22] whilst production fell. Average unit operating costs are now £17/boe and the number of fields with an operating cost of more than £30/boe has doubled in the last year. ^[23]

52. Whilst this expenditure contributes valuable income to the wider supply chain, it adds to the operator's costs and reduces the attractiveness of the UKCS for investment.

53. These rising costs come against a backdrop of a flat oil price and a gas price which is around 50-60% of the oil price. The return on prospective investment has therefore reduced and with it the competitiveness of UKCS investment internationally due to the increased cost of development per barrel.

Decommissioning costs and uncertainty

54. Another factor impacting investment now and in the future is the decommissioning of facilities and infrastructure in the UKCS.

55. Decommissioning represents both a major challenge and a major opportunity for oil and gas operators and the supply chain. Oil and Gas UK forecast that cumulative decommissioning expenditure will reach £40.6 billion (2013 prices) by 2040, and it accounted for 3.5% of total spend in 2013. ^[24]

56. The UK Government's introduction of the Decommissioning Relief Deed and the Scottish Government's confirmation it will honour that commitment in an independent Scotland is most welcome. However, evidence suggests that escalating decommissioning cost estimates are still impeding negotiations on the transfer of assets to new players able to delay the need to decommission.

Access to Finance: The changing nature of investors

57. The nature of UKCS investment is changing. There are examples of large fields in late-life being passed on to smaller companies with the ability and cost base to gain ever increasing recovery factors. The need for smaller specialists in exploration, development and production, has very much broadened the scale and business models of companies investing in the UKCS.

58. Access to finance has long been an issue in the upstream oil and gas industry, which the global financial crisis brought more sharply into focus. For the UKCS this has coincided with a general requirement to broaden the investor base and attract agile, entrepreneurial, and therefore often smaller, players. This is essential to ensure that the prevailing challenges of improving recovery from existing fields and the development of more difficult oil and gas fields are overcome and economic recovery is maximised.

59. Government needs to be aware of and develop policies that will help investors in this environment. Policies must address access to finance issues in relation to a company's balance sheet as well as in relation to the costs it incurs and the revenues it generates. This will help to ensure that both reinvestment and new investment are attracted to enhanced recovery from existing fields, as well as new exploration and development.

60. Government can seek to encourage banks and providers of equity finance to provide finance to the oil and gas sector - through the Business Investment Bank for example. A positive business environment created through the fiscal and regulatory regime will also help to alleviate these issues.

Access to Skills

61. The competition for scarce talent in the UK and internationally, within oil and gas companies and the broader supply chain, is constraining the market and affecting productivity and costs. The undesirable consequences of greatly-inflated wages, an over-reliance on a contractor workforce, and continued poaching need to be fully understood.

62. With high demand for skilled labour there is a lack of clarity in relation to the respective roles and responsibilities for skills development and delivery.

63. There has been too great a focus on employing skills rather than developing sustainable skills to meet the future needs of the industry. This has resulted in a tendency towards short-term solutions and recruitment strategies to attract skilled, qualified and experienced personnel, rather than on enhancing the stream of talent coming through from schools, colleges and universities. This is a recruitment culture which has perpetuated skills shortages and driven salary and employment cost inflation in the sector.

64. Whilst there are existing centres of excellence in areas such as subsea, these are not backed by the skills development infrastructure needed to consolidate and secure future advancement of existing and yet to be developed centres of excellence.

Development and uptake of new technologies

65. The level of oil and gas related research and development being undertaken in the UK has been consistently well below the level of the UK's main competitors.

66. Government focus on R&D in oil and gas has been primarily directed at the level of the oil majors. Investment by Government has as a result been gradually withdrawn since the late 1980's, and this has been matched by low levels of investment in R&D by the industry.

67. Whilst it is very difficult to quantify, it is estimated that investment by oil and gas companies in R&D is around a third of the UK average at 0.3% of sales ^[25] . This is compared with the UK average of 1.1% and the Norwegian average of 4%.

68. Despite this underinvestment across the whole industry and particularly by the indigenous supply chain, the industry has achieved a strong performance in certain areas, such as sub-sea technology. With a relatively small re-investment by Government in growing or developing areas to stimulate the competitiveness of the UK supply chain, substantial returns and spill-over benefits could be generated.

69. Whilst many domestic companies have continued to thrive, developing and bringing innovation and new technology to the market, the absence of Government led investment and the catalysing effect it can have, is likely to be a factor in the UK continuing to trail the US, Norway and France in supplying the global industry.

Access to and lack of investment in infrastructure

70. The ability of 3rd parties to access appropriate infrastructure for the purposes of field development, exports and exploration is currently being inhibited by a lack of stewardship from the Regulator, and by the cost of accessing such infrastructure.

71. Terms and tariffs are largely determined by the owner of the assets and set in line with narrow commercial interests. There are examples of protracted negotiations and failures to reach agreement, contributing to further driving up costs in the basin and prohibiting valuable activity from taking place.

72. A proactive approach to ensuring 3rd party access to infrastructure has the potential to turn what is currently a barrier to investment in to an enabler of increased recovery and value generation.

73. The impact of inadequate levels of infrastructure maintenance activity on production in recent years has been stark. It is very important that existing critical infrastructure is maintained to an appropriate standard to enable the extension of its life prior to decommissioning. This will also facilitate further field development and exploration through the use of that infrastructure.

74. Stimulating and accelerating production, field development and exploration will provide the incentive for further investment in infrastructure, which in turn can enhance the economics of marginal fields.

Legal and Commercial constraints

75. The Wood Review cites the UKCS as being seen as 'one of the most difficult and adversarial legal and commercial basins in the world', characterised by 'risk aversion to the detriment of value creation'.

76. As a basin it presents a complex scenario for entrants in terms of the Fiscal, Regulatory and Licensing regimes, which raises the cost of entry and impedes investment. The approach of operators and the Regulator currently lacks the required focus on or interest in MER and TVA.

Lack of sharing of information and data

77. The ability for new explorers to access existing seismic and well data is hampered by an unwillingness from operators to readily share this information, and a lack of involvement from the Regulator in facilitating this to encourage investment, increase exploration activity and prevent the need for repeat or additional unnecessary expenditure to gather already acquired data.

78. The acquisition of new data can be very expensive and there is a lack of collaboration on the part of the operators to share these costs and the results proactively.

Instability in the fiscal regime

79. The oil and gas sector exhibits characteristics that require special consideration in terms of economic policy and taxation. These characteristics include: revenue streams which are inherently uncertain and are secured over the long-term, significant up-front and decommissioning costs, and a range of technical and financial risks. The efficient collection of economic rents in practice has to reflect these complexities.

80. Translating this into a practical tax system has proved to be a fraught subject over many years, resulting in the current system in the UKCS which is now very complex in its operation due to its ad hoc development in response to specific short-term issues.

Overcoming the Barriers

81. In order for the UKCS to attract the sustained investment it needs and to ensure the full value from the UKCS is attained, oil and gas must occupy a prominent place within a cohesive energy policy. The short-term approach of Government to policy, fiscal management and ministerial and official appointments contrasts with the inherent long-term perspective that is taken by industry in making investment decision and planning.

82. In recognition of the economic opportunity that the UKCS still represents, Government strategy needs to be highly ambitious and well-balanced to encompass the needs and strengths of the industry as a whole. The broader energy policy framework must fully acknowledge this economic aspiration.

83. Through further discussion of an appropriate stewardship model and fiscal and regulatory regimes for the UKCS, this report will outline how many of the challenges and barriers identified in this chapter can be addressed.