economic future of north sea gas fields

Economic Future of North Sea Gas FieldsAuthor(s): Peter LangSource: The Journal of the Operational Research Society, Vol. 41, No. 2 (Feb., 1990), pp. 119-123Published by: Palgrave Macmillan Journals on behalf of the Operational Research SocietyStable URL: http://www.jstor.org/stable/2583730 .

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J. OpI Res. Soc. Vol. 41, No. 2. pp. 119-123, 1990 0160-5682/90 S3.50 + 0.00 Printed in Great Britain. All rights reserved Copyright <1990 Operational Research Sociely Lid

Economic Future of North Sea Gas Fields PETER LANG

Woodford Green

This paper briefly describes the development and complexities of the offshore taxation system of the United Kingdom. Use of OR techniques in North Sea oil and gas field development is discussed. The economic effects of recent tragic events in the North Sea are highlighted. The economic future of offshore gas fields is analysed using an econometric model.

Key words: econometric modelling, energy

INTRODUCTION

Exploration and development of oil and gas fields, particularly underwater, is a long and expensive activity. Decisions on whether to develop a particular field rest on questions about future prices, costs and production conditions as much as 10 to 20 years ahead. Offshore developments also depend on the effects of the tax system. The economics of offshore oil and gas fields are to a large extent influenced by the tax regime. If the tax system unduly penalizes certain activities, or if it changes unpredictably, it may render the development of some offshore fields uneconomic and seriously affect the likelihood of further development of many marginal fields.

BACKGROUND

The presence of natural gas under the North Sea had been a subject of speculation among geologists for many decades. The discovery of gas at Groningen in Holland in 1959 confirmed this, and the search for oil and gas under the North Sea began. The Continental Shelf Act was passed in 1964 and the first North Sea exploration and production licences were issued, covering an area of 42,000 square miles.

In 1965, the West Sole gas field was discovered off the coast of Grimsby. In 1966, the fields now known as Leman Bank, Indefatigable and Hewett were also discovered.' The discovery of these gas fields literally changed the course of the history of the British gas industry. In 1966, the then Chairman of the Gas Council, Sir Henry Jones, announced the decision to change nationally from manufactured gas to natural gas. Simultaneously a high-pressure transmission system to transport the gas to market from the onshore reception terminals was planned. Within a short period of 10 years, the demand for natural gas tripled. Natural gas now accounts for about 40% of the total quantity of fuel used for heating in the UK.

In 1969, oil was discovered, and large-scale production began in 1975. When North Sea exploration began in the 1960s, the oil price was about $2 per barrel. Then came the first of the Middle East crises (the Yom Kippur war). By the time UK production started, prices had risen to $12 per barrel. The Government was aware that increases in oil prices could produce windfall profits for the industry. Licence royalties were charged to onshore oil fields as from 1934 and extended to the UK continental shelf in 1964. The Oil Taxation Act of 1975 introduced Petroleum Revenue Tax (PRT) as a special tax on profits from offshore oil exploitation. It was levied on a field-by-field basis at a rate of 45%.

The older offshore gas fields are treated differently from oil fields for tax purposes. Gas fields for which contracts were signed before July 1975 are exempt from PRT. This covers nearly all the Southern Basin gas fields and some gas fields in the Northern North Sea, principally those from Brent and Frigg. The reason for this differentiation has been the different pricing basis of gas compared with oil.

Gas produced from the older gas fields, such as Leman Bank, was sold exclusively to the British Gas Corporation (now British Gas plc) at prices which gave the oil companies a lower return on their investment when compared to oil. These prices have been below free-market levels; therefore, only royalties and Corporation Tax have been levied. The pricing basis for gas has now changed

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because British Gas no longer holds the monopoly buying-power which it had previously. Gas produced from the newly developed fields can be sold to other companies at free-market levels. Hence, tax concessions are not extended to these fields, and PRT is levied at the same rate as for oil-producing fields.

THE OFFSHORE TAXATION SYSTEM

Before 1975, UK oil companies had to pay royalties (set at a rate of 12-L%) and Corporation Tax, which applied to all companies in the UK. PRT, introduced in 1975, was charged at 45% of gross revenues minus the sum of accrued field losses, operating costs, royalties and 175% of the main capital costs. Inclusion of an oil allowance, which allowed one million tonnes of oil per annum to be exempt from PRT, up to a cumulative limit of ten million tonnes, was aimed at reducing the burden on smaller fields. Interest on loans is not allowed as a deduction. It was in compensation for this that the so-called capital 'uplift" of 75% of expenditure was introduced. A mechanism called 'safeguard' limited the PRT liability in any chargeable period (6 months) to 80% of the amount by which gross profit exceeded 15% of cumulative 'upliftable' expenditure.

A number of tax changes have since taken place. In the 1979 Finance Act, the rate of PRT was increased to 60%, and at the same time, the uplift on capital expenditure was reduced to 35% and the oil allowance was reduced to five million tonnes. The annual oil allowance was halved to 0.5 million tonnes. In the Finance Act of 1980, the rate of PRT was increased again to 70%. Com- panies also have to pay an advance payment equal to 15% of the assessed liability for the same chargeable period in the previous year.

A new tax, Supplementary Petroleum Duty, was introduced in 1981. This was at a rate of 20% and was deductible for PRT and Corporation Tax. The 1981 Budget also put a restriction on the period during which the safeguard concession applies. It is now available only for a period half as long again as the time it takes for a field to reach payback. The 35% uplift on capital expenditure was restricted to expenditure incurred up to the time when cumulative incomings from a field first exceed cumulative outgoings.

The 1982 Finance Bill brought more changes. Supplementary Petroleum Duty was abolished. The rate of PRT was increased to 75%, accompanied by the introduction of Advance PRT. However, in the 1983 Budget it was decided that Advance PRT was to be gradually removed. For new fields not in the Southern Basin, royalties are abolished and the oil allowance for PRT is doubled.2 Corporation Tax is to be gradually reduced to 35%. These changes produce quite an effect on the economics of oil and gas fields. In particular, the removal of royalty payments pro- vides an incentive for the development of marginal fields.

THE EFFECT OF ONSHORE TRANSMISSION

The economics of gas field development is different from that of an oil field because of two factors. First of all, oil is mainly used as a transport fuel and as a chemical feedstock, whereas gas is mainly used for heating. The demand for oil throughout the year does not fluctuate very much, but the demand for gas during the winter is more than twice the summer demand. In fact, there are both daily and seasonal variations in gas demand. Secondly, oil can be easily Transported in bulk on land by road or rail transport, whereas gas can be transported economically on the large scale by pipeline only.

Oil produced from an offshore field can be transported by pipeline or tanker to shore. The end of the line is the refinery. However, because transmission by pipeline is the only safe and economic way to transport gas, the onshore high-pressure gas transmission system forms part of the economic equation. The complexities of designing a high-pressure gas transmission system have been discussed elsewhere3 and will not be described here. It is both time-consuming and expensive to build onshore transmission lines, especially since they do not attract any of the special allowances that cover offshore equipment. Hence, two similar gas fields located at a similar distance from the shore line will have a differently value if gas produced from one of them is landed at a 'wrong' part Of the transmission system.

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OR CONTRIBUTIONS

The development of North Sea oil and gas fields is both complicated and expensive. Not many commercial ventures can be compared with these projects, where good operational research techniques are vital from the very beginning right up to the end of the project life. Virtually all types of standard operational research techniques are used in North Sea projects.

North Sea operations work to very tight schedules. Most of the repair, maintenance and non- routine work can only be done in favourable weather. This includes fabrication, hook-up and commissioning of new equipment such as production platforms. From the early design stage, critical path analysis is used to help plan the project and determine the dates when vital activities can begin or end.

No two oil or gas reservoirs behave the same. Before a decision can be made as to how best to develop a field, the reservoir engineer has to have an idea of the reservoir characteristics of the particular field. His function is to estimate the amount of hydrocarbons in place, calculate the recovery factor and be able to attach a time-scale to the recovery.4 OR simulation techniques are best suited to work out how a reservoir may behave.

Oil or gas can be produced from a field by various combinations of wells, platforms (with or without the use of compressors) and pipelines. In some cases, tankers are used as well. Although the permutations are not infinite, it is definitely not an easy task to find an optimum solution. The linear programming approach making use of the revised simplex method5 is very efficient when the numbers of variables and constraints are large. An optimum plant combination can be found quickly on a computer if a good linear programming package is available.

There are two major decision points in the exploration and production of oil and gas: the decision for exploration and, if successful, the decision to develop. Each stage requires major financial investment. Economic analysis forms an essential part of the decision-making process. Once again, operational research methods are relied upon to manipulate available data and provide the most appropriate solution. The more important areas to be examined in an economic model are: (1) pricing, (2) finance, (3) taxation, (4) project evaluation.

All the above four areas are highly complex and related to each other in one way or another. It is outside the scope of this paper to discuss in detail the methods used to tackle the various parts of economic modelling. Some of the techniques used include long-term forecasting, dynamic programming and multi-criteria decision analysis.

RECENT DEVELOPMENTS IN THE NORTH SEA

In recent years it seems that an important objective of successive governments has been to maximize tax revenues. The taxation rules governing oil and gas operations in the UK North Sea, as described earlier, have become a complex maze of provisions. An immediate problem facing the producers is how to make sound long-term economic judgements on offshore production and exploration activities.

During the past 3 years, the price of oil on the world market fluctuated wildly. On more than one occasion, the price fell to below 10 US dollars per barrel. Although this has no effect on the gas fields already in production, the fall in oil price has a strong influence on the development and price negotiations of future gas reserves. This can lead to a slowing down in the pace of exploration and production, and adds to the uncertainty about future prospects.

There had been very few oil or gas field-related fatal accidents in the North Sea up to the middle of 1988. From 1976 to 1987 the average number of fatal accidents was about 10 per year. This was considered acceptable since the estimated number of people employed on offshore installations has been over 10,000 for all years. However, what happened in the latter half of 1988 has overshadowed all previous incidents. On 6 July, the Piper Alpha platform was completely destroyed by fire. A total of 167 people were killed. This number is greater than the sum of all

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fatalities from 1976 to 1987. Later, in September of 1988, the Ocean Odyssey rig was seriously damaged by fire. It was fortunate that 66 men were rescued, but still one man died. Towards the end of December, an oil-storage vessel belonging to Shell broke loose from its moorings. Although there were no casualties, UK oil production was cut by over 10% as a result. There is now heavy pressure on the Government to legislate for improved safety. This can only mean much higher capital and operating costs, resulting in a decrease in the net present value (NPV) of most (if not all) North Sea projects.

POST TAX ECONOMICS

The offshore tax regime is something not encountered in any onshore financial projects. Hence, to evaluate a North Sea project, tax must be taken into account. A computer program has been developed to model cash flow, taxation, NPV and rate of return of North Sea oil and gas projects. Figure 1 is a cash-flow profile of a typical North Sea field with recoverable reserves of between 3 and 5 TCF (trillion cubic feet) of gas. Information input into the program, such as costs and production data, is taken from standard publications, such as Offshore Engineer.

Cash flow at constant prices (gross revenue)

by

4y-

3y T ax paid 2y

y

0

x 2x 3x 4x 5x 6x 7x Bx 9x Iox Time (years)

FIl;. 1. Cash flow and taxation profile of North Sea gasfield.

It is usual to take between 3 and 6 years from the time designs are produced to the first gas being delivered. As shown in Figure 1, there is a negative cash flow in the first few years, when most capital is spent on design, procurement, fabrication and commissioning processes. The cash flow becomes positive when gas is being produced. The amount of revenue stays constant (at constant prices) throughout the plateau production stage of the field life. As production tails off towards the end of the field life, revenue decreases quite rapidly. PRT is charged as soon as break-even is achieved. The amount of tax paid decreases slowly during the plateau stage because operating and maintenance costs gradually increase. The amount of tax charged suddenly increases near the end of the plateau stage because the oil allowance has been used up. When the production declines, so too does the amount of tax paid. However, the figure shows quite clearly that most of the profits are made in the first half of the life to the field. Towards the end of the field life, there is very little incentive to 'squeeze' every last drop of gas out of the reservoir. This is so because the oil allowance has been used up and most of the revenue ends up as tax.

THE FUTURE

As described earlier, it is most likely that capital and maintenance costs will increase for reasons of improving safety standards. But any increase in cost has a detrimental effect on North Sea development. This is illustrated in Table 1. For example, at a 10% discount rate, an increase in cost of 10% leads to a decrease in NPV of about 23%. At a 20% discount rate, the reduction in value becomes 34%.

The growth of North Sea oil revenues was the most important fiscal development in the British economy in the 1980s. In view of the unfortunate incidents in 1988, continuing the imposition of such a tax regime will deter oil companies from exploration and development of some fields, especially marginal gas fields. The result may be an overall reduction of the Government's tax

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P. Lang-Economic Future of North Sea Gas Fields

TABLE I

Percentage decrease in net present value at

different discount rates Percentage increase

in cost 10%S, 155%, 20%,

10 23 25 34 25 45 55 71

income. In an ideal world, the Government should have a coherent depletion policy, tax revenue should be stable and the tax levied entirely on profits and not on revenue.

There are many ways that the Government encourages North Sea exploration and development. A more favourable fiscal system is probably the most important. As shown in Table 2, a

TABLE 2

Percentage increase in net present value at

different discount rates Petroleum revenue

tax rate 10%'S 15%, 20%,

74 2 3 5 72 6 9 18 70 12 17 34

reduction of PRT from 75% to 74% increases the NPV of a field by at least 2%. A reduction in PRT of 5% raises the NPV by 12% or more (depending on the discount rate). North Sea oil and gas are important assets of the nation. By introducing a more progressive tax system, confidence in the industry will increase and more developments, especially of marginal fields, will take place. This will benefit both the oil producers and the nation.

REFERENCES

1. SHELL UK (1979) Exploration and Production. North Sea Gas Southern Operations, London. 2. Finance Act (1983). 3. P. LANG (1988) Transmission-system design. J. Opl Res. Soc. 39, 459-466. 4. L. P. DAKE (1978) Fundamentals of Reservoir Engineering. Elsevier, Amsterdam. 5. D. T. PHILLIPS, A. RAVINDRAN and J. SOLBERG (1976) Operations Research: Principles and Practice. Wiley, New York.

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