4 July 2022

UK oil and gas needs an economic viability test

By Harry Benham

The Government’s response to the energy price crisis has been a smorgasbord of just about everything. Further and faster on renewables, nuclear reactors, LNG imports, even a ‘fresh look’ at fracking. Perhaps the most obvious mixed message concerns the North Sea, where industry has been exhorted both to drill for more oil and gas and to invest more in the zero-carbon energy transition.

While ‘all of the above’ is perhaps understandable as an emergency response, it does not make sense on an ongoing basis. The Ukraine situation makes the near future for energy supplies and costs highly uncertain, and poor policymaking now could result in spending public money for energy resources that we will not need.

Accelerating investment in wind and solar power plus battery storage is clearly sensible. It will cut bills and pollution, create jobs and help the UK get back on track to reach climate change targets, as well as undercutting the Russian war machine. It is popular and does not need public money; given recent price reductions for wind and solar power, all government has to do is remove barriers and let the market get to work. 

By contrast, hydrocarbons are increasingly unattractive. Oil is a globally-traded commodity – 80% of UK North Sea production is exported. Electric car sales doubled globally last year, and EVs are already suppressing oil demand by one and a half million barrels per day. EV sales are increasing exponentially, and as they do the costs fall further. As oil demand falls, extraction will inevitably concentrate where it is cheapest – which most definitely is not the UK North Sea. It takes around a decade to move from exploration to production. So, by exhorting companies and investors to step up exploration and development, ministers are basically asking them to bet that oil and gas produced in one of the most expensive basins on Earth will be profitable well beyond 2030 in an era of dwindling demand. 

For gas, the outlook is little better. The UK electricity system will rely almost exclusively on zero-carbon sources by 2035, while the global rollout of heat pumps, running on electricity, is set to slash prices and stimulate the replacement of gas boilers.

The UK government knows the age of inexorable decline has begun. So does the North Sea industry. Last year, the long-standing requirement on operators to extract every economically recoverable drop from their fields was quietly modified. Now, companies have to take the cost of carbon dioxide emitted into consideration when making their calculations. Operators ‘are obliged to maximise the expected net value of economically recoverable petroleum from relevant UK waters, not the volume expected to be produced.’ And ‘economic benefit’ applies to the proposed field’s impact on the UK economy overall, rather than the company’s annual return. 

If this seems somewhat distant from the ideal of unfettered private enterprise, that is because oil and gas in the UK is in effect a public-private partnership, wrapped up in reams of agreements and licences and a crucial tax deal.

Because no-one would invest in the North Sea without a subsidy, the Government gives them one. For years, oil and gas companies have enjoyed substantial tax breaks for exploration and development. During production they pay a higher rate of taxation than other sectors, followed by a second tax holiday for decommissioning. 

In theory this should still bring a net benefit to the UK public purse, the additional tax income during production outweighing the tax breaks. However this has not been the case in recent years, such has been the slowdown in global demand: net revenues have been tiny, and sometimes negative

Last month, as part of its response to the Russian invasion, the government dramatically increased the size of the tax giveaway. Now, the public purse will effectively pay companies to explore and develop new fields – fields which, given the timescales, are vanishingly unlikely to start production before Russia’s military adventurism ends, however that happens. And the end of Russian aggression will presumably see its hydrocarbons restored either quickly or more progressively to the global market.

There is no economically advantageous outcome here for the UK. If companies explore for new resources but pull out before production begins, the public purse will have funded them for nothing. If they explore and do begin production, they are likely to be undercut by returning Russian output. Even if not, prices will remain determined by decisions made in capitals such as Riyadh – which, since before Russian tanks crossed the Ukrainian border, has been withholding far more production from world markets than any new UK fields could provide. 

Aiming to sustain and possibly increase production in a world of declining demand would create a knock-on risk in the form of decommissioning. In the past, the dominance of household names such as BP and Shell would have guaranteed that unprofitable wells would be properly decommissioned. Today output is largely owned by hedge funds and players such as China National Offshore Oil Corporation, which have no public reputation to protect. Defaults in a collapsing sector, leading to a hefty public decommissioning bill, is therefore another possible outcome of over-stimulating investment.

There is a good deal of political theatre in the government’s responses to the energy price crisis. Ministers need to show they are leaving no stone unturned in support of Volodymyr Zelenskyy. Well, fair enough – Vladimir Putin’s thugs watch the theatre too, and might even believe some of it. But the UK public deserves to have its money protected from Cabinet’s Tiggerish enthusiasm, particularly when both household and national finances are so stretched. 

In the coming months, the Government will unveil a Climate Compatibility Checkpoint. Its details and modus operandi have yet to be revealed, but the aim is to make sure that new oil and gas projects do not compromise progress towards the legally binding net zero emissions target. To protect the taxpayer, the obvious step is to complement this environmental measure with a parallel Economic Viability Checkpoint rooted in the economic assessment element of the new oil and gas strategy. 

In addition to being assessed for compatibility with the net zero target, each proposed new development would be robustly and independently scrutinised to see whether it is likely to be a net asset or a net liability to the public purse. If there is a significant risk of the latter, a licence would be denied. Projects should go through the checkpoint at least twice – before issuing an exploration licence, and again before Final Investment Decision. This would ensure that decisions are based on the latest economic and geopolitical realities, with flexibility built into the system. And that is essential; because if there is one safe prediction to make about the oil price over the next 20 years, it is that it will be unpredictable. 

Given the public’s stake in this theoretically private industry, the Government‘s duty to protect taxpayers’ interests is clear. Last year’s oil and gas strategy made this explicit, and Putin’s aggression changes nothing beyond the immediate situation. Making the checkpoint a credible, independent and adaptable test of economic viability as well as climate compatibility offers a flexible and fair triage. 

We need to neuter the Russian war machine, but Britain’s long-term public finances and future energy vision should not become collateral damage.

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Harry Benham spent 31 years working at BP and Shell. He has executive roles in energy think-tanks Ember and New Automotive, and is a Director of the new North Sea Research Group

Columns are the author's own opinion and do not necessarily reflect the views of CapX.