Jon Morgan

Depletion control and profitability The case of the UK North Sea

Abstract The UK government now has very considerable legislative powers to control oil and gas depletion from North Sea fields. The authors examine here the possible effects of the use of these powers. They set up hypothetical models which allow investigation of a number of possible depletion control policies operated in the context of three possible world energy scenarios. They conclude that operation within guidelines so far specified by the UK government would not seriously affect the profitability of the larger fields but that some smaller fields might be more adversely affected. Extra uncertainty and extra cuts seem bound to be generated by depletion control.

Policy towards the Depletion of North Sea Oil

The importance of North Sea oil and gas to Britain, Norway and indeed to the rest of Western Europe, was discussed in Chapter 1.1 Despite the significance of the North Sea, there is little sign that the rate at which reserves should be depleted has received more than cursory consideration, although the Norwegians have perhaps devoted more attention to depletion policy than the British. In general, ideas on depletion appear to have been dominated by vague notions that companies would, if left to themselves, produce offshore reserves too quickly, and that governments have major roles to play as regulators of output from the North Sea. Such ideas are in danger of being accepted into the popular wisdom without serious criticism, presumably because they fit in with two related, prevailing fashions — the British economic establishment’s view that government intervention is almost invariably both benevolent and advantageous to society as a whole2 and the ‘conservationist’ belief that private markets will not properly allocate resources as between present and future generations.

Tax Systems for North Sea Oil in Britain and Norway

The impact of the British offshore oil taxation system on company rates of return is examined implicitly at various places in this book.1 In Chapters 4 and 6 rates of return are estimated on several price assumptions and in Chapter 7 the effect on profitability of depletion controls is discussed: since all the net present value and internal rate of return computations are after tax (that is, after royalties, Corporation Tax and Petroleum Revenue Tax) the taxation system figures in all these calculations. In this chapter, however, the impact of the United Kingdom taxation regime on company profitability and government revenues is investigated more explicitly and compared with the corresponding regime in Norway.2 An introduction to the taxation system for United Kingdom offshore oil appears in Chapter 4 and in Chapter 9 there are some comments on the overall size of British government revenues from oil.

North Sea Oil and the World Economy

The discovery of oil in the North Sea came at a critical time in the history of the world oil market. From the genesis of the modern oil industry — generally dated at the sinking of ‘Colonel’ Drake’s well in Pennsylvania in 1859 — the industry had expanded rapidly. Wartime periods apart, world oil production had risen steadily year after year as technological changes allowed oil to take an increasing share of the energy market: from a lubricant and a fuel for lamps, it became the power-source for the increasing numbers of motor vehicles and aeroplanes, substituted for coal in electricity generating plants and in general industrial use and, by the 1960s, provided the feedstock for the fast-growing petrochemical industry: Figure 1.1 (logarithmic vertical scale) shows the growth of world oil output from 1860 to 1970. After very large percentage rates of increase in the early years the average annual compound rate of increase was near to 7 per cent from 1900 to 1970, implying an output doubling time of approximately ten years.1

The Effects of Depletion Control on British North Sea Oil

The Petroleum and Submarine Pipelines Act of 1975 gives the United Kingdom’s Secretary of State for Energy very extensive powers to regulate North Sea oil depletion rates if he decides either that it is in the ‘national interest’ to do so or if he states that there is a ‘national emergency’.1 As pointed out in Chapter 2, there are also other means by which the Government could control North Sea output — for example, by means of the Energy Act of 1976, or by the licence allocation system, or through the operations of the British National Oil Corporation. In the detailed review of depletion policy in Chapter 2 it is argued that although there is a case for a reserve power to allow the government to control production in exceptional circumstances, there is only a very weak theoretical foundation for the kind of detailed regulation which the Petroleum and Submarine Pipelines Act seems to imply.

British North Sea Oil Supplies

In the short period during which the North Sea has been recognised as an important petroleum province, many changes have taken place in the environment in which the producing companies operate.1 It has also become clear that there are considerable variations in the characteristics of the fields so far discovered; there is no such thing as a typical North Sea field and it is therefore rather hazardous to predict the nature of any future discoveries. No doubt the future holds many surprises so that one needs to be cautious about projecting North Sea supplies ahead. Much of this book is concerned with the effects on North Sea supplies and profitability of changes in the operating environment — for example, variations in taxes (Chapter 5), changes in prices (Chapter 6) and the imposition of government depletion control (Chapter 7).

World Oil Prices, Profitability and the Supply of North Sea Oil

In Chapter 1 it was pointed out that North Sea oil producers are essentially price-takers: in the foreseeable future the price they obtain for their product will be determined by the price of OPEC crude oil (adjusted for location and quality differences). This chapter examines in some detail the effect of price on the profitability of North Sea oil, using as a basis the general analysis in Chapter 4 of rates of return on given assumptions about output, costs, tax rates and prices.1 Some conclusions are also drawn about how profitability changes may affect the supply of North Sea oil.

British North Sea Oilfields: Costs, Tax System and Rates of Return

In 1976 the North Sea accounted for more than 6 per cent of all fixed investment in the United Kingdom. According to estimates discussed in detail below, about £1500 million was spent on the construction and installation of production platforms, the manufacture of associated equipment, pipelines and terminals and on development drilling, compared with total Gross Domestic Fixed Capital Formation of about £23,000 million.1 If all the potentially commercial fields described in Chapter 3 are eventually developed, investment could remain at or above these levels until the early 1980s. During that period the costs of operating the North Sea installations could rise to well over £500 million per annum. Such investments in one industry probably have no precedent in modern times in this country — perhaps only the great rail construction boom of the last century can provide a similar example of such large-scale enterprise. Then, however, the necessary finance was raised in this country: now well over half the money has come from abroad.

The North Sea, Government Policy and the British Economy

Earlier chapters of this book concentrated on positive analysis. Essentially, they set out the results of an extensive effort by the authors to collect data on North Sea oilfields, to analyse that data by devising computer programs which conform to the particular needs of the North Sea, to review and draw out implications from the relevant legislation, and to put Britain’s offshore oil into an international context. The intention is both to make progress in the applications of economic methodology in a research field where some knowledge of the technology is essential and to reveal some of the future possibilities. Although in certain places it is inevitable that one moves away from positive assessment to normative statements — as, for example, in discussing the probable impact of depletion control — the principal aim of preceding chapters is to draw logical conclusions from specified assumptions which seem appropriate at this stage of development of Britain’s offshore area. The analysis is deliberately explicit since it is the authors’ belief that, given that no one can foresee the future with any precision, those who make ‘forecasts’ have a responsibility to explain clearly their assumptions and methods so that others can substitute such other assumptions as they prefer. The large number of sensitivity tests in the book may not appeal to those who like to see a view of the future which is clear-cut (and, therefore, almost inevitably incorrect) but the estimates made here are still a gross simplification of a very complex reality.

Effects of North Sea Oil on Britain’s Balance of Payments

As explained in Chapter 1, the first discoveries of oil in the British sector of the North Sea — from 1970 onwards — coincided with the initial show of strength by the less developed oil-producing countries, which achieved a remarkable increase in their ‘take’ from crude oil between 1970 and 1975.1 In 1970, the Saudi Arabian Government’s revenues were about 90 cents for every barrel of its light crude oil sold, whereas by late 1975 they were over