UKCS Taxes: A Golden Opportunity to Maximise Recovery

The Treasury and DECC have asked for comments on a new investment allowance intended to replace the existing plethora of allowances for small fields, heavy oil fields, deep water fields, brown fields, and the like. Now I have to declare an interest, our company has an undeveloped oilfield that would have had a heavy oil allowance, and that allowance was a really important part of making our proposed project profitable. So I am hoping that the new allowance will be as good as, if not better than, what went before. With the oil price less than half of what it was when we applied for the licence, everybody in the industry is looking for some relief from the tax burden on their projects.

But the point I want to make in this piece is much wider than just our project. Government is about to adjust the oil and gas tax system. Whatever adjustments they make will change what companies do; and what everybody in the industry wants to be incentivised to do is to maximise economic recovery of the oil in the ground: MER:UK, as Sir Ian Wood anointed it. 

Why do we need an incentive to do that? Well, despite all appearances to the contrary, the oil industry is deeply conservative and risk averse. The popular image is of wildcatters drilling frontier exploration wells but we are an industry obsessed with managing risk out of our prospects and projects. When a new technical innovation is imagined the whole industry joins a fierce competition to be the second or third company to adopt the technology. 

So innovations such as horizontal drilling and low salinity water flooding take a very long time to become commonplace. Meanwhile opportunities to maximise recovery are bypassed and lost.

Conversely, the industry is highly skilled and very nimble at optimising its tax position, you can be sure that the brightest minds in the upstream business are waiting to examine the Treasury's proposed revisions to the rulebook to see how they can reduce their employer’s tax burden.

It seems to me that the Government should simply change the tax base for projects that really maximise recovery. That would send those tax experts running down the corridor banging on the reservoir engineers' doors and asking what projects they could propose that would cut the mustard.

The reality of maximising recovery is that the very best time to optimise and improve the recovery factor from an oilfield development is before the development project starts. There are only two factors that really matter, one is the microscopic displacement efficiency (how much oil the fluids injected can squeeze out of the pores in the rocks) and the other is the macroscopic displacement efficiency (how efficiently those fluids get into all the nooks and crannies of the reservoir). The recovery factor is simply the product of those two numbers.

Changing the macroscopic efficiency is all about numbers and type of wells; drilling infill wells is always a good, low risk, incremental investment, so as long as the field development has started, these opportunities probably won't be missed.

However, to change the microscopic displacement efficiency operators have to inject different fluids (carbon dioxide, steam, low salinity water or polymers). To do that requires early, fundamental, and brave, decisions on the part of the operator. Trial projects are not the answer, they are inevitably carried out late in field life, after the easy oil has been extracted and when the operating cost of the facilities swamp the incremental benefits. That is why EOR (enhanced oil recovery) projects have such a bad name. The best time to get these decisions right is before the reservoir starts production, not when the game is almost over.

An operator has to decide to inject something different into the reservoir; maybe even to be the first company to do that, maybe to keep injecting for three or four years before they see any sign that what they are doing is working. That all adds up to taking a risk; and the industry's stage gate processes, risk registers and peer reviews are all designed to batter risks out of projects. Trouble is, opportunities get missed too.

The Treasury's new allowance is earned as capital is spent on a project. It is an elegant simple proposal designed to get projects off the ground. What I propose is that the Treasury double the rate at which the allowance is earned for projects which are actually doing something that really improves the recovery factor.

The new Oil and Gas Authority should be charged with defining what is a conventional development and determining if a proposed development scheme does materially enhance the recovery factor. This should be a relatively black and white test: low salinity waterflood, steam flood and carbon dioxide injection all require significant capital expenditure and all are very obviously different from a conventional water injection scheme.

Change the tax rate for enhanced oil recovery (EOR) projects in the UK and the UK will be the place that operators will try their EOR schemes out.

MER:UK is a great vision, but for it to deliver at scale, projects have to be done differently; everything else is tinkering at the edges. The Government has an opportunity to transform the North Sea into the basin where every operator wants to innovate, let us hope they grasp this golden opportunity.