Last week the Chancellor offered some relief to a North Sea industry suffering from high costs and low oil prices. He didn't do it out of the kindness of his heart but rather to keep new projects coming online and to make investment in old fields that bit more attractive.
Some commentators were distinctly unimpressed as they cast around the market for the companies for whom this really mattered. There are two main reasons why they were disappointed, firstly no amount of fiddling with tax rates helps companies that are losing money on a cash basis, and secondly quite a few of the listed North Sea companies have accumulated significant tax losses (either through their own investments or clever acquisitions of someone else's mistakes) and are busy pointing out to the market that they don't expect to pay tax until sometime in the distant future; by which time the rules will have changed yet again.
There were calls for the abolition of the supplementary charge and of course that would have been great, but tax cuts for the oil industry are never popular vote winners, so the package offered is really the best we could have hoped for. The changes included a reduction in the PRT rate to 35%, a new investment allowance to replace the multitude of allowances that had sprung up when the Government realised that the uplift in the supplementary charge had stifled new investment and most welcome of all a reduction in the headline rate of the supplementary charge back down to the 20% rate at which it had been first introduced. There were other changes but since my focus is on the taxes that apply to a new project I won't go through them in detail.
For those of you who have been following what I write I had previously come up with simple charts that show roughly how value per bbl varies with oil price for North Sea projects. I will update those charts for a few projects (Lancaster, Bentley & Pilot) to show how the Chancellor's changes to North Sea taxation have helped. As always I am using a very, very simplified economic model of these fields and the calculations are based on the information in the companies' competent person's reports (CPR). If you don't believe the CPR projections, the numbers won't get any better just because I have massaged them, and if you want to know for sure how the economics of these projects actually look, then be patient and I am sure that the companies will provide the market with updated CPRs soon.
This chart shows those three projects before and after the tax changes. The thin lines are pre-budget economics and the thick lines are post-budget economics. Both Pilot and Bentley would have had the benefit of an Ultra Heavy Oil allowance so the uplift for these projects is a bit more modest than that projected for Lancaster. If you can't find the Lancaster pre-budget line, it is hiding behind the Bentley post-budget line. If you are pondering the reason why these three projects with such similar breakeven oil prices have such different responses, the answer lies in the pace at which the oil is produced. The slope of the line is a function of the effective tax rate and the length of time it takes to produce the barrels.
This chart shows the impact on value per bbl on a percentage basis. You can see even more clearly on this chart that it is Lancaster than has gained the most with the tax changes. The reason for that is because as far as I could see Lancaster was not a beneficiary of any of the previous allowances. The new investment allowance, which is just a function of the amount of capital the company invests, seems much fairer and more consistent than the previous arrangements.
You might wonder then what impact the Chancellor's announcement had on the share price of Xcite and Hurricane. Everything else being equal, assuming my calculations are right and that a long run oil price of $80/bbl applies, Hurricane's valuation improved by about 70% when the Chancellor cut SCT and gave some (tax) credit for the investment needed to bring Lancaster on stream. Hurricane's share price soared from 15.5p to 14p. Xcite had a brief moment in the sun during which their share price increased from 29p to 32p, but it was back down to 29p by the end of the day. I guess the market decided that the improved profitability of the projects increased the likelihood that these companies would raise cash by issuing shares. But if the market is right to price Hurricane at 14p now, then it should have been pricing Hurricane at 8p before the tax changes.
On the tax system, there is still room for improvement, we would like to see some method of encouraging investment in enhanced oil recovery (EOR). We think that is something that needs to be pursued right from the start of field development and, given the uncertainties that still apply when investing in EOR, some incremental tax benefit would not go amiss.