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Can government have a grown-up discussion on the oil industry?

I have been harbouring a secret for several years, and the time has come to confess all.

I love Hansard. There, I said it.

I could spend days trawling through it, and an unhealthy proportion of my screen time is dedicated to it.

For those who don’t share my dirty habit, Hansard is a verbatim transcript of everything said in the UK Parliament. It is essential reading for a policy wonk and is where the nitty gritty detail of what is debated in Parliament lives.

It is also where you can really test the quality of debate among our legislators on the issues that matter to you and your community.

Been and gone

The future of the North Sea has been one of the dominant topics in parliament over the past year, largely because of the Energy Profits Levy (EPL).

Almost all of the chat has been about the windfall profits which, by the way, have been and gone. Very little time has been dedicated to the long-term implications of the fiscal instability thrust upon the sector since 2022. And absolutely no parliamentary time has been afforded to the technicalities of how the North Sea works and how threatened it now is under such a long-term tax raid.

With both Labour and the Conservatives in favour of expanding the windfall tax, our MPs owe it to the 200,000 jobs supported by offshore energy to consider these technicalities in detail. There is a real danger we will now trigger a domino effect that few have grasped – and it will result in significant job losses and astronomical costs for the UK government.

Neptune Energy's Cygnus
Neptune Energy’s Cygnus

First, there needs to be an understanding of the ownership model of our North Sea fields and the inherent vulnerability it contains.

Almost all fields are jointly-owned in the UK, which causes significant problems when one of the field partners is struggling financially.

Under a field’s Joint Operating Agreements (JOA), if one field partner cannot pay their bills then they have a very short period of remedy before they lose their rights to the revenue from the field for a period. Then, after about 60 days (different JOAs differ), they lose their rights altogether. 

Money flows

The point here is if they get into financial difficulty and cannot pay their bills, the business dies very quickly. That becomes more likely the harder it becomes to borrow money, which brings me to my second point.

Most exploration and production companies borrow money. The biggest borrow money based on the overall size of the business. The smaller ones typically have a reserved based lending (RBL) model.

This is a discounted cashflow model, so every six months the banks will determine the likely inputs – such as production and costs – then impose their own price deck. Therefore, every six months the bank borrowing base can move quite wildly. 

Labour proposes to increase the tax rate from 75%, under the current EPL, to 78%. This would reduce free cashflow by 12%, with further pain coming from the amount of tax relief you get on expenditure. At this point, you could see the number you can borrow halve or worse depending on the assumptions. 

This means companies could very quickly find themselves in a distressed situation with the banks as they would likely not be able to repay their debt.

Decommissioning

The other key moving finance piece for E&P companies is Decommissioning Security Agreements (DSA). Almost every field in the North Sea should have one of these now. Essentially, it calculates the discounted cashflow for the field under agreed parameters.

Once the future value of the field is less than the likely decommissioning cost of the field (with a risk factor) then companies have to post security. 

The big companies are normally allowed to post a Parent Company Guarantee. The smaller ones post Letters of Credit, which is effectively cash as it reduces their borrowing base.

The amount you have to post can already move significantly as you move each year nearer to decommissioning. The EPL is likely having a much bigger impact than any politician can imagine. 

The requirement for small companies to post security, in addition to challenges in accessing finance, means they probably cannot secure the funds needed. As a result, they go into default as per my first point.

And thus, the dominos fall.

On the hook

Should these small companies fold, the UK government could be on the hook for a huge financial liability. It is the last resort in funding these decommissioning obligations. This could leave the UK taxpayer on the hook for billions of pounds. And this is all thanks to mismanagement of the government of the day.

I bet the politicians are not up to speed on how that works in theory or in practice. But anyone advocating for the extension of the windfall tax should be.

And that’s the point. I suspect the politicians don’t know what a JOA, RBL or DSA is. And if they don’t, then they cannot possibly know the likely impact of their actions. 

It’s time to park the sound bites and start a grown-up discussion.

And they must remember that oil companies are happy to invest anywhere in the world. If the UK government thinks that these companies have to invest here, they are sadly mistaken.

Countries like Guyana, Suriname, Namibia cannot stop finding oil offshore. These large resources are bigger and more profitable than what is left in our basin. But we don’t seem to consider the competition at all.

Frankly, once they leave they won’t come back. And that’s where we are heading right now.

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