Chancellor pours oil on troubled North Sea

Tax breaks have brightened the mood of the UK's producers after years of decline. By Tom Bawden

The mood in Britain's oil and gas industry was so buoyant after last month's Budget, it was difficult to believe the North Sea has suffered from 12 consecutive years of rapid declines in production.

Part of the euphoria was relief that the Chancellor hadn't sprung another nasty surprise, as he did last year by slapping a multi-billion pound windfall tax on the UK oil and gas industry out of the blue.

But, instead, they got a pleasant surprise this time, as George Osborne announced new tax breaks on small and deepwater fields in the North Sea. He sweetened the day further by giving would-be investors in ageing oil fields the clarity they so desperately needed, guaranteeing hefty tax relief on the costs of decommissioning old infrastructure.

Describing the Budget as a "turning point", Malcolm Webb, the chief executive of the industry body Oil & Gas UK, declared that the new measures would prompt up to £50bn of extra investment over the lifetime of the North Sea basin. This, he predicted, would result in the recovery of an additional 1.7 billion barrels of oil and gas and generate an extra £1bn of taxes in the next five years alone.

Almost overnight – and after a dire 2011 in which oil and gas production slumped by a record 18 per cent to 1.8 million barrels a day and exploration halved – the mood in the North Sea brightened.

To put 2011's continuing decline into perspective, last year saw the North Sea producing well below its peak 1999 output of 4.5 million barrels a day.

The apparent resurrection of the UK's oil province was symbolically underlined by the return of two North Sea veterans to their roots after an absence of years. Last week, Algy Cluff, the septuagenarian resources entrepreneur who made his fortune from setting up the North Sea producer Cluff Oil in the 1970s, announced a return to his former stomping ground after years spent mining gold. He plans to raise money by listing a cash shell on the Aim market which he will use to make acquisitions.

"I find myself inclined to go back to the North Sea, where I made my first big discovery," he said. "My headmaster always said all the best things end up in the same place and I never knew what he meant. But I think I do now," Mr Cluff added.

Lord Browne of Madingley, who resigned as BP chief executive in 2007 after 41 years at the company, is also working on a plan to create a giant new North Sea oil company. Using his Riverstone investment vehicle, he is thought to be in advanced talks to buy North Sea producer Fairfield Energy.

Nor is it just the doyens of the oil industry who are looking for North Sea targets. Last week Cairn Energy bought Agora Oil and Gas, from the Rothschild family for £280m, while the Kuwait Foreign Petroleum Exploration Company is reported to be in advanced discussions to buy Ithaca Energy, owner of 22.5 per cent of the Athena oilfield in the Moray Firth, for about £500m.

"Certainly since the Budget a number of the small and mid-sized players we have spoken to are noticeably more optimistic about investment. We should see more deals as a result," says Andrew Whittock, an analyst at Liberum Capital.

The growing appetite for deals in the oil and gas industry is primarily down to a Government pledge to continue reimbursing up to three-quarters of the "decommissioning" costs of old fields, which companies must pay to dismantle and clean up when the reservoirs have run dry.

Removing fears that the tax relief could be reduced was crucial because, after decades of intensive production, many North Sea fields are nearing the end of their lives. Oil and Gas UK calculates that the guarantee to retain existing levels of decommissioning tax relief could stimulate £40bn of extra investment.

The introduction of new tax allowances for some new deepwater projects to the west of the Shetland Islands – technically in the North Atlantic, but generally lumped in with the North Sea for the purposes of Britain's oil industry – and increasing the number and value of tax breaks for smaller fields in the actual North Sea will unlock another £10bn of investment, the body says.

With such large figures being bandied around – and the UK oil and gas industry throwing cartwheels – one could be forgiven for thinking the North Sea is experiencing something of a rebirth.

Not so, the commentators say.

"Part of last year's decline in output was down to the large number of maintenance shutdowns, so it may bounce back a little this year. But the long-term trend is downwards and all the Budget will do is arrest the decline a bit," said Mr Whittock.

Although £50bn sounds like a lot, it won't make a huge difference because it will be spread over a number of years in an industry where production has been declining steadily at about 5 per cent a year, Mr Whittock added.

Moreover, Graham Stewart, the chief executive of the North Sea oil explorer Faroe Petroleum, said the Budget, while welcome, is essentially a short-term fix to the declining oil basin.

"So far the tax breaks have focussed on development and production, but this can only come through from exploration. What we need for the long term is many more discoveries to be made and for this to happen the Government needs to incentivise exploration," he added.

Many oil discoveries – inside and outside the North Sea – are made by pure exploration companies which bring in established oil producers to help extract the hydrocarbons once they are found.

Although they agree with Mr Stewart to a point, analysts argue that production-focused incentives have the knock-on effect of encouraging exploration because they increase the value of the discoveries and, in turn, the willingness of investors to take a punt on striking black gold.

When it comes to exploration, most of the attention of oil majors in the UK these days is centred on the relatively untapped "Atlantic frontier" region of the west of Shetlands – especially since the new field allowances were announced. Within days of the Budget, BP began exploratory drilling in the North Uist field, 80 miles west of Shetland, after securing a green light from the Government.

By contrast, the more mature fields of the actual North Sea are less attractive to the big players because the amounts of oil they contain is not enough to maintain their massive output.

As a result, these oilfields are moving into the hands of smaller operators, established players like EnQuest and Premier Oil and new entrants such as Lord Browne and Mr Cluff.

BP's chief executive Bob Dudley put the situation succinctly during the company's annual general meeting on Thursday. "We are divesting mature oil and gas fields that other companies can specialise in, such as in the southern North Sea," he said.

He added that "our commitment to the North Sea remains as strong as ever", signalling that BP's key focus for exploration in UK waters was west of Shetland.

Essentially, the North Sea's fortunes are mixed. While the basin will never be anything other than a shadow of its former glory, its prospects have increased as a result of the Budget and the expected continuation of the high oil price is likely to compensate for declining production.

And there is still plenty of money to be made. Individuals such as Mr Cluff could easily make new multi-million pound fortunes from the area. And by focusing on the newer segments, the oil majors can continue to produce vast quantities of hydrocarbons – albeit far less than they did a decade ago.

Oil & Gas UK forecasts that the industry stumped up £11.2bn of taxes from oil production in the year to April 2012, representing one-quarter of corporation tax. It also predicts that a further 11.8 billion barrels of oil will eventually be pulled out of the basin before it closes its doors. At current prices, that's $1,400bn (£881.91bn) worth and not to be sniffed at.