The UK Treasury is set to miss out on billions in tax revenues from higher oil prices this fiscal year, as a result of tax changes that are coming under scrutiny following a recovery in production in the North Sea.

Oil prices have risen above $70 a barrel this year for a sustained period for the first time since prices fell to below $30 in 2016. In sterling terms, prices have risen even further because of the weakening pound.

But according to Financial Times analysis, UK tax revenues from the North Sea will not reach even a quarter of the amount raised in 2010 — when prices were last near this level for a prolonged period — when adjusted for lower expected production volumes.

The dramatic decline follows changes to the tax system in 2016 under then-chancellor George Osborne. The changes, which reduced the tax rate on profits, were designed to boost investment in the UK continental shelf at a time when plunging oil prices raised questions for the sector’s future.

But rising oil prices, lower costs and an increase in production over the past three years have since helped stabilise the industry.

In the autumn, Mr Osborne’s successor, Philip Hammond, will set out his latest plans for tax and spending in the annual Budget. He faces the challenge of finding an additional £20bn a year for the National Health Service by 2023 at a time when the government has a wafer-thin majority to pass tax increases.

Graham Kellas, head of fiscal research at energy consultancy Wood Mackenzie, said: “It’s going to be interesting to see if there are going to be changes by the Treasury if current prices do stay around these levels.”

But he added: “If they did decide they want to change the tax rate, the industry’s reaction will be very, very negative.”

A Treasury spokesperson said the government was always reviewing taxation, and acknowledged the role of “fiscal reform” in reducing overall revenues from the oil industry. They added that the sector “continues to deliver significant economic benefits to the UK”.

The UK oil and gas sector has been undergoing a period of dramatic transition in recent years.

Energy majors have been joined by a host of smaller operators, many backed by private equity and focused on prolonging the life of decades-old fields or tapping smaller deposits.

This has helped boost UK oil and gas output from 1.42m barrels of oil equivalent per day in 2014 to 1.63m boepd in 2017, a 14.8 per cent increase. Industry figures say the rise in output demonstrates the effectiveness of tax changes introduced by Mr Osborne.

As chancellor, he slashed the petroleum revenue tax, a levy on profits, from 35 per cent to zero. The government also cut the additional corporation taxes oil and gas companies were required to pay.

This means companies in the basin now pay a marginal tax rate of 40 per cent on profits from all fields, down from about 60 per cent for newer fields and higher than that on the oldest and biggest fields.

In 2015, allowances for investment and other kinds of expenditure were also increased, sharply reducing the proportion of profits subject to tax.

Investment and costs for oil companies ballooned between 2011 and 2014, reducing the government tax take even as prices rose.

But the industry has now managed to lower costs from an average of £19.40 a barrel in 2014 to an estimated £11.80 a barrel this year, according to the UK Oil and Gas Authority, while total expenditure on investment and exploration has fallen from £15bn to £5bn over the same period.

Even so, the impact of the changes on the public finances were not fully apparent until oil prices recovered this year.

In 2016, the Office for Budget Responsibility estimated that the tax changes would cost £225m in lost revenue, a pittance compared to the £690bn the government collects in total tax receipts.

But the OBR said at the time that there was considerable uncertainty over the projections, depending on whether the oil price or production levels changed and profits recovered.

If the government raised £10 for every barrel of oil produced, as it did in 2010 when prices were broadly comparable with 2018, the exchequer would earn £6.1bn in tax revenue, based on UK Oil and Gas Authority production forecasts and the average oil price this year of £52 a barrel.

Yet current OBR forecasts, adjusted by the FT for higher-than-expected oil prices, suggest that the UK is instead expected to earn roughly £1.2bn from oil and gas production this fiscal year, depending on costs.

This includes an estimated £500m refund of previous years’ tax receipts owing to losses during the oil slump, as well as other allowances for capital spending and decommissioning costs. The government may also earn less revenue regardless, because production has fallen fastest in older fields, which faced the highest tax rates.

Romina Mele-Cornish, fiscal policy manager at industry body Oil & Gas UK, said the group had pushed for the tax changes because they feared that production would fall sharply without incentivising new investment.

“Long term, [raising taxes] would destroy investor confidence,” she said. “The cliff edge is still with us. We need more investment. We need more drilling.”

But critics argue that the size of the cuts was disproportionate, given previous strong investment in the sector in the years preceding the downturn in prices. Business investment in the sector reached a record high of £14.8bn in 2014.

Those in favour of higher taxes on the industry also say that the recovery in output since 2014 has shown that the North Sea has the potential to stem output declines when prices are higher.

“The government is decimating the tax take and putting the UK in a really bad position to get revenues from the last drops of the North Sea,” said Stuart McWilliam at Global Witness, an advocacy group.

Source: Financial Times