The strategic interaction between the government and international oil companies in the UK: An example of a country with dwindling hydrocarbon reserves Bart J.A. Willigers a,n,1 , Kjell Hausken b,2 a Palantir Economic Solutions, 56 Buckingham Gate, London SW1E 6AE, UK b Faculty of Social Sciences, University of Stavanger, 4036 Stavanger, Norway HIGHLIGHTS c The 2011 UK hydrocarbon tax increase is likely to cause overall value destruction. c Governments are unlikely to benefit from reducing their decommission liabilities. c Differences in payoff functions of producers and shippers control the game. c The distribution of reserves and decommissioning cost is a key factor in the game. article info Article history: Received 7 February 2012 Accepted 30 January 2013 Available online 6 March 2013 Keywords: Game theory UK tax regime Decommission liabilities abstract The 2011 UK tax rise on hydrocarbon exploitation activities obviously increases short term tax revenues however the longer term effects are less clear. The strategic interaction between the UK government, a producer and a shipper has been analyzed in a game theoretical model. A complex interaction between players is expected given (1) dwindling resources and large decommissioning liabilities and (2) the fact that much of the hydrocarbons produced in the North Sea are exported through an infrastructure with shared ownership. The 2011 UK tax adjustment will most likely result in value destruction for the government, producers and shippers. Our analysis suggests that governments are unlikely to ultimately benefit from reducing their decommission liabilities at the expense of International Oil Companies. In countries with unstable tax regimes, such as the UK, International Oil Companies will adopt their strategies in anticipation of future tax changes. Their adopted strategy is a function of decommissioning liabilities and remaining reserves as well as whether they are producers, shippers or producers and shippers. The ultimate payoff of a government is a function of the remaining reserves and total decommissioning liabilities, but also depends on the distribution of these value metrics between producers and shippers. & 2013 Elsevier Ltd. All rights reserved. 1. Introduction In March 2011 the UK government announced a fiscal change of increasing the tax burden on oil and gas exploitation activities. The impact of the tax amendment is not identically felt by each of the International Oil Companies (IOC) active in the UK. The type of operations (hydrocarbon production versus hydrocarbon shipping) and the exposure to abandonment liabilities are important differ- entiators regarding the impact experienced by an IOC. As a consequence of these differences one can expect a range of reactions and changed policies from the IOCs operating in the UK. In this study the strategic interaction between the government, an oil producer and a player who produces oil and operates an infrastructure has been analyzed in a game theoretic framework. The UK tax amendment relates to an increase of the Supple- mentary Charge (SC) from 20% to 32% (see Appendix A for details on the UK tax regime). This SC increase raised the headline rate of tax paid by the industry on the profits of Petroleum Revenue Tax (PRT) paying fields to 81%. Although the increased tax burden adversely affects the profits of oil and gas producers, the greatest concern expressed by the industry relates to the perception of the stability of the UK petroleum fiscal regime (Muslumov, 2011). Oil & Gas UK, a not-for-profit organization for the UK offshore oil and gas industry, stated that ‘‘The tax increase was wholly Contents lists available at SciVerse ScienceDirect journal homepage: www.elsevier.com/locate/enpol Energy Policy 0301-4215/$ - see front matter & 2013 Elsevier Ltd. All rights reserved. http://dx.doi.org/10.1016/j.enpol.2013.01.054 n Corresponding author. Tel.: þ44 118 9356940; fax: þ44 118 9353484. E-mail addresses: [email protected] (B.J.A. Willigers), [email protected] (K. Hausken). 1 Now at BG group. 2 fax: þ47 51 831632; fax: þ47 51 831550. Energy Policy 57 (2013) 276–286
Transcript
Energy Policy 57 (2013) 276–286
Contents lists available at SciVerse ScienceDirect
Energy Policy
0301-42
http://d
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E-m
kjell.hau1 N2 fa
journal homepage: www.elsevier.com/locate/enpol
The strategic interaction between the government and internationaloil companies in the UK: An example of a country with dwindlinghydrocarbon reserves
Bart J.A. Willigers a,n,1, Kjell Hausken b,2
a Palantir Economic Solutions, 56 Buckingham Gate, London SW1E 6AE, UKb Faculty of Social Sciences, University of Stavanger, 4036 Stavanger, Norway
H I G H L I G H T S
c The 2011 UK hydrocarbon tax increase is likely to cause overall value destruction.c Governments are unlikely to benefit from reducing their decommission liabilities.c Differences in payoff functions of producers and shippers control the game.c The distribution of reserves and decommissioning cost is a key factor in the game.
a r t i c l e i n f o
Article history:
Received 7 February 2012
Accepted 30 January 2013Available online 6 March 2013
The 2011 UK tax rise on hydrocarbon exploitation activities obviously increases short term tax
revenues however the longer term effects are less clear. The strategic interaction between the UK
government, a producer and a shipper has been analyzed in a game theoretical model. A complex
interaction between players is expected given (1) dwindling resources and large decommissioning
liabilities and (2) the fact that much of the hydrocarbons produced in the North Sea are exported
through an infrastructure with shared ownership.
The 2011 UK tax adjustment will most likely result in value destruction for the government,
producers and shippers. Our analysis suggests that governments are unlikely to ultimately benefit from
reducing their decommission liabilities at the expense of International Oil Companies. In countries with
unstable tax regimes, such as the UK, International Oil Companies will adopt their strategies in
anticipation of future tax changes. Their adopted strategy is a function of decommissioning liabilities
and remaining reserves as well as whether they are producers, shippers or producers and shippers. The
ultimate payoff of a government is a function of the remaining reserves and total decommissioning
liabilities, but also depends on the distribution of these value metrics between producers and shippers.
& 2013 Elsevier Ltd. All rights reserved.
1. Introduction
In March 2011 the UK government announced a fiscal change ofincreasing the tax burden on oil and gas exploitation activities. Theimpact of the tax amendment is not identically felt by each of theInternational Oil Companies (IOC) active in the UK. The type ofoperations (hydrocarbon production versus hydrocarbon shipping)and the exposure to abandonment liabilities are important differ-entiators regarding the impact experienced by an IOC. As a
ll rights reserved.
x: þ44 118 9353484.
Willigers),
consequence of these differences one can expect a range ofreactions and changed policies from the IOCs operating in theUK. In this study the strategic interaction between the government,an oil producer and a player who produces oil and operates aninfrastructure has been analyzed in a game theoretic framework.
The UK tax amendment relates to an increase of the Supple-mentary Charge (SC) from 20% to 32% (see Appendix A for detailson the UK tax regime). This SC increase raised the headline rate oftax paid by the industry on the profits of Petroleum Revenue Tax(PRT) paying fields to 81%. Although the increased tax burdenadversely affects the profits of oil and gas producers, the greatestconcern expressed by the industry relates to the perception of thestability of the UK petroleum fiscal regime (Muslumov, 2011).Oil & Gas UK, a not-for-profit organization for the UK offshore oiland gas industry, stated that ‘‘The tax increase was wholly
Fig. 1. Development of the present value of remaining tax revenue and the
present value of the decommission liability of the UK government.
B.J.A. Willigers, K. Hausken / Energy Policy 57 (2013) 276–286 277
unexpected and completely at odds with the Government’sassurances in public and private conversation that it understoodthe industry’s need for a stable fiscal regime which providedcertainty for investors’’ and ‘‘after the third major increase in therate of taxation in 9 years, the UK is now regarded as one of themost unstable oil and gas provinces in the world by manyinvestors.’’3
The development of the Laggan and Tormore gas fields west ofthe Shetland Islands underscores the frustration of the oil and gasindustry with the UK government. In 2010 the UK treasuryintroduced a capital allowance for the gas reserves under the deepand hostile waters of the UK Atlantic margin that include the Lagganand Tormore fields. In doing so the UK government recognized theeconomic challenges that the industry faces when developing theseresources. When in March 2010 the UK Government gave consent toTotal and Dong Energy to develop the Laggan and Tormore gas fieldsBusiness Secretary Lord Mandelson commented that: ‘‘The recentinitiative by the Treasury in extending Field Allowance to such fieldshas been particularly importanty’’.
In an interview in July 2011 Patrice de Vivi�es a Total seniorvice president, stated ‘‘We launched three gas investments lastyear [2010] in the UK, and the Laggan-Tormore development wasdecided in light of tax incentives received’’ and he added ‘‘TheSpecial Corporate Tax increase has fully offset the field allowancesreceived. Would it have been anticipated, there would have beenno project, with the consequences on the development of theWest of Shetlands.’’4
The industry is also worried whether the tax relief thatpresently exists on decommissioning costs will prevail in thefuture. In reference to decommissioning liabilities, Oil & Gas UKstated t‘‘Contrary to what the Budget suggests, we believe thatsuch a measure [increasing the tax rate and not increasing the taxrelief) will only raise concern about further detrimental changesto the regime and underlines industry fears that future Govern-ments could renege on their obligations.’’ Nothing in the aban-donment legislation mandates a payment from the Treasury(Whyatt, 1991) and it is quite possible that the Government willrefuse to pay its part once it is presented with the enormous costof the abandonment of large numbers of fields and infrastructureelements. With regard to the SC, the 2011 Budget indicates thatthe Government will restrict tax relief for decommissioning to the20% rate. Therefore the reliefs will not be available against the12% increase. The aim of this measure is to avoid incentivizingaccelerated decommissioning. Losses attributable to decommis-sioning are also given special treatment.
The first studies that investigated the impact of decommis-sioning cost on late-life North Sea field economics appeared over20 years ago (e.g. Griffith and Cox, 1986; Kemp, 1992). Since thesepublications were written the importance of the decommissioncost as a value driver has dramatically increased. The North Seahas become much more mature as an oil and gas producing basinand the number of fields that approach their end of life hasincreased (see Appendix B for details on the UK oil and gasindustry). In addition, the decommission costs of the oil and gasinfrastructure has escalated significantly. In 1988 the total cost ofabandonment was estimated at £4.4 billion (Kemp, 1992), theestimated costs were increased to £30 billion in 2011.5 Oil andGas UK6 estimated that about 75% of the increase over the pastdecade is the result of escalating cost whilst the remaining 25%results from the employment of new infrastructure.
In the fiscal year 2010–2011 the UK government receivedabout £9.3 billion in the production taxes.7 Fig. 1 shows thedevelopment of the present value of remaining tax revenue andthe present value of the decommission liability for the UKgovernment. The analysis assumes that tax revenue declinesannually by 10% as hydrocarbon production declines. It isassumed that the government pays 62% of the total decommissionliability, amounting to £30 billion, in 2040. This simple analysissuggest that in 2028 the present value of decommission liabilityand tax revenue in the UK are equal at about £6 billion.
Most of the North Sea oil and gas production is exported from theproducing fields by a system of pipeline, hubs and onshore terminals.In many cases, the players that own and operate the infrastructureare different from those players who produce the hydrocarbons(Willigers et al., 2010a). Infrastructure owners receive a paymentfor the services they provide to the user-fields. The economicimportance of commercial agreements between the hydrocarbonproducers and shippers (those who transport and process hydro-carbons) has been widely recognized in the industry8 and althoughseveral studies investigated the economic dynamics between user-fields and hosts (Willigers et al., 2009, 2010a, 2010b), these studiesdid not include the government as a player.
Several studies (Vernon, 1971; Moran, 1974; Smith and Wells,1975; Hosman, 2009) investigated the relationship and bargain-ing interface between governments and multinational corpora-tions. These studies investigate the early stages of the regionaldevelopment of a mineral exploitation industry. That situation isvery different from the mature E&P industry presently operationalin the British part of the North Sea which is analyzed in this study.
The game theoretic analysis developed in this study providesinsight in the impact of a perceived unstable tax regime in amature oil and gas producing basin such as the North Sea. Theproposed model illustrates the impact on the ultimately recov-ered reserves and realized value.
2. The model
2.1. Outline of the game
We consider two operational oil fields U and H. Operationsinclude some or all of the following activities: production ofhydrocarbons, transportation and processing of hydrocarbonsproduced by player U, and transportation and processing of
B.J.A. Willigers, K. Hausken / Energy Policy 57 (2013) 276–286278
hydrocarbons produced by player H. Player U, the user field, ownsand produces field U and exports its production using thefacilities of field H owned by player H. Player H, the host, ownsand produces field H and exports its production using its ownfacilities. Player G is the government and receives tax paymentsfrom player H and player U on the profit of their operations.All variables and assumptions are captured in Table 1.
The three players can choose the following strategies in eachtime period t, t¼0,1,y,N.
Player U: Choose the last time period TU from the strategy setTU¼{0,1,y,N} in which to produce.Player H: Choose the last time period TH from the strategy setTH¼{0,1,y,N} in which to operate.Player G: Choose the tax rate tt from the strategy set tt¼{tb,tr},where tb is the base tax rate and tr is the reduced tax rate,trotb.
We define T as the last time period where production occurs inboth fields U and H.
If TU¼TH¼T, both fields are decommissioned in period t¼T.The three players are then active in periods t¼0,1,y,T, and arenot active in periods t¼Tþ1,Tþ2,y.If TUoTH, player U terminates production in period t¼T. PlayerU produces in periods t¼0,1,y,T, and does not produce inperiods t¼Tþ1, Tþ2,y. Player H operates and player G
imposes tax in periods t¼0,1,y,TH, and do not produce andimpose tax in periods t¼THþ1, THþ2,y.If THoTU, player H terminates production in period t¼T. Thethree players produce and impose tax in periods t¼0,1,y,T,and do not produce and impose tax in periods t¼Tþ1, Tþ2,y.In periods t¼Tþ1, Tþ2,y TU, player H operates exclusively asa transportation-processing facility.
The decision by player G to change the tax rate impacts theprofits of players U and H and thus the strategic choices byplayers U and G.
The game ends in the following manners:
1)
TabPar
P
ty
G
P
P
Player H terminates production and continues operationstrictly as an oil transportation and processing infrastructure.After player H terminates production, player U pays player H to
le 1ameters and assumptions for players U and H in period t.
arameter
pe
Parameter Symbol Value
lobal Oil price Pt $1
Base tax rate tt¼tb 80%
Reduced tax rate tt¼tr 40%
Discount rate per period dt 10%
layer H Initial base production rate at t¼0 qH 100 bbl/period
Production decline rate dtH
10%/period
Abandonment cost hub DH $0rDHr$5,000
Cost to be shared between players U
and H
CHt $75/period
Uplift M 10%
layer U Initial base production rate at t¼0 qU 100
Production decline rate dtU
10%/period
Payment to player H SUt 0rSUtrCHt
Abandonment cost field DU $0rDUr$5000Kem
continue the transportation and processing of oil produced byfield U. Player U pays the total cost of operating field H plus anuplift to this cost. The game ends in the period player U cannotcarry the total cost.
2)
Player U terminates production. After the exit of player U, thegame ends in the period player H cannot carry the total cost.
A strategy in which the government increases tax has not beeninvestigated. In the recent tax ruling the tax rate increased but thedecommission allowance was left unchanged suggesting that it isunlikely that future tax raises will increase the decommissionallowances. Without an impact on decommission costs we con-sider the strategy of tax increases trivial as it will clearly benefitthe player G at the expense of player H and U.9
2.2. Formal description of the game
Player U’s payoff is
f U ¼XTU
t ¼ 0
ðRUtPt�CUt�SUtÞð1�ttÞdtU�DUð1�ttÞd
TU
U ð1Þ
where Pt is the oil price in period t, Cit is a cost for player i inperiod t, tt is the tax rate and di is the discount rate per period forplayer i. Di is the cost to decommission the field infrastructurewhich is incurred by player i in period Ti. Ti is defined below. SUt isthe payment player U makes in period t to the host, player H, forits services provided. The payment allows the host to recover itsexpenses for the provision of services. Rit is the oil produced byplayer i in period t.
Analogously, player H’s payoff is
f H ¼XTH
t ¼ 0
ðRHtPt�CHtþSHtÞð1�ttÞdtH�DHð1�ttÞd
TH
H ð2Þ
where SHt is the payment that player H receives from player U.Player G’s payoff is
f G ¼XTU
t ¼ 0
ðRUtPt�CUt�SUtÞttdtG�DUtt d
TU
G
þXTH
t ¼ 0
ðRHtPt�CHtþSHtÞttdtG�DHttd
TH
G : ð3Þ
Given that Rit and Pt are multiplied in the payoff functions forall three players a proportional change in either variable has anidentical impact on each payoff.
The production in field i fully owned by player i at the time t is
Rit ¼ qidti ð4Þ
where qi is the production at time zero for player i and di is aparameter, 0rdir1, that expresses how the production of field i
decreases over time.The payment SUt is proportional to the total amount of oil
processed and transported by the host multiplied by a propor-tional profit margin M generally referred to as uplift, i.e.
SUt ¼ SHt ¼ð1þMÞCHtRUt
ðRUtþRHtÞ: ð5Þ
The value of delaying payment of the decommissioning costfor player i for one period is
DDi ¼ Dið1�ttÞ dti�Dið1�ttþ1Þ d
tþ1i : ð6Þ
9 NPV is used as the decision metric opposed to NPV@10%/I@10% used by
p and Stephen (2011).
B.J.A. Willigers, K. Hausken / Energy Policy 57 (2013) 276–286 279
Assuming tt¼ttþ1 Eq. (6) can be reorganized as
DDi ¼ Dið1�ttÞdti ð1�di Þ: ð7Þ
Given that Di is constant for all periods, t can be rebased att¼0. Replacing dt
i with d0i ¼1 in (7) gives
DDi ¼ Dið1�ttÞð1� diÞ: ð8Þ
Player i will be operational in all periods when the following istrue:
ðRitPt�Cit�SitÞð1�ttÞþDDi40 ð9Þ
where the first term is the same as the first term in (1) for oneperiod, and the second term is the positive value of delayingpayment of the decommissioning cost one period. Inserting(8) into (9) and simplifying gives
ðRitPt�Cit�SitÞþDið1�diÞ40: ð10Þ
Above we defined T as the last time period where productionoccurs in both fields U and H, which means that both players earnpositive payoff. Applying (10) for both players thus gives
T ¼Min
X1
t ¼ 0
1ðRUtPt�CUt�SUtþDUð1�dUÞ40Þ,
X1t ¼ 0
1ðRHtPt�CHtþSHtþDHð1�dHÞ40Þ
0BBBB@
1CCCCA
ð11Þ
where 1(C)¼1 if C is true, and 1(C)¼0 if C is false. As productionRit decreases over time, while costs continue to be incurred, oneof the inequalities within the Min() sign in (11) will eventuallynot be satisfied causing this player to terminate production.
Player U terminates production before player H when
ToX1
t ¼ 0
1ðRHtPtþSHt�CHtþDHð1�dHÞ40Þ ð12Þ
which gives SUt¼SHt¼0 starting from period t¼Tþ1. This means thatplayer U provides no payment to player H and impacts player H’s costCHt. Player H continues production as the sole player until period
TH ¼ TþX1
t ¼ Tþ1
1ðRHtPt�CHtþDUð1�dHÞ 40Þ: ð13Þ
Player H terminates production before player U when
ToX1
t ¼ 0
1ðRUtPt�SUt�CUtþDU ð1�dUÞ40Þ ð14Þ
which gives RHt¼0 starting from period t¼Tþ1. Inserting RHt¼0into (5) gives SUt¼(1þM)CHt. Player H now exports player U’sproduction without being a producer itself. That is, the host fieldis strictly a transportation-processing facility. Player U continuesproduction as the sole player until period
TU ¼ TþX1
t ¼ Tþ1
1ðRUtPt�SUt�CUtþDUð1�dUÞ40Þ: ð15Þ
3. Results
The dynamics of the game has been analyzed by simulating anumber of scenarios. For each scenario three sets of results areshown in Table 2. The data labeled ‘‘Fixed tax’’ are the resultsassuming a fixed, i.e. constant tax rate. Data labeled ‘‘Variable taxno reaction’’ show the results after player G optimizes the tax rateprior to the strategic reaction of player U and player H. The thirddata set labeled ‘‘Variable tax with reaction’’ represents thenatural outcome after player U and player H have had anopportunity to react to a tax change imposed by player G.
A range of natural outcomes as a function of several selectedvariables is shown in the figures below.
3.1. Fixed tax
Scenario 1 shows (Table 2) that, given a fixed tax rate, bothplayer H and player U produce hydrocarbons for 18 periods andeach player produces a total volume of 1416.6 barrels. Scenario1 differs from the base case, scenario 2, by the lack of decom-missioning cost, DHi. The inclusion of $100 decommissioning costfor player U and player H extends the number of producing periodfrom 18 to 31. This extension of production reflects that the lossin each of the periods between periods 19 and 31 is less than thepresent value of delaying decommissioning with one period. Inthese periods Eq. (10) and the following is true for player U:
RUtPt�SUt�CUt o0 ð16Þ
and Eq. (10) and the following are true for player H:
RHtPtþSHt�CHt : ð17Þ
In scenario 3 player H has a decommission cost of $400 andplayer U has no decommissioning cost. Player U will abandon thefield in period 18, the first period that the cash flow turns negative.Given that player U will not contribute to the shared cost, CHt, in thesubsequent periods player H would make a loss if its operationswould proceed. Hence player H will also terminate operations inperiod 18. In scenario 4 player U has a decommissioning cost, DU, of$400 and player H has no decommissioning cost. Given that player U
pays uplift, M, to player H, the payoff of player H is positive inperiods 19–31. Hence player H and player U remain operational tillperiod 31. Scenarios 5 and 6 demonstrate that the number ofproducing periods for player H is extended if the decommissioningcost for player U or player H is increased to $2000. Eq. (10) holds forplayer U in all periods in scenarios 5 and 6 and decommissioning offield U is indefinitely deferred. Eq. (10) holds for player H in scenario6 causing an indefinite delay of decommission of field H. It is,however, obvious that these are strictly theoretical scenarios.
The payoff for player G is not only dependant on the overallproduction realized in the game but also depends on the dis-tribution of total production amongst player U and player H. Fig. 4shows the payoff for player G as a function of total abandonmentcost for three assumptions for initial production of player H, qH.The initial production is used as a measure of production realizedin the game. The total initial production of players U and H is fixedat 200 bbl/period (qUþqH¼200 bbl/period). In all three scenariosfor qH the payoff for player G decreases as the total decommissioncosts incrementally increases from $0. As the decommissioningcost further increases the payoff for player G reaches a minimum.This minimum has a different value in the three scenarios and isalso reached at different values for the total decommissioningcosts. As the decommissioning cost increases fields will beproducing for a longer period and the amount of oil that isultimately produced is increased. The payoff for player U isreduced under the burden of increased decommissioning cost.Although player H also pays an increasing decommissioning cost,this increase is offset by a larger payment it receives from playerU (Fig. 3). The payoff realized by player G deflects from adecreasing trend to an increasing trend once the increasing payofftrend of player H offsets the decreasing payoff trend of player U.
As a higher proportion of total production is realized by playerU the minimum payoff for player G is reduced (compare thescenarios shown in Fig. 2). In contrast to player U, player H doesnot pay an uplift on the cost share, hence player H has a lowercost base than player U. Given its lower cost base player U canrealize a larger amount of produced oil.
In scenarios with a very high total decommission costs theplayers U and H will adapt a strategy of extending operations tillinfinity (also see scenarios 5 and 6, Table 2). In this strategy theplayers will not pay for decommissioning hence the payoff of the
Table 2Modeling results.
Fixed tax Variable tax no reaction Variable tax with reaction Deltaa
Scenario 1: Players H and U have no abandonment liability, Di
Assumptions Hub fH
72.9 72.9 72.9
0.0
qi 100P
RH
1416.6 1416.6 1416.6
0.0
di 0.03 TH
18 18 18
0
CHt 100 Field fU
40.1 40.1 40.1
0.0
M 0.2P
RU
1416.6 1416.6 1416.6
0.0
DH 0 TU
18 18 18
0
DU 0 Government fG
452.1 452.1 452.1
0.0
Scenario 2: Base case
Assumptions Hub fH
73.7 70.7 71.2
�2.5
qi 100P
RH
2060.0 2060.0 1744.4
�315.7
di 0.03 TH
31 31 24
�7
CHt 100 Field fU
35.8 28.8 35.3
�0.6
M 0.2P
RU
2060.0 2060.0 1744.4
�315.7
DH 200 TU
31 31 24
�7
DU 200 Government fG
438.3 448.4 425.9
�12.3
Scenario 3: Player H has all the abandonment liability, Di
Assumptions Hub fH
58.5 58.5 58.5
0.0
qi 100P
RH
1416.6 1416.6 1416.6
0.0
di 0.03 TH
18 18 18
0
CHt 100 Field fU
40.1 40.1 40.1
0.0
M 0.2P
RU
1416.6 1416.6 1416.6
0.0
DH 400 TU
18 18 18
0
DU 0 Government fG
394.52 394.52 394.52
0.00
Scenario 4: Player H has all the abandonment liability, Di
Assumptions Hub fH
75.8 76.9 75.3
�0.6
qi 100P
RH
2060.0 2060.0 1744.4
�315.7
di 0.03 TH
31 31 24
�7
CHt 100 Field fU �2.5
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33.7 22.6 31.2
M 0.2P
RU
2060.0 2060.0 1744.4
�315.7
DH 0 TU
31 31 24
�7
DU 400 Government fG
438.3 448.4 425.9
�12.3
Scenario 5: Player H has a large abandonment liability, Di
Assumptions Hub fH 53.3 14.1 14.1
�39.2
qi 100P
RH 3424.3 3424.3 3424.3
0.0
di 0.03 TH N N N
0
CHt 100 Field fU 40.1 40.1 40.1
0.0
M 0.2P
RU 1416.6 1416.6 1416.6
0.0
DH 2000 TU 18 18 18
0
DU 0 Government fG 373.6 412.9 412.9
39.2
Scenario 6: Player U has a large abandonment liability, Di
Assumptions Hub fH 81.1 92.9 92.9
11.7
qi 100 fH 3424.3 3424.3 3424.3
0.0
di 0.03P
RH N N N
0
CHt 100 Field TH 28.6 7.2 7.2
�21.4
M 0.2 fU 3424.3 3424.3 3424.3
0.0
DH 0P
RU N N N
0
DU 2000 Government TU 439.1 448.8 448.8
9.7
Scenario 7: Players U and H have a three times larger initial production rate, qi
Assumptions Hub fH
384.6 384.6 384.5 0.1
qi 300P
RH
8960.1 8960.1 8602.7 �357.4
di 0.03 TH
69 69 61 �8
CHt 100 Field fU
344.7 344.5 344.7 0
M 0.2P
RU
8960.1 8960.1 8602.7 �357.4
DH 200 TU
69 69 61 �8
DU 200 Government fG
2917.3 2917.6 2916.9 �0.4
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32
,64
9.4
�3
14
.7
di
0.0
3T
H
10
91
09
10
2�
7
CH
t1
00
Fie
ldf U
14
28
.91
42
8.9
14
28
.90
.0
M0
.2P
RU
32
,96
4.2
32
,96
4.2
32
,64
9.4
�3
14
.7
DH
20
0T
U
10
91
09
10
2�
7
DU
20
0G
ov
ern
me
nt
f G1
1,5
91
.01
1,5
91
.01
1,5
91
.00
.0
aT
he
de
lta
isth
ev
alu
ed
iffe
ren
ceb
etw
ee
nth
e‘‘F
ixe
dta
x’’
an
dth
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ari
ab
leta
xw
ith
rea
ctio
n’’.
400.0
410.0
420.0
430.0
440.0
450.0
460.0
0 1000 2000 3000 4000 5000
fG (
in U
SD)
Total decommisioning cost (in USD)
qu = 200qu = 133.33qu = 66.67
Fig. 2. The payoff for player G given a fixed tax rate, tb and the total initial
production rate of players U and H equals 200 bbl/period (qUþqH ¼
200 bbl=period). Player U pays a third of the total decommissioning cost (DU/
(DHþDU)¼0.333).
-210
-160
-110
-60
-10
40
90
140
190
0 500 1000 1500 2000 2500 3000
NP
V (i
n U
SD
)
Total decommisioning cost (in USD)
Production revenue
Operating cost
Cost share revenue
Decommisioning cost
Fig. 3. The NPV for player H decomposed in four elements. Player U pays a third of
the total decommissioning cost (DU/(DHþDU)¼0.333) and qH¼66.67 bbl/period
and qU¼133.33 bbl/period.
350.0
370.0
390.0
410.0
430.0
450.0
470.0
0 1000 2000 3000 4000 5000
fG (
in U
SD)
Total decommisioning cost (in USD)
Du/(Du + DH) = 1
Du/(Du + DH) = 0.667
Du/(Du + DH) = 0.333
Du/(Du + DH) = 0
Fig. 4. The payoff for player G given a fixed tax rate, tb, an initial production rate
of 200 bbl/period for player U (qU ¼ 200 bbl=period) and an initial production rate
of player H of zero (qH ¼ 0 bbl=period).
B.J.A. Willigers, K. Hausken / Energy Policy 57 (2013) 276–286282
game is not impacted by a further increase in decommissioningcosts. These conditions are met in the horizontal sections of thegraphs shown in Fig. 2.
The distribution of decommission cost between players U and H
also affects the payoff for player G (Fig. 4). The curves in Fig. 4represent four different distributions of decommission costs betweenplayer U and H. For a given amount of total decommission costs the
400.0
410.0
420.0
430.0
440.0
450.0
460.0
470.0
0 200 400 600 800
fG (
in U
SD)
Total decommisioning cost (in USD)
qu = 200
qu = 133.33
qu = 66.67
qu = 1
Fig. 5. The payoff for player G given a variable tax with reaction. Player U pays a
third of the total decommissioning cost (DU/(DHþDU)¼0.333).
B.J.A. Willigers, K. Hausken / Energy Policy 57 (2013) 276–286 283
payoff for player G increases as the contribution of player U to thedecommission cost increases. The relationship reflects the incentiveand the ability of player U to share some of the benefits of continuedoperations with player H by paying an uplift to player H (analogs toscenario 4, Table 2). The consequential additional tax payment madeby players U and H explains the increased payoff for player G.
3.2. Variable tax no reaction
Player G will adjust the tax rate to its advantage hence thepayoff for player G, fG, is higher or equal when comparing the‘‘Variable tax no reaction’’ scenarios with ‘‘Fixed tax’’ scenarios(Table 2). On the contrary the payoff for player H, fH, and player U,fU, is generally reduced (Table 2).
3.3. Variable tax with reaction
Although player G has the option to change the tax rate,players U and H can anticipate the strategic choice of player G
and adapt their strategic choices accordingly. Player U and H caneither opt for an early field decommissioning prior to when theanticipated tax change occurs or they can choose to continueproduction. The base case (scenario 2, Table 2) shows thatalthough the payoff of player G increases after the tax rate isreduced (‘‘Fixed tax’’ versus ‘‘Variable tax no reaction’’) thispositive effect for player G is more than offset once player U
and H anticipate player G’s strategy and reduce the number ofproducing periods (‘‘Variable tax with reaction’’). The naturaloutcome of the game is that the payoff for all three players isreduced and player G suffers the largest absolute loss in payoff.Although accelerated decommissioning by players U and H canalso be observed in scenarios 7 and 8, the reduction in payoff inthis case is minimal. Scenarios 7 and 8 assume high initialproduction rate, qi, three times and ten times as large as in thebase case scenario 2. Eq. (4) shows that high qi causes a highamount Rit of oil produced by player i which, when RUt¼RHt, isequivalent to a high oil price Pt. As a consequence of high initialproduction rate, qi, the impact of the strategic choices of theplayers occurs far in the future. Hence the effect in terms ofdiscounted cash flows is minimal (scenario 8, Table 2). A gamewith a natural outcome in which the payoff for player G increasesoccurs when player U and/or player H pursue a strategy to delayfield decommission indefinitely (scenarios 5 and 6).
In the natural outcome of the game player G will switch thetax rate in the first period in which its total tax income turnsnegative. This situation occurs when the following is true
ðRUtPt�CUt�SUtÞþðRHtPt�CHtþSHtÞo0: ð18Þ
As decommission costs are not considered in player G’s choice ofstrategy the timing of this switch is independent of the decommis-sion costs. Players U and H will pay a larger part of the decom-missioning cost if they choose to maintain operational at the lowertax rate, tr. Hence, unless Eq. (10) is true for player U and player H,the individual players will choose to terminate operations anddecommission their fields in the period prior to the period in whichthe tax change is anticipated. Figs. 5 and 8 show the payoff of playerG for the natural outcome of the game as a function of thedecommission costs, Di. The payoff of player G decreases as thedecommissioning cost for players U and H incrementally increasesfrom zero. The four curves qU¼1qU¼0 shown10 represent differentinitial production rates for player U and a fixed amount of total
10 qU¼1 is shown opposed to qU¼0. Given that player U will exit the game
at t¼0 if player U has no initial production we consider this to be a trivial
game.
production: qHþqU ¼ 200 bbl=period11 (Fig. 5). The trend ofincreasing payoff for player G with a decreasing proportionalproduction of player U is the same as shown in Fig. 2 and is causedby the same dynamic (see Section 3.1). As the decommission costincreases the differences in payoff of player G decreases and thecurves for the four qU values in Fig. 5 converge to a straight line witha negative slope. This straight line closely corresponds to the curveassociated with qU¼1. The points where the curves join this straightline correspond with the decommission costs where the players Uand G will execute the decommisioning of their fields in the periodprior to the period in which player G reduces the tax rate.
The linear decreasing payoff for player G, as the decommissioncosts increases, continues until the following is true:
RUtPt�SUt�CUt ¼DUð1�dUÞ: ð19Þ
At this point player U will switch strategy from early abandon-ment to an indefinite delay of decommission. Although at thispoint the both strategies have an equal payoff for player U theprolonged payment SUt has a substantial positive impact on thepayoff for players G and H. This positive effect in player G’s payoffis shown as an upward jump for each of the four values of qU
(Fig. 6). As the initial rate, qU, increases Eq. (19) will hold forhigher values of DU, hence the jump in payoff for player G willoccur at higher values of total decommission cost (Fig. 6).
The anticipation of players U and H that player G will pursue astrategy of lower tax prevents player G, in general, from benefit-ting from this strategy (Fig. 7). The reaction of players U and H onthe anticipated tax change tends to result in a payoff reduction forplayer G. Only in the situation in which decommissioning isindefinitely delayed player G will benefit from this strategy(Fig. 7).
4. Discussion
4.1. The impact of the Budget 2011 tax change
In the days after the announcement of the increased SC underBudget 2011 shares of the UK oil and gas producers lost almost £2billion in value and some experts believe that the ultimate costfor these companies could be as high as £10 billion.12 It is a
11 Given that the decline rate is the same for both players the overall possible
production is identical in all four scenarios in shown in Figs. 7 and 8.12 www.telegraph.co.uk/finance/budget/8402612/Budget-2011-10bn-oil-in
dustry-tax-grab-wipes-2bn-off-shares.html and www.guardian.co.uk/uk/2011/
Fig. 6. The payoff for player G given a variable tax with reaction. Player U pays a
third of the total decommissioning cost (DU/(DHþDU)¼0.333). The rectangle
indicates the area shown in Fig. 5.
300.0
320.0
340.0
360.0
380.0
400.0
420.0
440.0
460.0
0 500 1000 1500 2000
fG (
in U
SD)
Total decommisioning cost (in USD)
Constant tax Variable tax with reaction
Fig. 7. The strategic choices of players U and H tend to prevent player G to benefit
from the strategy of tax reduction. Player G’s strategy only results in an increased
payoff if player H and U delay the pay out of decommission cost indefinitely.
DU/(DHþDU)¼0.333, qH¼133.33 bbl/period and qU¼66.667 bbl/period.
B.J.A. Willigers, K. Hausken / Energy Policy 57 (2013) 276–286284
challenging task to estimate the impact of this tax change to thevalue of producing assets, but it is still much more difficult toevaluate the effect of the tax alteration on the progression of E&Pprojects in the UK and the reduction in recoverable reserves.
If one would assume that Net Present Value (NPV) is the soledecision metric and that any project with a positive NPV warrantsan investment from an economic perspective, one could arguethat the UK tax adjustment in 2011 should not have affectedinvestments in E&P development programs given that the sign ofan NPV, for a fixed cash flow, is independent of the tax rate.However many IOCs use hurdle rates on the return on investedcapital as an additional decision metric. Using hurdle rates Kempand Stephen (2011) reported that the 2011 UK tax changes wouldincrease tax revenue with £51.6 billion but would also result in aproduction loss of 2254 million boe.13
The results of this study suggest that even if NPV were the soledecision metric used by IOCs the recent tax changes can have adetrimental effect on the future hydrocarbon production in theUK. The 2011 tax change is the most recent example of a largenumber of fiscal adjustments that undermines the trust ofinvestors in the future stability of the UK tax regime. As aprogressively large number of producing fields approach their
13 Kemp and Stephen reported several scenarios, the numbers quoted here
refer to an investment criterion of NPV@10%/I@10%Z0.5, a future oil price of 90$/
bll and a future gas price of 70 pence/therm.
decommissioning date the incentive for the UK government tochange the tax regime and alleviate itself from the decommissionliabilities will increasingly grow. As the analysis in this studysuggest the UK government risks facing an early decommission-ing of producing fields by players anticipating a tax ruling thatwill increase IOC’s exposure to decommission costs. The pursuitof this strategy by IOCs will result in a reduction of the hydro-carbon resources that ultimately will be recovered in the UK.
4.2. The impact of increased oil prices
Given that the amount of oil production, Rit, and oil price, Pt,are multiplied in the payoff functions for all three players, aproportional change in either variable has an identical impact oneach payoff. Thus a proportional change in hydrocarbon priceshas an identical impact on the game as the same proportionalchange of the initial base production rate at time t¼0 whenqi¼qU¼qH and di¼dU¼dH, see Eq. (4). A three fold increase in oilprice will, just as a three fold increase of the initial rate (scenario7, Table 2), delay the strategic interaction related to the abandon-ment liabilities. This delay causes the effect in terms of dis-counted cash flows to decrease. Apart from an increased payofffor all three players the fundamental game dynamics do notchange with increasing Rit or Pt. The anticipation of players U andH regarding player G’s strategy results in a loss of seven periods ofproduction in each of the three scenarios on Rit or Pt (scenarios 2,7 and 8, Table 2).
In reality, however, the game dynamics are expected to be muchmore complex. All equipments used in hydrocarbon recovery aredesigned and built to deliver safe and reliable operations over acertain life span. If the operations are to be extended beyond thisdesigned life span additional investments will be required. Theseadditional costs might offset the benefits of upward trending oilprices. Future profitability is also expected to be negatively affectedby the positive correlation between hydrocarbon prices and costsincurred by the operator (for example oil prices correlate with rigrental rates and steel prices; see Willigers (2009)).
The results presented here suggest that (some) UK players mightconsider an early abandonment of operations in the light of taxuncertainty. Under these conditions it is hard to envisage that thoseplayers would be willing to make pre-investments which wouldenable them to capitalize on more favorable future market conditions.
4.3. Producers and shippers in the North Sea
The two player types, producers and shippers, investigated inthis study can be reconciled with the IOCs currently operating inthe UK. Large players that operate the largest pieces of infra-structure represent the shipper- or shipper and producer-typeplayers. These players have been modeled as Player H. Examplesof major infrastructure include Forties Pipeline System owned byBP, SEAL Pipeline (Shearwater Elgin Area Line) owned by Shell andExxon and Frigg Pipeline System owned by Total. Much of theinfrastructure was installed to export hydrocarbons from thelargest fields in the North Sea. Declining production of thesefields resulted in spare capacity in these systems. This availablecapacity created an opportunity for other producers to utilizeexisting infrastructure and commence production from newfields. These new entrants in the North Sea are typically smallerplayers (Appendix B) and represent the producer-type player.These players have been modeled as player U. Given this dynamicin the North Sea a general distinction can be made between (1)large players that ship and produce hydrocarbons and have largeabandonment liabilities and (2) small players that producehydrocarbons and have much smaller abandonment liabilities inboth absolute and relative terms.
0200400600800
1000120014001600
Ann
ual p
rodu
ctio
n (M
MB
OE
)
Year
Forecast
Small players
Medium players
Large players
Exxon
Shell
BP
1969
1972
1975
1978
1981
1984
1987
1990
1993
1996
1999
2002
2005
2008
2011
2014
2017
Fig. 8. Hydrocarbon production in the UK by different types of players. Large players¼Total, British Gas, Conoco-Philips, Hess, Chevron, ENI, Talisman; Medium
Fig. 9. Hydrocarbon production in the UK by different sized fields.
B.J.A. Willigers, K. Hausken / Energy Policy 57 (2013) 276–286 285
5. Conclusions
In many mature hydrocarbon producing basins, such as the UKNorth Sea, high decommission costs are expected to be incurredin the coming decades. Given this situation governments will betempted to adjust tax regulations in order to alleviate themselvesfrom their decommissioning liability. However, particularly incountries where petroleum tax rules have been changed fre-quently International Oil Companies are anxious about suchfuture tax rulings. Companies might opt for early decommission-ing of their hydrocarbon producing fields especially of thoseassets carry a large decommissioning liability. Such early cessa-tion of production will ultimately result in a lower payoff for bothcompanies and governments. So in addition to the uncertaintyrelated to the value of remaining recoverable reserves, uncer-tainty regarding the stability of the local tax regime will becomean increasingly important driver in corporate decision making.
Economic dependencies that result from the sharing of oil andgas export and processing facilities between different playersincrease the complexity of the game. The payment structure forprovided services between fields as well as differences in remainingreserves and decommission liabilities within a cluster of fieldsintroduces an asymmetry between players. This asymmetry impactsstrategic preferences of governments and International Oil Compa-nies and hence affects the ultimate outcome of the game.
Appendix A. UK petroleum tax regime
The current UK fiscal regime has three main components14:
14 www.hmrc.gov.uk/international/ns-fiscal2.htm.
�
Petroleum Revenue Tax. � Ring Fence Corporation Tax. � Supplementary Charge on ring fence trades.
Petroleum Revenue Tax (PRT) is field-based and seeks to tax ahigh proportion of the economic rent (super-profits) from theexploitation of the UK’s oil and gas. PRT is currently charged at50% on profits after a series of allowances. PRT for new fielddevelopment was abolished on 16 March 1993 hence current PRTcharges are limited to fields that were sanctioned before thatdate. Ring Fence Corporation Tax (RFCT) is the standard corpora-tion tax that applies to all UK companies with the addition of a‘‘ring fence’’. The ring fence prevents companies to apply any formof relief from other business activities to RFCT. The rate ofCorporate Tax (CT) is currently 30%.
Companies also pay a Supplementary Charge (SC) on theirprofits from a ring fence trade. In the Budget 2011 the SCincreased from 20% to 32%. This SC increase raised the headlinerate of tax paid by the industry on the profits of PRT paying fieldsto 81%.
Appendix B. Oil and gas production in the United Kingdom
North Sea oil and gas exploitation started in 1965 when BPdiscovered the West Sole field. In 1975, just a decade later, thegiant Ekofisk-, Forties- and Brent fields had been discovered andNorth Sea hydrocarbon production had started.
Hydrocarbon production gradually increased from the 1970sto the mid-1980s. The vast majority of UK production in thisperiod was derived from a small number of giant fields. After 5years of stagnating production, oil and gas production graduallyincreased from the early-1990s till a maximum annual produc-tion of 1.4 billion BOE was achieved in 2002 (Fig. 8). In this periodan increasingly large proportion of production was derived from
B.J.A. Willigers, K. Hausken / Energy Policy 57 (2013) 276–286286
smaller fields with recoverable reserves smaller than 150 millionBOE. The contribution of these smaller fields to UK hydrocarbonproduction was insignificant in the 1970s but account for over60% of production in 2002 (Fig. 8). Since 2002 production hasfallen and a production level of 0.8 billion BOE is expected for2016.15
As an increasingly large part of production was derived fromsmaller fields an increasing number of smaller-sized companiesstarted operations in the North Sea. In the 1970’s production byBP, Shell and Exxon accounted for over half of UK’s North Seahydrocarbon production. Since 2002 their share of total UKproduction has fallen below 30% (Fig. 9).
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