Brown must ease tax pressure on oil firms to ensure supplies

WE need to buy time to find alternative sources of energy as production continues to fall.

WHILE everyone was fuming about the big, first-quarter profits posted by Shell and BP this week, the real story got lost. Shell actually pumped 6 per cent less crude year on year (though you have to dig deep into the company report to discover that fact). In fact, Shell's output of petroleum has been falling for several years and the company refuses to say when it might rise.

Shell is betting much of its future on extracting oil from Canadian tar sands. But this is a complicated and expensive technology so it comes as no surprise (again buried in the small print) that production fell by a whole 25 per cent due to "operational issues at the mine related to extreme cold weather conditions and unplanned maintenance".

In the case of BP, the company warned "if oil prices remain at $100 per barrel, we expect 2008 reported production to be broadly flat compared with 2007". In other words, even if we see record high prices throughout the rest of the year, BP won't be able to pump more oil and gas. The company also noted it had already "ramped up" several production fields last year, with the implication it couldn't get any more on line in the immediate future, no matter what we pay at the pumps.

The lesson is clear. Whether you view Shell and BP as rapacious multinationals, or as hi-tech companies working desperately to keep our lights on, both are finding it difficult to produce the very commodity on which they depend for a livelihood. A business where output is static or falling is not one with a long-term future.

For the record, we are not about to run out of oil immediately. Current output is around 87 million barrels per day and we could push that up by another 20-30mbpd over the next couple of decades. However, this merely buys us time to replace petroleum in our lives. All the cheap, easy-to-exploit oil has long since been found. Significant new finds are increasingly rare and expensive to exploit. Which makes nonsense of Gordon Brown's call for Shell and BP to invest their profits "in getting more oil out of the North Sea".

North Sea oil production peaked in 1997 and has fallen every year for the past five years. As a result, major companies such as Shell and BP have decided it makes more sense to invest where there is a chance of tapping new fields, rather than pour huge amounts of capital into the North Sea for a minimum gain in production.

That said, there are few incentives for oil firms to exploit new reserves in the North Sea, as a result of Mr Brown's high tax regime. The average size of new discoveries in the North Sea is now less than 20 millions barrels of oil – less than six hours of global oil use. At the same time, the cost of finding new oil is going up by 15 to 20 per cent a year. The return on investment is a third of what it was only five years ago. In this situation, tax levels are crucial to determining the level of prospecting and exploitation.

Yet the Treasury is bent on squeezing money out of the North Sea. The oil and gas operators in the area expect to pay £10 billion in corporation and petroleum revenue tax this year – up from £7.7 billion in 2007. In cash terms, that is the biggest tax bite since 1986. However, this forecast is based on an oil price of only $83.80 per barrel. We have been averaging over $100 this year.

Certainly the oil companies should pay their whack, but we also need more oil out of the North Sea. And the best way of doing that is for Mr Brown to incentivise the oil companies to put their profits into exploration and development, rather than simply handing it over to the Treasury.

For instance, the rate of tax on any new North Sea oil field is 50 per cent – try that in any other business and see what investment you get. If this were reduced to, say, 40 or even 30 per cent we would see more production.

Older fields are still paying petroleum revenue tax where the top slice going to the Treasury is around 75 per cent of profits. This is a major disincentive to squeezing extra oil out of these mature fields. They are also saddled with large decommissioning costs – another explanation for why the bigger companies are getting out of the area. There were some tiny modifications to the rules on offsetting decommission costs in Alistair Darling's Budget but the industry was disappointed (shocked?) by the failure to bring forward incentives to raise investment levels.

Beyond the North Sea, there are perhaps five billion barrels out in the Atlantic, west of the Shetland Islands. We have known about this for years yet it is still a long way from being tapped. Two years ago, in a burst of spin – to draw attention away from another increase in taxes in the North Sea – the government set up a "task force" to progress action on these Atlantic reserves. However, the latest Task force report says meekly: "Currently none of the technical solutions identified meet the economic hurdles for investment." Translation: it's still too expensive. Cue another good reason for tax reforms.

Yet even if we eventually get the Atlantic oil onshore, it is only equivalent to about two months' worth of global oil consumption. The stark fact is we need to maximise UK oil production, but only to give ourselves an economic breathing space to wean ourselves off oil completely. Achieving both targets will require the government to act. It is not enough for Mr Brown to blame the oil companies when he pockets most of their cash.