Most countries waste their petrodollars. They don’t put them back into investment – they squander them on things that do not, in themselves, create value.
In developing countries the squandering might be on a flashy palace or, in the west, it might be on subsidising universal benefits, unnecessarily free services or any other non value-creating project.
The imperative of reinvestment
It is critical that this money is used to re-invest. Consider the UAE – that is what they have done. They have built Dubai, Abu Dhabi and Emirates airline as part of the project to create a real hub and to create reasons to be there beyond the sand and the dwindling oil.
They have some hugely ambitious carbon neutral city projects as well. Look at the Masdar City initiative in Abu Dhabi, for example.
For Scotland, its oil and gas reserves are a real asset but they are time limited – and the remaining reserves are and progressively will be the most difficult and expensive to extract – which will see prices soar.
The risk Scotland runs is selling independence to voters in the 2014 referendum on promises of all sorts of transient goodies, continuing universal benefits, free higher education and free health – all to be paid for from oil and gas revenues.
All that this can do is to create a short term feel-good bubble and leave the country with nothing in the tank when that bubble bursts.
The hard fact is that we should plan not to spend one single petrodollar on anything which is not hard-nosed future-building.
Choices. consequences and politics
The key is a structural transformation in the economy – cutting costs, creating value – governed by a national plan to build a future sustainable on the new and forward-facing assets the last petrodollars can bring into existence.
Using oil to maintain the status quo of a culture the Scottish Labour leader has straightforwardly called ‘the something for nothing culture’ would be historically irresponsible, a weak waste of the last opportunity to build an economic raft.
The dedication of the petrodollar to future-building would be unpopular, since we are already well into the culture of promises of good times for all, come access to Scotland’s oil.
This unpopularity offers immediate hostages to political fortune.
Any government of a Scotland with control of the oil and gas industry in its waters and working to create the necessary long term economic step change with the accruing revenues, would struggle to survive without cross-party agreement on a national development plan.
In the larger interests of the country, such an agreement would have to be made.
This would need to be an agreed 25 year plan, covering the period from access to control of the industry [under whatever political system] to the effective dying away of the goose with the golden eggs.
These resources are finite, so the imperative is the maximisation of the impact of every dollar in creating an economic transformation in short order.
Scotland might also choose to leave some of the reserves in place as a hedge against dependence on others after oil has generally run out, giving us an independent reserve source.
Juggling with oil – the issues
The key issues dictating the national management of this industry, in this last phase of its existence, centre around the balance a government wishes to maintain between keeping the energy source [and economic activity] flowing and keeping a strategic recoverable reserve as a hedge against the transition period to other energy sources.
A parallel issue in this is the amount of revenue the state needs returned from the industry to, as we advise, drive its planned investment programme over the remaining period of supply of these resources.
If the very real environmental issue of disposal of toxic fluid wastes and protection of the water supply can be resolved – acceptably and transparently – there is every case, in energy supply and in generating economic activity, f0r exploiting Scotland’s potential reserves of shale gas.
The role and impact of taxation
Tied into extraction from both traditional and shale reserves and into accruing state revenues is the issue of the tax regime for the industry.
This is at once the generator of state revenues and the control device against over exploitation of the reserve.
Because the focus of this series of articles is explanatory, we’re not going into the minutiae of North Sea Tax but the summary position is that operating companies pay Corporation Tax on profits; and also pay a royalty tax based on the amount of the resource they extract.
From the companies’ position, a key issue is the stability of the tax regime. Because of the scale of the investments and the complexity of operations, they have to be able to plan ahead according to stable cost criteria over the long term.
Thus industry runs on 20-30 year investment cycles, planned to make, say, a 10% rate of return. If a country suddenly takes additional bites out of this return, then obviously it is unpopular, destabilising and leads to changes of direction in the industry. This is why it is important for governments to be trusted by the industry.
Governments have a habit of suddenly chucking in additional taxes in this area, which has been shown to be detrimental to the industry and consequently to the Exchequer.
In 2011, UK Chancellor George Osborne’s unexpected tinkering with oil industry taxes destabilised the industry’s financial planning and saw the UK lose out as investment was consequently switched to countries like Egypt and Ghana, which had become more competitive.
Deloitte showed that drilling in the North Sea dropped by 52% in the second quarter of that year.
Andrew Moorfield, global head of oil and gas at Lloyds Banking Group, a key lender to the sector, explained at the time: ‘When assessing credit risks, the industry considers both the political security of a country and the predictability of its tax regime. As an AAA-rated country, the UK has traditionally scored well on both counts, but is now performing poorly on the second.’
Moorfield pointed to Ghana – an emerging oil producing country – which has worked closely with the Norwegian oil ministry to develop a stable tax regime that ensures an acceptable allocation of profit between the state and foreign investors.
Its tax regime is based around petroleum sharing contracts with 35% corporation tax and a 3%-10% royalty tax, depending on the underlying commodity being extracted. This is agreed contract-by-contract, giving investing companies greater tax stability and transparency over the life of the project.
West Africa’s Gabon also uses a predictable service contract-based tax regime that has been stable since 1983. Egypt has a predictable petroleum-sharing contract regime combined with 40-55% corporation tax, unchanged since 2005.
Mr Osborne later reversed the changes he had made and reverted to stability, adding some tax breaks, noted above, with markedly positive results seen in the North sea.
Obviously, the more benign the tax regime, the more the companies have to invest – and this is where the strategic raising of the tax rate can be used deliberately to direct extraction rates and protect the reserve.
Norway and Scotland
Norway has been quite savvy with its oil and gas reserves.
Their taxes are sky high, like 80% on foreign investment – which they route back into their state fund for the future.
As a result of this tax regime they have not exploited that much of their reserve. if you tax in a regime that takes a total of 80% with oil at $100 a barrel, operators will only extract resource which costs less than $20 to extract – otherwise there is no point.
Not to have exploited much of the reserve sounds good but gives rise to a couple of issues. Government will not have the capital to invest in exploration and development; and they probably don’t want to take that risk anyway.
Scotland really needs to partner with big oil – but if you tax them too much they will not make money out of it and hence will choose to invest elsewhere.
The tax breaks in the North Sea recently have increased the number of smaller investors and hence increased the recoverable reserve. It’s all about the balance.
Scotland would have to look at that situation and play with the numbers to see where the balance is.
It might consider nationalising some of the asset to create employment, mandating Scottish workers and graduates to work on it and thereby building and retaining genuine engineering skills. This is the secret to Scotland’s future.
On the balance issue, there is a strategic argument around the assurance of supply. For example, Scotland might guarantee gas fired power stations from its own gas for 4 million people for a period to avoid importing.
But then, this way, you won’t make any money so you need to balance up what you need to reinvest. That decision would probably be made once you have your national plan and you know what development you want to focus on.
There is an equation on tax versus how much people invest. For example, if oil sales make $100 a barrel, then you will only extract the amount which is profitable at $100 a barrel.
If extraction costs then go up to $110 a barrel, logically you will stop production.
If, however, the price goes up to $200 you would work to find a lot more recoverable barrels – and your effective resource would go up again.
That is what is happening in the North Sea. The price goes up;. Companies put more money into extraction.
And you will get technological leaps because the more that can be extracted more cheaply than anticipated, the more the profit motive will uncover a greater recoverable reserve.
This means that the North Sea could be innovative in how to extract maximum resource from existing fields – and such knowledge is exportable.
The juggling in the state’s management of the oil and gas resource lies in maintaining a strategic balance between the key factors.
This involves balancing the revenue generation for capital investment to drive the agreed national plan against the impact of the chosen tax regime on investment in exploration, development and extraction by the oil companies – and considering how much of the reserve Scotland might choose to keep in reserve.
The key point is to plan to route every single petrodollar through the economy for investment in the creation of value; and not to spend any of it on annually recurring revenue needs. These must be met from other tax revenues.
That highlights the imperative to look rigorously at costs, to prioritise the needs and vulnerabilities any civilised society must protect and to be courageous enough to identify and cut or remove expenditure on any other.
What is involved here is the strategic direction of available resources to drive the national plan, accepting that everything cannot be supported and that some things will be left to market demand to carry on at whatever level or not.
These consequential issues focus attention on the cultural change Johann Lamont has already identified. Bringing about this change would be complex and necessarily incrementally built. It would involve education, employment, the benefits regime and a more independent balance between individual and collective responsibility.
Such matters will emerge from the following articles in this series.
This and subsequent articles in the series will be linked to the foot of the introductory article published on 31st December 2012: Scotland’s economic future: the brave or the grave.
Note 1: There is another aspect to the need for stability in tax regimes in the oil and gas industry – and one that directly affects most of us personally. Most people have their pension in the FTSE which is heavily oil weighted – so you want your homegrown companies to do well.
Note 2: According to Bloomberg, Norway’s $660 billion sovereign wealth fund, the world’s largest and based on oil revenues, returned 4.7% in the third quarter of 2012, making $29 billion – and it deposited 80 billion kroner more of oil revenue into the fund in that quarter. The return to the fund’s target return of 4% came after a drop to 2% and as global stock markets recovered after central banks from the U.S. to Japan stepped up efforts to stimulate growth.
Note 3: ‘Petroleum sharing contracts’ are not about sharing the petroleum itself but about sharing the profits from an extraction contract. For those interested in the detail of this revenue sharing arrangement, there is a straightforward account in Wikipedia here and an e-book here which includes a focus on the issue.