Should investors steer clear of North Sea oil companies?
Every year the budget produces some winners and losers, and it was no surprise to see that last week's edition continued this tradition. Smokers were hit particularly hard, with an extra 50p of tax on a cheap packet of fags, whilst beer duty rose by up to 10p a pint.
Since smokers and drinkers, along with motorists, are invariably hit with budget tax rises, it came as a bit of a shock when the Chancellor announced that petrol tax was actually being cut (by a mere 1p). But this was followed by the bombshell that this would be paid for by raising the "supplementary tax" paid on North Sea oil production from 20% to 32%.
Needless to say shares in companies with substantial North Sea oil interests fell sharply as a result, some by as much as 12% on the day.
With a stroke of the pen the minimum tax rate levied upon North Sea oil production has jumped from 50% to 62%, with a few oilfields being taxed at as much as 81%.
Jim Pearce of AT Kearney summed up what many oil companies and their shareholders are feeling, myself included, when he said that "Britain hasn't been considered a Banana republic where taxes change, but people may well think, if the Chancellor's going to blindside us like this, the stability of Britain loses its appeal."
This tax rise has effectively cut a firm's after-tax profits on their North Sea oil production by at least 24%. It's not been well received, to put it mildly, and it's been reported that at least one major North Sea asset sale has been cancelled as a result.
Playing politics with the North Sea
Some politicians have claimed that the tax rise is aimed at those firms which sell petrol. They're wrong; the vast majority of North Sea oil producers don't sell petrol.
The few firms which have North Sea production and sell petrol in Britain are the giant multinationals like BP (LSE: BP), ConocoPhillips, ExxonMobil (Esso) and Royal Dutch Shell (LSE: RDSB). Since the North Sea is a very small part of these firms' global businesses, this tax rise has very little effect on their overall profitability.
Instead it's the smaller companies with significant interests in the North Sea who are hit, such as EnCore Oil (LSE: EO), EnQuest (LSE: ENQ), Ithaca Energy (LSE: IAE), Premier Oil (LSE: PMO) and Valiant Petroleum (LSE: VPP).
All of these companies have made substantial investments in the North Sea in recent years. But the tax rise will put a big question mark over any future investments, which means fewer jobs and, ultimately, falling tax receipts.
Using allowances to reduce the tax burden
The supplementary tax doesn't affect each company in the same way because firms can always offset some of the rise by using tax credits which have been created by their exploration costs. For example, Premier Oil's CEO has said that its $1.1 billion of tax credits means the tax rise shouldn't affect its profits for several years.
Those North Sea companies with interests in heavy oil fields, such as Nautical Petroleum (LSE: NPE) and Xcite Energy (LSE: XEL), should be unaffected as they are able to benefit from more favourable tax allowances. But as Nautical's CEO has pointed out, "it's bound to affect investment in the industry."
It's also been argued that a few firms, most notably EnCore, won't be affected by this tax as they are still exploring and will most probably be sold to a producing company before they ever extract any oil. But any potential buyer will still be caught for the extra tax and so won't value these fields as highly they would have done a week ago.
Invest anywhere else
Arbitrarily raising taxes in this manner is akin to running an advertising campaign with the slogan "Don't invest in the North Sea. Go somewhere else".
Put yourself in the shoes of a multinational oil company. Thanks to this tax increase the project you were thinking of starting in the North Sea will now make roughly one-quarter less than you thought it would. Why not invest in another country which has a much more predictable tax regime?
The Chancellor has said that the supplementary tax will be cut if the price of oil falls significantly. I'd be surprised to see this happen since the parlous state of our public finances means that Britain could do with the extra taxes!
Not to mention the fact that temporary taxes have a way of becoming permanent taxes. Income tax was introduced in 1799 as a temporary measure to fund the Napoleonic Wars and Parliament maintains this fiction by renewing it every year!
Investors look elsewhere
Investors in oil companies are a fairly resilient bunch. We have to be since the oil business means that these firms tend to operate in some very politically unstable and corrupt nations.
But the way in which successive British governments have arbitrarily tinkered with the tax code over the last two decades is starting to make countries like Nigeria, Turkmenistan and Vietnam seem like safe havens in comparison!
I'm not going to sell my North Sea oil shares, at least for the next few months, as I believe that there's plenty more to come from their current drilling programmes (EnCore in particular).
But the North Sea has dropped off my radar for any future investments.
More from Tony Luckett:
> Tony owns shares in EnCore Oil, EnQuest and Premier Oil
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