Chris Wheaton

 | +44 (0) 20 7710 7623 | chris.wheaton@stifel.com

15 May 2024

 SECTOR REPORT

Europe - Oil & Gas Exploration andProduction

If UK windfall taxes go up again, will thelast energy company to leave the NorthSea please turn off the lights?

Harbour Energy (HBR LN) - Buy, 307p Ithaca (ITH LN) - Hold, 117p Serica (SQZ LN) - Buy, 185p Prices as of close on 14 May 2024 Completed: 15 May 2024 04:52EDT Disseminated: 15 May 2024 04:52EDT All sources unless otherwise stated: Company data, FactSet, Stifel estimates 

 Summary

We have noted recent discussion of further increases to the UK windfall tax and, evenmore concerning to us, consideration of removal of investment allowances that actas an incentive for investment. We, therefore, wish to contribute constructively to thisdiscussion by analysing potential financial and real-world impacts if the UK North Seaenergy industry were forced into a rapid decline through yet another increase in thewindfall tax via an increase in the headline tax rate and a reduction or removal of investment allowances.

Our conclusions are:

•

There is a multi-billion-pound paradox here: any further increases to thewindfall tax take, especially through the removal of investment allowances,would result in substantially lower investment and, therefore, lower tax income

for the UK, fewer jobs, loss of skills for the green transition, higher emissions, and theexport of jobs, skills and the UK's energy security to other energy-producing countries.

•

Short-term tax receipts would be higher...but only until 2029, and then muchlower thereafter.

 Our analysis indicates that an increase in the windfall tax to 78% andremoval of investment allowances would generate only an extra c.£6.5bn tax by 2029,not the £11bn that the proposed higher taxes are supposed to generate. From 2030Eonwards, annual tax take under this potential higher tax regime would be substantiallylower than under the current tax rates, as production volumes collapse due to the lossof investment — the Laffer curve in real life.

Direct tax receipts (corporation taxplus windfall tax) over the remaining lifespan of the UK North Sea would be c.£20bn lower even after this near-term boost to tax take.

•

This loss of tax income is because loss of investment will drive productionrapidly lower.

 We estimate c.£20bn lower capital investment between now and2035 - £30bn lower over the North Sea's remaining life - as higher tax take rendersinvestment projects uneconomic, which drives North Sea production volumes c.50%lower by the end of the decade. There would be substantially fewer barrels (andtherefore profits) to tax by 2030; hence, tax income for the UK Government droppingbelow that forecast under the current windfall tax structure.

•

Loss of investment means loss of jobs and skills for the energy transition.

Given the strong correlation between spending and jobs, the UK North Sea could lose100,000 of the current c.200,000 jobs that directly or indirectly are employed by theindustry, and possibly as quickly as by the next general election in 2029. This wouldharm the skills base needed for the energy transition; for example, the transferableskills between offshore energy, and floating wind farms, carbon capture, and hydrogenproduction.

•

Energy security is national security; the UK would lose both, with the declinein North Sea gas production leaving the UK importing 80% of its gas demandby 2030E (from c.55% now).

 Even under the most optimistic renewable energyand electrification rollout scenarios, the UK still needs up to 20GW of carbon-abatedgas-fired power in 2050 due to intermittent generation from renewables, even if theinvestment were available to triple offshore wind generation capacity from the currentplanned levels of 50GW by the mid-2030s. The UK would be left competing for importsof liquefied natural gas in a volatile and uncertain global gas market.

•

It's not Westminster warming, it's global warming; without the UK North Sea,total CO

2

 emissions from the UK's energy mix would be higher, with UKexporting its carbon emissions (along with jobs and investment) to energyproducers like Norway and the US.

 While shutting down the North Sea energyindustry would make the UK's own emissions look better, this is merely because higher emissions are being produced elsewhere. The UK would be importing more energyand at a higher carbon intensity, which would increase emissions from the UK's energysupply chain.

 

All relevant disclosures and certifications appear on pages 19 - 23 of this report.Stifel does and seeks to do business with companies covered in its research reports. As a result, investors should be awarethat the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider thisreport as only a single factor in making their investment decision.

 

Executive summary: what would happen if the UK North Sea were forced into a rapid decline?

Here’s a multi

-billion-pound paradox around how the UK North Sea is taxed: higher tax rates and lower tax allowances for investment won't result in higher tax income for the UK Government

, we think. Two factors combine to reduce tax revenue:

•

 

Decline in tax income as production volumes and, therefore, revenues decline

 against a relatively fixed cost base, thereby reducing taxable profit.

•

 

Decommissioning costs are brought forward

: an increase in the amounts payable by the UK government (from historic tax payments made by producing assets) for a share of decommissioning costs, as decommissioning schedules are brought forward.

Our analysis indicates that an increase of windfall tax to 78% and removal of investment allowances would generate only an extra c.£6.5bn tax by 2029E,

and from 2030E onwards, annual tax take under this potential higher tax regime would be

lower

than under the current tax structure. Over the remaining life of the North Sea, we estimate

the UK loses c.£20bn of tax payments

 if the UK North Sea is forced into this accelerated rate of decline.

Figure 1: UK North Sea tax payments decline rapidly as production decline accelerates

Source: Rystad Energy, Stifel estimates

-2000-1000010002000300040005000600070002024E 2026E 2028E 2030E 2032E 2034E 2036E 2038E 2040E 2042E 2044E 2046E 2048E 2050E

    U    K    N   o   r    t    h    S   e   a    t   a   x   p   a    i    d    £    M

Base case accelerated decline scenario

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Decline in tax revenue will be driven by rapid decline in production due to a collapse in investment- because if higher windfall taxes and removal of capital allowances were implemented, the UK would see its competitiveness for investment dramatically eroded further 

. Our reduced investment scenario is shown below, with investment almost completely ceasing by the early 2030s:

Figure 2: UK North Sea would lose £20bn of investment by 2035E, driving rapid production decline

Source: NSTA, Rystad Energy, Stifel estimates

Less investment also means fewer jobs

. We show recent employment data (both those directly employed and those jobs supported by the industry) below, which

—

 unsurprisingly, in our view

—

 appears to correlate well with total spending (capital investment plus operating costs) in the UK North Sea. We, therefore, conclude that in the event of a rapid decline in investment spending, a significant number of  jobs would also be at risk:

Figure 3: If investment declines and producing fields get shut down early, jobs will disappear

Source: gov.scot, Rystad Energy, Stifel estimates

0100020003000400050006000700080009000100002024E2026E2028E2030E2032E2034E2036E2038E2040E2042E2044E2046E2048E2050E

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Base caseaccelerated decline scenario

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$40.0050,000100,000150,000200,000

250,000

300,000350,000400,000450,000500,000

    T   o    t   a    l   c   a   p   e   x   +   o   p   e   x   s   p   e   n    d    $    b   n    T   o    t   a    l    U    K    j    o    b   s  -    d    i   r   e   c    t   +    i   n    d    i   r   e   c    t

Total UK North Sea jobs (direct + indirect)Capex + Opex:accelerated declinescenarioCapex + Opex spend:base case

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