Industry Perspectives

UKCS Rate of Return

Oil and gas extraction is a capital intensive industry, where significant expenditure has to be made at all stages of a development, from exploration and appraisal drilling through production to decommissioning. Because of the very nature of the projects, they have high degrees of risk attached to them and, once an investment has been made, very large “sunk” costs. These risks mean that investors look for better returns than in other industries and this increasingly affects oil and gas provinces as they mature.

The Office of National Statistics (ONS) regularly publishes details of the rates of return for the oil and gas sector. This profitability measure is more usually referred to as “Return on Capital Employed” (RoCE). It is an accountancy calculation of the ratio of earnings before tax and interest expressed as a percentage of capital employed. ONS follows the convention of reporting RoCE pre-tax. However, in so doing, it fails to highlight that oil and gas extraction is taxed at much higher rates (50% - 75%) than other businesses. Investors are more concerned with post-tax returns, as the recent pressure for a general reduction in corporate tax rates demonstrates, to which the government responded in March 2007’s Budget by lowering the rate of Corporation Tax from 30% to 28%, but not for the offshore oil and gas industry.

Figure 49: UKCS Rate of Return (Pre- and Post- Tax) 1995-2006

The above chart compares ONS RoCE, both pre-tax and post-tax, for the last twelve years (note the change of scale from annual to quarterly for 2006). Pre- and post-tax RoCEs initially rose last year, but have since declined rapidly following lower than expected production, higher costs and falling gas prices. The pressure on margins, particularly for gas, has started to raise fresh concerns about the longer term competitiveness of the province and its exposure to falling commodity prices, a point which the industry highlighted when the Supplementary Charge on Corporation Tax was increased in January 2006. Based on these new realities, in March 2007’s Budget, HM Treasury significantly reduced its projections of UKCS tax revenues compared with its previous forecast.

Oil & Gas UK has fundamental reservations about the use of RoCE as a method for determining profitability. Economic measures – like Net Present Value (NPV) or Expected Monetary Value (EMV) – are the ones which drive investment, rather than accountancy measures such as RoCE. Furthermore, Oil & Gas UK considers that the ONS understates the enormous scale of capital investment in the UKCS, thus leading to an over estimation of the RoCE. Interestingly, the ONS recognises this on its web-site, expressing concern about the use of this measure for the industry.