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This article first appeared in Commodities Now in May 2017.
The approach to the allocation of decommissioning liabilities between sellers and buyers in recent M&A transactions on the UK Continental Shelf (UKCS) and potential future changes to the rules relating to the availability of tax relief for decommissioning expenditure will conceivably unlock further M&A activity on the UKCS. We look at how this may come to be and potentially support the principle objective of maximising economic recovery from the UKCS (MER).
Recent deal activity on the UKCS indicates that the obituaries being written for it in 2015 and the first three quarters of 2016 as a result of the impact of a low oil price on a high cost province may have been premature. The November 2016 announcement of the up to US$1 billion acquisition by Siccar Point of OMV U.K. (with interests including Schiehallion and Rosebank) heralded a pick-up in M&A activity.1In January Chrysaor announced its US$3 billion transaction to acquire a portfolio of assets from Shell that will make it the UK’s leading independent oil and gas company focused on the North Sea.2Also in January, BP and Enquest announced the sale by BP to Enquest of a 25% interest in the Magnus Field and transfer of the operatorship of the Sulllom Voe Terminal and other infrastucture to Enquest for deferred cash consideration of US$85 million.3In February Delek Group agreed to acquire TSX and AIM listed Ithaca Energy in a recommended all cash offer valuing Ithaca at US$646 million.4It may be no coincidence that these transactions have taken place against the backdrop of a recovering and relatively stable oil price following the late 2016 agreement between OPEC and certain non-OPEC producers to curb supplies. The deals support anecdotal evidence from various stakeholders in the industry of a revived sense of optimism and confidence and renewed focus on growth after two years of punishing cost cutting. Oil & Gas UK note that 2017 is likely to be a “much busier year for mergers, acquisitions and assets transfers”, suggesting a narrowing valuation gap between sellers and buyers.5EY observe that “The positive trend in upstream has continued unabated, with several large deals announced in January 2017, pointing to an increase in momentum that will drive significant deal activity in 2017.”6
However, such increased M&A activity cannot shroud the fact that decommissioning remains one of the single biggest concerns for the UKCS: for operators and their co-venturers; for the regulator, the Oil & Gas Authority (OGA); for HMRC and for the UK taxpayer. From an M&A perspective the traditional allocation of decommissioning liability from sellers to buyers and the cost to buyers of providing security for such liabilities has, in recent years, become a significant challenge (some would say barrier) to M&A activity on the UKCS. At the same time there have been increased concerns regarding early decommissioning of infrastructure on fields that became uneconomic in the low oil price environment of 2015 and 2016 and the risk of a domino effect as decommissioning of one piece of infrastructure has a knock-on effect on the economic viability of other fields and accelerates their decommissioning. A higher oil price, reduced costs and a return of investment and deal making to the UKCS have neutered some of the more apocalyptic predictions regarding the pace and impact of decommissioning but the overall size and challenge of the task of decommissioning remains. Figures cited by the OGA indicate that there are over 250 fixed installations, over 250 subsea production systems, over 300 pipelines and approximately 5000 wells which need to be decommissioned, many of which are closely integrated. According to the OGA, the current mid-point estimate for the costs of this activity is approximately £47 billion (in today’s money) with an uncertainty range of +/- 40%. The costs associated with decommissioning, including to the UK taxpayer through decommissioning tax reliefs have also begun to receive wider attention, with the Financial Times reporting on 8 January, 2017 that “Decommissioning costs threaten to wipe out remaining oil and gas tax revenues” and noting that 2016 was the first year that the cost of decommissioning tax reliefs exceed the tax take by the Treasury.8
Much of the M&A activity on the UKCS in recent years has involved the majors and other bigger players disposing of non-core assets, often interests in mature/late-life producing fields, as they seek to free up organisational capacity and capital for investment and projects in more promising regions. Often the potential buyers of these assets are smaller, less well capitalised companies who may be better placed to exploit remaining reserves and/or extend the life of such fields and to carry out decommissioning on a lower cost basis. Generally sellers have continued to seek to achieve the “clean-break” model regarding decommissioning liabilities. Under this model the buyer agrees to take on all decommissioning liabilities in a sale and purchase agreement and provides the seller with security for such liabilities under a decommissioning security agreement (DSA). Such security is most commonly an irrevocable, on-demand letter of credit from a bank or a parent company guarantee. In this context, two challenges have been identified by the industry. The first is the absolute cost of decommissioning versus the value of remaining reserves coupled with the near term or immediate cost of providing security for decommissioning liabilities and the second is the availability or non-availability of tax reliefs.
In relation to decommissioning security, since the smaller company buyers are usually not in a positon to provide parent company guarantees their economic models need to reflect the cost of providing cash security or, more likely, an irrevocable, on-demand letter of credit from a bank, which may need to be cash-collateralised. The cost of such security drives down forecast returns and thus adversely affects the price that a buyer can offer. In the case of late life fields where transaction economics may already be challenging, this can be material. The advent of Decommissioning Relief Deeds following the Finance Act 2013 means that security under a DSA can now normally be provided on a “post-tax” basis (that is reflecting the cost of decommissioning after taking into account available tax reliefs), reducing the requirement for security and mitigating its price impact. However, given the often material range of uncertainty in estimates of future decommissioning costs sellers will often seek a generous buffer in their estimates of the relevant decommissioning liabilities which inflates the amount of security to be provided. In relation to the availability of tax reliefs for eventual decommissioning expenditure, the key issue identified by the industry has been one of tax “capacity”. Smaller companies who are new or recent entrants to the UKCS do not have a history of production and payment of tax on profits against which they can offset decommissioning expenditure. Such tax history belongs to the sellers who have developed and hitherto enjoyed the fruits of the production from the fields that they are now seeking to sell.
The transactions announced by the Shell with Chrysaor and BP with Enquest (referred to at the start of the article) suggest that some sellers at least are becoming more comfortable with a move away from the “clean-break” approach to decommissioning liabilities. The key feature of both transactions is that Shell and BP have agreed to retain a share of decommissioning liabilities. In the case of Shell it has retained up to US$1 billion of an estimated US$2.9 billion of liabilities. In the case of BP, it has retained the decommissioning liabilities for existing wells and infrastructure for the transferred assets. Enquest has agreed to pay BP further deferred consideration equal to 7.5% of BP’s actual decommissioning costs on a post-tax basis. This arrangement motivates Enquest to deliver decommissioning at a lower overall cost thereby reducing the deferred consideration it needs to pay. Such arrangement was not necessary in the Shell/Chrysaor deal where Chrysaor has taken on a very material amount of decommissioning liability itself. Enquest’s liability in respect of such deferred consideration is in any event capped at the amount of the cumulative positive cash flows received by it from the assets transferred. In both cases it is obvious how the material reduction or practical elimination of decommissioning liabilities will have facilitated the bridging of seller and buyer pricing expectations. Interestingly, BP has also granted Enquest a US$50 million option to undertake management of the physical decommissioning activities for Thistle and Deveron which BP retained decommissioning liability for in its 2002 transaction with DNO.
Neither of the announcements reference any arrangements relating to decommissioning security. In the case of Shell/Chrysaor it may be that the size and production profile of the portfolio being acquired by Chrysaor together with financing package put in place meant that the OGA and Shell’s co-ventuerers were satisfied with Chrysaor’s financial capability. In relation to the portfolio, the announcement states that no material decommissioning costs are expected in the near term whilst cessation of production on some of the assets is forecast to be more than 20 years in the future. To the extent arrangements relating to security are part of the transaction, reducing the liabilities that need to be secured by US$1 billion is clearly material. In terms of the financing package, Chrysaor is supported by Harbour Energy/EIG, an RBL facility from a “syndicate of leading international banks”, junior debt financing from Shell itself as well as credit support in the guise of a hydrocarbon lifting and sales agreement in relation to the interests being acquired. In the BP/Enquest transaction, given that BP has retained decommissioning liabilities associated with the assets the issue of Enquest providing security appears to have been moot. Just as Shell provided financing support to Chrysaor, BP has done so indirectly by providing a guarantee to a bank in relation to a working capital facility for Enquest.
The retention by a seller of part or all of the decommissioning liability associated with a licence interest being sold immediately mitigates or removes the issue of any lack of buyer capacity to enable it to obtain tax relief for decommissioning expenditure. To the extent the seller, not the buyer, is bearing decommissioning costs, tax relief for those costs is an issue for the seller not the buyer. It will have been a key feature for both Shell and BP that their transactions are structured in a way that preserves their ability to claim the relevant tax reliefs when they start to incur costs relating to the decommissioning expenditure. From a tax rules perspective the important point is that the seller is paying for the decommissioning of plant and machinery which comprises an offshore installation or pipeline which has been brought into use for the purpose of a ring-fence trade, broadly carrying on upstream oil and gas operations. For this, as well as other plain commercial reasons, retention of decommissioning liability is generally limited to those installations in place at the time of the sale transaction and does not extend to the decommissioning of installations added by the buyer after such date. The expenditure must be incurred in complying with an approved abandonment programme or in compliance with a condition imposed by the Secretary of State prior to agreement of an abandonment programme. Where Petroleum Revenue Tax (PRT) fields are involved the seller will have to retain an interest in the field licence at the time of decommissioning in order to be eligible for decommissioning relief. This is not the case for non-PRT fields. There has been some uncertainty whether a seller would be entitled to the tax relief where the buyer bears the primary liability for decommissioning expenditures and then is indemnified or reimbursed by the seller. At the time of the 2016 budget, HMRC provided guidance that a seller needed to be directly incurring decommissioning expenditures to qualify for the relief. Clearly this still leaves plenty of ambiguity and on any given transaction structure confirmation from HMRC may be desirable that reliefs will be available.
Notwithstanding this, where a buyer does take on liability for decommissioning, the issue of the ability of a buyer to have access to tax relief for decommissioning expenditures where they do not have a tax history in the UKCS remains. Although for PRT purposes relief for decommissioning costs can be carried back and met against PRT liabilities of former participants, for Ring Fence Corporation Tax and Supplementary Charge purposes losses arising from decommissioning costs can only be carried back against the ring fence profits of the company incurring the loss. On March 20, 2017 HM Treasury issued a discussion paper asking for comments on possible changes to the tax treatment of the sale of late life assets to, amongst other things, allow for the transfer of the tax history of a seller to a buyer to address this issue. The consideration of such changes had been previously flagged in the 2016 budget. The discussion paper illustrates the desire of the Government to support M&A activity in the UKCS in relation to late-life assets in the interests of MER but it is also clear that the Government has not yet decided what changes, if any, to make. Comments are due on the paper by June 30, 2017 and it is expected that any proposed changes will be announced in the Autumn Budget.
Structuring a transaction around the retention of decommissioning liability is not just a question of tax relief. Where the buyer takes ownership of the assets and will perform decommissioning obligations but the seller will pay all or a significant part of the costs then governance also becomes a key concern where the sums involved are material. How much involvement does the seller need in decisions made by the buyer and, where relevant, its co-venturers in relation to decommissioning? Where part of the commercial rationale of the transaction is the potential for the buyer to decommission for less than the seller, undue oversight or interference from the seller may prejudice that outcome. On the other hand, few organisations are happy for another to spend tens or hundreds of millions of their dollars without a reasonable degree of involvement. Sellers will also be concerned that the way in which the assets are operated may in fact increase decommissioning liabilities and their reputational exposure if something goes wrong during decommissioning operations. In drawing the appropriate line the seller will also have in mind its objective to release the organisational capability that has hitherto been dedicated to the relevant assets, something that may be compromised if substantial ongoing involvement is needed. Finally, putting a ring-fence around those installations that the seller will retain decommissioning liability for requires careful thought and definition. Whilst in many cases it may be clear what constitutes a new installation, what about modifications to or replacements of existing installations?
We have advised on a number of UKCS transactions over the past 24 to 36 months where a proposal for the seller to retain all or part of the decommissioning liability associated with the relevant licence interests has been tabled. In a number of these cases the proposal was not entertained whilst in others it was not the preferred option. Significantly, so far as we are aware, no alternative deal materialised. What is clear from this experience is that it is not in the interests of MER. Whilst Shell had previously retained decommissioning liabilities when it sold its interest in the Greater Kittiwake Area to Venture and Dana in 2003 and BP had done the same when it sold its interest in the Thistle /Deveron fields to DNO in 2002 and its interest in the Erskine field to Serica in 2015, there is a sense that the recent Chrysaor and Enquest deals reflect a coming of age of the notion that the “clean-break” is not the only way forward and that retention of decommissioning liabilities is now an acceptable and accepted feature of the UKCS M&A landscape. If this is the case, if the oil price stays at least within its more recent range and if HMRC can deliver some good news on the fiscal aspects of decommissioning relief later this year, then predictions of improved M&A activity on the UKCS may well come to pass.
Business Outlook 2017, p.8
Global Oil and Gas Transactions Review 2016, p.3
Oil & Gas Authority, Decommissioning Strategy p5.-p.6
Our aim is to help our clients understand the potential opportunities and challenges that COP25 may have on their business.
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