Weekly Offshore Rig Review: US vs UK

Last week, the US House passed new energy legislation aimed at extracting more taxes from the oil and gas industry. The tax changes focused primarily on removing royalty relief and increasing taxes for manufacturers, but they do have fairly broad tax implications for the industry that will result in US$14 to 15 billion becoming unavailable for future investment as it heads into the government treasury.

In last week's Weekly Offshore Rig Review, we discussed these changes as they related to the GOM deepwater leases that were issued during 1998 and 1999 without price thresholds for cutting off royalty relief when oil prices increased above certain levels. This week, we will be continuing our look at the potential impact that these tax changes could have on Gulf of Mexico drilling.

Currently in the GOM
The changes that are included in the new legislation aim primarily at deepwater production where operators have enjoyed lower royalty rates and more royalty relief options. As such, they will have more of an effect on deepwater rigs than on jackups or submersibles.

There are currently 39 semisubmersibles and drillships in the US Gulf of Mexico. Of these rigs, 33 are currently under contract, with 4 more undergoing modifications or repairs and 2 other rigs currently being inspected.

Looking at the last 6 years, 39 floating rigs is somewhat lower than the overall average number of rigs in the region. For the years from 2000 to 2003, the number of floating rigs in the US GOM held close to 50 rigs, varying slightly above or below that number through most of that time. In late 2003, the number of rigs declined notably, and has held near 40 rigs since then. At the same time, the number of floating rigs contracted in the US GOM has held fairly close to 30 rigs since early 2002. Just in 2006 did the number of contracted floaters move above 35 rigs. The number contracted is slightly lower now, but it will be back in the mid to upper 30 range within a few months.

With the number of contracted deepwater rigs in the region nearing a 5-year high, the question of how much of a cooling effect this $14 billion tax increase, if enacted, will precipitate looms large.

Looking to the UK for Guidance
The US and UK oil industries have some similarities that make comparisons between these two regions helpful. Among other things, both the UK North Sea and the US GOM are mature regions that have been under exploration for more than 30 years. Both regions are very open and accessible to investors and smaller players. Also, these two countries are home to the largest oil and gas companies in the world. Given these similarities and the fact that the government of the United Kingdom has twice enacted tax hikes on oil and gas companies in the last 5 years, examining the fallout of those changes can provide some indication of the possible effects in the US GOM.

In 2002
In April 2002, Gordon Brown shocked the oil and gas community by calling for a 33% increase in the tax rate (from 30% to 40%) for oil and gas companies in the UK. Reaction to the increase was negative with criticism coming from the UKOOA, ExxonMobil, and others including BP's Lord Browne who called the changes "damaging and foolish." At the time, Brent Crude prices were floating near US$25, and the tax increase was expected to bring in GBP600 million (US$900 million at 2002 exchange rates) per year.

Obviously, with rig contracts already in place and investments having been set months and years before, it took some time before the tax changes began to have an effect on drilling in the UK. But by March 2003, 11 months after the announcement of the changes, the number of rigs working in the UK had declined 24% from 34 rigs in April 2002 to 26 rigs in March 2003. The number of rigs working jumped back up slightly in 2003 before continuing to decline to a low of only 21 contracted rigs in February 2004. That represented a 43% decline in the number of rigs contracted in the UK from the high of 37 rigs before the tax law changes were announced to the low achieved 2 years later.

At the same time, day rates for offshore rigs working in the UK dropped from US$87,350 in 2002 to US$57,500 in January 2004. This drop marked a 34% decrease in day rates for these rigs. With the number of rigs contracted and day rates both falling, the revenues of the UK offshore drilling sector dropped 60% in just 20 months from the announcement of the tax changes to the low point reached in early 2004.

Lest one think that this was a more general slowdown not precipitated by the tax changes, let's examine a few other benchmarks. During the same 20 month period, the Brent crude price increased 15%. Outside the UK in the rest of the North Sea, the number of contracted rigs also dipped, although the total decrease was only 5 rigs (vs 14 rigs in the UK) out of a fleet that was essentially the same size as the UK fleet. And outside of the North Sea, the number of contracted rigs actually increased 5% while day rates held steady. The charts below illustrate the number of offshore rigs contracted in the UK versus Brent crude prices over this time period.

UK Rig Contracts vs Brent Crude Prices

In 2005
At the end of 2005, Gordon Brown again surprised the oil and gas industry by announcing a new increase in taxes on offshore operators. This time, the overall tax rate would be rising from 40% (where it stood after the 2002 increase) to 50%, a further 20% increase that was intended to generate more than GBP2.3 billion (US$4.3 billion at current exchange rates) in new tax revenue per year. Combined with the 2002 increase, this represented a 67% increase in oil company taxes in just over 3 years.

With Brent crude prices having averaged above $66 per barrel for 2006, and prices still above $50, this newest increase has yet to make a noticeable impact on offshore drilling in the UK North Sea. In fact, utilization in the region is at its highest level since 2001.

What's It All Mean?
The UK tax increase enacted in 2002 was intended to generate about US$900 million per year in extra tax revenues. By comparison, the new US oil company taxes are expected to raise about US$1.4 billion per year, which is more than 50% more than the UK increases were expected to generate. However, given that the US oil and gas industry is several times larger than the UK industry, the increase will not be felt as significantly in the US as in the UK. Combine that with the much higher oil prices that are currently in place, and the overall effect on the US industry will be much less significant than the 2002 tax increases in the UK.

Still, with the focus of the US tax law changes aiming largely at deepwater areas, this specific area and rig fleet will likely bear more of the decline than other segments. Since, the US GOM semisub and drillship fleet represents a rig fleet similar in size to the UK offshore rig fleet, it would not be surprising to see a clear decline in the number of rigs working in the deepwater Gulf of Mexico along the lines of what was seen in the UK during 2002-04. Again, it would not likely be as large as the UK decline, but seeing five to eight deepwater rigs leaving the GOM over the next 18 months seems quite probably, if this law is enacted.

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