Osborne, Laffer & the Cost of Black Gold Populism

As you’d expect, Brother Hoskin offers a fair summary of George Osborne’s difficulties with fuel duty. Osborne, backed it should be said by Danny Alexander, decided to pay for his fuel policies by levying additional taxes on North Sea oil production. How’s that worked out? Entirely predictably: North Sea Oil production fell by 18% last year* – the biggest fall ever. By some estimates, this cost the Treasury more than £2bn in lost oil revenues and thus, probably, rather more cash than Osborne planned to raise from his increased taxes on oil and gas.

Moreover, there was just half as much new exploration in 2011 as there was in 2010 as companies scampered away from Osborne’s penalising new taxes. According to Malcolm Webb, CEO of Oil & Gas UK:

It is becoming very clear that in order to stand still – let alone make progress in this basin – you have to keep running faster all the time. This is a mature basin with a range of challenges ahead of it, but that doesn’t mean to say it’s a basin without a huge potential still remaining.  “Twenty-four billion barrels of oil and gas is a very, very significant prize to play for. But the risk is that, if we carry on the way we are doing, we won’t get them all.” A year ago, industry leaders warned that companies could be forced to cancel or postpone major investment plans – putting thousands of jobs at risk – as a result of the Chancellor’s controversial decision to raise an extra £2bn a year from North Sea oil companies every year until 2016 to help fund the fuel duty cut. Mr Webb said: “Although headline investment has tripled over the last decade, the amount of oil and gas recovered per pound invested has fallen by two-thirds over the same period. This effectively leaves us fighting hard to stand still. “UK investment must be seen in light of this acute decline in capital efficiency and viewed in a global context – the UK attracts less than 4 per cent of global oil investment.”

Of course, Mr Webb is not a dispassionate observer. The industry plainly has an interest in lower taxes. Nevertheless, my (limited) understanding of north sea oil makes me think he may have a point. Because the North Sea is a “mature” resource, extracting the remaining oil often requires new technology which, in turn, means investing money in old rigs and other equipment to keep them fresh for purpose. If you scare companies away then the platforms deteriorate to a stage at which it becomes uneconomic or too difficult to upgrade them for modern production. The oil is not “left there” to be brought ashore later it is, instead, trapped by poor incentives and cheaper prospects elsewhere.

Osborne ought to know this. Oil is even more fungible than financial services. And, lo, in 2007, George Osborne did appreciate this, using a visit to the Granite City to reassure the industry that:

“The Treasury don’t seem to understand that the UK continental shelf [the North Sea oil and gas region] is a mature resource competing for investment in a fiercely competitive global market.

“They don’t recognise that investment in the North Sea cannot be taken for granted when there are potentially more profitable opportunities in West Africa, Mexico or Brazil. No wonder business can’t invest with confidence.

“We should aim to establish a tax regime that will stay in place for the rest of the life of North Sea oil and gas.”

Well quite. He made that speech after Gordon Brown increased taxes on the oil industry. As far as this part of the economy is concerned, however, there is neither a difference in degree or kind between George Osborne and Gordon Brown.

Granted, the oil companies are easy targets. Nevertheless, though some part of the industry’s warnings might be thought par for the course, their objections to a tax regime that pushes marginal rates above 80% in some fields are not wholly unreasonable. Perhaps Osborne and Alexander thought slapping additional taxes on oil and gas production would be painless and popular. Doubtless it is the latter but it ain’t the former. Oil companies respond to incentives; conservatives and liberals are supposed to believe in incentives. So none of this should surprise anyone, should it? Oil has its own Laffer Curve.