What the windfall tax means for oil producers

Chancellor Rishi Sunak‘s decision to introduce a windfall tax on North Sea oil producers certainly muddies the waters for investors and companies, writes Rupert Hargreaves. It is bound to create winners and losers and due to the complexities of the new regime, it’s not entirely clear who will benefit and who will struggle.

The North Sea tax regime was already fiendishly complex. The sector has to contend with a 40% corporation tax rate, and a ten percentage point supplementary charge. There is also a zero-rated petroleum revenue tax and a range of other investment and capital allowances. The new tax introduces a 25% levy on the “extraordinary profits” of oil and gas companies, but also brings in an 80% allowance on capital spending, allowing companies to save 91p for every £1 they invest. The windfall tax is supposed to be temporary, although a 2025 sunset clause suggests it might be more permanent than the government admits.

Companies cannot use prior losses or decommissioning spending to offset qualifying profits. This looks like it is aimed at drawing more money out of Shell (LSE: SHEL) and BP (LSE: BP). These “Big Oil” producers are already “tax negative” in the UK, according to Citi, because of spending on decommissioning of aged infrastructure. That said, the pair have already laid out multibillion-pound capital spending programmes for the next couple of decades, and are better placed to bring future projects forward to capitalise on the investment deduction. Doing so could mitigate the extra tax charges.

Given this room for manoeuvre, investors should take any estimates about the impact of the levy on corporate profits with a pinch of salt. With so many moving parts, such estimates will almost certainly prove incorrect. Still, the initial numbers emerging from the City do give some idea as to where the tax will fall the hardest.

The large integrated producers, Total, BP and Eni are unlikely to see much of a dent in their earnings. Total (part of TotalEnergies) is currently expected to book the largest charge in 2023 with a cost of $900m. (The tax only applies from 26 May, which is why takings are expected to be far higher next year.)

The levy will have a bigger impact on smaller North Sea producers. Serica Energy is particularly exposed. Stifel analyst Chris Wheaton notes that Serica’s capital expenditure is low compared with earnings before interest, depreciation, amortisation, and exploration. EnQuest, which specialises in squeezing oil and gas out of mature fields, is also exposed.

At the other end of the spectrum, Harbour Energy and Aim-listed Deltic Energy are expected to escape rather lightly as both have plans to make large investments in the next few years. Later this year Deltic will start drilling with its partner Shell on the Pensacola North Sea prospect, a major potential natural gas resource.

That said, rather than trying to pick winners and losers, investors should focus on companies that are well-placed to navigate the uncertainties of the commodity sector and the ongoing longerterm energy transition. That’s why I’d focus on Big Oil stocks. Not only are they better placed to manage the changing tax environment, but they also have more capital to invest in green energy projects.

It’s also worth remembering that the overall energy backdrop can be volatile – it was just two years ago that the oil price fell below zero. That might not happen again soon – but it shows just how drastically things can change in this sector. Diversified Big Oil companies are always going to have the edge over smaller producers in navigating these environments. So, in the UK at least, stick with BP and Shell.