Oil and Gas Authority publishes its Guidance on assessing “satisfactory expected commercial return” on investment in the UKCS

United Kingdom

The Oil and Gas Authority (“OGA”) has now published its Guidance on Satisfactory Expected Commercial Return (the “Guidance”), describing the approach it will usually take in assessing whether a project achieves satisfactory economic commercial return (“SECR”).

SECR and MER UK

The Maximising Economic Recovery Strategy (“MER UK Strategy”) created a legally binding obligation on industry to take the steps necessary to secure that the maximum value of economically recoverable petroleum is recovered from the UK Continental Shelf (“UKCS”). “Economically recoverable petroleum” is defined as petroleum where the market value is greater than the pre-tax hydrocarbon resource cost of extraction, excluding any sunk costs, and using a 10% real discount rate to bring costs and revenues to a common point. The MER UK Strategy includes a number of safeguards intended to ensure that this obligation does not discourage investment or damage the confidence of investors. One key safeguard provides that there is no obligation to make an investment or fund activity where there will not be a “satisfactory expected commercial return”. According to the Strategy, SECR is “an expected post-tax return that is reasonable having regard to all the circumstances including the risk and the nature of the investment (or other funding as the case may be) and the particular circumstances affecting the relevant person.”

OGA Consultation on SECR

Prior to publication of the Guidance, OGA consulted industry on its proposals for assessing SECR. OGA’s response to that consultation reports that overall respondents seemed to welcome and support the introduction of the Guidance. OGA noted, however, that respondents expressed concerns around references to an “efficient company” in the consultation document and how the “efficient operator” term was used in different contexts. The Guidance no longer makes reference to such terms.

Further, OGA re-emphasised that it is not attempting to introduce a ‘one size fits all’ test: in addition to numerical assessment, OGA will also have regard to project-specific factors. The regulator is at pains to confirm it does not seek to: (i) extend or redefine any part of the MER UK Strategy, nor the obligations and safeguards contained therein; (ii) set any new tests as to what should be considered economically recoverable petroleum; (iii) set the rate of return for projects or investments. The Guidance is instead intended to provide a framework for how OGA intends to assess whether a project achieved, or achieves, SECR.

The Framework

OGA considers that SECR is intended to be an objective safeguard, with a targeted number of metrics. OGA is aware companies use a wide range of approaches in assessing the anticipated return on investment, not all of which are included in OGA’s intended SECR assessment. OGA expects companies to continue to use their own project evaluation metrics for their commercial purposes. However, OGA considers that, due to “its economic validity and almost ubiquitous application by companies operating in the UKCS”, the Discounted Cash Flow (“DCF”) framework should normally be used when assessing the application of the SECR safeguard. The DCF method entails an analysis of a project’s expected future cash flows and the OGA points out this can then be used to generate a range of other economic metrics – the Guidance specifically identifies Net Present Value (“NPV”), Expected Monetary Value (“EMV”) and Discounted Profitability Index (“DPI”).

For the purposes of a formal numerical assessment, the Guidance indicates that, when considering the question of whether a project meets the SECR test, OGA expects a DCF-based SECR assessment will usually be submitted by the company for OGA to assess. The Guidance also notes that while the DCF analysis will be only forward looking, past cash flows may also have an impact, for example on the expected tax treatment of the asset in question.

Comment

The Guidance is intended to aid industry in those circumstances where a company may wish to persuade OGA that the SECR safeguard is relevant to the application of the MER UK Strategy. As a safeguard, SECR’s purpose is therefore twofold.

Firstly, it can provide a company with protection from OGA’s enforcement powers. Where the safeguard is raised in the context of OGA enforcement, the regulator states it will take a pragmatic approach. This will include participating in ongoing discussions with the relevant companies on all relevant project-specific factors and considering all the evidence presented. Should OGA agree any MER UK Strategy safeguards (including SECR) apply, any enforcement process will cease. However, if there is still an outstanding difference of opinion, OGA may choose to commence a formal investigation in line with its sanctions process. Further information may be requested of the company under OGA’s information gathering powers or the company may separately wish to submit more information to support reliance on SECR safeguard.

Secondly, the MER UK Strategy makes clear that companies are not obliged to invest in projects which would not pass the SECR test. In the circumstances where a company does not wish to invest in a project that would nevertheless achieve MER UK, the Strategy follows a default approach of “use it or lose it”; the company is obliged to seek alternative funding or to divest themselves of the asset. Failure of the project to meet the SECR test, however, will carve it out from this obligation.

The Guidance is to be kept under review and may be revised in the light of OGA’s further experience and developing law and practice.

The full Guidance can be found here.