Photo: Shearwater platform (illustration); Source: Shell

How will UK’s energy windfall tax hike impact oil & gas players?

Credit rating agency Moody’s has highlighted that the rise in the energy windfall tax will crimp the North Sea producers’ free cash flow generation. As a result, the latest changes are credit negative for oil and gas companies with upstream activities on the UK Continental Shelf (UKCS). This is especially the case for smaller and UK-focused E&P firms, although, oil majors will also feel its effects.

The UK government announced on 17 November 2022 plans to increase a windfall tax on oil and gas producers’ profits to 35 per cent from its current rate of 25 per cent. The new rate, which will apply from 1 January 2023 until March 2028, is part of a raft of budgetary measures aimed at shoring up the UK’s finances and tackling the cost of living crisis.

A few days before this announcement, Offshore Energies UK (OEUK) warned that the windfall ‘supertax’ proposal risks driving out oil and gas investments from the UK waters, which could hinder the UK’s energy security along with its transition plans for a low-carbon future.

Following the windfall tax hike, OEUK underscored that the UK offshore industry will be “hit hard” by these tax changes on oil and gas production, which threaten to drive out investors and drive up imports, leaving consumers increasingly exposed to global shortages.

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In line with this, Moody’s outlook confirms that the higher tax rate will result in lower projected positive free cash flow (FCF) generation and the related impact on cash flow will also last longer because of the levy’s extension beyond the end of 2025.

The credit rating agency expects the three independent E&P companies it rates – Ithaca Energy (Ithaca, B1 stable), EnQuest (B2 stable) and Neptune Energy Group Midco (Neptune, Ba2 stable) – which operate on the UKCS, to be affected by “varying degrees” by these revisions, depending on the geographic scope of their businesses and future investment plans.

In lieu of this, the agency emphasised that Ithaca Energy and EnQuest are more directly exposed than Neptune Energy to the rise in the levy because of their high operational concentration, albeit with some differentiation.

Furthermore, Ithaca has “a significant pipeline of growth projects” through its recent acquisition of Siccar Point. As this deal includes early life cycle hydrocarbon assets on the UKCS, Moody’s expect Ithaca to benefit from capital allowances aimed at encouraging companies to reinvest profits into hydrocarbon extraction activities in the UKCS, which would enable the firm to “significantly offset” the higher tax burden on its production activities.

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On the other hand, the higher tax-related outflows and lower scale of growth investments will weigh on EnQuest’s FCF generation, somewhat delaying the pace of reimbursement of drawings under the reserve-based lending facility, following the recent refinancing transaction. However, this is not expected to “significantly compromise” the company’s ability to meet upcoming debt maturities, says Moody’s.

In contrast, the credit rating agency expects the tax changes to have “a more limited adverse effect” on Neptune’s credit metrics, since, this firm has a diversified operational footprint with the UK accounting for 11.6 per cent of production during the first nine months of 2022. Regardless, the incremental taxation of Neptune’s activity in the UK could compound the effect of similar levies potentially introduced in other jurisdictions where the company operates, such as in the Netherlands.

How will oil majors fare?

Moody’s pointed out that the three largest European integrated oil and gas companies it rates — BP (A2 stable), Shell (Aa2 stable) and TotalEnergies (A1 stable) — will “also be hurt” by the tax hike, but their scale, global and downstream diversification will limit the financial effects. While the credit rating agency expects metrics and cash flow to remain strong for these companies, the higher tax will result in less surplus cash flow available for shareholder distributions or debt reduction.

Even though these changes were “largely expected,” they come just six months after the windfall tax was initially introduced by the UK government to help fund support for households struggling with soaring energy bills. Despite this, high inflation is “increasingly weighing on the UK’s economic performance and eroding households’ real purchasing power.”

After Russia’s invasion of Ukraine added to the already strong momentum for energy prices, oil and gas players’ profits have “risen sharply” this year. In light of this, Moody’s believes that energy companies’ earnings will ease in 2023 from record levels in 2022 in step with commodity prices, as the industry adjusts to slower growth in demand, amid a global economic slowdown.