Fracking in the UK: the Shale Gas Industry Begins to Take Shape

This past year was witness to the most significant events to date in the shale gas industry in the UK: the Government took tangible steps to demonstrate its commitment to aid development of the industry; the EU weighed in on the fracking debate to impose European requirements; and a number of significant players in the oil and gas industry opened their wallets (a little) and acquired interests in a number of potential shale plays.

Backing fracking: the UK Government shows industry support

In December 2012 the UK Government announced that the moratorium on shale gas exploration was to be lifted.  The ban on fracking had been in place since May 2011 after two seismic tremors occurred in the Bowland basin in northwest England where exploratory drilling was taking place.  Upon lifting the ban, the Government introduced a number of additional control mechanisms to mitigate such seismic risks, including the requirement for project developers to conduct a pre-fracking review to assess the existence of faults and determine seismic risks and continuous seismic monitoring before, during and after fracking.

Shortly afterwards, a new regulatory body for the shale industry - the Office of Unconventional Gas and Oil (or “OUGO”) - was established.  The Government has tasked OUGO with harmonising responsibilities across various public bodies and providing a single point of contact for investors, with the aim of ensuring a simplified and streamlined licensing and regulatory process.  Guidance notes relating to the planning process for obtaining project approvals have also been published.  Such initiatives are likely to be welcomed by the industry, particularly if they serve to significantly reduce the reported six-month wait faced by developers to obtain approval to frack a well.

The UK Government’s determination to provide a supportive investment environment for the shale gas industry became further evident when details were announced for proposed tax incentives attaching to shale gas developments. Implementing legislation for these tax incentives is contained in the draft Finance Bill 2014, which is expected to be passed by UK Parliament in the coming months.  The tax incentives take two forms:

• Presently, project developers are subject to the “ring fence” tax regime (comprising three separate taxes) in respect of oil and gas production in the UK.  The effect of this regime is a marginal tax rate of 62 per cent for production from most fields.  The tax incentives for shale gas developments take the form of a “pad allowance” which operates by exempting a portion of production income (being an amount equivalent to 75% of the development cost of the project) from the supplementary charge, which is levied at 32 per cent.  The effective tax rate on this proportion of production income benefiting from the allowance would therefore be 30 per cent based on current taxation levels.
• In addition, the ring fence expenditure supplement (which recognises that the value of unutilised losses and expenditure declines in real terms over time when not used, and compensates project developers by inflating the value of such expenditure and losses by 10 per cent) is to be extended to ten accounting periods in relation to shale gas developments (up from the current six that otherwise applies to oil and gas projects).  This extension recognises the longer payback period for shale gas projects due to steep decline rates requiring high and continuous investment in wells. 

In addition, the Government has also recently taken measures to endeavour to garner community acceptance of the industry.  It has announced that local authorities will be able to keep 100% of the business rates (the taxation that pays for local services) that they collect from shale gas sites, an increase from the current 50%.  This is in addition to the sweetener offered by the United Kingdom Onshore Operators Group (the representative body for UK onshore oil and gas companies), which has established a charter under which local communities will be entitled to a payment of £100,000 and 1% of the revenue from shale gas production.

The EU angle

The EU was also busy throughout 2013 in relation to the prospective development of a shale gas industry across Europe.  In October, the European Parliament voted in favour of an amendment to the EU’s Environmental Impact Assessment Directive which would require environmental impact assessments (“EIAs”) to be performed for hydraulic fracturing activities.  If the amendment becomes law (only achieved after approval from the EU Council) it will require all private and public shale gas and many other unconventional exploration projects involving fracking in the EU to undertake an EIA.

The effect of this change would be to remove the discretion that EU member states currently have as to whether or not to require a full EIA as part of the licensing process.  A full EIA can take up to a year to complete and can be costly, although provide a thorough and detailed survey of the aspects of the environment that are likely to be significantly affected, enabling informed assessments to be made during the licensing process and in respect of the project generally.

Should the amendment become binding EU law, each EU member state will have a certain period of time to implement the amendment into their national legislative framework.  There is currently no fixed timeframe for the EU Council to consider and vote on the amendment but the Member of European Parliament with the mandate to enter into discussions with the Council in respect of the amendment has said that he hopes the amended EIA Directive will be in force by 2016.

The European Commission also published its “shale gas initiative” in January 2014, consisting of: (i) a recommendation on the voluntary minimum principles for member states to apply if they intend to permit fracking; (ii) an outline of the opportunities and challenges of shale gas extraction in the EU; and (iii) an impact assessment of various options for regulating fracking in the EU).  The Commission originally considered publishing binding legislation regarding fracking but came under pressure not to do so from members states (including the UK and Poland) that are keen to encourage the industry.  The Commission has announced that it will review its approach in 18 months’ time and may decide that legislative proposals are needed – it will also report on the adherence to the minimum principles by each member state.

Industry heavyweights dip their toe

The past year has also seen a number of major players enter the UK shale market by acquiring interests in onshore licences – in June, Centrica acquired a 25% interest in a licence within the Bowland shale basin in Lancashire from Cuadrilla and AJ Lucas; in October, GDF Suez acquired a 25% interest in 13 licences throughout the Bowland basin from Dart Energy; and in January 2014, Total announced that it had acquired a 40% stake in two exploration licences in the Gainsborough Trough basin in Lincolnshire from IGas. 

These transactions make it clear that potentially significant investors have interest in the development of shale gas projects in the UK, but that at this stage those that have entered are not financially over-exposed – they are, in effect, dipping their toe in.

What next for 2014?

The fledgling UK industry is likely to see further development in 2014, with the prime minister stating that the Government will be “going all out for shale”.  The success or otherwise of the 2014 licensing round will provide a useful gauge of industry appetite.  Although the previous onshore licensing round in 2008 failed to generate high levels of interest, with only 55 licences being awarded out of a potential 182, the subsequent “shale boom” in the US and the M&A activity from Centrica, GDF Suez and Total may stimulate increased interest in this licensing round.

The next critical step for the development of the industry in the UK is that further drilling is undertaken.  Testing whether the geology performs as expected and whether commercial quantities of gas can be flowed is fundamental and, to date, the limited drilling that has taken place is simply insufficient to assess whether that will be (or can be) the case.  Cuadrilla and Dart Energy have both announced that they intend to drill a number of wells, though the precise timing is not entirely clear and it could be as late as 2015.

It is also possible that there may be some further acquisitions this year, but the M&A market is likely to remain relatively limited.  The catalyst for more significant activity will be the demonstration that commercial quantities of gas can sustain a development project and that may still be a year or two away. 

The industry can also expect to see continued opposition to fracking from environmental groups this year.  As well as undertaking demonstrations at proposed drilling sites (in some cases regardless of whether fracking was intended at that particular site or not), some activists and local landowners have recently made clear their willingness to use trespass laws in connection with their refusal to grant consent to fracking taking place under their land.  To remove this potential avenue of protest the UK Government has recently indicated that it may consider changing the trespass law, but that is unlikely to signal the end of the debate that surrounds the industry.

Darren Spalding and Adam Waszkiewicz of Bracewell & Giuliani (UK) LLP