Tax reform can be a powerful incentive for energy companies to increase spending on capital projects. For instance, BP (BP 2.86%) recently decided to ramp up spending on oil and gas projects in Alaska mainly because of new and favorable tax regulations in that state.
But of course, the flip side is when lawmakers decide to raise taxes on the energy industry. If the tax increase is large enough, it can prompt companies to drastically change their capital spending plans and, in some cases, even delay or abandon certain projects altogether. Statoil's (STO 6.63%) experience is instructive.
Statoil gets a rude awakening from Oslo
Last month, Norway's government unexpectedly announced that it would raise taxes on oil and gas companies operating in the country. On May 5, it proposed limiting the tax-deductible component of petroleum income, slashing exemptions on free cash flow from 30% to 22%.
It also plans to increase its special petroleum tax from 50% to 51%, while maintaining a top tax rate of 78%. The combined effect of these measures would be a 3 billion kroner ($517 million) annual increase in oil industry taxes.
Though the decision hasn't yet been signed into law, it has already affected capital decisions at Statoil, the largest Norwegian oil and gas producer by output. The spike in taxes, which lowers the profitability of certain projects, has prompted the company to delay developing its Johan Castberg oilfield in the Barents Sea.
Statoil, which is majority-owned by the Norwegian government, said last week that the unexpected fiscal move by Oslo would add about $7 per barrel to the project's breakeven cost of development. Even before the impact of the tax increase, the project's breakeven rate was higher than Statoil's group breakeven rate of around $50 a barrel.
The company had previously warned that the economics of the Castberg project, which includes the Skrugard and Havis discoveries, had become "more challenging." The oilfield, estimated to hold some 400 million to 600 million barrels of oil equivalent, has been in dire need of new infrastructure -- an issue compounded by the tax increase.
Challenges of drilling in the Arctic
As Statoil's experience highlights, tax increases can exacerbate some of the challenges companies drilling in the Arctic already face, such as harsh weather and the lack of infrastructure. Consider Royal Dutch Shell's (NYSE: RDS-A) Alaska drilling campaign, for instance, which has been beset by hurdles including regulatory uncertainty, environmental opposition, and equipment failures.
After having invested some $5 billion into its Alaska operations, the Hague-based company recently decided to halt all exploration and drilling activity in the region this year. Similarly, ConocoPhillips (COP 4.97%) recently announced that it's suspending plans to drill in Alaskan waters in 2014 because of regulatory and other uncertainties.
Some companies, though, are still hopeful. ExxonMobil (XOM 4.69%), through a joint venture with Russia's OAO Rosneft, added seven more licenses earlier this year to develop acreage in Russia's Arctic Shelf, while China National Offshore Oil, or CNOOC, recently announced that it's partnering with Iceland's Eykon Energy to apply for a license to explore and produce oil and gas in the Arctic waters off the coast of Iceland.
Final thoughts
Though the Arctic region could potentially hold vast oil and gas reserves, drilling in the area is accompanied by severe risks. In addition to high costs and lack of infrastructure, the threat of an environmental backlash, and the ramifications of an oil spill or other accident loom large. These are issues investors should be wary of when they invest in companies that are spending heavily to explore Arctic frontiers.
