How to make the last oil pay

North Sea oil operators say they won't be able to extract the UK's remaining reserves without lower taxes. Sarah Arnott reports

Pressure is mounting on the Government to ease the tax regime governing North Sea oil and gas in next month's pre-Budget report. Critics claim that the Government's talk of a need for a successful British industry to end the dependence on financial services and the City is undermined by the reality of a world-leading hydrocarbons industry that is being taxed into premature decline.

The common perception is that the North Sea is finished. But while some 40 billion barrels of oil and gas have been produced from the North Sea so far, there is another estimated 25 billion still to come.

That's the good news, both for the UK's increasingly uncertain energy security and for the economy. The bad news is that North Sea oil is by far the most highly taxed part of the economy with its own special rate of 50 per cent, rising to 75 per cent on production from older fields. The regime was created when the North Sea was still gushing with oil, and is in danger of choking the technically difficult – and more expensive – exploration and drilling required to make the most of what is left.

Industry representatives hope to meet Lord Davies, a minister in the Department for Business, in the coming weeks to discuss their concerns. But given the response from Lord Hunt, a minister at the Department of Energy, in recent talks, confidence is not high.

"The North Sea is the UK's unsung industrial hero," says John Gallagher, vice president of Shell's European upstream business. "This is about both maximising the UK continental shelf (UKCS) and keeping the world-leading industry even after that is over. The Government has not fully grasped the importance of what we've got at the moment, and what potentially might be lost."

There are major economic implications. Of the 25 billion barrels that are left, 10 billion are accounted for in commercial production plans. But the rest are not. If the last, hard-to-reach resources are too expensive to pursue, the difference to the UK economy – at an oil price of $70 – would be more than £1 trillion.

The woeful state of the public finances will no doubt make it harder for the Government to rein back on a regime that produces an annual £20bn in taxes. "They might just want to squeeze harder but that would be to the detriment of the longer term benefit of the asset," Mr Gallagher warns. "The Government needs to be careful how they nurture a national asset into middle age."

It is not just a question of the valuable reservoirs of oil and gas. It is also about the industry itself. Trickle-down spending amounts to £12bn per year and there are 450,000 people who work in the sector. And as global hydrocarbon reserves run down, and companies take on greater technical challenges, UK expertise is becoming a valuable export commodity. Export levels are rising at a rate of 10 per cent a year, hitting £5bn in 2008.

The UKCS pioneered a range of offshore technologies when the industry began in the 1970s, and continues to lead the world in a number of areas. One UK strong suit is sub-sea drilling, for example. The technology involved in offshore oil and gas production is awesome at the best of times. Sub-sea drilling is mindblowing. Rigs may stand in hundreds of metres of harsh sea conditions, before drilling hundreds of metres more into the rock below, dealing with the temperatures and pressures within the earth, as well as the immense complication of the sea.

Sub-sea is the same drilling process, but from a boat, ending with only a pipe leading back to a nearby oil rig as a hub. The difference in cost of a so-called "sub-sea tie-back" and a whole new rig is phenomenal. In a world where oil resources are depleting and demand is pushing companies to exploit larger numbers of smaller reservoirs, sub-sea tie-backs are a good place to be. And Aberdeen leads the world.

But the North Sea oil and gas sector is already showing signs of strain. Capital expenditure is falling – from £5.6bn in 2006, to £4.8bn in 2008, and trade group Oil & Gas UK estimates it could fall as low as £4bn this year. Drilling operations have declined by more than half in the last year, with only 15 exploration wells drilled in the three months to June, compared with a 50 per cent increase just over the border into the less heavily-taxed Norwegian North Sea.

"In this country, once we get an industry, we are not very good at holding on to it," Mr Gallagher complains. "The leading spending industry in the UK is being forgotten about."

The Government has not been completely deaf. April's Budget included slightly more favourable treatment of new field developments.

But the industry says the amounts are not enough to make a difference. And though Lord Mandelson, the Business Secretary, told the Labour Party conference that the future is "less financial engineering and a lot more real engineering", there is rarely any mention of the North Sea.

Malcolm Webb, chief executive of trade group OGUK, says: "Lord Mandelson says the UK needs to build on its industrial strength, and the North Sea is a huge one.

"We need to be clearly open for business in oil and gas in the UK and we need support from the Government in that message."

All at sea: Life on the rig

*It is hard to imagine the scale of an offshore rig. Some 100km out into the North Sea off Aberdeen, Shearwater's nine decks tower 20 metres above the 150 metre-deep, dark turquoise water. It is home to 92 people, who work a 12-hour shift pattern, with two weeks on the rig, then two weeks off, another two weeks on, then a month off.

"You have to be a special type of person to work on a platform," says Dave Blackburn, Shell's operations manager for three North Sea rigs. "But there is the most incredible atmosphere and teamwork." The culture has changed out of all proportion in recent years. Since the Piper Alpha disaster that claimed 167 lives in 1988, the macho ethos has been replaced by an overwhelmingly safety-conscious approach.

The advent of new technology in the form of commodity TV sets and the internet has also changed life on the rig. Stuart Sibbald, the medic on Shearwater, says: "Twenty years ago when there were no TVs or computers, there was a film every night and more communication between people. New technology means better communication with the rest of the world, but the people here communicate less."