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Fiscal System for oil

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  • 1.
    • Fiscal systems for Oil
  • 2. Landlord Vs tenant
    • “ Saudis wanted more money out of the concession. A good deal more”
    • - Daniel Yergin
  • 3. Landlord Vs tenant
    • Such demand were by no means restricted to Saudi Arabia
    • In late 1940s & 50s oil companies & government grapple continuously over financial terms for the petroleum order
  • 4. Landlord Vs tenant
    • The central issue was of the division
    • Uneasy & important term in economics of natural resources- RENTS
  • 5. Landlord Vs tenant
    • The idea was always the same: shift the revenues from the oil companies & the treasuries of the consuming countries
  • 6. Landlord Vs tenant
    • Ricardo, the famous economist, developed the framework for the battle between nation-states & oil companies
    • It was the notion of “rents” as something different from normal profits
  • 7. Landlord Vs tenant
    • His case study involved grain, but it can be applied to oil
    • Let’s see how it works?
  • 8. Ricardo’s rent
    • Given that there are 2 landlords
    • One with more fertile land, & the other with the less fertile land
    • They both sell the output at same price
  • 9. Ricardo’s rent
    • But given the difference in fertility; it costs less for one to produce as compared to the other
    • While the latter makes profit, but the former makes not only profit, but also something much larger- Rents
  • 10. Ricardo’s rent
    • His rewards, rents, are derived from the particular qualities of his land, which results not from his ingenuity, or hard work
    • But from nature’s bountiful legacy
  • 11. Ricardo’s rent
    • Oil was another of nature’s legacies
    • It’s geological presence has nothing to do with any of our activity
  • 12. Ricardo’s rent
    • This legacy too generated rents
    • “ Difference between market price, on one hand & on the other the cost of production plus an allowance for additional costs & for some return on capital”
  • 13. Ricardo’s rent
    • The point was:
    • Who, the host government, or the producing company, or the consuming country that taxed it, would get how much of rents?
  • 14. Ricardo’s rent
    • Interestingly enough there was no agreement on this elemental issue
  • 15. Landlord Vs tenant
    • M A Adelman hence said:
    • This is a great divide of the industry: a rich discovery means a dissatisfied landlord
    • … he knows that tenant’s profit is far greater than is necessary to keep him producing
  • 16.
    • Now let’s look more closely at the fiscal systems for oil
  • 17. The concept
    • Until 1960s petroleum exploration on an International scale was carried out by only a few large petroleum corporations
    • But in last few decades things have changed
  • 18. The concept
    • Exploration for petroleum occurs on the basis of concessions, leases, or contracts granted by governments
    • The terms & conditions of such arrangements are established by law or negotiations case by case
  • 19. The concept
    • One important aspect of arrangements is the fiscal terms & conditions
    • These would include, bonuses, rentals, royalties, production sharing arrangements, carried interest provisions, corporate income taxes, & special taxes
  • 20. Signature bonus
    • Some agreements provide for the holder to pay a “bonus” on date of the contract is signed or exploration license is granted
    • This can be called as “signature bonus”
  • 21. Signature bonus
    • This represents a major financial commitment for the holder
    • This is usually payable before production commences
    • No wonder it can have a major impact on profitability of the project
  • 22. Production bonus
    • These are sums paid when certain production thresholds are reached on a field
    • The contracts can also provide for “discovery bonus” to be paid
  • 23. Treatment of bonuses
    • Not all countries treat signature & production bonuses in the same way
    • Some treat them as deductible while others do not consider them to be deductible
  • 24. Government participation/carry
    • Many systems provide an option for the NOC to participate in development projects
    • Contractor bears the costs & risk of exploration & if there is a discovery, government enters for a percentage
  • 25. Government participation/carry
    • Interestingly, the government may or may not reimburse the contractor for past exploration costs
    • Many times the government contribution to capital & operating costs is normally paid out of production
  • 26. The concept
    • Together all the payments to the government required under a petroleum arrangement can be called “fiscal systems”
  • 27. The concept
    • In some countries, a single fiscal system applies to the entire country
    • In others a variety of fiscal systems exists
  • 28. The concept
    • Over the years an “International market” for exploration acreage has been developed
    • This was largely thanks to the large number of governments, wide diversity of areas, large companies interested in exploration
  • 29. The concept
    • Governments offer exploration acreage through formal bidding rounds or by case by case basis
    • The “price” for the acreage is the government take
  • 30. The concept
    • This is nothing but the total effect of the fiscal system on the cash flow of an oil field
    • This is generally expressed on percentage basis
  • 31. The concept
    • A government take of 55 per cent means:
    • that total government revenues resulting from the fiscal system represents 55 per cent of the cash flow from the oil field
  • 32. The concept
    • The world average “government take” is 64 per cent
    • Most “government takes” are between 40 per cent & 85 per cent
  • 33. The concept
    • The objective of a host government is to maximize wealth from its natural resources by encouraging appropriate levels of exploration & development activity
    • In order to accomplish this, governments must design fiscal systems
  • 34. The concept
    • The objectives of the oil companies are:
    • to build equity & maximize wealth by finding & producing oil & gas reserves at the lowest possible cost & highest possible profit margin
  • 35. The concept
    • Areas with least favourable geology, the highest costs, & lowest prices at the wellhead will offer best fiscal terms
    • On the contrary areas with geology, lowest costs, & highest prices at the wellhead will offer the toughest fiscal terms
  • 36. The concept
    • Malaysia has one of the toughest fiscal systems in the SE Asia
    • The reason is simple: it has a good geological potential
  • 37. The concept
    • Thus the balance between the prospectivity & fiscal terms is the fundamental theme in the industry
  • 38. The concept
    • Host government will design a fiscal system where exploration & development rights are acquired by those companies who place the highest value on these rights
    • In an efficient market, competitive bidding can help achieve this objective
  • 39. The concept
    • The hallmark of an efficient market is availability of information
    • Yet, exploration is dominated by numerous unknowns & uncertainty
  • 40. The concept
    • Nearly 9 out of 10 exploration efforts are not successful
    • This then becomes an important element of risk that strongly characterizes the upstream end of the oil industry
  • 41. The concept
    • With sufficient competition the industry will help determine what the market can bear, & profit will be allocated accordingly
    • In the absence of competition, efficiency must be designed into the fiscal terms
  • 42. The concept
    • Financial issue of how costs are recovered & profits are divided is the underlying theme, irrespective of which fiscal system is employed
  • 43. The concept
    • Governments must ideally design fiscal systems that:
    • Provide a fair return to state & industry
    • Avoid undue speculation
    • Limit undue administration burden
  • 44. The concept
    • Provide flexibility
    • Create healthy competition & market efficiency
  • 45.
    • Let’s now look more closely at the petroleum fiscal arrangements
  • 46. The framework
    • Governments have devised numerous framework for the extraction of economic rents from petroleum sector
    • Obviously some are very efficient & some perhaps not
  • 47. The framework
    • The fundamental issue however always remain the same:
    • Whether exploration & or development is feasible under the conditions outlined in the fiscal system
  • 48. The framework
    • The issue of division of profits lies at the heart of the contract negotiations
    • To reiterate again, the purpose of fiscal structuring & taxation is not to capture all the economic rent but also to provide a sufficient return to oil companies
  • 49. The framework
    • There are numerous kinds of contracts or fiscal arrangements in the world
    • Usually these basic themes fall under two main families:
    • Concessionary & Contractual systems
  • 50. Petroleum fiscal regimes Royalty / Tax system Contractual based system Service agreements Production sharing contracts Peruvian Indonesian Pure Hybrids Risk services
  • 51. Petroleum fiscal regimes
    • Service arrangements are divided upon whether remuneration is based upon a flat fee (Pure) or profit (Risk)
  • 52. Petroleum fiscal regimes
    • Within the PSC, Peruvian types divide gross production
    • In the Indonesian PSC, profit oil is divided
  • 53. Profit Oil
    • The proportion of oil left after deduction of the cost oil is known as profit oil
  • 54. Petroleum fiscal regimes
    • The issue of ownership is the fundamental distinction between the contractual & concessionary systems
    • Under the former government retains the title to the mineral resources
    • While under the later, oil company has the title to crude oil produced; against which it pays royalties & taxes
  • 55. Petroleum fiscal regimes
    • This ownership issues drives not only the language & jargon of fiscal systems; but so also the arithmetic
  • 56. Petroleum fiscal regimes
    • There are essentially two basic families of the systems- concessionary R/T systems & the contractual systems
    • Study of PSCs effectively covers all aspects of contractual systems; services hence are not dealt separately
  • 57. Petroleum fiscal regimes
    • Comparing & contrasting PSCs with the R/T systems provides the foundation to understand the petroleum fiscal system economics
  • 58. R/T systems
    • The concessionary system is termed the R/T system
    • Usually the concessionary system is not much more than a combination of royalties & taxes
  • 59. The R/T system flow Company share Government share Gross revenue $ 20 Royalty 12.5 % $ 2.50 Net revenue $17.50 Assumed costs $ 5.65 Deductions, like CAPEX & OPEX Taxable income $ 11.85 Special petroleum tax 25% $ 2.96 $ 8.89 $ 5.78 Income tax rate 35 % $ 3.11 $ 11.43 Division of gross revenues $ 8.57 $ 5.78 Division of cash flow $ 8.57 40 % Take 60 % 5.78 /($20-5.65) 8.57/ ($ 20-5.65)
  • 60. The R/T system flow
    • Royalty is first taken account off in the system
    • Next, deductions are taken care
    • Before calculations of taxes, the contractor is allowed to deduct operating costs, depreciation other related charges
  • 61. The R/T system flow
    • Finally revenues remaining after royalty & deductions are called taxable income
    • With tax deductions, the contractor share of gross revenues would be 57 %
    • Share in Gross revenues / Gross revenues or ($ 11.43/$ 20)
  • 62. The R/T system flow
    • Similarly the contractor share of profits would be 40 %
    • [Contractor cash flow / Gross revenue - assumed costs] or
    • ($ 5.78 / $ 20 -$ 5.65)
  • 63. R/T system cash flow summary Gross revenue 2,000,000 Total costs -565,000 Total profit 1,435,000 Bonus -5,000 Royalties 12.5% -250,000 SPT 25% -296,250 Income tax 35% -309,314 860,563 (GT) Company cash flow 574,438 Company take 40 % (574,438/1,435,000) Government take 60 % (860,563/1,435,000)
  • 64. R/T systems
    • The contractor take or the government take statistics give a quick measure of comparison between one fiscal system & another
    • They focus exclusively on division of profits
  • 65. R/T systems
    • As a rule always remember; complement of government take (1- GT) is contractor take
    • For example, GT is 75 %, then the contractor take is 25 %
  • 66.
    • Let’s now move on to another type of agreement, the production sharing contracts
    • As the name suggests they are contractual based systems
  • 67. PSCs
    • There isn’t many a differences between the two systems, the R/T & the PSCs
    • But for one small mechanical difference the cost recovery or the C/R limit
  • 68. PSCs
    • Among the many production sharing arrangements, there are certain common elements
    • The defining characteristics is of course the state ownership of the resources
  • 69. PSCs
    • The contractor receives a share of production for services performed
    • As more countries open up their industry, they use PSCs as opposed to the concessionary systems (R/T systems)
  • 70. PSCs
    • The first PSC was signed in August 1966, with Permina, the Indonesian National Oil Company
    • This is when the oil companies became contractors
  • 71. PSCs Contractor share Government share Gross revenue $ 20 Royalty 10% $ 2.00 $ 18.00 $ 5.65 assumed costs Cost recovery limit 50% $ 12.35 Profit Oil Profit oil split 40/60 $ 4.94 $ 7.41 ($ 1.48) Tax rate 30% $ 1.48 $ 3.46 $ 9.11 Division of Gross revenue $ 10.89 $ 3.46 Division of cash flow $ 10.89 24 % Take 76 % $ 3.46/ ($20-5.65) $ 10.89/ ($20-5.65)
  • 72. PSCs
    • Royalty like under the R/T systems comes right at the top
    • Before sharing of production, the contractor is allowed to recover costs out of the net revenues
  • 73. PSCs
    • Cost recovery is the means by which the contractor recoups costs of exploration, development, & operations out of gross revenues
  • 74. PSCs
    • Most PSCs place a limit on how much production will be made available for the recovery of costs in any given accounting period
    • This then is known as the C/R limit
  • 75. PSCs
    • If for some reason my costs are above the 50 % imposed limit, balance is carried forward & recovered later
    • The C/R limit is the only true distinctions between the R/T systems & the PSCs
  • 76. PSCs
    • Revenues remaining after the royalty & the C/R limit are referred to as profit oil split or P/O
    • Under the concessionary system or the R/T system it would be called taxable income
  • 77.
    • Let’s look at a more simplified version of what we just learnt
  • 78. Division of profits Take calculations Contents $ 100 Gross revenues -10 Royalty 90 Net Revenues -30 Cost recovery 60 Profit Oil -36 60 % to government 24 40 % to contractor -7.2 Corporate income tax 30 % 16.8 Contractor net income after tax
  • 79. Division of profits
    • Contractor take= 24 %
    • Contractor net income after tax (16.8) / gross revenue (100) – costs (30)
    • Government take= 76 %
    • [10 + 36 + 7.2 / (100-30)]
  • 80.
    • Effective royalty rate (ERR) & Access to gross revenue (AGR)
  • 81. ERR & AGR
    • The ERR is also referred to as revenue protection
    • ERR is defined as minimum share of gross revenues a government will get in any accounting period
  • 82. ERR & AGR
    • AGR is the maximum share of revenue the contractor or consortium can receive in any given accounting period
    • The complement of the ERR is the AGR
  • 83. ERR & AGR
    • In an R/T system with no C/R limits, the royalty is the only component of the ERR
    • That’s the only mechanism which provides the government revenue protection
  • 84. ERR & AGR
    • Under the PSCs with a C/R limits, the NOC is guaranteed a share of P/O
    • This is intuitive as certain percentage of production is always forced through the P/O split
  • 85. ERR & AGR
    • Royalties & the C/R limits guarantee the government a share of revenues or production
    • This is regardless of whether true economic profits are generated
  • 86. AGR calculations Take contents Contents 100 Gross revenues -10 Royalty 90 Net revenues -60 Cost recovery (limit = 60) 30 Profit Oil -18 60% to government 12 40% to contractor -0 Corporate income tax 30% 12 Contractor net income after tax
  • 87. AGR calculations
    • AGR = [Cost oil (60) + Company profit oil (12)]
    • Thus the AGR will be 72 %
    • ERR = [Royalty (10) + Government profit oil (18)]
    • Thus the ERR will be 28 %
  • 88.
    • Let’s now look at other concepts employed in the fiscal systems R factor
    • Ringfencing
  • 89. The R factor based systems
    • The R factor based systems is not a unique contract per se
    • It merely gives an idea about the payout
  • 90. The R factor based systems
    • Tax rate for instance may be subject to a factor R
    • R which stands for ratio, will be a function of X divided by say Y
    • R= X / Y
  • 91. The R factor based systems
    • X= Contractor cumulative receipts (after tax)
    • Y= Contractor cumulative expenditure
    • At payout, X = Y; this yields an R factor of 1
  • 92. Ringfencing
    • All costs associated with a given block or license must be recovered from revenues generated within that block
    • The block is essentially ringfenced
  • 93. Ringfencing
    • For the industry it is obviously not a welcome idea
    • I can swap through different blocks, & offset some kind of losses
    • Cross fence is a strong financial incentive to the industry
  • 94. Ringfencing
    • For the government though cross fence means that the government in effect subsidize unsuccessful exploration efforts
  • 95. Take calculations; to summarize A 100% Gross revenues B -10% Royalty C 90% Net revenues D -35% Assumed costs E 55% Profit Oil F -33% Government P/O G 22% Company P/O H -11% Income tax (50%) I 11% Company cash flow 83% GT (B+F+H)/(A-D) 16.9% CT [I /(A-D)] 1.31% R factor [(D+I)/D] 57% Entitlement (D+G)

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