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Fiscal System for oil


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Fiscal System for oil

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