An Overview of the RegulatoryFramework, Fiscal System, andMarketing of Oil and Gas in Italy

Po Valley BasinNorthern Italy

Italy is one of the most attractive oil andgas fiscal regimes within its peer group ofcountries. When considering keyperformance indicators such asgovernment take, full cycle rate of return,profit to investment ratio, and explorationcover ratio, Italy's fiscal regime is highlyranked. Italy is the fourth most populatedEuropean country and the third largestEuropean gas market after the UK andGermany.

Highly dependent on foreign energysources, Italy has some of the highestenergy prices in the world. What's more,emissions management, energy security,and new found concern regarding thedependence on and reliability of Russianand North African imports are putting a

premium on commercial gasreserves within Europe. Highenergy prices along with Italybeing a highly urbanizedcountry with a developedinfrastructure and extensivenational grid have resulted inattractive developmenteconomics. Consequently,reserves do not have to belarge and geographicallyconcentrated in order to becommercially viable.

ITALIANUPSTREAM OILANDGASREGULATIONSAND LICENSINGPROCESS

We note that principle termsand regulations may varyslightly in onshore Sicilycompared to the rest of Italyas Sicily has its ownregulations.

Exploration License Application Process

The first time a company applies forlicenses or farms into existing licenses,they must submit documentation to theMinistry of Economic Development(MOED) showing technical and financialcapability. MOED may ask for a bankguarantee.

On lodging an application with MOED,an announcement is published in theofficial bulletin of hydrocarbons (BUIG)which subsequently opens a 3-monthcompetition period where other partiesmay lodge an application covering thesame area. Upon reviewing applications tolicense, a technical committee of MOED

may:

1. Approve an award to a party thathas lodged an application

2. Propose a joint venture be formed3. Decline ail applications

Preliminary granting of licenses issubject to approval of an EnvironmentalImpact Assessment (EIA) report. If thelicense contains protected areas, a moredetailed environmental study may berequired as opposed to the standardscreening process. Onshore, the EIAprocedure is handled by the regionalgovernments with processes that maydiffer slightly region-to-region ranging fromclosed meetings among local authorities toopen meetings with local communities. Foroffshore licenses, the EIA reportauthorization is obtained from the Ministryof Environment. In any case, the public isalways informed about any EIA process.Upon approval of the EIA report, the finalgranting of the license is made by MOED.

Exploration Licenses

Exploration licenses are issued for asix-yearterm, with the option to extend fortwo additional 3-year terms subject to thefulfillment of the approved work program.One well is the minimum requiredcommitment in the 3 periods (6 years -t- 3+ 3).

Work programs are subject to apenalty for failure to perform equal to 10percent of the program investment, not toexceed €140,000. Deferrals to programsresulting from delays in parallelgovernment approvals and events beyondthe control of the licensee are acceptableprovided proper notification is made to therelevant authorities in a timely manner.

The government accepts thecommencement of civil works as the start

SEPTEMBER 2011 • 24 Map courtesy of Drilling Info International, 2011

Sara Edrnonson, Finance Manager, Po Valley Energy I imited (serlmonson@povalley.com)

Michael J. f erris, Chief Economist, Moyes & Co. (mferris@moyesco.com)

Christopher P. Moyes, President, Moyes & Co. (cmoyes@moyesco.com)

Picrluigi Vccchia, Program Manager, Po Valley Energy Limited (pvccchia(i7/povallcy.com)

of drilling operations. This is typically theconstruction of a drilling pad, which is amore substantial concrete platform than istypical of the global industry.

As an incentive the government offersup to a 40 percent refund of costs incurredfor the acquisition of new seismic subjectto submittal of documentation. Therefund, if approved, is made in the yearfollowing the submittal of documentation.

Production License Application Process

When a discovery has been made, theoperator has the exclusive right to proceedtoward development. As a consequence,the production license approval processdiffers from the exploration licenseapproval process because it is notexclusive. The remainder of the processincludes preliminary granting, EIA reportapproval, and final granting. Theapplication process may take more than ayear. MOED approves the work programconsidering both technical and economicissues. Oil and gas resources areconsidered state property.

Production Licenses

Production licenses are issued for 20years, with a 10-year extension grantedupon demonstration of continuedcommerciality and full respect of theapproved work program. MOED and theMinistry of Environment have full oversightregarding operations, health and safety,and environmental protection. BothMinistries have the right to stop anyactivity when warranted.

ITALIAN FISCAL SYSTEM

The fiscal system in Italy is based on aroyalty and tax model.

Royalty

Royalty rates vary depending onproduct type and location, onshore oroffshore. The exception to this is Sicily,where royalties are fixed at 10 percent forboth oil and gas independent of theconcession location (i.e. onshore oroffshore).

Oil '• Gas(percent) (percent)

Onshore

Offshore

10 10

Royalty exemptions also varydepending on product type and whetherproduction is onshore or offshore, againwith the exception of Sicily.

Onshore

Offshore

Oil(103 tonnes)

20

50

Gas(106 cubic meters)

25

80

These exemptions are quoted perfield and per year. Around 30 percent ofdomestic gas production and around 7percent of domestic oil production areultimately exempt from royalty.

For more information regarding oiland gas royalties in Italy, refer to theDirectorial Decree dated 22 March 2011published in BUIG LV No.3 dated 31 March2011.

Surface Fee

An annual surface fee is due with theamount ranging from €6.82 per sq kmduring the first period of an explorationlicense to €81.71 per sq km during theextension of a production license.

VAT

Value added tax (VAT) is charged at arate of 20 percent on all expendituresassociated with exploration anddevelopment activities. VAT is collected onall oil and gas sales at a rate of 20 percent.If oil and gas is sold to industrial or non-end users, the VAT rate is reduced to 10percent. Given the nature of the business,E&P companies will generally accumulatea VAT receivable in the first few years ofoperation. VAT receivables may be carriedforward each year without timeconstraints and, in addition to VATpayables, may be used to offset varioustaxes (e.g. corporate income tax, certainregional taxes, etc.) and employee welfareobligations up to €516,457 per annum.

Corporate Income Tax

Corporate income is taxed at a rate of27.5 percent (IRES) for oil and gascompanies with turnover of €25 million orless. If an oil and gas company's turnoverexceeds €25 million, an additional "RobinHood" tax is applied at the current rate of6.5 percent. On 13 August 2011, the Italiangovernment proposed an increase in the"Robin Hood" tax on energy producersfrom 6.5 to 10.5 percent for a three-yearperiod along with proposing to extend thetax to include energy transmissioncompanies. The plan will need theapproval of the Italian Parliament beforecoming into effect.

A regional income tax (IRAP) of 3.9percent is levied in addition to IRES unlessthe company's headquarters are located inthe Lazio or Sicily regions; in which casethe current tax rate is 4.8176 percent. InNovember 2008, the governmentapproved a decree that would allow -10percent of IRAP to be deductible for IRESpurposes.

Fiscal allowances on depreciation forintangible and tangible assets vary by assettype. As a general rule, fiscal depreciation

SEPTEMBER 20! 1 -25

An Overview of the Regulatory framework, Fiscal System, and Marketing of Oil and Gas in Italy

Pre-Tax Cash Flows: 5 BCF Gas Development, Onshore Po Valley Basin, Italy

on tangible assets is applied on a straight-line basis (as opposed to a unit-of-production basis) overthe economic usefullife of the asset. The Ministry of Financeprovides guidance on depreciation rates.On average the annual depreciation limitis 25 percent.

MARKETING OF OILANDGAS IN ITALY

Background

For 50 years, from 1953 to 1997 untilmarket liberalization began in 1998, oil andgas activities in the Po Valley region ofNorthern Italy were monopolized by thestate-owned oil company ENI-AGIP. Theliberalization process has gone throughvarious phases resulting in inter alia thebreak-up of ENI's monopoly. In 2000, theLetta Decree enabled legislation tointroduce competition in gas supply, toallow third-party access, and to require theunbundling of SNAM, local utilities, andmarket share restrictions on ENI.

The Po Valley region is a prolific gasproducing province with over 30 TCFproduced since production commenced inthe early 1950s.

With a consumer base of 60 million,an annual domestic production of around7 billion cubic meters of gas, and an annualdemand of around 80 billion cubic meters,Italy imports roughly 90 percent of itsannual gas requirements.

According to the latest official data(Ministry of Economic Development,

Department for Energy, 2010 AnnualReport), reserves are considerable: morethan 150 billion cubic meters of gas (2Punrisked) and approximately 2.5 billionbarrels of oil (2P unrisked), making Italyattractive for exploration activities. Italy'sstrategic geographic position makes it anatural hub for supplies to Europe fromAfrica, the Middle East, and the CaspianSea. Import pipeline and infrastructureconstruction was a primary focus for ENIand its affiliate SNAM in the 1970s andearly 80s enabling it to gain strategicownership of those assets. At present, Italyhas a diversified supply portfolio procuringfrom the North Sea, Russia, Algeria, andLibya. Most of the capacity is covered byTake or Pay contracts. This market dynamicplays an import role on domestic gas pricesand the structure of gas supply contracts.

Market Structure and Gas Pricing

Major downstream market sectorsinclude industry, power generation, andcommercial and residential use. Generally,gas in Italy is sold through long-term oil-indexed contracts with pricing based onENI Gas Release formulas; although fixedprices and the spot market are becomingmore popular within the industrial sector.The residential market is open tocompetition but prices are regulated.

ENI Gas Release formulas, which ENIupdates periodically, are driven by diesel,fuel, and crude oil prices. The formulae aregenerally calculated monthly based on amulti-month backward rolling average. It is

Size (BCF)

Gas Price ($/MCF)

Capex ($/MCF)

Opex ($/MCF)

Value ($/MCF)

NPV 10% (MM$)

5.00

15.40

2.44

0.58

7.19

35.97

noteworthy to mention that despite thevarious tariffs, calculation changes, andother updates, the difference between ENIGas Release formulas are generallyminimal and a smoothing mechanism isalways included (e.g. multi-monthbackward-rolling average). As of mid-year2011, wellhead gas prices for the onshorePo Valley Basin region of Italy have beenapproximately $15 per MMBTU.

In Italy the gas supply chain has beencompletely deregulated thereforedomestic producers may sell gas directly toend users. The capital and structuralrequirements (including a certain capacityof storage) for vertically integratedsuppliers create a natural barrier to entry.Gas sale contracts for domestic producershave a term of 3 to 5 years on average andare normally organized through a publictender.

Europe is becoming a more integratedmarket. Declining North Sea gasproduction and the temporary roadblocksto shale gas development (France) has hada strong ripple effect on the Italian andEuropean markets. Germany's recentdecision to phase out nuclear energy willhave a major impact on European energyprocurement. European governments mayfavor gas over alternative energy sourcesbecause of its availability from multiplesources at competitive prices and its lowercarbon emissions. The great paradox ofItaly is that although the regulatoryprocess creates time-to-market issues,market deregulation at the national andEuropean level and attractive profitmargins have significantly increased thenumber of very attractive commercialopportunities in the Italian energy market.

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