fiscal system for oil
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Fiscal systems for Oil
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Landlord Vs tenant
“Saudis wanted more money out of the concession. A good deal more”
- Daniel Yergin
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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
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Landlord Vs tenant
The central issue was of the division
Uneasy & important term in economics of natural resources- RENTS
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Landlord Vs tenant
The idea was always the same:
shift the revenues from the oil companies & the treasuries of the consuming countries
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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
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Landlord Vs tenant
His case study involved grain, but it can be applied to oil
Let’s see how it works?
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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
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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
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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
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Ricardo’s rent
Oil was another of nature’s legacies
It’s geological presence has nothing to do with any of our activity
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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”
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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?
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Ricardo’s rent
Interestingly enough there was no agreement on this elemental issue
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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
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Now let’s look more closely at the fiscal systems for oil
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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
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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
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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
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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”
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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
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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
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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
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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
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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
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The concept
Together all the payments to the government required under a petroleum arrangement can be called
“fiscal systems”
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The concept
In some countries, a single fiscal system applies to the entire country
In others a variety of fiscal systems exists
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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
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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
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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
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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
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The concept
The world average “government take” is 64 per cent
Most “government takes” are between 40 per cent & 85 per cent
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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
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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
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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
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The concept
Malaysia has one of the toughest fiscal systems in the SE Asia
The reason is simple: it has a good geological potential
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The concept
Thus the balance between the prospectivity & fiscal terms is the fundamental theme in the industry
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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
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The concept
The hallmark of an efficient market is availability of information
Yet, exploration is dominated by numerous unknowns & uncertainty
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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
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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
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The concept
Financial issue of how costs are recovered & profits are divided is the underlying theme, irrespective of which fiscal system is employed
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The concept
Governments must ideally design fiscal systems that:
Provide a fair return to state & industry
Avoid undue speculation
Limit undue administration burden
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The concept
Provide flexibility
Create healthy competition & market efficiency
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Let’s now look more closely at the petroleum fiscal arrangements
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The framework
Governments have devised numerous framework for the extraction of economic rents from petroleum sector
Obviously some are very efficient & some perhaps not
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The framework
The fundamental issue however always remain the same:
Whether exploration & or development is feasible under the conditions outlined in the fiscal system
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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
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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
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Petroleum fiscal regimes
Royalty / Tax system
Contractual based system
Service agreements
Production sharing contracts
Peruvian IndonesianPure
Hybrids Risk service
s
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Petroleum fiscal regimes
Service arrangements are divided upon whether remuneration is based upon a flat fee (Pure) or profit (Risk)
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Petroleum fiscal regimes
Within the PSC, Peruvian types divide gross production
In the Indonesian PSC, profit oil is divided
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Profit Oil
The proportion of oil left after deduction of the cost oil is known as profit oil
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Petroleum fiscal regimesThe 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
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Petroleum fiscal regimes
This ownership issues drives not only the language & jargon of fiscal systems; but so also the arithmetic
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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
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Petroleum fiscal regimes
Comparing & contrasting PSCs with the R/T systems provides the foundation to understand the petroleum fiscal system economics
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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
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The R/T system flowCompany 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)
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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
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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)
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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)
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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)
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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
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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 %
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Let’s now move on to another type of agreement, the production sharing contracts
As the name suggests they are contractual based systems
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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
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PSCs
Among the many production sharing arrangements, there are certain common elements
The defining characteristics is of course the state ownership of the resources
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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)
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PSCs
The first PSC was signed in August 1966, with Permina, the Indonesian National Oil Company
This is when the oil companies became contractors
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PSCsContractor 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)
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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
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PSCs
Cost recovery is the means by which the contractor recoups costs of exploration, development, & operations out of gross revenues
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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
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University of Petroleum & Energy Studies
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
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University of Petroleum & Energy Studies
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
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University of Petroleum & Energy Studies
Let’s look at a more simplified version of what we just learnt
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University of Petroleum & Energy Studies
Division of profitsTake 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
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University of Petroleum & Energy Studies
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)]
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University of Petroleum & Energy Studies
Effective royalty rate (ERR) & Access to gross revenue (AGR)
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University of Petroleum & Energy Studies
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
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University of Petroleum & Energy Studies
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
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University of Petroleum & Energy Studies
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
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University of Petroleum & Energy Studies
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
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University of Petroleum & Energy Studies
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
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University of Petroleum & Energy Studies
AGR calculationsTake 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
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University of Petroleum & Energy Studies
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 %
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University of Petroleum & Energy Studies
Let’s now look at other concepts employed in the fiscal systems
R factor
Ringfencing
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University of Petroleum & Energy Studies
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
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University of Petroleum & Energy Studies
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
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University of Petroleum & Energy Studies
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
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Ringfencing
All costs associated with a given block or license must be recovered from revenues generated within that block
The block is essentially ringfenced
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University of Petroleum & Energy Studies
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
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University of Petroleum & Energy Studies
Ringfencing
For the government though cross fence means that the government in effect subsidize unsuccessful exploration efforts
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University of Petroleum & Energy Studies
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)