Petroleum Fiscal System(The Trends & The Challenges)

Benny Lubiantara

(Updated: Dec 2009)

(email: blubiantara@yahoo.com)

Outline

I. IntroductionII. The Concept of Economic RentIII. Characteristic of the Upstream Petroleum IndustryIV. Classification of Upstream Petroleum ContractV. Main Elements in Petroleum Upstream ContractVI. Fiscal Policy DesignVII. Comparative AnalysisVIII. Economics Evaluation of Petroleum Upstream

ContractIX. Trends & ChallengesX. Summary

I. Introduction

• Fiscal arrangement is the Government’s most important tool for managing petroleum resources.

• From the international oil companies perspective, fiscal regimes is one of the most important factors to be considered for investment decisions.

• Many papers were published focusing on the comparative analysis of the worldwide petroleum fiscal system.

II. The Concept of Economic Rent (1)

In upstream petroleum industry, the economic rent is the different between the value of production and the cost to extract it.

Economic Rent = Gross Revenue – Total Cost – MARR*)

*) MARR is Minimum Attractive Rate of Return

Total Cost include: Exploration Cost, Development Cost, Operating Cost, Abandonment Cost.

Economic rent concept is important since the government attempt to capture as much as economic rent as possible through various levies, taxes, royalties and bonuses.

II. The Concept of Economic Rent (2)

III. Characteristics of the Upstream Petroleum Industry

• Finding hydrocarbon resources involve high risk. This risk is present at all stages of the project’s life cycle.

• The upstream petroleum industry is capital intensive, huge amount must be spent on exploration to discover sufficient oil reserves.

• Involve high technology.

• Despite its involve high risk, the petroleum industry also provide potential high reward / return.

Classification of Upstream Petroleum Contract

The first branch deals with the title to the mineral resources. Concessionary systems allow private ownership. In contractual systems, the state retains

ownership

Concession

A grant of access for a defined area and time period that transfers certain rights to hydrocarbons that may be discovered from the host country to an enterprise. 

The enterprise is generally responsible for exploration, development, production and sale of hydrocarbons that may be discovered.  Typically granted under a legislated fiscal system where the host country collects royalties, taxes and fees.

Main Features of Concession

1. The Multinational Oil Company (MOC), at its own risk and expense, generally has the exclusive right to explore for and exploit petroleum reserves in the concession area.

2. The MOC owns the production from within its concession area.

3. The MOC pay the royalty either in Cash or Production.

4. The MOC pay taxes to the host country on profit it derives from the production.

A Great disadvantage to the HC of the concession agreement is that it greatly limits the involvement by the HC.

Modern Concession

1. The concession area is only for certain block (instead of the whole country, province, etc).

2. The period of concession is shorter than the old concession type ( 20 years instead of 60 years in average).

3. There is also relinquishment obligation on the agreement.

4. Known also as Royalty/Tax System

Production Sharing Contract

In a production-sharing contract between a contractor and a host country, the contractor typically bears all risk and costs for exploration, development, and production. In return, if exploration is successful, the contractor is given the opportunity to recover the investment from production, subject to specific limits and terms.

The contractor also receives a stipulated share of the production remaining after cost recovery, referred to as profit hydrocarbons. Ownership is retained by the host government; however, the contractor normally receives title to the prescribed share of the volumes as they are produced.

Main Features of PSC

1. The Multinational Oil Company (MOC) is appointed by the HC as the contractor for certain area.

2. The MOC operate as its sole risk and expense under control of the HC.

3. Any production belongs to the HC.4. The MOC is entitled to a recovery of its costs out of the

production from the contractual area.5. After cost recovery, the balance of production is shared on a

pre-determined percentage split between the HC and the MOC.

6. The income of the MOC is liable to taxation.7. Equipment and installations are the property of the HC.

Pure Service Contract (1)

1. A pure-service contract is an agreement between a contractor and a host country that typically covers a defined technical service to be provided or completed during a specific period of time.

2. The service company investment is typically limited to the value of equipment, tools, and personnel used to perform the service. In most cases, the service contractor's reimbursement is fixed by the terms of the contract with little exposure to either project performance or market factors.

Pure Service Contract (2)

3. Payment for services is normally based on daily or hourly rates, a fixed rate, or some other specified amount. Payments may be made at specified intervals or at the completion of the service. Payments, in some cases, may be tied to the field performance, operating cost reductions, or other important metrics.

4. Risks of the service company under this type of contract are usually limited to nonrecoverable costs overruns, losses owing to client breach of contract, default, or contract dispute. These agreements generally do not have exposure to production volume or market price; consequently, reserves are not usually recognized under this type of agreement.

Risk Service Contract

1. These agreements are very similar to the production-sharing agreements with the exception of contractor payment. With a risked-service contract, the contractor usually receives a defined share of revenue (cash) rather than a share of the production (in kind).

2. As in the production-sharing contract, the contractor provides the capital and technical expertise required for exploration and development. If exploration efforts are successful, the contractor can recover those costs from the sale revenues and receive a share of profits through a contract-defined mechanism.

Division of Gross Production

Gross Production

Royalty

Production Net of Royalty

Investor’s Tax

Investor’s Production

Costs Deductions

Profit Oil (P/O)

Contractor’s Tax

Cost Oil

Host Govt’s P/O

Contractor’s P/O

Gross Production

Royalty

Royalty Tax PSC

One Barrel of Oil

$20

20% Royalty

$16.00

Federal Income Tax

40%Net Income After

Tax

Government Share

Deductions

(Op.Cost, DD & A, etc)$7.00

(Taxable Income)

Provincial Tax

10%$6.3

Contractor Share

$0.70

$2.52

$7.22

36%

$4.00

$9.00

$3.78

$12.78

64%

Concessions (Royalty Tax)

Source: Daniel Johnston, “International Fiscal System and PSC”, 1994

One Barrel of Oil

$20

10% Royalty

$18.00

Taxes

40%

Government Share

Cost Recovery

(Op.Cost, DD & A, etc)

(40% Limit)

($10.00)

Profit Oil Split

40% / 60%

(Taxable)

Contractor Share

$6.00

$1.60

$9.60

48%

$2.00

$8.00

($1.6)

$10.40

52%

$4.00

Production Sharing Contract (PSC)

Source: Daniel Johnston, “International Fiscal System and PSC”, 1994

V. Main Elements Petroleum Upstream Contract

• Area• Duration• Relinquishment• Work Program /Obligation• Bonuses• Royalty • Cost Recovery Limit• Profit Oil Split• Taxation• Depreciation Methods• Domestic Market Obligation• Gov. Participation• Others

(Focusing on Economics and Commercial Aspects)

Area: Wide variation, Typically +/- 150,000 - 350,000 acres .

Duration: • Exploration: Multiphase 2-4 years initial + extensions• Production: From 20 to 30 years from start up

Work Commitment, reflect the company’s willingness to pursue opportunities on a block. This commitment is typically in the form of an agreement to conduct seismic survey and drill a given number of wells or spend an agreed amount of money during a designated exploration period

Bonuses: • Signature Bonuses: in high, prospective areas.• Other Bonuses: Common, discovery, production, etc.

Main Economics & Commercial Aspects (cont.)(Focusing on Economics and Commercial Aspects)

• Royalty: Most countries have a royalty.

• Cost Recovery Limit: A phenomenon of PSCs, but about 20% of PSCs do not have a limit. World average is 60-65%; general range is 35-75%.

• Profit oil: PSC phenomena; about 80% are sliding scale. Most are based upon trenches of production.

• Taxation: Almost all systems have the equivalent of corporate income tax. The average is around 35%, other countries have withholding tax and special petroleum tax.

V. Main Elements Petroleum Upstream Contract(Focusing on Economics and Commercial Aspects)

• Depreciation: About half of world’s PSCs do not require depreciation for cost recovery, but most do for tax purposes. World average is 5 years or 20% yearly.

• Domestic Market Obligation (DMO): Many contracts specify the provision to supply domestic market when commercial production commences, a certain percentage of the contractor's profit oil has be sold to the government. The sales price to the government is usually at a discount to market prices.

• Gov. Participation: A government may, under the applicable petroleum legislation, have the option to demand as a condition for the grant of a license that a state enterprise designated for this purpose becomes a participant in such license .

V. Main Elements Petroleum Upstream Contract(Focusing on Economics and Commercial Aspects)

VI. Fiscal Policy Design

• Maximize value of the petroleum resource

Government Objective

Company Objective• Maximize stockholders interest

The challenge of fiscal system is to ensure the government receive as high share of the value as possible while encouraging the exploration and exploitation of petroleum resource.

The Art of DesigningVI. Fiscal Policy Design

Source: Daniel Johnston, International Petroleum Fiscal System and Production Sharing Contract, (1994)

Regressive vs. Progressive*)VI. Fiscal Policy Design

Non Profit based Government Take (Such as: Bonus, Royalty) are Regressive.

*) Source: Dr. Alfred Kjemperud, “Petroleum Fiscal Regimes”, Presentation Material for CCOP, 2003

VII. Comparative Analysis

Government Take represent the government’s share of economic profits from all means by which the state extracts rent: bonuses, royalties, profit oil, taxes, Government working interest, etc.

In percentage = (bonus + royalties + profit oil, taxes, Gov. working interest) divided by total economic profit

Total economic profit = Total gross revenue less total cost over life of the project

In order to make the comparative analysis among worldwide petroleum fiscal system, the term “Government Take” is one of the important criteria.

Government Take and Contractor Take

Government Take and Contractor Take are the terms used as a proxy for the division of profits between the contractor and the host country.

The government take is defined as the government's share of economic profits from all means by which the state extracts rent: bonuses, royalties, profit oil, taxes, etc.

EXPLORATION COSTS

DEVELOPMENT COSTS

OPERATING COSTS

CONTRACTOR TAKE

GOVERNMENT TAKE

GROSS REVENUE

TOTAL PROFIT

COST

RECOVERY

Government Take

Source: Daniel Johnston, International Petroleum Fiscal System and Production Sharing Contract, (1994)

Weaknesses of the Government Take Statistic

• Signature bonus• Ring-fencing Provisions• Front end Loading• Work Program Provision• Time Value of Money (unless using Discounted

GT)• Crypto taxes• Relinquishment Provision

It does not adequately capture the effect of*):

VII. Comparative Analysis

*) Source: Daniel Johnston’s Workshop, Dundee, 2006

Capital Budgeting - deciding which projects to accept.

Capital Budgeting Concept

Techniques:

• Payback Period

• Net Present Value (NPV)

• Internal Rate of Return (IRR)

• Profit to Investment (PI)

VIII. Economics Evaluation of Petroleum Upstream Contract

Production Rate

Facilities Design

Capex Opex

Fiscal Terms

Oil Price

Field Economics

Reserves

Economics Evaluation of Upstream Petroleum Contract

Production Plot

0

10000

20000

30000

40000

50000

60000

Year

BO

PD

Economics Evaluation of Upstream Petroleum Contract

Year Gross Royalty Gr. Revenue Cost Recovery Equity Contractor Contractor CF Host CountryRevenue 10% After Royalty Depre Non Cap Inv OPEX TOTAL Recovered Unrecovered To be Split Split Total Cash in Cash Out NCF Royalty Split Tax Total HC

$ M $ M $ M $ M $ M $ M $ M $ M $ M $ M $ M $ M $ M $ M $ M $ M $ M $ M $ M1 (10,000) (10,000) 2 (10,000) (10,000) 3 (10,000) (10,000) 4 (10,000) (10,000) 5 (176,000) (176,000) 6 (176,000) (176,000) 7 (128,000) (128,000) 8 383,250 38,325 344,925 64,000 200,000 54,750 318,750 318,750 - 26,175 6,544 325,294 325,294 (57,629) 267,665 38,325 19,631 2,879 60,836 9 638,750 63,875 574,875 64,000 91,250 155,250 155,250 - 419,625 104,906 260,156 260,156 (137,409) 122,748 63,875 314,719 46,159 424,753

10 638,750 63,875 574,875 64,000 91,250 155,250 155,250 - 419,625 104,906 260,156 260,156 (137,409) 122,748 63,875 314,719 46,159 424,753 11 638,750 63,875 574,875 64,000 91,250 155,250 155,250 - 419,625 104,906 260,156 260,156 (137,409) 122,748 63,875 314,719 46,159 424,753 12 574,875 57,488 517,388 64,000 82,125 146,125 146,125 - 371,263 92,816 238,941 238,941 (122,964) 115,977 57,488 278,447 40,839 376,773 13 517,388 51,739 465,649 73,913 73,913 73,913 - 391,736 97,934 171,847 171,847 (117,003) 54,843 51,739 293,802 43,091 388,632 14 465,649 46,565 419,084 66,521 66,521 66,521 - 352,563 88,141 154,662 154,662 (105,303) 49,359 46,565 264,422 38,782 349,769 15 419,084 41,908 377,175 59,869 59,869 59,869 - 317,306 79,327 139,196 139,196 (94,773) 44,423 41,908 237,980 34,904 314,792 16 377,175 37,718 339,458 53,882 53,882 53,882 - 285,576 71,394 125,276 125,276 (85,296) 39,981 37,718 214,182 31,413 283,313 17 339,458 33,946 305,512 48,494 48,494 48,494 - 257,018 64,255 112,749 112,749 (76,766) 35,983 33,946 192,764 28,272 254,981 18 305,512 30,551 274,961 43,645 43,645 43,645 - 231,316 57,829 101,474 101,474 (69,089) 32,384 30,551 173,487 25,445 229,483 19 274,961 27,496 247,465 39,280 39,280 39,280 - 208,185 52,046 91,326 91,326 (62,180) 29,146 27,496 156,139 22,900 206,535 20 247,465 24,746 222,718 35,352 35,352 35,352 - 187,366 46,842 82,194 82,194 (55,962) 26,231 24,746 140,525 20,610 185,881 21 222,718 22,272 200,447 31,817 31,817 31,817 - 168,630 42,157 73,974 73,974 (50,366) 23,608 22,272 126,472 18,549 167,293 22 200,447 20,045 180,402 28,635 28,635 28,635 - 151,767 37,942 66,577 66,577 (45,330) 21,247 20,045 113,825 16,694 150,564 23 180,402 18,040 162,362 25,772 25,772 25,772 - 136,590 34,147 59,919 59,919 (40,797) 19,123 18,040 102,442 15,025 135,508 24 162,362 16,236 146,126 23,195 23,195 23,195 - 122,931 30,733 53,927 53,927 (36,717) 17,210 16,236 92,198 13,522 121,957 25 146,126 14,613 131,513 20,875 20,875 20,875 - 110,638 27,659 48,535 48,535 (33,045) 15,489 14,613 82,978 12,170 109,761

6,733,120 1,481,874 640,911 4,610,335

IRR 14.98%

VIII. Economics Evaluation of Petroleum Upstream Contract

Example of Spreadsheet Calculation

Yearly Division of Gross Revenue

-

100,000

200,000

300,000

400,000

500,000

600,000

700,000

800,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

Production Period

$ M

Host Country Share

Contractor ShareCost Recovery

IX. Trends and Challenges

Some fiscal systems are adjusting automatically upward because of the price progressive structure of the systems;

Governments have changed fiscal terms;

Companies are bidding up government take in bid rounds;

Greater state participation by NOCs; and

Renegotiation.

Source: Van Meurs, Maximizing the Value of Government Revenues from Upstream Petroleum Arrangements, Fiscal Submit London, 9th February 2009

Regressive or Progressive – Fiscal Design?

Basis for Production Sharing: Fixed, Profitability, Production Rate, Oil Price ?

The Impact of Increasing Oil Prices to the Division of Increasing Profit ?

IX. Trends and Challenges(Related to Fiscal Design)

IX. Trends and Challenges(Related to Fiscal Design)

Royalty, Cost Recovery Limit, Profit Oil Split tend to subject to sliding scale instead of fix rate.

The idea is the more profitable the field(s), the more percentage of Government portion should be.

Basis for Profit Oil Split

Fixed? or Sliding Scale?

The Parameters:- Production (Daily or

Cumulative)?

- Oil Price?

- Water Depth?

- API Gravity?

- Etc.

Profitability Based? - ROR

- “R” Factor

Gross Production

Royalty

Cost Recovery

Profit Oil

Tax

Oil Company

Host Country

Profitability based (?)

Gross Production

Royalty

Cost Recovery

Profit Oil

Tax

Oil Company

Host Country

● More complicated from an administrative standpoint?

● Gold plating issue?

Basis for Profit Oil Split

80%

75%

25%

20%

The Effect of Increasing Oil Prices

In some types of upstream petroleum contracts, the Government Take, in fact, becomes lower as the oil prices increase (profit increase)

High Oil Prices

Low Oil Prices

NET PROFIT

Host Country

Investor

How to Improve Government Share?

Gross Production

Royalty

Cost Recovery

Profit Oil

Tax

Oil Company

Host Country

● Increasing State Participation?

● Introduce “Windfall Profit Tax”?

● “Price Cap Formula”?

● DMO Price ?

“Goldplating” – Inefficiencies in the fiscal system that may encourage the investor to spend more than it otherwise would

Saving Index (SI): part of an additional one dollar in profit (arising from a one dollar saving in cost) that accrues to the Investor

SI = 20 cent (from 1 dollar cost saving)

Issue on Goldplating

“Goldplating” and Saving Index (SI) concept in upstream Petroleum Contract was originally introduced by Daniel Johnston.

The objective of a host government is, inter alia, to maximize the nation’s wealth derived from the exploitation of its natural resources by encouraging appropriate levels of exploration and production activity.

The objective for the IOC is to gain access to these natural resources and to maximize the value to its stakeholders.

How costs are recovered and profits divided through time are the basic questions when considering a fiscal system.

As risks can differ substantially for different projects and countries, a petroleum contract model that provides an optimal outcome under all circumstances is not likely to be developed, a “one-size-fits-all model does not exist”

Designing an adequate fiscal regime has to take into account the geological, economic and political contexts of the country along with its short- and long-term objectives.

Conclusions:

Thank You