Fiscal System for oil

University of Petroleum & Energy Studies

Fiscal systems for Oil


Landlord Vs tenant

“Saudis wanted more money out of the concession. A good deal more”

- Daniel Yergin


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


Landlord Vs tenant

The central issue was of the division

Uneasy & important term in economics of natural resources- RENTS


Landlord Vs tenant

The idea was always the same:

shift the revenues from the oil companies & the treasuries of the consuming countries


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


Landlord Vs tenant

His case study involved grain, but it can be applied to oil

Let’s see how it works?


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


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


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


Ricardo’s rent

Oil was another of nature’s legacies

It’s geological presence has nothing to do with any of our activity


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”


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?


Ricardo’s rent

Interestingly enough there was no agreement on this elemental issue


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


Now let’s look more closely at the fiscal systems for oil


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


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


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


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”


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


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


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


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


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


The concept

Together all the payments to the government required under a petroleum arrangement can be called

“fiscal systems”


The concept

In some countries, a single fiscal system applies to the entire country

In others a variety of fiscal systems exists


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


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


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


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


The concept

The world average “government take” is 64 per cent

Most “government takes” are between 40 per cent & 85 per cent


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


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


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


The concept

Malaysia has one of the toughest fiscal systems in the SE Asia

The reason is simple: it has a good geological potential


The concept

Thus the balance between the prospectivity & fiscal terms is the fundamental theme in the industry


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


The concept

The hallmark of an efficient market is availability of information

Yet, exploration is dominated by numerous unknowns & uncertainty


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


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


The concept

Financial issue of how costs are recovered & profits are divided is the underlying theme, irrespective of which fiscal system is employed


The concept

Governments must ideally design fiscal systems that:

Provide a fair return to state & industry

Avoid undue speculation

Limit undue administration burden


The concept

Provide flexibility

Create healthy competition & market efficiency


Let’s now look more closely at the petroleum fiscal arrangements


The framework

Governments have devised numerous framework for the extraction of economic rents from petroleum sector

Obviously some are very efficient & some perhaps not


The framework

The fundamental issue however always remain the same:

Whether exploration & or development is feasible under the conditions outlined in the fiscal system


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


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


Petroleum fiscal regimes

Royalty / Tax system

Contractual based system

Service agreements

Production sharing contracts

Peruvian IndonesianPure

Hybrids Risk service

s



Service arrangements are divided upon whether remuneration is based upon a flat fee (Pure) or profit (Risk)



Within the PSC, Peruvian types divide gross production

In the Indonesian PSC, profit oil is divided


Profit Oil

The proportion of oil left after deduction of the cost oil is known as profit oil


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



This ownership issues drives not only the language & jargon of fiscal systems; but so also the arithmetic



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



Comparing & contrasting PSCs with the R/T systems provides the foundation to understand the petroleum fiscal system economics


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


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)


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


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)


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)


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)


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


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 %


Let’s now move on to another type of agreement, the production sharing contracts

As the name suggests they are contractual based systems


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


PSCs

Among the many production sharing arrangements, there are certain common elements

The defining characteristics is of course the state ownership of the resources


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)


PSCs

The first PSC was signed in August 1966, with Permina, the Indonesian National Oil Company

This is when the oil companies became contractors


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)


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


PSCs

Cost recovery is the means by which the contractor recoups costs of exploration, development, & operations out of gross revenues


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


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


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


Let’s look at a more simplified version of what we just learnt


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


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)]


Effective royalty rate (ERR) & Access to gross revenue (AGR)


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


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


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


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


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


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


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 %


Let’s now look at other concepts employed in the fiscal systems

R factor

Ringfencing


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



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



X= Contractor cumulative receipts (after tax)

Y= Contractor cumulative expenditure

At payout, X = Y; this yields an R factor of 1


Ringfencing

All costs associated with a given block or license must be recovered from revenues generated within that block

The block is essentially ringfenced


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


Ringfencing

For the government though cross fence means that the government in effect subsidize unsuccessful exploration efforts


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)

Fiscal System for oil

Business

petroleum fiscal regimes

factor based systems

production sharing arrangements

fiscal terms

ricardos rent

cash flow

fiscal system

fiscal systems