Countries that are blessed with petroleum resources must try to manage their wealth in the best way possible. Doing so often means allowing international oil companies (IOCs) to explore, develop and operate oil fields, because they have the technical know-how to extract the resource more efficiently and effectively than the government can do on its own.
When IOCs are involved, the government must set up a system for sharing profits that allows it to maximize the benefit its citizens receive from the oil wealth whilst making the country an attractive place for the IOCs to invest. How you organize the fiscal regime depends on whether the government needs revenue immediately, its ability to cover risks and how it wants to attract investors. These factors will all affect the final government take. Government take is government’s share of the net profit (gross production value – costs = net profit). This article will present some basic features of the three most common fiscal regimes: royalty/tax systems, production sharing contracts and service agreements, and how they affect government take.
These are systems that apply a tax rate and/or a royalty percentage. Normally, royalties are deducted on gross production value. Thereafter costs are deducted, and what is left is subjected to taxation. Royalties are useful for governments that are in dire need of revenue. Theoretically, costs may be equal to 100% of gross production value, which leaves nothing left for taxation. By imposing e.g. a 10% royalty tax the government will get some revenue regardless of the cost level. Another advantage is that royalties are relatively easy to administer. A production of 100 000 barrels per day means that, with a 10% royalty rate, 10 000 barrels will automatically be allocated to the government.
While royalties are fairly common, some countries, such as Norway, have abandoned this tax. The downsides of royalties are at least three depending on whether you have the government or the company perspective. By having a high royalty rate, the government will actually get a lesser take of the total profit when costs are reduced over time. This is shown in the table below:
|HIGH COST||LOW COST|
|GROSS REVENUE||100 USD||100 USD|
|ROYALTIES (20 %)||20 USD||20 USD|
|COSTS||30 USD||10 USD|
|TAX BASE||50 USD||70 USD|
|PROFIT TAX (30%)||15 USD||21|
|TOTAL GOVT. REVENUE||35 USD (royalties + profit tax)||41 USD (royalties + profit tax)|
|GOVERNMENT TAKE (GOVT.REVENUE/GROSS REVENUE-COSTS)||50 %||
When costs are reduced from 30 USD to 10 USD, government revenue (in absolute figures) increases. Government take however is reduced, and this is attributed to the high royalty rate. When costs decrease, more profit is subjected to taxation. It would be better for the government if the amount subjected to 20 % royalty tax was subjected to the 30 % profit tax instead.
Another disadvantage is that royalties do not take into account the profitability of an oil and gas field. If companies are making losses, they will still have to pay royalties. This may lead to shut-down of production and scare off potential investors. Profit tax is better correlated to the profitability of the oil and gas field, and is therefore regarded as more popular by the companies. From the company perspective it is also a disadvantage that royalties effectively block companies from booking all their costs and get them recovered. Therefore, government gets a greater share of the initial cash flow, and extends time lapsed before “break even” – the time when company cash flow exceeds costs and the company starts making profit.
Royalty/tax systems are usually found in Western Europe, with UK, Norway and the Netherlands as typical examples. Further reading on disadvantages of royalty systems can be found in the 2008 report by the US Government Accountability Office which concludes that “…the inflexibility of royalty rates to changing oil and gas prices has cost the federal government billions of dollars in foregone revenues” .
Production Sharing Contracts/Agreements
Production sharing contracts (also called agreements in some countries) (PSC) emerged in the 1960s and are seen as a tool of controlling cost-levels in oil and gas projects. This fiscal regime is most commonly found in South-East Asia and Africa.
PSCs are quite similar to royalty/tax systems except for one feature; cost recovery limits. Cost recovery limits mean that costs can only be recovered up to a certain limit, e.g. 50 %. Such limits ensure that government will always get a minimum share of the profit. The downside for the government is that it will take a much longer time to recover all costs because of the limit. Theoretically, an oil and gas field without a cost recovery limit may take five years to cover all investment costs, while a cost recovery limit of 50 % may extend this period to ten years.
After costs are deducted up to cost recovery limit, typically referred to as cost oil, the remaining profit is shared between government and the contractor. Such profit sharing can be done in many ways, but it usually involves a set of tranches/sliding scales. Profits may be shared differently based on production volume, profitability of the project (R-factor), oil and gas price etc. The general rule is that government’s share of profit increases with increase of production volume increases, profitability and oil and gas prices.
Unlike royalty tax/systems, PSCs are fiscal regimes that are usually ring-fenced. This means that within a country there are different tax levels for each negotiated PSC. In Norway all oil and gas companies have to pay the same profit tax, but in countries such as Indonesia, Myanmar, Tanzania and Nigeria government’s share of profit (which behaves like a tax) will differ between different oil and gas fields. Taxes and cost recovery limit are negotiable, which means that government take is also negotiable.
Countries that apply PSCs, typically, also use royalties and taxes. Taxes are applied on contractor’s share of profit. While this may potentially generate substantial government take, it also has some disadvantages. The system becomes very complex because of different fiscal terms for each PSC, which increases the need for competent tax authorities. PSCs, however, may be useful if there are uncertainties regarding potential oil and gas reserves. If the contractor does not make discoveries, no costs will be recovered. The average success rate of drilling is between 20-25 %. If the risk is considered to be high, and the contractor makes a discovery, the government take is likely to be less.
Service agreements use a simple formula: the contractor is paid a cash fee for performing the service of producing oil and gas resources. What is produced belongs entirely to the government. In some cases the fee also includes a certain percentage of costs. Service agreements are usually applied in countries with a high discovery rate and low costs. When companies are awarded service agreements, both government and the companies are sure of success. Such contracts are typically found in the Middle East where oil and gas resources are easily accessible. Service agreements lead to a very high government take, but this is generally accepted by companies because of low risks and relatively low costs.
Designing Fiscal Regimes for the Future
The three main categories of oil and gas fiscal regimes all have their pros and cons. In a world with volatile oil and gas prices governments need to choose fiscal regimes that do not scare off potential investors. The number and quality of bidders in a licensing round is usually an indicator of the success of a fiscal regime. In licensing rounds, such as the recent onshore oil and gas bidding round in Mexico, companies compete in offering the biggest share of pre-tax profits to the government via a weighted formula that also includes an investment commitment. While companies may offer a very favorable government take, the bid may be unrealistic when it comes to investment commitments.
Today, the world is experiencing low oil and gas prices, which lead to companies postponing their planned investments. Companies may have offered high royalty rates, a high cost oil limit and big government share, but the government’s ultimate interest is that oil and gas projects move from exploration phase to development phase. Therefore, a work programme detailing investments is also an important bid item.
As mentioned, exploration and development activities have been halted in many countries because of the drop in oil and gas prices. This has become a particular challenge in developing countries which have seen a big rise in expectations after major oil and gas discoveries. While companies are crying out for better fiscal terms for investments to take place, the countries are cautious about reducing government take. Fiscal regimes should however not only be designed for today’s low prices, but also for a future increase in oil and gas prices.