We live in a hydrocarbon age. 85% of our energy demand is fulfilled by hydrocarbons. The 2035 energy outlook published by BP is bleak, predicting the hydrocarbon composition to be 80% of our fuel mix. No matter how much we despise the hydrocarbons, we need it to fuel our economy.
Many countries are dependent on their hydrocarbon reserve to sustain their economy. The economical and sustainable exploitation of its hydrocarbon reserves is of strategic importance to any country in order to provide revenue, meet its customer’s demand and preserve its market share.
The legal framework supporting the extraction of hydrocarbon is called fiscal regime.
A country’s effectiveness in extracting hydrocarbon doesn't only depend on its geological advantage but also on how investment friendly its fiscal regime is. The challenge for any government while designing a fiscal regime is to collect appropriate hydrocarbon revenue while keeping it sufficiently rewarding for the investors.
Government’s Perspective
A nation requires hydrocarbon to fuel its economy. If the nation has surplus hydrocarbon, the revenue generated by its sale is used for the economic benefit of the nation.
A confluence of factors must be analyzed while designing a fiscal regime. Some of these factors are:
For the countries where oil rent contributes to a major chunk of the national revenue, additional factors would require critical consideration:
Any risk associated with the hydrocarbon project would add up to the capital costs and significantly diminish the oil rent. Hence, the framework should be designed in a way to minimize the risks for the investors.
Company’s Perspective
The valuation of an oil company depends on its Proven Reserve, Reserve Replacement Ratio, profit margin associated with different projects etc. The objective of the company is to earn profit and increase their hydrocarbon reserve in return to the service they provide.
The executive committee of the company decides upon a Hurdle Rate. The hurdle rate is the minimum rate of return a company is willing to accept in order for it to invest in the project.
The company analyses their Internal Rate of Return (IRR) based on the parameters set in the fiscal regime and the risks associated with the project. If the IRR is greater than the Hurdle Rate, then the company is likely to bid for acreage in the field.
The risks that require due considerations are:
They look for the fiscal regime which conform to the following considerations:
Life Cycle of a Petroleum Project
Petroleum Fiscal Regime
The design and structure of the Petroleum Fiscal Regime depends on several factors:
Some of the key terms in the hydrocarbon contacts are legislatively bound in the country’s constitution:
Some of the terms in the fiscal regime are open for bidding in the auction:
However, there are many common features to all fiscal regime systems:
Design of Fiscal Regime
Examples of Fiscal Regime
Revenue distribution in Concessionary & Contractual Agreements
Key Differences of Concessionary & Contractual Agreements
Additional Features of Production Sharing Contracts (PSC)
Economic Indicators of a Fiscal Regime
The following parameters are used by the company to analyze a fiscal regime and take investment decision:
Designing an efficient Fiscal System
There is no perfect Fiscal Regime. Every field is unique and require special provision to attract investments to economically and sustainably recover the underground resources. The government should strive to remove the barriers and provide an investment friendly environment for the investors.
The legal arrangements should be simple and adhere to the international standards. It should not impose heavy costs on the companies to meet audit and regulatory requirements. There should be segregation of the different legal systems – Hydrocarbon law, Tax law and Environmental law – to increases accountability, transparency, compliance, effectiveness and sustainability.
It is of utmost importance to minimize the front loaded regressive tax instruments like Signature Bonus, Royalty Tax and Cost Recovery Limits. The taxation can be made progressive by introducing sliding scale measures.
The regime must incentivize the oil company on reducing the costs and encourage them to develop marginal fields. The success of a fiscal regime will ultimately depend on the amount of hydrocarbon recovered and its contribution to the national revenue.
Bibliography
Many countries are dependent on their hydrocarbon reserve to sustain their economy. The economical and sustainable exploitation of its hydrocarbon reserves is of strategic importance to any country in order to provide revenue, meet its customer’s demand and preserve its market share.
The legal framework supporting the extraction of hydrocarbon is called fiscal regime.
A country’s effectiveness in extracting hydrocarbon doesn't only depend on its geological advantage but also on how investment friendly its fiscal regime is. The challenge for any government while designing a fiscal regime is to collect appropriate hydrocarbon revenue while keeping it sufficiently rewarding for the investors.
Government’s Perspective
A nation requires hydrocarbon to fuel its economy. If the nation has surplus hydrocarbon, the revenue generated by its sale is used for the economic benefit of the nation.
A confluence of factors must be analyzed while designing a fiscal regime. Some of these factors are:
- The expected revenue from the hydrocarbon reserve
- Profit margin to be allowed to the investor
- Encourage the company to reduce the costs
- Encourage the development of marginal fields
- Discourage the early abandonment of the fields
For the countries where oil rent contributes to a major chunk of the national revenue, additional factors would require critical consideration:
- Sensitivity of the revenue to the oil price
- Macroeconomic impact of the oil rent
- Country or political risk
Any risk associated with the hydrocarbon project would add up to the capital costs and significantly diminish the oil rent. Hence, the framework should be designed in a way to minimize the risks for the investors.
Company’s Perspective
The valuation of an oil company depends on its Proven Reserve, Reserve Replacement Ratio, profit margin associated with different projects etc. The objective of the company is to earn profit and increase their hydrocarbon reserve in return to the service they provide.
The executive committee of the company decides upon a Hurdle Rate. The hurdle rate is the minimum rate of return a company is willing to accept in order for it to invest in the project.
The company analyses their Internal Rate of Return (IRR) based on the parameters set in the fiscal regime and the risks associated with the project. If the IRR is greater than the Hurdle Rate, then the company is likely to bid for acreage in the field.
The risks that require due considerations are:
- Geological Risk – Frontier fields bear high risk due to the lack of data.
- Country Risk – Political instability would add up to the risk associated with any project.
- Financial Risk – The risk associated with recovering the sunk costs like exploration costs.
- Market Risk – The volatility in the price of oil can drive IRR to unfavorable region.
They look for the fiscal regime which conform to the following considerations:
- Stable – A regime that do not change its core features
- Flexible – A regime that adjusts itself depending on the conditions
- Neutral – A regime that deals with all the players on an arm’s length
- Higher Lifting Entitlements and Access to Gross Revenue (AGR)
- Ability to repatriate profits to its shareholders
- Minimum number of front-ended taxes
- Transparent
- Simple
Life Cycle of a Petroleum Project
Petroleum Fiscal Regime
The design and structure of the Petroleum Fiscal Regime depends on several factors:
- geological advantage to the country
- amount of oil rent the government is willing to collect
- willingness of the government to give decision making freedom to the private oil companies
Some of the key terms in the hydrocarbon contacts are legislatively bound in the country’s constitution:
- Mineral Rights
- Land Ownership
- Maximum stake of a foreign company in the investment
- Lifting Entitlements
Some of the terms in the fiscal regime are open for bidding in the auction:
- Signature Bonus
- Royalty Tax
- Split on the profit from the sale of oil
- Minimum Work Program
However, there are many common features to all fiscal regime systems:
- Licensing - Auction process to grant licenses to the oil companies. Relinquishment provisions are agreed upon during the licensing round.
- Royalty – Front ended tax instrument which is determined as a percentage of hydrocarbon sale. The price of the hydrocarbon in determined by the selling price in an arm’s length deal or the market price of an equivalent crude cocktail. The terms of royalty are usually set on a sliding scale which allow government to collect higher royalty during the period of higher profit.
- Tax Holiday – The exploration of a frontier area is usually granted a tax holiday to attract investment in return of higher risk.
- Ring Fencing – This is a cost center based fiscal instrument that restricts the revenue from one ring-fenced area to recover the costs of another ring- fenced area. It is usually unfavorable for oil companies as it limits their options to recover capital costs.
- Minimum Work Program – Exploration rights are usually divided into three phases, with each phase having distinct work commitments. It is usually measured in terms of wells drilled and seismic data acquired.
- Amortization/Depreciation – The provision for the oil companies to amortize their capital costs is to be agreed upon ex-ante:
- Straight Line
- Unit of Production
- Declining Balance
- Dry Well Cost Recovery – The oil companies are not allowed to recover the exploration costs in case the quest to discover hydrocarbon reserve results in a failure.
- Force Majeure – The shared cost and responsibility in an event of force majeure is agreed upon.
- Transfer of Technology – The training and transfer of technology terms are important for a country to learn from the experiences and expertise of the investing company.
- Local Workforce – The oil company may be obligated to use a certain percentage of their employees from the local labor workforce.
- Domestic Market Obligation – The terms could dictate the oil companies to sell all or a certain percentage of the hydrocarbon in the host country.
- Site Reclamation Funding – The provision on the amount of money to be allotted (and its recoverability) to the site reclamation fund which will be used for restoring the site after the cease of the license.
- Stability Clauses – The clauses with the fiscal regime are divided into two groups:
- Freezing Clauses – The terms that do not change with the prevailing market and geological conditions
- Equilibrium Clauses – The terms that adjusts the agreement depending on the prevailing market and geological conditions.
Design of Fiscal Regime
Examples of Fiscal Regime
Revenue distribution in Concessionary & Contractual Agreements
Key Differences of Concessionary & Contractual Agreements
Additional Features of Production Sharing Contracts (PSC)
- Cost Recovery – Companies are allowed to recover the capital and operating costs. The government monitors that only the legitimate costs are recovered.
- Profit Oil Split – The oil left after the depreciated capital costs and the operating costs are recovered is called Profit Oil. The share of Profit Oil that the company receives is governed by the sliding scale which could be based on any of the following criteria:
- Average Production
- R-factor
- Internal Rate of Return
- Cost Recovery Limit –The government imposes the limit to the amount of oil the company uses in a particular accounting period to recover its depreciated capital costs and the operating costs.
- Loss Carry Forward – The loss experienced by the company during a particular accounting period due to the cost limit can be carried forward to the next accounting period.
- Depletion Allowances – As the reserves are depleted, a certain percentage of income is allowed to be retained to explore new reserves.
- Interest Deduction Rules – The interest on project finance is usually deductible from the taxable income and qualify for cost recovery.
- Investment Uplift – In certain cases, government may allow the company to recover an additional percentage on their costs.
Economic Indicators of a Fiscal Regime
The following parameters are used by the company to analyze a fiscal regime and take investment decision:
- Net Present Value (NPV) – The present value of the expected cash flow from the project lifecycle.
- Internal Rate of Return (IRR) – The rate of return that the company expects based on the cost of equity, cost of debt and the risk premium associated with the project.
- Profitability Ratio – The ratio of the NPV of the project’s cash flow and the Capital Invested.
- Government Take – It represents the effective tax rate the company has to pay or a government may receive in a project over the project life cycle.
- Effective Royalty – It is the minimum share of revenue that the host government might receive in any given accounting
period. It captures the aggregate of the Royalty, Cost Recovery Limit and Profit Oil Split especially during the initial phase of the project when the capital costs
are still not recovered. The higher value of Effective Royalty suggests the fiscal regime to be front loaded and regressive.
- Access to Gross Revenue (AGR) – It is the maximum share of revenue the oil company can receive in any given accounting period. It gives a direct measure on how quickly the company may recover its costs.
- Savings Index – This parameter is used to determine if the fiscal regime incentivizes the oil company to reduce its costs. It is the percentage share that the company will receive for the reduced cost of the project. The minimum acceptable Savings Index in the industry is 35%. It implies companies are willing to reduce the cost by $100 if they receive minimum $35 from the amount. If the Savings Index is too low, companies are encourage to inflate their cost. This anomaly in the fiscal regime is called Gold Plating.
- Lifting Entitlement – As the company is valued by its Proven Reserve and Reserve Replacement Ratio in the stock market, it is essential for the company to invest in the regime which allows maximum discovered hydrocarbon to be booked in their reserve.
Designing an efficient Fiscal System
There is no perfect Fiscal Regime. Every field is unique and require special provision to attract investments to economically and sustainably recover the underground resources. The government should strive to remove the barriers and provide an investment friendly environment for the investors.
The legal arrangements should be simple and adhere to the international standards. It should not impose heavy costs on the companies to meet audit and regulatory requirements. There should be segregation of the different legal systems – Hydrocarbon law, Tax law and Environmental law – to increases accountability, transparency, compliance, effectiveness and sustainability.
It is of utmost importance to minimize the front loaded regressive tax instruments like Signature Bonus, Royalty Tax and Cost Recovery Limits. The taxation can be made progressive by introducing sliding scale measures.
The regime must incentivize the oil company on reducing the costs and encourage them to develop marginal fields. The success of a fiscal regime will ultimately depend on the amount of hydrocarbon recovered and its contribution to the national revenue.
Bibliography