Getting the 'fair share'

Sept. 5, 2017
Global upstream investment is still at a low ebb, while exploration companies working on conventional projects are beginning to cautiously seek new investment opportunities. Wood Mackenzie Ltd. forecasts the investment cycle will show the first signs of growth in 2017 since 2014 and final investment decisions will double compared with 2016.

Global upstream investment is still at a low ebb, while exploration companies working on conventional projects are beginning to cautiously seek new investment opportunities. Wood Mackenzie Ltd. forecasts the investment cycle will show the first signs of growth in 2017 since 2014 and final investment decisions will double compared with 2016.

Governments around the world are eager to attract this new investment, with more than 60 licensing rounds either active or soon to be launched. However, at current prices and with capital scarce, nervous companies can only greenlight the investments with the lowest cost and highest return.

The quality of geology in the blocks on offer is always the first consideration. Fiscal regimes are also a key differentiator in investment decisions as they can heavily influence the potential value of discoveries.

Governments don't want their fiscal systems to deter projects. But they desire to get a "fair share" of future value when the resources they own being produced. This provides governments challenges in today's buyer's market.

A recent WoodMac report, prepared for the 4th Oil & Gas Government Fiscal Summit to be held in London in October, explored some related issues in this insight.

Revenue or profit sharing?

"There are many angles to consider [a fair share'], but of central importance to investors is whether the government is seeking its 'fair value' of revenue or profits," WoodMac said.

Revenue-based systems, like royalty, increases breakeven prices and are more likely to deter investments. If the fiscal system is targeted on revenues, a $50/bbl price could mean as little as $25/bbl for the investor to cover costs and make a return.

So, during previous low price cycles, fiscal terms usually changed to target profits rather than revenues, as profits-based fiscal terms-like taxes-have much less impact.

But this cycle is different. Governments may believe that costs account for too much of the revenue under profit-based systems nd their share of what is left is not "fair," WoodMac said.

"Consequently, there is new interest in revenue-based fiscal systems. Governments would agree a share of revenue with contractors and the costs of the project are entirely the investor's concern. This removes the need for cost approvals and should enable projects to move ahead more quickly."

Both India and Indonesia have recently introduced such systems, to replace their traditional cost recovery-profit share models. The governments believe that this will generate a 'fair share' of revenue for the government and motivate companies to deliver lower cost projects.

Obviously, whether the prescribed revenue share will be deemed too low, or quite generous, will depend entirely on the contractor's ability to develop fields at low costs, relative to prevailing prices, WoodMac says.

Biddable fiscal terms

To many governments, letting the market effectively decide for them what the 'fair share' should be for each block is a good idea. So, beside work commitments, licensing bid factor is often included for at least one element of the fiscal terms.

However, government shares-either in royalty or profit share terms-could be driven too high by bidders to make projects economic, as companies may choose to "bid it to win it," hoping that they can renegotiate better terms latter.

The Mexican government's approach to respond to this problem, as it did in its second shallow-water round this year, includes a maximum limit on the government's profit share (75%), which aimed to avoid unrealistic bids, as well as minimum rates for each block. In a tie-break situation for the most sought-after blocks, the winner was decided on the additional signature bonus offered.

In that round, the government's share from individual blocks varied significantly. Much lower profit shares were awarded and in a third of the blocks no bids were received at all.

However, each can be considered as 'fair' as the market has decided what the blocks are worth, WoodMac said.

"The fact that the fiscal terms have been offered by the investor for the duration of the license should also build in more stability than a 'take it or leave it' fiscal policy."