SPOKESMEN CITE LACK OF U.S. UPSTREAM INCENTIVES

An analysis by Salomon Bros. shows the upstream return on investment (ROI) for selected major oil companies is much too low in the U.S. to encourage large investments there.

William L. Randol, managing director of the New York investment firm, called the ROI "abysmal" in testimony at a hearing before the U.S. Senate energy committee. The low ROI explains the flight of capital to more profitable exploration and production projects outside the U.S.

To help slow that flight, Marathon Oil Co. urged the U.S. government to consider the U.K.'s oil tax regime as a model for U.S. reforms.

Victor Beghini, Marathon president, told the hearing the U.S. alternative minimum tax (AMT) is a disincentive to E&P investment, and U.S. tax treatment of capital costs generally does not favor the oil industry.

At the same forum, Deputy Energy Sec. Bill White said the Department of Energy is examining the British system.

LOW U.S. ROI

Salomon Bros.' data show the 5-year average ROI for a representative group of seven major oil companies was only 7.3% during 1989-93 (see chart)(20581 bytes).

Excluding ARCO, "a company that shows an unusually high level of profitability due to its lucrative Alaskan oil production," the 5-year average for the remaining six companies drops to a "paltry" 6.3%.

Three companies in the group failed to earn an average ROI of 6%. They were Exxon, Mobil and Shell at 5.9%, 4.5%, and 3.8%, respectively

Randol cited several reasons for this "unacceptably" low level of profitability in U.S. oil and gas operations:

Crude oil and natural prices have been low and extremely volatile in recent years.
U.S. petroleum is a mature industry that has exploited the best prospects available.
There is no attractive fiscal regime to provide incentives for companies to explore for and produce oil and gas.

Expanding on those points, Randol pointed out that the price of West Texas intermediate crude averaged only about $17.25/bbl in 1994. By contrast, the price of benchmark Saudi Arabian light crude was $34/bbl in dollars of the early 1980s. That was when the dollar was worth considerably more than it is today.

"In fact," Randol said, "another cause of the low returns on investment in this industry is that the denominator of the ROI calculation, the investment base of capital in that business segment, is extraordinarily large due to massive investments made after the 1979 oil price shock, based on the high prices that were obtainable at that time."

A measure of maturity of the U.S. arena is the low volume of production per well.

The average U.S. oil well produces only about 12 b/d. In the North Sea, wells can typically produce 5,000 b/d or more, while wells in the Middle East that can produce 20,000 b/d are not uncommon.

Randol said, "An important corollary to this point is that the best geologic prospects going forward have by and large been denied access by the oil companies for environmental reasons.

"I am speaking of such areas as the Arctic National Wildlife Refuge, believed to contain vast reserves of petroleum. ANWR has been off limits to oil and gas exploration for many years.

"There are other potential oil and gas-bearing regions that have been prohibited for exploration, primarily in areas off both coasts and in some areas of the Gulf of Mexico."

Randol said countries that provide financial inducements for exploration and development are attracting the industry's capital.

"I'm speaking of countries like the U.K., which liberalized its taxation regime in response to the collapse in oil prices that look place in the mid-1980's, or even countries closer to home in Latin America, such as Colombia and Argentina, that have very attractive fiscal terms for oil and gas exploration and as a result are enjoying the benefits of rising petroleum production."

The U.S used to have financial incentives for the oil industry such as percentage depletion and tax credits for producing gas from tight reservoirs.

As evidence of poor returns in the U.S. and more attractive geologic and fiscal regimes overseas, non-U.S. earnings for major oil companies as a percent of total earnings has swelled to as much as nearly three fourths of total income for U.S. based companies like Exxon and Mobil.

Non-U.S. based majors with significant U.S. operations such as British Petroleum and the Royal Dutch/Shell Group have seen non-U.S. earnings rise to as much as 84% of total operating income.

The reason corresponding figures are not as high for Chevron and Texaco is that earnings of their jointly owned Caltex Petroleum, which generates large profits in the Far East, are not shown as foreign sourced income but as a line item of equity income in affiliated companies.

By the same token, Randol said, non-U.S. capital expenditures as a percent of total capital spending has ballooned to more than 70% in the case of certain companies such as British Petroleum, Exxon, and Shell.

Randol said, "The signs are there of an industry that is allocating capital to the best projects it can find, as it must do in the interests of its shareholders, and these prospects and projects are, sadly, not in the U.S."

U.K. SYSTEM

Beghini said the U.K. has recognized the importance of the oil industry's viability and adjusted its fiscal regime to provide a conducive environment. As a result, from 1989 to 1993 the U.K. finished second only to Saudi Arabia in hydrocarbon discoveries.

Beghini pointed out that the U.K. currently imposes only one level of tax, the corporation tax, on new oil and gas developments. The tax rate is a "relatively low" 33% applied to net income from U.K. activities.

Generally, immediate deductions are given for all exploration and appraisal drilling and directly incurred seismic and similar work. Tangible and intangible development costs qualify for 25% declining balance recovery per year.

For existing developments, there is a two-tier system of royalties and tax: corporation tax and the petroleum revenue tax (PRT). Royalty rate is 12.5%. PRT is a separate 50% tax applying strictly to the oil and gas industry.

Beghini said, "In enacting PRT, the U.K. government created an investment oriented tax system designed to encourage optimal production of its resources.

"The use of innovative concepts, such as supplemental expenditure allowance in addition to complete cost recovery, and exempting certain amounts of annual production from tax, ensure that U.K. oil and gas developments earn a reasonable return on capital invested before being burdened with PRT.

"A period of further tax minimization is allowed even after costs have been recovered. Marginal rate tax payments can begin thereafter. Consequently, a project must realize cash flow profit and a rate of return before it can be encumbered with PRT.

"This type of tax regime for existing fields, coupled with recision of PRT and royalty for new field developments, provides an attractive investment environment for the oil and gas industry."

Beghini recalled that major U.K. operators announced accelerated development plans in response to elimination of PRT.

"The abolition put the U.K. in the position of taxing oil ventures solely on the basis of normal company tax. The U.K. directed its tax policy toward ensuring maximum reserve recovery from older fields and maintaining a good flow of new developments."

Tax changes have allowed many operators to develop added reserves in older fields.

Beghini said, "The U.K. tax system provides no specific oil and gas incentives but, more important, provides no disincentives. The U.K. does not impose an overall disincentive even remotely resembling the U.S. AMT."

In the U.S., geological and geophysical costs (G&G) are capitalized until proven worthless or recovered over the depletable life of a lease. By contrast, in the U.K. G&G is 100% deductible in the year incurred.

In the U.S., intangible drilling costs receive a 70% current deduction with the remaining 30% amortized during 60 months. In the U.K., IDCs are 100% deductible.

AMT worsens this comparison. Tangible expenditures, once placed in service, are recovered in the U.S. over an extended life. But the U.K. generally allows a 25% annual allowance.

Beghini said the effect of the U.S. tax system is best shown by comparative project analysis. The economics of a Marathon E&P project currently being studied were analyzed under the U.S. and U.K. tax systems.

Beghini said, "The results indicate that the project, if done in the U.K. by a U.K. company, would have a net present value 30% higher than that of the project done in the U.S. by a U.S. company. This kind of economic difference is cause for concern.

"Reform of the U.S. tax system as it applies to the oil industry is critical. The AMT should be repealed or substantially reformed, and capital cost recovery rules should be modified."

He said the worldwide basis of U.S. taxation as applied to the oil industry creates competitive disadvantages, and the U.S. foreign tax credit limitations tend to increase the risk of double taxation in multiple jurisdictions.

"U.S. tax policy that singles out oil companies for adverse tax treatment is inappropriate, potentially detrimental to the economy, and adversely impacts the competitiveness of U.S. oil and gas companies in the world market."