Index useful for evaluating petroleum fiscal systems

Daniel Johnston
Daniel Johnston & Co. Inc.
Dallas

• Take and Acdcess to Gross Revenue Calculations [164,090 bytes]

A useful index for evaluating fiscal systems collapses a variety of elements such as royalty, cost recovery limit, and profit oil split. This adds a new dimension to "take" statistics by indicating a country's minimum share of revenue.

From the government's point of view, I refer to this index as "revenue protection" (RP). The complement of RP from the oil company point of view is "access to gross revenues" (AGR).

For example, contractor take for oil under the standard Indonesian and Malaysian contracts is roughly the same, in the low teens. Yet in any given accounting period, the government minimum revenue share in Indonesia is 14% and in Malaysia 36%. The maximum revenue oil companies may access, therefore, is 86% in Indonesia and only 64% in Malaysia.

Division of profits

Division of profits is a key element in contract negotiations for exploration or development rights. Statistics regarding the division of profits or "take" provide a useful means of comparing one fiscal system or contract with another.

Take statistics are widely quoted; yet standing alone they indicate little on how government/state take is structured. An important aspect of fiscal design stems from the fact that few governments are willing to allow an accounting period to pass, once production has begun, without receiving a share of generated revenue during that period.

Revenue protection (RP) is the minimum share of gross revenues a government (combination of a national oil company, taxing authorities, etc.) will receive in any given accounting period from a given production stream.

Access to gross revenues (AGR), the complement of RP, is the maximum share of gross revenues a company or consortium can receive from its working interest. AGR may be limited by government royalties, profit oil splits, and/or cost recovery limits.

RP and AGR indices provide an important analytical perspective. In a royalty/tax system with no cost recovery limit, the royalty provides the government revenue protection. The royalty therefore limits access to gross revenues. In most royalty/tax systems in any given accounting period, there is no limit to the amount of deductions a company may take and companies can be in a no-tax-paying position.

Under a production-sharing contract (PSC) with a cost recovery limit, the national oil company is ordinarily guaranteed a share of profit oil because a certain percentage of production is forced through the profit oil split.

Royalties and cost recovery limits guarantee the government a share of revenues regardless of whether true economic profits are generated. At the end of an oil field's life, the government-guaranteed share of gross revenues takes on the characteristics of a pure royalty.

The RP/AGR calculation requires a simple assumption, which is: expenditures and/or deductions in a given accounting period relative to gross revenues are unlimited. Therefore, cost recovery is at its maximum, and deductions for tax calculation purposes yield zero taxable income if appropriate for the fiscal system.

Situations like this can occur in the early stages of production, with marginal or submarginal fields, or at the end of a field's life. The object is to test the limits of the system with the RP/AGR index, which provides the absolute minimum revenue share that a government might expect and the theoretical absolute maximum AGR for an oil company.

First tranche

In fall 1988 and then later in spring 1989, Indonesia finalized what was then known as the "1988/89 incentive package." This included a relatively unique feature. The "commerciality clause," a standard feature of the Indonesian PSC up to that time, was abolished and replaced with the "first tranche petroleum" (FTP) concept.

The FTP effectively meant that 20% of gross production would be forced through the profit oil split and would not be available for cost recovery. The profit oil split at that time for most oil contracts was roughly 70/30% in favor of Pertamina the Indonesian national oil company. This meant that Pertamina was guaranteed at least 14% (70% of 20%) of gross production in any given accounting period.

Prior to the 1988/89 incentive package, the Indonesian standard contract had no royalty and no cost recovery limit. Companies had to petition for commercial status to be granted before they could go forward with development of a discovery.

The primary criterion was that they had to demonstrate that, under the PSC, Pertamina would receive at least 49% of the production over the field's life. This clause guaranteed that Pertamina would get at least this share, otherwise, they would not grant the right to develop the field.

First-tranche petroleum guaranteed Pertamina a minimum of 14% of production in any given accounting period during which there was production. It also guaranteed Pertamina receiving a minimum 14% of production over the field's life.

Analysts at the time and for a few years afterward argued as to whether the Indonesian FTP mechanism constituted the equivalent of a 14% royalty or an 80% cost recovery limit. In many respects both sides of this debate were correct.

But the more important part of this debate was that it highlighted the similarities between royalties and the effect that cost recovery limits can have.

These two fiscal elements, unlike others, will guarantee that in any given accounting period with oil or gas production, the government or the national oil company will receive a portion of the production or revenues whether or not true economic or accounting profits have been generated by the field.

The RP statistic collapses all of the effects of a royalty, cost-recovery limit, and profit-oil split into one useful index.

Calculating RP and AGR

The flow diagrams (Fig. 1 [141,995 bytes]) show a typical division of profits for a PSC with a 10% royalty, a 50% cost recovery limit, 60/40% profit oil split in favor of the national oil company, and a 30% tax.

Fig. 1a illustrates the division of revenues and profits over a field's life. It assumes that capital and operating costs over the field's life represent 30% of gross revenues.

Fig. 1b illustrates the division over an accounting period. It assumes unlimited deductions and shows the absolute minimum share of revenues the government can expect in any given accounting period or in the full cycle for that matter.

Analysis

The RP and AGR indices provide an important companion statistic to the normal "take" statistics. They go beyond the "how much" associated with take statistics and focus on "how."

Many analysts discuss the relative efficiency of a particular system or contract with qualitative terms such as front-end loaded, back-end loaded, or progressive-vs.-regressive.

With the exception of the heavy front-end loading of signature (or signing) bonuses, this statistic provides a direct index of front-end loading. Bonuses do not receive adequate representation in either the take or RP/AGR statistics.

A key financial consideration of many companies is how quickly they recover their money once production begins. This analytical approach provides an excellent perspective on that important issue. But depreciation rates and their potential delaying effect are not captured in the AGR/RP statistics.

While most taxes are based in part upon capitalized costs (depreciation), many PSCs do not require depreciation for cost recovery purposes. Though fairly minor, this is probably the main weakness of AGR/RP statistics.

In most respects, RP has characteristics of a royalty and can be considered an "effective royalty rate" with all the implications that go with it, such as, the regressive nature as well as the specter of premature abandonment. However, for some systems the RP/AGR statistics will be different for the early-vs.-later years of production. This is particularly true of systems with sliding scales based on tranches of daily production or systems with "R" factors or rate-of-return (ROR) features that usually infer profit oil splits and royalty.

In more than a few situations, a government and an oil company had an agreement that was well balanced as far as the division of profits was concerned. But trouble began once production started because of insufficient RP or AGR.

It is probably asking too much that governments be completely back-end loaded and go without revenue protection.

Another common way of calculating AGR for the same fiscal system as in Fig. 1 is shown in the box. A company with 20% working interest could never expect to receive over 13.2% of total gross revenue (66% of 20%) in any given accounting period.

The box also lists the AGR and RP for fiscal systems in nine countries.

Bibliography

1. Johnston, D., "Different fiscal systems complicate reserve values," OGJ, May 29, 1995, pp. 39-42.
2. Johnston, D., "Global petroleum fiscal systems compared by contractor take," OGJ, Dec. 12, 1994, pp. 47-50.