GOVERNMENTS, CONTRACTORS SEEN HEADED FOR ERA OF COOPERATION

E. R. McHaffie, M. G. Jarvis, Scott A. Barber
Amoco Production Co.
Houston

The oil and gas industry is on the threshold of a new era in international oil and gas investments.

It will be an era of increasing flexibility and cooperation among investors, oil companies, and host governments. And it will develop as a necessary response to flat oil prices and the growing mobility of capital.

This article will cover three essential elements of this topic:

• The effect of fiscal terms on the economics of a project investment.

• How recent changes in global economies have impacted the economics of the projects we evaluate at Amoco.

• Some potential trends that fiscal provisions, and the pattern of investment in the upstream petroleum industry, may take.

KEY PLAYERS

To all intents and purposes, the days of the concession contract are gone.

This does not mean that the fiscal elements of tax and royalty usually associated with concessions are obsolete; they are not. But the industry now generally accepts that a host government owns and has the right to control its mineral resources and to allocate them according to the terms of its contracts with investors and the forces of the market.

In 1992, the basic resource development project involves a host government and a contractor, and no company feels stigmatized in the latter role.

The contractual relationship between host government and contractor requires cooperation if it is to work. The host government brings its resources; the contractor brings technology, financial resources, management, and technical skills-all designed to release the value of the resources for the benefit of both parties.

The host government may itself be an investor in the project development. This is feasible and became very common during the 1970s, when governments or state companies, as mandatory partners, sought equity participation.

However, recent years have seen a reversal in this trend, with state companies being privatized and governments-wisely, in our opinion-reverting to a noninvestment role with respect to their resources and taking a more hands-off approach.

Thomas Walde of the University of Dundee recently wrote, "The reversal of nationalist policies filter down into detailed regulatory, contractual, and fiscal issues and finally into the crucial attitudes of government agencies towards foreign and private investment."

We see signs that this is true, and the contractors have a duty to let host governments know what they prefer to see in this revision of fiscal terms.

At higher levels of government take, only large projects with robust cash flows will be pursued. This is not in the interest of contractors or host governments.

THE FISCAL REGIME

As a primary goal, we seek a fiscal regime that allows projects of varying size to earn competitive returns. In particular, the terms should be structured so that even small or marginal field projects are economic.

Furthermore, the fiscal regime should reward risk-taking. Retaining "upside" in terms of economic benefit is essential to contractors in our high risk business. It allows contractors to survive the risks that do not pan out, and it provides capital for growth.

In the perfect world the fiscal terms would be tailored to individual projects. This is probably unrealistic, but in the case of marginal projects host governments should be prepared to receive overtures for fiscal relief from their contractors. Otherwise, there is the risk that substantial resources will stay in the ground.

An important factor in contractor economics is the level of government take over the life of the project. Those projects which require high initial investments require higher initial returns, since the principles of economics and discounted cash flow dictate that project economics will be severely eroded if the initial investment is not recovered early in the project's life.

As the search for oil and gas leads us inexorably into deep water, or as the giant reservoirs are found less and less frequently, the number of projects qualifying for the more reduced fiscal treatment can be expected to increase. Even giant reservoirs may need fiscal relief due to high levels of government take, enormous infrastructure costs, and high transportation costs.

However, government revenues should be maintained as more projects of smaller size are pursued, allowing the decrease in marginal government take to be offset. Fig. 1 shows the declining trend in discovery size.

It will require a close degree of cooperation, and a great deal of communication between the government and contractor to make these projects work.

OVERCOMING CONFLICT

The paradigm of conflict depicted in Fig. 2 has to be overcome in our new era. The figure notes that conflict arises because host governments and contractors have different objectives. But how truly different are these objectives?

The contractor, especially if it is a large integrated company, needs secure supplies for its downstream System. It needs to produce hydrocarbons. How is this different from a government's need to stimulate development of its resources?

Similarly, there is no reason that a government, s wish to maximize revenues is at odds with the contractor's desire to earn appropriate profits commensurate with its risk taking and investments.

It is also in the interests of both parties to ensure terms are stable and to provide for truly independent dispute resolutions when issues cannot be resolved between the parties. Even questions such as development of local markets need not be an issue if sufficient communication between the parties allows rational decisions to be made, leasing aside emotional issues such as nationalism.

At all costs, the parties must strive to avoid fiscal disincentives. When they exist, such disincentives over time reduce exploration and production activities, oil and gas production, and government revenues. An effect on one impacts the others, and over time as one decreases so do the others.

In the short term, one party may be able to benefit over the other, but in the long term this will only result in accelerating the decline in all of these elements.

It is no accident that in many of the countries where Amoco produces hydrocarbons today we have been doing so for more than 20 years-Argentina, Egypt, Trinidad, Netherlands, and the U.K. These countries are examples of where the host government and contractor have mutually worked to eliminate or diminish fiscal disincentives.

Fig. 3 provides examples of common fiscal instruments for investment disincentives and incentives. Whatever the nature of incentives or disincentives the balance of rewards should be the objective of all parties, all the time.

KEY DRIVER

The key driver in the increased importance of fiscal incentives and disincentives is oil price, in particular the expectations of world oil prices from the mid-1970s onward for perhaps a decade.

Oil industry professionals were in the forefront in predicting continuous price increases. Some forecasters saw prices of more than $100/bbl by the 1990s.

In such a scenario, it is little wonder that host governments sought to capture some of the anticipated high revenue stream, the economic rent from what are, after all, their resources. And capture it they did; hence, the disincentives to investment so common today.

As things turned out, of course, we professionals were wrong in our price forecasts. We are faced with lower prices than predicted, coupled with increased costs of exploration and production, with contractor economics being squeezed as a result.

Yet, even though this is apparent, a consequential adjustment in fiscal terms to reflect lower prices has not occurred except in a few countries. Nowhere have fiscal provisions been improved to reflect fully downward price trends.

Contractors thus become contractors in another sense: We are right-sizing, rationalizing, re-engineering, whatever the latest buzzword is, all in an attempt to retain returns to shareholders by reducing costs as our revenues decline.

While lower prices have reduced the magnitudes of the cash generated for governments and contractors, to date it is the contractors, primarily, who are most affected.

In the cooperative model discussed earlier, it is only a matter of time before governments share more of the impact.

CAPITAL ALLOCATION

The impact on governments will be seen in the decisions contractors take in allocating their capital. As pressures on capital mount, less and less will be available for investment, and typically capital for exploration projects will be curtailed first.

Countries that do not change fiscal terms established on unrealistic price projections will be the first to suffer.

There have been some disappointing responses to deepwater exploration bid rounds lately, with those in India providing a good example. This is perhaps an indication of the development of this trend.

Yet we still see only marginal improvement in fiscal terms to contractors in most countries. Governments that are seeking to encourage investment should quickly decide which disincentives to drop and which incentives to adopt.

The need for haste arises as a whole new arena joins the international competition for available capital: the former Soviet Union and its former East European satellites.

To attract exploration capital in this period of rising competition, countries will have little choice but to improve the fiscal terms they offer international contractors.

They may be able to increase interest by structuring terms so that critical aspects, such as royalty and production sharing split, are determined through competitive bid.

REFOCUSING EFFORTS

Amoco is currently active in exploration and production in almost 40 countries. We now are focusing our efforts such that the number of countries in which we operate will decrease substantially during the next 5 years.

We will seek investment opportunities in countries that have good hydrocarbon potential, overlain with fiscal and contractual terms that are attractive, flexible, negotiable, and stable.

If, as we suspect, other contractors do likewise, we could see substantial capital and resource flows into some countries and out of others. This prioritization of investments is necessary and will continue to be a feature of our industry as long as oil prices remain flat, as we now predict they will, for the duration of our planning cycles.

Countries having legislated, nonnegotiable fiscal terms may limit investment interest in marginal projects. Projects in countries open to negotiated terms for exploration, development, and production will more likely offer acceptable financial returns and be able to attract competitive industry interest.

ENCOURAGING EXPERIENCE

Amoco recently had an encouraging experience that shows how we hope future transactions can take place in an open, cooperative spirit.

In April 1990, Amoco signed a technical evaluation agreement with Romania to study an area close to existing production.

As our study progressed, we were advised that a competitive bid round would be held over open acreage in Romania.

In October 1990, companies were invited to inspect data packages. The state company, Rompetrol, prepared a model contract.

Bids were due in June 1991. By August, Rompetrol, given complete control over the licensing process by the government, had completed its bid analysis, and negotiations on production sharing contracts began in September 1991.

By November, negotiations with several companies of at least four nationalities were under way by Rompetrol, for which this was a new experience.

In August 1992, Amoco signed a definitive production sharing contract over onshore Romanian acreage.

Amoco's experience in Romania was enlightening.

The Rompetrol group remained intact throughout the negotiations, avoiding the need for constant backtracking to bring new personnel up to speed.

Both parties came ready, willing, and able to make a deal. We were empowered.

Rompetrol acted to coordinate concerns over fiscal provisions, bringing together U.S., Canadian, Dutch, and British companies to address their views on the fiscal terms in the proposed contract, and then worked effectively to get the contract finalized by the Romanian ministry of finance. Eventually, the appropriate legislation was passed.

It is extremely encouraging that a national oil company and its coventurers were able to act in this fashion.

Amoco and several other companies are already investing in Romania.

The lesson for other nations, some of which began licensing processes ahead of Romania but have seen no investment to date, should be clear.

COMPARING TERMS

Fig. 4 illustrates a critical point.

It compares takes and returns in two jurisdictions in the Pacific Rim from a barrel of production from offshore fields of similar size with similar water depths.

It is obvious which country will attract the most capital over time.

In this new era of cooperation, contractors and host governments must work together to achieve success in both countries represented here, both of which are prospective and both of which can succeed in attracting petroleum investment.

Contractors will increasingly seek out environments for investment that are flexible and that allow appropriate returns for risks undertaken.

As crude oil prices stay relatively flat, rigid fiscal terms fixed on unrealistic assumptions will eventually redirect capital flows away.

In the interests of those governments and contractors, resource development must continue, with each party earning appropriate rewards.

This may include downward shifts in expectations by host governments.

Where imbalances exist, it is in the interest of both parties to correct them, and this can best be achieved in a new era of cooperation.

Copyright 1993 Oil & Gas Journal. All Rights Reserved.