Chapter 2. How to evaluate fiscal terms?

David Johnston
Abstract This chapter provides guidelines for evaluating fiscal terms. Contrary to popular belief, we show here that the type of system used is of minor importance relative to other design concerns. Governments can achieve their fiscal objectives with whichever fiscal system they choose as long as the system is designed properly. Improper design can translate into money-left-on-the-table. Different types of systems are discussed and the few substantial differences that e ist between them are identified. !oving beyond our discussion of the type of system we consider different ways to study the design of a deal when evaluating its merits. Government Ta"e is the most popular statistic. The statistic is of some benefit but is often subject to misinterpretation and cannot tell the full story. In addition to Government Ta"e we describe a statistic#the $ffective %oyalty %ate#that is better at capturing how governments receive rent during accounting periods when no ta es are collected. &e then consider five further features that matter to governments and companies#the degree of government participation, which comes at some benefit to governments but at a cost to companies, the 'savings inde ( which gives a sense of the incentives facing companies to "eep costs down, responsiveness of the deal to changing economic conditions, provisions for minimi)ing ris", and provisions that allow companies to 'boo" barrels.( &e conclude with some observations on the options available to governments as they decide how to allocate acreage.

Introduction
*il is the world+s number one strategic commodity. It is of vital interest to developed and developing nations that rely more and more on imported oil and gas. It is also vitally important to e porting nations, many of them among the poorest countries in the world# the !iddle $ast aside. ,or countries with petroleum resources the contribution from the petroleum sector to the nation+s budget is often dramatically greater than the contribution to the country+s gross national product -G./0. ,or e ample if the petroleum sector were to represent say 123 of G./ it would li"ely represent from 42 to 523 of the nation+s budget. There are two reasons for this6 first, relative to most other industries, petroleum is very profitable7 second, the effective ta rate -Government Ta"e0 for the petroleum industry relative to other industries is usually about double or more. .umerous dynamics influence today+s industry. *il demand continues to grow, and at a faster rate than was e pected. Consumption went from 89 million barrels a day in :22: to ;5.< million in :225, leaping by : to 4 million =*/D each year, for a period for which e pectations had been on the order of 1 to 1.< million =*/D growth per year. !uch of the new demand comes from the >sian giants India and China. =ut supply of oil and gas is a function of e ploration and production. There is now every indication that e ploration and the resultant discoveries, have ?pea"ed,+ although we do not "now for sure when production will pea" -production pea"s lag e ploration pea"s, sometimes by as much as 42 years0. Gas is becoming more and more important but, because of the higher transportation and management costs, gas discoveries are still often characteri)ed -although this will li"ely have to change0 as being ?worse than a dry hole+ in many regions of the world. Gas is simply much more difficult to transport than oil and is still flared in many parts of the world#nearly 12 billion cubic feet of gas per day. .igeria flares almost : billion cubic feet per day in their .iger Delta oil fields#not far from some of the poorest people in the world. >nd in many other parts of the world gas discoveries are simply ?shut in.+

>s these features change there are also changes in relations between the main players in the industry6 the countries and .ational *il Companies -.*Cs0 that control the bul" of the available oil and gas reserves, and the International *il Companies -I*Cs0 that provide much of the financial, technical, organi)ational, and mar"eting needs of e porting and importing countries. *n the side of the producing countries there are economic and political comple ities associated with managing oil and gas. These issues are important for countries, but also affect the way these relate to private oil companies. !any of the problems associated with oil and gas e ploration and production, particularly in low-income countries, can be associated with corruption. =ut in some cases the problems stem from misunderstandings and poor communication. In these cases, the government, .*C, and the International *il Companies are suspected of stealing a nation+s wealth. Indigenous peoples of the world no longer sit idly by. The results are usually not healthy. &hile relations may be fraught with political difficulties, they are also important from a practical point of view. There is increasing competition among countries for the limited resources of the I*Cs. The ability of countries to attract I*C investment depends on prospectivity, stability, and their mar"eting s"ills. I*Cs want to reduce ris" in an inherently ris"y business. This is the subject of this chapter6 @ow do governments, .*Cs, and I*Cs wor" together and what types of contractual relations are li"ely to lead to better outcomes than we have seen in the pastA This Buestion is often e amined by focusing more on the broad differences between the 'families( or types of systems that e ist. In fact, although there are myriad ways to structure business relationships in the petroleum sector, the first observation is that in fact, for all practical purposes, there are only two main families of /etroleum ,iscal %egime6 'concessionary( systems and the 'contractual based( systems7 although differences e ist between them, from a mechanical and financial point of view the differences are not significant. Instead, in order to wor" out the merits of a particular

agreement, what is needed is a deeper understanding of how the different systems operate and particularly what the core fiscal elements areA These issues are discussed in Cection II. In Cection III we provide a framewor" for analy)ing the properties of different agreements, identifying what is at sta"e with different provisions in an oil contract, no matter what family of agreement is used. &e e amine two measures, beginning with the most commonly cited# 'Government Ta"e.( Government Ta"e is an important statistic, but while commonly used, the Government Ta"e statistic is flawed. ,or this reason companion statistics and other features of agreements are e amined. &e describe a companion statistic, the '$ffective %oyalty %ate( and show how it is calculated. =eyond this more careful consideration of particular provisions are reBuired. &e consider five features that matter for governments and companies#the degree of government participation, which comes at some benefit to governments but at a cost to companies, the 'savings inde ( which gives a sense of the incentives facing companies to "eep costs down, responsiveness of the deal to changing economic conditions, provisions for minimi)ing ris" and provisions that allow companies to 'boo" barrels.( &e conclude with some observations on the options available to governments as they decide how to allocate acreage

II Fiscal S stem
The two main families of fiscal system are 'concessionary( systems -more commonly "nown these days as royaltyDta -%DT0 systems0 and 'contractual based( systems -which include both production sharing contracts -/CCs0 and service agreements -C>s00. The distinguishing characteristic of each is where, when, and if ownership of the hydrocarbons transfers to the international oil company. .umerous variations and twists

are found under both the royaltyDta -concessionary0 systems and the contractual-based approaches.1 @owever, from a mechanical and financial point of view there are practically no differences between the various systems. The hierarchy of arithmetic such as -10 generation of production and revenue followed by -:0 royalty or royalty eBuivalent elements, followed by -40 cost recovery, ta deductions or reimbursement etc and -50 profits-based mechanisms such as profit-oil sharing andDor ta es are generally found in almost all systems. There are some interesting e ceptions to this general rule and they are most li"ely to be found among the C>s of this world. The ta onomy of petroleum fiscal systems is outlined in ,igure EClassificationF. Fi!ure "Classification of #etroleum Fiscal $e!imes%

In fact, preferences for one system over and certain elements or wellhead. conventions Inder %oyaltyDTa Cystems titleanother to hydrocarbons can be transferred at the generally tend to be regional. @ence %DT Cystems are often simply referred to as Concessions in some areas. =ut, the term ?concession+ has negative connotations in other $)*A+&* AC)0&$AC&1A+ parts of the world. It is,& simply not so politically correct. /olitical correctness also S*S&./S 2AS.D S*S&./S influences the difference between ?/CC+ vs. ?/C>+ terminology. In %ussia, the word ?agreement+ is favored over the word ?contract+ because of the negative connotation of in 'cash( -Cervice0 or in '"ind( -/CC0A
Is 'reimbursement( and 'remuneration(

&ho has 'title( to mineral resourcesA

the word ?contract+ when translated into %ussian. Get, a /C> is the same thing as a /CC.
Service A!reements #roduction Sharin! Contracts Come of the geographic influences can be seen in Table E%egionsF.

&ith /CCs, title to hydrocarbons transfers at the e port point.

&hat is sharedA 'gross production( -/eruvian type /CC0or 'profit oil( -Indonesian type /CC0

&able Is "$e!ions%' the (orld and the most prominent & pes of A!reement remuneration $e!ions based upon of a flat
fee -/ure0 or profit -%is"0A

$e!ion
1

& pe of A!reement

Indonesian & pe
as a separate category of profit oil.

>lthough these distinctions are not always clear. There are some ris" service agreements that appear totreated Unused cost oil 'ullage(

have more of the characteristics of a royaltyDta system -Hene)uela7 with royalties and ta es0, and some loo" more li"e a /CC -/hilippines7 with a cost recovery limit and profit oil split0.

#ure

$is3 Service

#eruvian & pe #SC

.! ptian & pe #SC

Service

Jatin >merica and !. $ast >frica and ,CI >frica ,ormer =ritish Colonies ,CI & >frica !iddle $ast

Cervice >greements %ate-of-return -%*%0 features Cost %ecovery Jimits based on .et /roduction &or" program bidding /C> Terminology -vs. /CC0 'Cost Ctop( Terminology -vs. Cost %ecovery limit0 Ta es 'in lieu(

The belief that systems are somehow fundamentally different from a financial point of view has led to a number of common misconceptions. Despite common claims to the contrary, neither %DT systems nor /CCs are inherently more li"ely to allocate more ris" to either the .*C or the I*C. Cimilarly, it is not the case that /CC+s 'allow the I*Cs to get their costs bac" faster ( or even that they get them bac" at all. .or is it necessarily true that /CC+s are more stable than %DT Cystems or that /C>+s -/CC+s0 are unsustainable. @owever, there are differences. &e discuss these below, but first we consider the different systems in more detail in turn.

II.4 $o alt &a5 S stems 6$,&7

/rior to the late 19K2s %DT Cystems, or Concessionary Cystems were, for all practical purposes, the only arrangements available. %DT systems are characteri)ed by a number of features6 *il companies are contracted for the right to e plore for hydrocarbons If a discovery is deemed to be commercial, the international oil company has the right to develop and produce the hydrocarbons &hen hydrocarbons are produced the international oil company will ta"e title to its share#gross production less the royalty#at the wellhead $ntitlement L Gross production less %oyalty. If the royalty is 123 the international oil company can ?lift+ 923 of production. If the royalty is paid in cash, then the I*C can ?lift+ 1223 of production $ ploration and production eBuipment is owned by the I*C The I*Cs pay ta es on profits from the sale of the oil

Sample Calculation The following e ample demonstrates the arithmetic performed to calculate Contractor and Government Ta"e, and $ntitlement. $ven though this analysis is 'full cycle( the hierarchy of arithmetic that would be e pected in any given accounting period is the same. In this particular case M:2.22D==J is assumed to represent average gross revenue per barrel over the life of the field -full cycle0. $o alt , &a5 S stem Flow Dia!ram )ne 2arrel of )il 6Full C cle7 123 %oyalty .o Cost %ecovery Jimit K23 Ta -1st Jayer0 423 Ta -:nd Jayer0 Compan Share *il /rice M:2D ==J Costs M<.K<D ==J

Cumulative 8ross $evenues 8overnment Share 92:.:: $o alt 123

92.::

9?.@?

>ssumed Costs

94=.:: Deductions 942.>? &a5able Income Special )il &a5 K23 9B.A4 Income &a5 423

9A.;A 694.A=7 9>.A@ 9;.44 9>.A@

M4.5KD -M:2.22-<.K<0

94.A= 94:.=; 94:.=; B@<

Division of Gross %evenues Division of Cash ,low &a3e +iftin! .ntitlement

2A<

M12.;9D -M:2.22-<.K<0

;:<
-M:2 - M:0D M:2.22

4:<
M:.22D M:2.22

In this e ample of an %DT Cystem, we calculate Government Ta"e over the full cycle of the project, which includes e ploration and early development through to field decline and abandonment. &e use one barrel of oil, or M:2, to represent average full cycle revenues -per barrel0 and show how that barrel of oil is divided between the Government and the Contractor. *f the M:2, the Government gets a 123 royalty N M:. >ssumed costs are deducted from the M1; left after the royalty is ta"en, leaving a ta able income of M1:.4<. Two layers of ta es are levied against the ta able income, first a K23 ta on the M1:.4< gives the Government M8.51 leaving M5.95. The second layer of ta , 423, is levied against the M5.95 giving the Government an additional M1.5; leaving the contractor with M4.5K. Ta"e statistics are a function of cash flow -gross revenue L costs0. >nd in this particular e ample Government Ta"e N Government cash flowDtotal cash flow or M12.;9D-M:2.22 M<.K<0 or 8K3.

II.2 #roduction Sharin! Contracts 6#SCs7

The concept of production sharing is ancient and widespread. ,armers in the IC> have been familiar with the concept for decades. The concept of the /CC as far as the oil and gas industry is concerned was conceived in Hene)uela in the mid 19K2s -per a /ermina brochure dated :2220. The first modern /roduction Charing Contract was signed in 19KK between II>/C* and /ermina, Indonesia+s .ational *il Company at the time. The characteristic features of this pioneering agreement included ->lso see Chapter E%adonF06 Title to the hydrocarbons remained with the Ctate -Indonesia0 /ermina maintained management control -Indeed, putting management control in the hands of /ermina is what really distinguished the /CC from the Indonesian predecessors0 Contractor submitted wor" programs and budgets for approval /rofit *il Cplit -/D*0 K<3D4<3 in favor of /ermina

Contractor bore the ris" Cost %ecovery Jimit was 523 Ta es paid in lieu -i.e. ta es paid for and on behalf of the I*C by /ermina0 /urchased eBuipment became property of /ermina Company $ntitlement N Cost *il O /rofit *il

Sample Calculation The following e ample demonstrates the arithmetic performed to calculate Contractor and Government Ta"e, and $ntitlement. In this case, li"e the e ample %DT above, we use the revenue from one barrel of oil#M:2 to represent average -per barrel0 gross revenue over the life of the field -full cycle0.

Fi!ure C & pical #SC D Flow Dia!ram )ne 2arrel of )il 6Full C cle7 123 <23 K23 423 %oyalty Cost %ecovery Jimit Government /D * Chare Corporate Income Ta -CIT0 *il /rice M:2D ==J Costs M<.K<D ==J

Cumulative 8ross $evenues 92:.:: Contractor Share $o alt 123 9?.@? >ssumed Costs 9A.;A 694.A=7 9>.A@ 9;.44 9>.A@ 2A< M4.5KD -M:2.22-<.K<0 ?>< -M<.K<O5.950D M:2.22 Division of Gross %evenues Division of Cash ,low &a3e +iftin! .ntitlement

8overnment Share 92.::

94=.:: Cost $ecover <23 Jimit 942.>? #rofit )il #rofit )il Split 52D K23 &a5 $ate 423 9B.A4 94.A=

94:.=; 94:.=; B@< M12.;9D -M:2.22-<.K<0 AB< -M:.22O8.510D M:2.22

This e ample is mathematically identical to the previous %DT Cystem e ample#with the obvious e ception of lifting entitlement#here the company cannot claim to boo" as many barrels. The terminology however is different. In the %DT Cystem we use the term deductions, whereas with /CCs the term ?cost recovery+ is used, and instead of a K23 ta , there is a K2D52 /rofit *il Cplit in favor of the Government. Ctill, the math is the same and Government and contractor ta"e calculations are identical to the %DT Cystem ta"e calculations. This illustrates that from a mathematicalDmechanical point of view the differences between %DT systems and /CCs are by far outweighed by the similarities.

.ote that from a mechanical point of view the Cost %ecovery Jimit is the only difference between %DTs and /CCs. In this case this difference did not matter because the cost recovery limit was not reached. .ote also, as signaled above, the difference between the entitlements in the two systems is dramatic.

II.> Service A!reements 6SA7

Cervice contracts or service agreements generally use a simple formula6 the contractor is paid a cash fee for performing the service of producing mineral resources ->lso see Chapter E%adonF0. >ll production belongs to the state. The contractor is usually responsible for providing all capital associated with e ploration and development -just li"e with %DT systems and /CCs0. In return, if e ploration efforts are successful, the contractor recovers costs through the sale of oil or gas plus a fee. The fee is often ta able. These agreements can be Buite similar to /CCs or %DT systems e cept for the issue of entitlement. >s mentioned earlier, other than the issue of entitlement, the Hene)uelan terms from the 199K round loo" and sound just li"e a %DT system#it has a royalty and ta es. =ut the /hilippine C> uses the terminology and structure of a /CC with a cost recovery limit and profit oil split. ,ollowing are e amples of various Cervice >greement fee structures.

II.>.4 Fi5ed Fee C 9,22+ > MD==J fee-based formula is used in the Point Hentures in .igeria, a few contracts in >bu Dhabi, and as part of Quwait+s proposed *perating Cervice >greement -*C>0. > simplified e ample is as follows6 ,irst, the I*C conducts operations in much the same way it would in virtually any fiscal system. ,or performing these services -in this e ample0 the I*C is able to recover its costs -assumed to average M5.22D==J0 out of revenues and is also paid a M:.22D==J fee for conducting operations. The e ample below shows how this simple arrangement loo"s at M:2.22D==J and MK2.22D==J oil prices. Ccenario 1 -M:2 D ==J0 Ccenario : -MK2 D ==J0

> = C D $

Gross %evenues -MD==J0 ,ee M:.22D==J .et %evenue >ssumed Costs Government /rofit -Cash ,low0 Company Cash ,low E=F Government Ta"e E$D->-D0F Company Ta"e E=D->-D0F

M:2.22 - :.22 1;.22 - 5.22 15.22 :.22 ;8.<3 1:.<3

MK2.22 - :.22 <;.22 - 5.22 <5.22 :.22 9K.53 4.K3

.otice with this structure the system is 'progressive,( as oil prices go up -or as profitability goes up0 Government Ta"e also goes up.

II.>.2 Fi5ed Fee D < of CostsE1plift >nother type of fee-based approach li"e that found in Iran under the 'buy-bac"s( and proposed in IraB under what is called a 'sBuee)e /CC( provides the I*C a means of recovering costs plus a fi ed fee that is a function of the anticipated costs. The e ample here assumes the I*C will be reimbursed for costs of M5.22D==J plus an uplift of say <23 -of those costs0. This is a simple e ample but it serves our purposes. The I*C would conduct operations in much the same way as with other petroleum operations. The e ample here shows how this arrangement would loo" with oil prices of M:2.22D==J and MK2.22D==J. > difference is that for a given 3 higher costs translate into a higher percentage for the oil company. Ccenario 1 -M:2 D ==J0 M:2.22 - 5.22 - :.22 15.22 :.22 ;8.<3 1:.<3 Ccenario : -MK2 D ==J0 MK2.22 - 5.22 - :.22 <5.22 :.22 9K.53 4.K3

> = C D C

Gross %evenues -MD==J0 I*C cost recovery -%eimbursement0 I*C ,ee <23 of costs -%emuneration0 Government /rofit -Cash ,low0 Company Cash ,low Government Ta"e EDD->-=0F Company Ta"e ECD->-=0F

.otice this system is also 'progressive,( as oil prices go up -or as profitability goes up0 Government Ta"e goes up.

II.>.> Fariable Fee D #ercenta!e of 8ross $evenues >nother type of fee-based approach -very rare0 provides the I*C with a direct share of revenues from which, hopefully, it would be able to recover its costs and ma"e a profit. This type of arrangement in its classic form would be referred to as the '/eruvian model.( >nother variation is the ,ilipino /articipation Incentive >llowance -,/I>0 which allows the contractor group a 8.<3 'incentive( if there is sufficient ',ilipino /articipation.( This 8.<3 allowance is based on gross revenues. > simple e ample here assumes the I*C will receive :<3 of gross revenues. The I*C conducts operations in much the same way it would under almost all petroleum systems. The e ample below shows how this simple arrangement loo"s at M:2.22D==J and MK2.22D==J oil prices. Ccenario 1 -M:2 D ==J0 M:2.22 - <.22 1<.22 - 5.22 1.22 94.8<3 K.:<3 Ccenario : -MK2 D ==J0 MK2.22 - 1<.22 5<.22 - 5.22 11.22 ;2.53 19.K3

> = C D ,

Gross %evenues -MD==J0 I*C ,ee :<3 of Gross %evenues Government /rofit -Cash ,low0 >ssumed Costs Company Cash ,low -=-D0 Government Ta"e ECD->-D0F Company Ta"e E,D->-D0F

.otice with this structure the system is 'regressive.( >s oil price or profitability goes up, Government Ta"e goes down. This is because while the I*C is guaranteed :<3 of gross revenues -almost li"e a negative royalty0 the Government is guaranteed 8<3, li"e a large royalty. %oyalties are notorious for being regressive, especially large royalties.

II.A Comparin! S stems

There are numerous sources or references that ma"e little distinction between /CCs and C>s other than differences regarding the transfer of title to hydrocarbons -discussed earlier0. This difference in ownership structure#where, when, and if ownership of the hydrocarbons is transferred to the I*C#is one of the distinguishing characteristics of

petroleum fiscal systems. &ith an %DT system title transfers to the I*C at the wellhead7 the I*C ta"es title to gross production less royalty oil. ,or a /CC title transfers at the e port point or fiscalization point. The I*C ta"es title to cost oil and profit oil. &ith Cervice >greements -by definition0 there is no transfer of title to hydrocarbons. This directly impacts an I*C+s ability to boo" barrels. &itle to facilities remains with the oil company under %DT Cystems, but under /CCs and Cervice >greements title to facilities transfers to the .*C or government. There is some variation to when title to facilities -production facilities, pipelines and other associated facilities0 transfers to the .*C or government but usually it transfers upon commissioning of the facilities. ,or e ample, in .igeria title to facilities transfers to the .igerian .ational *il Corporation -../C0 when the eBuipment is landed in-country. Come countries will wait until the facilities have achieved 'payout( at which point title transfers to the .*C. ,rom a financial point of view as far as normal production operations are concerned, there is little difference to the I*C whether or not they own the facilities or the government owns the facilities. The significant difference involves the abandonmentDsite-restoration liability. The important legal implication however is that the obligation for site restoration, abandonment, and cleanup is held by the owner in the absence of clear and well-crafted abandonment provisions. >nother, less evident difference between the systems, is with respect to how they handle entitlement. In the e amples we wor"ed through above we saw how a /CC and an %DT Cystem over the full cycle can be identical from a financial point of view yet contractor entitlement in the /CC system may be about half that of the %DT Cystem. =elow we describe in more detail the role entitlement plays in contract negotiation. ,inally, there may be difference based on proGect costs. Government Ta"e is li"ely to be much higher for a /CC for low profitability projects. To see this, consider Graph ETa"e vs. /rofitabilityF. The graph shows how the /CC in this particular case is more front-endloaded than the e ample %DT Cystem. It is the cost recovery limit that ma"es the /CC more front-end-loaded -or regressive0 than the %DT Cystem. In early years, Government

revenue is guaranteed for both systems because of the royalty. The /CC however also has the cost recovery limit that guarantees the Government additional revenue. In fact the Government Ta"e for sub-marginal fields can be e tremely high, so graphs li"e this are usually capped at 1213 #showing ta"es in the 1223O range is relatively meaningless. .ote that once the costs are lower the two systems are the same.

8overnment &a3e vs. #roGect #rofitabilit

& pical #SC' 123 %oyalty <23 Cost %ecovery Jimit K23 Government /D* Chare 423 Corporate Income Ta -CIT0 & pical $,& S stem' 123 %oyalty .o Cost %ecovery Jimit K23 Ta -1st Jayer0 423 Ta -:nd Jayer0
Cost $ecover +imit 6?:<7

4::< 8overnment =:< &a3e #SC $,& @:< 4::< =:< @:<

A:<

2:<

:<

&otal Costs as a #ercenta!e of 8ross $evenues

Table E,iscal Cystems # Cide-by-Cide ComparisonF summari)es the differences between systems. &hile the statistics in Table E&orld >verage ,iscal TermsF summari)e the fiscal terms associated with these different systems. The figures in these tables are from a :221 Database -'International /etroleum ,iscal Cystems( /enn&ell =oo"s, :221, Daniel Pohnston0 and therefore these statistics do not ta"e into consideration the recent oil price increases. =ut, "eep in mind that if most fiscal systems in the world are moderately regressive. The revenue the governments receive will go up, but Government Ta"e -discussed below0 will go down on average. ,inally note that in comparing across these systems it is important to remember that the differences in fiscal terms across the systems is not necessarily due to the different systems being used#as discussed similar

terms can be achieved across all of these systems7 rather differences reflect the different conditions in the different environments in which these systems are employed. &able "Fiscal S stems E SideCb CSide Comparison%
$,& S stems 8lobal FreHuenc 6< of S stems 7 & pe of #roGects )wnership of Facilities Facilities &itle &ransfer I)C )wnership of H drocarbons 6+iftin! entitlement7 H drocarbon &itle &ransfer Financial )bli!ation 8overnment #articipation Cost $ecover +imit 8overnment Control I)C +iftin! .ntitlement I)C Control 553 >ll types6 $ ploration, Development, $*% International *il Company .o transfer Gross production less royalty oil #SCs 5;3 >ll types6 $ ploration, Development, $*% Government .*C '&hen landed( or upon commissioning Cost oil O profit oil Delivery /oint, >t the wellhead ,iscali)ation /oint or $ port /oint Contractor 1223 Ges but not common .o Jow Typically Typically around 923 @igh Contractor 1223 Ges, common Isually @igh Isually from <2K23 Jow to !oderate Contractor 1223 Ges, very common Cometimes @igh .one -by definition0 Jow .one SAs ;3 >ll types but often non-e ploration Government .*C '&hen landed( or upon commissioning .one

&able "(orld Avera!e Fiscal &erms%

Cample of top :2th /ercentile Global Cample /CC %DT 8: K5 823 <93 4K countries :9 countries <3 ;3 :43 ;3 8<3 423 K43 9:3 493 <K3 K<3 .D> -=ased on /rospectivity0 /CC %DT 19 K 8;3 ;23 1: countries < countries <3 113 :93 113 923 443 <<3 ;93 423 483 K:3 .D>

.umber of Cystems Government Ta"e Government. /articipation %oyalty %ate $ffective %oyalty %ate %ingfenced Cystems Jifting $ntitlement Cavings Inde Cost %ecovery Jimit Cystems with %*% or '%(

factors 183 :<3 :K3 1K3 Source' International /etroleum ,iscal Cystems Data =ase, R Daniel Pohnston, /enn&ell :221

III 2eneath the surface' .valuatin! 3e elements of an oil contract

&ith the e ception of the Inited Ctates, Canada, and a very few old Cpanish land grants in Colombia, mineral rights belong to the Ctate. >nd, in most countries the nation+s mineral wealth is considered a ?Gift from God.+ The result is that managing a country+s mineral wealth is considered a ?sacred trust+ even though, in many situations, the .ation+s mineral wealth benefits only a few people. Countries with limited proven mineral wealth are see"ing e ploration activity and have limited leeway attracting it. Ctill, they want the best ?terms+ they can get. >ll countries have their own uniBue boundary conditions, concerns, and objectives. >nd, needs, traditions, perspectives, perceptions, and politics differ as well. =ut in general the major concerns facing a country are6 1. Getting a large -and fair0 share of the profits -Ta"e0 while "eeping costs down :. Guaranteeing a certain share each accounting period -$ffective %oyalty %ate andDor !inimum Government Ta"e0 4. *btaining, but not e ceeding the !a imum $fficient /roduction %ate -!$/%0 5. !aintaining a high degree of Control over the country+s resources <. >ttracting investment and the right kind of company even if the financial conditions appear not as good. -Trinidad awarded a bloc" to =@/ even though Talisman submitted a higher bid. The government was familiar and comfortable with =@/0 *il companies meanwhile want to e plore in regions where there is a reasonable chance of finding oil and gas. They want to deal with stable governments, and prefer contract ?terms+ that will provide a potential return-on-investment that is commensurate with the associated ris"s. They are also interested in -or rather obsessive about0 'boo"ing barrels.( Indeed in the eyes of &all Ctreet, oil companies are measured by their ability to replace production and by finding costs. If they can boo" more barrels their ?reservereplacement-ratio+ benefits and their finding costs go down. >nd they are measured on

finding and lifting costs and reserve replacement. This can be confusing and frustrating since the ability to boo" barrels and the amount of barrels a company can boo" strongly depends on the type of system and various other illogical elements. &e loo" at some determinants of a company+s ability to boo" barrels towards the end of this section The contract is the best indicator of how well these different goals have been met. There is however no single clause or number that you can loo" at in a contract to wor" out if the country or the company -or neither or both0 got a good deal. %ather evaluating the contract reBuires e amining a series of conditions, the most important of which are summari)ed in Table E'&hat+s in an oil contractA(F ->lso see Chapter E%adonF0. Despite the multiplicity of goals on the part of governments and contractors, and the range of issues to be negotiated, a number of attempts have been made to create single measures to summari)e the value of a contract. Chief among these is the 'Government Ta"e( statistic. &e discuss this ne t. &able' (hatIs in an oil contract? & pical Contract Conditions
Condition Area Description =loc" si)es range from e tremely small for developmentD$*% projects to very large bloc"s for e ploration. Typical e ploration bloc" si)es are on the order of :<2,222 acres -1,222 "m:0 to over a Duration $elinHuishment .5ploration )bli!ations million acres -S5,222 "m:0. $ ploration - Typically 4 /hases totaling K to ; years. /roduction :2 to 42 years, -typically at least :< years0 $ ploration :<3 after 1st /hase, :<3 of 'original( area after :nd /hase This is most common but there is wide variation. Includes seismic data acBuisition and drilling. Cometimes contract reBuirements can be very aggressive in terms of M and timing L $o alt #rofit )il Split depends on the situation. >ll bloc"s are different &orld average is around 83. !ost systems either have a royalty or an effective royalty -$%%0 due to the effect of a cost recovery limit. IniBue to /CCs and some Cervice >greements. !ost profit oil splits -appro imately <<-K230 are based upon a production-based sliding scale. *thers -around :2-:<30 are based upon an '%( factor or %*% Cost $ecover +imit system. IniBue to /CCs and some Cervice >greements. >verage K<3 Typically /CCs have a limit and most are based on gross revenues.

Come -perhaps around :230 are based on net production or net revenues -net of royalty0. *ver :23 have no limit -i.e. 12230. >ppro imately half of the worlds /CCs have no depreciation for cost &a5ation recovery purposes - but almost all do for ta calculation purposes0. &orld average Corporate Income Ta -CIT0 is probably between 424<3. @owever, many /CCs have ta es paid 'in lieu( L 'for and on behalf of the Contractor( out of .ational *il Company share of Depreciation profit oil. &orld average is < year Ctraight Jine Decline -CJD0 for capital costs. Isually depreciation begins 'when placed in service( or $in!fencin! 'when production begins( whichever occurs later.. !ost countries -<<30 erect a 'ringfence( or a modified ringfence -1430 around the contract area and do not allow costs from one bloc" to be recovered from another nor do they allow costs to 'cross 8ovrenment #articipation Cr pto &a5es the fence( for ta calculation purposes. Typically the national oil company -or eBuivalent0 is 'Carried( through e ploration. >ppro imately half of the countries with the option to participate do not reimburse 'past costs.( Crypto ta es are those costs and obligations the contractor must ta"e

on that are not readily captured in the Ta"e calculations Source' 'International /etroleum ,iscal Cystems(, /enn&ell =oo"s -:2210, Daniel Pohnston

III.4 &he J8overnment &a3eK statistic

'Government Ta"e( is the government+s share of economic profits counting almost income sources6 =onuses, royalties, profit oil, ta es, Government wor"ing interest, etc. -although, it does not measure all of the means by which a Government benefits such as employment benefits, s"ills transfers etc -collectively these are called 'Gross =enefits(07 and by definition 'crypto ta es( are not adeBuately captured in the ta"e statistics0. Government Ta"e is calculated using a number of assumptions such as oil prices, costs, escalation rates, production rates, cumulative production, etc. ,or the most part variations in these assumptions affect the anticipated profitability of a field or project. >nd, as can be seen from ,igure EGovernment Ta"e vs. /roject /rofitabilityF Government Ta"e can vary Buite dramatically with the profitability of a project.

The Government Ta"e statistic also does not adeBuately capture ris".

8overnment &a3e' Le Definitions

.conomic profit -M0 8overnment &a3e -30 Contractor ta3e -30 Compan ta3e -30 N Cumulative gross revenues less cumulative gross costs over life of the project -full cycle0. E>lso referred to as Cash Flow.F N Government receipts from royalties, ta es, bonuses, production or profit sharing, and Gvt. participation, divided by total $conomic profit N 1 - Government Ta"e N Contractor net cash flow divided by $conomic profit N 1 - Government Ta"e -e cluding Gvt. participation0

N Company net cash flow divided by $conomic profit 0ote' In the past most Ta"e statistics were based upon undiscounted cash flow. !ore recently ta"e
statistics are being Buoted from a present value point of view -i.e. the division of discounted cash flow0.

In principle the Government Ta"e statistic represents the division of profits 'full cycle( # over the full life of a field or fields. In other words, Government Ta"e represents the Government+s share of total net profits. This includes years when profits are )ero or low and years when profits are high#assuming there are profits. In principle however at the beginning of a project multiple ta"e statistics can be calculated, each conditional upon different possible outcomes. The Government Ta"e statistic, being a single number, fails to provide information about the timing of payments. Get this can be an issue of central concern to governments. ,or e ample, after =olivia+s first Gas &ar in :224, a new fiscal system was proposed. The new system would increase the share revenue to the =olivian Government in the early years of production from their newly discovered gas fields. The proposed system left Government Ta"e virtually unchanged but they would get their share of profits earlier rather than later. The proposed system attempted to "eep the revolutionaries happy without completely alienating the oil companies that ris"ed capital e ploring for and finding =olivia+s vast gas reservoirs. =olivia needed money sooner rather than later. =ut a comparison of the proposed system with the previously designed systems using undiscounted Government Ta"e would not have shown a difference. ,ew developing countries are able or willing to wait for profits to be generated from a developing field before they get a share. That is why we see signature bonuses, and other

front-end-loaded elements li"e royalties and cost recovery limits. >s discussed in other chapters ECtiglit)7 CramtonF, this decision may or may not be wise in different circumstances. =ut in any case the Government Ta"e statistic does not provide guidance on how front-end-loaded a payment schedule is. In fact unless it incorporates discounting it may not say anything at all about the time value of money. ,or this you need companion statistics -below we discuss the '$ffective %oyalty %ate( which is a companion statistic that helps show ?how+ a Government ta"es0. *ther "ey elements are left out altogether. ,or e ample, the ta"e statistic says nothing about ringfencing7 it does not measure contract or system stability and is silent on reserveDlifting entitlements7 and 'ownership( is not accounted for. These difficulties ma"e comparisons of Government Ta"e especially difficult. ,or e ample, country fiscal systems are often compared to those of neighboring countries. In one common comparison Chad+s ta"e is compared to other &est >frican countries -see for e ample ,igure 40. The graph appears to indicate that the government of Chad got a particularly bad deal, due, according to some accounts, to its lac" of e perience in negotiation. =ut unfortunately this comparison is misleading. Cuch low rates can be due to many other factors such as the Buality of the oil or transportation costs.
Fi!ure "&a3e Comparisons%

Cource6 'Chad+s *il6 !iracle or !irage( C%C

*ne curious thing to note with the above comparison is the timeframe used, :22:-:212. Cince Chad oil didn+t start shipping until :224, then this timeframe represents only the early years of production, when ta es would be minimal. It suggests that the Ta"e calculation has not been 'full cycle.( If so, then the comparison above is probably more of a representation of Chad+s $ffective %oyalty %ate and not Government Ta"e. In ,igure ETa"eF we give another indication of Ta"e rates around the world. This figure however shows how the ta"e figure depends on the price of oil. The figure represents fairly well the universe of systems that e isted during the late 1992s -and also includes the results of the recent feeding fren)y -Panuary $/C> IH license round0 in Jibya0. ,or each country the white bar indicates the ta"e statistic when oil prices are at M:2 a barrel. Come of the bars on the graph are wider than others because some countries have fi ed terms -narrow bars0 but many countries have either 'bid( or 'negotiated( terms and there is more variation and diversity found in the country+s agreements. >lso systems with '% factors( or 'rate-of-return( -%*%0 features can have greater range of financial outcomes than more conventional systems. The universe of systems represented in the figure were forged in an era when oil prices averaged a little over M1;.22D==J and around 923 of the time ranged between M1K.22 to M:2.22D==J. The natural Buestion is '@ow do terms change with MK2.22D==J oilA( The answer is given by the colored bars that are mar"ed for each country. .ote that in some cases the colored bars are to the left of the white bars7 in other cases they are to the right. In very many of the cases the systems are regressive# Government Ta"e goes down -colored bars are to the right of the white bars0. .otice that with most of these systems the ta"e only changes by a few points -:3 to 430. =ut some systems, such as in >)erbaijan or !alaysia, are progressive and Government Ta"e goes up and typically by more than just a few points -colored bars are to the left of the white bars0. The progressive systems are those with either an '% factor,( a %*% feature, or a price-cap-formula. !any countries around the world right now wish they had structured their systems to adjust their ta"e upward. In fact the scope for increasing the ta"e as prices go up is dramatic. The dotted line on the left hand side gives an indication of the ta"e, at MK2.22D==J, that would in fact yield the same economic benefits to oil

companies as the terms original M:2.22D==J ta"e would. The figure shows that for an international oil company to achieve the same economic benefits or values -including risked values such as '$ pected Halue(0 Government Ta"e can be Buite high. ,or e ample, from an international oil company point of view an average Government Ta"e of K83 during the late 1992s at M:2.22D==J is roughly eBuivalent to a Government Ta"e of 9:3 at MK2.22D==J.

8overnment &a3e Around the (orld 92:,22+ and 9@:,22+

1S -*CC0 Deepwater 1L 0ew Mealand Fal3land Islands Ar!entina -Challow0 1S -*CC0 South Africa &rinidad -Deepwater0 /on!olia #hilippines #a3istan -*ffshore0 Australia -%*%0 .cuador #a3istan II Cambodia 8abon /orocco #eru /oNambiHue ANerbaiGan ->I*C0 %*% Con!o M. /ala sia -Deepwater0 An!ola -/rice Cap ,ormula0 Colombia -%0 *emen Jate 1992s -%*%0 Indonesia 4rd Gen -,rontier0 .! pt *ffshore ANerbaiGan $D/C> -%0 $ussia Ca"halin II -%*%0 &imor 8ap T*C> 0orwa +ib a =loc" <9, :22< .! pt *nshore / anmar early 1992s Oatar %D/C> -%0 0i!eria Chelf /ala sia %DC -%0 1A. '*pec Terms( S ria 1995 !odel Indonesia Ctd.4rd Gen +ib a >verage :22< FeneNuela 199K -%0 +ib a =loc" <5, :22< Iran 1st =uybac" +ib a =loc" 1:5, :22<
4::< ;:< =:< B:<

.$$

<

8vt. #articIn

<

92: 9@: )il #rice Scenario

$o alt , &a5 S stem #SA Service A!reement +ib a .#SA IF Jan.P 2::? $ J$K Factor

$)$ $ate of $eturn Feature

2 2 < 9 15.K 1K.8 :.5 :<O 42 14.< 5 2 :< 1:.< :: :: 12 :4 19 2 1:.< 14 8.< ; 41 < 52 2 K 2 42 K1 4; 5K 1K-:2 1; 1; 1:.< K2 15 ;1.< 1K.8 ;8.K 42 ;9

2 2 2 2 2 2 :2 2-:< 2 2 2 2 2 :2 2 12 :< 2 2 12 :2 1< :2 42 1:.< 12 2 <2 2 2 42 K1 2 1< 2 2 1< K2 2 12 ;1.< 4< ;8.K 122 ;9
>:<

@:<

?:<

A:<

8overnment &a3e

Cource6 *il U Gas Pournal 1; >pril, :22< D Daniel Pohnson and Co. Inc.

III.2 .ffective $o alt $ate 6.$$7

The $ffective %oyalty %ate -$%%0 is a companion statistic to Government Ta"e that shows how front-end-loaded the system is -although as we will see, it does not measure all aspects of 'front-end-loadedness(0. It gives a feel for how Buic"ly a contractor can get its money bac". The effective royalty rate -$%%0 is the minimum share of gross revenues a government will receive in any given accounting period for a field. It typically does not include the .ational *il Company -.*C0 or *il !inister+s wor"ing interest share of production. This inde , developed by Daniel Pohnston in the mid 1992s, has become a standard metric in the industry. &ood !ac"en)ie refers to this sometimes as '!inimum Government Ta"e.( It is an important inde that adds dimension to the Vta"eV statistics. The complement of $%%, 'access to gross revenues( ->G%0 provides an important international oil company perspective. >G% is the maximum share of revenues a company or consortium can receive relative to their wor"ing interest in any given accounting period. It is limited by government royalties, andDor cost recovery limits and profit oil split -i.e. the $%%0. In a royaltyDta system with no cost recovery limit, the royalty is the only government guarantee. The $%% is the royalty rate. >G% is limited only by the royalty. In most royaltyDta systems in any given accounting period there is no limit to the amount of deductions a company may ta"e and companies can be in a no-ta -paying position -although this can occur with a /CC as well0. /roduction sharing contracts with cost recovery limits guarantee the .*C a share of profit oil because a certain percentage of production is always forced through the profit oil split. Thus both royalties and cost recovery limits guarantee the government a share of production or revenues regardless of whether or not true economic profits are generated.

The $%%D>G% calculations reBuire a simple assumption#that e penditures andDor deductions in a given accounting period relative to gross revenues are unlimited. Therefore cost recovery is at its ma imum -saturation0 and deductions for ta calculation purposes yield )ero ta able income. Cituations li"e this can occur in the early stages of production, with marginal or sub-marginal fields, or at the end of the life of a field. The object of the e ercise is to test the limits of the system. This provides the $%%D>G% indices. *ne "ey wea"ness of the $%% inde is that it does not measure the effects of depreciation or amorti)ation. >nd it does not include the effects of the guarantee provided by government participation if and where it e ists. @uge problems can arise if the $ffective %oyalty %ate is not ta"en into consideration when designing a fiscal system. Depending on costs and production, contractors could go years where they are in a no-ta -paying position. This can cause cash flow problems for governments as well as lopsided misperceptions. This was the case in $cuador in the mid 1992s because the $%% under their service agreement was )ero -230. In fact, although it may seem surprising, it is not hard to create a situation where no ta es are paid for many years. Consider the e ample shown in ,igure E.o Ta esF. The e ample shows an accounting period early in the development phase of a project where costs are high. In this e ample because of ta deductions on operating e penses, e ploration costs and depreciation, no ta es are paid by the contractor either in year 5 or even in year <. ->lthough this does not mean the government isn+t receiving revenue, as royalties and shares of profit oil can still be received.0

0o &a5es ?
Assumptions'
Dis cover siNe .5ploration costs Development costs Depreciation )#.4:: //22+s -%ecoverable0 9?: // -$ pensed0 9A:: // 2?<, ear 9>.?:,2 2+
&hese earl ears t picall represent the Jcapital cost recover phaseK of the field.

J)pe5 recover phaseK

#roduction *ear A A //22+s -Ctart-up0 *ear ? @ //22+s -%amp-up0 *ear @ 44//22+s -/lateau0 Decline rate 4:<

#roduction profile

Calculation of &a5 D eductionsP *ear A

$ ploration costs M<2 !! -$ pensed0 Depreciation M122 !! -:<3Dyear CJD0 */$W M15 !! -M4.< X 5 !!==JC0 Total M1K5 !!

)il #rice

92:.::, 22+

*ear A &a5 Calculation

M;2.22 - ;.22 8:.22 - 19.:2 <:.;2 - <:.;2 2 8ross $evenues 69//7 4:< $o alt .et %evenues 8vt. #,) Share @:< Contractor %evenues Ta deductions -no limit0 Contractor Ta =ase

*ear A $evenue Distribution

M;2.22 8ross $evenues 69//7 - ;.22 4:< $o alt 8:.22 .et %evenues - 52.22 Cost )il -Caturated - <23 limit0 4:.22 Total /rofit *il - 19.:2 8vt. #, ) Share @:< 1:.;2 Contractor /rofit *il -2.22 Income &a5 >:< 1:.;2 Contractor /D * O 52.22 Contractor CD * M<:.;2 KK3 of Gross %evenues

&+CF into Gear < N M1K5-<:.; !! N M111.: !!

&a5 Deductions for *ear ?

Ta Joss CD , Depreciation */$ W Total M111.: !! -M1K5 - M<:.; !!0 M122 !! -:<3Dyear CJD0 M:1 !! -M4.<D ==J X K !!==JC0 M:4:.: !!

Qa)a"hstan+s Qashagan /C> has a Government Ta"e of around ;43 or more -depending on various factors0, but only a :3 $%%. The contract is said to be e tremely comple and bac"-end-loaded. Co even though the Ta"e is high, in fact the Government does not receive the bul" of it until the later years. It is estimated that in the first < to 8 years of production, the Government will only receive :3 of gross revenues. Imagine being the Government or .*C *fficial that has to paint that picture for legislatures, the press, or the citi)ensA

Co how do you calculate the $ffective %oyalty %ateA The following figure calculates the $ffective %oyalty %ate of an Indonesian-Type /CC. >gain one barrel of oil is used to represent revenues for a single accounting period. Typically this would be an early accounting period following production start-up when accumulated costs are high and production is relatively low. In this e ample the Contractor is in a no-ta paying position, as in the e ample discussed above, still the Government receives a 123 royalty, and because of the Cost %ecovery Jimit, the Government is also guaranteed a percentage of the profit oil. The 453 $%% in this e ample is high by world standards. Table ECample Calculation of $%%F 123 <23 K23 423 %oyalty Cost %ecovery Jimit Government /D* Chare Corporate Income Ta -CIT0 *il /rice M:2D==J Costs >ssumed to be unlimited

Contractor Share

8ross $evenues 92:.:: $o alt 123 94=.::

8overnment Share

92.::

94:.::

Cost $ecover <23 Jimit 9=.:: #rofit )il

9>.2: 69:.::7 9>.2: 94>.2:

#rofit )il Split 52DK23 &a5 $ate 423

9A.=: 9:.::

Division of Gross %evenues $ffective %oyalty %ate

9@.=:
MK.;2D M:2.22

>A<

III.> &he 8overnment #articipation Fi!ure

!any systems provide an option for the national oil company to participate in development projects. Inder most government participation arrangements, the contractor bears the cost and ris" of e ploration and if there is a discovery the government bac"s-in for a percentage. Government participation typically is the result of a government option -through the .ational *il Company0 to ta"e up a wor"ing interest in the event of a commercial discovery. In other words the government is carried through e ploration. Technically the government through the .*C is 'carried( up to the 'commerciality( point# usually downstream by a well or two from the actual discovery well. The contract clause that deals with the reBuirement for delineationDappraisal wells following a discovery is referred to as the 'commerciality clause.( The government agent, usually the .*C, must decide whether to e ercise their right to 'bac"-in( once the 'commerciality point( has been reached. *nce the government e ercises the option it then ?pays-its-way+ for development and operating costs from the commerciality point forward just li"e any other wor"ing interest partner. Thus the government is ?carried+ through the e ploration and appraisal phase. *ver half of the countries worldwide have this option. Contractors prefer no government participation. This is not totally selfish, but stems from a desire for efficiency as well as economy. Point operations of any sort, especially between diverse cultures can have a negative impact on operational efficiency. *n the other hand if done right such joint operations can be beneficial for governments, both because of the financial benefits -more on this below0 and for building capacity. =ut they vary in how they are structured. The "ey aspects of government participation are6 &hat percentage participationA !ost range from 123 to <23. In Colombia the

government has the right to ta"e up to <23 wor"ing interest and will reimburse the contractor up to <23 of any successful e ploratory wells. In China, the government participation is <13. This usually defines the upper limit of direct government wor"ing interest involvement. The average is around 423. When does the government bac" inA This normally happens at commerciality. @ow much does the Government participateA This varies considerably from case to case. &hat costs will the government bearA Isually they bear their pro rata share of costs. @owever there is variation in whether governments reimburse '/ast Costs(
:

7 about half do and half do not.

@ow does government fund its share of costsA *ften out of up to a certain 3 of the Government+s share of production0

The financial effect of a government partner is similar to that of any wor"ing interest partner with a few important e ceptions. ,irst, as noted above, the government is usually carried through the e ploration phase and may or may not reimburse the contractor for past e ploration costs. Cecond, the government contribution to capital and operating costs is often paid out of production. ,inally, the government is seldom a silent partner. > "ey Buestion surrounding the calculation of government benefits from a contract is whether or not government participation should be included in the Ta"e calculation. That is, is this process truly a 'rent e traction( mechanismA Come analysts believe it is not appropriate to view this element of a system as a rent e traction mechanism on the grounds that such returns are just standard economic returns on investments made.4 @owever this approach contradicts some basic economic laws.
:

?/ast costs+ are defined as those costs incurred by the I*C after the ?effective date+ of the contract up to *ne &orld =an" study for a Jatin >merican country -Puly, :2240 argues6 'Government Ta"e as a result

the ?commerciality date+ when the .*C ?bac"s-in+.

4

of eBuity participation by government is really a government eBuity return, directly paid for by government, rather than a form of Government Ta"e. @ence, comparing Government Ta"e statistics by e cluding government eBuity participation is probably a more accurate representation of levels of ta"e.( E%$,F

>nd, it is easy to chec" by as"ing a simple Buestion6 'Does the 'bac"-in( cause the foreign investor financial painA( The answer is a certainly 'Ges.( >nd the pain is multidimensional. ,irst of all the value of a discovery to an e plorer will be reduced by almost e actly the amount of the 'carry( and secondly, the companies will not be able to 'boo"( as many barrels. > bac"-in option of <23 is not as costly to the company as a <23 ta on profits -both of which will guarantee the government an added <23 share of profits07 but just how different the financial impact depends on profitability and timing. >s profitability increases the bac"-in or participation element ta"es on more of the characteristics of a pure ta or a royalty depending on the point at which the Government ta"es its share of production. &hile it is conceptually a bit abstract, as costs relative to gross revenues approach )ero -the ultimate in profitability0 the bac"-in begins to ta"e on all of the characteristics of a ta . Thus, the less profitable a venture is, the less painful the government participation element is. $ither way though, both ta es andDor participation options cause the contractor financial pain to various degrees.5 >s we saw, comparing two fiscal systems on the basis of Government Ta"e alone is not a perfect comparison if one system has participation and the other does not. @owever, to simply ignore the participation element would be a greater misrepresentation. &hen comparing fiscal terms for e ploration rights it is not appropriate to e clude or ignore the participation element. /articipation should be considered as a part of the ta"e for governments.

III.A &he Savin!s Inde5' A measure of contractor incentive to save

The savings inde is a measure -from an undiscounted point of view0 of how much a company gets to "eep if it saves M1.22. =ecause of the great concern on the part of both Governments and companies about reducing costs, this statistic can be used to Buantify to
5

.ote however that from a project cash flow point of view, companies will certainly prefer <23

government participation to a <23 ta because at least with participation, after the .*C bac"s-in, it 'pays its way.(

some e tent the incentives companies have to "eep costs down. *nly the profits-based fiscal elements influence this statistic. %oyalties -based on production not profits0 have no influence. The e ample given above of an %DT system has two profits-based mechanisms. > K23 Cpecial /etroleum Ta and a 423 Income Ta . Therefore, if the company saves one dollar then there will be an added dollar of ta able income. The Government gets K23 of that. The company therefore has 52Y on the dollar saved prior to implementation of the Income Ta . &ith a 423 Income Ta the company only gets to "eep 823 of the 52Y. The savings inde then is :;Y on the dollar -saved0, or :;3. Inder a /CC a dollar saved means an e tra dollar of profit oil and hence a saving that corresponds to the contractors share of profit oil. .ote that the savings inde described above does not ta"e into account present value discounting. The present value effect can be interesting and it often magnifies the I*C+s incentive to "eep costs down.

III.? $esponsiveness to Chan!in! Conditions' $e!ressive S stems and Slidin! Scales

> regressive system is one where Government Ta"e goes down as profitability goes up. ,or a system to be regressive it must have at least one regressive fiscal element. Conversely, for a system to be progressive it must have at least one progressive element. Today, oil prices are more than double what they were when most of the e isting fiscal systems were designed or negotiated. &ith the higher oil prices came higher profitability, but with most systems a lower Government Ta"e. Governments are benefiting from the higher oil prices, total revenue does increase. =ut, their percentage share of net profit decreased for most of them as seen earlier in ,igure K. >nd, this is simply a function of system design.

!any systems have sliding scales built into them to ta"e advantage of the possibility of increased production -'production based sliding scales(0 but few systems were designed to ta"e advantage of the increased oil prices. The elements of a fiscal system that determine whether the system will be regressive or progressive are described in Table E/rogressiveF6 Table E/rogressiveF6 The /rogressiveness of Different /rovisions of an *il Contract .lement =onuses %oyalties Ta es Government /articipation '%( ,actors %*% systems Depletion >llowances Iplifts U Investment Credits Given the great volatility of oil prices it would be wise for countries negotiating contracts to estimate the returns to them -and to private sector partners0 under a range of different price scenarios. .ffect $ tremely %egressive Hery %egressive .eutral .eutral /rogressive /rogressive Hery /rogressive Clightly /rogressive

III.@ Factors that Affect .5posure to .5ploration $is3 62loc3 SiNeP $eliniHuishment and $in!fencin!7
!ost governments go to a lot of effort to distance themselves as much as possible from e ploration ris". This can be done through management of bloc" si)es, through relinBuishment and through ringfencing.

2loc3 siNe and confi!urations =loc" si)es range from small to huge. Typically, bloc" si)es will be smaller in proven geological provinces and much larger in frontier regions. The choice of bloc" si)e and

configuration is an important consideration. > challenge is to configure the bloc"s or licenses in order to provide interesting tracts instead of having just a few highly prospective bloc"s and others that will attract little interest. The larger regions can reBuire considerable e ploration e pense. @owever, the I*C may be able to recover dry hole and other e ploration costs in one part of a bloc" against a production in another part of the bloc". @owever, from the government+s perspective, with larger bloc"s there is the li"elihood of a greater accumulation of e ploration sun" costs prior to discovery. These e penses are typically cost recoverable andDor ta deductible and because of this with larger accumulations of sun" costs governments will receive fewer ta es. &ith smaller bloc"s governments can minimi)e or mitigate their e posure.

$elinHuishment provisions %elinBuishment options are diverse and there is a full spectrum of methods employed ranging from almost no relinBuishment -in the ordinary sense0 to very aggressive relinBuishment reBuirements li"e we see in the !iddle $ast. ,or e ample, in some of these countries only a discovery will be retained and all other acreage will be surrendered at the end of the final e ploration stage. In Indonesia for many years oil companies could "eep more than just development areas -discoveries0 at the end of the final official stage of e ploration. This meant that if a company made an economic discovery it could enjoy the opportunity to continue e ploration in their remaining acreage while they pursued development of their discovery.

$in!fencin! %ingfencing is the practice of disallowing companies to 'consolidate( their operations from one license area to another. It means that each license -typically0 is treated as a separate cost center for cost recovery and ta calculation purposes. Thus, ringfencing limits cost recovery or deductions that can be ta"en against production to the activity inside the ringfence. > number of countries will automatically ringfence a discovery once

a discovery is made. This would disallow deductions for e ploration activity outside the initial discovery area. This "ind of treatment is becoming more and more common. %ingfencing can protect a government from what might otherwise be a marginal or submarginal discovery, by limiting the costs that can be cost recovered andDor deducted against revenues generated by the discovery. @owever, it can be a negative incentive to the e ploration companies.

III.B 2oo3in! 2arrels' +iftin! .ntitlement and $eserves $eportin!

>s a general rule oil companies will 'boo"( barrels according to -10 their wor"ing interest and -:0 their lifting entitlement. @owever there are two main e ceptions to this rule6 -10 even though by definition under a service agreement there is no entitlement, companies do boo" barrels, -:0 with systems where ta es are 'in lieu( companies 'grossup( their actual entitlement and boo" the barrels they would have been entitled to lift had they paid ta es directly in cash. This is common with '$gyptian type /CCs.( %DT Cystems would be much preferred by an I*C wanting to ?=oo" =arrels+ because they can typically boo" about twice as many barrels as they would with a /CC. In general, /CC $ntitlements typically go up with falling oil prices and down with increasing oil prices. =ecause a company+s entitlement with a /CC is based on its share of cost oil and profit oil when oil prices went from M:2.22D==J to MK2.22D==J the typical entitlement under a /CC went down by around 1<3. This is because with higher prices it does not ta"e as much cost oil to recover costs and thus entitlement goes down. This is not an issue for %DT Cystems. ,or most companies the reserves they boo" will correspond to the reserves they are entitled to 'lift.( @owever, this is not a critical reBuirement. Co naturally, there are some interesting e ceptions6 Inder %oyalty Ta Cystems, entitlement eBuals gross production less royalty oil. @owever, many governments ta"e their royalty 'in cash( instead of 'in "ind.( In this case many companies are boo"ing those barrels as well. In /CCs,

entitlement eBuals profit oil O cost oil. @owever, with the $gyptian-type systems where ta es are 'in lieu( the companies are calculating what their profit oil share would have been -dividing their share by 1 minus the ta rate0 and boo"ing these 'imputed barrels.( >lso some companies are boo"ing gas or oil consumed on-site, fuel for operations.

Conclusions
&e conclude with some comments about how deals between governments and contractors should be made, issues that are ta"en up again in Chapters E%adonF and ECramtonF. ,iscal design elements discussed above are important, but so are the means by which governments choose to allocate acreage or projects. >s in the past, there is significant competition for a limited amount of e ploration capital. >t the same time, e citing acreage is hard to come by. If Governments want to increase e ploration activity in their countries, they have to offer terms commensurate with their geological potential, location, and political situation. >creage has begun to ta"e on more of the characteristics of a global commodity. There is over 4 times as much acreage available today as there was :< years ago. In the past : decades the Coviet Inion became the 'former( Coviet Inion -,CI0 and much of >frica and the $astern-bloc" Countries have opened up. ,urthermore, with more aggressive and specific relinBuishment provisions in contracts the mar"et for acreage or projects is more dynamic and robust. The means by which Governments determine how to award licenses are e tremely varied. Come governments -appro imately 42 to 52 each year0 have official 'bloc" offerings( or 'license rounds( where bloc"s are awarded on the basis of competitive bids. In competitive systems there can be a lot of variation over what in fact is bid for -elements that become part of a contract or a system are usually either negotiated, statutory, or bid items and wor"ing out which way to do it is of huge concern to many governments0. Jibya for e ample let companies 'bid the terms.( =y allocating licenses in

a competitive bid round it was ultimately the I*Cs who determined what the mar"et could bear for the Jibyan bloc"s. This ta"es the burden of fiscal 'design( off of the .*C personnel and places it on the I*Cs. This is possible#and profitable#because oil companies will suffer just about anything for highly prospective acreage or projects -referring bac" to ,igure ETermsF we see that in the Jibyan license rounds companies appear to have 'bid( terms consistent with nearly M<2.22D==J e pectations0. Hene)uela used a somewhat different approach. Hene)uela launched its e ploration round in 199K, putting 12 bloc"s up for bid. @owever, for all practical purposes Hene)uela had 12 separate license rounds, bloc"-by-bloc". *n !onday morning Panuary ::nd, 199K, bids were opened for the first bloc" only -the Ja Cieba bloc"0. These licenses were awarded on the basis of a single-parameter bid#a profits-based ta "nown as the '/$G.( Companies were to bid from 2 to a ma imum of <23. %oyalty and other fiscal elements were 'fi ed( -i.e. neither bidable nor negotiable0. Ties were to be bro"en by a subseBuent bonus bid round to follow the opening of the /$G bids within a couple of hours. *n the first bloc", Ja Ceiba, 11 companies bid and 9 tied with a full <23 /$G bid. The tie was bro"en with a bonus of M124,999,999 from the !obilDHebaD.ippon consortium. That afternoon the ne t license -/aria &est0 was awarded to Conoco under the same rules. This "ind of approach magnified the already intense competition by awarding licenses individually#one-at-a-time. &ith each 'round( the pool of bidders would potentially be reduced by perhaps only one group if any at all. This approach greatly reduced the chance that less-prospective bloc"s would receive no bid. There were however, two bloc"s that did not receive a bid. The resulting government 'ta"es( were around 9:3. ,inally, on the other end of the spectrum, in the Inited Ctates Gulf of !e ico, licenses are awarded solely on the basis of a bonus bid -in practice however, few countries worldwide e tract such a large portion of rent through bonuses0. These are e amples of competitive bidding systems. =ut other countries negotiate e ploration rights one-on-one with companies. &hile companies typically prefer negotiated deals, these situations can be just as competitive as an official tender. =ut it all depends on the prospectivity of a bloc" or area. &hen governments have good geology they are more li"ely able to allow companies to 'bid the terms.( Cealed bid license

rounds -auctions0 can be very beneficial for a government with highly sought-after acreage or projects. There is considerable pressure these days from the &orld =an", the International !onetary ,und and bodies such as the $ tractive Industry Transparency Initiative -$ITI0 for oil companies and governments to be more open and disclose more information. &ith these initiatives there is a strong push for governments to allocate acreage on the basis of public auctions similar to the highly publici)ed $/C> IH rounds in Jibya recently. This probably ma"es sense for interesting acreage. The problem is that unless the acreage is particularly interesting, the industry has been relatively unwilling to face the "ind of magnified 'head-on( competition that a 'sealed bid( type license round -li"e Jibya0 provo"es. It is somewhat unrealistic to e pect all governments to allocate all acreage and projects on the basis of sealed bids. !any countries, even .igeria and Qa)a"hstan, have some acreage and some projects that are not Buite as e citing as others. &hen it comes to attracting I*C investment, allocation of such acreage becomes much more important with less-than-e citing prospects. *ne of the most difficult things for I*Cs to contemplate is a direct 'heads-on( competitive sealed-bid license round for non-spectacular acreage or projects and countries are li"ely to find that with less e citing prospectivity they will li"ely have to design terms themselves and allocate licenses in a user-friendly way. In such cases a government may have no choice#negotiated deals may be the only option. *therwise they are li"ely to be disappointed with the level of e ploration activity in their country#a common complaint. In such cases allocating licenses through 'negotiated deals( can have its own advantages. Government officials -$nergy !inistry or .*C0 become aware of what the mar"et can bear as they entertain various proposals and offers. Ji"ewise the lac" of interest provides information too. There is nothing worse than a 'failed license round( for a .*C official. These considerations tend however to differ somewhat for different types of project. >s summari)ed in Table ECituationsF, competitive bidding tends to be more viable for frontier acreage or e ploration acreage than for development projects or enhanced oil

recovery projects. The greater the ris" the greater the range of bids possible, as ris" diminishes, such as in the case of development projects, the terms tend to be fairly fi ed. Different Situations E Different Considerations
.nhanced )il $ecover De!ree of $is3 2loc3 SiNe Acres 63m27 (or3 #ro!ram 6s7 Focus of 0e!otiations, Anal sis /ost Common Allocation Strate! !ed - @igh ,ield 5,222 or so -1K0 10 ,easibility Ctudy :0 /ilot /rogram 40 Development I%% .egotiated deals Development #roGects Jow Cmaller 4,222 - <,222 -1: - :20 10 >ppraisal :0 Development .5ploration Acrea!e @igh Jarge 1-: !!O -;,2220 $ ploration /rogram Frontier Acrea!e @ighest Hery Jarge 4-5 !!O -1K,2220 $ ploration /rogram

I%% .egotiated deals

Ta"e Competitive =idding and other means

Ta"e Competitive =idding and other means

=eyond this, which method is best then depends to a large e tent on the bargaining power of countries and what they can e pect I*Cs to accept. I*Cs prefer .egotiated Deals -such as are employed in Colombia, Trinidad and Tobago, or Indonesia0, after this ,i ed Terms with &or" /rogram =idding are preferred -as in IQ, .orway, >ustralia, or .ew Tealand0. ,i ed Terms with =onus =idding -as in the IC, .igeria, or =urma0 causes more pain to I*Cs and the least preferred form of bidding is the Cealed =id %ound with Terms =id6 -as in Hene)uela, Jibya0. >s described in Chapter ECramtonF in situations in which prospects are good, competitive bidding may be optimal and much care should go into auction design. @owever in situations in which governments are in a wea" bargaining position, negotiated deals may be reBuired. These raise special challenges for negotiators, as discussed in Chapter E%adonF, and they ris" raising political economy concerns6 In such situations it can be difficult for Governments to simultaneously "eep the oil companies and the citi)ens happy and it is easy to raise suspicions of foul play. This is where transparency can have a dramatic impact. It is part of the education process

and one of the best ways to control e pectations and promote a healthy business environment.

$eferences
Considine, Pennifer I., &illiam >. Qerr. :22:. 'The %ussian *il $conomy( $dward $lgar /ublishing Jtd Considine, Pennifer I., et al. :22<. $/ $nergy /olitics Issue HII -,all0. Pohnston, Daniel. 1995. 'International /etroleum ,iscal Cystems and /roduction Charing Contracts( Daniel Pohnston, /enn&ell =oo"s. Pohnston, Daniel. :224. 'International $ ploration $conomics, %is", and Contract >nalysis.( /enn&ell =oo"s Tsali", Cvetlana. :224. 'Caspian *il &indfalls6 &ho &ill =enefitA( *pen Cociety Institute.