Modest O&G royalty protects against distorted investments, production levels – IMF

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The International Monetary Fund (IMF) has found that Guyana’s royalty rate of two percent for its Stabroek Block, while seen as modest, will in fact protect the country from skullduggery in the form of distorted investments and production levels by operators, while at the same time providing some form of guaranteed government revenues.

The IMF put forward this view in a November 2017 report following a scoping mission in the South American country based on a request for technical assistance by authorities.

According to the International Financial Institution, “royalties have the advantages of producing early, dependable revenue, and relative ease of administration, but beyond modest levels they can seriously distort investment and production levels because of their insensitivity to underlying profitability.”

Essentially, higher royalty payments result in affected production and skullduggery on the part of operators in order to minimize payments at a given time, whereas a lower royalty payment would be seen as reasonable and readily paid as a “dependable revenue and of relative ease of administration.”

The royalty rate for the Stabroek PSA was originally set at one percent and paid out of the government’s share of profit oil. However, as part of an amendment process in 2016, the royalty was taken out of the pay-on-behalf system, and the rate increased to two per cent on an ad-valorem basis. Under the amended terms the royalty is now levied on the gross value of all oil and gas produced and saved from the contract area.

According to the IMF, “…with (Guyana’s) rates set at modest levels, royalties have the advantage of ensuring early and dependable revenue for the government.”

Royalties charged on the gross value of production are insensitive to costs and thus, to the underlying profitability of projects.

As such, “if set at high rates, investors may perceive them as an implicit depletion policy as they are likely to increase the marginal cost of extraction and reduce the range of feasible projects.”

According to the IMF, “this does not seem to be an issue in Guyana, however, as existing PSAs appear to enjoy royalty rates well below of what is observed internationally.”

Speaking to the returns for Guyana, the IMF scoping mission observed that with the 75 percent cap for cost oil in the Guyana PSAs, “combined with a fixed government share of profit oil of 50 per cent, (this) guarantees that the government will always receive a minimum of 12.5 percent of the total production.”

Once recoverable costs fall below the cost recovery limit, the amount of profit oil to be divided between the contractor and the government increases and so does the government share of profit oil.