Most governments go to a lot of effort to distance themselves as much as possible from exploration risk. This can be done through management of block sizes, relinquishment, and ringfencing, discussed in turn below.
Block size and configurations
Block size refers to the size of the territory demarcated for exploration. Block sizes can range dramatically. Typically, block sizes will be smaller in proven geological provinces and much larger in frontier regions. The choice of block size and configuration is an important consideration. A challenge is to configure the blocks or licenses in order to provide interesting tracts instead of having just a few highly prospective blocks and others that will attract little interest. The larger regions can require considerable exploration expense. The International Oil Company (IOC), however, may be able to recover dry hole and other exploration costs in one part of a block against a production in another part of the block.
From the government’s perspective, with larger blocks, there is the likelihood of a greater accumulation of exploration sunk costs prior to discovery. These expenses are typically cost recoverable and/or tax-deductible, leading to larger accumulations of sunk costs and resulting in less income in taxes for governments. With smaller blocks, governments can minimize or mitigate their exposure.
Relinquishment refers to a contract term that requires a certain percentage of the original contract area to be returned to the government at the end of the first phase of the exploration period. Relinquishment options are diverse and there is a full spectrum of methods employed, ranging from almost no relinquishment (in the ordinary sense) to very aggressive relinquishment requirements like we see in the Middle East. For example, in some of these countries, only a discovery will be retained, and all other acreages will be surrendered at the end of the final exploration stage. In Indonesia, for many years oil companies could keep more than just development areas (discoveries) at the end of the final official stage of exploration. This meant that if a company made an economic discovery it could enjoy the opportunity to continue exploration in their remaining acreage while they pursued development of their discovery (Johnston 2006).
Ringfencing is the practice of disallowing companies to “consolidate” their operations from one license area to another. It means that each license (typically) is treated as a separate cost centre for cost recovery and tax calculation purposes. Thus, ringfencing limits cost recovery or deductions that can be taken against production to the activity inside the ringfence. A number of countries will automatically ringfence a discovery once a discovery is made. This would disallow deductions for exploration activity outside the initial discovery area. This kind of treatment is becoming more and more common.
Ringfencing can protect a government from what might otherwise be a marginal or sub-marginal discovery, by limiting the costs that can be cost recovered and/or deducted against revenues generated by the discovery. However, it can be a negative incentive to the exploration companies.
The Savings Index: A measure of contractor incentive to save
The savings index is a measure (from an undiscounted point of view) of how much a company gets to keep if it saves $1. Because of the great concern on the part of both governments and companies about reducing costs, this statistic can be used to quantify to some extent the incentives companies have to keep costs down. Only the profits-based fiscal elements influence this statistic. Royalties (based on production, not profits) have no influence.
Under a Production Sharing Contract (PSC) a dollar saved means an extra dollar of profit oil and hence a saving that corresponds to the contractor’s share of profit oil. The savings index described above does not take into account the present value discounting. The present value effect can be interesting, and it often magnifies the IOC’s incentive to keep costs down.
Responsiveness to Changing Conditions: Regressive Systems and Sliding Scales
A regressive system is one where Government Take goes down as profitability goes up. For 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 very different from what they were when most of the existing fiscal systems were designed or negotiated. With the higher oil prices comes higher profitability, but with most systems, a lower Government Take. In other words, governments are benefiting from higher oil prices as total revenue does increase; it is their percentage share of net profit that decreases. This is simply a function of system design.
Many systems have sliding scales built into them to take advantage of the possibility of increased production (“production-based sliding scales”) but few systems were designed to take advantage of the increased oil prices. The elements of a fiscal system will determine whether the system will be regressive or progressive. Thus, 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 partners) under a range of different price scenarios (Humphreys et. al 2007).
Lifting Entitlement and Reserves Reporting
“Booking barrels” is the practice of counting oil among the assets of a company. As a general rule oil companies will book barrels according to primarily to their working interest and to their lifting entitlement. However, there are some less obvious ways in which barrels are often booked.
Under Royalty/Tax systems, entitlement equals gross production less royalty oil. However, many governments take their royalty ‘in cash’ instead of ‘in kind.’ In this case, many companies are booking those barrels as well.
In PSCs, entitlement equals profit oil plus cost oil. However, in systems where taxes are ‘in lieu,’ companies calculate what their profit oil share would have been and book the barrels they would have been entitled to lift had they paid taxes directly in cash (also called ‘grossing-up’). This is common with Egyptian-type PSCs. R/T systems would be much preferred by an IOC wanting to book barrels because they can typically book about twice as many barrels as they would with a PSC.
Finally, some companies book gas or oil consumed on-site as well as fuel for operations; and, even though, by definition, there is no entitlement under a service agreement, companies do sometimes book barrels in these cases also.
In general, PSC entitlements typically go up with falling oil prices and down with increasing oil prices. Given that a company’s entitlement with a PSC is based on its share of cost oil and profit oil when oil prices change, the typical entitlement under a PSC will also change in an inverse direction. With higher prices, it does not take as much cost oil to recover costs and thus entitlement goes down. This is not an issue for R/T Systems.