Depletion policy and licencing arrangements for Guyana’s oil reserves

The rate at which Guyana’s Offshore Basin oil reserves will be depleted will clearly be influenced by the licencing arrangements. The basic decisions regarding the frequency and size of licence rounds, the location of blocks on offer, and the relinquishment terms applied are all permissive factors in determining the timing and size of discovered reserves. Within the capacity limits of the exploration industry, increasing the amount of acreage on offer increases the chances of discoveries being made, though obviously, it does not guarantee success. Any future large licencing round can certainly be interpreted as a device to accelerate discovery rates and activity levels. The need for early oil production was generally agreed to be a national priority. The enormous success of subsequent discoveries and field developments should lead to some reappraisal.

Any comparatively small licencing rounds will probably reflect the view that a combination of the high success rate, large expected future production, and continued high activity rates, all emanating from round licences, will indicate that lower levels of new licence awards are consistent with “high” production and activity levels. The trend since 1999 of regular licence approval with relatively large numbers of acreages per blocks being offered in each contract reflects the view that there is a need to find additional reserves to prevent the total production profile from declining steeply.

In the long-run, successive governments will never intend for the fiscal system to be employed to alter depletion rates. As discussed, it is likely that the scheme in place in 1999 did lead to the postponement of the development of some fields. In more recent years it is at least theoretically possible that investment is inhibited by investors who are not in a tax-paying position when projects are initiated.

Through its rights to approve new field development plans, including the type of producing system and production profile, the Government of Guyana can exercise considerable influence on the depletion rates. It is sometimes suspected that it is not fortuitous that the speed with which permission has been granted for new field developments has been considerably greater in recent years.

The government has direct powers to control depletion rates through the imposition of:

• Development delays, and
• Production controls.

With both of these techniques, the direct costs are shared between investors and the government. Both parties experience a postponement in their cash flows from oil exploitation. (In the case of the government this is through royalty and tax receipts being postponed.) An evaluation of these schemes needs to take into account their effects not only on the production profile but on investment incentives.

With regard to production cuts, the discretion given to the Government of Guyana regarding the size and timing of cuts increases the uncertainty of the operating environment and could in principle cause disincentives. If the cuts are large and imposing at relatively short notice the effect on investor cash flows and project profitability could be considerable. There could be knock-on effects on incentives to invest in new projects, especially those which are expected to be only marginally attractive. The effects of production cutbacks at uniform rates across fields are likely to impact deferentially on investors. A small company relying on one field for much of its income could be seriously affected by production cuts which are regarded as tolerable by other investors.

To avoid the introduction of significant disincentives it is important that clear guidelines regarding:

• The possible extent of production cuts (or increases), and
• The timing of their introduction and duration be given. This would reduce the uncertainties and at least permit investors to incorporate the possibilities into their planning.

New field development delays might, in general, impose less extra costs on society than production cuts because unit production costs are not obviously increased. They can, of course, only be employed to cut production in the medium term: only production cuts can make a short-term impact. Investors will be concerned about how any development delay policy is put into effect. The regulations do not specify the maximum length of time over which a new development can be delayed. Further, the regulations do not specify the criteria which will determine the relative treatment of different new projects. The delayed development of a large field would make a greater difference to the total production profile compared to the delayed development of a small one. Would such considerations weigh with the authorities more heavily than the chronological order in which field development applications were made? The question years on of the equitable treatment of different investors and what, for example, defines a fair queuing system was not considered in the design of the regulations. In designing a system which minimized the uncertainties on investors, information regarding the maximum period of delay and how a fair queuing system would operate should be included in the regulations.

All the above should not suggest that a scheme of production cuts and development delays which maintains some investor confidence cannot be designed for the Guyana Offshore Basin conditions. In Guyana, there should be a system of production cutbacks imposed at the discretion of the government. Further, there should be some form of the existence of a de facto queuing system for field development consent. In a quite different operating environment, production controls have been prevalent for a very long time. The conclusion is that such policies do increase the uncertainties of the operating environment, and care is required in designing them to ensure that they do not introduce significant distortions and disincentives.

The only specific depletion control measure that should be taken by the Guyanese government must occur at the time when that decision is influenced by public sector considerations. Policies should be directed at stimulating activity with a prime objective of preventing a steep fall in production from taking place post-2020.

It will be interesting to examine the practical implications of a depletion policy that is required to affect both oil production and consumption at frequently varying levels of output. In this regard, the contribution of the delay in the development of the field could be last minute, because of its small size in relation to total production.

It is generally deemed to be in the national interest to procure early Guyana Offshore Basin revenues (primarily for balance of payments reasons). On these grounds, the early development of these very large fields could be considered. They will also be primarily responsible for the increase in production in the first half of the 2020s. If this increase were to have been reduced to a marked extent, significant cuts in production from these fields would have been necessary. Alternatively, the development of one of them could be delayed for some years. This would reduce the “early” income from the Guyana Offshore Basin. All this highlights the practical difficulties of implementing a depletion policy.

The most fundamental question is whether depletion controls should be introduced at all. This raise issues a full treatment of which there is a large literature on the question of the optimal depletion rate of a natural resource such as oil, based on the seminal works of Gray (1914) and Hotelling (1931). There are two approaches to the depletion question.

• First, there is the issue of investment in oil compared to other opportunities. Investors are presumed to maximize expected net present values from their investment possibilities. The net result is that under competition in equilibrium the price of oil will increase at the rate of interest.

This approach in its simplest form ignores the consumption aspect of the problem. Production of a natural resource facilitates consumption over time. Thus, the issue arises of the appropriate amount of consumption over time, both of the oil itself and anything else financed by borrowing against the stock of reserves of oil.

• Second, at any one time, the question arises of the relative merits of investing in the oil itself (and achieving returns in the form of real price increases) and investing in other assets. These two problems have both to be solved to indicate the appropriate rate of depletion.

The optimal consumption path over time is determined basically by society’s rate of time preference. The conventional assumption of a positive rate of time preference means that a specified level of consumption is valued more highly now than in future time periods. A zero rate of time preference means that total consumption is increased by reducing present consumption and increasing future production by the amount of the reduction plus accrued interest. A clue to the depletion problem is found by consideration of the concept of the amount of consumption which can be permanently maintained through the utilization of the stock of oil reserves.

The key is the return or income produced from the oil asset. Suppose that the stock of reserves has an initial total value from which a return of say, x%, is earned annually. This return could be in one of two forms, namely a real oil price increase, or through income earned from its investment elsewhere. If consumption is restricted to this return the real value assessment of Guyana’s Offshore Basin stock of oil could be maintained. This level of consumption may be termed the maximum permanent consumption from the oil reserves.

On the investment side, it is clear that if the oil price increases at the same rate as the return available on the next best investment there is indifference between investing elsewhere and holding the oil reserves. The optimal depletion rate is determined by both consumption and investment considerations. If in an equilibrium situation all investment possibilities in the economy (including oil) are earning the same return, then no additional depletion of oil is appropriate from the investment side. Depletion of oil would, however, be appropriate on consumption grounds as discussed above.

If investment returns are seen to be greater from non-oil assets, the depletion rates of oil should be increased as part of the investment programme. This should continue until investment opportunities are equalized between oil and non-oil assets. Conversely, if investment in oil is the highest-yielding investment, no net depletion should take place. Thus, both investment and consumption considerations are relevant to optimal oil depletion decisions.

From the above discussion, it is clear that interest rates and future oil prices play key roles in determining optimal depletion rates. At any one time there is a whole term structure of interest rates. Further, actual interest rates (however defined) have varied enormously. Rates of return in Guyana’s industry will also vary after 2020. There is very probably less variability in expected interest rates (which are relevant for the purpose of determining optimal depletion rates), but a range of possibilities is clearly still anticipated.

Historically a tremendous variation in oil prices has also been experienced in the world market. Further, the uncertainty surrounding future prices is extremely great. Given that the investment element of the depletion decision depends on the relationship between future interest rates and oil prices, very different results are possible. In simple terms, the lower the expected growth in real oil prices the higher the optimal depletion rate. The possibility that expected oil price increases vary enormously also changes the optimal depletion rate correspondingly.