Realisable economic rents and local risks for the Guyanese offshore licencing option

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The introduction of a contingent system of taxation is not the only possible response to the existence of exploration risk. The state could reduce the perceived risks by financing a programme of geological research. The fruits of this research would then be made known to all interested investors. In turn, this would enable investors to make their bids on the basis of fuller information of the prospects. The result would then be that bids should come closer to the likely realized economic rents. The cost of this type of scheme is the direct outlay which can be an assessment of Guyanese Offshore Blocks that can be the undertaking of the government for exploration research.

The issues raised regarding exploration risk illustrate a more general problem with regard to auction schemes. While competitive bidding may collect ex-ante or anticipated rents to the state, the system cannot ensure that the state receives the ex-post or realized rents. The difference can be very large. In particular, between the time when licences are issued and resulting discoveries are fully depleted, there can be major changes in oil prices. Further, the sizes of discoveries and the associated exploitation costs can only be estimated within margins of error which may be very large: many surprises have been experienced with regard to the size of discovery in the Guyana blocks.

In the particular time periods over which Guyana Basin licensing has taken place major fluctuations in oil prices have been experienced. These were almost certainly not fully anticipated. The majority of the first generation of oil fields emanate from licences awarded no earlier than 1999. This was before the dramatic oil price increase of the 2000s.

The realized economic rents will be considerably greater than most forecasters would have predicted when the licences were awarded. Reliance on a bidding system for the collection of rents would have left a considerable share of the realised rents in the hands of the investors. It is, of course, arguable that the investors who undertook the exploration risks deserved whatever returns were later obtained. The governments which have employed auction systems (in the USA and Canada) have generally not been willing to permit investors to obtain large windfall gains from oil price increases. This does not necessarily mean that their actions in levying special, additional taxes on production income well after licences were awarded through auctions were correct. Nonetheless, the practice has become well established and is typical of host government behaviour.

A more honest approach would be to establish a conditional fiscal system before licences were auctioned. This would ensure that governments obtained a share of ex-post economic rents without further discretionary intervention. Similarly, investors would know the total fiscal burden facing them before they made their bids. Their bids could, of course, consider the likely fiscal payments which would be required over the life of developed fields. If a conditional fiscal system were in place before licences were auctioned, the investor is probably faced with less sovereign risk in the fiscal area than he would be in the absence of such taxation. If the fiscal arrangements were well-designed the combination should not introduce distortions to investment or other disincentives. In the context of the award of licences by the Guyanese government, with the benefit of hindsight, it can certainly be concluded that the presence of conditional taxation is necessary to ensure that the state collected a substantial share of the realized economic rents.

It is sometimes claimed for the bonus bidding system; that it ensures that the most economically efficient exploration programmes take place: the highest bids should come from the most efficient explorers. It is claimed that the main alternative, namely bidding by work programme, can lead to non-optimal amounts of exploration. Thus, the results of an initial exploration effort in a particular area might be so disappointing that further drilling is felt by an investor not to be justified. Work obligations given as a condition of the award of a licence may require further drilling, however. In general, the danger must exist that bidding through work programmes could lead to uneconomic exploration. In the case of the Guyana Basin, the individual blocks are quite large. The considerable size does provide scope for competitive work programme bidding.

It does not necessarily follow from the above discussion that a system of bonus bidding always leads to the lowest exploration and field exploitation costs. The winning bid may reflect more optimistic assessments of reserve size and/or higher expectations of future oil prices: the winner’s costs need not necessarily be the lowest. On balance, however, uneconomic exploration work programmes are more likely to be avoided by the bonus-bidding system.

Other types of arguments are sometimes employed to justify the discretionary licensing system. The auction system favours companies with large financial reserves, and Guyana does not have any such companies. The consequence of widespread employment of the auction system would almost certainly have been that a very large proportion of the licences would have been won by foreign companies.

It must be noted that the government must place greater importance on the rapid and thorough development of the Offshore Blocks and on the reduction of Guyana’s dependence on foreign oil, than on the likely immediate benefits of competitive bidding. Hence, the greater the effort put into the exploration of the Guyana Basin, the greater would be the potential benefit to Guyanese firms supplying equipment and services to the licensees.

In pursuit of this policy, not only will the record of licensees in awarding work in Guyana be taken into account in assessing applications in new rounds, but a local supplies office must be set up in the  Department of Energy (DE) to enhance the opportunities for Guyana’s industry in the exploitation of the offshore basin. To underline the perceived importance of providing opportunities for the Guyanese industry; the essence is the requirement on the oil companies to offer ‘full and fair opportunity’ to the Guyanese industry to compete for orders. The DE must enhance its role of expediting the understanding in practical terms and monitoring progress.

The question of the extent to which the above considerations should influence licensing policy has several elements. It could be argued that the nationality of the investing company is irrelevant: it is in the national interest that petroleum exploitation is conducted by the most efficient investors. In practice, however, it may not be obvious which investors are likely to be the most economic explorers and developers of fields. As was noted previously, the highest bidder under an auction system need not necessarily be the most efficient investor.

It could be argued that the approach to be adopted by the Guyanese government in making new awards does enable them to take into account the previous record of applicants. Given that the relevant skills must exist in the Department of Energy to assess the past performance of applicants, the procedure has the potential to ensure that efficient, innovative and economical investors obtain licences.

The use of this discretionary power deliberately to favour Guyanese oil companies is clearly a more controversial matter. It may be to the benefit of Guyana that if there are two investors, one Guyanese and the other foreign, which are financially and technically of equal competence, propose work programmes of equal merit, the licence award should go to the Guyanese investor. This is because any ensuing stream of profits is more likely to remain in Guyana. The flow of dividends and profits overseas which would emanate from petroleum exploitation being undertaken by the foreign-owned company would increase the national income of the foreign country rather than that of Guyana.

In practice, the choice may well not be as straightforward as in the above case. Proposed work programmes of applicants are unlikely to be identical. The possibility of a more attractive work programme being offered by a foreign company than by a Guyanese one could well arise (just as a higher bid under an auction system could emanate from a foreign company). In this case, a judgment has to be made. The greater the extent to which general economic benefits to Guyana are allowed to determine decision making in the award of licences, the greater the possibility that marked inefficiencies from an energy viewpoint will be produced. In extreme cases, it would mean that fields are not even discovered (due to relatively inefficient exploration efforts), or that new fields are developed in an inefficient manner or not developed at all.

These observations obviously apply not only when the nationality of the investing company is employed as a (part) determinant of the award of licences but to all other criteria such as employment of Guyana’s citizens and purchases of supplies and equipment from Guyanese sources. It is clearly in Guyana’s interest that employment of Guyana nationals and purchases of Guyanese goods and services should be encouraged whenever this is economically justified. It is also arguable that, given that offshore petroleum exploitation is a new activity in Guyana, some mechanism to induce the effective participation of Guyana’s industry in a large market is desirable. The oil supply industry has been dominated by foreign, especially the US, suppliers, and, in principle, a scheme must be developed to ensure that the oil companies gave a fair opportunity to the Guyana industry to compete with established suppliers is sound. In essence, the mechanism must put pressure on the oil companies to pay full regard to the capabilities of actual and potential new suppliers.

The details surrounding both the design and implementation of such a scheme clearly play a major role in determining how effective it will be. A successful policy may be defined as one which facilitates the attainment of a high Guyana content without resulting in significant increases in development and operating costs. The extent to which government policy will facilitate the attainment of this major increase is not clear. It is to be expected that Guyana’s share would, in any case, be increased as the local industry develops expertise in offshore activities.

The definition of the Guyana content is not altogether unambiguous. It should include as Guyanese companies, the Guyanese-based subsidiaries of foreign companies. An estimate of the Guyana content should be based on actual expenditure (including small contracts) but excluding subsidiaries of foreign firms. The most important explanation will be that of the contribution of the subsidiaries of foreign companies. These clearly contribute to Guyanese output and employment. They do, however, entail a flow of profits overseas. The ownership distinction is important for another reason. It provides an indication of the possible scope for the Guyanese-based supply industry to compete in overseas markets. Multinational companies will probably utilise bases nearest to the markets in question. Guyanese-owned companies are more likely to employ Guyanese bases to supply the markets.

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