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Wednesday, November 25, 2020

Evaluating key elements of an oil contract for emerging petroleum economies

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Bobby Gossai, Jr.
Bobby Gossai, Jr. is currently pursuing the Degree of Doctor of Philosophy in Economics at the University of Aberdeen with a research focus on Fiscal Policies and Regulations for an Emerging Petroleum Producing Country. He completed his MSc (Econ) in Petroleum, Energy Economics and Finance from the same institution, and also holds an MSC in Economics from the University of the West Indies. Mr. Gossai, Jr.’s professional experiences include being the head of the Guyana Oil and Gas Association and senior policy analyst and advisor at the Ministry of Natural Resources and Environment.

Keep in mind, however, that most fiscal systems in the world are moderately regressive. The revenue the governments receive will go up, but Government Take will go down on average. Finally, it is important to remember that the differences in fiscal terms across systems are not necessarily due to the different families being used, similar terms can be achieved across all of these systems. Rather, differences reflect varying conditions in the diverse environments in which these systems are employed.

Beneath the Surface

With the exception of the United States, Canada, and a very few old Spanish land grants in Colombia, mineral rights belong to the state. Indeed, in many countries, managing a country’s mineral wealth is seen as a sacred trust.

Countries with limited proven mineral wealth seek exploration activity and have limited leeway attracting it. Still, they want the best contract terms they can get. All countries have their own unique boundary conditions, concerns, and objectives. Needs, traditions, perspectives, perceptions, and politics differ as well. In particular, the major concerns facing a country’s government are:

  1. Getting a large (and fair) share of the profits (Take) while keeping costs down;
  2. Guaranteeing a certain share of each accounting period (Effective Royalty Rate and/or Minimum Government Take);
  3. Obtaining, but not exceeding the Maximum Efficient Production Rate (MEPR) – the rate at which oil from an oil field can optimally be extracted;
  4. Maintaining a high degree of control over the country’s resources;
  5. Attracting investment and the right kind of company even if the financial conditions appear not as good.

Oil companies meanwhile want to explore 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 risks. As already mentioned, companies are also interested in booking barrels. Indeed, oil companies are measured by their ability to replace the barrels pumped as well as by their finding and lifting costs. If they can book more barrels their ‘reserve-replacement-ratio’ – a key measure of successful performance in the oil industry – benefits and their finding costs go down. This can be confusing and frustrating since the ability to book barrels and the amount of barrels a company can book strongly depends on the type of system and various other peripheral elements.

There is no single clause or number in an oil contract that conveys whether the country or company (or neither or both) got a good deal. Evaluating the contract requires examining a series of conditions. 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 summarize the value of a contract. Chief among these is the “Government Take” statistic.

The “Government Take” statistic

The most common statistic used for evaluating contracts is the Government Take: the government’s share of economic profits including almost all income sources, namely: bonuses, royalties, profit oil, taxes and government working interest. While the Government Take statistic includes most revenues accruing to the government it does not include “crypto taxes” or benefits such as employment benefits and skills transfers, items which are collectively included under ‘gross benefits’.

Although a widely used measure, Government Take as commonly calculated has numerous shortcomings that can undermine its usefulness (Johnston 2002). It is often calculated based on unrealistic assumptions; it cannot adequately capture risk; it does not take the timing of payments into account, and it leaves out other key elements altogether.

Government Take is calculated using a number of assumptions about oil prices, costs, escalation rates, production rates, cumulative production, etc. Variations in these assumptions can affect the anticipated profitability of a field or project. Moreover, Government Take can vary quite dramatically with the profitability of a project. Government Take also does not adequately capture risk.

In principle, the Government Take statistic represents the division of profits “full cycle” – over the full life of a field or fields. In other words, Government Take represents the government’s share of total net profits. This includes years when profits are low (sometimes zero) and years when profits are high – assuming there even are profits, to begin with. In principle, however, at the beginning of a project, multiple Take statistics can be calculated, each conditional upon different possible outcomes (Johnston 2006).

The Government Take statistic fails to provide information about the timing of payments. Yet, timing can be an issue of central concern to governments. For example, after Bolivia’s first Gas War in 2003, a new fiscal system was proposed (Chávez 2004). The new system was intended to increase the share of revenue accruing to the Bolivian government in the early years of production from their newly discovered gas fields. Bolivia needed money sooner rather than later. The proposed system attempted to keep the revolutionaries happy without completely alienating the oil companies that risked capital exploring for and finding Bolivia’s vast gas reservoirs. While a notable change to the timing of payments, the proposed system left the calculation of Government Take virtually unchanged because a comparison of the proposed system with the previously designed systems using undiscounted Government Take would not have shown a difference.

Few 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 there are signature bonuses and other front-end-loaded elements, like royalties and cost recovery limits. The decision to front-end-load payments may or may not be wise in different circumstances. Regardless of the wisdom of the decision, the Government Take 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. Taking timing into account requires companion statistics, such as the “Effective Royalty Rate”.

The Government Take measure excludes other key elements altogether. For example, the Take statistic says nothing about ringfencing – the practice of disallowing companies to consolidate their operations among more than one license area. Additionally, it does not measure contract or system stability; remains silent on reserve/lifting entitlements and does not account for ownership.

Overall, what the Government Take statistic does and does not include makes cross-national comparisons based on Take statistics especially difficult. All the more so since a country’s fiscal system is often compared to those of neighbouring countries. Also systems with “R” factors (tax rates based on predetermined pay-out thresholds, where the ‘R’ is typically the ratio of the company’s cumulative receipts divided by its cumulative expenditures factor); or a “rate-of-return” (ROR) feature (where the higher is the rate of return the greater is the tax rate facing corporations) can have a greater range of financial outcomes than more conventional systems.

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