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IBP1810_12 IMPACT OF FIELD DEFINITION FOR THE PURPOSE OF SPECIAL PARTICIPATION TAX CALCULATION IN UNCONVENTIONAL HYDROCARBONS Patrcia P.

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Copyright 2012, Instituto Brasileiro de Petrleo, Gs e Biocombustveis - IBP Este Trabalho Tcnico foi preparado para apresentao na Rio Oil & Gas Expo and Conference 2012, realizado no perodo de 17 a 20 de setembro de 2012, no Rio de Janeiro. Este Trabalho Tcnico foi selecionado para apresentao pelo Comit Tcnico do evento, seguindo as informaes contidas no trabalho completo submetido pelo(s) autor(es). Os organizadores no iro traduzir ou corrigir os textos recebidos. O material conforme, apresentado, no necessariamente reflete as opinies do Instituto Brasileiro de Petrleo, Gs e Biocombustveis, Scios e Representantes. de conhecimento e aprovao do(s) autor(es) que este Trabalho Tcnico seja publicado nos Anais da Rio Oil & Gas Expo and Conference 2012.

Resumo
Embora a indstria de no-convencionais esteja desenvolvida em outros pases, no Brasil esse ainda um assunto novo para a indstria e os reguladores. O arcabouo fiscal da indstria de leo e gs no Brasil foi baseado nos reservatrios convencionais existentes. Uma das reas que requer regulao a definio de que so reas produtoras, ou seja, campos para o clculo da participao especial. No entendimento atual, a definio de campo para reservatrios noconvencionais pode ser o play inteiro o que acarreta a gerao de altas taxas de participao especial. Os projetos de noconvencionais apresentam limitaes tcnicas dada a necessidade de um alto nmero de poos para a produo e o uso de tcnicas de fraturamento e esto sujeitos a insipiente indstria local. Uma vez que a participao especial foi criada com o objectivo de taxar projetos com grandes volumes e grandes rendimentos, importante garantir que a sua incidncia no impea uma nova indstria de se desenvolver.

Abstract
Although well established in other countries, in Brazil, the unconventional production is a new subject to the industry and the legislators. The current fiscal system in Brazil was based in the conventional reservoirs production and therefore has limitations when applied to unconventionals. One of the areas that need regulation is how to define the producing areas (fields) for the purpose of calculating the Special Participation Tax (SPT). In the current understanding the unconventional fields can be the whole play, which trigger higher rates of Special Participation Tax, decreasing the projects profitability. These projects have technical limitations due to the required well intensive activity associated with fracturing and are subject to an immature local supply industry. Once SPT was created with the objective to tax projects with great volumes and great profitability, it is important to make sure its application does not prevent a new industry to develop.

1. Introduction
It is well known that organic material buried under heat and pressure will latter give origin to hydrocarbons. This source rock, rich in petroleum however, is not where the hydrocarbons usually come from. Source rocks are not good reservoirs because the lack of permeability. The theory is that hydrocarbons migrate and are trapped in other types of rocks, from where it can be extracted. The ideal reservoir in order to have commercial quantities of hydrocarbons, requires porosity and permeability and is sealed to avoid the petroleum to escape to the surface. This is the brief history of oil and natural gas existence. However, source rocks can sometimes be reservoirs as well. Recently, the gas industry has experienced more and more production of natural gas from the source rock, called unconventional production. Although the existence of unconventional gas resources was not new to the industry, there were technical and economical limitations to its commercial production in the past. Nowadays, the shale gas areas and other unconventional reservoirs are increasing the participation as a source of natural gas production.

______________________________ 1 Master, Economist and Lawyer SHELL BRASIL PETROLEO

Rio Oil & Gas Expo and Conference 2012 Unconventional gas production may be from shale formation or tight sands mainly. In the last 10 years, in the United States of America (USA), the production from shale formation has grown at a 28% rate per year increasing from 30 million m3/d to 373 million m3/d1. There are several areas in the country where unconventional gas can be found. Those areas are mapped and under production. They contributed to 23% of the total USA dry natural gas produced in 2010 from 7% in 20072 . The main drivers for this increase were the development of the fracturing technology associated with the horizontal wells and the raise of gas prices. Conventional gas reservoirs are characterized by a well defined formation, with such porosity and permeability that allows the hydrocarbons to flow through the wells from all over the reservoir. In this sense it is relatively easy to define a field using the delimitation given by the geologic formation. In unconventional reservoirs, the gas is generated and sits throughout the shale formation, which is a sedimentary rock that most of the time is the source rock or the seal for conventional structures. It is unconventional due to the low permeability and consequently poor connectivity among the pores. In this case the gas is trapped in several small fields called sweetspots. For gas production it is necessary to reach each or a limited amount of sweetspots with a single well and to make use the fracturing technology to increase permeability and allow the gas to flow. In Brazil, since the first hydrocarbon discovery in 1939 in Bahia, the industry had developed with major discoveries offshore like the giant fields of Albacora in 1984, Marlin in 1985 and Roncador in 1996, reaching the level of 1 million barrels of oil equivalent in 1997. In 10 years the country had double its production of hydrocarbons after the discovery of the biggest gas field in Brazil, Mexilho. Brazil has its complexities with the deepwater fields, and pre-salt discoveries, but unconventional gas production has still not being done in the country. The legal framework for oil and gas in Brazil was developed based on the existing conventional oil and gas production. The system is a concession regime and the current model was established in 1997 with the Law N 9478 (06/08/1997) the Petroleum Law. In this law three new government contributions to the industry were created: Signature Bonus, Area Rentals and Special Participation Tax (SPT). The royalties already existed since 1953, but its rate was increase from 5% to 10% with the advent of the new Law. The SPT was regulated in a later Portaria from ANP (PORTARIA ANP N 10, DE 13/01/99 (D. O. U. DE 14/01/99) and its main purpose was to establish a mechanism of remuneration in case of high price of hydrocarbons. Oil and gas fields were defined by the Petroleum Law (Article 6, XIV) as producing area of oil and natural gas, from a single or multiple reservoirs, at variable depths, including facilities and equipments dedicated to production. (rea produtora de petrleo ou gs natural, a partir de um reservatrio contnuo ou de mais de um reservatrio, a profundidades variveis, abrangendo instalaes e equipamentos destinados produo), which can be easily applied to conventional discoveries, but it can raise questions when applied to unconventional reservoirs.

2. Unconventional Fields
The structures where hydrocarbons exist in nature are called reservoirs. Other than large pools of oil or gas the reservoir is composed of grains, which makes it resembles a sponge. The existence of pores creates the void space for the hydrocarbons to stay and as long as the spaces are connected the hydrocarbons will flow, or be permeable. The level of porosity and permeability will vary, but will encompass most of the reservoir area. Throughout the hydrocarbon history, the decision makers had to choose how to best invest in the projects. In the early years of the business, oil and gas prices were significantly low allowing only the production from easy fields to succeed. Those fields had to be of easy accessibility, with higher production rates and low unit production and development costs to be profitable. Hard to extract hydrocarbon meant higher cost and consequently lower or unprofitable projects. Sometimes the exploration program would find the presence of hydrocarbons, but under such conditions that would not justify the investment to produce them. This is the story of unconventional reservoirs. In USA, the shale gas formation was first extracted in 1821, but in was not until 1970 that the production reached industry scale, with government investment in research, partnership with private companies and tax incentives. The enablers for unconventional production were the development of new technologies and increase of natural gas prices that allowed the use of horizontal wells combined with hydraulic fracturing technology to extract the hydrocarbons. The unconventional reservoirs are tight-gas sands, coal-bed methane, heavy oil, and gas shales. They are usually referred as plays other than fields. Shale plays, for example, are defined as areas which are shale formations containing significant accumulations of natural gas and which share similar geologic and geographic properties3 . Other than being
1 2

http://www.gasbrasil.com.br/noticia/noticia.asp?NotCodNot=48583 EIA 3 http://www.eia.gov/energy_in_brief/about_shale_gas.cfm 2

Rio Oil & Gas Expo and Conference 2012 called as fields the unconventional reservoirs are mostly referred as plays due to the lack of delimitation of a defined permeable area from which it would be producible. Conventional gas reservoirs are created when natural gas migrates toward the Earth's surface from an organic-rich source formation into highly permeable reservoir rock, where it is trapped by an overlying layer of impermeable rock. In contrast, shale gas resources form within the organic-rich shale source rock. The low permeability of the shale greatly inhibits the gas from migrating to more permeable reservoir rocks. Without horizontal drilling and hydraulic fracturing, shale gas production would not be economically feasible because the natural gas would not flow from the formation at high enough rates to justify the cost of drilling. 4 Given the physical structure, the presence of a geological trap and the accumulation of hydrocarbon in conventional reservoirs, the producing area is well delimited to determine the fields. However, in unconventional resources, the delimitation will vary, depending on how the hydrocarbons are disposed within the formation. There are areas of more concentration of hydrocarbons called the sweetspots. These will be the producing areas. It will resemble several independent small fields in a play, other than a continuous producing area. Another important factor that will contribute to this interpretation is how the development of unconventional plays happens.

Figure 1. Conventional vs. Unconventional Gas In order to produce the natural gas, a well intensive campaign is required, including horizontal drilling and hydraulic fracturing to enable the gas to flow. In conventional reservoirs the permeability allows the hydrocarbon to flow through the wells in a comprised area. The number of the wells per area is significantly lower and the production plateau is also longer. The graphs below illustrate the typical production curves for a conventional and unconventional well. As the decline in the unconventional reservoirs is rapid, it requires more wells to be produced, in the order of 100 to 1000 in average, when the average conventional reservoirs are drained with 2 to 10 wells.
4

http://www.eia.gov/energy_in_brief/about_shale_gas.cfm

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Figure 2. Typical Conventional Well Production

Figure 3. Typical Unconventional Well Production

The direct implication of a well intensive campaign is the increase of the cost associated with the production and the environmental impact due the high level of activity and intense use of water for hydraulic fracturing.

3. Implication of Field Definition for the application of SPT


The production of the natural gas from unconventional reservoirs in other countries, such as the USA, has not raised the discussion on how to define fields. Those areas are treated as plays and no issues related to it were present. However, in Brazil, as some taxes are paid by field there is need to discuss such term. Depending on the field definition the SPT can impact significantly the project economics. The Special Participation Tax (SPT) was created by the Petroleum Law in 1997 with the objective to tax the projects in case of higher profits. In order to reach its purpose, its rate calculation was based on the amount of production the field was experiencing with different production triggers for onshore and offshore fields below and above 400 meters of water depth. The tax rates were also set to be differently applied depending on the year of production. The basis for application of the tax was the profit of the field using the law allowed deductions in the calculation. In order to illustrate the impact of field definition in the application of the SPT, it was assumed a fictional simplified example with the following characteristics: Gas Volumes = 24 bln m3 Production time = 7 years Production profile Table 1. Production Profile
Year mln m3/d 1 7.1 2 11.3 3 11.3 4 11.3 5 11.3 6 7.1 7 4.2

Producing Well cost = $20 mln Total number of wells = 168 Opex = $4.4/ m3 Royalty = 5% Gas Price = $ 7/MMbtu Income Tax Rate = 34% Onshore production.

3.1. Comparison of Rates for the Special Participation Tax The SPT rates are determined based on the production profiles. In the proposed example of an onshore unconventional gas production, with the objective to show the impact of field definition, it was assumed that the producing play could be treated as a single, two or three producing areas, and consequently will have one, two or three fields. In graph 1, if the play has 1 field, the rates of SPT for the proposed example will vary from 3% to 12%, using the onshore SPT table described in table 2. In graph 2 if, in the play has 2 producing areas the rates now vary from 0 to 6% and in graph 3 about the same range is present with and average lower rate than in graph 2.

Table 2. SPT table for onshore 4

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Rate Year 1 Year 2 Year 3 Year 4+

Onshore production per quarter thousand m3 0% 10% 20% 30% 35% 0 450 900 1350 1800 0 350 800 1250 1700 0 250 700 1150 1600 0 150 600 1050 1500

40% 2250 2150 2050 1950

Play has 1 field


12 10 8 6 4 2 1 2 3 4 Year 5 6 SPT Rates 7 18% 15% 12% 9% 6% 3% 0%

mln m3/d

Production

Figure 4. Graph1 Play has 1 Field

12

Play has 2 equal fields

18%

12 10

Play has 3 equal fields

SPT Rates

18% 15%

10
mln m3/d
8 6 4

15%

9% 6%

6 4 2 1 2 3 4 Year 5 6 7 Production Field 1 Production Field 2 SPT Rate per Field

9% 6% 3% 0%

2
1 2 3 4 Year Production Field 1 Production Field 2 5 6 7

3%
0%

SPT Rate per field

Production Field 3

Figure 5. Graph2 Play has 2 Fields

Figure 6. Graph3 Play has 3 Fields

As the graphs show, depending on how many fields exist in the play, SPT applicable rates will vary and will impact the project results.

3.2. Comparison of Projects Internal Rate of Return Once the SPT can be deducted from the income tax, the integrated view of the cash flow is also required to analyze the impact of field definition. If the play has only one field, the project will have a lower net present value and internal rate of return (IRR), which will reduce the attractiveness of the projects and could result in non-investment. Figure 6 illustrates the IRR for the different scenarios described above.

SPT Ratese

mln m3/d

12%

12%

SPT Rates

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200 150 100 50 0 -50 0 -100 -150 -200 -250 -300 -350

Cashflow Comparison

$ mln

4 Years

10

Cashflow - Play has 1 field

Cashflow - Play has 2 equal fields


Cashflow - Play has 3 equal fields

Figure 6. Cashflow Comparison

Table 3. Internal Rate of Return Comparison

Cashflow - Play has 1 field Cashflow - Play has 2 equal fields Cashflow - Play has 3 equal fields

IRR 8% 11% 12%

4. Conclusion
In the recent years, development of the unconventional gas industry worldwide brought the opportunity to produce more gas generating more energy. Such areas that were not considered profitable before, were enabled by technology providing access to new resources. Latest news have pointed the existence of potential large unconventional natural resources in Poland, which had driven the country into studies and incentives to embrace the opportunity to reduce the dependency of imported natural gas from Russia. China as well is investing in developing unconventional resources such as coalbed methane and tight gas. And in the USA, the participation of shale gas production increased over 3 times its participation in the country natural gas production from 2007 to 2010. The unconventional natural gas production using modern technology does not exist in Brazil, but the country has potential to have this play as an important contributor to the national energy matrix. For this reason, it is important that the issues related to the topic are raised and addressed by the proper parties as soon as possible. Well defined rules for any industry are important because it enables investors to make informed economic decisions and it reduces the fiscal risks for the investment. Brazil legal framework for the oil and gas industry was based on a successful hydrocarbon history of conventional reservoir discoveries. On this basis, the special participation tax was created in order to tax excess profit by field. However the application of the existing understanding of the law to unconventional reservoirs may bring issues such as considering unconventional reservoirs as one single field, which will trigger higher levels of special participation tax that may prevent the development of a project. The physical characteristics of unconventional reservoirs require discussion to define what a production area or field is within an unconventional play. This industry is new to the country; it is capital intensive as it requires a large number of wells for production, not to mention the required infrastructure to be put in place. In the USA, the development of unconventionals had a strong participation of the government with sponsored studies, partnership with private companies to drill wells and tax incentives. There is an opportunity to develop a new industry and foster economic growth in frontier areas of the country but as this is a new area for all the industry players in Brazil, a close dialogue among the players should be best strategy to understand unconventional reservoirs and together help define the appropriate legal framework that will suits better the interests of the country. The earlier it happens the sooner results will appear.

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5. References
NAIK, G. C. Tight Gas Reservoirs An Unconventional Natural Energy Source for the Future. SPE, 2003. U.S. Energy Information Administration, Drilling SidewaysReview of Emerging Resources: U.S. Shale Gas and Shale Oil Plays, (Washington, DC, July 2011), ftp://ftp.eia.doe.gov/natgas/usshaleplays.pdf (last visited on May 31st, 2012). U.S Department of Energy Office of Fossil Energy National Energy Technology Laboratory Modern Shale Gas Development in the United States: a Primer, DE-FG26-04NT15455 (Oklahoma City, OK, April 2009). http://www.fossil.energy.gov/programs/oilgas/publications/naturalgas_general/ShaleGasPrimer_Online_4-2009.pdf (last visited on May 31, 2012). http://www.eia.gov/energy_in_brief/about_shale_gas.cfm (last visited on May 31st, 2012) Brazil, PORTARIA ANP N 10, DE 13/01/99 (D. O. U. DE 14/01/99) http://www.gasbrasil.com.br/noticia/noticia.asp?NotCodNot=48583 (last visited on May 31st, 2012) www.eia.gov (last visited on May 31st, 2012) http://www.state.gov/e/enr/rls/rem/2012/183875.htm (last visited on May 31st, 2012) http://blog.planalto.gov.br/o-petroleo-no-brasil/ (last visited on May 31st, 2012)