Petroleum Fiscal System

(The Trends & The Challenges)

Benny Lubiantara
(email: blubiantara@yahoo.com)

(Updated: Dec 2009)

 Outline

I. Introduction
II. The Concept of Economic Rent
III. Characteristic of the Upstream Petroleum Industry
IV. Classification of Upstream Petroleum Contract
V. Main Elements in Petroleum Upstream Contract
VI. Fiscal Policy Design
VII. Comparative Analysis
VIII. Economics Evaluation of Petroleum Upstream Contract
IX. Trends & Challenges
X. Summary
 I. Introduction

• Fiscal arrangement is the Government’s most important

tool for managing petroleum resources.

• From the international oil companies perspective, fiscal

regimes is one of the most important factors to be
considered for investment decisions.

• Many papers were published focusing on the

comparative analysis of the worldwide petroleum fiscal
system.
 II. The Concept of Economic Rent (1)

In upstream petroleum industry, the economic rent is the

different between the value of production and the cost to
extract it.

Economic Rent = Gross Revenue – Total Cost –

MARR*)

*) MARR is Minimum Attractive Rate of Return

Total Cost include: Exploration Cost, Development Cost,

Operating Cost, Abandonment Cost.
 II. The Concept of Economic Rent (2)

Economic rent concept is important since the

government attempt to capture as much as
economic rent as possible through various
levies, taxes, royalties and bonuses.
 III. Characteristics of the Upstream
Petroleum Industry

• Finding hydrocarbon resources involve high risk. This risk is

present at all stages of the project’s life cycle.

• The upstream petroleum industry is capital intensive, huge

amount must be spent on exploration to discover sufficient oil
reserves.

• Involve high technology.

• Despite its involve high risk, the petroleum industry also

provide potential high reward / return.
 Classification of
Upstream Petroleum Contract
The first branch deals with the title to the mineral resources. Concessionary systems allow
private ownership. In contractual systems, the state retains ownership
 Concession

A grant of access for a defined area and time period that

transfers certain rights to hydrocarbons that may be discovered
from the host country to an enterprise.

The enterprise is generally responsible for exploration,

development, production and sale of hydrocarbons that may be
discovered. Typically granted under a legislated fiscal system
where the host country collects royalties, taxes and fees.
 Main Features of Concession

1. The Multinational Oil Company (MOC), at its own risk and expense,
generally has the exclusive right to explore for and exploit petroleum
reserves in the concession area.

2. The MOC owns the production from within its concession area.

3. The MOC pay the royalty either in Cash or Production.

4. The MOC pay taxes to the host country on profit it derives from the
production.

A Great disadvantage to the HC of the concession agreement is that it greatly

limits the involvement by the HC.
 Modern Concession

1. The concession area is only for certain block (instead of the

whole country, province, etc).

2. The period of concession is shorter than the old concession

type ( 20 years instead of 60 years in average).

3. There is also relinquishment obligation on the agreement.

4. Known also as Royalty/Tax System

 Production Sharing Contract

In a production-sharing contract between a contractor and a host

country, the contractor typically bears all risk and costs for
exploration, development, and production. In return, if exploration
is successful, the contractor is given the opportunity to recover
the investment from production, subject to specific limits and
terms.

The contractor also receives a stipulated share of the production

remaining after cost recovery, referred to as profit hydrocarbons.
Ownership is retained by the host government; however, the
contractor normally receives title to the prescribed share of the
volumes as they are produced.
 Main Features of PSC

1. The Multinational Oil Company (MOC) is appointed by the HC as the

contractor for certain area.
2. The MOC operate as its sole risk and expense under control of the HC.
3. Any production belongs to the HC.
4. The MOC is entitled to a recovery of its costs out of the production from
the contractual area.
5. After cost recovery, the balance of production is shared on a pre-
determined percentage split between the HC and the MOC.
6. The income of the MOC is liable to taxation.
7. Equipment and installations are the property of the HC.
 Pure Service Contract (1)

1. A pure-service contract is an agreement between a contractor and

a host country that typically covers a defined technical service to
be provided or completed during a specific period of time.

2. The service company investment is typically limited to the value of

equipment, tools, and personnel used to perform the service. In
most cases, the service contractor's reimbursement is fixed by the
terms of the contract with little exposure to either project
performance or market factors.
 Pure Service Contract (2)

3. Payment for services is normally based on daily or hourly rates, a

fixed rate, or some other specified amount. Payments may be
made at specified intervals or at the completion of the service.
Payments, in some cases, may be tied to the field performance,
operating cost reductions, or other important metrics.

4. Risks of the service company under this type of contract are

usually limited to nonrecoverable costs overruns, losses owing to
client breach of contract, default, or contract dispute. These
agreements generally do not have exposure to production
volume or market price; consequently, reserves are not usually
recognized under this type of agreement.
 Risk Service Contract

1. These agreements are very similar to the production-sharing

agreements with the exception of contractor payment. With a risked-
service contract, the contractor usually receives a defined share of
revenue (cash) rather than a share of the production (in kind).

2. As in the production-sharing contract, the contractor provides the

capital and technical expertise required for exploration and
development. If exploration efforts are successful, the contractor can
recover those costs from the sale revenues and receive a share of
profits through a contract-defined mechanism.
 Division of Gross Production

Royalty Tax PSC

Gross
Gross Production
Production

Royalty
Royalty
Cost Oil
Production Net
of Royalty
Profit Oil (P/O)

Costs
Deductions

Investor’s Host Govt’s Contractor’s

Tax P/O P/O

Investor’s
Production
Contractor’s
Tax
 Concessions (Royalty Tax)
One Barrel of Oil
$20

Contractor Government
20% Royalty Share
Share
$16.00 $4.00
Deductions
$9.00 (Op.Cost, DD & A, etc)
$7.00
(Taxable Income)
Provincial Tax
$0.70
10%
$6.3

Federal Income Tax

$2.52
40%
$3.78 Net Income After Tax

$12.78 $7.22

64% 36%
Source: Daniel Johnston, “International Fiscal System and PSC”, 1994
 Production Sharing Contract
(PSC)
One Barrel of Oil
$20
Contractor Governme
Share nt Share
10% Royalty $2.00
$18.00
Cost Recovery
(Op.Cost, DD & A, etc)
$8.00 (40% Limit)

($10.00)
Profit Oil Split
$4.00 40% / 60% $6.00

(Taxable)
Taxes
($1.6) $1.60
40%
$10.40 $9.60

52% 48%
Source: Daniel Johnston, “International Fiscal System and PSC”, 1994
V. Main Elements Petroleum Upstream Contract
(Focusing on Economics and Commercial Aspects)

• Area
• Duration
• Relinquishment
• Work Program /Obligation
• Bonuses
• Royalty
• Cost Recovery Limit
• Profit Oil Split
• Taxation
• Depreciation Methods
• Domestic Market Obligation
• Gov. Participation
• Others
Main Economics & Commercial Aspects (cont.)
(Focusing on Economics and Commercial Aspects)

 Area: Wide variation, Typically +/- 150,000 - 350,000 acres .

 Duration:
• Exploration: Multiphase 2-4 years initial + extensions
• Production: From 20 to 30 years from start up

 Work Commitment, reflect the company’s willingness to

pursue opportunities on a block. This commitment is
typically in the form of an agreement to conduct seismic
survey and drill a given number of wells or spend an agreed
amount of money during a designated exploration period

 Bonuses:
• Signature Bonuses: in high, prospective areas.
• Other Bonuses: Common, discovery, production, etc.
V. Main Elements Petroleum Upstream Contract
(Focusing on Economics and Commercial Aspects)

• Royalty: Most countries have a royalty.

• Cost Recovery Limit: A phenomenon of PSCs, but about 20% of

PSCs do not have a limit. World average is 60-65%; general range is
35-75%.

• Profit oil: PSC phenomena; about 80% are sliding scale. Most are
based upon trenches of production.

• Taxation: Almost all systems have the equivalent of corporate

income tax. The average is around 35%, other countries have
withholding tax and special petroleum tax.
V. Main Elements Petroleum Upstream Contract
(Focusing on Economics and Commercial Aspects)

• Depreciation: About half of world’s PSCs do not require

depreciation for cost recovery, but most do for tax purposes. World
average is 5 years or 20% yearly.

• Domestic Market Obligation (DMO): Many contracts specify

the provision to supply domestic market when commercial
production commences, a certain percentage of the contractor's
profit oil has be sold to the government. The sales price to the
government is usually at a discount to market prices.

• Gov. Participation: A government may, under the applicable

petroleum legislation, have the option to demand as a condition for
the grant of a license that a state enterprise designated for this
purpose becomes a participant in such license .
 VI. Fiscal Policy Design

Government Objective
• Maximize value of the petroleum resource

Company Objective
• Maximize stockholders interest

The challenge of fiscal system is to ensure the government

receive as high share of the value as possible while
encouraging the exploration and exploitation of petroleum
resource.
 VI. Fiscal Policy Design
The Art of Designing

Source: Daniel Johnston, International Petroleum Fiscal System and Production Sharing Contract, (1994)
 VI. Fiscal Policy Design
Regressive vs. Progressive*)

Non Profit based Government Take (Such as: Bonus, Royalty) are Regressive.

*) Source: Dr. Alfred Kjemperud, “Petroleum Fiscal Regimes”, Presentation Material for CCOP, 2003
 VII. Comparative Analysis

In order to make the comparative analysis among worldwide

petroleum fiscal system, the term “Government Take” is one
of the important criteria.

 Government Take represent the government’s share of

economic profits from all means by which the state
extracts rent: bonuses, royalties, profit oil, taxes,
Government working interest, etc.

 In percentage = (bonus + royalties + profit oil, taxes,

Gov. working interest) divided by total economic profit

 Total economic profit = Total gross revenue less total

cost over life of the project
 Government Take and Contractor Take

T
G
O
R T
O A
L GOVERNMENT TAKE
S
S P
R
O
R F
I
E T CONTRACTOR TAKE
V C R
E O E OPERATING COSTS
S C
N T O
V DEVELOPMENT COSTS
U E
E R
EXPLORATION COSTS
Y

 Government Take and Contractor Take are the terms used as a

proxy for the division of profits between the contractor and the host
country.

 The government take is defined as the government's share of

economic profits from all means by which the state extracts rent:
bonuses, royalties, profit oil, taxes, etc.
 Government Take

Source: Daniel Johnston, International Petroleum Fiscal System and Production Sharing Contract, (1994)
 VII. Comparative Analysis
Weaknesses of the Government Take Statistic

It does not adequately capture the effect of*):

• Signature bonus
• Ring-fencing Provisions
• Front end Loading
• Work Program Provision
• Time Value of Money (unless using Discounted GT)
• Crypto taxes
• Relinquishment Provision

*) Source: Daniel Johnston’s Workshop, Dundee, 2006

VIII. Economics Evaluation of Petroleum Upstream Contract
Capital Budgeting Concept

Capital Budgeting - deciding which projects to accept.

Techniques:

• Payback Period
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Profit to Investment (PI)
Economics Evaluation of Upstream Petroleum
Contract

Field
Fiscal Economics
Terms

Oil
Price

Production Facilities Capex

Rate Design Opex
Reserves
 Economics Evaluation of Upstream Petroleum
Contract
Production Plot
60000

50000

40000
BOPD

30000

20000

10000

Year
 VIII. Economics Evaluation of Petroleum Upstream Contract
Example of Spreadsheet Calculation
Year Gross Royalty Gr. Revenue Cost Recovery Equity Contractor Contractor CF Host Country
Revenue 10% After Royalty Depre Non Cap Inv OPEX TOTAL Recovered Unrecovered To be Split Split Total Cash in Cash Out NCF Royalty Split Tax Total HC
$M $M $M $M $M $M $M $M $M $M $M $M $M $M $M $M $M $M $M
1 (10,000) (10,000)
2 (10,000) (10,000)
3 (10,000) (10,000)
4 (10,000) (10,000)
5 (176,000) (176,000)
6 (176,000) (176,000)
7 (128,000) (128,000)
8 383,250 38,325 344,925 64,000 200,000 54,750 318,750 318,750 - 26,175 6,544 325,294 325,294 (57,629) 267,665 38,325 19,631 2,879 60,836
9 638,750 63,875 574,875 64,000 91,250 155,250 155,250 - 419,625 104,906 260,156 260,156 (137,409) 122,748 63,875 314,719 46,159 424,753
10 638,750 63,875 574,875 64,000 91,250 155,250 155,250 - 419,625 104,906 260,156 260,156 (137,409) 122,748 63,875 314,719 46,159 424,753
11 638,750 63,875 574,875 64,000 91,250 155,250 155,250 - 419,625 104,906 260,156 260,156 (137,409) 122,748 63,875 314,719 46,159 424,753
12 574,875 57,488 517,388 64,000 82,125 146,125 146,125 - 371,263 92,816 238,941 238,941 (122,964) 115,977 57,488 278,447 40,839 376,773
13 517,388 51,739 465,649 73,913 73,913 73,913 - 391,736 97,934 171,847 171,847 (117,003) 54,843 51,739 293,802 43,091 388,632
14 465,649 46,565 419,084 66,521 66,521 66,521 - 352,563 88,141 154,662 154,662 (105,303) 49,359 46,565 264,422 38,782 349,769
15 419,084 41,908 377,175 59,869 59,869 59,869 - 317,306 79,327 139,196 139,196 (94,773) 44,423 41,908 237,980 34,904 314,792
16 377,175 37,718 339,458 53,882 53,882 53,882 - 285,576 71,394 125,276 125,276 (85,296) 39,981 37,718 214,182 31,413 283,313
17 339,458 33,946 305,512 48,494 48,494 48,494 - 257,018 64,255 112,749 112,749 (76,766) 35,983 33,946 192,764 28,272 254,981
18 305,512 30,551 274,961 43,645 43,645 43,645 - 231,316 57,829 101,474 101,474 (69,089) 32,384 30,551 173,487 25,445 229,483
19 274,961 27,496 247,465 39,280 39,280 39,280 - 208,185 52,046 91,326 91,326 (62,180) 29,146 27,496 156,139 22,900 206,535
20 247,465 24,746 222,718 35,352 35,352 35,352 - 187,366 46,842 82,194 82,194 (55,962) 26,231 24,746 140,525 20,610 185,881
21 222,718 22,272 200,447 31,817 31,817 31,817 - 168,630 42,157 73,974 73,974 (50,366) 23,608 22,272 126,472 18,549 167,293
22 200,447 20,045 180,402 28,635 28,635 28,635 - 151,767 37,942 66,577 66,577 (45,330) 21,247 20,045 113,825 16,694 150,564
23 180,402 18,040 162,362 25,772 25,772 25,772 - 136,590 34,147 59,919 59,919 (40,797) 19,123 18,040 102,442 15,025 135,508
24 162,362 16,236 146,126 23,195 23,195 23,195 - 122,931 30,733 53,927 53,927 (36,717) 17,210 16,236 92,198 13,522 121,957
25 146,126 14,613 131,513 20,875 20,875 20,875 - 110,638 27,659 48,535 48,535 (33,045) 15,489 14,613 82,978 12,170 109,761
6,733,120 1,481,874 640,911 4,610,335
IRR 14.98%
 Yearly Division of Gross Revenue

800,000

Host Country Share

700,000
Contractor Share
600,000 Cost Recovery

500,000
$M

400,000

300,000

200,000

100,000

-
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Production Period
 IX. Trends and Challenges

 Some fiscal systems are adjusting automatically upward

because of the price progressive structure of the systems;

 Governments have changed fiscal terms;

 Companies are bidding up government take in bid rounds;

 Greater state participation by NOCs; and

 Renegotiation.

Source: Van Meurs, Maximizing the Value of Government Revenues from Upstream
Petroleum Arrangements, Fiscal Submit London, 9th February 2009
 IX. Trends and Challenges
(Related to Fiscal Design)

 Regressive or Progressive – Fiscal Design?

 Basis for Production Sharing: Fixed,

Profitability, Production Rate, Oil Price ?

 The Impact of Increasing Oil Prices to the

Division of Increasing Profit ?
 IX. Trends and Challenges
(Related to Fiscal Design)

 Royalty, Cost Recovery Limit, Profit Oil Split tend to

subject to sliding scale instead of fix rate.

 The idea is the more profitable the field(s), the more

percentage of Government portion should be.
 Basis for Profit Oil Split

Fixed? or Sliding Scale?

Gross
Production

The Parameters:
- Production (Daily or Cumulative)?
Royalty
- Oil Price?
- Water Depth?
- API Gravity?
Host Cost Oil
Country Recovery Company - Etc.

Profit Oil
Profitability Based?
- ROR
- “R” Factor
Tax
Basis for Profit Oil Split
Profitability based (?)
Gross
Production

Royalty

Host Cost Oil

Country Recovery Company

Profit Oil

Tax

● More complicated from an

administrative standpoint?
● Gold plating issue?
 The Effect of Increasing Oil Prices

In some types of upstream petroleum contracts, the Government Take, in fact,

becomes lower as the oil prices increase (profit increase)

High Oil
Prices

NET 25%
Investor
PROFIT
Low Oil
75%
Prices 20% Host Country

80%
 How to Improve Government Share?

● Increasing State Participation?

Gross
Production ● Introduce “Windfall Profit Tax”?
● “Price Cap Formula”?
Royalty ● DMO Price ?

Host Cost Oil

Country Recovery Company

Profit Oil

Tax
 Issue on Goldplating

“Goldplating” –
Inefficiencies in the fiscal
system that may encourage
the investor to spend more
than it otherwise would

Saving Index (SI): part of an

additional one dollar in profit
(arising from a one dollar
saving in cost) that accrues
to the Investor

SI = 20 cent (from 1 dollar cost saving)

“Goldplating” and Saving Index (SI) concept in upstream Petroleum Contract was originally introduced by
Daniel Johnston.
 Conclusions:
 The objective of a host government is, inter alia, to maximize the nation’s wealth
derived from the exploitation of its natural resources by encouraging appropriate
levels of exploration and production activity.

 The objective for the IOC is to gain access to these natural resources and to
maximize the value to its stakeholders.

 How costs are recovered and profits divided through time are the basic questions
when considering a fiscal system.

 As risks can differ substantially for different projects and countries, a petroleum
contract model that provides an optimal outcome under all circumstances is not
likely to be developed, a “one-size-fits-all model does not exist”

 Designing an adequate fiscal regime has to take into account the geological,
economic and political contexts of the country along with its short- and long-term
objectives.
Thank You