Balancing Upstream Investment Performance and Government Take:

Empirical Evidence of the Mechanics and Impact of Petroleum Fiscal Terms

By

Adeogun Oyebimpeadeogunoyebimpe@gmail.com

Omowumi IledareWumi.iledare@yahoo.com

Emerald Energy Institute, University of Port HarcourtNigeria

1

40th International Association for Energy Economics Conference, Singapore, 2017

Presentation Outline

• Overview

• Fiscal System Design

• Balancing Prospectivity and Contract Terms

• Global Exploration Prospectivity and Risk

• Model Specifications and Assumptions

• Performance Metrics and System Measures

• Results

• Conclusion

2

Elements of Petroleum Fiscal Systems (PFS)• Describe the legislative, tax,

contractual and fiscalelements under whichpetroleum operations areconducted in a petroleumprovince, region or nation.

• Define the relationshipbetween mineral owners(host government) and the oiland gas companies (IOC,NOC, & DOC).

• Determine equitably howcost are recovered andprofits are shared betweenfirms, the host governments,and mineral owners.

3

Fiscal System DesignThe following are criteria for an efficient and effective fiscal regime:

• Promote healthy competition and market efficiency

• Discourage undue speculation

• Ensure a fair return to all stakeholders, balancing risk and reward

• Ensure stable business environment and minimize risks

• Allow enough flexibility to accommodate changes in perceived prospectivity and economic conditions

4

Classification of Petroleum Fiscal Systems

5

• Resource Ownership• Taxation mechanism and imposition

Source: Johnston 2003, Hassan 2016

Elements of Petroleum Fiscal Systems

6

7

Global Fiscal Regime Distribution

8Source: Hassan, 2016

Balancing Prospectivity and Contract TermsProspectivity• Expected field size distribution

• Petrophysical characteristics: porosity, permeability, hydrocarbon saturation, etc.

• Well deliverability

• Estimated success probability: Source, seal, reservoir, migration, etc.

• Oil vs gas: fluid properties, API gravity, was H2S etc.

• Data: quality and quantity

• Exploration Drilling Success

• Post Discovery costs: development drilling, production facilities, transportation cost, operating costs

• Water depth and climate

• Political risk

Contract Terms• Type of system: PSC, Service, R/T

system

• Signature bonus

• Working program: seismic and relinquishment, drilling expenses, timing, bank guarantees

• Royalty

• Cost recovery limit

• Effective royalty rate

• Government take

• Government Participation

• Entitlement

• Cost savings Index

• Ring-fencing

• Crypto taxes

• Contract stability9

Source: Johnston, 2003

Balancing Prospectivity and Contract Terms

• Regions with unfavourable geological prospectivity generally

have higher costs and lower wellhead hydrocarbon prices offer

the best and most lenient fiscal regimes

• On the contrary, those with excellent geological prospectivity,

lowest production costs and higher wellhead prices offer the

toughest fiscal system.

• A fundamental theme in the industry is creating a balance

between the two extremes

• Issues arising in fiscal regimes bothers on how profits are shared

and costs are recovered.10

Global Exploration Prospectivity and RiskRegion Risk/Business

ClimateFiscal System Exploration

PotentialTypical Exploration Cost

Argentina Good Business Climate

Good Same potential as the US 30 years ago

US $3-4 MM

West Africa Harsh Political risks Fair to good terms

Rich/Virgin Potential, Lots of Deepwater

Shallow water: US $8-12 MMDeepwater: US $ 14 – 35 MM

United Kingdom Excellent Infrastructure, Market for gas, good business climate, Green peace risk

Excellent terms Geologic targets are smaller

US $ 7 – 9 MM

Australia Good market for gas in many areas

Very good Variety of plays onshore, offshore

Low Cost environment

Gulf of Mexico Market for gas Excellent. No ring-fencing

Multiplay prospects but smaller targets

Low Cost environment: US $ 3-4 MM; Deepwater : US $ 20 –30 ++ MM

China High Risk/Low risk available

Terms are negotiable but government understands market

All kinds of deals available onshore/offshore

Low cost driven hydrocarbon province.

11Adapted from Johnston, 2003

Model Specification and Assumptions

• Hypothetical 50 MM bbl field located onshore is evaluated under different fiscal regimes.

• Technical costs were assumed to be the same for the different fiscal regime.

• Fiscal cost was dependent on legislated terms

• Performance and system measures evaluated are Internal rate of return(IRR), Front Loading Index (FLI), Savings Index (SI) and Host Government Take (HGT)

• Hurdle rate was assumed to be 15%

12

Model Input ParametersInput Parameters

Production period 25years

Estimated Reserve 50MMBBL

Initial Oil Production 4500BOPD

Build up period (Oil) 2years

Oil Peak rate 6849BOPD

Plateau Period (Oil) 3years

Total Period 28years

Build up production 2.5MMBBL

Plateau production 7.5MMBBL

Effective Decline rate (Oil) 0.021

Total Wells to drill 5

Average Well cost 15$mm

13

Model SpecificationAfter Tax Net Cash Flow for concessionary and contractual systems are given in equation (1) and (2) as follows:

NCF = GRt – ROYt – CAPEXt – OPEXt – BONUS t – TAXt – OTHt 1

NCF = GRt – ROYt – CAPEXt – OPEXt – BONUS t – PO|Gt - TAXt – OTHt 2

Where:

NCF = After Cash Net Cash Flow in year t

GRt = Gross Revenue in year t

ROYt = Total Royalties paid in year t

CAPEXt = Total capital Expenditure in year t (Both tangible and intangible)

OPEXt = Total Operating Expenditure in year t

BONUS t = Total Bonus paid in year t

TAXt = Total taxes paid in year t

OTHt = Other costs paid in year t

PO|Gt = Profit oil share to the government in year t

14

Performance Metrics and System MeasuresThe IRR is simply the discount rate at which the NPV becomes 0. Mathematically expressed as:

• 𝑁𝑃𝑉 𝑟, 𝑡 = 𝑡=0𝑁 𝑁𝐶𝐹 𝑡

1+𝐼𝑅𝑅 𝑡 = 0 3

• 𝐹𝐿𝐼 =𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑒𝑑 𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝑇𝑎𝑘𝑒

𝑈𝑛𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑒𝑑 𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝑇𝑎𝑘𝑒− 1 4

𝐻𝑜𝑠𝑡 𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝑇𝑎𝑘𝑒, 𝑡𝐻𝐺 =𝑁𝑃𝑉 (𝐻𝐺𝑇)

𝑁𝑃𝑉 𝐶𝑇 + 𝑁𝑃𝑉 (𝐻𝐺𝑇)5

Where:

𝑁𝑃𝑉 (𝐻𝐺𝑇) = Net present value of host government take,

𝑁𝑃𝑉 (𝐶𝑇) = Net present value of contractor take

r is the discount rate or the cost of capital.

15

Deterministic Model Results

16

80.00%

85.00%

90.00%

95.00%

20 30 40 50 60 70 80

HG

T (%

)

Oil Price ($/bbl)

Impact of Oil Price on Fiscal Regimes

Concessionary System

Contractual System

Deterministic Model Results

0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00%

IRR

SI

FLI

FLI, SI, IRR (%)

Contractual

Concessionary

17

Stochastic Simulation Results

89.7168% 89.8993%

5.0% 5.0%90.0%

0

200

400

600

800

1000

1200

1400

1600

1800

89

.65

%

89

.70

%

89

.75

%

89

.80

%

89

.85

%

89

.90

%

89

.95

%

90

.00

%

90

.05

%

90

.10

%

90

.15

%

Concessionary Host Government Take Statistics / (%)

Und…

18

86.483% 87.251%5.0% 5.0%90.0%

0

20

40

60

80

100

120

140

160

180

200

85

.5%

86

.0%

86

.5%

87

.0%

87

.5%

88

.0%

88

.5%

89

.0%

89

.5%

Contractual Host Government Take Statistics / (%)

Undiscounted TakeStatistics /HOSTGOVTA(CITA)($MM)

Stochastic Simulation Results

19.231% 22.336%

5.0% 5.0%90.0%

0

10

20

30

40

50

60

18

.0%

18

.5%

19

.0%

19

.5%

20

.0%

20

.5%

21

.0%

21

.5%

22

.0%

22

.5%

23

.0%

23

.5%

Concessionary/Internal Rate of Return / (%)

InternalRat…

19

17.868% 19.812%5.0% 5.0%90.0%

0

10

20

30

40

50

60

70

80

17

.0%

17

.5%

18

.0%

18

.5%

19

.0%

19

.5%

20

.0%

20

.5%

Contractual/ Internal Rate of Return (%)

InternalRate ofReturn /CONTRACTOR A(CITA)($MM)

Stochastic Simulation Results

0.04362 0.063305.0% 5.0%90.0%

0

10

20

30

40

50

60

70

80

0.0

35

0.0

40

0.0

45

0.0

50

0.0

55

0.0

60

0.0

65

0.0

70

0.0

75

Concessionary FLI / (%)

FLI /H…

20

0.0781 0.10315.0% 5.0%90.0%

0

10

20

30

40

50

60

0.0

4

0.0

5

0.0

6

0.0

7

0.0

8

0.0

9

0.1

0

0.1

1

0.1

2

Contractual FLI / (%)

FLI / HOSTGOVTB4(CITA)($MM)

Discussion• Progressive fiscal instruments should be incorporated in the

fiscal systems of regions with high geologic prospectivity.

• The model outputs are IRR, SI, HGT and the FLI. It is observed that under different fiscal regimes, there is a 90% confidence that the IRR can vary from 19.23% - 22.34% and 17.87% to 19.84% for concessionary and contractual systems respectively for a hurdle rate of 15%. Under the same assumptions, the HGTvaries from 89.72% - 89.90% and 86.44% to 87.25% for both fiscal systems respectively. The FLI shows a range from 0.04 –0.06 and 0.08 – 0.10.

• Fiscal regimes with high FLI are less attractive to investors. An ideal system has FLI = 0, which suggests that there are no front loading terms.

21

Concluding Remarks• Host government of regions with geological

prospectivity should design fiscal systems that are flexible, stable and progressive in order to attract investment opportunities in the upstream oil and gas industry

• Profitability indicators such as Internal Rate of Return (IRR), Host Government Take (HGT), Savings Index (SI) and Front Loading Index (FLI) are measures used by investors to evaluate the performance of oil and gas assets.

• The use of progressive and effective fiscal terms are essential to create a balance between prolific geologic prospectivity and fiscal contract terms.

22

23