taxation of natural gas projects graham kellas 25 · 2008. 9. 26. · draft taxation of natural gas...

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TAXATION OF NATURAL GAS PROJECTS

Graham Kellas

September 25, 2008

This paper was prepared for the IMF conference on Taxing Natural Resources: New Challenges, New Perspectives, September 25-27, 2008. It is work in progress: please do not cite without permission. Views expressed here should not be attributed to the International Monetary Fund, its Executive Board, or its management.

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Taxation of Natural Gas Projects

Graham KellasWood Mackenzie Ltd.

IMF Resource Tax ConferenceWashington DC, September 2008

IMF Resource Taxation Conference 2008 - 2


The taxation of gas production is varied around the world and often highly complex. There are normally several links in the value chain between producer and consumer and each link seeks a share of the economic rent generated.

Gas prices are often established in other countries or regulated for domestic consumers. This presents a variety of issues and choices which need to be addressed in the fiscal regime.

This presentation identifies the topics involved and highlights some of the different policies being pursued.

Introduction>



Contents

Natural gas projects• natural gas value chain

• defining the taxable entity

• upstream vs mid/downstream vs integrated taxation

Natural gas pricing & taxation• subsidised prices or Government Take?

• deriving tax prices from final market prices

• upstream natural gas prices

Gas vs oil fiscal termsImplications for fiscal policy

Appendix: Global LNG projects



Natural Gas ProjectsNatural Gas Value Chain

Gas Production

Gas Production

Processing / liquefaction

Processing / liquefactionPipelinePipeline TransportationTransportation ConsumerConsumer

Price /Rent?

Price /Rent?

Price /Rent? Market Price

Re-gasification / distribution /

power generation

Re-gasification / distribution /

power generation

Price /Rent?

Upstream RegimeMid/downstream Regime

Note: number of links in each chain depends on the project (e.g. gas may be sold directly to consumer after processing)



Natural Gas ProjectsNatural Gas Value Chain

The chain can be ‘segmented’ – i.e. different ownership of each link – or ‘integrated’ – i.e. the same companies own the entire chainMost integrated projects are either LNG exports or domestic power generation (IPP)Major distinction between domestic and export sales = prices

• domestic energy prices in developing countries are normally regulated and kept as low as possible - although currently they are almost universally increasing

• export prices normally significantly higher and agreed under long term sales contracts, often with some linkage to oil prices

Another distinction = costs• export of gas normally incurs significant additional processing and transportation costs

In a segmented chain, ‘arm’s length’ agreements will tend to dictate the price and level of economic rent achieved in each linkGovernment may own one or more links of the chain and remove any economic rent from its links (e.g. early Indonesian LNG plants)Where there is common ownership but differentiated tax systems for each link, there are no ‘arm’s length’ prices and proxy transfer prices need to be establishedThe alternative is to treat the entire project as the taxable entity



Elements of the fiscal regime may only apply to specific links in the chainMid/downstream elements tend to be treated as general industrial projects and are subject only to standard corporate income tax

• major projects, such as greenfield LNG plants, may also receive fiscal incentives such as tax holidays

Upstream production tends to be subject to more complex fiscal terms• bonuses, royalty, production sharing, windfall profits taxes

• corporate income tax may also be payable or replaced with a special petroleum profit tax

• oil and gas production may be treated separately or together for tax purposes

• individual licences or fields may be ring-fenced for elements of the fiscal regime

The fiscal ‘take’ tends to be much higher from upstream than mid/downstreamOnly projects which have a fiscal ‘ring fence’ around the entire project are truly ‘integrated’ -if different tax systems apply to upstream and mid/downstream then, even with common ownership, the project is ‘segmented’

Natural Gas ProjectsDefining the taxable entity



Natural Gas ProjectsUpstream vs mid/downstream vs integrated taxation

Common ownership of upstream and mid/downstream operations and differentiated tax systems creates an incentive to manipulate transfer prices and keep as low as possible –government needs to carefully monitor proxy transfer pricesAlternative of including mid/downstream with upstream is rare because:

• only really works if all gas supplies come from a single source (e.g. field or licence/contract area)• difficult to apply if upstream producers are also selling gas to other projects• downstream cost recovery will delay higher government take from upstream

There are some examples:• Rasgas LNG (Qatar) – development of North Field gas subject to consolidated royalty/tax regime• Yemen LNG – all gas comes from Block 18 PSC area and special PSC terms apply to gas production with

downstream costs included in cost recovery• Snøhvit LNG (Norway) – onshore operations are liable to 28% corporate tax but not the offshore 50% special

tax. All offshore operations are consolidated for tax purposes and investors preferred the entire Snøhvit LNG project to be treated as offshore - with accelerated depreciation - and receive immediate tax relief at effective 78% rate from oil revenue, even though future profits will be liable to tax at the 78% rate

• North West Shelf LNG (Australia) – mid/downstream costs included in the upstream ring fence for royalty, excise and tax purposes

• Okpai IPP (Nigeria) – all capital costs are allowed to be consolidated with the Eni JV’s oil operations and receive 85% tax relief, with upstream gas profits (which are minimal) taxed at 30%



Natural Gas ProjectsSegmented taxation example: Malaysian LNG

Source: Wood Mackenzie’s LNG Service

UPSTREAMTAX SYSTEM

DOWNSTREAMTAX SYSTEM

PLANTGATE



Natural Gas ProjectsIntegrated taxation example: Yemen LNG


INTEGRATEDPSC TERMS



Natural Gas Pricing & TaxationSubsidised prices or Government Take?

Domestic gas pricing and fiscal policies must be developed simultaneously

• Subsidised consumer prices can often render projects uneconomic

• Fiscal terms need to be adjusted to take this into account

• Regressive fiscal terms (i.e. revenue rather than profit based) can be particularly harmful in a low price environment

In extreme cases, government may have to subsidise producers as well

• e.g. Nigerian domestic prices have been so low that only oil producers who receive 85% tax relief on capital costs (but pay 30% tax on gas profits) can supply gas economically

Government must decide between subsidising consumers and collecting fiscal revenue

-2

-1

-

1

2

3

4

5

6

7

8

9

Domestic Export

US$

/mm

btu Govt Take / Company Profit

Dow nstream Costs

Upstream Costs

Consumer Price

Source: Wood M ackenzie

Gas price too low

-2

-1

-

1

2

3

4

5

6

US$

/mm

btu Company Prof it

Government Take

Upstream Costs

Maximum Dow nstream Price

Source: Wood M ackenzie

Government Take too high



Major challenge for taxation of export projects• ensure the country netback is fair• there is a very limited number of reported global FoB gas prices• also normally very few, if any, comparable projects in-country• most export sales are under long term contracts and terms can reflect

numerous factors, so prevailing price for one contract may not be relevant to current market conditions – e.g. price floors and ceilings often apply

• contract prices should reflect and/or be linked to established spot market prices (e.g. Henry Hub), less differentials

Establishing deductible costs between final market and export prices• Buyer may pay for gas when it receives it, for final use, or at the wellhead

or somewhere in between• LNG delivery to to consumer involves shipping, re-gasification and

delivery to market• Integrated project owners may control each of these links and have an

interest in moving economic rent to lowest-taxed link• Tanker freight rates are quoted and can be benchmarked against internal

charges to project• Pipeline tariffs could refer to established FERC/NEB regulations in US

and Canada (based on cost recovery plus regulated return)

Natural Gas Pricing & TaxationDeriving tax prices from final market price

Consumer Price(gas sales agreement)

Export Price(basis for taxation)



Natural Gas Pricing & TaxationExample methodology for defining the netback price for an LNG project

FOB Price = Henry Hub Price x (100-(A+B+C))% – (W+X+Y+Z)A+B+C = losses (c. 5%-10% of loaded volumes); W+X+Y+Z = tariffs

Define 3 -4 generalregas areas in GOM

Assess basis differentialsfor each area

Assess regas projectsunder development orwith a high probability

of development

Assess typical scale ofregas projects

Assess capex & opexbased on published

data

Calculate appropriateregas tariff for notional

terminalY

Define averagedistance to

notional terminal

Assess pipelineconnections around

each area

Calculate averagebasis differential

across the 2010 -2020 timeframe

W

Assess average pipeline lengths

Calculate appropriatepipeline tariff

Regas losses

Analysis of reasonableshipping assumptions

Boil off

Calculate appropriateshipping tariff tonotional terminal

X

B

Z

A

Pipeline losses C

Define 3 -4 generalregas areas in final market

Assess basis differentialsfor each area

Assess regas projectsunder development orwith a high probability

of development

Assess typical scale ofregas projects

Assess capex & opexbased on published

data

Calculate appropriateregas tariff for notional

terminalY

Define averagedistance to

notional terminal

Assess pipelineconnections around

each area

Calculate averagebasis differential

over relevant timeframe-W

Assess average pipeline lengths

Calculate appropriatepipeline tariff

Regas losses

Analysis of reasonableshipping assumptions

Boil off

Calculate appropriateshipping tariff tonotional terminal

X

B

Z

A

Pipeline losses C

Source: Wood Mackenzie



Natural Gas Pricing & TaxationSharing in trading upside

Market A$8 /mmbtu

Market B$12 /mmbtu

ProducingCountry

Buyer takes delivery of LNG on FOB basis at the LNG plantBuyer agrees FOB contract price with producers based on netback from sales price in Market A on expectation that cargoes will be delivered to Market ABuyer realises Market B is paying premium (e.g. $4 /mmbtu) and diverts cargo to Market BBuyer gains entire upside unless sales agreement specifically provides for sharing any gainsFoB contract pricing formula could provide a price “floor”, based on Market A, but if the realised price is greater then the difference is shared



Government owns gas and only reimburses costs, e.g. Algeria, Oman, UAEGovernment establishes prices for royalty/taxation purposes e.g. Alberta’s “select prices”Spot markets: currently US, Canada and UK and beginning to develop in EuropeGas price formulae are established in upstream contract, e.g. Egyptian PSCConsumer contracts

• normally 20-30 years with volume and price commitments – this is the most common form of pricing for direct sales to consumers in developing countries

• consumer contracts for export sales are normally agreed with the plant owners and the upstream “share” of the price (i.e. netback) needs to be established

Consumer price netbacks• upstream receives final sales price less regulated tariffs/tolls payable to mid/downstream

operations (e.g. Indonesia, Trinidad (Atlantic LNG 2/3/4))• upstream receives a fixed % of FOB sales price (e.g. Nigeria LNG)• upstream and downstream agree sharing of final sales price (e.g. Trinidad (Atlantic LNG 1))

If upstream and mid/downstream owners are the same but tax rules are different, a proxy transfer price is required

Natural Gas Pricing & TaxationUpstream natural gas prices



LNG price

Capital annuity on upstream capital (including risk premium)

Capital annuity on downstream capital (including risk premium)

Gas

Tra

nsfe

r Pric

e

Netback

GTP

Cost Plus

Upstream operating cost

Downstream operating costs

Source: Australian Government (Department of Resources, Energy & Tourism)

Ongoing capital costs changes GTP over time

Natural Gas Pricing & TaxationEstablishing a proxy upstream price: example

Australia’s residual pricing mechanism establishes a transfer price for integrated LNG projects which shares the “value gap” between upstream and downstream operationsUpstream is subject to Petroleum Resource Rent Tax (PRRT), mid/downstream is not



Differentiating Fiscal TermsGas vs Oil - 1

Upstream gas project economics are normally much less robust than oil• lower prices per boe (either domestic regulations or export netbacks)

• higher transportation costs

• longer, flatter production profiles (which impacts the “present value” of future production)

To compensate, many governments offer fiscal incentives to gas• lower royalty rates (e.g. Nigeria, Tunisia, Vietnam)

• higher cost recovery ceilings and/or profit shares (e.g. Egypt, Indonesia, Malaysia)

• lower tax rates (e.g. Nigeria, Tunisia, Papua New Guinea)

• exemption from certain oil taxes (e.g. Trinidad & Tobago (SPT))

Alternative approach is to levy additional taxes on export sales to reduce incentive to export• e.g. Argentina, Russia

Where local gas prices are not regulated, fewer (if any) incentives offered• e.g. USA, Canada, Norway, UK

• can create problems if a divergence between oil and gas prices emerges



Differentiating Fiscal TermsGas vs Oil - 2

Increasing trend toward linking fiscal take to project profitability enables the same fiscal terms to apply to oil and gas

• automatically provides lower take from less valuable projects and vice versa

Major issue in differentiated fiscal regimes is the treatment of liquids associated with gas production (condensate) – treat as oil or gas revenues?

• high liquids content reduces breakeven gas prices and can often “make or break” gas projects

• very high taxation (i.e. oil rates) on condensate can nullify this – e.g. recent changes in taxation proposed for North West Shelf gas project in Australia

• particularly important issue when gas is associated with oil production

Many PSC regimes only include terms for oil; gas will be subject to separate agreement• if gas is associated with oil, it may be delivered to government for free, with upstream

development and operating costs recoverable from oil revenues

• non-associated gas will be subject to separate agreement – and government may argue that the existing PSC owners have no rights at all to gas discoveries



Conclusions and implications for fiscal policy

Domestic gas pricing and fiscal policies must be developed simultaneouslyIf upstream and downstream fiscal regimes are different – which is normal – there is a strong rationale for upstream and mid/downstream operations to be segmentedWhere ownership of upstream and mid/downstream operations is the same, a proxy transfer price needs to be establishedAlternative approach is to have a separate tax regime for integrated gas projects and treat the entire project as the taxable entityRole of national oil company normally very important as it may have different equity interests in upstream and mid/downstreamIn integrated export projects, government needs to closely monitor and benchmark agreed market prices and costs in each link of the chain to ensure taxable income is fairly calculatedGovernment and producers should aim to share in realised market prices which are greater than expected – needs to be addressed in gas sales agreementsGas projects may require more attractive fiscal terms than oil projects - although fiscal terms linked to project profitability could apply to bothWhere liquids are taxed at a higher rate than gas, it is important to consider how condensate is treated – if liquids, then higher tax revenue, but also a higher price will be required for gas



AppendixGlobal LNG Projects


Regas - ExistingSupply - Existing Supply - Under Construction Regas - Under ConstructionSupply - Proposed Regas - Proposed

Kenai

Peru LNG

Atlantic LNG 1Atlantic LNG 2Atlantic LNG 3Atlantic LNG 4Train X

Algeria LNGSkikda RebuildArzew Exp.

Iran LNGPars LNGPersian LNG

Snohvit

NLNG BaseNLNG ExpansionNLNG PlusNLNG 6NLNG VII+

Delta Caribe LNG

EG LNGEG LNG 2

Marsa El BregaMarsa El B. Exp.

DamiettaDamietta Exp.ELNG 1ELNG 2

Angola LNG

Yemen LNG

ADGAS

OLNGQalhat

RasGasRasGas IIRL 3

QatargasQatargas-2Qatargas-3Qatargas-4

Sakhalin 2Sakhalin

Arun

MLNGMLNG DuaMLNG Tiga

Brunei

Bontang

TangguhTangguh Exp.

North West ShelfPlutoGorgonScarboroughWheatstoneGorgon Expansion

DarwinIchthysBrowseGreater Sunrise

PNG LNG

Shtokman

CurtisGladstoneGLNGSun LNG

Brass LNGOK LNGNigeria Flex



Graham KellasVP, Energy ConsultingT: +44 203 060 0452E: [email protected]

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