FUNDAMENTALS OF PETROLEUM ECONOMICS

AND PROPERTY EVALUATION

Petroleum Economics
This course teaches the fundamentals of petroleum Economics from two
key perspectives, the Government and Investor.
Module 1:

• Economic rents

• Production Decline Curves

• Cash Flow

• Depreciation methods

• Time value of money

• Profitability analysis in oil and gas investments

• Risk and Uncertainty in oil and gas exploration

• Fiscal devices and their effects applied to petroleum exploitation

• Production sharing systems – effects and clauses
• Nigerian Petroleum profit tax law
International Petroleum Taxation

Module 2:

Modelling of oil and gas fiscal systems

• Constructing a spreadsheet post-tax computer model

• Business Game: Negotiating an Exploration Contract
 Production Decline Curves
• Forecasting future production is the most important part of
the economic analysis of exploration and production
expenditure

• It is usually based on little if any actual production

performance
– Hence the weakest part of our analysis

• It is a useful tool for forecasting future production during

capacity production during production from wells, leases or
reservoirs

• The basis of this procedure is that factors which have

affected production in the past will continue to do so in the
future
Factors to Characterize Decline Curve
• Decline curves can be characterized by three factors:

1. Initial production rate or rate at some particular time

2. Curvature of the decline and
3. Rate of decline

• These factors are a complex of function of numerous

parameters within :

– the reservoir,
– wellbore and
– surface handling equipment
Factors that contribute to the Character of
Decline Curves
Formation parameters include:

– Porosity
– Permeability
– Thickness
– Fluid saturations
– Fluid viscosity
– Production mechanism and
– Fracturing
Factors that contribute to the Character of
Decline Curves
Wellbore parameters include:

– Hole diameter
– Formation damage
– Lifting mechanisms
– Solution gas
– free gas
– Fluid level
– Completion interval and
– mechanical conditions
Factors that Directly Affect the Decline
in Production Rate
• These factors include:

– Reduction in average reservoir pressure

– Increases in the field water cut in water drive fields

– Increases in the field gas-oil ratio in depletion type fields

– Reduction in the liquid levels in gravity drainage fields

Conditions that must Prevail before Decline
Curve Analysis
1. Production must have been stable over the period being
analyzed

2. That is the well must have been produced with constant

choke size or constant wellhead pressure

3. Pumping well must have been pumped off or produced

with constant fluid level

4. The production decline observed should truly reflect

reservoir productivity and not be the result of external
causes such as:
– Change in production conditions
– Well damage
– Production controls
– Or equipment failure
 Uses of Production Decline Curves

• Estimation of performance of a well or reservoir in the absence

of change and compare it to the actual performance when there
is a change

– Such comparison enable us to determine the technical and

economic success of our efforts

• It is also used in the evaluation of new investment and the audit

of previous expenditures
Uses of Production Decline Curves
• Associated with it is the sizing of equipment and facilities
such as pipelines, plants and treating facilities

• Also associated with the economic analysis is the

determination of reserves for a well, lease or field

• It is an independent method of reserve estimation the result

which can be compared with volumetric and MBE methods
 Economic Limit
This is the end of production
decline curve
qi

It is defined as the production rate observed predicted

that will just meet the direct q

operating expenses of a well.

qa

In determining the economic limit it 0 t1 t2 t

is advisable to analyze the
expenditure charged against a well
and determine how much would
actually be saved if the well were
to be abandon
 Economic Limit

• Reduction in the direct operating costs and increase in

crude oil or natural gas price increases the amount of
economically recoverable oil or gas

• While increase in direct operating costs and reduction in

crude oil or natural gas price causes a reduction in the
economically recoverable oil or gas
 Example
Determine the economic limit rate for a well using the
following information data:

• Crude oil price per barrel = $30

• Severance tax = 5%
• Ad valorem tax = 3%
• Royalty = 12.5%
• Estimated direct operating
cost at economic limit = $2,800/month
 Solution
Net income per barrel = royalty * severance tax* ad valorem
tax* price of crude

= 7/8(1-0.05)(1-0.03)(30) = $24.19

= 3.81 gross bbl/day = 116 gross bbl/day

 Classification of Decline Curves
• There are three commonly recognized types of decline
curves:

– Constant Percentage decline curve(exponential)

– Harmonic decline

– Hyperbolic decline
Classification of Decline Curves
Characteristic shapes of Decline Curves
For constant –percentage decline,
– rate versus time is a straight line on a semi-log paper
– And rate versus cumulative is a straight line on
coordinate paper

• For harmonic decline:

– rate versus cumulative is a straight line on a semi-log
paper
– All other plots give a curvature

For Hyperbolic
– All plots gives a curve
 Ideal Decline Curve
qi

observed predicted
(2)
q

qa

0 t1 t2 t
• The t=0 point can be chosen
arbitrarily
• Q is the oil or gas production rate
• t is time
• The area under the curve between t1
and t2 is a measure of the
cumulative production during this
time period given as:
 Nominal and Effective Decline
• The effective decline rate per unit time D’ is the drop in
production rate from qi to qi+1 over a period of time equal to
unity ( 1 month of I year) divided by the production rate at
the beginning of the period

(3)

Where:
qi = production rate at time t
qi+1= production rate 1 time unit later
 Effective Decline
• It is a stepwise function, hence in agreement with actual
production practices
• D’ is the decline rate more commonly used in practice
• D’ is commonly expressed as a percentage

q1
q2
q3
Production rate, q

qt qt+1

0 1 2 3 Time, t
 Nominal Decline (D)
• This is also called instantaneous or continuous decline rate

• D is defined as the negative slope of the curvature

representing the natural logarithm of the production rate
(q) versus time (t)
or

(4)
dq
q

dt

t
 Constant Percentage Decline
• A plot of production rate versus time is generally a curve but
the plot of production rate versus cumulative production is
sometimes a straight line on the Cartesian coordinate paper

• The equation that governs the straight line is given as:

(5)

Where:
qi = production rate at the beginning of decline
QD = cum. Production when rate equals qt
α = slope of the straight line
Constant Percentage Decline
• If q versus QD is a straight line, the
nominal decline rate is equal to the slope
qi
of the straight line and is constant

• Hence the name constant- percentage

q decline

qa

QPD QPDa

• Rate versus Cum. production

Constant Percentage Decline
• It is the simplest, most conservative and most widely used decline
curve equation

• The decline is most frequently used for the following reasons:

1. Many wells and fields actually follow a constant-percentage
decline over a great portion of their productive life.
 They only deviate significantly towards the end of the this period

2. The mathematics of constant –percentage decline are much

simpler and easier to use than the other two types of decline
curves

3. The divergence between a constant-percentage and the other

types of decline occurs frequently quite a few years in the future
 Constant Percentage Decline
• From equation (5)

(6)

• Differentiating equation 5 wrt time yields

(7)
But

(8)

Hence, (9)
 Constant Percentage Decline

• This is the equation that describes constant percentage

decline

• It states that the instantaneous or nominal decline rate is a

constant percentage of the instantaneous production rate

• The rate-time relation can be derived by integrating eq (9)

(10)

Or
(11)
 Constant Percentage Decline
• The rate-cumulative relation may be obtained by
integrating eq (11):

(12)

Or
(13)

Or
(14)
 Useful Plots of Constant Percentage
Decline
• Taking logarithms of eq(11) gives:

(15)

• A plot of logq versus t on a Cartesian coordinate will give a

straight line with slope given as:

(16)

• Extrapolation of the straight will yield future production

rates until the economic limit is reached (qa)
 Useful Plots of Constant Percentage
Decline
• Another useful plot is made by making a plot of q versus
QD
• This will also give a straight line and the nominal decline
rate can be determined using the expression:

(17)
• The reserve at any time can be determined using the
equation:
(18)
• Maximum amount of oil or gas producible regardless of
economic consideration is given as: qi/D.

• The number (qi/D) is sometimes called the “ movable oil or

movable gas”
 Relationship between Effective and
Nominal Decline Rates
• From the definition of effective decline rate considering a
unit time is:
(19)

• Also, for 1 time unit, eq(11) becomes:

(20)
• From eq (19) & (20):

(21)
 Relationship between Effective and
Nominal Decline Rates
• Where r is the ratio of production rates of successive years

Thus

(22)

and
(23)
 Relationship between Annual and Monthly
Effective and Nominal Decline Rates
• From eq (19):

(24)
• Where Da’ and Dm

• Also from eq (20):

(25)

Or
Da = 12 Dm (26)
Where Dm is the nominal monthly decline rate and Da is the
nominal annual decline rate
 Time to Reach Abandonment
• The time to reach abandonment is given as:

(27)

• or

(28)
 Conditions where Constant-Percentage
could be Applicable

• Production above bubble point follows this decline exactly

• Production from solution drive reservoirs approximates it

closely
 In Terms of Annual Decline Rate
• Considering an annual average production rate for year 1 ( )

• Then cumulative production for t years (QD) will be:

(29)

• For constant percentage decline with an effective annual

decline rate:

(30)
 In Terms of Annual Decline Rate
• Substituting eq (30) into 29 yields

(31)

• Multiplying through by and subtracting from

eq(29) yields:

Or
(32)

The relationship btw annual and instantaneous production

rates is :
(33)
 Reserve to Production Ratio
• (Q/q) is a useful evaluation and a screening tool

• It is dependent on reservoir and fluid parameters as well

as well and produced fluids conditions

• The ratio can be related mathematically to the remaining

life of the producing unit being analysed and the rate of
annual production decline

• Assuming a constant percentage decline, eq (32) can be

written as:
(34)
 Reserve to Production Ratio
• But by definition, constant percentage decline is given as:

(35)

• Therefore, substituting eq(34) into (35) gives:

(36)
 Reserve to Production Ratio
Where:
Qo = remaining reserves at the end of previous year
= previous year’s production
= current year’s production
D’ = effective annual decline rate
t = remaining life, years
 Implications of Q/q
• Normally, a producing unit will exhibit (Q/q) of between 2
and 10 during two-thirds of its producing life

• It is higher during the early development period

• Approaches 1.0 for the year of abandonment

• A higher than normal value is an indication that the

reserves are not fully developed or that they are overstated

• A high Q/q ratio occurs if there are significant reserves

behind pipe awaiting future recompletion( e.g multipay or
highly faulted field)
 Implications of Q/q
• The high Q/q ratio also indicates that the reserve estimate
is too high due to poor reservoir and/or geologic data

• Or it may indicate that the recovery efficiency is less than

expected

• Very tight reservoirs will also exhibit high Q/q ratios,

• Thus a high Q/q indicates that further evaluation is

needed
 Implications of Q/q
• A low Q/q indicates that the reserve may be underestimated

• Or that there may have been a recent change in production

performance

• A high permeability reservoir also tends to have lower Q/q

than normal

• Thus a low Q/q can also indicate that additional evaluation is

needed
 Example

• Using the following production qo(bbl/day) Np(bbl)

data, estimate 200 1.00E+04
210 2.00E+04
a) The future production down to a 190 3.00E+04
rate of 50bbl/day 193 6.00E+04
170 1.00E+05
b) Instantaneous (nominal or 155 1.50E+05
continuous) decline rate 130 1.90E+05
123 2.20E+05
c) Effective monthly and annual 115 2.30E+05
decline rates 110 2.40E+05
115 2.50E+05
d) Extra time necessary to obtain
future production down to
50bbl/day
 Solution
250

qo(bbl/day) Np(bbl)
200 1.00E+04
200
210 2.00E+04
190 3.00E+04

Production rate (bbl/day)

193 6.00E+04 150
170 1.00E+05
155 1.50E+05
130 1.90E+05 100

123 2.20E+05
115 2.30E+05
50
110 2.40E+05
115 2.50E+05

0
0 100 200 300 400 500 600
Np ,(bbl) Thousands

rate versus cum production

 Solution Cont’d
• A graph of production rate versus Cum. Prod. Is a straight
line on the Cartesian coordinate
• This is an indication that the production follows a constant
percentage decline
(a)
From the graph:
Np = 396,000bbl at q = 50bbl/day

Future production = 396,000 – 250,000 = 146,000 bbl

 Solution Cont’d
(b)
The nominal (instantaneous) decline rate is given by the
slope of the straight line:
Picking two points on the straight line:
q= 215 bbl/day and Np = 0 bbl
and
Q= 100bbl/day and Np = 276,000bbl
Nominal daily decline
Slope Dd =y2-y1 = 100-215= -0.000417/day
x2-x1 276,000

Or from the equation of the straight line:

y= -0.0004x+211.55, the slope = -0.0004/day
 Solution Cont’d
• The nominal monthly decline rate is given as:

Dm = 30.4Dd = 30.4 * 0.000417 = 0.0127/month

And the nominal yearly decline rate will be:

Da = 12Dm = 365Dd = 12 * 0.0127/year

(c)
The effective monthly decline rate

= 1.26%/month
 Solution Cont’d
• And the effective annual decline rate:

= 14.1%/year

(d)
Time to reach production rate of 50bbl/day or remaining life :

Substituting values gives:

Therefore = 5.5 years

 Fraction of Reserve produced at a
Restricted Rate
• This is mainly used in the calculation of the schedule of
production

• It consist of mainly two segment:

– A constant production rate period(proration period) and
– A decline period

• Relationship for the fraction of reserves produced under

restricted or allowable production can be derived from rate-
cum. Production
 Fraction of Reserve produced at a
Restricted Rate
• For constant percentage decline:

qi
qr

A
A B qa B
Time
Time
 Example 2
• It has been determined from volumetric calculations that
the ultimate recoverable reserves for a proposed well are
30 MMMscf of gas by analogy with other wells in the area.
Also given are:
Nominal decline rate = 0.04/month
Allowable production rate = 400MMscf/month
Economic limit = 30MMscf/month

What is the production per year

 Solution
• Since there is no production history available, we can
assume constant percentage decline

• Cum. Production during decline can be obtained using

eq(6)

• The duration of decline period can be calculated using

eq(27)

= 64.76 months
 Solution Cont’d
• Students should complete solution
CASH FLOWS
 DEFINITIONS
• A set of Payments made by a company in any project in
order to run it are called cash out items

• Whereas payment made to the company as a result of the

project are called cash-in items

• Hence the net result of the payments for any particular

period will comprise of cash-out and cash in items

• A series of annual cash deficit/surplus figures for

successive years is what is defined as CASH FLOWS
 DEFINITIONS
• Simply; Cash Flow = Cash in- Cash out

• Cash flow of a project can either be negative (deficit) or

positive (surplus)

• The Net cash flow is the basis for all economic decisions

• It is formed from the year-by-year sums of projected

investments, income and expenses

• It could be developed on either before tax or after tax basis

• Cash flows can be expressed in terms of Real and money-

of- the- day basis
 Net Cash Flow
• Items included in the after tax cash flow analysis are both:
– cash items (monies actually received or paid) and
– noncash items( bookkeeping items required for income
tax calculation)

• Examples of cash items in the oil & gas economic

evaluations include:

– Working interest revenue, state and local taxes,

operating costs, overhead, capital investments, bonus
and leasehold costs, property sales, federal incomes
taxes capital gains taxes, investment tax credit and
windfall profits
 Net Cash Flow
• Examples of cash items in the oil & gas economic evaluations
include:
– Working interest revenue,
– state and local taxes,
– operating costs,
– overhead,
– capital investments,
– bonus and leasehold costs,
– property sales,
– federal incomes taxes,
– capital gains taxes,
– investment tax credit and windfall profits
 Net Cash Flow
• Examples of noncash items include:

– depreciation,
– depletion,
– amortization,
– deferred deductions,
– capitalized investments,
– expensed investments and
– book value
 Terms & Concepts
• Revenue : funds received by a company during a period
under consideration

• Operating Income: all the money taken in by a company

from the sale of crude oil, natural gas, natural gas liquids
and refined products

• Costs and Expenses: costs of doing business that must

be paid from the revenues received by the company

• Intangible drilling and development costs(IDC): are

certain expenses incurred by a company in drilling to
develop new crude oil and natural gas reserves. E.g
money paid for labor, fuel, repairs etc
 Terms & Concepts
• Depreciation: decline in the value of machines and plants due to wear
and tear of normal use and to obsolescence.

• Cost Depletion: the reduction in the value of an investment in producing

oil and gas acreage

• Amortization: similar to depreciation whereby the costs of certain assets

(e.g patents, copyrights, goodwill, pollution control devices) are charged
against income over a period of years

• Royalty: a right to oil and gas or minerals in place that entitles its owner
to a specific fraction in kind or value of the total production from the
property

• Working interests: an interest in the minerals in place that bears the

development and operating costs of the property
 Example of a Typical Cash Flow(Before tax)
2008 2009 2010 2011 2012 2013 2014
Assumptions
Inflation (%) 3 3 3 3 3 3 3
Oil Price (Real) $ 100 100 100 100 100 100 100
Producing days 350

Real cash flow calculations Totals

Production (bbls/d) 10000 10000 10000 7000 3000

Production (mmbbls) 14 0 0 3.5 3.5 3.5 2.45 1.05

Capex $ 4E+08 2E+08 2E+08

Opex $ 5E+08 1E+08 1E+08 1E+08 1E+08 1E+08

Revenue ($ million) 1400 0 0 350 350 350 245 105

Capex ($ million) 400 200 200 0 0 0 0 0
Opex ($ million) 500 0 0 100 100 100 100 100

Net Cash Flow ($ million) 500 -200 -200 250 250 250 145 5
A typical Cash Flow pattern of an E&P
company
ANNUAL CASHFLOW

First oil date

30
Cash Surplus ($mm.)

20
10
0
-10
-20
-30
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Cashflow
Economic
lifetime

Time (years)
 Basic algorithm for Before Tax NCF
• Net cash flow = Revenue
- capital cost
- operating
or
= Revenue
- operating cost
- overhead costs
- depreciation
- expensed investment
- depletion
 Basic algorithm for After Tax NCF
Net Cash Flow = Gross Revenue
- Royalties
- Tangible capital costs
- Intangible capital costs
- Operating costs
- Bonuses
- Taxes
Or
= Gross Revenue
- Royalties
- depreciation, depletion & Amortization
-Intangible capital costs
- Operating costs
- Bonuses
- Taxes
 Definitions & Hints
• Gross Revenue = Total oil and gas Revenues

• Net Revenue = Gross Revenue – Royalties

• Bonuses are not always deductible for tax calculation

purposes

• In many systems, no distinction is made between

operating costs and intangible capital costs and both are
expensed
DEPRECIATION
• This is the process of prorating that expenses the capitalized
costs of certain items over a period of years

• It is a noncash charge

• It is deductible from the tax base which represents a

reasonable allowance for the exhaustion, wear and tear and
obsolescence of depreciable property used in business or
held for the production of income

• Enables companies to recover the cost of a depreciable asset

during its estimated useful life
 Depreciation
• Examples of depreciable assets include:
– Well equipment (tangible drilling and development
costs) and
– Surface equipment

• Hence, a depreciable asset will have a value if not utilized

to the exhaustion of its useful life (salvage value)

• The salvage value of an item is the amount of money that

will be realized upon the sale of that item or disposition for
other use
 Types of Depreciation Methods
• Basically, there are five methods of computing depreciation
allowance:

– The straight line method

– The declining balance method

– The sum of the year digits method

– Combination of the declining balance and the straight-

line method and

– The units of production method

 Straight Line Method
• This method allows the deduction of an equal amount
from the taxable income each year over the life of the
asset

• The formula for calculating straight –line depreciation

allowance is:
D = C-S
n
Where: D= depreciation allowance per year
S = salvage value
n = estimated asset life in years

The depreciation rate = 1/n

 Declining Balance method
• This method allows the calculation of the annual
depreciation at 150% or 200% of the straight-line rate
applied to the undepreciated balance of the asset which is
the book value

• The salvage value is not deducted from the cost of the

depreciated equipment

• Hence, the total depreciation cannot exceed the total cost

of the asset less its salvage value
 Declining Balance method
• The formula for calculating the depreciation allowance is
given as:
D = F (Cu)
n
Where:
F = depreciation factor
Cu= undepreciated balance for a given year

If F= 2, the depreciation rate = 2/n( double the straight line

rate), hence called double declining balance depreciation
method
 Declining Balance method
• The double declining balance rate is the highest declining
balance rate permissible

• Thus is the most widely used in the industry

• The rate is a constant

• The rate is applied to a declining balance each year

• A larger depreciation deduction is taken for the first year

and gradually reduced deduction is taken in subsequent
years
 Sum of the Years Digit

• This method uses a declining rate per year that is applied

to the total costs of the asset less the salvage value.

• The rate is determined by a fraction with the remaining life

of the equipment as of the beginning of the year

• while the denominator is the sum of the digits in the total

life of the asset
 Sum of the Years Digit

• The formula for the sum of the year digits method is given
as:

• Where m= life of the asset up to the time of calculation in

years
 Units of Production Method
• This is based on equipment usage

• The depreciated is charged at a fixed amount per unit

produced during the accounting period

• In the case of crude oil production, the total tangible

expenditures (less salvage value) are divided by the total
estimated net working interest barrels of oil to be
recovered

• Thus determining the depreciation per barrel

 Units of Production Method
• This value can then be applied to the estimated production
for each period to determine depreciation for the period

• The formula for units of production method is :

D= (C-S)P
R
where:
R = total recoverable reserves
P = production for a given year
 Example
• A piece of oil production equipment with an estimated life
of 5years is purchased for $33,000. its salvage value at
the end of the fifth year is estimated to be $3000. it has the
following production profile:

Year Production(‘000bbls)
1 500
2 2000
3 1300
4 800
5 400
Total 5,000
 DEPLETION
• It is defined as the exhaustion of a natural resource as a
result of its extraction

• Oil and gas are finite resources, thus nonrenewable

• A depletion allowance represents the amount allowed as

an annual deduction in arriving at the net income for
taxable year from mineral properties

• Only an operating owner or an owner of economic interest

may claim depletion deductions
 Methods of computing depletion allowance
• Basically, there are two methods of estimating depletion
allowance:

– Cost depletion and

– Percentage depletion

• The tax payer must deduct the larger of cost depletion and
percentage depletion

• The amount that may be deducted from taxable income is

known as allowance depletion
 Cost Depletion
• Cost depletion basis for minerals includes:
– The cost of acquiring a mineral property and
– the exploration expenditures incurred in discovering the
deposit

• The mineral right acquisition cost includes:

– Lease bonuses
– Geological and geophysical survey costs
– Legal costs and
– Assessment cost
 Cost depletion
• Cost depletion can be computed using the formula:

• Where:
CD = annual cost depletion allowance
B = the adjusted basis of the property
P = the units of Production sold or for which payment
was received during the tax year
R = recoverable units of production remaining at the
end of the tax year
 Example
• The purchase price of a producing ore property was
$3,000,000 and exploration and development costs
included in the cost depletion basis amounted to
$2,000,000. Engineering estimate of the recoverable
reserves is 4,000,000 barrels. Estimate the annual cost
depletion given the following yearly production

Year Production (Barrels)

1 400,000
2 200,000
3 150,000
Economic rents in the petroleum industry
 Why Tax?

Why is taxation a legitimate government fiscal

instrument?

• From a Government perspective: What is the purpose of taxation

and what is it that the Government should be attempting to tax?

• From a Company perspective: Why is taxation not necessarily a

disincentive to invest, or a barrier to profitable company growth?
Concept of Economic Rent

Economic rents are the returns accruing to a factor

of production in excess of its transfer earnings…

• These earnings generally refer to those obtainable in the

factors next most valuable alternative use.

• The original concept, derived by David Ricardo, referred to

the difference between what a factor earns and what is
necessary to bring it into employment.

You could imagine economic rents are the surplus returns for somebody or a
company.
Ricardo’s Concept of Rent

Two landlords: one with fields much more fertile than

the other…
Both sell their grain for the same price.

But the costs of the one with the more fertile fields are much less
than the one with the less fertile fields.

The latter makes, perhaps, a profit, but the former, the one with the
more fertile fields, receives not only a profit, but also something
much larger – rents.

His rewards are derived from the particular qualities of his land,
which result not from his ingenuity or hard work, but uniquely from
natures legacy

This example recognise that some fields are more prolific than others
Concept of Economic Rent

Revenues earned from the exploitation of a natural

resource can be divided into two parts:

1. The economic cost required to find, develop, and produce the resource

– To allocate capital and labour to resource exploitation they must

be paid a sum sufficient to bid them away from their most highly
valued alternative use.

2. The residual difference between this total economic cost and the
revenue received.

When revenues exceed the total economic cost, positive

economic rents are being earned

We have to acknowledge that the investor has to make a certain profit before continuing with
the economic activity
Concept of Economic Rent

The Total Economic Cost is the

necessary supply price in the industry

The Economic Rents are any remaining

surpluses

This would need to include profits as the investor will not carry without them. The difficulty is to
determine how much profit.
Class Exercise

Exploration Opportunity
As an experienced geologist, you believe that there is oil in a small onshore
concession that you can purchase for $10,000. You believe that there is at least
10,000 barrels below ground that could be extracted over three years and sold at
$28/bbl.

However, as a start-up you have very little equity available – only $10,000 cash. To
drill a well and to erect infrastructure will cost a further $100,000. You estimate
operating costs to be $20,000 p.a.

The only alternative you have for your $10,000 is to put it into a bank. The interest is
very good – 15% p.a. which in three years could give you a return of $15,200.
However, the bank is also willing to loan you $100,000, and at a rate of interest of
10% you would be expected to pay back $133,000 after three years.

Assuming that you are not, by nature, risk averse what will you do. What do
you think is the economic rent?
Taxable Capacity and Economic Rent

Revenue Equity
$10 k Devex

$100 k

Interest
$280 k
$33 k
Opex
Residual
$60 k Profit (Value) less
original equity

Normal
$71.8 k
Return less
original equity
$5.2 k
Concept of Economic Rent

Economic Rents and Quasi-Rents…

• In considering the supply price it is important to distinguish

between genuine economic rents and quasi-rents.

• Quasi-rents are earnings which have no short-term effects on the

supply of investment to a particular activity, but do influence
investment supplies in the longer term (in petroleum – future
earnings from exploration efforts)
Supply Price of Petroleum

Price MCT

Finding Costs
P
Economic D
Rents
MCD+P
Quasi-Rents
of Exploration
MCT C E Development Costs

MCP
MCD+P
B
F
MCP Production Costs
A

0 Q Output
Concept of Economic Rent

Application of Economic Rent…

• Natural resource extraction is an activity that is likely to generate

some rents

• It is legitimate for a government to extract a share of these rents

for the benefit of the population

• Revenues should be raised without causing any distortion in the

allocation of resources
Application of Economic Rent

There are problems regarding the application of the concept of

economic rents in petroleum exploitation…

• Oil is a non-renewable resource (rents should be declining)

• Exploration and development costs can differ greatly within and
across geographical boundaries

• Petroleum does not conform to the textbook definition of perfect

competition.
Objectives of Investors and
Governments
The Investor

The investors main objective is to obtain maximum or

satisfactory profits from petroleum exploitation…

1. Other objectives include the freedom to determine the size, characteristics

and phasing of:

• Exploration programme
• Appraisal activity
• Development plan
• Production plan

2. Freedom to dispose of petroleum without restriction

3. Freedom to choose investment partners,

4. Freedom to source supplies of equipment and labour, to import currency

and convert local currency to foreign currencies at market rates
The Investor

Objectives of Investor…

• Market pricing with no interference regarding petroleum or equipment

purchases .

• Freedom to use equity and loan capital without restriction, and to borrow
from any source

• Stable and modest levels of regulation to be applied to petroleum activities

• A stable and predictable legislative framework over the contract term
• Low levels of taxation, especially in early years of field life (pre-payback)
• ‘Profit’ related fiscal regime that shares the investment risk
• No residual liability after Contract termination
The Government

Objectives of Government…

To obtain large share of economic rents from oil exploitation

To regulate exploration and development

To ensure security of supplies for domestic market

To regulate pace of production

To influence domestic price of oil

To obtain some local ownership of resource

The Government

Objectives of Government…
• To enhance local participation in employment and provision of supplies and
equipment.

• If enforced preferential treatment for local suppliers is substantial then

project costs will increase, resulting in less profit oil or taxes to government.

• Investors may have preference for supplies from affiliates. Government

should ensure that this does not involve purchase at prices higher than
competitive levels

• Government will prefer the investor to take high share of investment risk and
cost.

• Government will prefer some early and predictable tax revenues

Exploration
Issues at Exploration Stage…
• Government will generally prefer quick and thorough exploration,
where investor is bearing costs and risks.

• Government is likely to prefer high levels of exploration, though cost

recovery and loss of profit share may be a consequence

• Investor is likely to prefer longer exploration period than government.

Investor may have other exploration obligations.

• Where discovery is only marginal investor may prefer longer appraisal

period, particularly if investor is bearing initial risks and costs

• Government will prefer early bonuses (signature, discovery). Investor

will view bonuses as high risk and potentially non-recoverable

• When a prolific discovery is made both government and investor will

prefer fast appraisal and development.
Relinquishment
Relinquishment Issues…
1. Investor will prefer long period before relinquishment to maximise corporate
flexibility – large companies will have a long time horizon.

2. At time of first relinquishment Government will wish share of acreage

surrendered to be high:

a) Encourages investor to undertake thorough exploration

b) Enable more acreage to be made available to new investors

3. At time of first relinquishment investor will wish to retain high share of original
acreage:

• to maximise later exploration opportunities and to preserve competitive

advantage (acreage ‘in the bank’ not available to competitors)
Development

Issues at Development Stage…

1. Possible conflict over phasing of investments in large field.

2. Possible conflict over producing systems – environmental issues e.g.

offshore tanker loading compared to pipeline to shore.

3. Government has potentially to consider impact of many developments

occurring at a similar time – impact of construction yards, imports and
their inflationary consequences.

4. Government will need to consider optimal use of infrastructure –

pipelines, terminals. Different perspective to that of investor.
Production

Issues at Production Stage…

1. Conflict may arise over rate of depletion – the Government
perspective may be driven by revenue considerations.

2. Phasing of field developments. Government will need to consider

flow of total production from all fields.
Other Issues

Disposal & Security of Supply…

1. Investor will prefer to dispose of oil freely, including the right to
export (hard currency), and, if integrated the freedom to supply
refineries.

2. Government will be concerned with security of supply to the

domestic market – short term disruptions.

3. Government may impose domestic market obligation either a fixed

quantity or a discretionary right to request petroleum when required.

4. Investor will prefer clearly stated obligations

Other Issues

Domestic Price of Petroleum…

• Investor will prefer free market prices in all markets.
• Government may prefer controlled prices:
a) Anti-inflation purposes
b) To prevent hardship to domestic consumers
c) To assist industries using petroleum as an input

• In general petroleum should be priced to reflect its full values to the

economy – normally its market price.
Other Issues

Domestic Price of Petroleum…

• Rather than domestic pricing the nation should obtain benefit from
production through tax revenues.

• Poor consumers are best helped through direct financial

assistance schemes.

• The same argument applies to gas – its value to the economy is

best measured by the price of the alternative fuel which it can
replace (e.g. fuel or gas oil, both of which can be exported).
Other Issues

Local Ownership and Participation…

• Investor may prefer to be sole risk investor (no partners). This

increases upside potential but also increases downside risks and losses.

• Investor may prefer a partner to share risks and costs

• Investors will prefer partners who share equally in risks, rewards and
costs (not partners who are carried)

• Participation by a local oil company on preferential terms (e.g. carried

exploration risk) increases net costs to the investor

• If investor has no title to oil in ground then reserves cannot be used as

security for loans .
Other Issues

Local Employment…

• Government may desire to enhance employment of local

citizens. Investors usually happy to undertake training as a
contractual obligation.

• Local restrictions on employment of foreign nationals can cause

operational difficulties and add to cost.
Government Fiscal Objectives
Government Fiscal Objectives

• To achieve high overall level of take

Fair consistent with encouragement of
development of fields which are viable on a
pre-tax basis.
Non
distorting
• To receive at least part of the fiscal take
comparatively early in field life.
Simple
• To establish an ‘appropriate’ degree of
project risk sharing through the fiscal system.
Government Fiscal Objectives

Fair

Non
distorting Should avoid distorting behaviour such as:
• premature abandonment
• over-investment
Simple
• or ‘gold plating’.
Government Fiscal Objectives

Fair

Non
distorting

• Should be straightforward to administer.

Simple
• Not overly burdensome
• Not confusing
• Should not require sophisticated analysis or
processes
Additional Investor Objectives

Fair

Non
distorting
• Sanctity of contracts: Stable and predictable

Simple • Stability critical in growth phase to encourage

investment
• Should underpin confidence in investment
Stable decisions
Optimal Fiscal System

An Optimal System should be targeted at Economic

Rent….

This requires a scheme that is sensitive to variations in the following

– Oil price
– Field Size
– Development Costs
– Operating Costs
• The scheme should react progressively to prices and costs
• It should permit recovery of costs ‘plus’ an “adequate” return on the
risk investment
Optimal Fiscal System

An Optimal System should….

• Avoid the incentive to ‘gold plate’

• Avoid premature field abandonment.

• Share risks to a degree acceptable to government

• Generate some early government revenues.

• Manageable administration and compliance costs

Measuring the Economic Rent

The size of economic rents on a single project may be

determined by the same criteria employed by investors…

• Payback period
• Maximum Cash Exposure
• Real Net Present Value at various discount rates (reflecting
opportunity cost of capital and project risk
• Real Internal Rate of Return
• Real Profit/Investment Ratio
Measuring the Economic Rent

Economic rents at the field Development stage are

defined as the NPV measured at the investors discount
rate. The real net present value is then available for
collection or sharing by the host government

Economic Rents at the Exploration stage are defined as

the expected monetary value or EMV, which is the
expected NPV from development, weighted by the chance
of discovery less the explorations costs
Economic and Risk Indicators
Agenda

• Investment criteria

• Discounting techniques

• The problem of inflation

• Exploration Economics (EMV)

Investment criteria employed by
investors at field development stage

1. The primary goal of oil companies, like other commercial organisations, is

to conduct their operations so as to produce maximum or at least
satisfactory long run post-tax returns.

2. Oil companies, like other companies, are in the business to make profits
and to increase the wealth of the company for the company’s
shareholders.

3. Other financial objectives include:

a. Immediate or recovery of investment costs

b. Generation of large cash surpluses
c. Limited cash exposure
d. Balancing the level of financial risk and reward

4. In the petroleum industry investors generally give prominence to

discounted cash-flow techniques that account for the time value of
money.
Investment criteria employed by
investors at field development stage

1. Investment decisions are made with reference to a large

number of economic yardsticks and guidelines.

2. Not all criteria will be given equal weight by a given investor,

and different companies are likely to place more emphasis on
some criteria than on others.

3. The following yardsticks and guidelines are commonly

employed in the petroleum industry when new field
development projects are being considered.
Recap: Cash Flow of a Petroleum
Project

ANNUAL CASHFLOW

First oil date

30
Cash Surplus ($mm.)

20
10
0
-10
-20
-30
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Cashflow
Economic
lifetime

Time (years)
 Profitability Indicators

1) Payback Period

2) Maximum (Cumulative) Cash Exposure

3) Net Present Value (NPV) at zero discount rate

4) NPV at various discount rates, reflecting Cost of Capital

and Risk of project

5) Internal Rate of Return

6) Real Profit/Investment Ratio

These indicators can be calculated in real or nominal terms

 Payback Period
• This is the exact time period needed by an
organization to recover the initial investment
in a project
Payback Method – from first oil

Payback Method - Time required to recover investment costs.

Project A T0 T1 T2 T3 T4 T5

Investment ($mm.) -100 -100

Operating Costs ($mm) -20 -20 -20 -20
Revenue ($mm) 100 140 160 180
Cumulative NCF ($mm) -100 -200 -120 0 140 300
Payback: Year 2

Project B T0 T1 T2 T3 T4 T5

Investment ($mm.) -150 -200

Operating Costs ($mm) -20 -20 -20 -20
Revenue ($mm) 100 140 170 180
Cumulative NCF ($mm) -150 -350 -270 -150 0 160
Payback: Year 3
 Screening and Ranking Tool
Screening criterion
A project is considered to be economically viable if its
payback period is no more than a fixed maximum duration,
set by the organization.

Ranking criterion
If projects are ranked in order of increasing payback period, a
higher position in the list indicates greater economic
attractiveness.
Payback Method

The payback period is defined at the point in time where the accumulated NCF
becomes positive or accumulated revenue equals the initial cumulative
investment.

The payback period is a useful measure of the attractiveness of an investment as

it measure the rate at which revenue is utilised for a project.

The payback period is also a crude measure of risk.

– The shorter the payback period, the less risk imposed by the uncertainty of
future events
– Until payback is achieved the project represents an asset liability in a
financial sense
– From payback the project becomes a positive asset

Normally payback refers to recovery of costs from first production.

 Critique

However, payback does not provide any indication of profit following

payback nor does it measure total profit generated.

The payback method only considers cash flows up to the achievement of

project payback.

It does not consider the asset appreciation potential to the investor

It does not properly consider the time value of money.

It varies with different types and magnitudes of investment.

Companies need to consider all relevant costs and revenues throughout

the life of project, including exploration, appraisal, development,
operating and abandonment phases.
Economic versus risk measurement role
• The payback period is therefore a simple measure of
economic attractiveness;

• It is also a simple measure of project risk, in that , a longer

payback period means that some or all of the investment is
at risk for a longer time. Once payback has been reached,
the cumulative cash flow of the project is positive.
Payback Method and Maximum Cash Exposure

CUMULATIVE CASHFLOW

120 Cumulative cash surplus

100
80
Cash Surplus ($mm.)

Payout Time
60
40
20
0
-20 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
-40
-60
-80

Maximum
exposure
Time (years)
Discounted Cashflow Techniques

The following all involve discounted (DCF) techniques.

1) Net Present Value

2) Internal Rate of Return

3) Profit to Investment Ratio

4) Incremental Cashflow Analysis

Discounting Techniques
Discounting is the reverse of compounding. It is used in the petroleum
industry to highlight the value at a base year (usually the present year) of
expenditures and receipts accruing at different times in the future.

Compounding to future value (FV)

FV1 = S0(1+r)
If S = $100 and r = 10% then FV1 = $110

FV2 = S (1+r)2
FV2 = $121

Discounting to Present Value

PV of FV1 = 110 = $100

1+r 1+0.1

PV of FV2 = 121 = $100

(1+r)2 (1+0.1)2
Discounting Techniques

The more distant the expected future value the less valuable it is today.

The higher the discount rate the less valuable is future income in
today’s terms.

Example: r = 20%

PV0 of FV2 = $121 = $84.03

(1+r)2 (1.2)2
Net Present Value (NPV’s)

The sum of the present values of the profits (revenue minus operating
costs) minus the initial investment costs

T0 T1 T2 T3

Investment (I) -200

Revenues (R) +200 +200 +200
Operating Costs (O) -100 -100 -100

Net Cash Flow -200 +100 +100 +100

i=n
NPV =  Ri-Oi
(1+r)i
- Io [r = cost of capital]
i=1
Net Present Value (NPV’s)

If r = 10%, NPV = -200 + 100 + 100 + 100

1+0.1 (1+0.1)2 (1+0.1)3

= +$ 48.6M

If r =25%, NPV = -200 + 100 + 100 + 100

1+0.25 (1+0.25)2 (1+0.25)3

= -$ 4.8M

When NPV is positive project is acceptable

When NPV is negative project is not acceptable

Net Present Value (NPV’s)

Net present value (NPV) is one of the most commonly used investment
appraisal criteria.

It is sometimes known as present value (PV), present worth (PW) or net

present worth (NPW).

The NPV measures the present value of a project’s NCF discounted at a

specific discount rate to a common reference point, usually the
current year or another base year period.

The NPV yields a measure of value with the same monetary units as the
NCF e.g. dollars, sterling, roubles.

When the NPV is greater than zero for the company’s hurdle discount rate
the company earns more from investing in the project than by
investing in the ‘average’ project. Asset appreciation has occurred
enabling the company to achieve its basic objective – maximising
shareholder wealth.
Net Present Value (NPV)

• The NPV calculation is a weighting scheme with the greatest weight attached
to early cashflows and declining weights applied to future cashflows.
• The weighting concept is based on the idea that most people value money
today more highly than money received in the future
Characteristics of NPV
Uses all the relevant costs and revenues over the life of the project.

Enables consistent decisions among alternative investments, and

distinguishes between large and small projects.

Gives greater weight to early NCF’s.

Emphasises the wealth generated by the project. The scale of the project is
highlighted.

Because NPV is a monetary figure, projects can be compared in a

meaningful manner.
Net Present Value (NPV)
Using the NCF in the table below and a 10% discount rate calculate the project
NPV.
Highlight text below in
white for the answer

Year Discount Factor NCF NPV

0 1.0 -50,000 -50,000

1 0.909 20,000 18,181.82

2 0.826 20,000 16,528.93

3 0.7513 20,000 15,026.30

4 0.683 20,000 13,660.27

Total 30,000 13,397.32

Internal Rate of Return

• The internal rate of return began to be used in addition to traditional

methods of investment appraisal such as payback and return on capital
employed in the 1950’s and 60’s.

• The IRR is the rate of discount which equates the sum of the present
values of revenues minus operating costs with the investment costs.

OR

• The IRR is the discount rate at which the net present value of a project
NCF is equal to zero. The solution is found by the following equation.

• The equation above is solved iteratively – usually with the aid of a computer
program.

• Computer programs typically solve the equation by progressively

increasing the discount rate, computing the NPV each time, until
the NPV changes from a positive to a negative value.
Internal Rate of Return (IRR)

The rate of discount which equates the sum of the present values of
revenues minus operating costs with the investment costs.

OR: The rate of discount which makes NPV = 0

T0 T1 T2 T3

Net Cash Flow -200 + 100 + 100 + 100

Find r for 200 = 100 + 100 + 100

1+r (1+r)2 (1+r)3

r = 0.234

= 100 + 100 + 100

1.234 (1.234)2 (1.234)3

200 = 81.0 + 65.7 + 53.2

Internal Rate of Return (IRR)

Meaning of IRR
An IRR of 23.4% means that the project earns sufficient profits
to recover the investment plus a return of 23.4% on the
outstanding balance of that investment.

Value of Cash Return Capital

Investment flows on capital Recovery
at beginning from outstanding
of year project
$Million 23.4%

T1 200.00 100 46.74 53.26

T2 146.74 100 34.29 65.70
T3 81.0 100 18.90 81.00

200
Real Profit to Investment Ratio

NPV at project discount rate

= PV of project investment costs

This indicator can be calculated in real or nominal terms

Profit-to- Investment Ratio or Profitability
Index
Profit-to- Investment Ratio or Profitability
Index
 Example

NPV and PV Data for Project A at 10%

 Procedure
• We have no information on the OPEX within the cash
flows, so will have to limit ourselves to calculating
PI(CAPEX).

• Assuming that there are no OPEX and no revenues within

Year 1, and no CAPEX within Year 2 and later years,
PV(CAPEX) is $10,000.

• On the definition involving the addition of 1, therefore,

PI(CAPEX) (10%) for Project A is (724/10,000) + 1, or
1.0724.
The Problem of Inflation

When there is significant inflation it is useful to distinguish between

returns in money of the day terms (MOD) and in real terms.

The real return shows the return after the effects of inflation have been
removed. It is expressed in terms of prices at base year (normally
the initial year of the project).
The Problem of Inflation

T0 T1 T2 T3

Net Cash Flow -200 + 100 + 100 + 100

(MOD)

NPV at 10% = -200 + 90.91 + 82.64 + 75.13

NPV at 10% = + $48.6M
NPV at15% = + $28.3M

Suppose inflation is at 15%

15% discount factor = 1 + 1 + 1 + 1

1+0.15 (1+0.15)2 (1+0.15)3

= 1 + 0.869 + 0.756+ 0.657

NPV at 10% (real) =(1*-200) + (.869*90.91) + (0.756*82.64) + (0.657*75.13)

NPV at 10% (real) = -$9.07M

EXPECTED MONETARY VALUE
 EXPECTED MONETARY VALUE
• The expected value of an outcome is the product obtained
by multiplying the probability of occurrence of the outcome
and the conditional value (or worth) that is received if the
outcome occurs

• The value received if an outcome occurs can be expressed

in various ways:
– Monetary profits and losses

– Opportunity losses

– Preference or utility values based on associated profits

and losses etc.
 EXPECTED MONETARY VALUE
• Preference or utility values based on associated profits and
losses etc.

• Where the values received are expressed as monetary

profits or losses the products the profit is usually called
EXPECTED MONETARY VALUE of the outcome or EMV

• The EXPECTED VALUE of an outcome is the algebraic

sum of the expected values of each possible outcome that
could occur if the decision alternative is accepted

• It can be positive, zero or negative

• It is the numerical criterion used to compare competing

decision choices
Exploration Economics

EMV = P(NPV) - E - P(A)

Where:
EMV = Expected Monetary Value
P = Chance of Discovery
NPV = Net Present Value
E = Initial Exploration Costs
A = Appraisal Costs
Expected Monetary Value (EMV)

Net present value weighted by chance of discovery, minus

exploration costs

Exploration Costs (E) = $50m

NPV from discovery (NPV) = $500m
Chance of discovery (P) = 1 in 5 (0.2)

EMV = P(NPV)-E

= 0.2(500)-50

= +$50m

If %P = 1 in 15 (0.06667)

EMV = -$16.667m
 Illustrating Expected Monetary Value
Consider the gamble that consists of flipping a fair coin. The
rewards are a win of $5 if the result is a head and a loss of
$2 if the result is a tail. Should you accept the gamble?

outcome Prob. Of Conditional Expected

Occurrence value value of
recieved outcome
Head 0.5 +$5.00 +$2.50
Tail 0.5 -$2.00 -$1.00
EMV +$1.50

Decision: accept the gamble since the EMV is $1.50

compared to $0 if we don’t accept.
 Properties and Rules of mathematical expectations

• Any number of outcomes can be considered so long as the

probabilities for all outcomes listed sum up to 1.0

• Any number of decision alternatives can be considered

• The conditional values can be expressed as before tax or

after tax monetary values and can be discounted or
undiscounted NPV

• The decision rule for special case of EMV implies that the
decision maker is totally impartial to money and the
magnitude of money involved in the gamble
 Decision Tree
• A decision tree is a pictorial representation of a sequence
of events and possible outcomes

• There is no scale to a decision tree hence, the lengths of

the lines or branches have no significance

• Also the angles between the branches have no meaning

• Hence, the analyst need not worry about being precise in

drawing the tree itself.
 Decision Tree
• The trees normally read from left to right

• They are drawn in the same order as the actual sequence

in the decision choices and chance events occur in the real
world
Example To Illustrate Decision Tree
An investor is planning to buy a pizza restaurant near the
university campus. If he buys the restaurant, there are
three possible outcomes: a low demand, a medium
demand and a high demand for pizza. The probability of
occurrence of each outcome and the discounted net
present value profit are given below:

Possible Probability of NPV Profits

Outcomes Occurrence
Low demand 0.6 -$25,000
Medium demand 0.3 +$50,000
High demand 0.1 +$150,000
 Risk and Uncertainty

• Risk (Chance) is the probability of a discrete (generic) event occurring

• Uncertainty is the range of possible outcomes, if that discrete (generic) event

occurs.
Upstream Oil Industry ... reserves assessment

Prospect Assessment Uncertainty re

resource size GRV
*
N/G
[Remember that units are tricky ... GRV is measured in acre *
ft, and reserves are quoted in barrels,
so use the conversion factor of 7758 barrels per acre foot.]
Ø
*
Shc
*
Issues: Re
Types of input distribution *
Dependencies and their levels FVF

Recoverable Resources
100 1000

.750 750
Recoverable
.500 500

Resources
.250 250

0 0

0.00 200.00 400.00 600.00 800.00

MBO
So what …?
• So we don’t know whether a thing (such as
finding hydrocarbons) is going to happen
• And we don’t know how big it is going to be if it
does happen
• So how can we value the option of finding out?
Well …
• We can assess the probability of something happening
… CoS (CoD)
• And we can assess the range of possible sizes, if it does
happen
• And we can assess the probabilities associated with
each size in the range
• And we can value each size, if it happens
• So we have all we need to construct a decision, or value,
tree
Magee, quoted in Newendorp, Decision
Analysis

“The decision tree can clarify for management, as no

other analytical tool that I know of, the choices, risks,
objectives, monetary gains and information needs
involved in an investment problem”
A way of depicting risk …
• Probability of making a discovery … and if
there is a 30% chance of making a
discovery, then there is a 70% (i.e. 100 –
30) chance of drilling a dry hole
Discovery
30%

Drill

70%
Dry Hole
 … and uncertainty

• If a discovery is made, what is the range of

possible sizes, and their probabilities?
30% High estimate

40%
Discovery Best estimate

Swanson’s Rule 30% Low estimate

And …
• We can combine these two concepts, forming
the basics of a decision, or value, tree
An Example Decision/Value Tree
Risked Outcome
US$ Millions

High estimate
Worth $ 100 million
(30%)
9
9% probability of occurrence

Best estimate Worth $ 30 million

Discovery
(40%)
3.6
(30%)
12% probability of occurrence

Worth $ 1 million
0.09
Low estimate
9% probability of occurrence
(30%)

Dry Hole
(70%)

Cost $ 10 million
(7)
70% probability of occurrence

Risked Value of Drilling Prospect $5.69 MM

Fiscal devices and their effects applied
to petroleum exploitation
Collecting Economic Rent
Collecting the Economic Rent

Main Types of Fiscal Devices…

• Auctions & bids for the awards of licences or leases

• Conventional Corporate Income Tax

• Special Taxation Measures – directed at petroleum

• Production Sharing Agreements

• Hybrid Systems – Competitive bidding followed by

negotiations between investor and government.
Collecting the Economic Rent

Fiscal devices can be judged in several ways…

• Do they produce economic distortions (is exploration, new field

developments or production impaired) ?

• Do these devices specifically target economic rents and

therefore create less distortions ?
Collecting the Economic Rent

Regressive Schemes…

• A regressive scheme is both inequitable and likely to

produce economic distortions in relation to changes in
economic rents

• A regressive scheme collects a higher share of the rents the

lower these rents become – either through higher costs or
lower prices.
Collecting the Economic Rent

Progressive Schemes…

• A progressive scheme collects a higher share of the rents

the higher the rents become (either from rising oil prices or
lower costs)

• A progressive scheme is likely to be more equitable and

less distorting but can lead to ‘gold plating’ in some instances.
Collecting the Economic Rent

Other Considerations…
• Equity (should not distort post tax)
• Efficiency (complexity, administration, allowances, information
required, investment efficiency)

• Neutrality (ranking of profits, acceleration or delay of projects,

neutral in relation to other industries)

• Site Specific (ring fencing – geological, contract area)

•Revenue adequacy (concept of minimum tax take)
• Revenue balance (system should not impair new developments
and exploration)
Types of Fiscal Devices

Australia: Resource Rent Tax + Income Tax (progressive)

UK: Pre-1993 wholly profit related. New fields CT only – profit

related (neutral)

China: Royalty, Production Sharing, Income Tax and State

Participation (Regressive)

Malaysia: Royalty, Production Sharing, Income Tax (regressive)

Indonesia: Production Sharing, Income Tax (regressive)

Types of Fiscal Devices

Papua New Guinea: Resource Rent Tax + Income Tax

(progressive)

USCS: Bonus bids, Royalty, Federal Income Tax plus Windfall

Profits Tax.

Nigeria: Joint Ventures with Royalty (water depth based) and

Petroleum Profits Tax, Memorandums of Understanding (MOU’s),
PSC’s with Royalty (water depth based).
Types of Fiscal Systems
Fiscal Systems

There are several types of fiscal systems…

• Bidding systems
• Special taxes
• PSC or PSA’s
•…
Bonus Bidding

Competitive Bidding by investors for exploration and

production via sealed bid auction…

• Bids should reflect anticipated economic rents

• Early lump sum revenues to host government
• Realised economic rents may differ from anticipated rents.
Uncertainties due to..

– Chance of discovery
– Size of Discovery
– Oil Price
– Investment/operating costs
Bonus Bidding

There are several types of Bonus Bidding systems…

• Cash Bonus Bids

• Royalty Bidding
• Net Profit Sharing Bidding
• Work Programme bidding
Bonus Bidding

The advantages of bonus bidding ….

1. Should not produce distortions and should reflect size of economic
rents

2. Investor does the work - estimates EMV’s, discounts future costs and
revenues at own discount rate, makes estimates of the probability of
success at E&A stage.

a) Bids reflect investors perceptions

b) Payments are voluntary
c) No disincentives
d) Administration costs small

3. For government the expected economic rents are received before the
commencement of exploitation.
Bonus Bidding

The disadvantages of bonus bidding ….

• A high degree of competition is required to avoid collusion between bidders
• Bonus bids are made ‘ex ante’ – the accuracy of bids is dependant on the
accuracy of information – geology, prices, exploration costs.

• There will be many circumstances where ‘ex-post’ economic rents will

diverge from ‘ex-ante’ rents

• Geological knowledge is often limited – the investor therefore often applies a

risk premium

• In this sense the government shares in the risk

• Where there’s uncertainty it is unlikely that bids will reflect realized rents.
Royalty Bidding

Bidders compete to pay a Royalty…

• Advantages over bonus bids – no front end payments.

• Small companies at no disadvantage – increased competition.
• Royalty bids may be so high projects may be uneconomic on a
post-royalty basis.

• Similarly high royalty bids may lead to early field abandonment.

• In US 1974 royalty bids tested – winning bids ranged from 56% to
82%.
Net Profit Bidding

Bidders compete to handover a share of the

profits…
• Less chances of disincentives emerging with a scheme based
on profits.

• However bidding can still reach levels that makes fields

subsequently discovered uneconomic

• In one case of a drainage sale in California winning net profits

bid was 95.5%.

• Simplicity of bidding system greatly reduced – net profits have

to be defined (valuation of petroleum, write-off of investment
expenditures)
Work Programme Bidding

Bidders compete to complete a work programme…

• Could lead to a non-optimal level of exploration taking place

• Initial results might be disappointing but obligations may require
further drilling.

• Some governments may consider thorough exploration so

important that additional costs are worthwhile.

• Other bid systems are more neutral with respect to exploration

• It does not follow that exploration will be minimised under bonus
bidding system.
Special Taxation Measures
Special Taxation Measures

Special Tax Regimes are usually associated with

discretionary forms of taxation….

• Private company has equity in ownership in petroleum and

incurs investment risk.

• Licenses or concessions are granted on a discretionary basis

• Government earns revenue from taxation - royalty, production
tax, income tax, special tax.

• Petroleum costs are recoverable against tax.

• Possible State company participation with some risk and cost
sharing
Rentals

A usual component but often small…

• Non profit-related

• Based on the acreage or number of concessions held by the

Investor.
 Often a small fee of a tax nature (annual and fixed)

– Early revenues.
– Estimation easier than profits-based taxes.
– Leave risks mostly on investors.
Royalties & Production Taxes

Royalties are inflexible and not well targeted on

Economic Rents…

• A flat-rate could leave a high share of rents with the investor but
also deter development of marginal fields.

• Payments are due on fields with low or zero profits.

• The Royalty can cause early field abandonment

Royalty regimes can be distorting…..
Effect of 10% Royalty Rate…

Low cost project Government

100 share = 14.3%

20
10 70
10 60
– Royalty does not
discriminate
between high cost
and low cost
projects
High cost project
100 – As a result, it can
Government be a very
60 share = 50%* regressive tax with
distorting effects

20 20
10 10

Revenue Operating Deprecia- Operating Royalty Profit

costs tion profit @10% after tax
Royalty System in Denmark

Production Royalty Rate %

(barrels/day) (Incremental Basis)

0 - 5,000 2%

5,000 - 20,000 8%

> 20,000 16%

Netherlands (licenses after 1976)
Rates of Royalty (Slab Basis)
Annual Production (000 cubic metres) % Rate
0 – 100 0
100 – 200 1
200 – 300 2
300 – 400 3
400 – 500 4
500 – 1000 5
1000 – 2000 6
2000 – 3000 7
3000 – 4000 8
4000 – 5000 9
5000 – 6000 10
6000 – 7000 11
7000 – 8000 12
8000 – 9000 13
9000 – 1000 14
> 10000 15

Production costs (including the depreciation of development costs) are deductible

Royalties & Production Taxes

Sliding scale royalties that adjust as production increases are

more flexible when rents are a function of field size…

• Economic rents are also a function of oil & gas prices and costs.
The Sliding scale royalty is not sensitive to these.

• The Dutch System with a zero rate band plus deductibility of

drilling costs makes the scheme more sensitive.

Conclusion

– Only modest use should be made of royalties because of its

comparative inflexibility.
Corporate Income Tax

Most countries apply a Corporate (or Profits) Tax to all

companies operating in their country…
• The tax is generally applied to profits after deduction of depreciated
investment costs

• CT is more sensitive to profitability than royalties or production

taxes.

• CT is less likely to cause disincentives to field developments.

• The effective rate of tax is a function of

– the nominal tax rate,
– and the pace of write-off costs.

• Investors prefer a fast rate of write-off for exploration costs

Corporate Income Tax

Many countries ‘ring fence’ their upstream oil activities for CT….

• In the UK the original purpose was to prevent profits chargeable to CT being

eroded by costs or losses arising from other activities

• In the UK it is now used additionally as the basis for charging a higher rate
of tax on upstream oil profits.

• It determines the tax base for the special Supplementary Charge in the UK
and, from April 2008, it is used to determine a higher rate of CT (30%) on oil
industry ring fenced profits compared to 28% for other corporate activities.

• In computing ring fence profits in the UK only expenditure incurred for the
ring fence trade may be allowed.

• Losses arising from non-ring fence activity, whether downstream, overseas,

or any other type of activity cannot be deducted.
Corporate Income Tax

Treatment of capital expenditures for Corporate Tax…

• Exploration costs can often be written off 100% first year

• Development costs are usually written-off more slowly, e.g. 5 years

straight-line or 25%-30% declining balance.

• Development drilling costs are often written-off faster.

• The write-off can commence with first expenditure or related income

Corporate Taxes are generally not directly targeted on economic rents

They are usually a flat % rate and not progressively related to profits
Fiscal Aspects of Nigerian Petroleum Law

Sources of Government Income from the Petroleum Industry …

• Direct tax on the profits of the oil company

– Levied in accordance with the provisions of the PPT Act 1959 as

subsequently amended by various enactments

• Bonuses

– Paid on the grant of OPL and Signature bonuses paid on the

execution os PSA and Service Agreements between NNPC and Such
contractors
These are other sources of revenue for the Nigerian Government from
petroleum exploration activities
Fiscal Aspects of Nigerian Petroleum Law

Sources of Government Income from the Petroleum Industry …

• Fees and rents

– Derived from concessions and grants made to oil companies under
the Petroleum Act 1969
– Include fees Paid in connection with the application, grant,
assignment etc. of
• Oil Exploration and Oil Prospecting License
• Oil Mining Leases
• Permits to Survey
• Oil Pipeline licenses
• Production sharing and Service Agreements

These are third Source of revenue into the Federal Government coffers
from petroleum activities
Fiscal Aspects of Nigerian Petroleum Law

Sources of Government Income from the Petroleum Industry …

• Revenue from Royalties

– Paid on crude oil, casing head production spirit and gas produced
from on-shore and offshore operations

– They are sums paid by the producer on the quantity of petroleum

produced at the percentage rate fixed by NNPC

They constitute a major source of income to the Nigerian Governement

Fiscal Aspects of Nigerian Petroleum Law

Sources of Government Income from the Petroleum Industry …

• Payment made under the Provisions of the Oil Terminal Act 1969

– Oil Terminal dues are the payments made to Nigerian Ports Authority (NPA)
under the provision of the Oil Terminal Dues Act 1969

– The levy is made on ships evacuating crude oil at any terminal in Nigeria

– Oil terminal dues are required principally to be paid by the master or owner of
the ship evacuating crude oil and not by the company that has won or saved
oil

These payments do not qualify as deductible items of expense in the

computation of a company’s taxable income under the PPT Act
Fiscal Aspects of Nigerian Petroleum Law

Sources of Government Income from the Petroleum Industry …

• Bank Charges or Commission Paid to the Central Bank of Nigeria (CBN)

in connection with the PPT, Royalties and Lease Rentals Payments

– CBN determines from time to time the foreign exchange equivalent of the
PPT, royalty and rent liabilities of oil companies

– Such liabilities are discharged in the converted foreign exchange amount even
though these are levied in naira

The bank commissions paid to CBN by the oil companies yields

income to Federal Government coffers
 Petroleum Profit Tax(PPT) Act

• The Act was enacted in 1959

• The current rate is 85 percent

• The act is meant to apply to the taxation of the assessed

incomes of companies which engage in petroleum and
liquefied natural gas operations

• The Federal Board of Inland Revenue is charged with the

duty of imposition and collection of the taxes
 Petroleum Profit Tax(PPT) Act
• Under the PPT Act, a company’s profits ascertainable for
taxation purposes must be related to the company’s income
in respect to a given accounting period and shall be the
aggregate of:
 The proceeds of sale of all chargeable oil sold by the company during
the period

 The value of all chargeable oil delivered by the company to a refinery

without a formal sale or to an adjacent storage tank for refining by the
company during the period

 The value of all chargeable natural gas during the period

 All incidental incomes to the company which are traceable to any of the
company’s petroleum operations during the period
• The accounting period is usually one calendar year i.e from
1January and terminates at 31 December of the same year
 Adjusted Profits in PPT
• This is the balance of the profits earned by the company
during a given accounting period after the deductions of the
following items of expenditure:

– Rents paid by the company for land and buildings occupied by it in

connection with its petroleum operations

– Settled damage claims and compensation paid for the acquisition of

surface rights, way-leaves and other claims arising directly from the
company’s petroleum operation

– All royalty payments for chargeable oil produced and exported

including royalties paid on natural gas sold and delivered to NNPC
.
– Interest aid on money borrowed and which was employed in the
petroleum operations
 Adjusted Profits in PPT

– The cost of renewal, repair and alteration of the

premises, plants, machinery or fixtures, articles, utensils
and implements employed in petroleum operations

– Bad debts directly arising from the company’s operation,

which are owed to the company

– Intangible drilling costs of the first two appraisal wells in a

particular field including expenditure in respect of cement
and casing and well fixtures
 Adjusted Profits in PPT

– Contributions to a provident, pension and death benefits

plan for the company’s employee’s

– Imposts, stamp duties, fees and rates to Local, State or

Federal Government authorities. Custom and excise
duties are not deductible

– Such other deductibles as may be prescribed under the

PPT Act
 Assessable Profits in PPT
– This is an amount left of the adjusted profit after the
following listed deductions:

 Any trading loss suffered by the company during a previous

accounting period

 In case of a purchase and transfer of a foreign petroleum

company to Nigeria ownership, the loss incurred by the new
owner in its first accounting period
 Chargeable Profits in PPT
– This is an amount left after deducting the lesser of the
following two amounts from the assessable profits:

 The aggregate amount of all allowances due to the company

under the provisions of the Second Schedule to the PPT Act for
the relevant accounting period; and

 An amount equal to 85 percent of the assessable profits of the

company for the accounting period less 170 percent of the total
deductions allowed in the determination of the company’s
chargeable tax
 Assessable Tax

This is 85 percent of total chargeable profits of

the company for that same accounting period.
No deductions features
 Chargeable Tax
– This is the final amount in the computation process for
petroleum profit tax for the relevant accounting period.

– It is arrived at by effecting the following deductions from

the company’s assessable tax for the accounting period
of the expenses incurred:
 All royalties paid in respect of locally disposed chargeable oil

 All non productive rents

 Custom and excise duty or similar levies paid in respect of items

such as tubulars, plant, storage tanks, tools, machinery and
equipment that are essential to petroleum operations

 Investment tax credit

 Algorithm For Calculating PPT
– The posted price or tax value of crude for the accounting
period plus all petroleum operations related incidental
incomes during the same period
Less
Purchase cost
Crude oil royalty
Any other purchase costs
Operating Costs and Expenses
Operating costs
Repair and maintenance charges
Office services and general charges
Intangible drilling costs
Wildcat and appraisal well costs
Custom duties- non-essential
Crude oil inventory net charge
Any other deductible costs

Sub-total deductions = Adjusted Profits

 Algorithm For Calculating PPT
Less
Any other loss brought forward
= Assessable Profits
Less
Capital allowance
= Chargeable Profits
Apply tax rate = 85 percent for export crude and 65.75 percent for
domestic supply
= Assessable tax
Less
custom duties- essential
Non-productive rentals
Royalties-domestic crude supply
investment tax credit
= Chargeable Tax or Tax Liability
 Example
The following is an example to illustrate the manner in
which PPT is computed

– JOESCO’S PETROLEUM COMPANY LTD

COMPUTATION OF PETROLEUM ROFITS TAX FOR
THE ACCOUNTING PERIOD 1ST JANUARY- 31ST
DECEMBER 2009
 Solution to Example
(N ‘000)

Income- Fiscal value of chargeable oil exported 200,000

Sales within Nigeria of crude oil and gas 2,000
Miscellaneous income 1,000
203,000

Deductions – Production and administrative expenses 8,000

Intangible drilling expenditure 4,000
Survey preparatory to drilling 1,000
OPL and OML rents 2,000
Royalties on export 40,000
Cost of first two appraisal well 3,000
58,000

Assessable Profit 145,000

 Example
(N ‘000)
Chargeable Allowances- Current accounting period allowances
• Building 500
• Drilling 1,000
• Plant, etc 3,000
Total Allowances 5,000
Chargeable Profit 140,000

Assessable Tax - Of chargeable profits

• 65.75% * N 1,000 658
• 85% * N 139,000 118,150

140,000
118,808
 Example
(N ‘000)
Less - Tax Offsets
• Royalties on sales within Nigeria for local
refining purpose 300
• Onshore non-producing concession rental 500
• Custom duties on essential supplies 1,000
Investment Tax Credit:
• Building 200
• Drilling 208
• Plant, etc 600
1,008
Total Allowances 2,808

Chargeable Tax 116,000

Extra: Present Value of Money
• Compounding to future value (FV)

Future Value1 = S0(1+r)

If S = $100 and r = 10% then FV1 = $110

FV2 = S (1+r)2, then FV

2 = $121

• Discounting to Present Value

Present Value of FV1 = 110 = $100

1+r 1+0.1

PV of FV2 = 121 = $100

(1+r)2 (1+0.1)2
Extra: Net Present Value and IRR
• Net Present Value (NPV) = add the calculated present value of all
years
• When NPV is positive project is acceptable

• When NPV is negative project is not acceptable

• Internal Rate of Return (IRR)

– The IRR is the rate of discount which equates the sum of the present values of
revenues minus operating costs with the investment costs.
OR
– The IRR is the discount rate at which the net present value of a project NCF is
equal to zero. The solution is found by the following equation.
Depreciation Terms

Investment Depr PV Factor PV of Depr. PV of

(5 yr SL) @ 10% Depr. Depr.

T0 100 20 1 20

T1 20 0.909 18.2

T2 20 0.826 16.5

T3 20 0.751 15.0 20 15.0

T4 20 0.683 13.7 20 13.7

T5 83.4 20 12.4

T6 20 11.3

T7 20 10.2

62.7
Declining Balance Depreciation

Costs to be Remaining Balance

Depreciated

13.35
17.80 4.45
23.73
31.64 5.93
42.19
7.91
56.25
75 10.55
100 14.06

18.75

Depreciation allowance
25.0 (25% of the remaining balance)

T0 T1 T2 T3 T4 T5 T6 T7
Declining Balance Depreciation

Depreciation
Remaining
Investment Allowance
Balance
(25% rate)

T0 100 25.00 75.00

T1 18.75 56.25
T2 14.06 42.19
T3 10.55 31.64
T4 7.91 23.73

T5 5.93 17.80

T6 4.45 13.35
etc..
PV of Depreciation Allowance (%)
Discount Rate = 10%, Initial Capital Expenditure = $100m. in Year T0

5 year straight line 83.39

Declining balance @ 25% pa over 8 years 80.04

8 year straight line 73.36

10 year straight line 67.59

5 year straight line 62.66

12 year straight line 62.46

15 year straight line 55.78

10 year straight line (t3) 50.78

10 year straight line (t5) 41.91

t3 = relief begins after a time period of three years.

Double Declining Balance Method

• Length of depreciation period (n) = 5 years

• Allowance in first year is double straight line depreciation.
• For remaining years (except last year) allowance is 2/n*remaining balance
• For the last year allowance is residual value.

Investment Allowance
T0 100 2 x 20 = 40

T1 2 x 60 = 24
5

T2 2 x 36 = 14.4
5

T3 2 x 21.6 = 8.64
5

T4 12.96
Sum of the Year’s Digits Method

Length of depreciation period = 5 years 5+4+3+2+1=15

Investment Depreciation
Allowance

T0 100 5x 100 = 33.33

15

T1 4 x 100 = 26.67
15

T2 3 x 100 = 20
15

T3 2 x100 = 13.33
15

T4 1 x100 = 6.67
15

100
Losses Carried Forward

For Corporate Income Tax it is important that pre-

production losses can be carried forward…
1. When calculating income tax [(gross revenues minus costs nad
deductions)*tax rate], there will be times at which the calculation returns a
negative value.

2. These “losses” can be carried forwards against future profits until the
losses are exhausted.

3. It is important to allow for this in petroleum exploration & development for

CT because lead times (exploration to first production) can be very long.

4. Terms that are comparable with Western countries are generally

desirable. These vary considerably, ranging from 5 years to indefinite.

5. The alternative is to capitalise losses and write-off when income

available.
Inflation

Taxation can be adversely affected by inflation….

• high inflation rates in host country

• long lead times between investment expenditure and

income.

• Real value of depreciation allowances can be greatly

reduced
Inflation

Solutions…
• Undertake tax accounting in local currency but index all costs for
inflation. Very cumbersome and complex. Problem of reliable
inflation indicators.

• Employ dollar accounting. Convert all costs to dollars at time of

expenditure. Compute tax in dollars. Pay in local currency at
exchange rate at time of payment.

• Dollar accounting for Profits Tax and Profit Oil and Gas Sharing.
Loan Interest

1. For creditability of Profits Tax it is desirable that interest is a

deductible cost.

2. Problem of investor employing company with very high debt : equity

ratio. Possible device to repatriate profits before payment of Profits
Tax.

Solutions:
– Impose a ceiling on the proportion of debt capital employed
as % of total investment.
– Impose a withholding tax on interest sent abroad.
Other Income Tax Issues (Tax Credits)

1. Government should allow branch activity so that the investor is able to

write-off of exploration costs in parent country.

2. Should be designed to permit creditability, especially in USA. This is

easier if the tax meets the following criteria…
• realisations
• gross receipts, and
• net income requirements

3. Corporate income tax should be structured as above to bring in useful

revenues while not producing disincentives.
Creditable vs deductible foreign tax
Host Country Foreign Country
Summary
HC Tax Return Foreign Tax Return Taxes paid
Revenues 100 Revenues 100 in HC 14
Cost (60) Cost (60) Taxes paid
Creditable Pre-tax 40 0
Pre-tax 40 in FC
Tax @ 35% 14
Total Taxes 14
Tax @ 35% 14 Foreign Credit (14)
Payable tax 0

HC Tax Return Foreign Tax Return Taxes paid

in HC 14
Revenues 100 Revenues 100
Cost (60) Taxes paid
Cost (60)
Tax deduction (14) in FC 9.1
Deductible Pre-tax 40
Total Taxes 23.1
Pre-tax Profit 26
Tax @ 35% 14
Tax @ 35% 9.1
Measuring the Tax Take

How do we measure the Government’s Tax Take?

Total field lifetime tax bill expressed as % of field pre-tax cash

flows in money-of-the-day (MOD) terms

Total field tax bill in present value terms expressed as % of

field pre-tax net present value (NPV).

NB: The Government and Investors choice of

Discount Rate may differ
Effect of Royalty & Tax

A. Pre-Tax $M
T0 T1 T2 T3

Investment -200
Revenues 200 200 200
Operating Cost -100 -100 -100
Net Cash Flow -200 +100 +100 +100

MOD NCF = $100M NPV @ 10% = $48.68M

IRR = 23.75%

B. Royalty @ 5%
0 10 10 10
Post-tax Net Cash Flow -200 +90 +90 +90

MOD NCF = $70M NPV @ 10% = $23.8M

IRR = 16.6%

GOV. TAKE: a) MOD = 30 = 30%

100
b) PV @ 10% =9.09 + 8.26 + 7.5 = 24.86 =51%
48.68 48.68
Effect of Royalty & Tax

C. Income Tax @ 25%, depreciation 3-year straight line (33.33%) (zero royalty)
Investment -200
Depreciation 0 66.67 66.67 66.67
Tax Base 0 33.33 33.33 33.33
(Revenues-Op. Cost-Depreciation)
Income Tax @ 25% 0 8.33 8.33 8.33
Post-tax Net Cash Flow -200 91.67 91.67 91.67
(Revenues minus all costs and tax)

MOD NCF = $75M NPV @ 10% = $27.97M

IRR = 17.78%

GOV. TAKE: a) MOD = 25 = 25%

100
b) PV @ 10% = 7.57+6.9+6.3 = 20.8 = 42.7%
48.68 48.68
Effect of Royalty & Tax
D. Royalty @5% plus Income Tax @25% with 3 years s.l. depreciation (Royalty deductible for Inc. Tax)
T0 T1 T2 T3
Investment -200
Revenues 200 200 200
Operating Cost -100 -100 -100
Pre-Tax Cash Flow -200 +100 +100 +100 Net Cash Flow = $100M
IRR = 23.75%
NPV @ 10% = $48.68M
Royalty @ 5% 0 10 10 10

Depreciation 0 66.67 66.67 66.67

(200/3)
Tax Base 0 23.33 23.33 23.33
(Revenue-Operating Cost, Royalty and Depreciation, 200-100-10-66.67=23.33)
Income Tax @ 25% 5.8 5.8 5.8

Post-tax Cash Flow -200 84.2 84.2 84.2

(Revenues - all Costs, Royalty and Income Tax) Net Cash Flow = $52.6M
IRR = 12.6%
NPV @ 10% = $9.4M
GOV. TAKE:
a) MOD = 15.8 + 15.8.+ 15.8 = 47.4%
100

b) PV @ 10% = 14,36+13.06+11.9 = 39.30 = 80.7%

48.68 48.68
Class Exercise

Investment 100 100

Revenue 200 300 300 300 300
Operating Cost 100 100 100 100 100
Operating Profit
Pre-Tax
Undiscounted NCF
Discount Factors
Pre-Tax Discounted
NCF
Pre-Tax NPV@10%
Class Exercise

On your computers construct a spreadsheet based on

the table in the previous slide…

• Apply a royalty of 10%

• Calculate the Govt Take Undiscounted and Govt Take PV@10%
• Increase Investment Costs to 125, 150 and 175
• Re-calculate the Government take in Undiscounted and PV terms
• Plot your results

slide 241
Class Exercise

Using the same spreadsheet...

• Apply a Corporate Tax of 30% (5 year SL Depreciation from year of

first income), with Royalty deductible.

• Calculate the Govt Take Undiscounted and Govt Take PV@10%

• Increase Investment Costs to 125, 150 and 175
• Re-calculate the Government take in Undiscounted and PV terms
• Show the following:
•Royalty 10%,
•CT 30% & Royalty 0%,
•CT 30% & Royalty 10%
Resource Rent Tax
The Resource Rent Tax (RRT, APT, etc.)

The Resource Rent Tax was introduced to target economic rents

generated by natural resource exploitation …

• The RRT allows the investor to achieve a specified threshold rate

of return on the investment before tax is payable.

• The threshold rate of return is used to compound forward the

investors net cash flows.

• These flows will initially be negative (as they represent E&A

activity)

• The accumulated total will become a larger and larger negative

figure
Resource Rent Tax

When production begins and income is generated the

accumulated figure attains a lower and lower negative value…

• Eventually the cumulative NCF becomes positive. When this

happens the resource rent tax is levied.

• The RRT continues to be levied on the positive annual net cash

flows

• Later on in field life substantial incremental investment may occur

and net cash flows could go negative for a time.

• In that event the RRT calculation begins again.

Example of RRT

Time Periods

0 1 2 3 4 5
Investment 100 100 - - - -
Profits - - 100 200 200 200
NCF -100 -100 100 200 200 200

Threshold Rate 20% (15% + 5%)

Accumulated
Net Cash Flow -100 -220 -164 +3.2 - -

Tax Base - - - 3.2 200 200

Tax @ 50% - - - 1.6 100 100
The Resource Rent Tax

Specifying the Threshold Rate…

Threshold rate is normally specified in 2 parts

• Market rate currently available

• A rate of return to reflect investment risk

In Tanzania there are 2 rates:

– The US Goods Produced price index + 20%

– The US Goods Produced price index + 30%

Resource Rent Tax

The Australian RRT has three Threshold Rates…

The three rates depend on types of expenditure

1. For E&A expenditures rate is 15% + the long term

government borrowing rate

2. For other expenditures rate is 5% + the long term

borrowing rate

3. For E&A outside the 5 year rule rate is the GP inflation

factor.
Resource Rent Tax

Multiple Tiers…

1. When profitability is very high it is possible to design a multi-tier

scheme whereby further tax is levied as achieved rate of return
rises.

2. When higher rate of return is achieved an extra tier of resource

rent tax is levied.

3. In principle there can be several tiers of resource rent tax.

Two Tiered Resource Rent Tax
$ MILLION
Time Periods 0 1 2 3 4 5
Investment -100 -100 --- --- --- ---
Revenues 200 300 300 300
Operating Costs --- --- -100 -100 -100 -100
Pre-Tax Net Cash Flow -100 -100 100 200 200 200

1st Tier Threshold Rate = 20% (15% + 5%), 2nd Tier Threshold rate = 25%
1st Tier Tax Rate = 25%, 2nd Tier Tax rate = 35%

Accumulated Net Cash Flow @ 20% -100 -220 -164 +3.2

1st Tier Tax Base --- --- --- 3.2 200 200
1st Tier Tax @ 25% --- --- --- 0.8 50 50
Net Cash Flow after 1st Tier Tax -100 -100 +100 +199.2 +150 +150
Accumulated Net Cash Flow @ 25% -100 -225 -181.25 -27.36 +115.8
2nd Tier Tax @ 35% --- --- --- --- 40.5 52.5
Total Tax --- --- --- 0.8 90.5 102.5
Post Tax Net Cash Flow -100 -100 +100 +199.2 +109.5 +97.5

Marginal Rate of Tax = .25 + .35 (1 - .25) = 51.25%

NPV @ 10% = $176.7m, NPV @ 15% = $130.7m, NPV @ 20% = $93.4m, IRR = 39.6%
Class Exercise

Using the spreadsheet from the previous exercise…

• Compute a two tiered Resource Rent Tax based on post-tax NCF

• Tier 1 Threshold 20% Tier 1 Tax 25%
• Tier 2 Threshold 25% Tier 2 Tax 35%
• Calculate the Govt Take Undiscounted and Govt Take PV@10%
• Increase Investment Costs to 125, 150 and 175
• Re-calculate the Government take in Undiscounted and PV terms
Resource Rent Tax

Issues in the Construction of the RRT include….

• Choice of threshold rate

• Single rate or multi-rate (progressive) system?

• Prior tiers deductible or non-deductible

• Interaction with any Royalty and Corporate Income tax

– Should it be levied after Corporate Tax but still be deductible for
Corporate Tax?
– Should it be levied before Corporate Tax (i.e. on Pre-tax returns)

• The RRT Base

– Field-by-Field (ring fence)
– Contract area (allow offset of ongoing exploration)
– Whole Country
Resource Rent Tax

Advantages of the RRT include…

• Stability of fiscal system - no change in tax or threshold rates

required if oil prices or costs change.

• Automatic protection for marginal fields/cost overruns.

• From the investor’s viewpoint the RRT provides a high

degree of risk-sharing with Government.

• From investor’s viewpoint there is no early fiscal burden.

Resource Rent Tax

Disadvantages of the RRT include…

• No early revenue for Government. Therefore likely to desire a

Royalty or advance RRT.

• Government’s willingness to “Risk-Share”.

• Stability of thresholds and tax rates – in practice might be

changed.

• Size of annual cash flows.

• Gold plating incentives.

Resource Rent Tax

Summary…

• RRT meets most of the criticisms that are made of

conventional royalty and Corporate Income Tax.

• It offers the possibility of extracting economic rents while

ensuring no inhibitions on exploration and development
activities

• Care is needed particularly in choice of thresholds and to

avoid the gold-plating problem.
Brown Tax
Brown Tax

The Brown Tax is based on Corporate Net Cash

Flows and is named after E.C. Brown….

• The Government taxes all cash flows generated by the project at a

constant proportional rate.

• The Government therefore collects positive taxes in years when cash flows
are positive

• And pays subsidies (negative taxes) in years when net cash flows are
negative.

• The subsidy acts like a cash grant. Where there is no income this grant is
provided by government to the extent of the tax rate.
Brown Tax

Characteristics of the Brown Tax…

• All exploration, development and operating costs are recoverable on 100%

first year basis.

• No ring fence provisions.

• All expenditures on new activities can immediately be set against existing
income.

• Brown tax is completely neutral and highly effective at targeting economic

rent.

• The effect of the tax is to leave the post-tax IRR unchanged from pre-tax
and to reduce the NPV.
Brown Tax

If the NPV is positive before tax it remains

positive after tax

• Since no accumulation for time is needed there is no threshold

rate and no requirement for government to estimate investors
discount rate.

• Given the complete neutrality of the tax, rates could be set very
high without deterring any project.

• The Brown tax is simple and neutral but generally unpalatable to

governments due to large project risk sharing.
Brown Tax

A. Pre-Tax
T0 T1 T2 T3
Investment -200
Profits +100 +100 +100
Pre-Tax NCF -200 +100 +100 +100

IRR = 23.38%
NPV @ 10% = $48.68
million

B. Post-Tax (Tax Rate = 50%)

Post-Tax NCF -100 +50 +50 +50

IRR = 23.38%
NPV @ 10% = $24.34 million
Modern tax regimes worldwide
Types of Fiscal Devices

Australia: Resource Rent Tax + Income Tax (progressive)

UK: Pre-1993 wholly profit related. New fields CT only – profit

related (neutral)

China: Royalty, Production Sharing, Income Tax and State

Participation (Regressive)

Malaysia: Royalty, Production Sharing, Income Tax (regressive)

Indonesia: Production Sharing, Income Tax (regressive)

Types of Fiscal Devices

Papua New Guinea: Resource Rent Tax + Income Tax (progressive)

USCS: Bonus bids, Royalty, Federal Income Tax plus Windfall

Profits Tax.

Nigeria: Joint Ventures with Sliding Scale Royalty (if offshore based
on water depth) and Petroleum Profits Tax, Memorandums of
Understanding (MOU’s), PSC’s with Sliding Scale Royalty (water
depth based).
Production sharing systems
Agenda

• Key characteristics

• Comparisons with other systems

• Methods of Cost Recovery and Profit Oil Sharing

• The original Indonesian Model

• Review of PSA’s and upstream contracts worlwide

Overall Economic Objectives of PSCs

Mechanism which enables costs, rewards and risks to be shared between

host Government (or its agent) and investor in a manner which is
acceptable to both parties.

The Investor is a contractor, incurs initial investment and risks, and shares
fruits of activity.

Provision of at least some stability for duration of contract compared to most

free standing, discretionary tax systems.

Mechanism for determining rights and other work obligations of respective

parties.

Mechanism for clarifying relationships of contract with other laws in host

country.
Production Sharing Contracts

The Government grants a licence or enters into a

contract with an operator for a given contract area…

• The Contractor incurs the investment risks and costs.

• The petroleum produced is divided into

– Cost Oil
– Profit Oil

• ‘Cost Oil’ is available for recovery of investment and

operating costs.

• The remaining or ‘Profit Oil’ is shared between the state and

the contractor.
Production Sharing Contracts

Important Issues….

• PSC terms are often negotiable

• From a fiscal viewpoint the key issues to consider are:

– Cost recovery conditions.

– Profit sharing provisions.

Cost Recovery

The Cost Recovery Mechanism…

1. Cost recovery is the means by which the contractor recoups costs of

E&A, investment and operating costs.

2. Cost recovery conditions are similar to depreciation terms under

income tax

3. Frequently a ceiling is placed on proportion of production available for

cost recovery purposes. 50% is common.

Usually when actual costs available for recovery are less than the
ceiling the difference becomes part of profit oil, which is then
shared.
Cost Recovery

Cost Recovery conditions are similar to depreciation terms for

Corporate Tax….

1. Unrecovered costs can be carried forward and recovered in

succeeding years.

2. Normally costs are recovered in order:

a) Previous unrecovered costs
b) Operating costs
c) E&A
d) Depreciated capital costs
Cost Recovery
$

OIL PROFIT OIL

REVENUE

COST
RECOVERY
LIMIT

COST OIL

YEARS
Cost Recovery

An uplift can be introduced….

An uplift is a fiscal incentive whereby the government allows the

contractor to recover some additional percentage of tangible
capital expenditure. Similar to an investment credit, but applies
to a large category of costs
Cost Recovery: Uplift
$

PROFIT OIL
OIL
REVENUE

COST
RECOVERY UPLIFT
LIMIT
COST OIL

YEARS
 Cost Recovery
Variations from Conventional Cost Recovery Mechanisms….
• A ceiling based on quarterly production available for cost recovery that
varies with cumulative production

– This can inhibit investment in incremental projects in later field life

• Sometimes no cost recovery is specified – Direct Sharing
– Under this scheme all production is shared between investor and
Government.

– This can inhibit incremental projects when sharing is on progressive

scale in relation to production

• In a few agreements when costs available for recovery are less than the
ceiling all the difference goes to the state rather than becoming part of profit oil
– This is like a 100% marginal tax and does not encourage cost
consciousness
Cost Recovery

The Cost Recovery Ceiling determines how soon Profit Oil

becomes available for sharing between investor and state…

• The more quickly costs are recovered the less likely are
possibilities of marginal developments being deterred

• Original production sharing schemes had flat-rate split on profit

oil/gas. This is still the case in some countries, e.g. Indonesia.

• More frequently profit oil/gas is split on progressive or

incremental basis with the state’s share increasing with annual
production.
Production Sharing

The Indonesian PSC…

• Indonesia pioneered PSC’s in the mid 1960’s and is the standard

of comparison for all PSC’s.

• In Indonesia there is an 85% / 15% government/ contractor split.

• The 85% / 15% split remains the same regardless of the amount
of costs, as long as the contractor is able to recover all costs. This
is because there is no royalty in Indonesia.
Production Sharing

The Indonesian PSC…

• The 85/15 Indonesian contractor government take is comprised

of two mechanisms:

• A Profit Oil Split of 71.1538% / 28.8462% in favour of the

government

• An effective tax rate of 48% based on 2 layers of taxation – 35%

income tax and 20% withholding tax (levied after income tax).

• Effective Rate = 0.35+0.2(1-0.35) = 48%

 Indonesian PSC

Government Contractor
$30/bbl

Cost Recovery Cost Oil

Limit 40% 12.0

20% WT
0.675 35% IT Profit Oil
1.817 71.1538%

18.0
15.30 12.807 28.8462%

35% IT
5.192
20% WT
3.375
2.70

85% Profit Share 15%

Production Sharing

Production Government Share

(‘000 b/d) of Profit Oil (%)

<15 10%
15-30 20%
30-50 30%
50-70 40%
70-100 50%
>100 60%
Production Sharing

Traditional Production Sharing…

• To the extent that economic rents increase with field size this
increases flexibility of the scheme and is more desirable.

• The system is not so flexible with fluctuating oil/gas prices

(though less oil/gas is required for cost recovery if prices rise
and so the state will get more profit oil).
Production Sharing

A more flexible scheme relates the state’s share

of profit oil to the contractor’s achieved rate of
return on the investment.
Production Sharing

Profit Oil Sharing based on Rate of Return…

1. The resource rent tax concept determines the state’s share. Several
(increasing) threshold rates and associated (increasing) state shares are
often used.

2. No resource rent tax is payable. It is merely a device to determine the

state’s share.

3. The scheme described in above is very flexible to variations in

profitability from all sources, namely

(a) oil/gas price movements,

(b) variations in field sizes, and
(c) variations in depreciation costs.
Production Sharing

Contractor’s State’s Share

Rate of Return (%) of Profit Oil (%)

<15 10%
15-20 20%
20-25 30%
25-30 40%
>30 50%
Rate of Return Based Production Sharing
with Income Tax
ROR Production Sharing with CIT

The following slides show the calculation of a post-tax

ROR system with Corporate Income Tax, as follows:

1. Cost Recovery ceiling = 75%

2. Profit oil sharing based on post-tax return
3. Profit oil payments a deduction for CIT
4. CIT 50% (depreciation 3 year straight line)
Post-tax ROR Profit-Oil Share to State
% %

<20 0
>20<30 30
>30 50
Step1: Pre-Tax NCF, NPV and IRR

T0 T1 T2 T3

Million $
Investment -100
Gross Revenues 200 200 200
Operating Costs -100 -100 -100
Pre-Tax NCF -100 +100 +100 +100
NPV @ 10% = $148.68 m

IRR = 83.93%
Step 2: FISCAL CALCULATIONS, CIT & Post-Tax NCF

T0 T1 T2 T3
Million $
Investment -100
Gross Revenues 200 200 200
Operating Costs -100 -100 -100
Pre-Tax NCF -100 +100 +100 +100

Depreciation (3 yr SL) 33.3 33.3 33.3

CIT Base (excluding
66.7 66.7 66.7
Profit Oil Payments)
CIT @ 50% 33.35 33.35 33.35

Post-Tax NCF -100 66.65 66.65 66.65

Step 3: Cost Recovery & Profit Oil

T0 T1 T2 T3

Million $
Investment -100
Gross Revenues 200 200 200
Operating Costs -100 -100 -100

Cost Recovery Ceiling (75%) 150 150 150

Costs Recovered (Cost Oil) 150 150 100

Unrecovered Cost -100 -50 0 0

Profit Oil 50 50 100
 Step 4: Testing Post-Tax NCF

T0 T1 T2 T3
Million $
Investment -100
Gross Revenues 200 200 200
Operating Costs -100 -100 -100

Pre-Tax NCF -100 +100 +100 +100

Depreciation 33.3 33.3 33.3

CIT Base (excluding
66.7 66.7 66.7
Profit Oil Payments) (see step 2)
CIT @ 50% 33.35 33.35 33.35

Post-Tax NCF (see step 2) -100 66.65 66.65 66.65

Post-Tax NCF Compounded at 20% -100 -53.35 2.63 69.8 *1.2
Post-Tax NCF Compounded at 30% -100 -63.35 -15.7 46.2 *1.3
Step 5: Post Profit Oil Payment IT
Post-Tax & Profit Oil Payments NCF

T0 T1 T2 T3

Million $
Payment of Profit Oil to Govt. at 30% - - 15 30
New CIT Base less Profit Oil
Payment - 66.7 51.7 36.7

CIT Paid at 50% - 33.35 25.85 18.35

Post-Tax NCF with Profit Oil Payment 66.65 59.15 51.65
-100
(= Pre-Tax NCF - PO Payment - CIT)

15= 30% of profit oil in year two

30 = 30% of profit oil in year three
 Step 6: Post-Tax & Profit Oil Payment
Calculation of NPV & IRR
T0 T1 T2 T3
Million $
Post-Tax (with Profit Oil Payment) -100 -63.35 -23.2 21.48
NCF Compounded at 30%
Profit Oil Payment to Govt. @ 50% - - - 50
New CIT Base including Profit
Oil Payments - 66.7 51.7 16.71

CIT Paid at 50% - 33.5 25.85 8.35

Total Profit Oil Payments to Govt. - - 15 50

Total Payments to Government - 33.35 40.85 58.35

Post-Tax NCF
-100 66.65 59.15 41.65
(Pre-Tax NCF – All Payments)
NPV @ 10% = $40.767m

IRR = 34%
R-Factor Scheme

The R-Factor Scheme is a device to relate Governments

share of profit oil to the profitability of the project…

1. The Government’s share is determined by the following ratio:

Contractor’s accumulated revenues after all

royalty, tax & Government profit oil share to date
Contractor’s accumulated costs to date

3. Government’s share of profit oil increases as the R-Factor increases.

4. The R-Factor achieved varies with the profitability of the project from all
sources
R-Factor Scheme

Contractor’s accumulated revenues after all

R-Factor ratio = royalty, tax & Government profit oil share to date
Contractor’s accumulated costs to date

Government’s Share
R-Factor of Profit Oil (%)

<1 a
1-1.5 b
1.5-2 c
2-2.5 d
>2.5 e
a<b<c<d<e
R-Factor Scheme

Disadvantages of the R-Factor Scheme…

• Important to determine which costs are included in the denominator.

• The R-Factor is profit related but is not targeted on economic rent
because there is no built in factor to represent the cost of capital.

• In later field life government may experience a reduction in revenues from

both declining production and a reduced profit share (as R-Factor ratio
declines)

• This could happen in circumstances where the investor achieved rate of

return had not declined

• Gold plating issues

Production Sharing

Issues related to Profit Oil Sharing…

• In some agreements Government’s share of profit oil increases with

cumulative production. This can produce very high take in later field life
and inhibit incremental investments.

• With profit oil sharing based progressively on project ROR the returns to
investment in incremental projects may be quite low.

• The take at the top rate achieved by the overall field will continue to
apply in the situation where the incremental project is financed from
total field cash flow.

• Only where the total field cash flow becomes negative will the threshold
return compounding mechanism be employed.
Production Sharing Key Features

Optional Elements

1. Bonuses
2. Royalty
3. Profits Tax
4. Other special Taxes
Bonuses (a tax?)

Highly sought but a bone of contention…

• Signature Bonus:
A cash bonus is paid upon finalisation of negotiations.

• Discovery Bonus:
Paid upon discovery of hydrocarbons at a commercial level

• Production Bonus:
Paid when production from a given contract area or field reaches a
specified level (or even at startup of production).

– Negotiated for each case

– Early revenues.
– Leave risks mostly on investors.
Signature Bonuses

• Obvious advantage to Government of front-end receipt.

• Size of payment reflects expected return from investment with

risks fully taken into account.

• May well not reflect realised returns. Difference could be very

large.

• Normally not cost recoverable (but tax deductible).

Royalty in PSC’s

1. Conceptually royalties should not be incorporated in

PSC’s where the investor is contractor

2. Royalty is common in the majority of PSC’s as a

mechanism to increase early revenues to the state.
Profits Tax in PSC’s

1. PSCs originally (Indonesia) had no taxes or royalties. Profits tax has

been introduced in order to provide a creditable tax in the parent
country of the investor.

2. Profit oil payments made to the state are not regarded as a tax by IRS
but akin to a royalty.

3. Profits Tax may be paid on behalf of investor by state company or

other state body and still qualify for creditability purposes
Profits Tax in PSC’s

4. Evidence may well be required that a payment has actually been

made and that the tax in question conforms to the definition of tax in
the parent country concerned.

5. Such a device can enhance fiscal stability for the investor.

6. Sometimes the grossing up issue arises. The payment of tax made

on behalf of the investor may be regarded as additional income to
him in which case the taxable income is grossed up at the income tax
rate.
Concept of Direct Sharing in PSC’s
Direct Sharing

Under Direct Sharing Arrangements there is no distinction

between Cost Oil and Profit Oil…

1. Employed in only a few countries such as in some Libyan and Trinidad

contracts.

2. Because there is no distinction between cost oil and profit oil the Investor
pays his costs out of his share which will reflect that obligation.

3. Apparent simplicity of scheme masks problems:

a) Simple sharing of production (even on progressive scale) does not

result in efficient collection of economic rents to the state.

b) The scheme does not react to variations in costs or oil prices in

appropriate manner.
Direct Sharing

Direct Sharing could lead to…

• investment disincentives when oil prices low and/or costs high, and

• high share of economic rents being left with investor when oil prices are
high and/or costs low.

b) A more efficient scheme would require the sharing to be done on

the basis of the contractor’s return or R-Factor.

c) If no profits tax is payable the foreign investor will not have any
tax to credit against his tax payable on the Russian production in
his home country. At best he will get a deduction, but not a more
valuable credit.
Direct Sharing

The introduction of direct sharing together with conventional PSA’s

(and licences) adds to the complexity of the arrangements…

• Compliance costs are increased for all parties. Diversion of time and
effort to seek most advantageous scheme.

• State can obtain early income through design of cost recovery and profit
oil sharing terms. Not at all clear that state would obtain higher share
with direct sharing.

• Lack of profits tax payments and credit could mean that foreign
companies will seek higher share under direct sharing scheme as
compensation.
Examples of Production Sharing
Contracts Around the World
 Indonesian Terms Standard Terms

• First tranche petroleum is equal to 20% of production.

• For cost recovery there is depreciation of costs with intangible drilling

costs written off on a 100% first year basis.

• Profit oil is shared on the basis: Government 71.1538, Investor

28.8462%

• An investment credit is available for cost recovery equal to 110% of field

development costs. The credit forms part of taxable income.

• Income tax (including dividends tax) is levied at an effective rate of

48%. Depreciation is on the same basis as for cost recovery purposes.

• A domestic market obligation of 25% of pre-tax profit oil is applicable in

Indonesia. The market price is payable for the first 5 years of the field’s
life, thereafter the investor receives only 15% of the export price.
 Indonesian Terms Frontier Terms

• First tranche petroleum is equal to 15% of production.

• For cost recovery there is depreciation of costs with intangible drilling costs
written off on a 100% first year basis.

• Profit oil is shared on the basis: Government 32.6923%, Investor

67.307%

• No investment credit is available under this system.

• Income tax (including dividends tax) is levied at an effective rate of 48%.

Depreciation is on the same basis as for cost recovery purposes.

• A domestic market obligation of 25% of pre-tax profit oil is applicable in

Indonesia. The market price is payable for the first 5 years of the field’s life,
thereafter the investor receives only 25% of the export price.
 Russia – Sakhalin II PSA

Bonuses…
1. Signature Bonuses – None
2. Commencement Date Bonus when Agreement ratified
by Parliament - $15m
3. Development Date Bonus at the beginning of the
development of Piltun-Astokhskoye - $15m
4. Development Date Bonus at the beginning of Lunskoye
- $20m
 Russia – Sakhalin II PSA

Rental & Fees – None

Corporate Income Tax - 35%. All Expenses including those

qualifying for cost recovery and bonuses are deductible in full. Capex
depreciated o a straight line basis 3years. 15 year loss carry forward.

Cost Oil - No Cost Oil Limit (net of Royalty). All costs expensed.
Cost recovery includes $100mm for Sakhalin Regional Development
Fund and $160mm compensation for prior Russian Exploration
Expenditures. Bonuses not cost recoverable
Russia – Sakhalin II PSA

Profit Oil Split

Before Profit Oil Split To

Government IRR

10% <17.5%
50% 17.5% > IRR < 24%

70% >=24%

No Participation by State Oil Company

 Russia – Sakhalin II PSA

Other...
1. $100mm to Sakhalin Regional Development Fund, paid in equal
instalments over 5 years beginning at development approval.
2. $160mm contribution for reimbursement of prior Russian
exploration expenditures.
3. Payment starts with first production at rate of $4 mm per quarter
until $80 mm is paid.
4. The remaining $80 mm to be paid at rate of $4 mm per quarter
beginning when Russian/Contractor profit oil split changes to 70:30
 Angolan Old Style PSA

1. Petroleum Income Tax: 50% (levied on the contractors share of Profit

Oil

2. Price Cap: $20/bbl (previously $13/bbl) inflated according to UN Total

Unit Value index of manufactured goods exports (base year 1978)

3. Profit Sharing based on Cumulative Production

Cumulative Production Contractor Share

<75 mmbbls 40%

75 – 100 mmbbls 20%

100> mmbbls 10%

 Angolan Old Style PSA

• All development costs are uplifted by 25% and depreciated on a

straight line basis over 5 years.

• The Cost Recovery Oil Limit is 40% of total revenues

• If the limit is not fully exploited then the unused cost recovery oil is
to be treated as part of the fields profit oil.
 Angolan New Style PSA

1. Petroleum Income Tax: 50% (levied on contractors share of

Profit Oil).

2. Profit Sharing based on Rate of Return

Contractors Government Contractors

Rate of Return Share Share

<15% 30% 70%

15-25% 40% 60%
25-30% 60% 40%
30-40% 80% 20%
40%> 90% 10%
 Angolan New Style PSA

The rate of return calculation begins at the commercial discovery

date…

• The Cost Recovery Limit is 50% and is increased to 65% if costs are not
fully recovered 5 years after they have occurred and the field has been in
production for at least 5 years.

• All development costs are uplifted by 50%

• Sonangol has a 20% equity share in this block.
• The company shares in the exploration and appraisal costs, but 50% of
Sonangol’s share is carried through the E&A phase and is not repayed.
 São Tomé and Príncipe/Nigeria
JDZ PSA

1. Royalty: 0% below 20,000 b/d

5% above 70,000 b/d
Linear sliding scale between these values

2. Cost oil limit 80% of (sales revenue – royalty)

Annual rents are added to royalty before this calculation

All recoverable costs are expensed (exploration, appraisal,

scholarships, development, decommissioning provision)

Recoverable head office overhead is limited to a percentage of other

recoverable costs (three tranches, capped at $4m p.a.)
 São Tomé and Príncipe/Nigeria
JDZ PSA

3. Tax oil is calculated before the profit oil split

50% of (sales revenue - royalty - costs)

Allowable costs are as for recoverable costs except:

Fees for drilling permits, hydrocarbon sample export, etc are included

Development costs depreciated (20% p.a. straight line)

Exploration costs after first exploration well depreciated

Appraisal costs after second appraisal well depreciated

50% Investment Tax Allowance (uplift) on depreciated costs

 São Tomé and Príncipe/Nigeria
JDZ PSA

4. Profit oil split based on R factor:

Joint Development Authority share:

20% for R factor below 1.2
75% for R factor above 2.5
Linear sliding scale between these values

R factor = (cumulative cost oil + cumulative

investor’s share of profit oil) /
cumulative recoverable costs
 Chinese Terms Offshore Terms

Royalty Terms:

Prod. 000b/d 0-20 20-40 40-60 60-100 100-150 >150

Rate (%) 0% 4% 6% 8% 10% 12.5%

Cost Recovery from 62.5% of production (interest on unrecovered

development costs).

Profit Sharing
Prod. 000b/d 0-20 20-40 40-60 60-100 100-150 >150

Govt. Share (%) 0% 10% 20% 30% 40% 50%

State participation: 51% (carried interest basis).

Corporate Income Tax: 33%.
 Azerbaijan

Foreign Investment Law…

1. The Azeri law is a modified version of the Soviet Law which protects investors
from adverse changes in legislation for a period of 10 years after their
incorporation.

2. Expropriation and/or confiscation is only permitted in exceptional

circumstances, and requires prompt and adequate compensation paid in
foreign currency.

3. Azeri Law grants the right to foreign enterprises to repatriate profits after
payment of taxes and duties, but does not grant the unconditional right to
convert profits into hard currency prior to repatriation.

4. Azeri Law requires that investment disputes be settled in national courts by

arbitration, unless otherwise provided by treaty.
 Azerbaijan

Petroleum Related Legislation…

1. Azerbaijan does not have a law on the subsoil as in Russia and

Kazakhstan.

2. The Law on State Property was passed in November 1991, giving the
Republic of Azerbaijan control over its natural resources including those
in the Caspian Sea.

3. Foreign investors proceed on the basis of the Foreign Investment Law

which allows the Government to grant contracts which are then ratified
by Parliament.

4. This procedure was adopted by the Western consortium in the contract

to develop the Azeri, Guneshli and Chirag fields.
 Azerbaijan

Profits Tax - Rate at 25%.

VAT
Payable at 20% on imported goods. VAT paid on the purchase of equipment or
intangible assets cannot be offset against the VAT collected from customers.
This payment is considered as capital expenditure and is recovered through
depreciation.

Land Tax Rates

Determined as a percentage of the minimum wage
In Baku the rate is 1% of the minium wage per square meter, in other areas it
varies between 0.4%-0.8%.

Export Tariffs
Export tariff rates for crude oil were 30 European Community Units (ECUs) per
tonne and 40 ECUs per tonne for key petroleum products.
 Azerbaijan

Export Duty
The duty applies to crude oil and the rate is specified as 70% of the difference
between the contract price and the wholesale price.

Import Tariffs
Exemptions include goods imported as contributions to charter funds of
enterprises wholly owned by foreigners, and raw materials, equipment and wares
imported for the “productive needs” of enterprises.

Payroll Taxes
Payroll taxes are substantial.
They include:
- payments to the Social Insurance Fund (35% of gross wages + 1% of
the employee’s salary net of income tax).
- payment to the employment fund (2% of gross wages).
 PSA: Azeri, Chirag, Gunashli

A major agreement to develop these fields was signed in 1994. It

provides for…

1. Bonuses
2. Profit Oil sharing based on the investor’s rate of return
3. Profits Tax

• The agreement is complicated by the terms being dependent on:

– whether or not early production is achieved.

– the transportation costs.

• Cost recovery provisions allow operating costs to be recovered from total

production.

• Capital costs are recovered from a maximum of 50% of oil remaining after
the deduction of operating costs.
 PSA: Azeri, Chirag, Gunashli

Total bonus payments are $300 million…

1. 50% (minus any payments made) is payable within 30 days of

the effective date.

2. 25% is payable within 30 days of production reaching 40,000

b/d.

3. 25% is payable within 30 days from the date at which crude oil
has been exported from the main export pipeline for a period
of 60 days.
 PSA: Azeri, Chirag, Gunashli

Depreciation Terms….

25% declining balance for equipment and fixed assets

10% per annum straight line for bonus payments
2.5% per annum straight line for permanent office buildings
5% per annum straight line for temporary office buildings

• Losses can be carried forward indefinately

• Interest on loans is a deductible expense
 PSA: Azeri, Chirag, Gunashli

Profit Oil Sharing Terms….

1. Profit Oil is be split between SOCAR and the Contractor on the

basis of:

- whether the Contractor achieves early oil production.

- the cumulative after tax real rate of return achieved at the
end of the preceding calendar quarter.
- total transport costs calculated on a per barrel basis
restated in real terms at the effective date.

2. The Contractor is liable for profits tax. This is taken into account
in determining the Contractor’s Rate of Return.

3. The rate of Profits Tax is fixed at 25%.

 PSA: Azeri, Chirag, Gunashli

• The contractor’s Rate of Return (ROR) is calculated at the end of

each calendar quarter on the basis of Net Cash Flow (NCF).

• NCF is compounded at 3.948% (annual rate of 16.75%), multiplied by an

inflation multiple and accumulated from the effective date:

CCNF1 (currant calendar quarter) = [(1.03948 x I x CCNFt-1) + NCF1]

Where…

CCNF1 = Cumulative Compounded Net Cash Flow @ 16.75% annual RROR.

NCF = Net Cash Flow.
I = Inflation Adjustment for the Current Calendar Quarter.
1.03948 = Quarterly RROR @ annual rate of 16.75%.
 PSA: Azeri, Chirag, Gunashli

The contractor’s NCF is also compounded at 5.258% (annual rate of 22.75%),

multiplied by an inflation multiple and accumulated from the effective date:

CCNF1 (currant calendar quarter) = [(1.05258 x I x CCNFt-1) + NCF1]

In any calendar quarter, the Contractor’s RROR is calculated as:

Contractor’s Net Cash Flow RROR (%)

CCNCF1 < 0 16.75%

CCNCF2 < CCNF1>= 0 >= 16.75% < 22.75%
CCNCF2 >= 0 >= 22.75%
 PSA: Azeri, Chirag, Gunashli
Profit Oil is shared between the contractor and SOCAR according to the cumulative after-tax real
rate of return achieved by the contractor. The precise sharing depends on (1) whether early
production is achieved and (b) transport costs:
If Total Transport Costs are less than or equal to $3/bbl and the contractor achieves
early oil
Contractor RROR SOCAR Share % Contractor Share %

Less than 16.75% 30 70

16.75% or more but less 55 45

than 22.75%
22.75% or more 80 20

If Total Transport Costs are greater than $3/bbl but less than $4/bbl and the contractor
achieves early oil
Contractor RROR SOCAR Share % Contractor Share %

Less than 16.75% (1-P)*30%+P*25% (1-P)*70%+P*75%

16.75% or more but less (1-P)*55%+P*50% (1-P)*45%+P*50%

than 22.75%

22.75% or more (1-P)*80%+P*75% (1-P)*20%+P*25%

 PSA: Azeri, Chirag, Gunashli
Where P = total transport costs per barrel less $3.00 expressed as a decimal fraction of $1.00
If Total Transport Costs are greater than $4/bbl and the contractor does achieve early
oil
Contractor RROR SOCAR Share % Contractor Share %

Less than 16.75% 25 75

16.75% or more but less 50 50

than 22.75%
22.75% or more 75 25

If Total Transport Costs are greater than or equal to $4/bbl and the contractor does not
achieve early oil
Contractor RROR SOCAR Share % Contractor Share %

Less than 16.75% 20 80

16.75% or more but less 50 50

than 22.75%
22.75% or more 75 25
 PSA: Azeri, Chirag, Gunashli
Where P = total transport costs per barrel less $3.00 expressed as a decimal fraction of $1.00
If Total Transport Costs are greater than ir equal to $3/bbl but less than $4/bbl and the
contractor does not achieve early oil
Contractor RROR SOCAR Share % Contractor Share %

Less than 16.75% (1-P)*25%+P*20% (1-P)*75%+P*80%

16.75% or more but less (1-P)*55%+P*50% (1-P)*45%+P*50%

than 22.75%

22.75% or more (1-P)*80%+P*75% (1-P)*20%+P*25%

If Total Transport Costs are greater than or equal to 3/bbl and the contractor does not
achieve early oil
Contractor RROR SOCAR Share % Contractor Share %

Less than 16.75% 25 75

16.75% or more but less 55 45

than 22.75%

22.75% or more 80 20
 PSA: Azeri, Chirag, Gunashli

Abandonment….

1. An abandonment fund in the form of an escrow account is to

be jointly opened by the Contractor and SOCAR.

2. Contributions to the fund begin when 70% of the reserves

identified in the development plan have been recovered.

3. Contributions will not exceed 10% of all capital costs..

4. Contributions are recoverable as operating costs.

 PSA: Azeri, Chirag, Gunashli

Foreign Exchange rules…

1. The PSC allows the Contractor to operate foreign exchange
accounts inside and outside Azerbaijan. It also allows the Contractor
to export or dispose of any proceeds from petroleum sales.

2. Exemption from import duties on equipment are provided for in the

agreement.

Changes to the Contract

The stabilisation provision insures the Contractor against
adverse changes in Azeri law.
The Saga of Kashagan
The Saga of Kashagan
The Kashagan project is a huge oil field (9bn barrels of reserves,
>1mmbbl/day) being developed in Kazakhstan.

• The PSA for the north Caspian Sea, the area that includes Kashagan, was
signed in 1997, with a group of companies including ENI (the operator), Exxon
Mobil, Total, Royal Dutch Shell, Conoco Philips and Inpex (Japan).

•The first phase, described as “experimental”, would take production to 350,000

bbls/day, which would imply revenues of about $6bn a year (at a $60 price)

• The details have been kept out of the public domain, but a copy was obtained by
Platform, a campaign group that monitors oil companies.

• It has emerged that, for the first 10 years after the field was expected to start
production, Kazakhstan will receive only about 2 per cent of the oil revenues -
$120 million.
The Saga of Kashagan
The terms of the original deal have created a bitter conflict…

• Under the terms of the PSC, investors can delay paying Kazakhstan royalties
until development costs are recovered.

•After that, once the project’s capital costs had been paid off, the government’s
income was to rise steeply, although much of the risk would remain with
Kazakhstan

•Greg Muttitt of Platform said: “The contract was signed at a time when the
government of Kazakhstan was extremely weak. The oil companies took
advantage of that weakness to lock in contract terms that would last for 40 years.”

•The companies argued that the generous terms they received, although agreed
before the Kashagan field was discovered in 2000, were only a fair
reflection of the challenges the project presented.
The Saga of Kashagan
The Oil Companies say that they simply weighed the risks and
rewards...

• The field is in shallow water, requiring every vessel working on it to be specially

designed with a shallow draught. The bitterly cold winter weather puts great strain
on the facilities.

• The oil also has a hydrogen sulphide content of up to 18 per cent, and it is under
very high pressure, forcing GE, one of the contractors, to invent special
equipment to handle it.

• These challenges are daunting. But because the companies are allowed to
recover most of their costs from project’s revenues, much of the risk is shared
with the government.

• As work started costs for oil and gas projects around the world began to
rise, in some cases doubling or tripling from their original estimates. Eni,
the project’s operator, has also admitted to a very costly mistake.
The Saga of Kashagan

Costly mistakes have led to a long Cost Recovery period…

• The facilities are being sited on artificial islands, and the design of the development
had to be reconfigured after it emerged that the staff accommodation was being sited
too close to the plant for extracting the toxic hydrogen sulphide from the oil.

• Rectifying that one mistake cost approx. $2bn, and delayed the project by up to 18
months. As the costs rose, and the planned start date was put back, the returns to
Kazakhstan declined even further.

• In 2007 the consortium raised its estimate of the capital costs of phase one from
$10bn to $19bn, and put back the planned date for first oil from 2008 to 2010.

• Kazakhstan revealed that the estimated total 40-year cost, including both capital
and operating expenditure, had risen from $57bn to $136bn.

• Askar Balzhanov, the chief executive of KazMunaigas’s London-listed arm, told the
Financial Times recently that under the terms of the 1997 contract, the rise in costs
would have meant that Kazakhstan would not have received a dividend for 25 years!.
The Saga of Kashagan
The ROR to the companies, assuming an oil price of $60 a barrel, was
estimated by Deutsche Bank at a healthy 18.5 per cent…

• Set in the context of countries such as Russia and Venezuela setting an example of
how to exert influence to win more favourable terms from international oil companies,
renegotiation was inevitable.

• The government’s very low share of the proceeds, which have been further reduced by
delays and cost increases, has fuelled Kazakhstan’s determination to push for better
commercial terms and a renegotiation of the 1997 terms (summer 2007).

•Legislation allowing the government to annul natural resource contracts deemed

damaging to national interest intensified pressure on the consortium group

• Any settlement is expected to include a redistribution of equity in the project to give

KazMunai-gas, Kazakhstan’s state oil company, a bigger stake than its 8.33 per cent.

• Kazakhstan is also entitled to fine the oil companies for the late start-up, and may
demand cash compensation for losses arising from the increased cost of the field.
The Saga of Kashagan

Giving a greater share to the State company appeared to be some kind of

solution…

• Disagreements within the consortium have complicated negotiations over

redrawing the contract terms.

• Exxon was reluctant to dilute its 18.5% stake, despite other members of the
group agreeing in principle to surrender shares to KazMunai-gas (20
December 2007)
The Saga of Kashagan

“A sucessful end to long and difficult negotiations”…(January 2008)

• The consortium agreed to pay Kazakhstan $2.5bn-$4.5bn in compensation for the

project’s late start, depending on oil price and over 20 years

• It will also sell shares to KazMunaiGas, the national oil company, so its stake doubles
to 16.8%

•KMG will pay $1.78bn for the shares, estimated to be about half their market value
•ENI will lose operating control of the oilfied (its crown jewel) after the end of the first,
experimental phase.

•A new operating company representing other shareholders, will be established to

manage all subsequent staged of the development. The new entity will report to a
management committee led by KazMunaiGas

•The contract expires in 2041.

Other forms of contractual relationships for oil
and gas exploitation
Contractual relationships

Other arrangements

• Risk Service Contracts

• Pure Service Contracts

• Buy Back contracts

• Technical Assistance Contracts, EOR Contracts

• Association Contracts / Joint Ventures

Risk Service Contracts
The contractor is paid a cash fee for performing the
service of producing mineral resources.
• All production belongs to the government.

• The contractor is usually responsible for providing all capital

associated with exploration and development of petroleum
resources.

• If exploration efforts are successful, the government allows the

contractor to recover those costs through sale of the oil or gas
and pays the contractor a fee that is usually based on a
percentage of the remaining revenues. This fee is often then
subject to taxes.

• Risk service contracts have been used in Argentina, Brazil,

Chile, Ecuador, Peru, Venezuela, Iran and Malaysia.
Pure Service Contracts
When the contractor carries out exploration and/or
development work on behalf of the host country for a
fixed fee. All ordinary exploration risk is borne by the
state.
• Characteristic of the Middle Eastern region, where the state
often has substantial capital and seeks only expertise.

• Can be quite similar to those arrangements found in the oil

service industry (drilling services, development services and
exploration services).
Buy Back Contracts
A Iranian contractual arrangement under which foreign
companies that participate in developing a project are
repaid from a share of sales revenue.
• The system circumvents Iran's constitution, which prohibits
foreigners from holding equity stakes in oil and gas projects

• The oil company is a contractor

• The host Government retains full title to oil in the ground

throughout the life of the contract.

• The host Government or national oil company can procure title

to equipment in the project.

• Companies that participate in developing a project are repaid

from a share of sales revenue.
Buy Back Contracts
• The contractor incurs all investment and operating
expenditures. Costs can be recovered up to a ceiling (agreed in
the contract) when three conditions have been met:
• successful completion of development activity,
• acceptance of the facilities by NIOC,
• achievement of an agreed production level.

• Investment costs and operating costs are repaid in fixed

monthly instalments over an agreed period.

• Companies are repaid via a negotiated remuneration fee.

Buy Back Contracts
• In a typical agreement the contractor therefore receives
– a repayment of its investment expenditure, operating costs
and related bank charges,
– plus its negotiated remuneration fee, paid from production
revenues - typically up to 60% of production revenues under
long term agreements.

• Development cost and project completion risks are borne by the

contractor under buy-back.
Technical Assistance Contracts,
EOR Contracts
• Used for enhanced oil recovery (EOR) projects or
rehabilitation/redevelopment schemes administered under a
PSC or a concessionary system.

• These normally involve proved reserves that are beyond the

primary recovery stage.

• The contractor takes over operations including equipment and

personnel if applicable. The assistance that includes capital
provided by the contractor is principally based on special
technical know-how.

• Exploiting potential such as infill drilling or undrilled deeper

horizons often provides the primary financial incentive.

• An example is the formation of the Dubai Petroleum

Establishment (DPE).
Technical Assistance Contracts,
EOR Contracts
• Key elements of there arrangements are:
– Government need for technology and capital
– Associated personnel
– Existing proved reserves
– Existing infrastructure and equipment
– Joint management

• The critical aspect of exploration risk is missing, albeit not the

estimation and control of costs and timing.

• If there is existing production a baseline decline rate or

production profile is agreed and exempt from any sharing
agreement (goes directly to the government). Production above
the baseline is “incremental” production and normally subject to a
production sharing agreement, although TACs can be found
under a variety of systems.
Technical Assistance Contracts,
EOR Contracts
• Rehabilitation projects are often structured in three phases that
follow a logical sequence:
– feasibility study,
– pilot program
– and commercial development.
The contractor has the option to proceed into each subsequent
phase. The decision to go forward is based on the technical
results of each phase.

• Technical assistance contracts have also been used in

Azerbaijan and Iraq now seems to be taking this route.
Association Contracts / Joint Ventures

• Common in the international oil industry as most companies are

willing to take on partners for large-scale or high risk ventures in
order to diversify.

• Joint ventures are not a type of fiscal/contractual system. The

term applies to a number of partnership arrangements between
individual oil companies or between a company and a host
government.

• Typically an oil company or consortium carries out sole risk

exploration efforts with a right to develop any discoveries made.
Development and production costs as well as revenues then
are shared pro rata between partners in the joint venture.

• The partners pay applicable taxes out of their profits.

Association Contracts / Joint Ventures

• In a pure joint venture, the host government or NOC and the

companies share in costs and risks in proportion to their
percentage stakes, whenever these costs and risks occur.

• However, in practice the oil company usually bears the costs

and risks of exploration and the government/NOC is “carried”
through exploration. Various provisions exist for non payment or
payment of carried costs at a later date, with or without accrued
interest.

• In some cases, governments/NOC are not initially part of the

venture but there are usually clauses that stipulate a right to join
in development as a working interest partner. The motive for this
is not purely financial, as it provides an opportunity for
technology and knowledge transfers.

• Joint ventures are governed by a joint operating agreement

(JOA) between the partners.