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ABSTRACT: The unprecedented rising crude oil prices has prompted most oil rich host governments to
revisit their petroleum contracts with International Oil Companies with a view to renegotiating the fiscal
terms to reflect current developments. Nigeria is the latest country to consider renegotiating its PSCs and
Joint Venture contracts with the IOCs. The early deep offshore PSCs are based on a production based
sliding scale which analysts have argued is not a proxy for project profitability. This paper will attempt to
quantitatively discuss the impact of changing oil prices on a production based profit split vis--vis other
sliding scale mechanisms like the R factor and ROR profit split. It will also briefly discuss the implications
of contract renegotiations.
The author is an MSc Candidate in Energy Studies with specialization in Oil and Gas Economics, Centre
for Energy, Petroleum and Mineral Law and Policy, University of Dundee, Scotland. He is an Analyst
under the Sub-Sahara African Research Team, Wood Mackenzie, in Edinburgh. E-Mail:
idorns@yahoo.com
TABLE OF CONTENTS
2.1
2.2
3.0
4.0
4.1
5.0
6.0
CONCLUSION ........................................................................................... 15
BIBLIOGRAPHY ................................................................................................... 17
ii
ABBREVIATIONS
CT
Contractor Take
GT
Government Take
IOC
IRR
JV
Joint Venture
NNPC
NPV
PSCs
RoR
Rate of Return
iii
1.
INTRODUCTION
The emergence of Deep Offshore West Africa as one of the worlds prolific spots for
petroleum exploration has generated significant interest amongst petroleum analysts
and policy makers. According to Douglas-Westwood world deep water report, deep
water West Africa is expected to account for about 34% of total deep offshore
reserves for the period 2003-20071. Commercial deep offshore discoveries in Nigeria,
Angola and Equatorial Guinea are steadily coming on stream, and this development is
expected to boost current reserves of the aforementioned countries.
The growth in offshore reserves in West Africa is occurring against the backdrop of
soaring prices of crude oil in the international market. The unprecedented increase in
oil prices has prompted most oil rich countries to revisit their oil contracts with
International Oil Companies with a view to renegotiating these contracts to reflect
current market trends. Nigeria is the latest oil producing country to consider
renegotiating its oil contracts2 and the 1993 deep offshore PSCs are amongst the
petroleum contracts that have been slated for renegotiation. The argument by the
Nigerian authorities is based on the fact that majority of these contracts were signed in
the early nineties when crude oil price was closer to $20 dollar per barrel and cost of
exploring in frontier deep offshore was very high. The Nigerian government has also
argued that distinct terms for gas exploration were not factored into the contracts.
For comprehensive overview on this issue, see Townsend, D., Golden triangle dominates, Petroleum
Economist, October 2002, Volume 69, p.18
2
Green, M., Nigeria threatens to renegotiate generous contracts of oil groups, Financial Times, 24
October 2007.
The early deep offshore PSCs in Nigeria are based on a production sliding scale
which analysts have argued is not an effective proxy of project profitability,3 hence
the resultant profit oil split under a production based sliding scale inevitably results in
minimal impact of increasing crude oil prices on government take
In view of the foregoing argument, this paper will attempt to discuss the justification
for the proposed renegotiations of the deep offshore PSCs in Nigeria particularly in
the context of rising crude oil prices.
A quantitative approach with generic data is utilized with a view to observing the
effects of oil price changes on different profit oil split models. Within this context, the
effects of price changes on production based sliding scale and the R factor system
ceteris paribus are observed. The Rate of Return (RoR) approach is also discussed.
Section two discusses why PSCs are attractive to host governments as an instrument
for capturing economic rent while section three discusses the introduction of PSCs in
Nigeria. Section four provides a simple quantitative analysis of the effects of price
increase under different profit splits scenarios. Section five briefly discusses the
implications of renegotiation of petroleum contracts to the host government and
contractor. Brief conclusions are drawn in Section six.
Kemp, A., Petroleum Policy Issues in Developing Countries, Energy Policy Journal volume 20, issue
2, pg. 104-115. McPherson, C.P., and Palmer, K., New Approaches to Profit Sharing in Developing
Countries, Oil and Gas Journal 119, 1984. See also Johnston, D., Progressive Elements of Petroleum
Fiscal Systems: Options for
African Producers. Volume 4, Issue 3, September 2006
(www.gasandoil.com/ogel/members/search/welcome.html)
West Africa
1,422
13,073
14,495
US GoM
4,063
8,330
12,393
NW Europe
3,126
3,126
Mediterranean
23
1,845
1,868
Brazil
4,847
3,549
8,396
Asia-Pacific
731
1,409
2,139
Total
11,085
31,332
42,417
309
310
311
313
314
6 oN
3000 m
312
315
317
318
319
320
WARRI
316
210
209
ERHA
5 N
PORT HARCOURT
211
321
OML118
BONGA
248
322
212
323
213
324
249
4 oN
325
BONGA SW
214
250
326
327
328
215
251
223
200 m
329
330
AGBAMI
252
216
242
222
217
243
244
245
255
256
262
261
218
219
220
1000 m
221
247
3 oN
258
246
100 KM
o
3 E
331
4000 m
AKPO
253
254
264
263
4 E
257
o
5 E
7 E
6 E
260
8 E
259
2.
Kemp (1992) defined economic rents from petroleum exploration as the returns in
excess of those required to sustain production, new field development and
exploration. The ability of a host government to maximize economic rent from
petroleum exploration is dependent on the type of petroleum fiscal system it puts into
place. The petroleum fiscal system will spell out the terms that underpin the
relationship between the investors and mineral/petroleum owners in petroleum
exploration.4 The economic rent is to a large extent determined by the price of oil,
costs of exploration and size of the recoverable reserves.
Figure 2 attempts to illustrate the excess profits a host government would seek to
capture through its fiscal system. Economic rents from oil exploration can be captured
through royalties, profit taxes and production sharing etc. Taxes such as signature
bonuses and royalties are referred to as regressive because they do not target project
profitability, while taxes and profit sharing are regarded as progressive. 5
Fiscal systems can be classified into two broad categories, concessionary and
contractual systems. From a practical perspective, PSCs could be regarded as a subset
For a detailed overview of Fiscal system design refer to NEXT- Petroleum Economics Interactive
Software (2006)
5
Johnston, D., International Exploration Economics, Risk and Contract Analysis (Tulsa: Penwell
publishing company 2003)
See also, Tordo, S., Fiscal Systems for Hydrocarbons: Design Issues, World Bank Working Paper No.
123 (www.worldbank.org/INTOGMC/Resources/fiscal_systems_for _hydrocarbons. PDF) ) Website
last visited 4th November 2007
Bindemann, K., Production Sharing Agreements : An Economic Analysis (Oxford : Oxford Institute
for Energy Studies 1999)
7
Supra note 5
For a detailed overview on the evolution of Production Sharing Contracts in Indonesia, refer to
PriceWater House investment guide to Oil and Gas taxation in Indonesia (1998)
9
Taverne, B., Cooperative Agreements in the Extractive Petroleum Industry. (The Hague: Kluwer Law
International, 1996)
10
Bindemann, K., Suppra note 6 and Johnston, D., Supra note 5
11
Johnston, D., International Petroleum Fiscal Systems and Production Sharing Contracts (Tulsa:
Penwell publishing company 1994)
PSCs seek to attract multinational corporations willing to risk capital and to use its
technological expertise to develop a countrys reserves. The multinational corporation
is conventionally referred to as the contractor, and in the event that an unsuccessful
discovery is made, the host government is insulated from the risks associated with
exploration.
Al-Attar et al also viewed host government and investor agreements as a function of
country proven reserves and exploration and production costs.12 In this regard, he
posited that countries where reserves where large with medium exploration costs
would opt for PSCs arrangements. Countries in this category include Nigeria,
Kazakhstan and Oman. Other West African countries that have embraced PSC models
include Angola and Equatorial Guinea.
Although PSC have enjoyed wide appeal by oil producing countries, Al-Attar et al
and, Masseron13 observed that concessionary systems are still predominant in oil
producing industrial countries like the United Kingdom, United States and Norway.
The choice for this system could be attributed to the low reserves and high costs
associated with production in these regions.
2.2 Generic Features of a Standard PSC
Smith E. et al14 enumerated the salient issues usually associated with a typical PSC to
include:
12
Al-Attar, A., and Alomar, O., Evaluation of Upstream Petroleum Agreements and Exploration and
Production Costs. OPEC Review Bulletin vol. 29 Number 4
13
Masseron, J., Petroleum Economics (Rueil-Malmaison: Institut Francais du Petrole,1990). See also,
Al-Attar, A., et al., Ibid.
14
Smith, E., Dzienkowski J., Anderson O., Conine G., and Lowe J., International Petroleum
Transactions (eds) (Denver: Rocky Mountain Mineral Law Foundation, 1993)
Johnston15 also observed that these aforementioned elements are usually subject to
contract negotiations. Government compensation is usually captured from royalty oil,
profit taxes and profit oil. With regard to profit oil split, government and contractor
shares could adjust as a function of cumulative or daily production, this system is
conventionally referred to as production based sliding scale. Conversely, the profit
split could also be based on an R factor formula or Rate of Return (RoR) sliding
scale16. Within this context, Johnston also observed that a significant difference
between the production based sliding scale approach and the R factor/ RoR model is
that the former has no effect on government take when price increases while
government take progresses with increase in oil price in the R factor/RoR model.17
Kellas also classified two broad categories of incentives (fiscal and non fiscal
incentives) which should be taken into consideration when designing a petroleum
fiscal regime. In this regard, he observed that fiscal incentives such as tax rates,
investment credits, royalties, cost recovery ceilings etc fall under the category of
incentives which can be influenced by government or the appropriate authorities. On
the other hand, non fiscal incentives which include geological recovery, exploration
costs, oil prices etc. are not within the control of the government.18 In view of the
inherent uncertainties associated with the non-fiscal terms, the need to integrate
flexible fiscal terms that can spontaneously react to changes in oil price, cost of
exploration etc must be taken into consideration. This approach would significantly
15
Supra note 11
The production based sliding scale, R factor and RoR can also be used to determine royalty and tax
rates.
17
Johnston, D., Progressive Elements of Petroleum Fiscal Systems: Options for African Producers.
Volume 4, Issue 3, September 2006 (www.gasandoil.com/ogel/members/search/welcome.html)
18
Kellas, G., Fiscal Vs. Non- Fiscal incentives, Journal of Energy Finance and Development (2003)
Vol. 2 No. 1 pp 121-135
16
mitigate frequent contract renegotiations and other cognate issues. This case will be
quantitatively established in Section 4.
3.
19
For a historical overview on the Nigerian PSC and JV arrangements refer to presentation titled Joint
Venture and Production Sharing Contracts by Engineer Philip Chukwu, Former Group General
Manager NAPIMS. Nigeria
20
The issue of government participation in Nigerias oil and gas sector is encapsulated in the World
Banks report on Taxation and State Participation in Nigeria (2000)
as a vehicle for achieving deep offshore production and increasing the countrys crude
oil reserves.
The terms of the 1993 PSC are given below21
Production
Threshold BBLS
Profit Share %
Government
Contractor
0-350
20
80
351-700
35
65
701-1000
45
55
1001-1500
50
50
1501-2000
60
40
Beyond 2000
Negotiable
50%
Ring fence
21
Although profitability elements have been incorporated into subsequent PSCs in Nigeria, they did
not have any retroactive effects on the 1993 model.
10
4.
In view of the foregoing issues discussed, this section would attempt to analyze the
implications of crude price increases on government take using two profit split
models. For the purpose of this analysis, the ceteris paribus condition would be
assumed for all other parameters22. Also, no consideration is given to
tangible/intangible expenses, investment credits and depreciation. It is also important
to note that this analysis does not attempt to compute or forecast the discounted cash
flows for a given project. It only attempts to observe the effects of price changes on
government take. This analysis assumes that the IRR and NPV for the project are
attractive to the investor. Adjustments on cost recovery can also be analyzed and its
effects on government take observed23 however this exercise would just be limited to
variations in oil prices.
The concept of what constitutes take (either government or contractor take) has
been a salient issue of discussion in the literature. (Johnston 1994, 2003; Kaiser 2004;
Tordo 2007)
Kaiser (2004) argued that a definitive take is a fiscal statistic and not an economic
measure and would be of more interest to the host government.
Johnston (2003) also identified some weaknesses of the government take statistic to
include the fact that the take statistic does not indicate if the fiscal system is front end
22
This section will draw on previous work on PSCs in Tordo (2007) ;Johnston (2006); McPherson
(1984); Kaiser (2004)
23
Detailed discussion on cost recovery in PSCs can be found in Johnston (2003); he argues that the
cost recovery ceiling could be used as a mechanism for guaranteeing the host government a share of
profit oil in any accounting period.
11
or back end loaded, it also does not take into account government participation, and
he argued that it also does not take into cognizance the timing of the cash flows.
Although the take statistic could be misleading, this analysis solely seeks to observe
the effect of oil price increase on full cycle government take irrespective of the
aforementioned concerns. Government take is expressed as a percentage of the sum of
royalty, profit taxes and government profit oil over the economic profits (total costs
deducted from gross revenues) It is represented as:
GT = Roy + PT + PO/ GR NC
Where GT is undiscounted Government Take expressed in percentage, Roy is
Royalty, PT is Profit Tax, PO is Profit Oil, GR is Gross Revenue and NC is Net Costs
Key Assumptions24
Recoverable reserves = 800 thousand BBLS
15% in peak year of production
Field life = 10 years
Total Costs assumed as 12% of Gross Revenues25
Royalty Rate =10%
Tax rate = 30%
Oil Price = Adjusted from $25 in the first year of production to $85 in the last year.
4.1 Analysis of Results
24
The figures are fictitious and do not depict any real situation but the production sliding scale and R
factor principles are applied.
25
Although this assumption is quite modest, it enables the calculation of the R factor on a yearly basis
to be straight forward
12
The analysis is simulated under two scenarios. Scenario one is based on the
production scale sliding model and scenario two is based on the R factor model. The
thresholds required to trigger changes in the profit splits for the cumulative production
are consistent with the original 1993 PSC terms illustrated in figure 4. Similarly, the
threshold levels adopted for the R factor scenario are drawn from a previous worked
example in Johnston (2006).
The R factor is derived by dividing the assumed cumulative contractor profits by
cumulative costs on a yearly basis.
Tordo26 noted that the definition of R factor tends to be country and in some cases
contract specific. She also observed that the choice of trigger rates and thresholds is a
key issue for all fiscal systems. This issue could be reduced by determining the
thresholds and trigger rates as a function of the recovery factor, size of reserves and
the costs of exploration of a given field.
From the simple analysis, it is observed that Government Take under scenario one
does not respond to increases in oil price, this could largely be attributed to the fact
that government take is not a function of profitability of the project but only as a
function of
government take increases with increase in oil price, this occurs as a result of basing
government take as a function of project profitability through the R factor27 Figure
five graphically captures the difference in government take in percentage under the
two scenarios. From the illustration, it is observed that government take is about 58%
under the production based approach while it is 68% using the R factor approach.
26
27
Supra note 5
Spreadsheet analysis is attached as appendix 1 and 2
13
Another profit oil split approach, the Rate of Return system, also captures all the
proxies of project profitability and at the same time it takes into cognizance the timing
of the cash flows (McPherson 1984). However, the RoR approach is not analyzed in
this exercise because it would require establishing indicators such as the internal rate
of return (IRR) and Net Present Value (NPV) and also assuming a predetermined
trigger rate (this is usually negotiated between the host government and contractor) .
Once the trigger rate is reached, additional payments are made to the host
government. This approach was adopted in Papua New Guinea.
Also, the adoption of the RoR approach creates the opportunity for the exploration of
associated gas, because the same terms applicable for oil exploration, will apply to
gas and if the gas is less profitable this would trigger fewer rates of return
thresholds28. This structure would discourage the development of independent terms
for gas exploration.
Johnston noted that the RoR method could be difficult to manage and it also
encourages gold plating amongst investors. Although managing the RoR system
could be onerous, he posited that it is one of the most flexible profit oil split models.29
28
For comprehensive details on gas fiscal terms in Nigeria refer to the International Monetary Fund
report on Taxation and State Participation in Nigeria (2000)
29
Supra note 17
14
Fig 3. Government Take: Production Based Sliding scale Vs. R factor (Full cycle)
70%
68%
66%
64%
62%
60%
58%
56%
54%
52%
Production Sliding Scale
R factor
Government Take
5.
30
Kolo, A., Walde, T., Renegotiation and Contract Adaption in the International Investment Projects:
Applicable Legal Principles and Industry Practices.
Volume
1,
Issue
01,
February
2004.
(www.transnational-disputemanagment.com/members/articles/welcome.asp ) Website last visited 14th January 2008
15
governments that can adjust to project profitability would significantly reduce the
contractual risks to the investor and guarantee him of long term fiscal stability.
6.
CONCLUSION
The proposed renegotiation of deep offshore PSCs in Nigeria could be linked to the
inability of the current terms of the PSCs to adjust to project profitability. It has been
observed that the current production based sliding approach is not an effective proxy
of project profitability and the current upward trend in oil prices results in minimal
effects on government take. In this regard, the need to adopt progressive flexible
profit split approaches cannot be overemphasized. The R factor and the RoR approach
31
Raymond Vernons work titled Sovereignty at Bay is encapsulated in the article Re-examining the
Obsolescing bargain a study of Canadas Energy Program by Jenkins.
32
Cameron, P., Contract Stability in the Petroleum Industry: Changing the rules and the consequences.
Middle East Economic Survey Vol. XLIX No. 22
16
adjust to project profitability and trigger increases in government take in the event of
oil price increases or changes in exploration costs.
correlation between rising oil prices and exploration costs, the R factor and RoR
systems spontaneously adjust to reflect current investor profitability and the
government revenue is also adjusted accordingly. This approach would significantly
mitigate frequent contract renegotiations which usually distorts the investors long
term strategies. Though it could be argued that it usually encourages gold plating,
effective monitoring by appropriate authorities could significantly reduce this trend.
With the current paradigm shift towards natural gas, the incorporation of fiscal terms
for associated gas in PSCs could also be considered. Quantitative analysis could be
carried out to determine the effects of incorporating fiscal terms for offshore
associated gas exploration in R factor/RoR PSCs
17
BIBLIOGRAPHY
1.0 Secondary Sources
1.1
Books
Articles
Al-Attar, A., and Alomar, O., Evaluation of Upstream Petroleum Agreements and
Exploration and Production Costs. OPEC Review Bulletin vol. 29 Number 4
Cameron, P., Contract Stability in the Petroleum Industry: Changing the rules and the
consequences. Middle East Economic Survey Vol. XLIX No. 22
Kemp, A., Petroleum Policy Issues in Developing Countries. Energy Policy Journal
volume 20, issue 2, pg. 104-115.
McPherson, C.P., and Palmer, K., New Approaches to Profit Sharing in Developing
Countries. Oil and Gas Journal 119, 1984
Kellas, G., Fiscal Vs. Non- Fiscal incentives, Journal of Energy Finance and
Development Vol. 2 No. 1 pp 121-135
18
1.3
Other Sources
Kolo, A., Walde, T., Renegotiation and Contract Adaption in the International
Investment Projects: Applicable Legal Principles and Industry Practices.
Volume
1,
Issue
01,
February
2004.
(www.transnational-disputemanagment.com/members/articles/welcome.asp ) Website last visited 14th January
2008
Tordo, S., Fiscal Systems for Hydrocarbons: Design Issues, World Bank Working
Paper No. 123 (www.worldbank.org/INTOGMC/Resources/fiscal_systems_for
_hydrocarbons. PDF) Website last visited 4th November 2007
19
1.3.4 Periodicals
Townsend, D., Golden Triangle Dominates. Petroleum Economist volume 69, Pg. 18
October 2002
1.3.5 Newspaper Articles
Green, M., Nigeria threatens to renegotiate generous contracts of oil groups.
Financial Times, Wednesday 24th October 2007
1.3.6 Interactive Software
NEXT- Petroleum Economics Interactive Software
20